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776813_1999.txt | 776813_1999 | 1999 | 776813 | Item 1. Business
The Registrant, Amrecorp Realty Fund III, (the "Partnership"), is a limited partnership organized under the Texas Uniform Limited Partnership Act pursuant to a Certificate of Limited Partnership dated August 30, 1985 and amended on November 21, 1985. On December 31, 1999, the Partnership consisted of a corporate general partner, LBAL, Inc. (wholly owned by Robert J. Werra) and 281 limited partners owning 2,382 limited partnership interests at $1,000 per interest. The distribution of limited partnership interests commenced November 26, 1985 pursuant to a Registration Statement on Form S-11 under the Securities Act of 1933 (Registration #33-00152) as amended.
The Partnership was organized to acquire a diversified portfolio of income-producing real properties, primarily apartments, as well as office buildings, industrial buildings, and other similar properties
The Partnership intends to continue until December 31, 2015 unless terminated by an earlier sale of its Properties.
Univesco, Inc.("Univesco"), a Texas corporation, controlled by Robert J. Werra, manages the affairs of the Partnership. Univesco acts as the managing agent with respect to the Partnership's Properties. Univesco may also engage other on-site property managers and other agents, to the extent management considers appropriate. Univesco and the general partner make all decisions regarding investments in and disposition of Properties and has ultimate authority regarding all property management decisions.
No material expenditure has been made or is anticipated for either Partnership-sponsored or consumer research and development activities relating to the development or improvement of facilities or services provided by the Partnership. There neither has been, nor are any anticipated, material expenditures required to comply with any federal, state or local environmental provisions which would materially affect the earnings or competitive position of the Partnership.
The Partnership is engaged solely in the business of real estate investments. Its business is believed by management to fall entirely within a single industry segment. Management does not anticipate that there will be any material seasonal affects upon the operation of the Partnership.
Competition and Other Factors
The majority of the Property's leases are of six to twelve month terms. Accordingly, operating income is highly susceptible to varying market conditions. Occupancy and local market rents are driven by general market conditions which include job creation, new construction of single and multi-family projects, and demolition and other reduction in net supply of apartment units.
Rents have generally been increasing in recent years due to the generally positive relationship between apartment unit supply and demand in the Partnership's markets. However, the property is subject to substantial competition from similar and often newer properties in the vicinity in which they are located. Capitalized expenditures have increased as units are updated and made more competitive in the market place. Item 2.
Item 2. Properties
At December 31, 1999 the Partnership owned Las Brisas Apartment, a 376 unit apartment community located at 2010 South Clark Street, Abilene, Taylor County, Texas 79606. The Partnership purchased a fee simple interest in Las Brisas Apartments on July 30, 1986. The property contains approximately 312,532 net rentable square feet, one clubhouse, and five laundry facilities located on approximately 19.11 acres of land.
The property is encumbered by a mortgage note payable in monthly installments of principal and interest through December 31, 2003, when a lump-sum payment of approximately $2,642,000 is due. For information regarding the encumbrances to which the property is subject and the status of the related mortgage loans, see " Management`s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" contained in Item 7 hereof and Note B to the Financial Statements and Schedule Index contained in Item 8.
Occupancy Rates
Per Cent
1995 1996 1997 1998 1999 Las 92.4% 91.7% 84.8% 90.7% 95.4% Brisas
Item 3.
Item 3. Legal Proceedings
The Partnership is not engaged in any material legal proceedings.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of security holders during the fourth quarter of the fiscal year.
By virtue of its organization as a limited partnership, the Partnership has outstanding no securities possessing traditional voting rights. However, as provided and qualified in the Limited Partnership Agreement, limited partners have voting rights for, among other things, the removal of the General Partner and dissolution of the Partnership. PART II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholders Matters
The Partnerships outstanding securities are in the form of Limited Partnership Interests ("Interests"). As of December 31, 1999 there were approximately 281 limited partners owning 2,382 interests at $1,000 per interest. A public market for trading Interests has not developed and none is expected to develop. In addition, transfer of an Interest is restricted pursuant to the Limited Partnership Agreement.
The General Partner continues to review the Partnership's ability to make distributions on a quarter by quarter basis, however, no such distributions have been made to the limited partners in several years and none are anticipated in the immediate future due to required debt service payments and the existence of the Special Limited Partner, Mr. Robert J. Werra. The Special Limited Partner has first right to all net operating cash flow and net proceeds from disposals of assets to the extent of the special limited partner distribution preference. During 1999 and 1998, the Special Limited Partner received distributions from the Partnership totaling $265,000 and $65,000 respectively.
An analysis of tax income or loss allocated and cash distributed to Investors per $1,000 unit is as follows:
YEARS INCOME GAIN LOSS CASH DISTRIBUTED
1986 $0 $0 $186 $0 1987 0 0 286 0 1988 0 0 310 0 1989 0 0 278 0 1990 0 0 231 0 1991 0 0 142 0 1992 0 0 0 0 1993 0 153 162 0 1994 24 0 0 0 1995 0 0 5 0 1996 20 0 0 0 1997 0 0 (21) 0 1998 4 0 0 0 1999 72 0 0 0
Item 6.
Item 6. Selected Financial Data
The following table sets forth selected financial data regarding the Partnership's results of operations and financial position as of the dates indicated. this information should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained in Item 7
Item 7. Management Discussion and Analysis of Financial Conditions and Results of Operations
This discussion should be read in conjunction with Item 6 - "Selected Financial Data" and Item 8 - "Financial Statements and Supplemental Information". Results of Operations: 1999 VERSUS 1998
Revenue from Property Operations increased $115,271 or 7.82%. Rental income increased $99,147 or 7.17% as compared to 1998, principally due to an decrease in vacancy and increased rents. Other income increased $16,124 or 17.96% due to increased fee income from residents. The following table illustrates the increases or (decreases):
Increase (Decrease) ---------- Rental income $99,147 Other $16,124 ---------- Net Increase $115,271 ==========
Property operating expenses for 1999 decreased $25,180 or 1.71%. Repair and maintenance expenses decreased from 1998 by $22,205 or 10.50% primarily due less deferred maintenance activities needed. Utilities decreased $16,264 or 9.45% due to increased utility conservation measures. Payroll increased $8,578 or 3.52% due to increased salaries. Interest expense decreased by $4,898 from 1998 due to normal principal amortization. Property management fees are paid to an affiliated entity and represents 4% of gross operating revenues (see Note 4 to Financial Statements and Schedule Index contained in Item 8.) The following table illustrates the increases or (decreases):
Increase (Decrease) ------------- Payroll $8,578 Utilities (16,264) Real estate taxes (651) Repairs and Maintenance (22,205) General & Administration (9,583) Interest (4,898) Depreciation and amortization 14,080 Property management fees 5,763 ------------- Net Decrease $(25,180) =============
Results of Operations: 1998 VERSUS 1997 -
Revenue from Property Operations increased $43,207 or 3.02%. Rental income increased $29,737 or 2.2% as compared to 1997, principally due to an decrease in vacancy. Other income increased $13,470 or 17.65% mainly due to increased fees from residents. The following table illustrates the increases or (decreases):
Increase (Decrease) ------------- Rental income $29,737 Other 13,470 ------------- Net Decrease $43,207 =============
Property operating expenses for 1998 decreased $11,584 or 0.78%. Real estate taxes increased $10,221 or 9.48% primarily due to an increase in the assessed valuation of the property. Repair and maintenance expenses decreased from 1997 by $25,402 or 10.72% primarily due less deferred maintenance activities needed. Payroll decreased $25,177 or 9.36% due to reduced maintenance activities. Interest expense decreased by $4,848 from 1997 due to normal principal amortization. Property management fees are paid to an affiliated entity and represents 4% of gross operating revenues (see Note 4 to Financial Statements and Schedule Index contained in Item 8.) The following table illustrates the increases or (decreases):
Increase (Decrease) ------------------ Payroll $(25,177) Utilities 5,219 Real estate taxes 10,221 Repairs and Maintenance (25,402) General & Administration 12,523 Interest (4,848) Depreciation and amortization 13,719 Property management fees 2,161 ------------------ Net Increase $(11,584)
Liquidity and Capital Resources
While it is the General Partners primary intention to operate and manage the existing real estate investment, the General Partner also continually evaluates this investment in light of current economic conditions and trends to determine if this asset should be considered for disposal. At this time, there is no plan to dispose of Las Brisas Apartments.
As of December 31, 1999, the Partnership had $44,453 in cash and cash equivalents as compared to $36,249 as of December 31, 1998. The net increase in cash of $8,204 is principally due to the operations of the asset.
The property is encumbered by a non-recourse mortgage with a principal balance of $2,941,638 as of December 31, 1999. The mortgage payable bears interest at 8.15% and is payable in monthly installments of principal and interest until December 2003 when a lump-sum payment of approximately $2,642,000 is due. The required principal reductions for the five years ending December 31, 2003, are,$67,640 $73,363, $79,571,$2,721,064 and $0, respectively.
For the foreseeable future, the Partnership anticipates that mortgage principal payments ( excluding balloon mortgage payments), improvements and capital expenditures will be funded by net cash from operations. The primary source of capital to fund the balloon mortgage payment will be proceeds from the sale, financing or refinancing of the Property.
The $1,315,231 in Special Limited Partner equity is the result of previous fundings for operating deficits and other partner loans made to the Partnership by a related entity. These loans were reclassified to equity during 1993. The Special Limited Partner has first right to all net operating cash flows and net proceeds from disposals of assets to the extent of the Special Limited Partners distribution preference. During 1999 and 1998, the Special Limited Partner received distributions from the Partnership totaling $265,000 and $65,000, respectively.
Item 7a
Item 7a - Quantitative and Qualitative Disclosure about Market Risk
Market Risk
The Partnership is exposed to interest rate changes primarily as a result of its real estate mortgages. The Partnerships interest rate risk management objective is to limit the impact of interest rate changes on earnings and cash flows and to lower its overall borrowing costs. To achieve its objectives, the Partnership borrows primarily at fixed rates. The Partnership does not enter into derivative or interest rate transactions for any purpose.
The Partnerships' activities do not contain material risk due to changes in general market conditions. The partners invests only in fully insured bank certificates of deposits, and mutual funds investing in United States treasury obligations.
Risk Associated with Forward-Looking Statements Included in this Form 10-K This Form 10-K contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are intended to be covered by the safe harbors created thereby. These statements include the plans and objectives of management for future operations, including plans and objectives relating to capital expenditures and rehabilitation costs on the Properties. The forward-looking statements included herein are based on current expectations that involve numerous risks and uncertainties. Assumptions relating to the foregoing involve judgments with respect to, among other things, future economic, competitive and market conditions and future business decisions, all of which are difficult or impossible to predict accurately and many of which are beyond the control of the Company. Although the Company believes that the assumptions underlying the forward-looking statements are reasonable, any of the assumptions could be inaccurate and, therefore, there can be no assurance that the forward-looking statements included in this Form 10-K will prove to be accurate. In light of the significant uncertainties inherent in the forward- looking statements included herein, the inclusion of such information should not be regarded as a representation by the Company or any other person that the objectives and plans of the Company will be achieved.
AMRECORP REALTY FUND III FINANCIAL STATEMENTS AND INDEPENDENT AUDITORS' REPORTS
December 31, 1999 and 1998
Page
Independent Auditors' Reports 1
Financial Statements
Balance Sheets as of December 31, 1999 and 1998 3
Statements of Operations for the years ended December 31, 1999, 1998 and 1997 4
Statements of Partners' Equity (Deficit) for the years ended December 31, 1999, 1998 and 1997 5
Statements of Cash Flows for the years ended December 31, 1999, 1998 and 1997 6
Notes to Financial Statements 7
Schedule III - Real Estate and Accumulated Depreciation 13
All other schedules have been omitted because they are not applicable, not required or the information has been supplied in the financial statements or notes thereto.
INDEPENDENT AUDITORS' REPORT
To the General Partner and Limited Partners of Amrecorp Realty Fund III
We have audited the accompanying balance sheets of Amrecorp Realty Fund III, a Texas limited partnership (the "Partnership") as of December 31, 1999 and 1998, and the related statements of operations, partners' equity (deficit), and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the December 31, 1999 and 1998 financial statements referred to above present fairly, in all material respects, the financial position of Amrecorp Realty Fund III as of December 31, 1999 and 1998, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. Schedule III for the year ended December 31, 1999 and 1998 is presented for the purpose of complying with the Securities and Exchange Commission's rules and is not a required part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly states, in all material respects, the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
January 21, 2000 Dallas, Texas
INDEPENDENT AUDITORS' REPORT
To the General Partner and Limited Partners of Amrecorp Realty Fund III Dallas, Texas
We have audited the accompanying statements of operations, partners' equity (deficit) and cash flows of Amrecorp Realty Fund III (a Texas limited partnership) (the "Partnership") for the year ended December 31, 1997. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on the financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material respects, the results of operations and cash flows for the year ended December 31, 1997, in conformity with generally accepted accounting principles.
DELOITTE & TOUCHE LLP
Dallas, Texas February 23, 1998
AMRECORP REALTY FUND III BALANCE SHEETS December 31, 1999 and 1998
ASSETS 1999 1998 ----------------------------- Investments in real estate at cost Land $1,000,000 $1,000,000 Buildings, improvements and furniture and fixtures 6,517,060 6,427,489 ----------------------------- 7,517,060 7,427,489 Accumulated depreciation (3,624,944) (3,318,128) ----------------------------- 3,892,116 4,109,361
Cash and cash equivalents 44,453 36,249 Restricted cash 52,000 44,000 Escrow deposits 144,366 133,983 Capital replacement reserve 42,928 28,187 Liquidity reserve 90,503 95,258 Other assets 11,450 11,651 ----------------------------- TOTAL ASSETS 4,277,816 4,458,689 =============================
LIABILITIES AND PARTNERS' EQUITY
Mortgage payable 2,941,638 3,004,001 Accrued interest payable 19,979 20,402 Accounts payable 32,801 33,688 Real estate taxes payable 117,361 118,013 Due to affiliates 122,513 124,990 Security deposits 51,441 44,045 ------------------------------ TOTAL LIABILITIES 3,285,733 3,345,139
PARTNERS' EQUITY 992,083 1,113,550 ------------------------------ TOTAL LIABILITIES AND PARTNERS' EQUITY $4,277,816 $4,458,689 ==============================
AMRECORP REALTY FUND III STATEMENTS OF OPERATIONS For the Years Ended December 31, 1999, 1998 and 1997
1999 1998 1997 ------------------------------------------ INCOME Rentals $1,482,853 $1,383,706 $1,353,969 Other 105,915 89,791 76,321 ------------------------------------------ Total income 1,588,768 1,473,497 1,430,290
OPERATING EXPENSES Depreciation and amortization 306,816 292,736 279,017 Payroll 252,273 243,695 268,872 Interest 242,107 247,005 251,853 Repairs and maintenance 189,342 211,547 236,949 Utilities 155,825 172,089 166,870 Real estate taxes 117,362 118,013 107,792 General and administrative 93,048 102,631 90,108 Property management fee to affiliate 79,438 73,675 71,514 Administrative service fee to affiliate 9,024 9,024 9,024 ------------------------------------------ Total operating expenses 1,445,235 1,470,415 1,481,999 ------------------------------------------ NET INCOME (LOSS) $143,533 $ 3,082 $(51,709) ==========================================
NET INCOME (LOSS) PER LIMITED PARTNERSHIP UNIT - BASIC $59.65 $1.28 $(21.49) ==========================================
LIMITED PARTNERSHIP UNITS OUTSTANDING - BASIC 2,382 2,382 2,382 ==========================================
AMRECORP REALTY FUND III STATEMENTS OF PARTNERS' EQUITY (DEFICIT) For the Years Ended December 31, 1999, 1998 and 1997
Special General Limited Limited Partner Partners Partners Total
Balance, January 1, 1997 $(138,563) $1,828,231 $(279,491) $1,410,177
Distributions --- (183,000) --- (183,000)
Net loss (517) --- (51,192) (51,709) --------------------------------------------------
Balance, December 31, 1997 (139,080) 1,645,231 (330,683) 1,175,468
Distributions --- (65,000) --- (65,000)
Net income 31 --- 3,051 3,082 --------------------------------------------------
Balance, December 31, 1998 (139,049) 1,580,231 (327,632) 1,113,550
Distributions --- (265,000) --- (265,000)
Net income 1,435 --- 142,098 143,533 --------------------------------------------------
Balance, December 31, 1999 $(137,614) $1,315,231 $(185,534) $992,083 ==================================================
AMRECORP REALTY FUND III STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1999, 1998 and 1997
1999 1998 1997 -------------------------------------- CASH FLOWS FROM OPERATING ACTIVITIES Net income (loss) $143,533 $3,082 $(51,709) Adjustments to reconcile net income (loss) to net cash provided by operations: Depreciation and amortization 306,816 292,736 279,017 Changes in assets and liabilities: Restricted cash (8,000) (14,000) --- Escrow deposits (10,383) (18,371) (857) Other assets 202 5,413 (4,049) Accrued interest payable (424) (391) (360) Security deposits 7,396 9,531 (546) Accounts payable (887) (4,608) 14,020 Due to affiliates (2,477) (3,459) 5,664 Real estate taxes payable (652) 10,221 9,376 -------------------------------------- Net cash provided by operating activities 435,124 280,154 250,556
CASH FLOWS FROM INVESTING ACTIVITIES Investments in real estate (89,571) (147,786) (81,084) Capital replacement reserve (14,741) 25,922 38,848 -------------------------------------- Net cash used for investing activities (104,312) (121,864) (42,236)
CASH FLOWS FROM FINANCING ACTIVITIES Payments on mortgages and notes payable (62,363) (57,498) (53,013) Liquidity reserve 4,755 (4,755) (7,915) Distributions (265,000) (65,000) (183,000) -------------------------------------- Net cash used for financing activities (322,608) (127,253) (243,928) -------------------------------------- Net increase (decrease) in cash and cash equivalents 8,204 31,037 (35,608)
Cash and cash equivalents at beginning of period 36,249 5,212 40,820 -------------------------------------- Cash and cash equivalents at end of period $44,453 $36,249 $5,212 ======================================
Supplemental disclosure of cash flow information: Cash paid during the year for interest $242,531 $246,614 $252,213 ======================================
AMRECORP REALTY FUND III NOTES TO FINANCIAL STATEMENTS December 31, 1999 and 1998
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations
Amrecorp Realty Fund III (the "Partnership"), a Texas limited partnership, was formed on August 30, 1985, under the laws of the state of Texas, for the purpose of acquiring, maintaining, developing, operating, and selling buildings and improvements. The Partnership owns and operates rental apartments in Abilene, Texas. The Partnership will be terminated by December 31, 2015, although this date can be extended if certain events occur. LBAL, Inc., a Texas corporation wholly owned by Mr. Robert J. Werra, is the general partner. Mr. Werra is the first special limited partner and third special limited partner. The second special limited partner is an affiliate of the general partner.
An aggregate of 25,000 limited partner units at $1,000 per unit are authorized, of which 2,382 units were outstanding for each of the three years ended December 31, 1999, 1998 and 1997. Under the terms of the offering, no additional units will be offered. Effective November 1, 1993, the partnership agreement was amended to establish a first, second and third special limited partner status as referred to above.
Allocation of Net Income (Loss) and Cash
Net income and net operating cash flow, as defined in the limited partnership agreement, are allocated first to the limited partners in an amount equal to a distribution preference (as defined) on capital contributions from the first day of the month following their capital contribution and thereafter generally 10% to the general partner and 90% to the limited partners. Net loss is allocated 1% to the general partner and 99% to the limited partners.
Net income from the sale of property is allocated first, to the extent there are cumulative net losses, 1% to the general partner and 99% to the limited partners; second, to the limited partners in an amount equal to their distribution preference as determined on the date of the partners' entry into the Partnership; and, thereafter, 15% to the general partner and 85% to the limited partners.
Cash proceeds from the sale of property or refinancing are allocated first to the limited partners to the extent of their capital contributions and distribution preference as determined on the date of the partners' entry into the Partnership; and, thereafter, 15% to the general partner and 85% to the limited partners.
AMRECORP REALTY FUND III NOTES TO FINANCIAL STATEMENTS December 31, 1999 and 1998
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED
All distributions of net operating cash flow and net proceeds of the Partnership shall be distributed first to special limited partners to satisfy the special limited partner distribution preference, then to repay any unreturned portion of their contribution. The total distribution preference due to the special limited partners is approximately $1,419,000 as of December 31, 1999. Any additional available cash will then be distributed in accordance with the partnership agreement. During 1999, 1998 and 1997, distributions of $265,000, $65,000 and $183,000, respectively, were made to the special limited partners in accordance with this agreement.
Basis of Accounting
The Partnership maintains its books on the basis of accounting used for federal income tax reporting purposes. Memorandum entries have been made to present the accompanying financial statements in accordance with generally accepted accounting principles.
Investments in Real Estate and Depreciation
Buildings, improvements, and furniture and fixtures are recorded at cost and depreciated using the straight-line method over the estimated useful lives of the assets ranging from 5 to 27.5 years.
Income Taxes
No provision for income taxes has been made since the partners report their respective share of the results of operations on their individual income tax return.
Revenue Recognition
The Partnership has leased substantially all of its rental apartments under cancelable leases for periods generally less than one year. Rental revenue is recognized on a monthly basis as earned.
Syndication Costs
Costs or fees incurred to raise capital for the Partnership are netted against the respective partners' equity accounts.
AMRECORP REALTY FUND III NOTES TO FINANCIAL STATEMENTS December 31, 1999 and 1998
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED
Cash and Cash Equivalents
The Partnership considers all highly liquid instruments with a maturity of three months or less to be cash equivalents.
Restricted Cash
Restricted cash consists of tenant security deposits. It is management's policy to set aside funds in a separate bank account for the repayment of such deposits.
Reclassification
Certain 1998 and 1997 amounts have been reclassified to conform with the 1999 financial statement presentation.
Long-Lived Assets
In accordance with Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting For the Impairment of Long-Lived Assets and For Long-Lived Assets to be Disposed Of", the Partnership records impairment losses on long-lived assets used in operations when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets' carrying amount. SFAS No. 121 also addresses the accounting for long-lived assets that are expected to be disposed of. Based on current estimates, management does not believe impairment of operating properties is present.
Computation of Earnings Per Unit
The Partnership has adopted Statement of Financial Accounting Standards ("SFAS") No.128, "Earnings per Share". Basic earnings per unit is computed by dividing net income (loss) attributable to the limited partners' interests by the weighted average number of units outstanding. Earnings per unit assuming dilution would be computed by dividing net income (loss) attributable to the limited partners' interests by the weighted average number of units and equivalent units outstanding. The Partnership has no equivalent units outstanding for any period presented.
Concentration of Credit Risk
Financial instruments which potentially subject the Partnership to concentrations of credit risk consist primarily of cash. The Partnership places its cash with various financial institutions. The Partnership's exposure to loss should any of these financial institutions fail would be limited to any amount in excess of the amount insured by the Federal Deposit Insurance Corporation. Management does not believe significant credit risk exists at December 31, 1999.
AMRECORP REALTY FUND III NOTES TO FINANCIAL STATEMENTS December 31, 1999 and 1998
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles 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 that reporting period. Actual results could differ from those estimates.
Environmental Remediation Costs
The Partnership accrues for losses associated with environmental remediation obligations when such losses are probable and reasonably estimable. Accruals for estimated losses from environmental remediation obligations generally are recognized no later than completion of the remedial feasibility study. Such accruals are adjusted as further information develops or circumstances change. Costs of future expenditures for environmental remediation obligations are not discounted to their present value. Recoveries of environmental remediation costs from other parties are recorded as assets when their receipt is deemed probable. Project management is not aware of any environmental remediation obligations that would materially affect the operations, financial position or cash flows of the Project.
Comprehensive Income
Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income, (SFAS 130), requires that total comprehensive income be reported in the financial statements. For the years ended December 31, 1998, December 31, 1997, and December 31, 1996, the Partnership's comprehensive income (loss) was equal to its net income (loss) and the Partnership does not have income meeting the definition of other comprehensive income.
Segment Information
The Partnership is in one business segment, the real estate investments business, and follows the requirements of FAS 131, "Disclosures about Segments of an Enterprise and Related Information."
AMRECORP REALTY FUND III NOTES TO FINANCIAL STATEMENTS December 31, 1999 and 1998
NOTE B - MORTGAGE PAYABLE
The mortgage payable of $2,941,638 and $3,004,001 at December 31, 1999 and 1998, respectively, bears interest at a rate of 8.15% and is payable in monthly installments of principal and interest of $25,408 through December 2003, at which time a lump sum payment of approximately $2,642,000 is due. This mortgage note is secured by real estate with a net book value of $3,892,117.
At December 31, 1999, required principal payments due under the stated terms of the Partnership's mortgage note payable are as follows:
2000 $ 67,640 2001 73,363 2002 79,571 2003 2,721,064 2004 --- -------------- $2,941,638 ============== NOTE C - RELATED PARTY TRANSACTIONS
The Partnership agreement specifies that certain fees be paid to the general partner or his designee. An affiliate of the general partner receives a property management fee that is approximately 4% of the Partnership's gross receipts. In addition, a Partnership fee equal to 1% of gross revenues from operations is to be paid from Excess Property Income, as defined in the partnership agreement. 1999 1998 1997 -------------------------------- Property management fee $63,550 $58,940 $57,211 Partnership fee 15,888 14,735 14,303
Administrative service fees paid to an affiliate of the general partner were $9,024 for each of the years ended December 31, 1999, 1998 and 1997.
Resulting from the above transactions, amounts due an affiliate of the general partner as of December 31, 1999 and 1998, totaled $122,513 and $124,990, respectively.
NOTE D - COMMITMENTS
The Partnership will pay a real estate commission to the general partner or his affiliates in an amount not exceeding the lessor of 50% of the amounts customarily charged by others rendering similar services or 3% of the gross sales price of a property sold by the Partnership.
AMRECORP REALTY FUND III NOTES TO FINANCIAL STATEMENTS December 31, 1999 and 1998
NOTE E - RECONCILIATION OF BOOK TO TAX LOSS (UNAUDITED)
If the accompanying financial statements had been prepared in accordance with the accrual income tax basis of accounting rather than generally accepted accounting principals ("GAAP"), the excess of expenses over revenues for 1999 would have been as follows:
Net income per accompanying financial statements $143,533
Add - book basis depreciation using 306,816 straight-line method
Add - difference in expenses recognized by GAAP 12,599
Deduct - income tax basis depreciation expense using ACRS method (271,300)
Deduct - income tax basis amortization (19,705) of loan costs ---------------------
Excess of revenues over expenses, $171,943 accrual income tax basis =====================
NOTE F - ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS
The following estimated fair value amounts have been determined using available market information or other appropriate valuation methodologies that require considerable judgement in interpreting market data and developing estimates. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that the Partnership could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.
The fair value of financial instruments that are short-term or reprice frequently and have a history of negligible credit losses is considered to approximate their carrying value. These include cash and cash equivalents, accounts payable and other liabilities.
Management has reviewed the carrying values of its mortgages payable and notes payable to related parties in connection with interest rates currently available to the Partnership for borrowings with similar characteristics and maturities and has determined that their estimated fair value would approximate their carrying value as of December 31, 1999 and 1998.
The fair value information presented herein is based on pertinent information available to management. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since that date, and therefore, current estimates of fair value may differ significantly from the amounts presented herein.
AMRECORP REALTY FUND III Schedule III - Real Estate and Accumulated Depreciation December 31, 1999
Initial Cost to Partnership ----------------------------------- Description Encumb Land Building Total Cost rances and Improve Subsequent ments to Acquisi tion Twenty-eight two-story apartment buildings of concrete block construction with brick veneer, stucco and wood siding exterior, and composition shingled roofs located in Abilene, Texas (b) $1,000,000 $5,721,811 $795,249
Gross Amounts at Which Carried at Close of Year --------------------------------------- Land Buildings Total Accumu Date of Date Life on and Improve (c)(d) lated Construc Acquired Which ments Deprec tion Deprecia iation tion is (c) Computed Complete at Date $1,000,000 $6,517,060 $7,517,060 $3,624,944 Acquireed 7/31/86 (a) =============================================================================
See notes to Schedule III.
AMRECORP REALTY FUND III Schedule III - Real Estate and Accumulated Depreciation (Continued) December 31, 1999
NOTES TO SCHEDULE III:
(a) See Note A to financial statements outlining depreciation methods and lives.
(b) See description of mortgages and notes payable in Note B to the financial statements.
(c) The reconciliation of investments in real estate and accumulated depreciation for the years ended December 31, 1999, 1998 and 1997 is as follows:
Investments Accumulated in Real Depreciation Estate ----------------------------------------
Balance, January 1, 1997 $7,198,619 $ 2,746,375
Acquisitions 81,084 --- Depreciation expense --- 279,017 ----------------------------------------
Balance, December 31, 1997 7,279,703 3,025,392
Acquisitions 147,786 --- Depreciation expense --- 292,736 ----------------------------------------
Balance, December 31, 1998 7,427,489 3,318,128
Acquisitions 89,571 --- Depreciation expense --- 306,816 ----------------------------------------
Balance, December 31, 1999 7,517,060 3,624,944 ========================================
(d) Aggregate cost for federal income tax purposes is $6,054,244.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure On November 6, 1998, an 8-K was filed to disclose the change in auditors. No financial statements were issued in conjunction with this filing. The Registrant has not been involved in any disagreements on accounting and financial disclosure.
PART III
Item 10. Directors and Executive Officer of the Partnership
The Partnership itself has no officers or directors. LBAL, Inc., a Texas Corporation, which is wholly owned by Robert J. Werra, is the General Partner of the Partnership.
Robert J. Werra, 60, joined Loewi & Co., Incorporated ("Loewi") in 1967 as a Registered Representative. In 1971, he formed the Loewi real estate department, and was responsible for its first sales of privately placed real estate programs. Loewi Realty was incorporated in 1974, as a wholly owned subsidiary of Loewi & Co., with Mr. Werra as President. In 1980, Mr. Werra, along with three other individuals, formed Amrecorp Inc. to purchase the stock of Loewi Real Estate Inc., and Loewi Realty. In 1991 Univesco, Inc. became the management agent for the Partnership. Limited Partners have no right to participate in management of Partnership.
Item 11. Management Remuneration and Transactions
As stated above, the Partnership has no officers or directors. Pursuant to the terms of the Limited Partnership Agreement, the General Partner receives 1% of Partnership income and loss and up to 15% of Net Proceeds received from sale or refinancing of Partnership properties (after return of Limited Partner capital contributions and payment of a 6% Current Distribution Preference thereon).
The Partnership Agreement allows for a management fee of five percent (5%) of the gross income from operations. In connection with the new loan obtained from Lexington Mortgage Company, Univesco, Inc. entered into a management agreement that pays Univesco, Inc., an affiliated company, four percent (4%) of the monthly gross income from operations. The Partnership's obligation to pay an additional one percent (1%) of the monthly gross income from operations shall be paid by the Partnership from Excess Property Income, as that term is defined in the Loan Agreement between Lexington Mortgage Company and the Partnership dated November 12, 1993. The Partnership is also permitted to engage in various transactions involving affiliates of the General Partner as described under the caption "Compensation and Fees" at pages 6-8, "Management" at pages 18-20 and "Allocation of Net Income and Losses and Cash Distributions" at pages 49- 51 of the Prospectus as supplemented, incorporated in the Form S-11 Registration Statement which was filed with the Securities and Exchange Commission and made effective on November 26, 1985.
For the Fiscal year ended December 31, 1999, 1998, and 1997, property management fees earned totaled $63,550, $58,940, and $57,211, respectively. An additional administration service fee was paid to the general partner of $15,888, $14,735, and 14,303 for the years ended December 31, 1999, 1998 and 1997 respectively.
Item 12. Security Ownership of Certain Beneficial Owners and Management
(a)
Title of Class Name and Address Amount and Nature Percent of
Limited William E. Kreger 300 units 12.59% Partnership 3301 Biddle Ave. #1101 Interest Wyandette, MI 48192
Juanita L. Werra 127 units 5.33% 5881 Prestonview Blvd. #143 Dallas, TX 75243
Monty L. Parker 127 units 5.33% 9144 North Silver Brook Lane Brown Deer, WI 53223
(b)
By virtue of its organization as a limited partnership, the Partnership has no officers or directors. The General Partner is responsible for management of the Partnership, subject to certain limited democracy rights of the Limited Partners. The following persons performing functions similar to those of officers and directors of the partnership own units of limited partnership interest in the partnership.
Title of Name and Address Amount and Nature Percent of Class of Beneficial Owner of Beneficial Ownership Class
Limited Robert J. Werra 10 units .42% Partnership 6210 Campbell Road, Interest Suite 140 Dallas, TX 75248
(c) There is no arrangement, known to the Partnership, which may, at a subsequent date, result in a change in control of the Partnership.
Item 13. Certain Relations and Related Transactions
As stated in item 11., the Partnership has no officers or directors. Pursuant to the terms of the Limited Partnership Agreement, the general partner receives 1% of partnership income and loss and up to 15%of Net Proceeds received from the sale or refinancing of Partnership Properties (after return of Limited Partner capital contributions and payment of a Current Distribution Preference thereon).
Univesco, Inc. (an affiliate of the General Partner), is entitled to receive a management fee with respect to the Properties. For residential Properties (including all leasing and releasing fees and fees for leasing- related services), the lesser of 5% of gross receipts of the Partnership from such Properties or an amount which is competitive in price and terms with other non-affiliated persons rendering comparable services which could reasonably be made available to the Partnership. The Partnership is also permitted to engage in various transactions involving affiliates of the general partner as described under the caption "Compensation and Fees" at pages 6-8, "Management" at pages 18-20 and "Allocation of Net Income and Losses and Cash Distributions" at pages 49-51 of the definitive Prospectus, incorporated in the form S-11 Registration Statement which was filed with the Securities and Exchange Commission and made effective of November 26, 1985 and incorporated herein by reference. PART IV
Item 14. Exhibits, Financial Statements, Schedules and Reports on Form 10- K
(A) 1. Financial Statements
The financial statements of Amrecorp Realty Fund III are included in Part II, Item 8. | 6,478 | 44,617 |
276747_1999.txt | 276747_1999 | 1999 | 276747 | ITEM 1. BUSINESS - ------ -------- GENERAL - ------- Robinson Nugent, Inc. (the "Company"), an Indiana corporation organized in 1955, designs, manufactures and markets electronic devices used to interconnect components of electronic systems. The Company's principal products are integrated circuit sockets; connectors used in board-to-board, wire-to-board, and wire-to-wire applications; and custom molded-on cable assemblies. The Company also offers application tooling that is used in applying wire and cable to its connectors.
The Company's products are used in electronic telecommunication equipment including switching and networking equipment such as servers and routers, modems and PBX stations; data processing equipment such as mainframe computers, personal computers, workstations, CAD systems; peripheral equipment such as printers, disk drives, plotters and point-of-sale terminals; industrial controls and electronic instruments; consumer products; and a variety of other applications.
Major markets are the United States, Europe, Japan, and the Southeast Asian countries including Singapore and Malaysia. Manufacturing facilities are located in New Albany, Indiana; Dallas, Texas; Fremont, California; Reynosa, Mexico; Sungai Petani, Malaysia; Inchinnan, Scotland; and Hamont-Achel, Belgium.
Corporate headquarters are located in New Albany, Indiana, which also is the site for the Company's corporate engineering, research and development, preproduction and testing of new products. International headquarters are located in s- Hertogenbosch, Netherlands; Singapore; and Tokyo, Japan.
PRODUCTS - -------- The Company produces a broad range of sockets that accommodate a variety of integrated circuit package styles. Sockets are offered for dual-in-line package (DIP) and pin grid array (PGA) devices, as well as plastic leaded and leadless chip carriers (PLCC).
Sockets are used in a wide variety of applications within electronic equipment, but are primarily used to connect integrated circuits, such as microprocessors and memory devices, to an electronic printed circuit board (PCB). In many applications, semiconductor devices have been subject to replacement, which encouraged the use of a socket rather than soldering the device directly to the printed circuit board. But, due to the improved reliability of semiconductor technology, more and more semiconductor chips are being soldered directly to PCB's. This trend will continue to reduce the worldwide demand for sockets.
Dual in-line memory module (DIMM) sockets were introduced in fiscal 1992 and were designed to interconnect dual in-line memory modules with electronic printed circuit boards. During 1996, the industry acceptance of this
technology resulted in a migration of DIMM products from being customer specific design components, to become a standardized component. The enlarged worldwide market volume has resulted in increased competition and rapid price erosion. The Company introduced a lower cost version of this DIMM product line in an attempt to be more competitive at the lower market prices. During 1998, the Company decided to phase out certain models of the low-cost version of this product line because increased offshore competition had resulted in unacceptable profit margins. The Company has been able to continue to profitably sell the original version of this product in recent years.
In addition to DIMM sockets, the Company offers several other products that interconnect memory devices to electronic printed circuit boards. These include small outline dual in-line memory module sockets (SO-DIMM) and PCMCIA memory card headers, sockets and type III PC card kits.
The Company provides a broad range of electronic connectors, such as insulation displacement flat cable connectors (IDC), used in cable-to-cable and cable-to-board applications. The use of insulation displacement connectors in electronic hardware increases productivity by eliminating the labor involved in stripping insulation from wires prior to attachment to the leads. This technology permits the automated manufacturing of cable assemblies. The range of connectors also includes several product styles that provide for board-to-board or board-stacking (parallel-mounting) applications.
The Company offers several product families in the two-piece style of connectors. These connectors are used to connect printed circuit boards which are positioned either at right angles, in-line, or parallel stacked at close intervals. The products offered include .025 inch square post connectors and receptacle sockets; DIN series connectors; high-density, high-pin- count connectors (HDC); half-pitch, high-density (RN PAK-50- Registered Trademark-) connectors; and a higher pin count 2- millimeter-spaced connector (METPAK-Registered Trademark-2) used in backplane applications. In addition, a line of high density .8mm (RN PAK 8-TM-) and .5mm (RN PAK 5-TM-) board stacking interconnects are offered by the Company to address the growing demand for miniaturized connectors in the portable computer, communication equipment and other markets.
The DIN series of connectors has many variations in connecting configurations and pin count. The product is based on a European standard, but has gained wide acceptance in the U.S. and other markets worldwide. While there are a large number of producers of DIN connectors in Europe, the Company is one of a limited number of manufacturers producing the product in the U.S.
The high-pin-count, high-density connector (HDC) includes pin counts ranging from 60 to 492 in a three- and four-row configuration. This connector family, along with DIN connectors, is widely used on backplane applications and frequently requires the terminals to be press-fit to the backplane. This is accomplished by forming a compliant section in the tails of the connector contacts that, when pressed into a plated through-hole on a backplane PCB, it forms a reliable gas-tight connection. The Company has become recognized as a leader in press-fit backplane connectors and has focused marketing efforts in promoting its products for this type of application.
The Company's half-pitch (PAK-50) connector family has been accepted as one of the industry's most reliable .050 inch spaced connectors. The contact design and compact shape has gained wide acceptance in applications, such as small form factor computers that require connectors that are highly reliable yet consume little space.
The METPAK-Registered Trademark-2 series of connectors includes four and five row versions of both standard and inverse configurations. The METPAK-Registered Trademark-2 is an industry standard connector style used in board-to-board and board-to-back plane applications and over time has displaced some of the more mature product types such as the DIN series and HDC connectors. This product line has wide acceptance in many new applications, primarily in the computer workstations, telecommunication and data communication equipment and other networking equipment used to support the Internet. The inverse METPAK-Registered Trademark- 2 is a Company patented design which has gained acceptance in mid- range computer, networking and communications equipment.
Robinson Nugent introduced a new line of high-speed backplane connectors in 1999 to the U.S. and Asian markets. These connectors are known throughout the industry as Compact PCI connectors that comply with existing industry standards for this type of product. Robinson Nugent is marketing this product line as the next generation backplane connector for use in data communication, telecommunication, and other high-speed, high- density applications.
Our engineers have developed a new generation of high-speed backplane connectors that will provide the basis for additional sales growth in this market niche in the coming years. These high-speed, hard-metric connectors (HSHM) will provide the customer with the capability to process signals at speeds that are not economically or commercially feasible with existing generations of backplane connectors. This new product line provides for higher-speed data signal transmissions with greater signal integrity, at a greater contact density than connectors currently available. These backplane connectors will be available in the spring of 2000.
PAK-5-TM- and PAK-8-TM-represent the latest high density, surface mount, fine pitch board-to-board interconnect systems offered by the Company. As electronic systems continue to downsize and the need for higher pin counts continues to increase, electronic interconnect manufacturers are forced to shrink connector geometry. The PAK-5-TM- series is available with a "floating" contact, accommodating potential torsional and positional discrepancies incurred with tolerance build up when stacking connectors. The PAK-8-TM-series utilizes a hermaphroditic two- point contact construction that maximizes contact wiping action, minimizes contact resistance and insures a highly reliable contact interface. This connector series is available in sizes ranging from 16 position to 100 position product and in stacking heights ranging from 3mm to 11.5mm. These interconnects offer system designers the board-to-board stacking solutions required for today's miniaturized electronic system designs.
Technology continues to move the industry to an ever- increasing number of circuits per socket or connector to meet the increasing complexity, capacity and processing speed of electronic and semiconductor devices. This trend has caused increased demand for all types of high-density connector products. The Company is focusing its new product development in socket and connector products that meet these technology trends.
Cablelink, Incorporated, a wholly-owned subsidiary of the Company, produces electronic cable assemblies of various types including insulation displacement connector, fabricated and molded-on cable assemblies. Cablelink utilizes Robinson Nugent connectors whenever possible, but also provides cable assemblies with other manufacturers' connectors if the customer is specific regarding its requirements.
In addition to standard products, the Company provides engineering assistance, product design, and manufacturing of custom and derivative products. These products may require special production tooling that, in some cases, is paid for by the customer, shared, or amortized over future orders, depending upon contractual agreements reached with the customer. In some cases, the customer supplies the Company with a complete product design, but more often the design is produced solely by Company engineers. Current trends in the market indicate a growing demand for custom and derivative products. There is also an increased demand for the Company's engineers to be involved in the early development of the customer's product design.
RESEARCH, DEVELOPMENT AND ENGINEERING - ------------------------------------- The Company's worldwide engineering efforts are directed toward the development of new products to meet customer needs, the improvement of manufacturing processes and the adaptation of new materials to all products. New products include new creations as well as the design of derivative products to meet both the needs of the general market and customer proprietary custom designs. Engineering development covers new or improved manufacturing processes, assembly and inspection equipment, and the adaptation of new plastics and metals to all products. In recent years, the Company's products have become more sophisticated and complex in response to developments in semiconductors and their applications. The Company has the engineering capability to analyze customer designed, high-speed applications and to design connectors that reduce electrical interference that can result from very high processing speeds of newer and more powerful microprocessors.
The Company's expenditures for research, development and engineering were approximately $3.5 million in 1999, $4.0 million in 1998 and $3.4 million in 1997.
Consistent with industry direction, the Company is active in improving manufacturing processes through automation and also designs and builds its proprietary assembly equipment. The Company continues to apply advanced technologies, such as laser and video devices, to automatically inspect products during the assembly process. All new assembly machines are direct microcomputer-controlled, which provides greater flexibility in the manufacturing process. The Company continues to incorporate the latest technology in its high-speed precision stamping and electroplating processes, and has replaced older injection molding machines and material handling equipment with new machines and equipment that will improve the productivity of these operations.
SALES AND DISTRIBUTION - ---------------------- The Company sells its products in the United States and international markets. The primary market for Robinson Nugent is the United States, which produces approximately two-thirds of the consolidated sales of the Company. Its principal markets outside the United States are Europe, including the United Kingdom and Scandinavia, Japan, Singapore, Malaysia, Hong Kong, and the emerging market of China. Sales to other Far East countries will continue to provide business opportunities and are expected to grow moderately. Sales in China have been initiated and have resulted in the Company doing business in China through a Hong Kong distributor.
Sales outside the United States accounted for 37 percent of total sales in 1999, 36 percent in 1998, and 38 percent in 1997. The Company believes that the growth and development of its presence in global markets is essential to support its customer base. This was particularly the case in Asia, where until recently the market was considered the fastest growing in the world. It is still currently considered the second largest market for electronics and connector products. The Company does not believe that its international business presents any unusual risks. The recent economic crisis in Asia had a minimal impact on the Company's operating results in the current year. While sales in Japan were unfavorably impacted by the strengthening of the U.S. dollar against the Japanese yen, operating results in Southeast Asia were not affected significantly. Most of the Company's sales to customers in Southeast Asia are transacted in U.S. dollars. These sales were not significantly affected by the currency crisis. The following table sets forth the percentage of Company sales by major geographical location for the periods shown:
YEARS ENDED JUNE 30 ----------------------------- 1999 1998 1997 ---- ---- ---- United States 63% 64% 62% Europe 25 25 26 Asia 9 9 10 Other 3 2 2 --- --- --- 100% 100% 100% === === ===
During 1999 the Company had sales of approximately $8.4 million to a single customer, which represents 12 percent of total sales. No sales to a single customer exceeded 10 percent of total net sales in 1998 or 1997.
Other financial data relating to domestic and foreign operations are included in Note (17), Business Segment and Foreign Sales, of Notes to Consolidated Financial Statements and the Management's Discussion and Analysis of the Results of Operations and Financial Condition, included herein or incorporated by reference as a part of this Report.
Principal markets in North America, Europe, and Asia are served by the Company's direct sales force and a network of distributors serving the electronics industry. The Company has U.S. regional offices located in the San Francisco, California and Chicago, Illinois metropolitan areas. Other Company sales offices are located in Japan, Singapore, England, Germany, France, Sweden, and Netherlands. These offices service customers to whom the Company sells directly, provide coordination between the plants and customers, and technical training and assistance to distributors and manufacturers' representatives in their respective territories. Additional marketing expertise is provided by the product marketing specialists located in New
Albany, Indiana; Dallas, North Carolina; Kent, England; Singapore; and s.Hertogenbosch, Netherlands.
The Company engages independent manufacturers' representative firms in the United States, Canada and several European and Far East countries. These firms are granted exclusive territories and agree not to carry competing products. These firms are paid on a commission basis on sales made to original equipment manufacturers and to distributors. All representative relationships are subject to termination by either party on short notice.
The Company has an international network of distributors who are responsible for serving their respective customers from an inventory of the Company's products. Approximately one-third of the Company's worldwide sales are made through the distributor network. No distributor is required to accept only the franchise of the Company. All distributor agreements are subject to termination by either party on short notice.
BACKLOG - ------- The Company's backlog was approximately $13.0 million at June 30, 1999, compared to $10.2 million at June 30, 1998 and $14.5 million at June 30, 1997. These amounts represent orders with firm shipment dates acceptable to the customers. The Company does not manufacture pursuant to long-term contracts, and purchase orders are generally cancelable subject to payment by the customer for charges incurred up to the date of cancellation. With just-in-time delivery objectives, customers have reduced order quantities, but are placing orders more frequently and expecting shorter lead times from point of order to point of shipment.
COMPETITION - ----------- There is active competition in all of the Company's standard product lines. The Company's competitors include both large corporations having significantly more resources than the Company and smaller, highly specialized firms. The Company competes on the basis of customer service, product performance, quality, and price. Worldwide price erosion continued in a variety of the Company's product lines, reflecting a migration of some products to a commodity category, and the leveraging of higher volume purchases. Management believes that the Company's capabilities in customer service, new product design and its continued efforts to reduce cost of products are significant factors in maintaining the Company's competitive position.
MANUFACTURING - ------------- The Company's manufacturing operations include plastic molding, high-speed precision stamping, electroplating and assembly. The Company designs and builds the majority of its automated and semi-automated assembly machines. Robinson Nugent manufactures most of its goods in-house and utilizes subcontractors and brokered products on a limited basis. The Company is currently developing a plan to relocate a portion of its high-labor content connector manufacturing processes from Dallas, Texas into its facility in Reynosa, Mexico. The Company is making this move in order to enjoy the use of the high- quality, low-cost workforce available in its existing facility.
RAW MATERIALS AND SUPPLIES - ------------------------- The Company utilizes copper alloys, precious metals, and plastics in the manufacture of its products. Although some raw materials are available from only a few suppliers, the Company believes it has adequate sources of supply for its raw material and component requirements. Raw material prices did not increase or decrease materially during fiscal year 1999.
The use of gold, while still significant, has declined substantially over the past several years. Plating processes using ROBEXTM, a palladium nickel alloy, and tin have accelerated in demand from customers of the Company.
HUMAN RESOURCES - --------------- As of June 30, 1999, the Company had approximately 722 full- time employees; 410 in the United States, 190 in Europe and 122 in Asia and Japan.
PATENTS AND TRADEMARKS - ---------------------- Management believes that success in the electronic connector industry is dependent upon engineering and production skills and marketing ability; however, there is a trend in the industry toward more patent consideration and protection of proprietary designs and knowledge. The Company has pursued patent applications frequently. The Company reviews each new product design for possible patent application. The Company has been granted several patents over the past several years and is presently awaiting acceptance on other pending applications. The Company has obtained registration of its trade and service marks in the United States and in major foreign markets.
ENVIRONMENT - ----------- The Company's manufacturing facilities are subject to several laws and regulations designed to protect the environment. In the opinion of management, the Company is complying with those laws and regulations in all material respects and compliance has not had and is not expected to have a material effect upon its operations or competitive position.
EXECUTIVE OFFICERS OF THE COMPANY - --------------------------------- The current executive officers of the Company are:
SERVED IN PRESENT NAME AGE POSITIONS HELD CAPACITY SINCE - -------------------- --- -------------- ---------------- Larry W. Burke 59 President & Chief 1990 Executive Officer
Robert L. Knabel 41 Vice President, January 1997 Treasurer & Chief Financial Officer
W. Michael Coutu 48 Vice President of 1992 Information Technology
Raymond T. Wandell 51 Vice President Sales, 1999 North America
Dennis I. Smith 50 Vice President of 1999 Global Marketing
The Bylaws of the Company provide that the officers are to be elected at each Annual Meeting of the Board of Directors. Under the Indiana Business Corporation Law, officers may be removed by the Board of Directors at any time, with or without cause. Mr. David W. Pheteplace, Vice President and General Manager, North American Business Division, resigned as of April 1998.
ITEM 2.
ITEM 2. PROPERTIES - ------ ---------- The Company owns a 36,000-square-foot building used for its executive offices, engineering, quality assurance and administrative operations, and an adjacent 83,000-square-foot manufacturing facility located on approximately four acres in New Albany, Indiana. A limited amount of manufacturing operations are performed there, but most of the connector finished goods inventory sold in the U.S. is held at the New Albany site. A major portion of the New Albany manufacturing facility is utilized by the Company's engineering, research and preproduction development groups. In addition, the New Albany facility is instrumental in training plant personnel on new equipment and manufacturing processes prior to release to the manufacturing facilities in Dallas, Europe and Malaysia.
The Company owns a 60,000-square-foot manufacturing facility located on approximately five acres in Dallas, Texas, and a manufacturing and engineering facility with approximately 14,000 square feet in Hamont-Achel, Belgium. In addition, the Company currently leases a facility with approximately 50,000 square feet in Inchinnan, Scotland under a short-term lease arrangement. Management is currently involved in negotiations to purchase this facility for approximately 1.2 million pounds sterling (approximately $1.8 million). Financing for this purchase will be obtained from a bank in the United Kingdom. Robinson Nugent also occupies a manufacturing facility with approximately 21,000 square feet under a long-term lease arrangement in Sungai Petani, Malaysia. This Malaysian facility was originally leased to establish the Cablelink operation in Asia, and currently both cable assemblies and connectors are manufactured there.
In March 1999, Robinson Nugent sold its manufacturing facility in Delemont, Switzerland for approximately $2.0 million in cash. This facility has been idle ever since the Company's manufacturing operations were relocated to Scotland.
The Company's primary electronic cable assembly operations are currently located in a leased manufacturing facility, with approximately 44,000 square feet, in Reynosa, Mexico. Robinson Nugent's Cablelink division began cable assembly operations in Reynosa in September 1998. All operations in Kings Mountain, North Carolina were discontinued by December 1998. The Company is currently obligated under a long-term lease on the Kings Mountain facility through July 2012. Management intends to sublet this facility to minimize the financial impact of this obligation.
Robinson Nugent also leases office space for customer service, sales and administration in the Netherlands; Germany; France; Sweden; the United Kingdom; Tokyo, Japan; Singapore; Chicago, Illinois and Freemeont, California.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS. - ------ ------------------ Other than ordinary routine litigation incidental to the business, there are no pending legal proceedings to which the Company is a party.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. - ------- --------------------------------------------------- No matters were submitted to a vote of security holders of the Company during the fourth quarter of the fiscal year covered by this report.
PART II ------- ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER - ------- ------------------------------------------------------- MATTERS ------- The information included under the caption "Price Range and Dividend Information" of the Company's 1999 Annual Report to Shareholders (the "1999 Report") is incorporated herein by reference.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA. - ------- ---------------------- The information contained in the columns "1995-1999" in the table under the caption "Five-Year Financial Summary" of the 1999 Report is incorporated herein by reference.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ------- ------------------------------------------------------- THE RESULTS OF OPERATIONS. -------------------------- The information contained under the caption "Management's Discussion and Analysis of the Results of Operations and Financial Condition" of the 1999 Report is incorporated herein by reference.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. - ------- -------------------------------------------- The information contained in the "Consolidated Financial Statements of the Company and Notes thereto" and the report of independent auditors in the 1999 Report is incorporated herein by reference.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND - ------ ------------------------------------------------------- FINANCIAL DISCLOSURE. -------------------- There have been no disagreements with the Company's independent auditors on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, or any reportable events.
PART III ------- ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. - -------- --------------------------------------------------- The information included under the captions "Nominees," "Business Experience of Directors," "Family Relationships," and "Compliance with Section 16(a) of the Securities Exchange Act of 1934" in the Company's definitive 1999 Proxy Statement filed pursuant to Rule 14a-6 is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION. - -------- ----------------------- The information included under the captions "Compensation of Directors," "Compensation Committee Interlocks and Insider Participation," "Executive Compensation," "Report of the Compensation and Stock Option Committees," and "Stock Performance Graph" in the Company's definitive 1999 Proxy Statement filed pursuant to Rule 14a-6 is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. - -------- ----------------------------------------------------- The information contained under the captions "Beneficial Ownership of Common Shares" and "Nominees" in the Company's definitive 1999 Proxy Statement filed pursuant to Rule 14a-6 is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. - -------- ---------------------------------------------- The information contained under the caption "Certain Transactions" in the Company's definitive 1999 Proxy Statement filed pursuant to Rule 14a-6 is incorporated herein by reference.
PART IV ------- ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. - -------- -------------------------------------------------------
(a) DOCUMENTS FILED AS A PART OF THIS REPORT. ---------------------------------------- (1) FINANCIAL STATEMENTS -------------------- Reports of Independent Auditors
Consolidated Balance Sheets as of June 30, 1999, 1998, and 1997
Consolidated Statements of Operations and Comprehensive Income for the years ended June 30, 1999, 1998, and 1997
Consolidated Statements of Shareholders' Equity for the years ended June 30, 1999, 1998, and 1997
Consolidated Statements of Cash Flows for the years ended June 30, 1999, 1998, and 1997
Notes to Consolidated Financial Statements
(2) FINANCIAL STATEMENT SCHEDULE ---------------------------- Schedule for the years ended June 30, 1999, 1998, and 1997:
II Valuation and Qualifying Accounts
All other schedules are omitted, as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes.
(3) EXHIBITS -------- 3.1 Articles of Incorporation of Robinson Nugent, Inc. (Incorporated by reference to Exhibit 3.1 to Form S-1 Registration Statement No. 2-62521.)
3.2 Articles of Amendment of Articles of Incorporation of Robinson Nugent, Inc. filed September 1, 1978 (Incorporated by reference to Exhibit B(1) to Form 10-K Report for year ended June 30, 1980.)
3.3 Articles of Amendment of Articles of Incorporation of Robinson Nugent, Inc. filed November 14, 1983 (Incorporated by reference to Exhibit 3.3 to Form 10-K Report for year ended June 30, 1984.)
3.4 Amended and Restated Bylaws of Robinson Nugent, Inc. adopted November 7, 1991. (Incorporated by reference to Exhibit 19.1 to Form 10-K Report for year ended June 30, 1992).
4.1 Specimen certificate for Common Shares, without par value. (Incorporated by reference to Exhibit 4 to Form S-1 Registration Statement No. 2-62521.)
4.2 Rights Agreement dated April 21, 1988 between Robinson Nugent, Inc. and Bank One, Indianapolis, NA. (Incorporated by reference to Exhibit I to Form 8-A Registration Statement dated May 2, 1988.)
4.3 Amendment No. 1 to Rights Agreement dated September 26, 1991. (Incorporated by reference to Exhibit 4.3 to Form 10-K Report for year ended June 30, 1991.)
4.4 Amendment No. 2 to Rights Agreement dated June 11, 1992. (Incorporated by reference to Exhibit 4.4 to Form 8-K Current Report dated July 6, 1992.)
4.5 Amendment No. 3 to Rights Agreement dated February 11, 1998 (Incorporated by reference to Exhibit 4.5 to Form 10-Q Report for the period ended December 31, 1998.)
10.1 Robinson Nugent, Inc. 1983 Tax-Qualified * Incentive Stock Option Plan. (Incorporated by reference to Exhibit 10.1 to Form 10-K Report for year ended June 30, 1983.)
10.2 Robinson Nugent, Inc. 1983 Non Tax- * Qualified Incentive Stock Option Plan. (Incorporated by reference to Exhibit 10.2 to Form 10-K Report for year ended June 30, 1983.)
10.3 1993 Robinson Nugent, Inc. Employee and * Non-Employee Director Stock Option Plan. (Incorporated by reference to Exhibit 19.1 to Form 10-K Report for the year ended June 30, 1993.)
10.4 Summary of The Robinson Nugent, Inc. * Employee Stock Purchase Plan. (Incorporated by reference to Exhibit 19.2 to Form 10-K Report for the year ended June 30, 1993.)
10.5 Deferred compensation agreement dated * May 10, 1990 between Robinson Nugent, Inc. and Larry W. Burke, President and Chief Executive Officer. (Incorporated by reference to Exhibit 19.1 to Form 10-K Report for year ended June 30, 1990.)
10.6 Trust Agreement dated July 1, 1999 * between Robinson Nugent, Inc. and Strong Retirement Plan Services, related to the deferred compensation agreement between Robinson Nugent, Inc. and Larry W. Burke, President and Chief Executive Officer.
10.7 Summary of the 1993 Robinson Nugent, Inc. * Employee and Non-employee Director Stock Option Plan, as amended. (Incorporated by reference to Exhibit 10.7 to Form 10-K Report for the fiscal year ending June 30, 1998).
10.8Summary of Robinson Nugent, Inc. Bonus Plan for fiscal year ended June 30, 2000.
13.0 1999 Annual Report to Shareholders of Robinson Nugent, Inc.
16.0 No exhibit.
21.0 The subsidiaries of the registrant are: JURISDICTION NAME OF ORGANIZATION ------ ------------
Cablelink, Incorporated Indiana
RNL, Inc. Indiana
Robinson Nugent-Dallas, Inc. Texas
Robinson Nugent Design Services, Inc.Pennsylvania
Robinson Nugent S.a.r.l. France
Robinson Nugent GmbH Germany
Robinson Nugent Ltd. Great Britain
Nihon Robinson Nugent K.K. Japan
Robinson Nugent dba Cablelink Malaysia (Malaysia) Sdn. Bhd.
Robinson Nugent (Malaysia) Sdn. Bhd. Malaysia
Robinson Nugent S.A. Switzerland
Robinson Nugent (Scotland) Limited Scotland
Robinson Nugent International, Inc. Virgin Islands
Robinson Nugent (Europe) B.V. Netherlands
Robinson Nugent (Belgium) B.V.B.A. Belgium
Robinson Nugent (Asia Pacific) Pte. Ltd. Singapore
Robinson Nugent Nordic, filial-till Sweden Robinson Nugent (Europe) B.V. The Netherlands
Robinson Nugent S. de R.L. de C.V. Mexico
23.1 Consent of Deloitte & Touche LLP Independent Auditors
23.2 Consent of PricewaterhouseCoopers LLP Independent Accountants
27.0 Financial Data Schedule.
* Management contracts or compensatory plans
(b) REPORTS ON FORM 8-K ------------------- No exhibit.
SIGNATURES ----------
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
ROBINSON NUGENT, INC.
Date: 9/24/99 By: /s/ Larry W. Burke ------- ------------------------------- Larry W. Burke, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Date: 9/24/99 By: /s/ Samuel C. Robinson ------- ------------------------------- Samuel C. Robinson, Director
Date: 9/24/99 By: /s/ Larry W. Burke ------- ------------------------------- Larry W. Burke, Director, President and Chief Executive Officer (Principal Executive Officer)
Date: 9/24/99 By: /s/ Patrick C. Duffy ------- ------------------------------- Patrick C. Duffy, Director
Date: 9/24/99 By: /s/ Richard L. Mattox ------- ------------------------------- Richard L. Mattox, Director
Date: 9/24/99 By: /s/ Jerrol Z. Miles ------- ------------------------------- Jerrol Z. Miles, Director
Date: 9/24/99 By: /s/ James W. Robinson ------- ------------------------------- James W. Robinson, Director
Date: 9/24/99 By: /s/ Richard W. Strain ------- ------------------------------- Richard W. Strain, Director
Date: 9/24/99 By: /s/ Ben M. Streepey ------- ------------------------------- Ben M. Streepey, Director
Date: 9/24/99 By: /s/ Donald C. Neel ------- ------------------------------- Donald C. Neel, Director
Date: 9/24/99 By: /s/ Robert L. Knabel ------- ------------------------------- Robert L. Knabel, Vice President, Treasurer and Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)
ROBINSON NUGENT, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENT SCHEDULES
JUNE 30, 1999, 1998, AND 1997
Financial Statement Schedule for the years ended June 30, 1999, 1998, and 1997 is included herein:
II Valuation and Qualifying Accounts
All other schedules are omitted, as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes.
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS ROBINSON NUGENT, INC. AND SUBSIDIARIES (IN THOUSANDS OF DOLLARS)
See footnotes on following page.
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS (cont'd.) ROBINSON NUGENT, INC. AND SUBSIDIARIES (IN THOUSANDS OF DOLLARS)
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders of Robinson Nugent, Inc. New Albany, Indiana
We have audited the consolidated financial statements of Robinson Nugent, Inc. and subsidiaries as of June 30, 1999 and 1998, and for each of the two years in the period ended June 30, 1999, and have issued our report thereon dated August 3,1999; such consolidated financial statements and report are included in your 1999 Annual Report to Stockholders and are incorporated herein by reference. Our audits also included the consolidated financial statement schedules of the Company, listed in Item 14. These consolidated financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
DELOITTE & TOUCHE LLP
Louisville, Kentucky August 3, 1999
REPORT OF INDEPENDENT ACCOUNTANTS ---------------------------------
To the Board of Directors and Shareholders of Robinson Nugent, Inc.
We have audited the accompanying consolidated balance sheet of Robinson Nugent, Inc. and Subsidiaries as of June 30, 1997, and the related consolidated statements of operations and comprehensive income, shareholders' equity and cash flows and the financial statement schedule for the year then ended as listed in Item 14 of Form 10-K for the year ended June 30, 1997. These consolidated financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and the financial statement schedule based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respect, the financial position of Robinson Nugent, Inc. and Subsidiaries as of June 30, 1997 and the results of their operation and their cash flows for the year then ended in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information required to be included therein for the year ended June 30, 1997.
/s/ Coopers & Lybrand L.L.P.
Louisville, Kentucky August 5, 1997
ROBINSON NUGENT, INC.
FORM 10-K FOR FISCAL YEAR ENDED JUNE 30, 1999
INDEX TO EXHIBITS ------------------ NUMBER SEQUENTIAL ASSIGNED IN NUMBERING SYSTEM REGULATION S-K PAGE NUMBER ITEM 601 DESCRIPTION OF EXHIBIT OF EXHIBIT - -------------- ---------------------- ---------------
(3) 3.1 Articles of Incorporation of Robinson Nugent, Inc. (Incorporated by reference to Exhibit 3.1 to Form S-1 Registration Statement No. 2-62521.)
3.2 Articles of Amendment of Articles of Incorporation of Robinson Nugent, Inc. filed September 1, 1978 (Incorporated by reference to Exhibit B(1) to Form 10-K Report for year ended June 30, 1980.)
3.3 Articles of Amendment of Articles of Incorporation of Robinson Nugent, Inc. filed November 14, 1983 (Incorporated by reference to Exhibit 3.3 to Form 10-K Report for year ended June 30, 1984.)
3.4 Amended and Restated Bylaws of Robinson Nugent, Inc. adopted November 7, 1991. (Incorporated by reference to Exhibit 19.1 to Form 10-K Report for year ended June 30, 1992).
(4) 4.1 Specimen certificate for Common Shares, without par value. (Incorporated by reference to Exhibit 4 to Form S-1 Registration Statement No. 2-62521.)
4.2 Rights Agreement dated April 21, 1988 between Robinson Nugent, Inc. and Bank One, Indianapolis, NA. (Incorporated by reference to Exhibit I to Form 8-A Registration Statement dated May 2, 1988.)
4.3 Amendment No. 1 to Rights Agreement dated September 26, 1991. (Incorporated by reference to Exhibit 4.3 to Form 10-K Report for year ended June 30, 1991.)
4.4 Amendment No. 2 to Rights Agreement dated
June 11, 1992. (Incorporated by reference to Exhibit 4.4 to Form 8-K Current Report dated July 6, 1992.)
4.6 Amendment No. 3 to Rights Agreement dated February 11, 1998 (Incorporated by reference to Exhibit 4.5 to Form 10-Q Report for the period ended December 31, 1998.)
(9) No exhibit.
(10) 10.1 Robinson Nugent, Inc. 1983 Tax-Qualified * Incentive Stock Option Plan. (Incorporated by reference to Exhibit 10.1 to Form 10-K Report for year ended June 30, 1983.)
10.2 Robinson Nugent, Inc. 1983 Non Tax- * Qualified Incentive Stock Option Plan. (Incorporated by reference to Exhibit 10.2 to Form 10-K Report for year ended June 30, 1983.)
10.3 1993 Robinson Nugent, Inc. Employee and * Non-Employee Director Stock Option Plan. (Incorporated by reference to Exhibit 19.1 to Form 10-K Report for the year ended June 30, 1993.)
10.4 Summary of The Robinson Nugent, Inc. * Employee Stock Purchase Plan. (Incorporated by reference to Exhibit 19.2 to Form 10-K Report for the year ended June 30, 1993.)
10.5 Deferred compensation agreement dated * May 10, 1990 between Robinson Nugent, Inc. and Larry W. Burke, President and Chief Executive Officer. (Incorporated by reference to Exhibit 19.1 to Form 10-K Report for year ended June 30, 1990.)
10.6 Trust Agreement dated July 1, 1999 * between Robinson Nugent, Inc. and Strong Retirement Plan Services, related to the deferred compensation agreement between Robinson Nugent, Inc. and Larry W. Burke, President and Chief Executive Officer.
10.7 Summary of the 1993 Robinson Nugent, Inc. * Employee and Non-employee Director Stock Option Plan, as amended. (Incorporated by reference to Exhibit 10.7 to Form 10-K Report for the fiscal year ending June 30, 1998).
10.8Summary of Robinson Nugent, Inc. Bonus Plan for fiscal year ended June 30, 2000.
(11) No exhibit.
(12) No exhibit.
(13) 13.0 1999 Annual Report to Shareholders of Robinson Nugent, Inc.
(16) No exhibit.
(18) No exhibit.
(21) 21.0 The subsidiaries of the registrant are: JURISDICTION NAME OF ORGANIZATION ------- ---------------- Cablelink, Incorporated Indiana
RNL, Inc. Indiana
Robinson Nugent-Dallas, Inc. Texas
Robinson Nugent Design Services, Inc.Pennsylvania
Robinson Nugent S.a.r.l. France
Robinson Nugent GmbH Germany
Robinson Nugent Ltd. Great Britain
Nihon Robinson Nugent K.K. Japan
Robinson Nugent dba Cablelink Malaysia (Malaysia) Sdn. Bhd.
Robinson Nugent (Malaysia) Sdn. Bhd. Malaysia
Robinson Nugent S.A. Switzerland
Robinson Nugent (Scotland) Limited Scotland
Robinson Nugent International, Inc. Virgin Islands
Robinson Nugent (Europe) B.V. Netherlands
Robinson Nugent (Belgium) B.V.B.A. Belgium
Robinson Nugent (Asia Pacific) Pte. Ltd. Singapore
Robinson Nugent Nordic, filial-till Sweden Robinson Nugent (Europe) B.V.
The Netherlands
Robinson Nugent S. de R.L. de C.V. Mexico
(22) No exhibit.
(23) 23.1 Consent of Deloitte & Touche LLP Independent Auditors
23.2 Consent of PricewaterhouseCoopers LLP Independent Accountants
(24) No exhibit.
(27) 27.0 Financial Data Schedule.
(28) No exhibit.
* Management contracts or compensatory plans | 6,361 | 44,205 |
315858_1999.txt | 315858_1999 | 1999 | 315858 | ITEM 1. BUSINESS
General Description of Business - -------------------------------
BFC Financial Corporation and its subsidiaries are collectively identified herein as the "Registrant", "BFC" or the "Company". BFC Financial Corporation is a unitary savings bank holding company as a consequence of its ownership interest in the common stock of BankAtlantic Bancorp, Inc. ("BBC"). BBC is also a unitary savings bank holding company which owns 100% of the outstanding stock of BankAtlantic, A Federal Savings Bank ("BankAtlantic") and its subsidiaries and Ryan Beck & Co., Inc., ("Ryan Beck") and its subsidiaries, an investment banking and securities brokerage firm.
At December 31, 1999, the Company's ownership in BBC Class A Common Stock and Class B Common Stock was approximately 26% and 48%, respectively, in the aggregate representing 31% of all of the outstanding BBC Common Stock. Class B Common Stock is the voting common stock of BBC. The Company's principal business is the ownership of BBC.
The Company acquired control of BBC in 1987 for a total investment of approximately $43 million. From 1987 through June 1993, the Company increased its ownership in BBC to 77.83%. In November 1993, the Company's ownership of BBC decreased to 48.17%, as a consequence of the Company's and BBC's sales of shares of BBC Common Stock and since that time has been further reduced to its current levels by issuances of common stock by BBC in connection with acquisitions and the exercise of stock options. At December 31, 1999, the Company's investment in BBC, represented approximately 76% of the Company's assets.
During 1999, the Company invested approximately $6.7 million in five unaffiliated technology entities. During 2000, these investments were contributed to a specified asset limited partnership managed by an affiliate of the Company. Interests in such partnership were sold in March 2000 to accredited investors in a private offering and the Company received approximately $6.2 million of the proceeds. The Company's net investment after receipt of the proceeds will be approximately $1.8 million. It is anticipated that the Company may form additional partnerships in the future to invest in the technology sector.
In addition, the Company owns and manages real estate. Since its inception in 1980, and prior to acquiring control of BBC, the Company's primary business was the organization, sale and management of real estate investment programs. A subsidiary of the Company continues to serve as the corporate general partner of a public limited partnership which files periodic reports with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Subsidiaries of the Company also serve as corporate general partners of a number of private limited partnerships formed in prior years. The Company ceased the organization and sale of real estate investment programs in 1987.
BBC - ---
BBC's principal assets include the capital stock of:
o BankAtlantic, a Federal Savings Bank and its subsidiaries and o Ryan Beck & Co., Inc., an investment banking firm and its subsidiaries, acquired June 30, 1998.
BankAtlantic is a federally-chartered, federally-insured savings bank organized in 1952, which provides a full range of commercial banking products and services directly and through subsidiary corporations. The principal business of BankAtlantic is attracting checking and savings deposits from the public and general business customers and using these deposits to originate or acquire commercial, small business, residential and consumer loans and make permitted investments such as the investments in mortgage-backed securities, tax certificates and other investment securities. BankAtlantic currently operates in 18 Florida counties through 68 branch offices located primarily in Miami-Dade County, Broward and Palm Beach Counties in South Florida as well as branches located throughout Florida in Walmart SuperStores. As reported by an independent reporting service, BankAtlantic is the largest independent financial institution headquartered in the State of Florida based on assets at September 30, 1999. BankAtlantic is regulated and examined by the Office of Thrift Supervision ("OTS") and the Federal Deposit Insurance Corporation ("FDIC") and its deposit accounts are insured up to applicable limits by the FDIC.
On October 31, 1997, BankAtlantic Development Corp ("BDC"), a wholly owned subsidiary of BankAtlantic acquired the St. Lucie West Holding Corp. ("SLWHC") which is the developer of the master planned community of St. Lucie West, ("SLW") located in St. Lucie County, Florida. On December 28, 1999, BDC completed the acquisition of Levitt Corporation ("Levitt"), which is focused on the development of active adult communities.
Real Estate and Other Activities - --------------------------------
In addition to its investment in BBC and unrelated to the public limited partnership programs and its property management activities, the Company holds mortgage notes receivable of approximately $1.3 million which were received in connection with the sale of properties previously owned by the Company. Further, in recent years, the Company has made additional real estate investments. In 1994, the Company agreed to participate in certain real estate opportunities with John E. Abdo, Vice Chairman of the Board, and certain of his affiliates (the "Abdo Group"). Under the arrangement, the Company and the Abdo Group will share equally in profits after interest earned by the Company on advances made by the Company. The Company bears any risk of loss under the arrangement with the Abdo Group.
The Company has acquired interests in two properties pursuant to this arrangement with the Abdo Group. In June 1994, an entity controlled by the Company acquired from an independent third party 23.7 acres of unimproved land known as the "Cypress Creek" property located in Fort Lauderdale, Florida. In March 1996, the Cypress Creek property was sold to an unaffiliated third party for approximately $9.7 million and the Company recognized a gain of approximately $3.3 million. As part of the sale of the Cypress Creek property, the Company received a limited partnership interest in an unaffiliated limited partnership that entitled it to receive approximately 4.5% of any profits from the development and operation of the property. In January 1999, the Company received approximately $259,000 when the limited partnership was liquidated. In December 1994, an entity controlled by the Company acquired from an unaffiliated seller approximately 70 acres of unimproved land known as the "Center Port" property in Pompano Beach, Florida. Through December 31, 1999, approximately 50 acres of the Center Port property had been sold to unaffiliated third parties for approximately $13.6 million and the Company recognized net gains from the sales of real estate of approximately $3.4 million. Included in cost of sales is approximately $2.4 million representing the Abdo Group's profit participation from the transaction. Payment of any profit participation to the Abdo Group will be deferred until the Company is repaid on advances and interest. The remainder of the Center Port property is currently being marketed for sale.
In October 1996, the Company sold a 50% interest in Delray Industrial Park, located in Delray Beach, Florida. Since the Company was the sole maker on the non-recourse mortgage note on the property and since the Company maintained a 50% interest in the subject property, the gain on the sale of approximately $632,000 was deferred, reducing the Company's carrying value in the real estate and the mortgage remained on the Company's books. During May 1998, the property was refinanced with the other 50% owner also becoming liable for the amount owed under the note. At that time, the Company recognized 50% of the $632,000 deferred profit on the transaction, and removed the mortgage from the Company's books. The remaining investment in the property is reflected using the equity method of accounting.
A description of BBC and BankAtlantic is incorporated herein by reference to the Annual Report on Form 10-K of BBC for the year ended December 31, 1999.
Holding Company Regulation - --------------------------
As the holder of approximately 31% of all of BBC's outstanding Common Stock, BFC is a unitary savings bank holding company subject to regulatory oversight by the OTS. As such, the Company is required to register with and is subject to OTS examination, supervision and certain reporting requirements. In addition, BBC is subject to the same oversight by the OTS as discussed herein with respect to the Company.
BankAtlantic is a member of the Federal Home Loan Bank ("FHLB") system and its deposit accounts are insured up to applicable limits by the FDIC. BankAtlantic is subject to supervision, examination and regulation by the OTS and by the FDIC as the insurer of its deposits. BankAtlantic must file reports with the OTS and the FDIC concerning its activities and financial condition. The OTS and the FDIC periodically review BankAtlantic's compliance with various regulatory requirements. The regulatory structure also gives regulatory authorities extensive discretion with respect to the classification of non-performing and other assets and the establishment of adequate loan loss reserves for regulatory purposes.
The Home Owner's Loan Act ("HOLA") prohibits a savings bank holding company from directly or indirectly acquiring control, including through an acquisition by merger, consolidation or purchase of assets, of any savings association (as defined in Section 3 of the Federal Deposit Insurance Act) or any other savings and loan or savings bank holding company, without prior OTS approval. In considering whether to grant approval for any such transaction, the OTS will take into consideration a number of factors, including:
o competitive effects of the transaction; o financial and managerial resources; o future prospects of the holding company and its bank or thrift subsidiaries following the transaction; and o compliance records of such subsidiaries with the Community Reinvestment Act.
Generally, a savings bank holding company may not acquire more than 5% of the voting shares of any savings association unless by merger, consolidation or purchase of assets, in each case subject to prior OTS approval. Another provision of HOLA permits a savings bank holding company to acquire up to 15% of the voting shares of certain undercapitalized savings associations.
Federal law allows the Director of the OTS to take action when it determines that there is reasonable cause to believe that the continuation by a savings bank holding company of any particular activity constitutes a serious risk to the financial safety, soundness, or stability of a savings bank holding company's subsidiary savings institution. The Director of the OTS has oversight authority for all holding company affiliates, not just the insured institution. Specifically, the Director of the OTS may, as necessary:
(i) limit the payment of dividends by the savings institution; (ii) limit transactions between the savings institution, the holding company and the subsidiaries or affiliates of either; or (iii) limit any activities of the savings institution that might create a serious risk that the liabilities of the holding company and its affiliates may be imposed on the savings institution.
Restrictions on Transactions with BankAtlantic and BBC -- BankAtlantic and BBC is subject to restrictions in its dealings with the Company and any other companies that are "affiliates" of the Company under HOLA and certain provisions of the Federal Reserve Act ("FRA") that are made applicable to savings institutions by the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") and OTS regulations.
Restrictions on BBC's Ability to Pay Dividends to the Company - -------------------------------------------------------------
While there is no assurance that BBC will pay dividends in the future, BBC has paid a regular quarterly dividend to its common stockholders since August 1993. Each share of BBC Class A Common Stock is entitled to receive cash dividends equal to at least 110% of any cash dividends declared and paid on the BBC Class B Common Stock. Management of BBC has indicated that it will seek to declare regular quarterly cash dividends on the BBC Common Stock. However, the payment of dividends by BBC is subject to declaration by BBC's Board of Directors and will depend upon, among other things, the results of operations, financial condition and cash requirements of BBC and on the ability of BankAtlantic to pay dividends or otherwise advance funds to BBC, which in turn is subject to OTS regulations and is based upon BankAtlantic's regulatory capital levels and net income.
BankAtlantic must file a capital distribution notice or a capital distribution application with the OTS in connection with distributions to BBC. Current regulations applicable to the payment of cash dividends by savings institutions impose limits on capital distributions based on an institution's regulatory capital levels.
BankAtlantic meets the definition as a "well capitalized" institution; however, BankAtlantic's capital distribution exceeds net income for the prior two years and therefore must file a capital distribution application with the OTS prior to making distributions to BBC.
A "well capitalized" institution must have risk-based capital of 10% or more, core capital of 5% or more and Tier 1 risk-based capital (based on the ratio of core capital to risk-weighted assets) of 6% or more and may not be subject to any written agreement, order, capital directive or prompt corrective action directive issued by the OTS to meet and maintain a specific capital level or a specific capital measure. At December 31, 1999 BankAtlantic met the capital requirements of a "well capitalized" institution as defined above.
Federal and State Taxation - --------------------------
The State of Florida imposes a corporate income tax at the rate of 5.5% on taxable income as determined for Florida income tax purposes. Taxable income for this purpose is based on federal taxable income in excess of $5,000 as adjusted by certain items.
Employees - ---------
At December 31, 1999, BFC Financial Corporation employed 6 full-time employees and 2 part-time employees. Management believes that its relations with its employees are satisfactory. The employee benefits offered by the Company are considered by management to be generally competitive with employee benefits provided by other major employers in Florida. The Company's employees are not represented by any collective bargaining group.
ITEM 2.
ITEM 2. Properties
BFC maintains its offices in approximately 1,500 square feet located in a building owned by BankAtlantic. The space is leased on terms no less favorable than that which management believes could be obtained from an independent third party.
The properties listed below are not utilized by the Company but are held by the Company as investments. All are zoned for their current uses.
o A parcel of land located in Fort Lauderdale, Florida, referred to herein as the Center Port property, containing approximately 70 acres of which approximately 50 acres have been sold through December 31, 1999.
o A shopping center known as the Burlington Manufacturers Outlet Center ("BMOC") located in Burlington, North Carolina containing approximately 265,265 leaseable square feet.
o A 50% interest in an industrial park known as Delray Industrial Park located in Delray Beach, Florida containing approximately 134,237 leaseable square feet.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The following is a description of certain lawsuits to which the Company is a party.
Alan B. Levan and BFC Financial Corporation v. Capital Cities/ABC, Inc. and - --------------------------------------------------------------------------- William H. Wilson, in the United States District Court for the Southern District - -------------------------------------------------------------------------------- of Florida, Case No. 92-325-Civ-Atkins. - --------------------------------------- On November 29, 1991, The ABC television program 20/20 broadcast a story about Alan B. Levan and the Company which purportedly depicted a number of securities transactions in which Mr. Levan and the Company were involved. The story contained numerous false and defamatory statements about the Company and Mr. Levan and, on February 7, 1992, a defamation lawsuit was filed on behalf of the Company and Mr. Levan against Capital Cities/ABC, Inc. and William H. Wilson, the producer of the broadcast. In December 1996, a jury found in favor of the Company and Mr. Levan and awarded a compensatory judgment of $1.25 million to the Company and $8.75 million to Mr. Levan. Capital Cities/ABC, Inc. and William H. Wilson filed an appeal in this matter and the Appellate Court reversed the lower court judgment. The Company and Mr. Levan filed a petition for certiorari review with the Supreme Court On February 28, 2000, the petition was denied.
The Company is also a party to certain other litigation arising in the ordinary course of its business. Management does not believe such litigation will have a material adverse effect on its financial condition or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
INCORPORATION BY REFERENCE - --------------------------
Part I - Items 1 through 3 pertaining to BFC's significant subsidiary, BBC is incorporated herein by reference to the annual report on Form 10-K of BankAtlantic Bancorp, Inc. for the fiscal year end December 31, 1999.
PART II
ITEM 5.
ITEM 5. MARKET PRICE OF AND DIVIDENDS ON THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Prior to October 1997, the Company's outstanding capital stock consisted of a single class of common stock. On October 6, 1997, the Board of Directors of the Company declared a five for four stock split effected in the form of a 25% stock dividend, payable in shares of the Company's newly authorized Class A Common Stock. The Class A Common Stock was a newly authorized series of the Company's capital stock and no shares were outstanding prior to the dividend. Pursuant to the Company's Articles of Incorporation, the Company's then existing common stock was automatically redesignated as Class B Common Stock without changing any of its rights and preferences upon the authorization by the Board of the stock dividend. The Class A Common Stock and the Class B Common Stock have substantially identical terms except that (i) the Class B Common Stock is entitled to one vote per share while the Class A Common Stock will have no voting rights other than those required by Florida law and (ii) each share of Class B Common Stock is convertible at the option of the holder thereof into one share of Class A Common Stock.
The following table sets forth, for the periods indicated, the high bid and low asking prices of the Class A Common Stock and the Class B Common Stock, as reported by the National Quotation Bureau, L.L.C. The Company's Class A and Class B common stock trades on the OTC Bulletin Board under the symbol BFCFA and BFCFB, respectively.
Year: - ---- Class A Common Stock Class B Common Stock Price -------------------- -------------------------- Quarter High Low High Low ------- ---- --- ---- --- 1997: 1st Quarter n/a n/a $ 3.73 $ 3.00 2nd Quarter n/a n/a $ 4.00 $ 3.13 3rd Quarter n/a n/a $ 10.13 $ 3.93 4th Quarter $ 10.17 $ 9.33 $ 10.40 $ 7.33 1998: 1st Quarter $ 15.50 $ 9.34 $ 15.17 $ 9.33 2nd Quarter $ 12.63 $ 9.25 $ 12.75 $ 9.00 3rd Quarter $ 11.63 $ 6.25 $ 10.88 $ 6.00 4th Quarter $ 7.13 $ 4.00 $ 7.75 $ 5.00 1999: 1st Quarter $ 7.00 $ 4.88 $ 7.50 $ 6.00 2nd Quarter $ 6.38 $ 3.88 $ 7.00 $ 5.00 3rd Quarter $ 5.88 $ 4.75 $ 5.88 $ 5.00 4th Quarter $ 5.13 $ 2.94 $ 5.75 $ 3.00
On March 22, 2000, there were approximately 1,150 record holders of the Class A Common Stock and 1,082 record holders of Class B common stock.
The last sale price during 1999 of the Company's Class A and Class B common stock as reported to the Registrant by the National Quotation Bureau was $3.00 and $3.38 per share, respectively.
There are no restrictions on the payment of cash dividends by Registrant.
As noted in Part I, Item I under "Business - Regulation - Restrictions on BBC's Ability to Pay Dividends to the Company," there are restrictions on the payment of dividends by BankAtlantic to BBC and by BBC to its common shareholders, including BFC. The source of funds for payment by BBC of dividends to BFC is currently dividend payments received by BBC from BankAtlantic.
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BFC FINANCIAL CORPORATION AND SUBSIDIARIES Selected Consolidated Financial Data (In thousands, except for per share data and percents)
- ---------- (a) Ratios were computed using quarterly averages. (b) Since its inception, the Company has not paid any dividends. (c) The operations of BBC have been eliminated since there is a dividend restriction between BBC's primary subsidiary, BankAtlantic, and BBC. (d) Prior to 1997 there were no Class A common shares outstanding. All shares outstanding prior to 1997 were Class B common shares. While the Company has two classes of common stock outstanding, the two-class method is not presented because the company's capital structure does not provide for different dividend rates or other preferences, other than voting rights, between the two classes. (e) I.R.E. Realty Advisory Group, Inc. ("RAG") owns 1,375,000 of BFC Financial Corporation's Class A Common Stock and 500,000 shares of BFC Financial Corporation Class B Common Stock. Because the Company owns 45.5% of the outstanding common stock of RAG, 624,938 shares of Class A Common Stock and 227,500 shares of Class B Common Stock are eliminated from the number of shares outstanding for purposes of computing earnings per share and book value per share. (f) Gain from extinguishment of debt of $61,000, net of income taxes of $39,000. (g) Gain on settlements of Exchange litigation of approximately $756,000, net of income taxes of $475,000, net gain from extinguishment of debt of $115,000, net of income taxes of $72,000 and net gain from debt restructuring of approximately $181,000, net of income taxes of $114,000. (h) Gain on settlements of Exchange litigation of approximately $853,000, net of income taxes of $611,000. (i) Gain from extinguishment of debt of approximately $460,000, net of income taxes of $218,000 and gain on settlements of Exchange litigation of approximately $3.2 million, net of income taxes of $1.5 million. (j) Net loss from extinguishment of debt of approximately $179,000, net of income taxes benefit of $112,000 and net gain on settlement of litigation of approximately $354,000, net of income taxes of $222,000. (k) Investment real estate, net represents the properties acquired in the 1989 and 1991 Exchange.
ITEM 7.
ITEM 7. BFC FINANCIAL CORPORATION'S MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
General - BFC Financial Corporation ("BFC" or "the Company") is a unitary savings bank holding company which owns in the aggregate approximately 31.3% of the outstanding BankAtlantic Bancorp, Inc. ("BBC") Common Stock. BBC is the holding company for BankAtlantic, A Federal Savings Bank ("BankAtlantic") and owns 100% of its outstanding common stock. The Company's ownership interest in BBC has been recorded by the purchase method of accounting. Based on the equity method of accounting, the Company's investment in BBC represents approximately 76% of the Company's consolidated assets as of December 31, 1999. At December 31, 1999, the Company owned 8,296,891 shares of BBC Class A Common Stock and 4,876,124 shares of BBC Class B Common Stock representing 31.3% of all outstanding BBC Common Stock. At December 31, 1999, the Company's ownership in the outstanding BBC Class A and B Common Stock was approximately 26% and 48%, respectively. In January 2000, BBC's Board of Directors approved a corporate transaction to redeem and retire approximately 5.4 million publicly held outstanding shares of Class B common stock. The transaction is subject to BBC shareholder and regulatory approval. If consummated the transaction will result in BFC being the sole holder of the Class B Common Stock representing 100% of BBC voting rights of BBC. The aggregate market value of the Company's investment in BBC at December 31, 1999 was approximately $59.2 million or approximately $14.5 million less than the carrying value in the financial statements. Management does not believe that there is any permanent impairment in the value of the investment in BBC.
In addition to its investment in BBC, the Company owns and manages real estate. Since its inception in 1980 and prior to the acquisition of control of BankAtlantic in 1987, the Company's primary business was the organization, sale and management of real estate investment programs. Effective as of December 31, 1987, the Company ceased the organization and sale of new real estate investment programs, but continues to own and manage real estate assets. At December 31, 1999, a subsidiary of the Company continues to serve as the corporate general partner of one public limited partnership which files periodic reports with the Securities and Exchange Commission under the Securities Exchange Act. Other subsidiaries of the Company also serve as corporate general partners of a number of private limited partnerships formed in prior years.
During 1999, the Company invested approximately $6.7 million in five unaffiliated technology entities. During 2000, these investments were contributed to a specified asset limited partnership managed by an affiliate of the Company. Interests in such partnership were sold in March 2000 to accredited investors in a private offering and the Company received approximately $6.2 million of the proceeds. The Company's net investment after receipt of the proceeds will be approximately $1.8 million. It is anticipated that the Company may form additional partnerships in the future to invest in the technology sector.
Results of Operations - ---------------------
The Company's basic and diluted earnings per share for common stock were $.93 and $.84 for the year ended December 31, 1999, $.05 and $.04 for the year ended December 31, 1998 and $1.23 and $1.12 for the year ended December 31, 1997, respectively.
Net income for the year ended December 31, 1999, 1998 and 1997 was approximately $7.4 million, $380,000 and $9.8 million, respectively. Operations for 1999 and 1997 included gains on settlements of litigation, net of income taxes of approximately $354,000 and $756,000. Operations in 1999 included an extraordinary loss from extinguishments of debt, net of income tax benefit of approximately $179,000. Operations in 1998 and 1997 included extraordinary gains, net of income taxes, of $61,000 and $115,000, respectively, from extinguishment of debt. Operations in 1997 included extraordinary gain, net of income taxes, of $181,000 from debt restructuring.
The Company's equity in BBC's net income was approximately $10.5 million for the year ended December 31, 1999, a net loss for the year ended December 31, 1998 of approximately $1.4 million, and net income for the year ended December 31, 1997 of approximately $12.1 million. The Company's 1999, 1998 and 1997 operations included a net gain on the sale of real estate of approximately $1.4 million, $3.2 million and $335,000, respectively. The Company's 1997 operations also included a net gain on the sale of BBC Class A Common Stock of approximately $1.3 million and the reversal of a provision for litigation of approximately $2.3 million. Interest on subordinated debentures was approximately $408,000, $492,000 and $723,000 in 1999, 1998 and 1997 operations, respectively. The Company's 1999 operation included an allowance for loss on mortgage notes of approximately $300,000 and 1998 operations included a write-down of an investment in a real estate limited partnership of approximately $184,000.
The following table shows the components of revenues and the changes between the periods indicated (in thousands):
December 31, 1999 to 1998 to ------------------------- 1998 1997 1999 1998 1997 Change Change ------- ------- ------ ------- ------- Interest on mortgage notes and related receivables $ 1,284 1,108 221 176 887 Interest and dividends on securities available for sale and escrow accounts 245 228 445 17 (217) Earnings on real estate rental operations, net 1,112 979 1,034 133 (55) Sale of real estate 3,488 11,706 967 (8,218) 10,739 Net gain from sale of stock -- -- 1,349 -- (1,349) Earnings from real estate limited partnerships 851 -- -- 851 -- Equity in earnings (loss) of BBC 10,501 (1,397) 12,129 11,898 (13,526) Other income 218 34 209 184 (175) ------- ------- ------ ------- ------- $17,699 12,658 16,354 5,041 (3,696) ======= ======= ====== ======= =======
Interest on mortgage notes and related receivables increased for the year ended December 31, 1999 as compared to the same period in 1998 due to interest received in 1999 of approximately $954,000 from an affiliated limited partnership. The loan from the limited partnership was satisfied in 1996 but the accrued interest remained unpaid. In 1999, the limited partnership obtained the funds through the sale of its real estate properties allowing it to make the interest payment. This increase was offset in part by a decrease of approximately $734,000 in interest earned from advances associated with the Company's development and construction of the Center Port property. Interest on mortgage notes and related receivables increased for the year ended December 31, 1998 as compared to the same period in 1997 primarily due to recognition of approximately $910,000 of interest earned on advances associated with the development and construction of the Center Port property.
Interest and dividends on securities available for sale and escrow accounts decreased for the year ended December 31, 1998 as compared to the 1997 period primarily due to decreases in investable funds.
Earnings on real estate rental operations include earnings from investment real estate and deferred profit recognition on sales of real estate by the Company and its subsidiaries other than BBC. Earnings on real estate rental operations, net increased for the year ended December 31, 1999 as compared to the same period in 1998 due to decreases in depreciation and repair and maintenance expenses at the Company's Burlington Manufacturers Outlet Center ("BMOC") property. Earnings on real estate rental operations, net decreased for the year ended December 31, 1998, as compared to the same period in 1997 primarily due to an increase in landscaping maintenance and repairs and maintenance at BMOC.
During 1999, the Company sold:
o the ownership interest in parcels of land occupied by two Toys R Us stores located in Springfield, Massachusetts and Aurora, Illinois for approximately $825,000. The Company recognized a net gain on this transaction of approximately $766,000, and o approximately 8 acres of the Center Port property for approximately $2.7 million and recognized a net gain from the sale of approximately $626,000.
During 1998, the Company sold:
o approximately 38 acres of the Center Port property to unaffiliated third parties for approximately $10.9 million and recognized a net gain from the sale of real estate of approximately $2.6 million, and o approximately 15,000 square feet of the BMOC property to an unaffiliated third party for $500,000 and the company recognized a net gain from the sale of real estate of approximately $301,000.
In 1996, the Company sold a 50% interest in a property located in Delray Beach, Florida, included in investment real estate, net. Since the Company was the maker on the non-recourse mortgage note on the Delray Beach property and since the Company maintained a 50% interest in the subject property, the gain on the sale of approximately $0.6 million was deferred. During the quarter ended June 30, 1998, 50% of the deferred profit of approximately $0.3 million was recognized upon refinancing the property's mortgage note. The remaining deferred profit will be recognized upon the sale of the remaining interest in the property.
During 1997, the Company sold:
o 12.7 acres of land located in Birmingham, Alabama to an unaffiliated third party for approximately $149,000 and a net gain on the sale of approximately $131,000 was recognized in 1997, and o approximately four acres of the Center Port property to unaffiliated third parties for approximately $818,000 and the Company recognized a net gain from the sale of real estate of approximately $204,000.
In June 1997 and January 1997, the Company sold an aggregate of 449,805 shares of BBC's Class A Common Stock. Net proceeds received from these sales amounted to approximately $3.7 million and a net gain of approximately $1.3 million was recognized in 1997.
During 1999, the Company received distributions of approximately $588,000 from a real estate limited partnership in which the Company holds an interest when the limited partnership sold 31 of 34 convenience stores that it owned. The Company has a 49.5% interest in this partnership and had written off its investment of approximately $441,000 in 1990 based on the bankruptcy of the entity leasing the real estate. The $588,000 distribution has been included in earnings from real estate limited partnerships. In March 1996, as part of the sale of the Company's Cypress Creek property in Fort Lauderdale, Florida, the Company received a 4.5% limited partnership interest in the partnership that acquired the property. In 1999, the Company received a distribution of approximately $263,000 from the liquidation of this partnership. The $263,000 has also been included in earnings from real estate limited partnerships.
BBC's net income (loss) available for common shareholders for each of the years in the three year period ended December 31, 1999 are summarized below (in thousands):
For the Years 1999 1998 Ended December 31, to to ----------------------------- 1998 1997 1999 1998 1997 Change Change ------- ------- ------ ------ -------
Income from continuing operations $28,792 10,186 23,658 18,606 (13,472) Income (loss) from discontinued operations, net of taxes 2,077 (18,220) 4,111 20,297 (22,331) ------- ------- ------ ------ ------- Net income (loss) $30,869 (8,034) 27,769 38,903 (35,803) ======= ======= ====== ====== =======
The Company's equity in BBC's net income was approximately $10.5 million for the year ended December 31, 1999, a net loss for the year ended December 31, 1998 of approximately $1.4 million, and net income for the year ended December 31, 1997 of approximately $12.1 million. The increase in the Company's equity in earnings of BBC for the year 1999 as compared to 1998 was due to an increase in earnings by BBC. BBC's income from continuing operations increased by 183% during the year ended December 31, 1999 compared to the same period during 1998 whereas income from continuing operations decreased by 57% during the year ended December 31, 1998 compared to the same period during 1997. The primary reasons for BBC's increase in income from continuing operations during 1999 compared to 1998 were:
1) an increase in net interest income relating to a larger loan, securities available for sale and investment securities portfolio, 2) higher transaction and ATM fee income due to an expanded ATM network and a restructuring of transaction accounts, 3) enhanced income from Ryan Beck operations, 4) a significant increase in earnings from land sales related to BDC, 5) lower bank operations expenses resulting from the December 1998 corporate restructuring discussed below, and 6) gains on the sale of property and equipment and foreclosed assets.
The above BBC's increases were partially offset by:
1) an increase in the provision for loan losses resulting from charge-offs and delinquency trends in BBC's indirect consumer and small business loan portfolios, and 2) lower gains on the sale of loans, securities available for sale and trading activities.
BBC's income from discontinued operations for the year ended December 31, 1999 resulted primarily from a lower than anticipated cost to sell mortgage servicing rights and a recovery of a portion of the 1998 valuation allowance due to rising interest rates during 1999. BBC's valuation allowance was established based upon the interest rate environment at year end, which anticipated certain prepayment speeds. Due to rising interest rates during 1999, prepayment speeds were less than estimated resulting in an increase in mortgage servicing rights market value.
The primary reasons for BBC's decrease in income from continuing operations during 1998 compared to 1997 was:
1) a significant increase in the provision for loan losses resulting from recent delinquency trends in the consumer indirect and small business loan portfolios and growth in small business loans, 2) an increase in employee compensation and benefits expense from bank operations due to expanded product lines and branch network, 3) higher occupancy expenses due to the opening of 10 branches and the expansion of BankAtlantic's ATM network , 4) increased advertising and promotion expenses to introduce BankAtlantic's new corporate logo and to promote new product lines, 5) increased expenses associated with the higher administrative costs of managing a larger branch and ATM network , and 6) restructuring charges and write-downs.
The above BBC items were partially offset by an increase in net interest income due to a larger loan portfolio, income from real estate operations and a net pension curtailment gain.
BBC determined in December 1998 to discontinue the mortgage servicing business. Included in the loss from discontinued operations during the year ended December 31, 1998 was a $6.1 million provision for the disposal of the mortgage servicing business (net of income taxes). The remaining loss from discontinued operations during 1998 primarily resulted from rapidly declining interest rates during 1998 causing prepayments and declines in the value of the mortgage servicing rights asset.
The following table gives information regarding the Company's ownership interest in BBC at the dates indicated:
BBC BBC Class A Class B Common Common Total Stock Stock Outstanding ----- ----- ----------- December 31, 1997 30.6% 45.6% 35.6% December 31, 1998 25.1% 47.1% 31.3% December 31, 1999 26.1% 47.5% 31.3%
The decrease in ownership at December 31, 1998 as compared to 1997 was attributable to BBC's issuance of Class A Common Stock in connection with acquisitions. This decrease was offset in part by reductions in the outstanding shares of BBC Common Stock primarily due to BBC's repurchases of its shares.
Other income increased for the year ended December 31, 1999 as compared to the same period in 1998 primarily due to proceeds received relating to advances due from an affiliate which were written-off in prior years and management fees from BankAtlantic Development Corporation for the compensation of accounting and other administrative services.
The following table shows the components of costs and expenses and the changes between the periods indicated (in thousands):
1999 1998 December 31, to to --------------------- 1998 1997 1999 1998 1997 Change Change ---- ---- ---- ------ ------ Interest on subordinated debentures $ 408 492 723 (84) (231) Interest on mortgages payable and other borrowings 1,205 1,420 1,996 (215) (576) Cost of sale of real estate 2,097 8,525 632 (6,428) 7,893 Allowance for loss on mortgage notes 300 -- -- 300 -- Write-down of investment -- 184 -- (184) 184 (Income) expenses related to real estate held for development and sale, net (37) 68 130 (105) (62) Reversal of provision for litigation -- -- (2,272) -- 2,272 Employee compensation and benefits 1,264 1,190 1,153 74 37 Occupancy and equipment 53 50 40 3 10 General and administrative, net 975 778 964 197 (186) -------- ------ ------ ------ ------ $ 6,265 12,707 3,366 (6,442) 9,341 ======== ====== ====== ====== ======
Interest on subordinated debentures decreased for the year ended December 31, 1999 as compared to same period in 1998 due to the redemption of the Company's outstanding Subordinated Debentures at a price of 100% of the principal amount plus accrued interest through the date of redemption. Interest on subordinated debentures decreased for the year ended December 31, 1998 as compared to the same period in 1997 primarily due to reduction in the outstanding amount of Debentures and the accrual of interest on certain Debentures during 1996 related to the delayed funding of the 1989 Exchange settlement liability.
Interest on mortgage payable and other borrowings decreased for the year ended December 31, 1999 as compared to the same period in 1998 due to lower average borrowings outstanding and for year ended December 31, 1998 as compared to the same period in 1997.
The Company recorded an allowance for loss on mortgage notes due from affiliated limited partnerships of $300,000 during 1999. This allowance for mortgage notes was based upon management's determination regarding the net carrying value of the loans and the estimated fair value of the underlying loan collateral. In June 1998, the Company also reduced its carrying value on an investment in an affiliated partnership by $184,000.
The (income) expenses relating to real estate held for development and sale, net represent the Company's expenses and revenues relating to the Center Port property located in Pompano Beach, Florida and a 50% interest in Delray Industrial Park property ("Delray") located in Delray Beach, Florida. (Income) expenses related to real estate held for development and sale decreased for the 1999 period as compared to the 1998 period primarily due to decreased property taxes, administrative expenses and an increase in rental income at Center Port and Delray. Expenses relating to real estate held for development and sale, net decreased for the year ended December 31, 1998 as compared to the same period in 1997 primarily due to decreased property taxes and administrative expenses at the Center Port property. As development is completed and parcels of land are sold from the Center Port project, these expenses are expected to continue to decline.
General and administrative, net increased for the year ended December 31, 1999 as compared to the same period in 1998 primarily due to an increase in professional and consulting fees relating to a registration statement that was subsequently abandoned. This increase was partially offset with a decrease in stockholders relation expenses, leasing fees and intangible taxes. General and administrative, net, decreased for the year ended December 31, 1998 as compared to the same period in 1997 primarily due to decreased legal fees, trustee fees and amortization expense. This decrease was offset in part by an increase in intangible taxes.
In connection with the litigation entitled Short vs. Eden, et al., the Company at December 31, 1996 had an accrual of approximately $3.0 million included in other liabilities. The Company in April 1997 disbursed approximately $783,000 and received a release and satisfaction of judgment. Accordingly, the remaining accrual of approximately $2.3 million was reversed during 1997.
The Company does not include BBC and its subsidiaries in its consolidated income tax return with its wholly-owned subsidiaries since the Company owns less than 80% of the outstanding stock of BBC. The Company utilizes the asset and liability method to account for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. As of December 31, 1999, 1998 and 1997, the Company's deferred income taxes were approximately $13.6 million, $13.2 million and $11.7 million, respectively. The increase in deferred income taxes at December 31, 1998 as compared to December 31, 1997 was primarily due to the deferred taxes associated with the increase in the investment in BBC of approximately $2.4 million.
Financial Condition - -------------------
The Company's total assets at December 31, 1999 and 1998 were $96.7 million and $91.3, respectively. The majority of the difference at December 31, 1999 as compared to December 31, 1998 was due to increases in venture capital investments. This increase was offset in part with decreases in
o investment in BBC o mortgage notes and related receivables, net
During 1999, the Company invested approximately $6.7 million in five unaffiliated technology entities. During 2000, these investments were contributed to a specified asset limited partnership managed by an affiliate of the Company. Interests in such partnership were sold in March 2000 to accredited investors in a private offering and the Company received approximately $6.2 million of the proceeds. The Company's net investment after receipt of the proceeds will be approximately $1.8 million. It is anticipated that the Company may form additional partnerships in the future to invest in the technology sector.
Investment in BBC decreased primarily due to BBC's unrealized depreciation on securities available for sale, net of deferred income taxes of approximately $9.6 million, dividends of approximately $1.2 million and other BBC capital transactions of approximately $493,000. This decrease was offset in part by the equity in earnings of BBC of approximately $10.5 million.
Mortgage notes and related receivables, net decreased due to an allowance for loss on mortgage notes due from affiliated limited partnerships of approximately $300,000. This allowance for notes was based upon management's determination regarding the net carrying value of the loans and the estimated fair value of the underlying collateral.
The Company's total liabilities at December 31, 1999 and 1998 were approximately $37.8 million and $33.6 million, respectively. The increase in total liabilities was primarily due to additional borrowings of approximately $8.08 million. This increase was offset in part by the redemption of the Company's subordinated debentures and deferred interest. Approximately $1.4 million in principal amount of subordinated debentures were redeemed together with approximately $2.2 million in accrued interest through the date of redemption.
Purchase Accounting - -------------------
The acquisition of BBC was accounted for as a purchase and accordingly, the assets and liabilities acquired were revalued to reflect market values at the dates of acquisition. The discounts and premiums arising as a result of such revaluation are generally being accreted or amortized (i.e. added into income or deducted from income), net of tax, using the level yield or interest method over the remaining life of the assets and liabilities. The net impact of such accretion, amortization and other purchase accounting adjustments was to increase consolidated net earnings during the year ended December 31, 1999 by approximately $658,000 and by approximately $741,000 during each of the years ended December 31, 1998 and 1997. Excess cost over fair value of net assets acquired at December 31, 1999 and 1998, was approximately $331,000 and $454,000, respectively. Such excess cost over fair value of net assets acquired is included in the investment in BBC in the accompanying statements of financial condition.
Liquidity and Capital Resources - -------------------------------
The primary sources of funds to the Company for the year ended December 31, 1999 were distributions from real estate limited partnerships, proceeds from the sale of real estate, increase in borrowings, principal reductions on loan receivables, revenues from property operations, and dividends from BBC. These funds were primarily utilized to reduce mortgage payables and other borrowings, redemption of the outstanding subordinated debentures and interest accrued, to fund development and construction costs at the Center Port property, to invest venture capital in technology entities, and to fund operating expenses and general and administrative expenses.
In September 1999, the Company redeemed all of its outstanding Subordinated Debentures by paying approximately $3.6 million to a Trustee, representing the principal balance of approximately $1.4 million and the payment of accrued interest of $2.2 million. The Company recognized an extraordinary loss from extinguishment of debt, net of income tax benefit of approximately $179,000 due to the write-off of the subordinated debentures valuation discount and other related costs.
In accordance with the terms of the applicable escrow agreements established to fund payment of amounts associated with a settlement of litigation, at September 30, 1999, approximately $2.7 million remained in escrow accounts to fund future payments. In January 2000, approximately $2.5 million remaining in escrow was released to the Company and any future payments associated with these settlements will be paid from the Company's working capital. Payments are made when a claimant presents a subordinated debenture that was cancelled upon settlement of the litigation. At December 31, 1999, there was approximately $5.1 million associated with these settlements that could be presented for payment. The Company is not obligated to pay interest on these amounts.
During 1999, the Company invested approximately $6.7 million in five unaffiliated technology entities. During 2000, these investments were contributed to a specified asset limited partnership managed by an affiliate of the Company. Interests in such partnership were sold in March 2000 to accredited investors in a private offering and the Company received approximately $6.2 million of the proceeds. The Company's net investment after receipt of the proceeds will be approximately $1.8 million. It is anticipated that the Company may form additional partnerships in the future to invest in the technology sector.
In December 1994, an entity controlled by the Company acquired from an unaffiliated seller approximately 70 acres of unimproved land known as the "Center Port" property in Pompano Beach, Florida. Through December 31, 1999, approximately 50 acres of the Center Port property had been sold to unaffiliated third parties for approximately $13.6 million and the Company recognized net gains from the sales of real estate of approximately $3.4 million. The remainder of the Center Port property is currently being marketed for sale. The unsold property is unencumbered.
As previously indicated the Company holds approximately 31.3% of all outstanding BBC Common Stock. The payment of dividends by BBC is subject to declaration by BBC's Board of Directors and will depend upon, among other things, the results of operations, financial condition and cash requirements of BBC and the ability of BankAtlantic to pay dividends or otherwise advance funds to BBC, which in turns is subject to OTS regulation and is based upon BankAtlantic's regulatory capital levels and net income. Currently, BBC pays a quarterly dividend of $.025 and $.023 per share for Class A and Class B Common Stock, respectively.
BBC requires funds to pay certain operating expenses, payments required for the 9 1/2% Cumulative Trust Preferred Securities, interest on the 5 5/8%, 6 3/4%, 9% Debentures and 10% Subordinated Investment Notes and regular quarterly cash dividend payments to its common shareholders, subject to regulatory restrictions. It is anticipated that funds for payment of these items, which were $23.2 million for the year ended December 31, 1999, will be provided by dividends received from BankAtlantic.
At December 31, 1999, BankAtlantic's core, Tier 1 risk-based and total risk-based capital ratios were 7.71%, 12.04% and 13.30%, respectively. Based on these capital ratios, BankAtlantic meets the definition of a well-capitalized institution; however, BankAtlantic's capital distribution exceeds net income for the prior two years and therefore must file a capital distribution application with the OTS prior to making distributions to BBC.
Cash Flows - ----------
A summary of the Company's consolidated cash flows follows (in thousands):
For the Years Ended December 31, -------------------------------- 1999 1998 1997 ------- ------- ------- Net cash provided (used) by: Operating activities $(2,249) (1,152) (8,925) Investing activities (2,649) 12,538 10,812 Financing activities 3,920 (9,467) (3,079) ------- ------- ------- Increase (decrease) in cash and cash equivalents $ (978) 1,919 (1,192) ======= ======= =======
Impact of Inflation - The financial statements and related financial data and notes presented herein have been prepared in accordance with GAAP, which require the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative purchasing power of money over time due to inflation. BFC does not believe that inflation has had any material impact on the Company. Inflation could also have an effect on the market value of the Company's ownership in its BBC Common Stock. Virtually all of the assets and liabilities of BBC are monetary in nature. As a result, interest rates have a more significant impact on BBC's performance than the effects of general price levels. Although interest rates generally move in the same direction as inflation, the magnitude of such changes varies.
Market Risk - -----------
Market risk is defined as the risk of loss arising from adverse changes in market valuation which arise from interest rate risk, foreign currency exchange rate risk, commodity price risk and equity price risk. The Company's primary market risk is equity risk through its investment in BBC.
Equity Pricing Risk - -------------------
The Company's primary equity investment is its investment in BBC. This investment was entered into for purposes other than trading purposes. Since this investment is carried using the equity method of accounting, changes in market price of BBC stock would not have a direct impact on the financial statements, however, a change in market price may have an impact on the investment community's view of the Company. The following table shows changes in the market value of the Company's investment in BBC at December 31, 1999 based on percentage changes in market price. Actual future price changes may be different from the changes identified in the table below (in thousands):
Percent Change In Market Market Price Value ------------ ----- 20.00% $ 71,058 10.00% 65,136 0.00% 59,215 (10.00)% (53,293) (20.00)% (47,372)
The Company has provided venture capital to various entities with the anticipation that it will be able to achieve a return on its investment when these entities are either acquired by other companies or sell their stock in public offerings. It is possible that the products being developed by these entities will not gain market acceptances or that the public markets will not support a pricing of these entities that would allow the Company to make a return on or recoup its investments in these entities.
Management does not believe that market risk on other equity instruments would have a significant impact on the financial condition of the Company.
Below is an analysis of BBC's equity pricing risk at December 31, 1999. BBC (including Ryan Beck) maintains a portfolio of trading and available for sale securities, which subjects BBC to equity pricing risks. The change in fair values of equity securities represents instantaneous changes in all equity prices segregated by trading, securities sold not yet purchased and available for sale securities. The following are hypothetical changes in the fair value of BBC's trading and available for sale securities at December 31, 1999 based on percentage changes in fair value. Actual future price appreciation or depreciation may be different from the changes identified in the table below.
Available Securities Total Percent Trading for Sale Sold Not Dollar Change in Securities Securities Yet Change from Fair Value Fair Value Fair Value Purchased 0% ---------- ---------- ---------- ---------- ----------- (dollars in thousands) 20 % $ 27,973 $ 21,863 $ 3,155 $ 8,832 10 % $ 25,642 $ 20,041 $ 2,892 $ 4,416 0 % $ 23,311 $ 18,219 $ 2,629 $ 0 (10) % $ 20,980 $ 16,397 $ 2,366 $ (4,416) (20) % $ 18,649 $ 14,575 $ 2,103 $ (8,832)
BankAtlantic expanded its proprietary trading group during 1999. Their activities include trading in options and future contracts on U.S. Treasury Notes and Bonds as well as Eurodollar time deposits that settle in three months or less. Eurodollar time deposits are indexed to the LIBOR interest rate. In addition, Ryan Beck is a market maker in equity securities, which could, from time to time require them to hold securities during declining markets. BBC attempts to manage its equity price risk by maintaining a relatively small portfolio of securities and evaluating equity securities as part of BBC's overall asset and liability management process.
Interest Rate Risk - ------------------
The majority of BBC's assets and liabilities are monetary in nature subjecting BBC to significant interest rate risk. BBC has developed a model using standard industry software to quantify its interest rate risk. A sensitivity analysis was performed measuring BBC's potential gains and losses in net portfolio fair values of interest rate sensitive instruments at December 31, 1999 resulting from a change in interest rates. BBC Interest rate sensitive instruments included in the model were:
o loan portfolio, o debt securities available for sale, o investment securities, o FHLB stock, o Federal Funds sold, o deposits, o advances from FHLB, o securities sold under agreements to repurchase, o Federal Funds purchased, o Subordinated Debentures, o notes and bonds payable, o Trust Preferred Securities, and o off-balance sheet loan commitments.
BBC has no off-balance sheet derivatives other than fixed rate loan commitments aggregating $8.8 million at December 31, 1999.
The model calculates the net potential gains and losses in net portfolio fair value by:
(i) discounting anticipated cash flows from existing assets, liabilities and off-balance sheet contracts at market rates to determine fair values at December 31, 1999, (ii) discounting the above expected cash flows based on instantaneous and parallel shifts in the yield curve to determine fair values, (iii) the difference between the fair value calculated in (i) and (ii) is the potential gains and losses in net portfolio fair values.
BBC's management has made estimates of fair value discount rates that it believes to be reasonable. However, because there is no quoted market for many of these financial instruments, BBC's management has no basis to determine whether the fair value presented would be indicative of the value negotiated in an actual sale. BankAtlantic's fair value estimates do not consider the tax effect that would be associated with the disposition of the assets or liabilities at their fair value estimates.
The prepayment assumptions used in the model are disclosed in BankAtlantic's Cumulative Rate Sensitivity GAP at December 31, 1999. Subordinated debentures, notes and bonds payable and Trust Preferred Securities were valued for this purpose based on their contractual maturities or redemption date. BBC's interest rate risk policy has been approved by the Board of Directors and establishes guidelines for tolerance levels for net portfolio value changes based on interest rate volatility. BBC's management has maintained the portfolio within these established tolerances.
Presented below is an analysis of BBC's interest rate risk at December 31, 1999. The table measures changes in net portfolio value for instantaneous and parallel shifts in the yield curve in 100 basis point increments up or down.
Net Portfolio Changes Value Dollar in Rate Amount Change ------- ------ ------ (dollars in thousands) +200 bp $ 249,790 $ (98,884) +100 bp $ 297,870 $ (50,804) 0 bp $ 348,674 $ 0 -100 bp $ 381,219 $ 32,545 -200 bp $ 362,742 $ 14,068
Certain assumptions by BBC in assessing the interest rate risk were utilized in preparing the preceding table. These assumptions related to:
o interest rates, o loan prepayment rates, o deposit decay rates, o market values of certain assets under various interest rate scenarios, and o repricing of certain borrowings
It was also assumed that delinquency rates would not change as a result of changes in interest rates although there can be no assurance that this would be the case. Even if interest rates change in the designated increments, there can be no assurance that BBC's assets and liabilities would perform as indicated in the table above. In addition, a change in U.S. Treasury rates in the designated amounts, accompanied by a change in the shape of the yield curve could cause significantly different changes to the fair values than indicated above. Furthermore, the result of the calculations in the preceding table are subject to significant deviations based upon actual future events, including anticipatory and reactive measures which BBC may take in the future.
Year 2000 Considerations - ------------------------
The Company has not and does not expect to experience any problems associated with year 2000 issues.
With respect to the Company's subsidiary BBC, BBC did not experience any system interruptions associated with the year 2000 event. BBC is currently monitoring its loan customers for possible year 2000 losses. Management of BBC has indicated that the year 2000 event has not had and is not expected to have a material impact on BBC's consolidated financial condition or results of operations.
ITEM 8.
ITEM 8. INDEX TO FINANCIAL STATEMENTS
Independent Auditors' Report
Financial Statements:
Consolidated Statements of Financial Condition - December 31, 1999 and 1998
Consolidated Statements of Operations - For each of the Years in the Three Year Period ended December 31, 1999
Consolidated Statements of Stockholders' Equity and Comprehensive Income - For each of the Years in the Three Year Period ended December 31, 1999
Consolidated Statements of Cash Flows - For each of the Years in the Three Year Period ended December 31, 1999
Notes to Consolidated Financial Statements
INDEPENDENT AUDITORS' REPORT
The Board of Directors BFC Financial Corporation:
We have audited the accompanying consolidated statements of financial condition of BFC Financial Corporation and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of operations, stockholders' equity and comprehensive income and cash flows for each of the years in the three-year period ended December 31, 1999. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of BFC Financial Corporation and subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1999, in conformity with generally accepted accounting principles.
KPMG LLP
Fort Lauderdale, Florida March 20, 2000
BFC Financial Corporation and Subsidiaries Consolidated Statements of Financial Condition December 31, 1999 and 1998 (in thousands, except share data)
Assets 1999 1998 ---- ---- Cash and cash equivalents $ 1,545 2,523 Securities available for sale 255 107 Investment in BankAtlantic Bancorp, Inc. ("BBC") 73,764 74,565 Venture capital investments 8,408 343 Mortgage notes and related receivables, net 1,325 1,740 Investment real estate, net 5,803 6,172 Real estate held for development and sale 1,840 1,811 Other assets 3,805 3,996 -------- -------- Total assets $ 96,745 91,257 ======== ========
Liabilities and Stockholders' Equity
Subordinated debentures, net -- 1,452 Deferred interest on the subordinated debentures -- 2,217 Mortgage payables and other borrowings 18,253 10,784 Other liabilities 5,933 5,967 Deferred income taxes 13,594 13,206 -------- -------- Total liabilities 37,780 33,626
Stockholders' equity: Preferred stock of $.01 par value; authorized 10,000,000 shares; none issued -- -- Class A common stock of $.01 par value, authorized 20,000,000 shares; issued and outstanding 6,454,494 in 1999 and 6,453,994 in 1998 58 58 Class B common stock, of $.01 par value; authorized 20,000,000 shares; issued and outstanding 2,354,907 in 1999 and 2,355,407 in 1998 21 21 Additional paid-in capital 25,890 26,095 Retained earnings 38,086 30,660 -------- --------
Total stockholders' equity before accumulated other comprehensive income 64,055 56,834
Accumulated other comprehensive income- net unrealized appreciation (depreciation) on securities available for sale of the Company and BBC, net of deferred income taxes (5,090) 797 -------- --------
Total stockholders' equity 58,965 57,631 -------- --------
Total liabilities and stockholders' equity $ 96,745 91,257 ======== ========
See accompanying notes to consolidated financial statements.
BFC Financial Corporation and Subsidiaries Consolidated Statements of Operations For each of the years in the three year period ended December 31, 1999 (in thousands, except per share data)
1999 1998 1997 ---- ---- ---- Revenues: Interest on mortgage notes and related receivables $ 1,284 1,108 221 Interest and dividends on securities available for sale and escrow accounts 245 228 445 Earnings on real estate rental operations, net 1,112 979 1,034 Sale of real estate 3,488 11,706 967 Net gain from sale of stock -- -- 1,349 Earnings from real estate limited partnerships 851 -- -- Equity in earnings (loss) of BBC 10,501 (1,397) 12,129 Other income 218 34 209 -------- -------- -------- Total revenues 17,699 12,658 16,354 -------- -------- --------
Costs and expenses: Interest on subordinated debentures 408 492 723 Interest on mortgages payable and other borrowings 1,205 1,420 1,996 Cost of sale of real estate 2,097 8,525 632 Allowance for loss on mortgage notes 300 -- -- Write-down of investment -- 184 -- (Income) expenses related to real estate held for development and sale, net (37) 68 130 Reversal of provision for litigation -- -- (2,272) Employee compensation and benefits 1,264 1,190 1,153 Occupancy and equipment 53 50 40 General and administrative, net 975 778 964 -------- -------- -------- Total cost and expenses 6,265 12,707 3,366 -------- -------- -------- Income (loss) before income taxes and extraordinary items 11,434 (49) 12,988 Provision (benefit) for income taxes 4,183 (368) 4,222 -------- -------- -------- Income before extraordinary items 7,251 319 8,766 Extraordinary items: Net gain from debt restructuring, net of income taxes of $114,000 in 1997 -- -- 181 Net (loss) gain from extinguishment of debt, net of income tax (benefit) expense of ($112,000) in 1999, $39,000 in 1998 and $72,000 in 1997 (179) 61 115 Gain on settlements of litigation, net of income taxes of $222,000 in 1999 and $475,000 in 1997 354 -- 756 -------- -------- -------- Net income $ 7,426 380 9,818 ======== ======== ========
Basic earnings per share: Before extraordinary items $ 0.91 0.04 1.10 Extraordinary items 0.02 0.01 0.13 -------- -------- -------- Net income $ 0.93 0.05 1.23 ======== ======== ========
Diluted earnings per share: Before extraordinary items $ 0.82 0.04 1.00 Extraordinary items 0.02 -- 0.12 -------- -------- -------- Net income $ 0.84 0.04 1.12 ======== ======== ========
Basic weighted average shares outstanding 7,957 7,954 7,938 ======== ======== ========
Diluted weighted average shares outstanding 8,818 9,101 8,731 ======== ======== ========
See accompanying notes to consolidated financial statements.
BFC Financial Corporation and Subsidiaries Consolidated Statements of Stockholders' Equity and Comprehensive Income For each of the years in the three year period ended December 31, 1999 (in thousands)
See accompanying notes to consolidated financial statements.
BFC Financial Corporation and Subsidiaries Consolidated Statements of Cash Flows For each of the years in three year period ended December 31, 1999 (In thousands)
For the years ended December 31, ----------------------- 1999 1998 1997 ---- ---- ---- Operating activities: Net income $ 7,426 380 9,818 Adjustments to reconcile net income to net cash (used in) operating activities: Depreciation 521 575 683 Net gain from debt restructuring, net of income taxes -- -- (181) Net (gain) loss from extinguishment of debt, net of income tax (benefit) expense 179 (61) (115) Gain on settlements of litigation, net of income taxes (354) -- (756) Gain on sale of real estate, net (1,391) (3,181) (335) Net gain from sale of stock -- -- (1,349) Equity in (earnings) loss of BBC (10,501) 1,397 (12,129) Earnings from real estate limited partnership (851) -- -- (Income) expenses related to real estate held for development and sale, net (37) 68 130 Provision (benefit) for deferred income taxes 4,103 (458) 4,222 Allowance for loss on mortgage notes 300 -- -- Amortization on subordinated debentures 5 11 13 Accretion of discount on loans receivable (39) (40) (45) Increase in real estate development and construction costs (1,863) (2,631) (388) Reversal of provision for litigation -- -- (2,272) Fundings for litigation settlement -- -- (1,801) Increase in the escrows for called debenture liability -- -- (5,158) Proceeds from escrow for called debenture liability -- 2,166 -- Increase in deferred interest on the subordinated debentures 403 482 656 Accrued interest income on escrow accounts (148) (124) (237) Interest accrued regarding called debenture liability -- -- 52 Increase (decrease) in other liabilities 112 (4) 45 Decrease (increase) in other assets (114) 268 222 -------- -------- -------- Net cash used in operating activities (2,249) (1,152) (8,925) -------- -------- --------
Investing activities: Proceeds from sales of real estate 1,663 495 128 Proceeds from the sale of stock -- -- 3,720 Common stock dividends received from BBC 1,236 1,187 1,025 Purchase of venture capital investments (8,065) -- -- Purchase of securities available for sale -- (8,788) (19,225) Proceeds from redemption and maturities of securities available for sale -- 9,768 24,535 Principal reduction on mortgage notes and related receivables, net 154 159 182 Decrease in real estate held for development and sale 2,433 9,800 490 Addition to office properties and equipment -- -- (21) Improvements to investment real estate (152) (83) (22) Other 82 -- -- -------- -------- -------- Net cash (used in) provided by investing activities (2,649) 12,538 10,812 -------- -------- --------
Financing activities: Issuance of common stock -- 35 91 Increase in borrowings 8,079 -- 9,144 Repayments of borrowings (4,159) (9,502) (12,314) -------- -------- -------- Net cash provided by (used in) financing activities 3,920 (9,467) (3,079) -------- -------- --------
(Decrease) increase in cash and cash equivalents (978) 1,919 (1,192)
Cash and cash equivalents at beginning of period 2,523 604 1,796 -------- -------- -------- Cash and cash equivalents at end of period $ 1,545 2,523 604 ======== ======== ========
See accompanying notes to consolidated financial statements.
BFC Financial Corporation and Subsidiaries Notes to Consolidated Financial Statements For the years ended December 31, 1999, 1998 and 1997
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Financial Statement Presentation - BFC Financial Corporation ("BFC" or the "Company") is a unitary savings bank holding company as a consequence of its ownership of the Common Stock of BankAtlantic Bancorp, Inc. ("BBC"). BankAtlantic, a Federal Savings Bank, ("BankAtlantic") is a wholly-owned subsidiary of BankAtlantic Bancorp ("BBC"). The Company's primary asset is the capital stock of BBC and its primary activities currently relate to that asset. The financial statements have been prepared in conformity with generally accepted accounting principles ("GAAP"). In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the statements of consolidated financial condition and income and expenses for the periods presented. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change in the next year relate to the determination of the valuation allowance for real estate and the allowance for mortgage notes and related receivables.
The consolidated financial statements and notes to consolidated financial statements of BankAtlantic Bancorp, Inc. and Subsidiaries are incorporated herein by reference.
Principles of Consolidation - The consolidated financial statements reflect the activities of BFC and its wholly owned subsidiaries. Because the Company's ownership in BBC is less than 50%, the Company's investment in BBC is carried on the equity method.
Cash Equivalents - Cash equivalents include liquid investments with original maturities of three months or less.
Securities Available for Sale - The Company's securities are available for sale. These securities are carried at fair value, with any related unrealized appreciation or depreciation reported as a separate component of stockholders' equity, net of income taxes. A write-down is reflected in the statement of operations to the extent that securities are other than temporarily impaired.
Mortgage Notes and Related Receivables, net - Mortgage notes and related receivables, net, are carried at the lower of cost or fair value.
Allowance for Loan Losses - Non-collateral dependent loan impairment is based on the present value of the estimated future cash flows. Impairment losses are included in the allowance for loan losses through a charge to the provision for loan losses. Adjustments to impairment losses resulting from changes in the fair value of an impaired loan's collateral or projected cash flows are included in the provision for loan losses. Upon disposition of an impaired loan, any related valuation allowance is removed from the allowance for loan losses.
Real Estate - Investment real estate is held for use. Real estate held for development and sale includes land held for development and land held for sale. Costs clearly associated with the development of a specific parcel are capitalized as a cost of that parcel. Indirect land development costs are allocated to parcels based upon the square footage of parcels benefited. Land costs were allocated to the various parcels based upon the relative sales value method. Real estate held for sale is stated at the lower of carrying amount or fair value less cost to sell. Real estate held for development is evaluated for impairment based upon the undiscounted future cash flows of the property compared to the carrying value of the property. If the undiscounted future cash flows are lower than the carrying value of the property, a valuation allowance is established for the difference between the carrying amount of the parcel and the fair value of the parcel, less cost to sell. The fair value of real estate is evaluated based on existing and anticipated market conditions. The evaluation takes into consideration the current status of the property, various restrictions, carrying costs, costs of disposition and any other circumstances which may affect estimated fair value.
Profit or loss on real estate sold is recognized in accordance with Statement of Financial Accounting Standard No. 66, "Accounting for Sales of Real Estate". Any estimated loss is recognized in the period in which it becomes apparent.
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of - Long-lived assets and assets held for sale are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. In performing the review for recoverability, the Company estimates the future cash flows expected to result from the use of the asset and its eventual disposition. If the sum of the expected future cash flows (undiscounted and without interest charges) is less than the carrying amount of the asset, an impairment loss is recognized. Measurement of an impairment loss for long-lived assets and identifiable intangibles that the Company expects to hold and use is based on the fair value of the asset.
Depreciation - Depreciation is computed on the straight-line method over the estimated useful lives of the assets which generally range up to 31.5 years for buildings and 4 years for tenant improvements.
Income Taxes - The Company does not include BBC and its subsidiaries in its consolidated income tax return with its wholly owned subsidiaries, since the Company owns less than 80% of the outstanding stock of BBC. Deferred income taxes are provided on elements of income that are recognized for financial accounting purposes in periods different than such items are recognized for income tax purposes.
The Company utilizes the asset and liability method to account for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in the period that includes the statutory enactment date. A valuation allowance is provided to the extent it is more likely than not that deferred tax assets will not be utilized.
Excess Cost Over Fair Value of Net Assets Acquired (Goodwill) - The ownership position in BBC was acquired at different times. In some acquisitions, the fair market value of the net assets of BBC were greater than the Company's cost. At other acquisitions, the Company's cost was in excess of the fair market value of BBC's net assets. The excess of fair market value over cost was recorded as a reduction to the fair market value of non-current assets. The excess purchase price over fair market value was recorded as goodwill and is being amortized on the straight-line basis over a 15-year period. The excess of such cost basis over the Company's purchase price was recorded as a reduction to property and equipment and is being amortized on a straight-line basis over a ten-year period. Cost over fair value of net assets acquired and other intangible assets is evaluated by management for impairment on an on-going basis based on the facts and circumstances related to the net assets acquired. That evaluation includes a review of current and estimated future earnings and dividend paying ability.
Earnings Per Share - While the Company has two classes of common stock outstanding, the two-class method is not presented because the Company's capital structure does not provide for different dividend rates or other preferences, other than voting rights, between the two classes. Basic earnings per share excludes dilution and is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if options to issue common shares were exercised. Common stock options, if dilutive, are considered in the weighted average number of dilutive common shares outstanding. The options are included in the weighted average number of dilutive common shares outstanding based on the treasury stock method. For all periods, the shares of the Company issued in connection with a 1984 acquisition are considered outstanding after elimination of the Company's percentage ownership of the entity that received the shares issued in that acquisition.
Stock Based Compensation Plans - The Company maintains both qualifying and non-qualifying stock-based compensation plans for its employees and directors. The Company has elected to account for its employee stock-based compensation plans under APB No. 25.
Reclassifications - For comparative purposes, certain prior year balances have been reclassified to conform with the 1999 financial statement presentation.
2. INVESTMENT IN BANKATLANTIC BANCORP, INC.
The Company has acquired its 31.3% ownership of all outstanding BBC Common Stock at December 31, 1999 through various acquisitions and sales. Where appropriate, amounts throughout this report of all BBC share and per share amounts have been adjusted for stock splits declared by BBC. BBC's Class A Common Stock is non-voting and is entitled to receive cash dividends equal to at least 110% of any cash dividends declared and paid on the Class B Common Stock. At December 31, 1999, the Company owned 8,296,891 shares of BBC Class A Common Stock and 4,876,124 shares of BBC Class B Common Stock. The aggregate market value of the Company's investment in BBC at December 31, 1999 was approximately $59.2 million or approximately $14.5 million less than the carrying value in the financial statements. Management does not believe that there is any permanent impairment in the value of the investment in BBC. The following table reflects BFC's percentage ownership in BBC:
Class A Class B Common Common Total Stock Stock Outstanding ----- ----- ----------- December 31, 1997 30.6% 45.6% 35.6% December 31, 1998 25.1% 47.1% 31.3% December 31, 1999 26.1% 47.5% 31.3%
A reconciliation of the carrying value in BBC to BBC's Stockholders equity at December 31, 1999 and 1998 is as follows:
1999 1998 ---- ---- BBC stockholders' equity $ 235,886 240,440 Ownership percentage 31.3% 31.3% --------- -------- 73,913 75,340 Purchase accounting adjustments (149) (775) --------- -------- Investment in BBC $ 73,764 74,565 ========= ========
The acquisition of BBC has been accounted for as a purchase and accordingly, the assets and liabilities acquired have been revalued to reflect market values at the dates of acquisition. The discounts and premiums arising as a result of such revaluation are generally being accreted or amortized (i.e. added into income or deducted from income), net of tax, using the level yield or interest method over the remaining life of the assets and liabilities. The net impact of such accretion, amortization and other purchase accounting adjustments was to increase consolidated net earnings during the year ended December 31, 1999 by approximately $658,000 and by approximately $741,000 during each of the years ended December 31, 1998 and 1997.
Excess cost over fair value of net assets acquired at December 31, 1999 and 1998, was approximately $331,000 and $454,000, respectively. Excess cost over fair value of net assets acquired at December 31, 1999 and 1998 is included in the investment in BBC in the accompanying statements of financial condition, in addition to other unamortized purchase accounting adjustments.
The following are equity transactions of BBC that impact the Company's ownership percentage of BBC:
In January 2000, BBC's Board of Directors approved a corporate transaction that would result in the redemption and retirement of approximately 5.4 million publicly held outstanding shares of Class B common stock, subject to shareholder and regulatory approval. BBC's Class B Common Stock represents 100% of the voting rights of BBC. As a result of the transaction, the Company would be the sole holder of BBC's Class B Common Stock.
BBC paid $10 million in cash and on October 6, 1999 issued 848,364 shares of restricted Class A common stock in connection with an investment in an internet-based company that provides marketing information, application solutions and customer relationship management applications.
In July 1999, BBC's Board of Directors approved the repurchase in the open market of up to 3.5 million shares of BBC's common stock. During the year ended December 31, 1999, BBC paid $1.6 million to repurchase and retire 221,345 shares of Class B common stock pursuant to the above repurchase plan. Subsequent to December 31, 1999, BBC paid $2.3 million to repurchase 391,000 shares of Class B common stock.
The decrease in the ownership percentage at December 31, 1998 from 35.6% to 31.3% of all outstanding common stock of BBC was primarily due to BBC's issuance of Class A Common Stock to acquire Ryan Beck and LTI. This decrease was offset in part by changes in BBC's outstanding common stock primarily due to BBC's repurchases of its shares.
In June 1998, BBC acquired Ryan, Beck & Co., Inc. ("Ryan Beck"), an investment banking firm that is principally engaged in the underwriting, distribution and trading of tax-exempt obligations and bank and thrift equity and debt securities and in June 1999, Ryan Beck acquired the assets of Southeast Research Partners, Inc. In connection with these acquisitions, an incentive and retention pool was established under which shares of BBC's Class A Common Stock were allocated to key employees. The retention pool consists of restricted shares of Class A Common Stock which will vest at various dates to employees who remain through the vesting dates. BFC's ownership percentage of BBC, as of December 31, 1999, assumes that the shares of restricted Class A Common Stock are not outstanding. In January 2000, each participant in the retention pool was provided the opportunity to exchange the restricted shares that were allocated to such participant for a cash-based deferred compensation award in an amount equal to the aggregate value at the date of the Ryan Beck acquisition. In March 2000, the majority of the retention pool shares were exchanged.
In March 1998, BBC acquired Leasing Technology Inc. ("LTI"), a company engaged in the equipment leasing and finance business. BBC issued 718,413 shares of Class A Common Stock to acquire LTI. Upon regulatory approval, on June 30, 1998, BBC contributed LTI at its book value to BankAtlantic.
In March 1998, BBC announced a plan to purchase up to 2.3 million shares of common stock. During the year ended December 31, 1999 and 1998 BBC paid $8.4 million and $10.9 million to repurchase and retire 1,149,655 and 0 shares of Class A common stock and 0 and 769,500 shares of Class B common stock, respectively.
During the year ended December 31, 1998, BBC issued 907,319 shares of Class A Common Stock upon the conversion of $5.9 million in principal amount of BBC's 6 3/4% Convertible Subordinated Debentures due 2006.
The payment of dividends by BBC is subject to declaration by BBC's Board of Directors and will depend upon, among other things, the results of operations, financial condition and cash requirements of BBC and the ability of BankAtlantic to pay dividends or otherwise advance funds to BBC, which in turns is subject to OTS regulation and is based upon BankAtlantic's regulatory capital levels and net income. BankAtlantic meets the definition as a "well capitalized" institution; however, BankAtlantic's capital distribution exceeds net income for the prior two years and therefore must file a capital distribution application with the OTS prior to making distributions to BBC. Currently, BBC pays a quarterly dividend of $.025 and $.023 per share for Class A and Class B Common Stock, respectively.
3. SUBORDINATED DEBENTURES
In September 1999, the Company redeemed all of its outstanding Subordinated Debentures by paying approximately $3.6 million to a Trustee, representing the principal balance of approximately $1.4 million and the payment of accrued interest of $2.2 million. The Company recognized an extraordinary loss from extinguishment of debt, net of income tax benefit of approximately $179,000 due to the write-off of the subordinated debentures valuation discount and other related costs.
Included in other liabilities at December 31, 1999 and 1998 is approximately $5.1 million and $5.3 million, respectively, representing amounts due in connection with the settlement of class action litigation that arose in connection with exchange transactions that the Company entered into in 1989 and 1991.
Initially, the amount that was to be paid under these settlements was not determined with certainty because the amount of settlement depended upon whether the class member still owned the debenture issued to them in the exchange transaction ("Class Members Still Owning Debentures") or whether the class member sold the debenture transferred to them in the exchange transaction ("Class Members No Longer Owning Debentures"). The determination of which group a debenture holder falls into was complicated by the fact that when a transfer of ownership occurs, the transfer may not have been a bona fide sale transaction (i.e., involved a transfer to street name or to a family member). When a debenture is held by a Class Member Still Owning Debentures, the amount of gain recognized on that debenture is greater because the debenture and any related accrued interest was removed from the books whereas if the debenture was sold to a non class member, a settlement payment is made to the Class Member No Longer Owning the Debenture and the debenture and all related accrued interest remained on the books in the name of the current holder of the debenture. When the settlements were recorded, the gain recorded was based upon the determination that if the debenture had been transferred since issue, the debenture was classified in the group of Class Members No Longer Owning Debentures. As debentures were presented for payment, if a determination was made that the debenture belonged in the group of Class Members Still Owning Debentures, an adjustment was made and additional gain was recognized. Extraordinary gains, net of income taxes of approximately $292,000 and $756,000 were recognized for the years ended December 31, 1999 and 1997, respectively, based upon claims made and paid pursuant to the settlements of litigation relating to Class Members No Longer Owning Debentures (as defined).
The components of the gain from the settlements of litigation are as follows (in thousands):
For the years ended December 31, ------------ 1999 1997 ---- ---- Decrease in subordinated debentures, net $ 421 710 Decrease in deferred interest on the subordinated debentures 622 735 ------- ------ 1,043 1,445 Amounts due under settlement (467) (214) ------- ------ Pre-tax gain on settlement of litigation 576 1,231 Income taxes 222 475 ------- ------ Net gain on settlements of litigation $ 354 756 ======= ======
For financial statement purposes, the Debentures in the 1991 and 1989 Exchange Transactions had been discounted to yield 19% and 12%, respectively, over their term. The interest on the debentures in the 1991 and 1989 Exchange Transactions was 13% and 12%, respectively per annum.
During the year ended December 31, 1998, the Company reacquired approximately $603,000 of debentures and accrued interest for approximately $503,000 resulting in a gain of approximately $100,000. Such gain is reflected as an extraordinary item, net of income taxes of $39,000 in the accompanying financial statements. During the year ended December 31, 1997, the Company reacquired approximately $1,147,000 of debentures and accrued interest for approximately $960,000, resulting in a gain of approximately $187,000. Such gain is reflected as an extraordinary item, net of income taxes of $72,000 in the accompanying financial statements.
4. VENTURE CAPITAL INVESTMENTS
Through December 31, 1999, the Company had provided venture capital to seven entities in the early stages of their development. Two of these entities are in the retail sector and five of these entities are in the internet technology industry. The Company's venture investments are not public entities and therefore there is no liquidity and no available quoted market value for these investments. Accordingly, they are carried at the Company's cost, which is believed to approximate market value.
During 1999, the Company invested approximately $6.7 million in five unaffiliated technology entities. During 2000, these investments were contributed to a specified asset limited partnership managed by an affiliate of the Company. Interests in such partnership were sold in March 2000 to accredited investors in a private offering and the Company received approximately $6.2 million of the proceeds. The Company's net investment after receipt of the proceeds will be approximately $1.8 million. It is anticipated that the Company may form additional partnerships in the future to invest in the technology sector.
5. MORTGAGE NOTES AND RELATED RECEIVABLES - NET
Mortgage notes and related receivables as of December 31, 1999 and 1998 are summarized below (in thousands):
1999 1998 ---- ---- Originating from: Investment properties $ 3,221 3,375 Less: Principally, deferred profit (824) (863) Allowance for impairment (1,072) (772) ------- ------ Total $ 1,325 1,740 ======= ======
An allowance for loss on mortgage notes due from affiliated limited partnerships of $300,000 was recorded during 1999. This allowance for loss was based upon management's determination regarding the net carrying value of the loans and the estimated fair value of the underlying collateral.
6. INVESTMENT REAL ESTATE
Investment real estate consists of the following (in thousands):
December 31, ------------ 1999 1998 ---- ---- Land $ 1,031 1,031 Buildings and improvements 10,355 10,203 Other real estate 74 86 ------- ------ 11,460 11,320 Less: Accumulated depreciation 4,940 4,431 Deferred profit 717 717 ------- ------ 5,657 5,148 ------- ------ $ 5,803 6,172 ======= ======
In October 1998, the Company sold approximately 15,000 square feet of the BMOC property to an unaffiliated third party for $500,000 and the Company recognized a net gain from the sale of real estate of approximately $301,000.
7. REAL ESTATE HELD FOR DEVELOPMENT AND SALE
In 1999, the Company received approximately $259,000 for liquidation of a retained interest from a 1996 sale of real estate held for development and sales. In December 1994, an entity controlled by the Company acquired from an unaffiliated seller approximately 70 acres of unimproved land known as the "Center Port" property in Pompano Beach, Florida. Through December 31, 1999, approximately 50 acres of the Center Port property had been sold to unaffiliated third parties for approximately $13.6 million and the Company recognized net gains from the sales of real estate of approximately $3.4 million. Included in cost of sales is approximately $2.4 million representing profit participation from the transaction to John E. Abdo, Vice Chairman of the Board and certain of his affiliates (the "Abdo Group"). Payment of any profit participation to the Abdo Group will be deferred until the Company is repaid on advances and interest. The remainder of the Center Port property is currently being marketed for sale.
8. MORTGAGES PAYABLE AND OTHER BORROWINGS
Mortgages payable and other borrowings at December 31, 1999 and 1998 are summarized as follows (in thousands):
December 31, Approximate ------------ Type of Debt Maturity Interest Rate 1999 1998 ------------ -------- ------------- ---- ---- Related to mortgage receivables 2000-2010 6% - 9.5% $ 1,275 1,434 Related to real estate 2007 9.20% 8,898 8,999 Other borrowings 2000 Prime plus 1% 8,080 351 ----- ------- $ 18,253 10,784 ====== ======
All mortgage payables and other borrowings above are from unaffiliated parties. Included in other borrowings at December 31, 1999 and 1998 is approximately $8.08 million and $351,000, respectively, due to financial institutions.
At December 31, 1999, the Company had a revolving line of credit in the amount of $8.08 million requiring only interest payments at prime plus 1% and a maturity date of May 2000. The outstanding balance at December 31, 1999 was $8.08 million.
In August 1997, a $3.5 million note due in September 1999 was converted to a revolving line of credit, requiring only interest payments at prime plus 1% and a maximum amount of $2,857,600. In September 1999, the line of credit was paid. At December 31, 1998 the balance due on the revolving line of credit was $350,000.
In December 1994, the Company established a broker line of credit in the amount of $850,000 which is currently collateralized by 170,000 shares of BankAtlantic Bancorp, Inc. Class B Common Stock. At December 31, 1999, the outstanding balance on the above line was zero.
At December 31, 1999 the aggregate principal amount of the above indebtedness maturing in each of the next five years is approximately as follows (in thousands):
Year ending December 31, Amount ------------ ------ 2000 $ 8,361 2001 307 2002 325 2003 246 2004 240 Thereafter 8,774 ------ $ 18,253 ======
The majority of the Company's marketable securities, mortgage receivables, real estate held for development and sale and investment real estate, net are as to real estate and marketable securities, encumbered by, or, as to mortgages receivable, subordinate to mortgages payable and other debt. In the aggregate, approximately 26% of the shares of common stock of BBC owned by BFC are pledged as collateral on mortgages payable and other borrowings.
9. INCOME TAXES
The provision for income tax expense (benefit) for the years ended December 31, 1999, 1998 and 1997 consists of the following (in thousands):
Year Ended December 31, ----------------------- 1999 1998 1997 ---- ---- ---- Current: Federal $ 80 90 -- ------- ------ -----
Deferred: Federal 3,528 (394) 3,621 State 575 (64) 601 ------- ------ ----- 4,103 (458) 4,222 ------- ------ ----- Total $ 4,183 (368) 4,222 ======= ====== =====
For the years ended December 31, 1999, 1998 and 1997, deferred income taxes applicable to extraordinary items were $110,000, $39,000 and $661,000, respectively.
A reconciliation from the statutory federal income tax rate of 35% for the years ended December 31, 1999, 1998 and 1997 to the effective tax rate is as follows (in thousands):
Year ended December 31, ----------------------- 1999(1) 1998(1) 1997(1) ------- ------ ------ Expected tax expense (benefit) $ 4,002 (17) 4,546 Provision (benefit) for state taxes net of federal effect 374 (42) 410 Dividend received deduction (346) (333) (287) Other, net 153 24 (447) ------- ------ ------ 4,183 (368) 4,222 ======= ====== ======
(1) Expected tax is computed based upon income (loss) before extraordinary items.
The tax effects of temporary differences that give rise to significant components of the deferred tax assets and tax liabilities at December 31, 1999, 1998 and 1997 were (in thousands):
December 31, ------------ 1999 1998 1997 ---- ---- ---- Deferred tax assets: Mortgages receivable $ 398 283 284 Other liabilities 118 118 134 Other assets 131 74 53 Alternative minimum tax credit 157 66 -- Net operating loss carryforwards 4,352 5,649 6,945 -------- ------- ------- Total gross deferred tax assets 5,156 6,190 7,416 -------- ------- -------
Deferred tax liabilities: Real estate, net 424 722 1,353 Investment in BBC 18,265 18,574 17,656 Securities available for sale 61 -- -- Subordinated Debentures -- 100 118 -------- ------- ------- Total gross deferred tax liabilities 18,750 19,396 19,127 -------- ------- ------- Net deferred tax liability 13,594 13,206 11,711 Less deferred tax liability at beginning of period (13,206) (11,711) (5,277) Less deferred provision for income tax applicable to extraordinary items (110) (39) (661) Decrease (increase) in deferred tax liability on the Company's unrealized (appreciation) depreciation on securities available for sale included as a separate component of stockholders' equity (60) -- -- Decrease (increase) in deferred tax liability on BBC's unrealized depreciation (appreciation) on debt securities available for sale and other capital transactions included as a separate component of stockholders' equity 3,885 (1,914) (1,551) -------- ------- ------- Deferred provision (benefit) for income taxes $ 4,103 (458) 4,222 ======== ======= =======
The Company believes it will utilize its deferred tax assets through taxable income generated in future years by the reversal of deferred tax liabilities existing as of December 31, 1999.
At December 31, 1999, the Company had estimated state and federal net operating loss carry forwards as follows (in thousands):
Expiration Year State Federal ---- ----- ------- 2006 919 -- 2007 4,235 5,144 2008 2,332 3,322 2011 1,662 1,831 2012 669 984 ---- ------- ------ $ 9,817 11,281 ======= ======
The Company made income tax payments of approximately $ 92,000 and $62,000 during the years ended December 31, 1999 and 1998, respectively and none in 1997. The Company received income tax refunds of approximately $23,000 and $70,000 during the years ended December 31, 1999 and 1997, and none in 1998. BBC is not included in the Company's consolidated tax return.
10. STOCKHOLDERS' EQUITY
The Company's Articles of Incorporation authorize the issuance of up to 10,000,000 shares of $.01 par value preferred stock. The Board of Directors has the authority to divide the authorized preferred stock into series or classes having the relative rights, preferences and limitations as may be determined by the Board of Directors without the prior approval of shareholders. The Board of Directors has the power to issue this preferred stock on terms which would create a preference over the Company's Common Stock with respect to dividends, liquidation and voting rights. No further vote of security holders would be required prior to the issuance of the shares.
The Company's Articles of Incorporation authorize the Company to issue both a Class A Common Stock, par value $.01 per share and a Class B Common Stock, par value $.01 per share. The Class A Common Stock and the Class B Common Stock have substantially identical terms except that (i) the Class B Common Stock is entitled to one vote per share while the Class A Common Stock will have no voting rights other than those required by Florida law and (ii) each share of Class B Common Stock is convertible at the option of the holder thereof into one share of Class A Common Stock.
On January 10, 1997, the Board of Directors of BFC Financial Corporation adopted a Shareholder Rights Plan. As part of the Rights Plan, the Company declared a dividend distribution of one preferred stock purchase right (the "Right") for each outstanding share of BFC's Class B Common Stock to shareholders of record on January 21, 1997. Each Right will become exercisable only upon the occurrence of certain events, including the acquisition of 20% or more of BFC's Class B Common Stock by persons other than the existing control shareholders (as specified in the Rights Plan), and will entitle the holder to purchase either BFC stock or shares in the acquiring entity at half the market price of such shares. The Rights may be redeemed by the Board of Directors at $.01 per Right until the tenth day following the acquisition of 20% or more of BFC's Class B Common Stock by persons other than the existing controlling shareholders. The Board may also, in its discretion, extend the period for redemption. The Rights will expire on January 10, 2007.
11. EARNINGS ON RENTAL REAL ESTATE OPERATIONS, NET
Following are the components of earnings on real estate rental operations, net for each of the years in the three year period ended December 31, 1999 (in thousands):
Year ended December 31, ----------------------- 1999 1998 1997 ---- ---- ---- Operations from investment real estate (see note 6) $1,074 939 989 Deferred profit recognized 38 40 45 ------ ----- -----
$1,112 979 1,034 ====== ===== =====
12. RELATED PARTY TRANSACTIONS
Related party transactions arise from transactions with affiliated entities. In addition to transactions described in notes elsewhere herein, a summary of originating related party transactions is as follows (in thousands):
Year ended December 31, ---------------------- 1999 1998 1997 ---- ---- ---- Property management fee revenue $ 7 10 90 ==== == ===
Reimbursement revenue for administrative, accounting and legal services $167 52 121 ==== == ===
The Company has a 49.5% interest and affiliates and third parties have a 50.5% interest in a limited partnership formed in 1979, for which the Company's Chairman serves as the individual General Partner. The partnership's primary asset is real estate subject to net lease agreements. The Company's cost for this investment, approximately $441,000, was written off in 1990 due to the bankruptcy of the entity leasing the real estate. Any recovery will be recognized in income when received. During 1999, the Company received distributions of approximately $588,000 from the partnership due to the sale of its 31 of 34 convenience stores that it owned. The $588,000 has been included in earnings from real estate limited partnerships.
Included in other assets at December 31, 1999, 1998 and 1997 was approximately $152,000, $202,000 and $158,000, respectively due from affiliates.
Alan B. Levan, President and Chairman of the Board of the Company also serves as Chairman of the Board and Chief Executive Officer of BankAtlantic Bancorp, Inc. and BankAtlantic.
John E. Abdo, Vice Chairman of the Board of the Company also serves as Vice Chairman of the Board of Directors of BBC and BankAtlantic and is a director and President of BankAtlantic Development Corporation ("BDC"), a wholly owned subsidiary of BankAtlantic.
Glen R. Gilbert, Executive Vice President of the Company also serves as a director and Executive Vice President of BDC.
Florida Partners Corporation owns 133,314 shares of the Company's Class B Common Stock and 366,615 shares of the Company's Class A Common Stock. Alan B. Levan may be deemed to beneficially be the principal shareholder and is a member of the Board of Florida Partners Corporation. Glen R. Gilbert, Executive Vice President and Secretary of the Company holds similar positions at Florida Partners Corporation.
The trustee for the escrow account with respect to the called debenture liability maintains such account at BankAtlantic. Pursuant to terms of escrow agreement, in January 2000, the amount remaining in escrow was released to the Company. The Company received approximately $2.4 million.
13. EMPLOYEE BENEFIT PLANS
The Company's Stock Option Plan provides for the grant of stock options to purchase shares of the Company's Common Stock. The plan provided for the grant of both incentive stock options and non-qualifying options. The exercise price of a stock option will not be less than the fair market value of the Common Stock on the date of the grant and the maximum term of the option is ten years. The following table sets forth information on all outstanding options:
Class B Outstanding Options Price per Share ------- --------------- Outstanding at December 31, 1996 1,548,753 1.13 to 1.32 Issued 918,750 4.07 to 4.47 Exercised (72,096) 1.13 to 1.32 ----------- Outstanding at December 31, 1997 2,395,407 1.13 to 4.47 Issued 532,500 10.34 to 10.34 Exercised (8,500) 4.07 to 4.07 ----------- Outstanding at December 31, 1998 2,919,407 1.13 to 10.34 Issued 182,500 6.00 to 6.00 ---------- Outstanding at December 31, 1999 3,101,907 1.13 to 10.34 ========= Exercisable at December 31, 1999 2,919,407 1.13 to 4.47 ========= Available for grant at December 31, 1999 543,125 ==========
The weighted average exercise price of options outstanding at December 31, 1999, 1998 and 1997 was $4.03, $3.90 and $2.47, respectively. The weighted average price of options exercised was $4.07 and $1.24 during the years 1998 and 1997, respectively and none in 1999.
The adoption of FAS 123 under the fair value based method would have increased compensation expense by approximately $134,000, $3,099,000 and $1,066,000 for the years ended December 31, 1999, 1998 and 1997, respectively. The effect of FAS 123 under the fair value based method would have affected net income and earnings per share as follows:
For the Years Ended December 31, ------------------- 1999 1998 1997 ---- ---- ---- Net income (loss): As reported $ 7,426 380 9,818 Proforma 7,344 (1,441) 9,164 Basic earnings per share: As reported .93 .05 1.23 Proforma .92 (.18) 1.15 Diluted earnings per share: As reported .84 .04 1.12 Proforma .83 (.16) 1.05
The option model used to calculate the FAS 123 compensation adjustment was the Black-Scholes model with the following grant date fair values and assumptions:
* Both non-qualified and incentive stock options were granted.
The employee turnover was considered to be none. The weighted average fair value of options granted during the years ended December 31, 1999, 1998 and 1997 was $4.99, $5.87 and $1.71, respectively.
The following table summarizes information about fixed stock options outstanding at December 31, 1999:
The Company has an employee's profit-sharing plan which provides for contributions to a fund of a sum as defined, but not to exceed the amount permitted under the Internal Revenue Service Code as deductible expense. The provision charged to operations was approximately $30,000, $20,000 and $10,000 for the year ended December 31, 1999, 1998 and 1997, respectively. Contributions are funded on a current basis.
14. LITIGATION
The following is a description of certain lawsuits to which the Company is or has been a party.
Alan B. Levan and BFC Financial Corporation v. Capital Cities/ABC, Inc. and - --------------------------------------------------------------------------- William H. Wilson, in the United States District Court for the Southern District - -------------------------------------------------------------------------------- of Florida, Case No. 92-325-Civ-Atkins. - --------------------------------------- On November 29, 1991, The ABC television program 20/20 broadcast a story about Alan B. Levan and the Company that purportedly depicted a number of securities transactions in which Mr. Levan and the Company were involved. The story contained numerous false and defamatory statements about the Company and Mr. Levan and, on February 7, 1992, a defamation lawsuit was filed on behalf of the Company and Mr. Levan against Capital Cities/ABC, Inc. and William H. Wilson, the producer of the broadcast. In December 1996, a jury found in favor of the Company and Mr. Levan and awarded a compensatory judgment of $1.25 million to the Company and $8.75 million to Mr. Levan. Capital Cities/ABC, Inc. and William H. Wilson filed an appeal in this matter and the Appellate Court reversed the lower court judgment. The Company and Mr. Levan filed a petition for certiorari review with the Supreme Court. On February 28, 2000, the petition was denied.
The Company is also a party to certain other litigation arising in the ordinary course of its business. Management does not believe such litigation will have a material adverse effect on its financial condition or results of operations.
15. QUARTERLY FINANCIAL INFORMATION (unaudited)
Following is quarterly financial information for the years ended December 31, 1999 and 1998 (in thousands, except per share data):
1999 Quarter Ended ------------------ Mar 31 Jun 30 Sep 30 Dec 31 Total ------ ------ ------ ------ ----- Revenues $4,827 4,053 5,355 3,464 17,699 Costs and expenses 1,531 1,095 946 2,693 6,265 Income before extraordinary items 1,920 1,943 2,795 593 7,251 Net income 1,920 1,943 2,908 655 7,426 ====== ===== ===== ===== ======
Basic earnings per share: Before extraordinary items .24 .24 .35 .07 .91 Extraordinary items -- -- .01 .01 .02 ------ ----- ----- ----- ------ Net income .24 .24 .36 .08 .93 ====== ===== ===== ===== ======
Diluted earnings per share: Before extraordinary items .22 .22 .32 .07 .82 Extraordinary items -- -- .01 .01 .02 ------ ----- ----- ----- ------ Net income .22 .22 .33 .08 .84 ====== ===== ===== ===== ======
Basic weighted average number of common shares outstanding 7,957 7,957 7,957 7,957 7,957 ====== ===== ===== ===== ======
Diluted weighted average number of common shares outstanding 8,928 8,853 8,780 8,660 8,818 ====== ===== ===== ===== ======
During the three month periods ended March 31, 1999, June 30, 1999 and December 31, 1999 the Company sold 4 acres, 1 acre and 3 acres of the Center Port property to unaffiliated third parties for approximately $829,000, $243,000 and $1,591,000, respectively. The Company recognized net gains of approximately $250,000, 74,000 and $302,000 during the three month periods ended March 31, 1999, June 30, 1999 and December 31, 1999, respectively.
During the three month period ended September 30, 1999, the Company sold the ownership interest in parcels of land occupied by two Toys R Us stores located in Springfield, Massachusetts and Aurora, Illinois for approximately $825,000. The Company recognized a net gain on this transaction of approximately $766,000.
During the quarter ended March 31, 1999, the Company received distributions of approximately $588,000 from a real estate limited partnership in which the Company holds an interest when the limited partnership sold 31 of 34 convenience stores that it owned. The Company has a 49.5% interest in this partnership and had written off its investment of approximately $441,000 in 1990 due to the bankruptcy of the entity leasing the real estate. Also, during the quarter ended March 31, 1999, the Company received a distribution of approximately $263,000 from the liquidation of a retained interest relating to a piece of real estate sold in 1996.
Operations during the quarter ended September 30, 1999 and December 31, 1999 included extraordinary gains, net of income taxes of approximately $292,000 and $62,000, respectively, due to settlement of litigation. Operations during the quarter ended September 30, 1999 included an extraordinary loss from extinguishments of debt, net of income taxes of approximately $179,000.
1998 Quarter Ended ------------------ Mar 31 Jun 30 Sep 30 Dec 31 Total ------ ------ ------ ------ ----- Revenues $2,431 6,400 1,953 1,874 12,658 Costs and expenses 1,129 3,645 4,067 3,866 12,707 Income (loss) before extraordinary item 991 1,753 (1,196) (1,229) 319 Net income (loss) 991 1,770 (1,152) (1,229) 380 ====== ===== ===== ===== ======
Basic earnings (loss) per share: Before extraordinary items .13 .22 (.15) (.15) .04 Extraordinary items -- -- .01 -- .01 ------ ----- ----- ----- ------ Net income (loss) .13 .22 (.14) (.15) .05 ====== ===== ===== ===== ======
Diluted earnings (loss) per share: Before extraordinary items .11 .19 (.13) (.14) .04 Extraordinary items -- -- -- -- -- ------ ----- ----- ----- ------ Net income (loss) .11 .19 (.13) (.14) .04 ====== ===== ===== ===== ======
Basic weighted average number of common shares outstanding 7,949 7,952 7,957 7,957 7,954 ====== ===== ===== ===== ======
Diluted weighted average number of common shares outstanding 9,252 9,161 9,049 8,972 9,101 ====== ===== ===== ===== ======
During the three month periods ended June 30, 1998, September 30, 1998 and December 31, 1998, the Company sold approximately 18 acres, 17 acres and 3 acres of the Center Port property to unaffiliated third parties for approximately $3.4 million, $4.4 million and $3.1 million, respectively. The Company recognized a net gain from the sale of real estate of approximately $1.0 million, $1.3 million and $0.3 million for the three month periods ended June 30, 1998, September 30, 1998 and December 31, 1998, respectively.
Operations for the quarter ended June 30, 1998 and September 30, 1998 included extraordinary gains of approximately $17,000 and $44,000, respectively, net of income taxes due to extinguishment of debt.
16. CONSOLIDATED STATEMENTS OF CASH FLOWS
In addition to the non-cash investing and financing activities described elsewhere herein, other non-cash investing and financing activities are as follows:
Year Ended December 31, ----------------------- 1999 1998 1997 ---- ---- ---- The change in stockholders' equity resulting from the Company's proportionate share of BBC's net unrealized (depreciation) appreciation on securities available for sale, less related deferred income taxes (5,983) 539 (53) ====== ===== ======= Change in stockholders' equity resulting from the Company's net unrealized appreciation on securities available for sale, net of deferred income taxes 96 -- -- ====== ===== ======= Net (loss) gain from extinguishment of debt, net of income taxes (179) 61 115 ====== ===== ======= The net gains associated with the settlements of litigation, net of income taxes 354 -- 756 ====== ===== ======= Net gain on debt restructuring, net of income taxes -- -- 181 ====== ===== ======= Transfers from escrow accounts to reflect payments on subordinated debentures 356 306 10,930 ====== ===== ======= Net (loss) gain effect of BBC capital transactions, net of income taxes (205) 2,510 2,759 ====== ===== ======= Conversion of mortgage receivable to an equity interest in an affiliated partnership -- -- 184 ====== ===== ======= Increase in equity for the tax effect related to the exercise of employee stock options -- 25 65 ====== ===== ======= Deferred profit recognized -- 316 -- ====== ===== ======= BBC dividends on common stock declared and paid in subsequent period 322 303 288 ====== ===== ======= Interest paid on borrowings 3,381 1,444 2,073 ====== ===== =======
17. ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS
The information set forth below provides disclosure of the estimated fair value of the Company's financial instruments presented in accordance with the requirements of Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" (FAS 107) issued by the FASB.
Management has made estimates of fair value discount rates that it believes to be reasonable. However, because there is no market for many of these financial instruments, management has no basis to determine whether the fair value presented would be indicative of the value negotiated in an actual sale. The Company's fair value estimates do not consider the tax effect that would be associated with the disposition of the assets or liabilities at their fair value estimates. The fair value of the investment in BBC and securities available for sale were based upon their respective stock prices at December 31, 1999 and 1998.
The following table presents information for the Company's financial instruments as of December 31, 1999 and 1998 (in thousands):
December 31, 1999 December 31, 1998 ----------------- ----------------- Carrying Fair Carrying Fair Value Value Amount Value ----- ----- ------ ----- Financial assets: Cash and cash equivalents $ 1,545 1,545 2,523 2,523 Investment in BBC 73,764 59,215 74,565 77,096 Securities available for sale 255 255 107 107 Venture capital investments 8,408 8,408 343 343 Mortgage notes and related receivables, net 1,325 1,325 1,740 1,740 Escrow for called debentures 2,659 2,659 2,738 2,738
Financial liabilities: Mortgage payables and other borrowings 18,253 18,253 22,943 22,943 Subordinated debentures, net -- -- 7,263 7,263 Deferred interest on debentures -- -- 2,106 2,106
18. EARNINGS PER SHARE
The following table reconciles the numerators and denominators of the basic and diluted earnings per share computations for each of the years in the three year period ended December 31, 1999 (in thousands, except per share data):
Year Ended December 31, ----------------------- 1999 1998 1997 ---- ---- ---- Basic Numerator: Net income $7,426 380 9,818 ====== ===== =====
Basic Denominator Weighted average shares outstanding (3) 7,957 7,954 7,938 ====== ===== =====
Basic earnings per share $ .93 .05 1.23 ====== ===== =====
Diluted Numerator: Dilutive net income $7,426 380 9,818 ====== ===== =====
Diluted Denominator Basic weighted average shares outstanding (3) 7,957 7,954 7,938 Options (2) 861 1,147 793 ------ ----- ----- Diluted weighted average shares outstanding 8,818 9,101 8,731 ====== ===== =====
Diluted earnings per share $ .84 .04 1.12 ====== ===== ===== - ---------- (1) Prior to 1997 there were no Class A common shares outstanding. All shares outstanding prior to 1997 were Class B common shares. While the Company has two classes of common stock outstanding, the two-class method is not presented because the company's capital structure does not provide for different dividend rates or other preferences, other than voting rights, between the two classes. (2) The number of options considered outstanding shares for diluted earnings per share is based upon application of the treasury stock method to the options outstanding as of the end of the period. (3) I.R.E. Realty Advisory Group, Inc. ("RAG") owns 1,375,000 of BFC Financial Corporation's Class A Common Stock and 500,000 shares of BFC Financial Corporation Class B Common Stock. Because the Company owns 45.5% of the outstanding common stock of RAG, 624,938 shares of Class A Common Stock and 227,500 shares of Class B Common Stock are eliminated from the number of shares outstanding for purposes of computing earnings per share.
19. SEGMENT REPORTING
The standard for disclosures about segments of an enterprise establishes standards for reporting information about operating segments and related disclosures about products and services. Operating segments are defined as components of an enterprise about which separate financial information is available that is regularly reviewed by the chief operating decision maker in deciding how to allocate resources and in assessing performance. Reportable segments consist of one or more operating segments with similar economic characteristics, products and services, production processes, type of customer, distribution system and regulatory environment. The information provided for segment reporting is based on internal reports utilized by management. The presentation and the net contribution calculated under the management approach may not reflect the actual economic costs, contribution or results of operations of the unit as a stand alone business. If a different basis of allocation was utilized, the relative contributions of the segments might differ but the relative trends in segments would, in management's view, likely not be impacted.
The Company utilizes three reportable segments:
o Investment in BBC o Real estate operations o Other
Investment in BBC consist of the Company's ownership interest in the common stock of BBC. The Company's ownership position is carried on the equity method and the Company's ownership in BBC for each of the years ended December 31, 1999 and 1998 was approximately 31.3% and as of December 31, 1997 was 35.6% of all of the outstanding BBC Common Stock. In addition to its investment in BBC, the Company owns and manages real estate, included in the Consolidated Statements of Financial Condition as investment real estate, net and real estate held for development and sale. Investment real estate, net includes the BMOC property and a 50% interest in the Delray property. The real estate held for development and sale is the Center Port property, part of which is being developed and the remainder of which is being held for sale. Real estate operations also include mortgage notes receivable that relate to the sale of properties previously owned by the Company. Other includes venture capital investments, securities available for sale, repurchase agreements and escrow accounts related to a portion of debentures that were cancelled in connection with the settlement of litigation.
The accounting policies of the segments are the same as those described in the summary of significant accounting policies.
The Company evaluates segment performance based on its operating profit (loss) before tax and overhead allocations. The table below is segment information for the three years ended December 31, 1999, 1998 and 1997:
* * * * * * * * * * * * * * * * * * * * * * * * * * * *
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
Items 10 through 13 are incorporated by reference to the Company's definitive proxy statement to be filed with the Securities and Exchange Commission, no later than 120 days after the end of the year covered by this Form 10-K, or, alternatively, by amendment to this Form 10-K under cover of Form 10K/A not later than the end of such 120 day period.
Item 14
Item 14 (d), financial statements of subsidiaries not consolidated and fifty percent or less owned persons, is incorporated by reference to the annual report on Form 10-K of BankAtlantic Bancorp, Inc. for the fiscal year ended December 31, 1999, Commission File Number 34-027228, filed with the Securities and Exchange Commission.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)-1 Financial Statements - See Item 8
(a)-2 Financial Statement Schedules - All schedules are omitted as the required information is either not applicable or presented in the financial statements or related notes.
(a)-3 Index to Exhibits
3.1 Articles of Incorporation, as amended and restated - See Exhibit 3.1 of Registrant's Registration Statement on Form 8-A filed October 16, 1997.
3.2 By-laws - See Exhibit (3.1) of Registrant's Registration Statement on Form 8-A filed October 16, 1997.
10.1 BFC Financial Corporation Stock Option Plan - See Exhibit A to Registrant's Definitive Proxy Statement filed September 24, 1997.
12 Statement re computation of ratios - Ratio of earnings to fixed charges - attached as Exhibit 12.
21 Subsidiaries of the registrant:
State of Name Organization ---------------------------------------------- ------------ BankAtlantic Bancorp, Inc. Florida Eden Services, Inc. Florida U.S. Capital Securities, Inc. Florida I.R.E. Realty Advisory Group, Inc. Florida I.R.E. Real Estate Investments, Inc. Florida I.R.E. Real Estate Investments, Series 2, Inc. Florida I.R.E. Property Management, Inc. Florida I.R.E. Real Estate Funds, Inc. Florida I.R.E. Pension Advisors II, Corp. Florida Center Port Development, Inc. Florida I.R.E. BMOC, Inc. Florida I.R.E. BMOC II, Inc. Florida BFC Venture Partners, Inc. Florida
23 Consent of KPMG LLP - Attached as Exhibit 23
27 Financial data schedule for the year ended December 31, 1999. - Attached as Exhibit 27.
(b) Reports on Form 8-K
None
(c) Exhibits - See 14(a) - 3 above.
(d) Financial statements of subsidiaries not consolidated and fifty percent or less owned persons:
Annual report on Form 10-K for the fiscal year ended December 31, 1999 of BankAtlantic Bancorp, Inc.is incorporated herein by reference.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
BFC FINANCIAL CORPORATION Registrant
By: /S/ Alan B. Levan March 21, 2000 ----------------------------------- Alan B. Levan, President
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
/S/ Alan B. Levan March 21, 2000 - ---------------------------------------- ALAN B. LEVAN, Director and Principal Executive Officer
/S/ Glen R. Gilbert March 21, 2000 - ---------------------------------------- GLEN R. GILBERT, Chief Financial Officer
/S/ John E. Abdo March 21, 2000 - ---------------------------------------- JOHN E. ABDO, Director
/S/ Earl Pertnoy March 21, 2000 - ---------------------------------------- EARL PERTNOY, Director
/S/ Carl E.B. McKenry, Jr. March 21, 2000 - ---------------------------------------- CARL E. B. McKENRY, JR., Director | 20,123 | 129,234 |
835666_1999.txt | 835666_1999 | 1999 | 835666 | Item 1: Business --------
(a) General Development of Business: -------------------------------
ML Futures Investments L.P. (the "Partnership") was organized under the Delaware Revised Uniform Limited Partnership Act on November 14, 1988 and began trading operations on March 1, 1989. The Partnership made a single offering of its units of limited partnership interest ("Units"). Units may be redeemed as of the end of each calendar month. The Partnership engages (currently, through an investment in a limited liability company, see below) in the speculative trading of a portfolio of futures, options on futures, forwards and options on forward contracts and related options in the currencies, interest rates, stock index, metals, agricultural and energy sectors of the world futures markets. The Partnership's objective is achieving, through speculative trading, substantial capital appreciation over time.
Merrill Lynch Investment Partners Inc. ("MLIP") is the general partner of the Partnership and selects and allocates the Fund's assets (through the Fund's investment in ML Multi-Manager Portfolio LLC ("MM LLC"), among professional advisors ("Advisors"), each of which trades independently of the others. The Partnership and MM LLC are referred to throughout this document, either individually and/or collectively, as the "Fund". Merrill Lynch Futures Inc. ("MLF") is the Fund's commodity broker. A portion of the Fund's assets is held by a commodity broker, other than MLF, to facilitate the trading of a certain independent advisor. MLIP is a wholly-owned subsidiary of Merrill Lynch Group, Inc., which, in turn, is a wholly-owned subsidiary of Merrill Lynch & Co., Inc. ("ML&Co."). The Commodity Broker is an indirect wholly-owned subsidiary of ML&Co. (ML& Co. and its affiliates are herein sometimes referred to as "Merrill Lynch.").
Prior to October 1, 1996, the Partnership placed assets with the Advisors by opening individual managed accounts with them. For the period from October 1, 1996 to May 31, 1998, the Partnership placed assets with certain of the Advisors through investing in private funds ("Trading LLCs") sponsored by MLIP, through which the trading accounts of different MLIP-sponsored funds managed by the same Advisor pursuant to the same strategy were consolidated. The only members of the Trading LLCs were commodity pools sponsored by MLIP. Placing assets with an Advisor through investing in a Trading LLC rather than a managed account had no economic effect on the Partnership, except to the extent that the Partnership benefited from the Advisor not having to allocate trades among a number of different accounts (rather than acquiring a single position for the Trading LLC as a whole). As of June 1, 1998, MLIP consolidated the trading accounts of nine of its multi-advisor funds (the "Multi-Advisor Funds"), including the Fund. The consolidation was achieved by having these Multi-Advisor Funds invest in a single Delaware limited liability company, MM LLC, which opened a single account with each Advisor selected. MM LLC is managed by MLIP, has no investors other than the Multi-Advisor Funds and serves solely as the vehicle through which the assets of such Multi-Advisor Funds are combined in order to be managed through single rather than multiple accounts. The placement of assets into MM LLC did not change the operations or fee structure of the Partnership. The administrative authority over the Partnership, as well as MM LLC, remains with MLIP. The following disclosures relate to the operation of the Partnership through its investment in MM LLC.
As of December 31, 1999, the capitalization of the Fund was $17,051,954, and the Net Asset Value per Unit, originally $100 as of March 1, 1989, had risen to $238.05.
Through December 31, 1999, the net gain in the Net Asset Value per Unit was 138.05%. The highest month-end Net Asset Value per Unit through December 31, 1999 was $242.21 (April 30, 1999) and the lowest, $99.88 (March 31, 1989).
(b) Financial Information about Segments: ------------------------------------
The Partnership's business constitutes only one segment for financial reporting purposes, i.e., a speculative "commodity pool." The Partnership does not engage in sales of goods or services.
(c) Narrative Description of Business: ---------------------------------
General
The Fund trades (currently, through its investment in MM LLC) in the international futures, options on futures and forward markets with the objective of achieving substantial capital appreciation over time.
MLIP is MM LLC's trading manager, with responsibility for selecting Advisors to manage MM LLC's assets, allocating and reallocating MM LLC's assets among different Advisors.
Considered as a whole, the Partnership (currently, through its investment in MM LLC) trades in a diversified range of international markets. Certain of the Advisors, considered individually, concentrate primarily on trading in a limited portfolio of markets. The composition of the "sectors" included in the Partnership's portfolios varies substantially over time.
MLIP may, from time to time, direct certain individual Advisors to manage their Fund accounts as if they were managing more equity than the actual capital allocated to them.
One of the objectives of the Fund is to provide diversification to a limited portion of the risk segment of the Limited Partners' portfolios. Commodity pool performance has historically often demonstrated a low degree of performance correlation with traditional stock and bond holdings. Since it began trading, the Fund's returns have, in fact, frequently been significantly non-correlated with the United States stock and bond markets.
Use of Proceeds and Interest Income
Market Sectors. The Fund trades in a diversified group of -------------- markets under the direction of multiple independent Advisors. These Advisors can, and do, from time to time, materially alter the allocation of their overall trading commitments among different market sectors. Except in the case of certain trading programs which are purposefully limited in the markets which they trade, there is essentially no restriction on the commodity interests which may be traded by any Advisor or the rapidity with which an Advisor may alter its market sector allocations.
Market Types. The Fund trades on a variety of United States ------------ and foreign futures exchanges. Substantially all of the Fund's off-exchange trading takes place in the highly liquid, institutionally-based currency forward markets.
Many of the Partnership's currency trades are executed in the spot and forward foreign exchange markets (the "FX Markets") where there are no direct execution costs. Instead, the participants, banks and dealers in the FX Markets take a "spread" between the prices at which they are prepared to buy and sell a particular currency and such spreads are built into the pricing of the spot or forward contracts with the Partnership.
In its exchange of futures for physical ("EFP") trading, the Partnership acquires cash currency positions through banks and dealers, including Merrill Lynch. The Partnership pays a spread when it exchanges these positions for futures. This spread reflects, in part, the different settlement dates of the cash and the futures contracts, as well as prevailing interest rates, but also includes a pricing spread in favor of the banks and dealers, which may include a Merrill Lynch entity.
As in the case of its market sector allocations, the Fund's commitments to different types of markets -- U.S. and non-U.S., regulated and unregulated -- differ substantially from time to time as well as over time.
The Fund's financial statements contain information relating to the types of markets traded by the Fund. There can, however, be no assurance as to which markets the Fund may trade or as to how the Fund's trading may be concentrated at any one time or over time.
Custody of Assets. The majority of the Fund's assets are ----------------- currently held in customer accounts at Merrill Lynch.
Interest Paid by Merrill Lynch on the Fund's U.S. Dollar and ------------------------------------------------------------- Non-U.S. Dollar Assets. ----------------------- A majority of the Partnership's U.S. dollar assets are maintained at MLF. On assets held in U.S. dollars, Merrill Lynch credits the Partnership with interest at the prevailing 91-day U.S. Treasury bill rate. The Partnership is credited with interest on any of its net gains actually held by Merrill Lynch in non-U.S. dollar currencies at a prevailing local rate received by Merrill Lynch. Merrill Lynch may derive certain economic benefit, in excess of the interest which Merrill Lynch pays to the Partnership, from possession of such assets.
Merrill Lynch charges the Partnership Merrill Lynch's cost of financing realized and unrealized losses on the Partnership's non-U.S. dollar-denominated positions.
Charges
The following table summarizes the charges incurred by the Fund during 1999, 1998 and 1997.
----------------------------
Subsequent to October 1, 1996, Brokerage Commissions, Administrative Fees and Profit Shares are not representative of the actual amounts paid by the Fund, because the Fund paid the bulk of these fees as an investor in the Trading LLCs or MM LLC. See "Description of Current Charges." During 1999, the Fund had 100% of its assets invested in MM LLC.
The foregoing table does not reflect the bid-ask spreads paid by the Fund on its forward trading, or the benefits which may be derived by Merrill Lynch from the deposit of certain of the Fund's U.S. dollar assets in offset accounts.
The Fund's average month-end Net Assets during 1999, 1998 and 1997 equaled $19,015,569, $22,492,364, and $25,313,271, respectively.
Subsequent to October 1, 1996, interest income is not representative of the actual amounts received by the Fund since the bulk of the interest was received by the Fund as an investor in the Trading LLCs or MM LLC. During 1999, the Fund had invested 100% of its assets in MM LLC. During 1998 and 1997, the Fund earned $204,729 and $537,761 in interest income, or approximately 0.91% and 2.12% of the Fund's average month-end Net Assets.
Effective February 1, 1997, the Brokerage Commissions paid by the Fund were reduced from 9.75% to 8.75% per annum.
The variations in charges are primarily due to placing assets in Trading LLCs and MM LLC (See Item 7).
------------------------------
Description of Current Charges
Regulation
MLIP, the Advisors and MLF are each subject to regulation by the Commodity Futures Trading Commission (the "CFTC") and the National Futures Association. Other than in respect of its periodic reporting requirements under the Securities Exchange Act of 1934, the Partnership itself is generally not subject to regulation by the Securities and Exchange Commission. However, MLIP itself is registered as an "investment adviser" under the Investment Advisers Act of 1940.
(i) through (xii)-- not applicable.
(xiii) The Partnership has no employees.
(d) Financial Information about Geographic Areas --------------------------------------------
The Fund trades on a number of foreign commodity exchanges. The Partnership does not engage in the sales of goods or services.
Item 2:
Item 2: Properties ----------
The Partnership does not use any physical properties in the conduct of its business.
The Partnership's only place of business is the place of business of MLIP (Merrill Lynch Investment Partners Inc., Princeton Corporate Campus, 800 Scudders Mill Road Section 2G, Plainsboro, New Jersey 08536). MLIP performs all administrative services for the Partnership from MLIP's offices.
Item 3:
Item 3: Legal Proceedings -----------------
ML&Co. -- the sole stockholder of Merrill Lynch Group, Inc. (which is the sole stockholder of MLIP) -- as well as certain of its subsidiaries and affiliates have been named as defendants in civil actions, arbitration proceedings and claims arising out of their respective business activities. Although the ultimate outcome of these actions cannot be predicted at this time and the results of legal proceedings cannot be predicted with certainty, it is the opinion of management that the result of these matters will not be materially adverse to the business operations or the financial condition of MLIP or the Fund.
MLIP itself has never been the subject of any material litigation.
Item 4:
Item 4: Submission of Matters to a Vote of Security Holders ---------------------------------------------------
The Partnership has never submitted any matter to a vote of its Limited Partners.
PART II
Item 5:
Item 5: Market for Registrant's Common Equity and Related Stockholder Matters ---------------------------------------------------------------------
Item 5(a)
(a) Market Information: ------------------
There is no public trading market for the Units, nor will one develop. Rather, Limited Partners may redeem Units as of the end of each month at Net Asset Value.
(b) Holders: -------
As of December 31, 1999, there were 866 holders of Units, including MLIP.
(c) Dividends: ---------
The Partnership has made no distributions, nor does MLIP presently intend to make any distributions in the future.
Item 5(b)
Not applicable.
Item 6:
Item 6: Selected Financial Data
The following selected financial data has been derived from the audited financial statements of the Partnership:
The variations in income statement line items are primarily due to investing in Trading LLCs and in MM LLC.
Pursuant to CFTC policy, monthly performance is presented from January 1, 1995, even though the Units were outstanding prior to such date.
ML FUTURES INVESTMENTS L.P. December 31, 1999
Type of Pool: Selected-Advisor/Publicly-Offered/Non-"Principal Protected"(1) Inception of Trading: March 1, 1989 Aggregate Subscriptions: $86,500,700 Current Capitalization: $17,051,954 Worst Monthly Drawdown(2): (5.70)% (8/97) Worst Peak-to-Valley Drawdown(3): (8.63)% (6/95-7/96)
-------------
Net Asset Value per Unit, December 31, 1999: $238.05
(1) Pursuant to applicable CFTC regulations, a "Multi-Advisor" fund is defined as one that allocates no more than 25% of its trading assets to any single manager. As the Fund may allocate more than 25% of its trading assets to one or more Advisors, it is referred to as a "Selected-Advisor" fund. Certain funds, including funds sponsored by MLIP, are structured so as to guarantee to investors that their investment will be worth no less than a specified amount (typically, the initial purchase price) as of a date certain after the date of investment. The CFTC refers to such funds as "principal protected." The Partnership has no such feature.
(2) Worst Monthly Drawdown represents the largest negative Monthly Rate of Return experienced since January 1, 1995 by the Fund; a drawdown is measured on the basis of month-end Net Asset Value only, and does not reflect intra-month figures.
(3) Worst Peak-to-Valley Drawdown represents the greatest percentage decline since January 1, 1995 from a month-end cumulative Monthly Rate of Return without such cumulative Monthly Rate of Return being equaled or exceeded as of a subsequent month-end. For example, if the Monthly Rate of Return was (1)% in each of January and February, 1% in March and (2)% in April, the Peak-to-Valley Drawdown would still be continuing at the end of April in the amount of approximately (3)%, whereas if the Monthly Rate of Return had been approximately 3% in March, the Peak-to-Valley Drawdown would have ended as of the end of February at approximately the (2)% level.
(4) Monthly Rate of Return is the net performance of the Fund during the month of determination (including interest income and after all expenses have been accrued or paid) divided by the total equity of the Fund as of the beginning of such month.
Item 7:
Item 7: Management's Discussion and Analysis of Financial Condition and ---------------------------------------------------------------- Results of Operations ---------------------
Results of Operations - ---------------------
Advisor Selections - ------------------
The Fund's results of operations depend on MLIP's ability to select Advisors and the Advisors' ability to trade profitably. MLIP's selection procedures and trading leveraging analysis, as well as the Advisors' trading methods, are confidential, so that substantially the only available information relevant to the Fund's results of operations is its actual performance record to date. Because of the speculative nature of its trading, the Fund's past performance is not necessarily indicative of its future results.
MLIP has made and expects to continue making frequent changes to both trading asset allocations among Advisors and Advisor combinations as well as from time to time adjusting the percentage of the Fund's assets committed to trading.
MLIP's decision to terminate or reallocate assets among Advisors is based on a combination of numerous factors. Advisors are, in general, terminated primarily for unsatisfactory performance, but other factors - -- for example, a change in MLIP's or an Advisor's market outlook, apparent deviation from announced risk control policies, excessive turnover of positions, changes in principals, commitment of resources to other business activities, etc. -- may also have a role in the termination or reallocation decision. The market judgment and experience of MLIP's principals is an important factor in its asset allocation decisions.
MLIP has no timetable or schedule for making Advisor changes or reallocations, and generally makes a medium- to long-term commitment to all Advisors selected. There can be no assurance as to the frequency or number of Advisor changes that may take place in the future, or as to how long any of the current Advisors will continue to manage assets for the Fund.
General - -------
A number of the Advisors are trend-following traders, whose programs do not attempt to predict price movements. No fundamental economic supply or demand analyses are used by these Advisors, and no macroeconomic assessments of the relative strengths of different national economies or economic sectors. Instead, the programs apply proprietary computer models to analyzing past market data, and from this data alone attempt to determine whether market prices are trending. These technical traders base their strategies on the theory that market prices reflect the collective judgment of numerous different traders and are, accordingly, the best and most efficient indication of market movements. However, there are frequent periods during which fundamental factors external to the market dominate prices.
If a trend-following Advisor's models identify a trend, they signal positions which follow it. When these models identify the trend as having ended or reversed, these positions are either closed out or reversed. Due to their trend-following character, these Advisors' programs do not predict either the commencement or the end of a price movement. Rather, their objective is to identify a trend early enough to profit from it and detect its end or reversal in time to close out the Fund's positions while retaining most of the profits made from following the trend.
In analyzing the performance of trend-following programs, economic conditions, political events, weather factors, etc., are not directly relevant because only market data has any input into trading results. Furthermore, there is no direct connection between particular market conditions and price trends. There are so many influences on the markets that the same general type of economic event may lead to a price trend in some cases but not in others. The analysis is further complicated by the fact that the programs are designed to recognize only certain types of trends and to apply only certain criteria of when a trend has begun. Consequently, even though significant price trends may occur, if these trends are not comprised of the type of intra-period price movements which the programs are designed to identify, a trend-following Advisor may miss the trend altogether.
In the case of the Advisors which implement strategies which rely more on discretion and market judgment, it is not possible to predict, from their performance during past market cycles, how they will respond to future market events.
Performance Summary - -------------------
This performance summary is an outline description of how the Fund performed in the past, not necessarily any indication of how it will perform in the future. In addition, the general causes to which certain price movements are attributed may or may not in fact have caused such movements, but simply occurred at or about the same time.
The Advisors, as a group, are unlikely to be profitable in markets in which such trends do not occur. Static or erratic prices are likely to result in losses. Similarly, unexpected events (for example, a political upheaval, natural disaster or governmental intervention) can lead to major short-term losses as well as gains.
While there can be no assurance that any Advisor will be profitable, under any given market condition, markets in which substantial and sustained price movements occur typically offer the best profit potential for the Fund.
During 1999, all of the Fund's assets were invested in MM LLC. The Fund received trading profits as an investor in MM LLC. The following commentary for 1999 describes the trading results for MM LLC during the year.
The Fund finished 1999 with gains in energy, stock index and agricultural trading and losses in currency, interest rate and metal trading. Commodities spent 1999 in a transition phase, shifting from bearishness to a more neutral position. Lack of demand, particularly in Asia, was the dominant factor in the overall decline in commodity prices.
Overall, the Fund profited from trading in crude oil, heating oil, and unleaded gas in 1999. Positions in crude oil offset losses from short positions in natural gas and gas oil trading. In March, OPEC ratified new production cuts totaling 1.716 million barrels per day at its conference, which resulted in higher prices for crude. In the natural gas markets, prices rallied sharply resulting from a decline in US natural gas production, along with high levels of energy consumption and weather scares throughout the country. Near the end of the year, there was a continued upward momentum in crude oil reflecting the tightening between supply and demand and a new, higher OPEC-indicated target price.
Stock index trading was profitable for the first half of 1999. Also of note, the Dow Jones Industrial Average closed above the 10,000 mark for the first time ever at the end of March, setting a record for the index, and equity markets rallied worldwide in April and June. In the second half of the year, the Fund suffered losses in stock index positions as trading was mixed due to significant volatility globally. However, there was profitable trading in Hang Seng, Nikkei 225 and Topix Indices which resulted in gains during November and December. Such activity depicted evidence of Japan's stronger-than-expected recovery coupled with a sudden decline in its unemployment rate.
In agricultural trading, gains in live hogs and live cattle offset losses in corn position. Initially, the corn market continued to struggle due to supply/demand imbalances and ongoing favorable weather in South America. These factors also led to an increase in prices as there was a sharp decline in crop ratings during the second half of the year. There was also a sharp upturn in soy prices, and losses in coffee trading became evident due to cold temperature and lack of rainfall in Brazil.
Currency trading produced losses for the Fund throughout the year. Long Japanese yen positions resulted in losses despite the yen trading higher against the dollar. The Bank of Japan lowered rates to keep their economy sufficiently liquid to allow fiscal spending to restore some growth to the economy and to drive down the surging yen. The European Central Bank raised the repo rate in November due to inflation pressures. On a trade-weighted basis, the Swiss franc ended the first quarter to close at a seven-month low, mostly as a result of the stronger U.S. dollar. The Canadian dollar also underwent similar fluctuations throughout the year.
Interest rate trading was also volatile as the flight to quality in the bond market reversed during the first half of 1999 and the Federal Reserve raised interest rates three times during the year. Early in the year, interest rate trading proved unprofitable for the fund, which was triggered by the Japanese Trust Fund Bureau's decision to absorb a smaller share of futures issues, leaving the burden of financing future budget deficits to the private sector. Interest rate trading did gain strength at mid-year as the flight to quality in the bond market reversed and concerns about higher interest rates in the U.S. continued to rattle the financial markets. During the third quarter, Eurodollar trading generated losses amidst speculation of the probability of a tightening by the U.S. Federal Reserve, which became evident with the higher interest rates in their November 16 meeting due to concerns of inflation. In December, the yield on the 30-year Treasury bond recently surpassed its October high propelled by inflation worries and fears the Federal Reserve might tighten further in 2000.
Metals trading was mixed for the year as gold played a major part in the volatility of the metals market. Gold had failed to maintain its status as a safety vehicle and a monetary asset during the first half of 1999. In early June, gold had reached its lowest level in over 20 years. A major statement from the president of the European Central Bank stated that the member banks had agreed not to expand their gold lending. This sent gold prices sharply higher in late September. Unfortunately, the Fund held short positions in gold futures at the time. Gold prices had stabilized in the fourth quarter following the price surge. Early in the year, burdensome warehouse stocks and questionable demand prospects weighed on base metals as aluminum fell to a five-year low and copper fell to nearly an 11-year low. The economic scenario for Asia, Brazil, Europe and emerging market nations helped to keep copper and other base metals on the defensive as demand receded with virtually no supply side response in the second quarter. A substantial increase in Chinese imports combined with the recovery in the rest of Asia and Europe had significantly improved demand for aluminum pushing prices higher during December.
Total Trading Results
Interest Rates and Stock Indices $ 151,114 Commodities (38,478) Currencies (610,635) Energy (12,000) Metals (295,665) --------- $(805,664) =========
Global interest rate markets provided the Fund with its most profitable positions for the first quarter, particularly in European bonds where an extended bond market rally continued despite an environment of robust growth in the United States, Canada and the United Kingdom, as well as a strong pick-up in growth in continental Europe. In the second quarter, swings in the U.S. dollar and developments in Japan affected bond markets, causing the Fund's interest rate trading to result in losses. This was turned around in the third quarter, as markets worldwide were turned upside down and the Fund's non-correlation with general equity and debt markets was strongly exhibited, and trading was particularly profitable in positions in Eurodollars, German and Japanese bonds, and U.S. Treasury notes and bonds. Global investors staged a major flight to quality, resulting in a significant widening of credit spreads on a global basis. In October, investors pushed the yields on U.S. Treasury bonds to a 31-year low. The long bond yield fell about 75 basis points in 1998 as the world economy slowed more than expected, inflation continued to fall, the anticipated small U.S. budget deficit turned into substantial surplus, and the Fed lowered interest rates.
Trading results in stock index markets were mixed in early 1998, despite a strong first-quarter performance by the U.S. equity market as several consecutive weekly gains were recorded with most market averages setting new highs. Second quarter results were profitable as the Asia-Pacific region's equity markets weakened across the board. In particular, Hong Kong's Hang Seng index trended downward during most of the second quarter and traded at a three-year low. As U.S. equity markets declined in July and August, the Fund profited from short positions in the S&P 500, most notably during August, when the index dropped 14.5%. Volatility in September made for a difficult trading environment in the stock index sector, and the Fund incurred modest losses, although results remained profitable for the quarter and the year overall in these markets.
In energy markets, demand for crude oil in the Middle East was affected by low oil prices early in the year, and trading resulted in losses. Initially buoyed on concerns about a U.S.-led military strike against Iraq, crude oil fell to a nine-year low, as the globally warm winter, the return of Iraq as a producer and the Asian economic crisis added to OPEC's supply glut problems. Despite production cuts initiated by OPEC at the end of March, world oil supplies remained
excessive and oil prices stood at relatively low levels throughout the first half of 1998. Short heating oil positions in the third quarter proved profitable for the Fund as the market for heating oil prices dropped to its lowest level in more than a decade. In early December, oil and natural gas prices dropped sharply, causing continued problems for many emerging market countries that depend on commodity exports for economic growth and government financing. These price pressures were mainly due to excessive supply availability and near-term weather indications that inventories would remain at more than adequate levels even in the event of a cold Northern Hemisphere winter. Also, the December U.S. air attack on Iraq failed to cause any damage to oil pumping and shipping operations, and oil prices fell over 10%.
In currency markets, results early in the year were mixed, but unprofitable. During the second quarter, strong gains were realized in positions in the Japanese yen, which weakened during June to an eight-year low versus the U.S. dollar. Significant gains from Japanese yen trading continued into the third quarter, and Japan's problems spread to other sectors of the global economy, causing commodities prices to decline as demand from the Asian economies weakened. Japan's deepening recession and credit crunch continued through the fourth quarter, and the Fund achieved gains from long yen positions.
In agricultural commodity markets, 1998 began with strong gains as live cattle and hog prices trended downward throughout the first quarter. In the second quarter, although the U.S. soybean crop got off to a good start which contributed to higher yield expectations and a more burdensome supply outlook, soybean prices traded in a volatile pattern. Sugar futures maintained mostly a downtrend, as no major buyers emerged to support the market. Similarly, coffee prices trended downward, as good weather conditions in Central America and Mexico increased the prospects of more output from these countries. The third quarter resulted in losses as the U.S. soybean crop increased relative to the USDA's production estimate as a result of timely rains, which contributed to lower prices. These losses continued into the fourth quarter as the Fund was caught on the short side of the soybean complex, as the soybean supply surplus became more manageable following the November 10th USDA reports, causing prices to gain upward momentum.
Gold prices began the year drifting sideways, and continued to weaken following news in the second quarter of a European Central Bank consensus that ten to fifteen percent of reserves should be made up of gold bullion, which was at the low end of expectations. Gold was unable to extend third quarter rallies or to build any significant upside momentum, resulting in a trendless environment. This was also the case in the fourth quarter, as gold's cost of production declined. Also, silver markets remained range-bound, while also experiencing a significant selloff in November, and aluminum traded at its lowest levels since 1994, with many aluminum smelters operating at a loss.
Total Trading Results
Interest Rates and Stock Indices $ (537,115) Commodities 58,137 Currencies 1,536,465 Energy (136,640) Metals 661,486 ---------- $1,582,333 ==========
Trend reversals and extreme market volatility, affected by such factors as the Asian flu and El Nino, were characteristic of most of 1997. However, the year proved to be a profitable one overall for the Fund as trends in several key markets enabled the Advisors to profit despite the significant obstacles. Although trading results in several sectors may have been lackluster, the global currency and bond markets offered noteworthy trading opportunities, which resulted in significant profits in these markets during the year. Additionally, the currency and interest rate sectors of the Fund's portfolio represented its largest percentage of market commitments.
In currency markets, the U.S. dollar rallied and started 1997 on a strong note, rising to a four-year high versus the Japanese yen and two-and-a-half year highs versus the Deutsche mark and the Swiss franc. However, the dollar underwent two significant corrections during the year. The first correction occurred in the Spring against the Japanese yen, due to the G7 finance ministers' determination that a further dollar advance would be counter-productive to their current
goals. From August through mid-November, the dollar corrected against the Eurocurrencies in advance of a well-advertised tightening by the Bundesbank. By mid-December the dollar had bounced back to new highs against the yen and was rallying against the mark.
Global interest rate markets began the year on a volatile note, as investors evaluated economic data for signs of inflation. By the middle of the year, economic data in key countries was positive indicating lower inflation and igniting a worldwide rally in the bond markets. Specifically, investor sentiment was particularly strong in the U.S., where prices on the 30-year Treasury bond and 10-year Treasury note rose to their highest levels in over two years. This followed a largely positive economic report delivered by Federal Reserve Chairman Greenspan in testimony before Congress. Effects of the plunge in the Hong Kong stock market in late October spread rapidly throughout the world's financial markets, including global bond markets. After continued volatility in subsequent months made trading difficult, 1997 interest rate trading ended on a positive note when U.S. and Japanese bond markets rallied as a flight to safety from plunging stock markets around the world occurred in December.
In energy markets, a slump in crude oil prices was characteristic of its lackluster performance from the beginning of the year. Early in 1997, volatility returned in the energy markets, reflecting the impact of a winter significantly warmer than normal. By mid-year, the decline in prices reversed sharply as Saudi Arabia and Iran, together representing about 45% of OPEC's oil production, joined forces to pressure oil-producing nations to stay within OPEC production quotas. In December, financial and economic problems in Asia reduced demand for oil, and, in combination with ample supplies, resulted in crude oil prices declining once again.
Variables Affecting Performance - -------------------------------
The principal variables which determine the net performance of the Fund are gross profitability and interest income. During all periods set forth under "Selected Financial Data," the interest rates in many countries were at unusually low levels. The low interest rates in the United States (although higher than in many other countries) negatively impacted revenues because interest income is typically a major component of the Fund's profitability. In addition, low interest rates are frequently associated with reduced fixed income market volatility, and in static markets the Fund's profit potential generally tends to be diminished. On the other hand, during periods of higher interest rates, the relative attractiveness of a high risk investment such as the Fund may be reduced as compared to high yielding and much lower risk fixed-income investments.
The Fund's Brokerage Commissions and Administrative Fees are a constant percentage of the Fund's assets allocated to trading. The only Fund costs (other than the insignificant currency trading costs) which are not based on a percentage of the Fund's assets (allocated to trading or total) are the Profit Shares payable to the Advisors on an Advisor-by-Advisor basis. During periods when Profit Shares are a high percentage of net trading gains, it is likely that there has been substantial performance non-correlation among the Advisors (so that the total Profit Shares paid to those Advisors which have traded profitably are a high percentage, or perhaps even in excess, of the total profits recognized, as other Advisors have incurred offsetting losses, reducing overall trading gains but not the Profit Shares paid to the successful Advisors) - -- suggesting the likelihood of generally trendless, non-consensus markets.
Unlike many investment fields, there is no meaningful distinction in the operation of the Fund between realized and unrealized profits. Most of the contracts traded by the Fund are highly liquid and can be closed out at any time.
Except in unusual circumstances, factors -- regulatory approvals, cost of goods sold, employee relations and the like -- which often materially affect an operating business have virtually no impact on the Fund.
Liquidity; Capital Resources - ----------------------------
The Fund sells no securities other than the Units. The Fund borrows only to a limited extent and only on a strictly short-term basis in order to finance losses on non-U.S. dollar denominated trading positions pending the conversion of the Fund's dollar deposits. These borrowings are at a prevailing short-term rate in the relevant currency. They have been immaterial to the Fund's operation to date and are expected to continue to be so.
Substantially all of the Fund's assets are held in cash. The Net Asset Value of the Fund's cash is not affected by inflation. However, changes in interest rates could cause periods of strong up or down price trends, during which
the Fund's profit potential generally increases. Inflation in commodity prices could also generate price movements which the strategies might successfully follow.
Except in very unusual circumstances, the Fund should be able to close out any or all of its open trading positions and liquidate any or all of its securities holdings quickly and at market prices. This permits an Advisor to limit losses as well as reduce market exposure on short notice should its strategies indicate doing so. In addition, because there is a readily available market value for the Fund's positions and assets, the Fund's monthly Net Asset Value calculations are precise, and investors need only wait 10 business days to receive the full redemption proceeds of their Units.
Year 2000 Compliance Initiative
In 1999, Merrill Lynch completed its efforts to address the Year 2000 issue (the "Y2K issue"). The Y2K issue was the result of a widespread programming technique that caused computer systems to identify a date based on the last two numbers of a year, with the assumption that the first two numbers of the year are "19". As a result, the year 2000 would be stored as "00", causing computers to incorrectly interpret the year as 1900. Left uncorrected, the Y2K issue may have caused serious failures in information technology systems and other systems.
In 1995, Merrill Lynch established the Year 2000 Compliance Initiative to address the internal and external risks associated with the Y2K issue. The initiative consisted of six phases, completed by the millennium: planning, pre-renovation, renovation, production testing, certification, and integration testing. Contingency plans were established in the event of any failure or disruptions.
Through the date of this filing, there have been no material failures or disruptions of systems or services at Merrill Lynch attributable to the Y2K issue. Similarly we have not been notified of any material failure or disruption of systems or services affecting third parties in their capacity to transact business with Merrill Lynch or in Merrill Lynch's capacity to transact business with others. Merrill Lynch continues to monitor the performance of its systems for any possible future failures or disruptions attributable to the Y2K issue.
As of December 31, 1999, the total estimated expenditures of existing and incremental resources for the entire Year 2000 Compliance Initiative was approximately $510 million, including $102 million of occupancy, communications, and other related overhead expenditures, as Merrill Lynch is applying a fully costed pricing methodology for this project. At December 31, 1999, of the total estimated expenditures, approximately $12 million, related to continued testing, contingency planning, risk management, and the wind down of the efforts, had not yet been spent.
Item 7A:
Item 7A: Quantitative and Qualitative Disclosures About Market Risk ----------------------------------------------------------
Not Applicable.
Item 8:
Item 8: Financial Statements and Supplementary Data -------------------------------------------
The financial statements required by this Item are included in Exhibit 13.01.
The supplementary financial information ("selected quarterly financial data" and "information about oil and gas producing activities") specified by Item 302 of Regulation S-K is not applicable. MLIP promoted the Fund and is its controlling person.
Item 9:
Item 9: Changes in and Disagreements with Accountants on Accounting and --------------------------------------------------------------- Financial Disclosure --------------------
There were no changes in or disagreements with independent auditors on accounting or financial disclosure.
PART III
Item 10:
Item 10: Directors and Executive Officers of the Registrant
10(a) & 10(b) Identification of Directors and Executive Officers: --------------------------------------------------
As a limited partnership, the Partnership itself has no officers or directors and is managed by MLIP. Trading decisions are made by the Advisors on behalf of the Partnership. MLIP promoted the fund and is its controlling person.
The directors and executive officers of MLIP and their respective business backgrounds are as follows.
John R. Frawley, Jr. Chairman, Chief Executive Officer, President and Director
Jeffrey F. Chandor Senior Vice President, Director of Sales, Marketing and Research and Director
Michael L. Pungello Vice President, Chief Financial Officer and Treasurer
Allen N. Jones Director
Stephen G. Bodurtha Director
Michael J. Perini Director
Steven B. Olgin Vice President, Secretary and Director of Administration
John R. Frawley, Jr. was born in 1943. Mr. Frawley is Chairman, Chief Executive Officer, President and a Director of MLIP and Co-Chairman of MLF. He joined Merrill Lynch, Pierce, Fenner & Smith Incorporated ("MLPF&S") in 1966 and has served in various positions, including Retail and Institutional Sales, Manager of New York Institutional Sales, Director of Institutional Marketing, Senior Vice President of Merrill Lynch Capital Markets and Director of International Institutional Sales. Mr. Frawley holds a Bachelor of Science degree from Canisius College. Mr. Frawley served on the CFTC's Regulatory Coordination Advisory Committee from its formation in 1990 through its dissolution in 1994. Mr. Frawley has served four consecutive one-year terms as Chairman of the Managed Funds Association (formerly, the Managed Futures Association), a national trade association that represents the managed futures, hedge funds and fund of funds industry. Mr. Frawley currently serves as a member of the CFTC's Global Markets Advisory Committee.
Jeffrey F. Chandor was born in 1942. Mr. Chandor is Senior Vice President, Director of Sales, Marketing and Research and a Director of MLIP. He joined MLPF&S in 1971 and has served as the Product Manager of International Institutional Equities, Equity Derivatives and Mortgage-Backed Securities as well as Managing Director of International Sales in the United States, and Managing Director of Sales in Europe. Mr. Chandor holds a Bachelor of Arts degree from Trinity College, Hartford, Connecticut. Mr. Chandor is serving a two-year term as a director of the Managed Funds Association.
Michael L. Pungello was born in 1957. Effective May 1, 1999, Mr. Pungello became Vice President, Chief Financial Officer and Treasurer of MLIP. He was First Vice President and Senior Director of Finance for Merrill Lynch's Operations, Services and Technology Group from January 1998 to March 1999. Prior to that, Mr. Pungello spent over 18 years with Deloitte & Touche LLP, and was a partner in their Financial Services practice from June 1990 to December 1997. He graduated from Fordham University in 1979 with a Bachelor of Science degree in accounting and received his Master of Business Administration degree in Finance from New York University in 1987.
Allen N. Jones was born in 1942. Mr. Jones is a Director of MLIP and, from July 1995 until January 1998, Mr. Jones was also Chairman of the Board of Directors of MLIP. Mr. Jones graduated from the University of Arkansas with a Bachelor of Science, Business Administration degree in 1964. Since June 1992, Mr. Jones has held the position of Senior Vice President of MLPF&S. From June 1992 through February 1994, Mr. Jones was the President and Chief Executive Officer of Merrill Lynch Insurance Group, Inc. ("MLIG") and remains on the Board of Directors of MLIG and its subsidiary companies. From February 1994 to April 1997, Mr. Jones was the Director of Individual Financial Services of the Merrill Lynch Private Client Group. In April 1997, Mr. Jones became the Director of Private Client marketing.
Stephen G. Bodurtha was born in 1958. Mr. Bodurtha is a Director of MLIP. In 1980, Mr. Bodurtha graduated magna cum laude from Wesleyan University, Middletown, Connecticut with a Bachelor of Arts degree in Government. From 1980 to 1983, Mr. Bodurtha worked in the Investment Banking Division of Merrill Lynch. In 1985, he was awarded his Master of Business Administration degree from Harvard University, where he also served as Associates Fellow (1985 to 1986). From 1986 to 1989, Mr. Bodurtha held the positions of Associate and Vice President with Kidder, Peabody & Co., Incorporated where he worked in their Financial Futures & Options Group. Mr. Bodurtha joined MLPF&S in 1989 and has held the position of First Vice President since 1995. He has been the Director in charge of the Structured Investments Group of MLPF&S since 1995.
Michael J. Perini was born in 1947. Effective May 11, 1999, Mr. Perini became a Director of MLIP. Since February 1998, Mr. Perini has been First Vice President and Senior Director of the Defined and Managed Funds Group, which includes Defined Asset Funds, Special investments and MLIP. This is part of the Investment Strategy Product Group of Merrill Lynch Private Client. Previously Michael Perini was Director of Defined Asset Funds and has held various management positions since he joined Merrill Lynch in 1970. Mr. Perini attended St. John's University and New York University as well as The Stanford University Marketing Management Program. He was elected to the Board of Governors of the Investment Company Institute in Washington, D.C., and is Chairman of the Unit Investment Trust Committee of the Institute.
Steven B. Olgin was born in 1960. Mr. Olgin is Vice President, Secretary and the Director of Administration of MLIP. He joined MLIP in July 1994 and became a Vice President in July 1995. From 1986 until July 1994, Mr. Olgin was an associate of the law firm of Sidley & Austin. In 1982, Mr. Olgin graduated from The American University with a Bachelor of Science degree in Business Administration and a Bachelor of Arts degree in Economics. In 1986, he received his Juris Doctor degree from The John Marshall Law School. Mr. Olgin is a member of the Managed Funds Association's Government Relations Committee and has served as an arbitrator for the NFA. Mr. Olgin is also a member of the Committee on Futures Regulation of the Association of the Bar of the City of New York.
As of December 31, 1999, the principals of MLIP had no investment in the Fund, and MLIP's general partner interest in the Fund was valued at approximately $244,458.
MLIP acts as general partner to eleven public futures funds whose units of limited partnership interest are registered under the Securities Exchange Act of 1934: The Futures Expansion Fund Limited Partnership, ML Futures Investments II L.P., John W. Henry & Co./Millburn L.P., The S.E.C.T.O.R. Strategy Fund (SM) L.P., The SECTOR Strategy Fund (SM) II L.P., The SECTOR Strategy Fund (SM) V L.P., The SECTOR Strategy Fund (SM) VI L.P., ML Global Horizons L.P., ML Principal Protection L.P., ML JWH Strategic Allocation Fund L.P. and the Fund. Because MLIP serves as the sole general partner of each of these funds, the officers and directors of MLIP effectively manage them as officers and directors of such funds.
(c) Identification of Certain Significant Employees: -----------------------------------------------
None.
(d) Family Relationships: --------------------
None.
(e) Business Experience: -------------------
See Item 10(a)(b) above.
(f) Involvement in Certain Legal Proceedings: ----------------------------------------
None.
(g) Promoters and Control Persons: -----------------------------
Not applicable.
Item 11:
Item 11: Executive Compensation ----------------------
The directors and officers of MLIP are remunerated by MLIP in their respective positions. The Partnership does not itself have any officers, directors or employees. The Partnership pays Brokerage Commissions to an affiliate of MLIP and Administrative Fees to MLIP. MLIP or its affiliates may also receive certain economic benefits from holding the Fund's assets. The directors and officers receive no "other compensation" from the Partnership, and the directors receive no compensation for serving as directors of MLIP. There are no compensation plans or arrangements relating to a change in control of either the Partnership or MLIP.
Item 12:
Item 12: Security Ownership of Certain Beneficial Owners and Management --------------------------------------------------------------
(a) Security Ownership of Certain Beneficial Owners: -----------------------------------------------
As of December 31, 1999, no person or "group" is known to be or have been the beneficial owner of more than 5% of the Units.
(b) Security Ownership of Management: --------------------------------
As of December 31, 1999, MLIP owned 1,027 Units (unit- equivalent general partnership interests), which was less than 1.43% of the total Units outstanding.
(c) Changes in Control: ------------------
None.
Item 13:
Item 13: Certain Relationships and Related Transactions ----------------------------------------------
(a) Transactions Between Merrill Lynch and the Fund
All of the service providers to the Fund, other than the Advisors, are affiliates of Merrill Lynch. Merrill Lynch negotiated with the Advisors over the level of its advisory fees and Profit Share. However, none of the fees paid by the Fund to any Merrill Lynch party were negotiated, and they are higher than would have been obtained in arms-length bargaining.
The Fund pays Merrill Lynch substantial Brokerage Commissions and Administrative Fees as well as bid-ask spreads on forward currency trades. The Fund also pays MLF interest on short-term loans extended by MLF to cover losses on foreign currency positions.
Within the Merrill Lynch organization, MLIP is the direct beneficiary of the revenues received by different Merrill Lynch entities from the Fund. MLIP controls the management of the Fund and serves as its promoter. Although MLIP has not sold any assets, directly or indirectly, to the Fund, MLIP makes substantial profits from the Fund due to the foregoing revenues.
No loans have been, are or will be outstanding between MLIP or any of its principals and the Fund.
MLIP pays substantial selling commissions and trailing commissions to MLPF&S for distributing the Units. MLIP is ultimately paid back for these expenditures from the revenues it receives from the Fund.
(b) Certain Business Relationships: ------------------------------
MLF, an affiliate of MLIP, acts as the principal commodity broker for the Fund.
In 1999, the Fund expensed the following fees: (i) Brokerage Commissions of $1,689,484 to MLF, which included $214,975 in consulting fees earned by the Advisors, and (ii) Administrative Fees of $48,271 to MLIP. In addition, MLIP and its affiliates may have derived certain economic benefits from possession of the Fund's assets, as well as from foreign exchange and EFP trading.
See Item 1(c), "Narrative Description of Business -- Charges" and "-- Description of Current Charges" for a discussion of other business dealings between MLIP affiliates and the Partnership.
(c) Indebtedness of Management: --------------------------
The Partnership is prohibited from making any loans, to management or otherwise.
(d) Transactions with Promoters: ---------------------------
Not applicable.
PART IV
Item 14:
Item 14: Exhibits, Financial Statement Schedules and Reports --------------------------------------------------- on Form 8-K - -----------
(a)2. Financial Statement Schedules: -----------------------------
Financial statement schedules not included in this Form 10-K have been omitted for the reason that they are not required or are not applicable or that equivalent information has been included in the financial statements or notes thereto.
(a)3. Exhibits: --------
The following exhibits are incorporated by reference or are filed herewith to this Annual Report on Form 10-K:
(b) Report on Form 8-K: ------------------
No reports on Form 8-K were filed during the fourth quarter of 1999.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
ML FUTURES INVESTMENTS L.P.
By: MERRILL LYNCH INVESTMENT PARTNERS INC. General Partner
By: /s/John R. Frawley, Jr. ----------------------- John R. Frawley, Jr. Chairman, Chief Executive Officer, President and Director (Principal Executive Officer)
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, this report has been signed on March 30, 2000 by the following persons on behalf of the Registrant and in the capacities indicated.
(Being the principal executive officer, the principal financial and accounting officer and a majority of the directors of Merrill Lynch Investment Partners Inc.)
MERRILL LYNCH INVESTMENT General Partner of Registrant PARTNERS INC. March 30, 2000
By: /s/John R. Frawley, Jr. ----------------------- John R. Frawley, Jr.
ML FUTURES INVESTMENTS L.P.
1999 FORM 10-K
INDEX TO EXHIBITS -----------------
Exhibit -------
Exhibit 13.01 1999 Annual Report and Independent Auditors' Report | 8,603 | 55,869 |
1002517_1999.txt | 1002517_1999 | 1999 | 1002517 | ITEM 1. BUSINESS
GENERAL
On January 6, 1999, we sold our hardware business to a newly formed subsidiary of Primax Electronics, Ltd. for approximately $7 million. On March 2, 1999, Visioneer acquired ScanSoft, Inc., an indirect wholly owned subsidiary of Xerox Corporation, in a cash election merger. The corporate entity "Visioneer" survived the merger, but changed its name to "ScanSoft, Inc." In addition, we changed the ticker symbol for our common stock, that trades on the Nasdaq, to "SSFT." In this Report, the "Company," the "Registrant," "ScanSoft," "We," "Our" and "Visioneer" refer to the surviving company unless the context otherwise requires.
Under our agreement with Primax, Primax's subsidiary acquired our hardware business, including all of our hardware assets, liabilities and related intellectual property, and the name "Visioneer," and assumed our Fremont, California lease. In addition, we entered into a multi-year licensing agreement with Primax's subsidiary (now called Visioneer) to bundle PaperPort software products with the Visioneer line of hardware imaging products.
Pursuant to the terms of the agreement with Xerox, we acquired ScanSoft for approximately 6.8 million shares of common stock, a warrant to purchase up to an additional 1.7 million shares of common stock exercisable upon certain events, approximately 3.6 million shares of non-voting Series B Preferred Stock and the assumption of 1.7 million ScanSoft stock options. In connection with the merger, approximately 5.1 million shares of our outstanding stock, which shares are now owned by Xerox, were cashed out at $2.06 per share with consideration from Xerox. Additionally, approximately 330,000 shares were cashed out at $2.06 per share with consideration from the Company. Xerox owns approximately 45% of the outstanding shares of our common stock and has two designees on the Board, including Paul A. Ricci, the new Chairman of the Board.
PRODUCTS
Our PaperPort products provide an integrated hardware and software solution at the desktop through compact sheetfed scanners and larger flatbed scanners. Our PaperPort sheetfed scanners and PaperPort flatbed scanners and their associated intellectual property were sold as part of the sale of our hardware business to Primax in January 1999. After the merger with ScanSoft in March 1999, we acquired additional software products based on patented optical character recognition ("OCR") and image processing technologies. The Software products acquired in the merger with ScanSoft include TextBridge Pro, Pagis Pro, ProOCR 100 and ScanWorks.
We provide digital imaging software products for retail, OEM and corporate markets. Our products capture and convert paper documents and photos into digital documents and images and enhance a user's ability to organize and share digital documents and images in the office, at home and on the Internet. Our products are based on patented optical character recognition ("OCR") and image processing technologies, designed to address the
needs of a broad group of users ranging from consumers and small office to medium sized businesses and large corporations.
Our software products include OCR, personal document management and software suites that offer various combinations of these products and often third party offerings. We believe that our ability to achieve broad market acceptance of our products will depend on several factors, including, but not limited to, ease-of-use, OCR accuracy, speed, and overall functionality. In addition, the ability of our software to integrate with desktop operating systems, word processing applications, email software, fax applications, image editing products and Internet publishing tools will affect our ability to achieve market acceptance for our products. In that regard, our strategy is to maintain and enhance our technological position by investing in OCR and image processing technology and strategic business and technology partnerships with other leading companies.
We also provide software in two other emerging markets: enterprise imaging and Internet imaging software. The enterprise imaging software market includes high-end OCR products and software targeted at the emerging network scanning market. The network scanning and multifunction market includes devices from Xerox, Canon, Ricoh, and Hewlett Packard. Several network multifunction devices offer scanning options that use client software to convert, edit, organize and distribute digital documents via fax, email and the Internet. Currently, we bundle client software with Xerox network multifunction devices.
The Internet imaging software market includes products that make it easier to publish and share paper documents and photos via the Internet. Currently, our products allow users to capture and convert paper-based documents to Joint Photographic Experts Group ("JPEG"), Hypertext Mark-up Language ("HTML") and Portable Document Files ("PDF") files and share photos and documents via email or as part of an Internet site.
During 1998, we provided an integrated hardware and software solution at the desktop through compact sheetfed scanners and larger flatbed scanners. PaperPort's high-performance scanners intelligently automated the paper input process by performing multiple operating functions without user intervention and provided advantages in scanning speed, image quality and image orientation. Since we sold our hardware assets, liabilities and intellectual property to Primax on January 6, 1999, our products have been entirely focused on software as described above.
PRODUCT DESCRIPTION
The following is a description of our PaperPort Deluxe, PaperPort Scanner Suite and Visual Explorer software products, as well as the TextBridge Pro, Pagis Pro, ProOCR 100 and ScanWorks software products which were acquired in the merger with ScanSoft in March 1999.
PRODUCTS FOR BUSINESSES AND PROFESSIONAL USERS
PAPERPORT DELUXE -- PaperPort Deluxe is paper management software designed for small office and home office users. It turns a scanner or multi-function-peripheral into a versatile solution for filing, copying, finding and sharing paper and photographs. PaperPort Deluxe provides a visual desktop with thumbnail file representations that allow users to quickly browse and locate images, Web pages and electronic files. Other key features include SimpleSearch, which enables users to find scanned images, electronic documents and Web pages by searching file names, content or keywords, and ScanDirect, which enables direct scanning into linked applications. PaperPort Deluxe is compatible with the Windows 95, Windows 98 and Windows NT 4.0 operating systems.
PAPERPORT SCANNER SUITE -- PaperPort Scanner Suite combines all the features of PaperPort Deluxe and TextBridge Pro to provide a easy way scan, organize, edit and share paper documents, photos, Web pages and electronic files. PaperPort Scanner Suite is compatible with the Windows 95, Windows 98 and Windows NT 4.0 operating systems.
TEXTBRIDGE PRO -- TextBridge Pro is a very accurate and versatile OCR software that allows users to easily edit paper documents, turn price lists into spreadsheets, or brochures into Web pages. TextBridge Pro combines
OCR with page layout comprehension to recreate electronic files that are similar to the paper originals in terms of page layout, font characteristics and graphics. For flexibility, TextBridge Pro provides text, table and picture zoning tools that allow users to choose what sections of a document they want to recognize. In addition, TextBridge Pro offers built-in post-recognition editing, which enables users to conveniently proofread converted documents against the original scanned image. TextBridge Pro is a Windows 95, Windows 98 and Windows NT compliant application. There are also versions available for Windows 3.x and Macintosh System 8.x. TextBridge Pro supports recognition for twelve languages and is localized for European distribution.
PAGIS PRO -- Pagis Pro is a comprehensive scanning suite that combines the Pagis digital imaging desktop with TextBridge Pro and MGI PhotoSuite to transform an office personal computer into a paper-to-digital solution for electronically filing, copying, editing and sharing documents and photos. Pagis Pro intelligently scans color documents and photos and creates color images that are easy to view, share, and print. Its folders provide visual image thumbnails to quickly browse and locate scanned images, and Pagis Pro provides powerful full-text and keyword indexing to help users retrieve document images, photos and electronic files. Using the Extended Image File Format ("XIFF"), Pagis Pro can store and send high-quality color document image files that are a fraction of the size of images saved in a standard image file format, such as Tagged Image File Format ("TIFF"). An image viewer provides image editing, selection and annotation tools. These tools help users enhance an image, select a portion of the image they want to work with, and add highlights or notes to an image. TextBridge Pro is integrated into the Pagis desktop, so users can easily convert paper documents and bring the recognized pages into a word processor or spreadsheet. For photo editing and photo projects, Pagis Pro integrates a third party photo editor. Pagis Pro is compatible with Windows 95, Windows 98 and Windows NT 4.0 operating systems.
PRODUCTS FOR CONSUMERS
VISUAL EXPLORER -- Visual Explorer enables users to visually manage all their electronic files and Web pages. Visual thumbnails of documents and Web pages enable users to quickly identify their files. In addition, the software includes SimpleSearch, which enables users to find documents and Web pages by searching file names, URLs, content or keywords. A MiniViewer allows users to easily open and view any email attachments (documents) sent to them. Visual Explorer is compatible with the Windows 95 and Windows 98 operating systems.
PROOCR 100 -- ProOCR100 is OCR software that is designed for simplicity and ease-of-use. Users can simply click on the Auto-OCR button to automatically walk through the text recognition process. Designed to handle real documents, ProOCR100 can recognize pages with degraded text (like faxes and photocopies) and complex documents with multiple columns and tables. ProOCR100 is compatible with the Windows 95, Windows 98 and Windows NT 4.0 operating systems.
SCANWORKS -- ScanWorks combines the Pagis digital imaging desktop with MGI PhotoSuite to provide an easy to use, consumer oriented scanning software suite that enables users to edit and share photos, keep track of important documents and conveniently make color copies at home. ScanWorks intelligently scans color photos and documents and creates color images that are easy to view, share, and print. ScanWorks folders provide visual image thumbnails to quickly browse and locate scanned images, and ScanWorks provides powerful full-text and keyword indexing to help users retrieve document images, photos and electronic files. Using the XIFF file format, ScanWorks can store and send high-quality color document image files that are a fraction of the size of image files saved in an uncompressed image format. ScanWorks also has a image viewer with image editing, selection, and annotation tools. For more advanced image editing and photo projects, ScanWorks integrates a third party photo editor. ScanWorks is compatible with the Windows 95, Windows 98 and Windows NT 4.0 operating systems.
OEM PRODUCTS
We bundle various versions of Pagis, PaperPort, Visual Explorer and TextBridge with leading scanner, multifunction device and storage device manufacturers and leading independent software vendors. OEM customers often require us to integrate products with other applications or customize existing products to meet specific requirements. Therefore, we offer OEM customers both packaged products to bundle and a software developer's toolkit to facilitate the integration of OCR functionality with other applications.
PRODUCTS SOLD TO PRIMAX
Our sheetfed and flatbed scanners and their associated intellectual property were sold to Primax Electronics, Ltd. on January 6, 1999. These products are described below:
PAPERPORT SHEETFED SCANNERS -- The PaperPort sheetfed scanners are integrated hardware and software solutions for paper input and digitized document and image management that are easy to use, fast and cost-effective. The PaperPort Vx and mx grayscale scanners are small in size (12" x 2.5" x 3.75") and are designed to operate on the desktop between the keyboard and monitor. The PaperPort Vx is compatible with Macintosh personal computers, while the PaperPort mx is compatible with Windows 3.1, Windows 95, Windows 98 and Windows NT. The PaperPort ix, a scanning keyboard, is a grayscale scanner fully integrated into a keyboard and is compatible with the aforementioned Windows releases. The PaperPort Strobe is a color scanner that was smaller (11" x 2.5" x 2") and faster than our grayscale predecessors. It is available in both Macintosh and Windows versions, Windows 3.1, Windows 95 and Windows 98. The Windows versions are also available in either a parallel or serial interface, and the Macintosh version incorporates a SCSI interface. PaperPort sheetfed scanners are designed to handle multiple sizes, shapes and textures of paper, including business cards, newspaper articles, business memos, receipts and photographs, and a broad range of paper types. In 1998, we recognized the end of life of our grayscale sheetfed scanners and produced only the color PaperPort Strobe. This scanner features 24-bit, 600 dpi color images, offering high quality and high-resolution.
PAPERPORT FLATBED SCANNERS -- Our product line included three distinct groups of flatbed scanners. The first group, the 30-bit line, scans 30-bit color images in either 300 x 600 dpi optical resolution or 600 x 1200 dpi optical resolution. In addition, we sold the 3100USB, a scanner with the above characteristics that utilizes the Universal Serial Bus (USB) port on newer personal computers that run Windows 98. The second group, the 36-bit line, scans 36-bit color images in 600 x 1200 dpi. The third group, the OneTouch line, scans 36-bit color images in either 300 x 600 dpi optical resolution or 600 x 1200 dpi optical resolution with the press of a single button. This scanner features five-button functionality that was automatically linked with the software. All three groups of scanners are compatible with Windows 95 and Windows 98 and featured a pass-through parallel port design, as well as USB compatibility for the 3100USB, that allows them to easily connect to a Windows PC. In addition to the base version of our document management and image editing software, these flatbed scanners were bundled with Visioneer's Web Publishing Kit, a collection of Internet tools and utilities, which simplify the creation of Web sites.
NEW PRODUCTS
We intend to design and develop products to extend the life and usability of our products for our installed base through the development of software upgrades and add-on accessory products. We also intend to offer these upgrades to our OEM partners. We also plan to incorporate new software features into our software, and to expand our software product lines in 1999 through the development of alternative form factors comprising enhanced imaging capabilities, and other features and functionality. We believe that the development of these and other products and features is essential to our success. Accordingly, we will continue to make significant investments in the research and development of new products. Such expenses may fluctuate from quarter to quarter depending on a wide range of factors, including the status of various development projects.
ENABLING TECHNOLOGY
We have devoted substantial resources to develop software technologies to create comprehensive, easy-to-use, and versatile products for users of image capture devices, such as scanners, multifunction peripherals and digital cameras.
Our software is developed using OCR and image processing technologies, Application Programming Interfaces (APIs), object-oriented development tools, and modern graphical user interface designs. In addition, our products employ commercial text retrieval database systems, electronic document format conversion toolkits, and standard scanner device interfaces.
API -- Our TextBridge and PerfectScan APIs are the foundation for products in both the TextBridge product-line and Pagis product-line. These APIs provide an interface to the OCR and image processing technologies and provide image text conversion, image processing and cleanup, scanner and digital camera control, image file format read and write with image compression, and image printing.
For PaperPort and Visual Explorer products, software applications on the hard drive are recognized, and linking icons to applications supported by the PaperPort API are placed on the PaperPort or Visual Explorer desktop. In addition, "AutoLaunch" technology allows users to launch input with digitized documents directly into third-party software applications and peripherals already installed on the user's personal computer. The PaperPort software locates these paper-enabled third-party software applications and peripherals and builds drag and drop buttons for one-button distribution of these digitized documents. Using the PaperPort API, developers can create PaperPort links to expedite the intelligent transfer of documents between the PaperPort software and their applications. These functions allow developers to automate certain tasks such as user interface management, file conversion, software initialization, object control and OCR.
OCR -- Our OCR technology provides image-to-text document conversion. This technology provides high quality character recognition accuracy with page layout retention, including the ability to reconstruct headers, footers, columns, paragraphs, embedded images, captions, inverted text and character font attributes. Additionally, the OCR engine provides document export directly to Rich Text Format ("RTF"), PDF, HTML and ASCII text, and many other industry standard electronic document formats via third-party conversion technology. The OCR engine employs a number of technologies to improve document recognition accuracy. These technologies are described below:
CHARACTER/WORD ACCURACY -- Character accuracy refers specifically to correctly identifying the actual characters in a page image. Traditional OCR contains basic capabilities for identifying the shapes of the characters through pattern recognition techniques. The TextBridge OCR engine employs a variety of different recognition "experts," which work cooperatively in the OCR process.
SEGMENTATION -- Segmentation is the process of differentiating between the text and picture components of a given page image. The segmentation in TextBridge performs that function as well as identifies the appropriate lexicographical ordering of the regions of text on the page, so that the final output will appear in correct read order.
OUTPUT FORMATTING -- TextBridge's formatting capabilities make it possible to reconstruct most compound document formats, including multiple columns, cell tables, pictures, captions, headers and footers, thereby saving the end-user reformatting time and effort. The most recent additions to TextBridge's reformatting abilities include reverse video (white-black) text output and insets.
IMAGE PROCESSING -- Our image processing technology provides capture, enhancement and compression techniques. The heart of the image processing core engine is page segmentation capabilities which provide the ability to decompose a page image into its components, including text, pictures, background tints, and text color. The image processing core engine also provides efficient page enhancement technologies such as auto-crop, auto-straighten, automatic picture enhancement, high-speed rendering, line removal, speck removal, tint removal and forms field detection.
Our advanced image compression technologies employ wavelet, JPEG, symbol-based and Huffman compression techniques to facilitate the process of capturing high-quality compound color documents and store them in the compact XIFF image format. XIFF images are a fraction of the size of images saved in a standard image file format, such as TIFF. Moreover, the text is clean and suitable for OCR, faxing or printing.
MARKETING, SALES AND DISTRIBUTION
The primary market for our products is comprised of computer users who required access to both paper and electronic information. The SOHO (Small Office, Home Office) market, which represented a significant majority of our branded business, has been targeted by us because mobile and home-based professionals require office-like
productivity without access to copiers, fax machines and scanners. This market, within the last 18 months, has been increasingly attracted to scanners offering color imaging capability. With the advent of color sheetfed and flatbed scanners, the grayscale sheetfed scanner market continued its decline in 1998.
In 1998 we derived substantially all of our branded revenues from sales through our independent distributors, retailers and resellers. Although we have established strategic software OEM partnerships, we expect that sales through our independent distributors and resellers will continue to account for a substantial portion of our revenues for the foreseeable future. Our top four retail customers for 1998 were Sam's Club (owned by "Wal-Mart"), Office Depot, Inc., Best Buy Company, Inc. and CompUSA, Inc. for distribution of our products in North America. Sales to these top four independent distributors and resellers accounted for 46% of our total net revenues in 1998 in the aggregate, or 18%, 12%, 9% and 7%, respectively, as compared to 38% of our total revenues in 1997. With the transition to a software only business, we expect to derive the majority of our revenue through our independent distributors, including Ingram Micro, Tech Data and Merisel. These distributors in turn sell to computer superstores, such as Comp USA and Fry's Electronics; consumer electronic stores, such as Best Buy and Circuit City; mail order houses, such as PC Connection and MicroWarehouse; and office superstores, such as Office Max, Office Depot and Staples. Our agreements with our distributors and resellers are not exclusive, and each of our distributors and resellers can cease marketing our products with limited notice and with little or no penalty. There can be no assurance that our independent distributors and resellers will continue to offer our products or that we will be able to recruit additional or replacement distributors. The loss of one or more of our major distributors or resellers would have a material adverse effect on our business, operating results and financial condition. Many of our distributors and resellers offer competitive products. There can be no assurance that our distributors and resellers will give priority to the marketing of our products as compared to competitor's products. Any reduction or delay in sales of our products by our distributors and resellers would have a material adverse effect on our business, operating results and financial condition.
We grant our distributors and resellers price protection and certain rights of return with respect to products purchased by them. In addition, we offered various end-user rebate programs for our products. We accrue for expected returns, anticipated price reductions, and anticipated rebate redemption in amounts that the Company believes are reasonable. However, there can be no assurance that these accruals will be sufficient or that any future returns, price protection charges, or rebate redemption will not have a material adverse effect on our business and operating results, especially in light of the rapid product obsolescence which often occurs during product transitions. The short product life cycles of our products and the difficulty in predicting future sales increase, the risk of new product introductions, price reductions by our competitors, or other factors affecting the paper input market could result in significant product returns. In addition, there can be no assurance that new product introductions by competitors or other market factors will not require us to reduce prices in a manner or at a time or rate which gives rise to significant price protection charges and which would have a material adverse effect on our operating results. Any product returns, price protection charges, or rebate redemption in excess of recorded allowances would have a material adverse effect on our business, operating results and financial condition.
Net revenues from resellers and distributors outside North America represented approximately 7% of net revenues in 1998 as compared to 10% in 1997. Prior to the acquisition of ScanSoft, we had limited experience in developing international versions of our products and marketing, distributing, servicing and supporting such products. However, ScanSoft derived 19% of its revenues in 1998 from international sales and has a subsidiary in the United Kingdom. We expect our combined revenues from international sales to account for approximately 13% of revenues in 1999.
Domestically, full-featured software product customers who register with us currently receive limited hotline technical support and product information at no cost. Additional technical support services are available on a "fee for support" basis. We currently offer several technical support options to customers of packaged products. These include telephone, fax or email support by a customer support representative or self help by accessing our technical information bulletins or frequently asked questions on the Internet. Outside of the U.S., full-featured software product customers receive technical support from a third party company on both a fee and non-fee basis.
OEM RELATIONSHIPS
Prior to the merger with ScanSoft, we had software OEM agreements with several companies including Western Digital Corporation, Brother Industries, Ltd., Minolta Co. Ltd., Omron Software Company, Ltd., Agfa-Gevaert N.V. and Epson America, Inc. These OEM agreements remained with us after the merger.
ScanSoft, as an indirect wholly owned subsidiary of Xerox Corporation, had software OEM agreements with several companies including: Mustek Systems, Inc., Microtek International, Inc., Seiko-Epson Corporation, Canon Computer Systems, Inc., IBM, Plustek USA, Inc., Primax Electronics, Inc., Avision Labs, Inc., Compaq Computer Corporation, Acer Peripherals, Inc. and Symantec Corporation. Additionally, ScanSoft also entered into multiple non-exclusive agreements with Xerox Corporation (a significant stockholder) in which ScanSoft agreed to license Xerox the royalty-bearing right to copy and distribute certain versions of Pagis and TextBridge software programs with Xerox's multi-function peripherals.
We are pursuing and may enter into additional OEM agreements to distribute our software products. However, there are certain risks associated with such relationships, including whether sufficient priority will be given by such OEM partners to market our products and whether such OEM partners will continue to offer our products. Such risks have been experienced by us in regards to our agreements with Hewlett-Packard and Compaq. The loss of any OEM partnership or our inability to enter into additional OEM partnerships could have a material adverse effect on our business, operating results and financial condition. See "Item 7 - -Management's Discussion and Analysis of Financial Condition and Results of Operations--Overview."
RESEARCH AND DEVELOPMENT
Our research and development team, after the merger on March 2, 1999, is located at our headquarters in Peabody, Massachusetts. As of December 31, 1998, we employed 21 full-time and 4 contract software design and quality assurance engineers, technicians and support staff in Fremont, California. The primary activities of these employees during 1998 were the design and development of the sheetfed and flatbed scanner lines, the development of the PaperPort flatbed line of products, the development of a new release of PaperPort Deluxe Software, the development of other new software products (ProOCR 100, Visual Explorer, Scanner Suite and ScannerWorks), enhancements of existing products, product testing, and technical documentation development.
In 1998, the research and development team in Fremont, California was restructured into a smaller group. Our strategy was to concentrate our efforts on software development, and leverage the hardware and mechanical engineering capabilities of our manufacturing partners to design and build our future hardware products. The 30 bit, 36-bit, and One Touch flatbed scanners, introduced in 1998, were designed in cooperation with our manufacturing partners, Avision, Inc and Primax Electronic, Ltd. However, all flatbed and sheetfed scanners and their associated intellectual property were part of the sale of hardware assets, liabilities and intellectual property sold to Primax Electronics, Ltd. on January 6, 1999.
Since the completion of the merger, we are consolidating the research and development organization to the new corporate headquarters. We expect to complete the transition by the end of June 1999.
Our growth and future financial performance will depend in part upon our ability to enhance existing applications, and develop and introduce new applications that keep pace with technological advances, meet changing customer requirements, respond to competitive products and achieve market acceptance. As a result, we expect that we will continue to commit substantial resources to product research and development in the future.
MANUFACTURING
In the past, we contracted nearly all materials procurement, manufacturing, assembly, testing and quality assurance to third party manufacturers. Purchase orders were placed on our manufacturing partners for final assemblies or subassemblies, which in turn were delivered to other manufacturing partners who perform final assembly, pack-out and shipment to our customers. This outsourcing strategy allowed us to leverage off of the manufacturing
and engineering expertise and economies of scale of our manufacturing partners, while allowing our manufacturing and operations team to concentrate on value added activities, such as vendor management, product price negotiations and cost reduction efforts. However, all flatbed and sheetfed scanners and their associated intellectual property were part of the sale of our hardware business in January 1999.
We had six significant independent manufacturing partners in 1998. Primax Electronics, Ltd., Orient SemiConductor Ltd, Flextronics International Marketing (L) Ltd., NMB Technologies, Inc., Avision, Inc. and DisCopyLabs. Flextronics manufactured our standalone grayscale product lines, the PaperPort Vx for Macintosh, and the PaperPort mx for Windows. NMB manufactured our scanning keyboard product, the PaperPort ix, and our color sheetfed scanners, the PaperPort Strobe. On January 19, 1998, we notified NMB that we wished to terminate the manufacturing agreement for the PaperPort Strobe, based on NMB's inability to comply with certain cost reduction stipulations as specified. As of March 16, 1998, we had qualified two manufacturers for the PaperPort Strobe products, Orient SemiConductors, Ltd. and Flextronics.
In 1999, following the sale of our hardware business to Primax, we have reduced our key supplier list to one supplier on the west coast, DCL and one supplier on the east coast, Omnet Technology Corporation, for our software products.
Unforeseen factors with our suppliers may result in production delays. Any performance problems or production delays could have a material adverse effect on our business, operating results and financial condition. In addition, there can be no assurance that current or future manufacturing partners will be able to meet our requirements for manufactured products. Any inability to increase manufacturing capacity as required could have a material adverse effect on our business, operating results and financial condition. In addition, the current purchase order arrangements with our manufacturing partners would allow them to terminate the arrangements by not accepting our purchase orders. The unanticipated loss of any of our manufacturing partners could cause delays in our ability to ship orders while the Company identifies a replacement manufacturer. Such an event would have a material adverse effect on our business, operating results and financial condition. In addition, we are continually exploring alternative manufacturing sources, including potential sources for new products. However, there can be no assurance that such alternative sources can be successfully developed.
Our manufacturing policies were designed to reduce our investment in inventories, yet still respond to rapid changes in customer demand, but may in certain instances result in excess or insufficient inventory, or inappropriate mix of component inventory, if orders do not match forecasts. To the extent we have excess inventories, we may experience inventory write-downs or may have to lower prices of our products which would result in substantial price protection charges and a negative impact on gross margins. To the extent we have insufficient inventory, we may be materially adversely impacted by the loss of one or more of our distribution and reseller relationships and the inability to obtain market acceptance of our products.
COMPETITION
The digital imaging market is highly competitive. It is subject to rapid change along with frequent new product introductions and enhancements, as well as constant pressure to reduce prices. We believe that the principal competitive factors in this market include OCR accuracy, ease of understanding and use, product reliability, tolerance for poor media, product features and functions, price/performance characteristics, brand recognition, and quality of product support. Our competition within the digital imaging software market ranges from large corporations to small independent software vendors. We also expect to encounter continued competition, both from established companies and from new companies that are now developing, or may develop, competing products.
The TextBridge family of OCR products face competition in two markets: the market for packaged OCR application programs and OEM bundled OCR products. Several companies offer packaged OCR application programs through the channel, including companies such as Caere Corporation and Adobe Corporation and several small independent software vendors. We face significant price pressure in the retail channel. In the OEM market in which companies "bundle" the OCR technology with related hardware products, such as scanners or multifunction peripherals, or incorporate OCR technology into third party application software products, competitors include
Caere Corporation and several small independent software vendors. We have experienced significant price competition in the OEM market and expect this to continue. In addition, the "bundled" OCR products themselves present competition to our fully featured shrinkwrap products.
The Pagis and PaperPort family of products compete with various products in the digital imaging software marketplace. In the personal document management segment there are several competitors, including DocuMagix, Inc. (a division of JetFax Corporation), Caere Corporation, Newsoft (a subsidiary of UMAX Corporation), and Eastman Software (a subsidiary of Kodak Corporation). With decreasing prices driving affordable scanning solutions into the mainstream, we expect to face increasing competition in this product category from a variety of software developers.
In the scanning software suite segment, our products include various combinations of the products mentioned above and often include photo-editing capabilities. Competitors include Adobe Corporation. Caere Corporation has also announced plans to enter this market segment. Microsoft and MGI Software offer photo-editing products and could offer products in this market segment in the future.
We expect that some consolidation in the digital imaging software industry will occur over the next few years through strategic acquisitions or alliances, and we expect increased competition from new entrants, including the possibility that Microsoft will add digital imaging components to its Windows operating system. In addition, according to PC Data, Inc., the average retail price of scanners dropped by 47% for the nine months ending September 30, 1998, as compared to the same period in 1997. Based on this historical trend, we expect that scanner prices will continue to decline in the future. We believe that the downward price trend of scanners may reduce prices for digital imaging software products. These changes in the market could result in price erosion, reduced gross margins or loss of market share, any of which could have a material adverse effect on our business, operating results and financial condition.
There can be no assurance that we will be able to compete successfully against current and future competitors, especially those with greater financial, marketing, recruiting, technical and other resources, or that competitive pressures will not materially adversely affect our business, operating results and financial condition.
PROPRIETARY TECHNOLOGY
We rely on certain technology which we license from third parties, including software which is integrated with internally developed software and used in our products to perform key functions and software which is bundled with our software to provide additional functionality. There can be no assurance that these third-party technology licenses will continue to be available to us on commercially reasonable terms or at all. The loss of or inability to maintain any of these technology licenses could result in delays or reductions in product shipments until equivalent technology is identified, licensed and integrated or bundled. Any such delays or reductions in product shipments would materially adversely affect our business, operating results and financial condition.
We generally enter into confidentiality or license agreements with our employees, consultants and vendors, and generally control access to and distribution of our software, documentation and other proprietary information. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use our products or technology without authorization, or to develop similar technology independently. To license our products, we primarily rely on "shrink wrap" licenses that are not signed by the end-user customer and, therefore, may not be enforceable under the laws of certain jurisdictions. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. Policing unauthorized use of our products is difficult. There can be no assurance that we will be able to protect our technology, or that our competitors will not independently develop technologies that are substantially equivalent or superior our technology. In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as do the laws of the United States. Furthermore, litigation may be necessary to enforce our intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Such litigation could result in substantial
costs and diversion of resources and could have a material adverse effect on our business, operating results or financial condition.
We currently have two pending U.S. patent applications and one pending Canadian patent application. As a result of the merger, we have entered into a license agreement with Xerox that includes limited licenses and the assignment of certain patents and trademarks. In addition, we have filed counterpart applications in several European countries, Canada, Japan and Australia. We may file additional U.S. and foreign patent applications in the future. On January 6, 1999 we sold all assets, liabilities and intellectual property associated with our hardware business. There can be no assurance that patents will issue from any application filed by the Company or that, if patents do issue, the claims allowed will be sufficiently broad to protect our technology. The source code for our proprietary software is protected both as a trade secret and as a copyrighted work.
EMPLOYEES
As of December 31, 1998, we had a total of 54 full-time salaried employees, 21 of which were in research and development, 19 of which were in sales, marketing, and customer support, 4 of which were in operations and 10 of which were in administration and finance. Prior to our merger with ScanSoft, we implemented a restructuring plan to reduce operating expenses. This restructuring plan included a decrease of approximately 20% of total employee and consultant headcount.
Following the sale of our hardware business to Primax and upon the completion of the merger with ScanSoft, we had a total of 138 full time employees, all of whom are based in the United States and the United Kingdom. Of the total, 46 are engaged in sales, marketing and support, 67 in research and development, 20 in administration, MIS and finance and six in operations and manufacturing. Following the consolidation of research and development on the east coast, the research and development staff will be reduced to 58 people. Our future performance depends in significant part on the continued service of our key technical and senior management personnel. None of our employees are represented by a labor union. We have not experienced any work stoppages and consider our relations with our employees to be good.
FACTORS AFFECTING RESULTS
DIFFICULTIES OF INTEGRATING TWO COMPANIES. The anticipated benefits merging with ScanSoft will depend in part on whether we can integrate our operations and products in an efficient and effective manner. We cannot guarantee that this will occur. Successful integration will require integration of each company's products and coordination of each company's operating procedures, financial controls, development efforts and sales and marketing efforts. This integration may be difficult to accomplish smoothly or successfully, and may take longer than we expect. If serious difficulties are encountered during integration, management will have to divert its attention from normal business operations to address these issues, which could have an adverse effect on the surviving corporation's business. In addition, the merger may cause potential customers to cancel or delay orders as the result of uncertainty over the successful integration of the two companies. Furthermore, there could be an adverse effect on employee morale and on the ability of the surviving corporation to retain key personnel. Failure to effectively accomplish the integration of the two companies' operations could have a material adverse effect on the surviving corporation's business, operating results and financial condition.
SUBSTANTIAL EXPENSES RESULTING FROM THE MERGER. We expect to incur certain costs in connection with the integration of Visioneer and ScanSoft's operations. Such costs cannot now be reasonably estimated, because they depend on future decisions to be made by our management, but they could be material. Such costs could relate to the elimination of duplicate facilities and operations, integration of internal and customer-related activities, and cancellation and/or overlap of contractual obligations. These costs and expenses will affect results of operations in the first quarter of 1999, the quarter in which the merger is consummated.
FAILURE TO ACHIEVE SYNERGIES COULD LEAD TO DECLINE IN STOCK PRICE. The market price of our common stock may decline significantly if:
o the integration of the combined companies is not successful;
o we do not experience business synergies as quickly or to the extent expected by financial analysts; or
o the effect of the merger on earnings per share and operating results is not in line with the expectations of financial analysts.
DEPENDENCE ON DEVELOPING MARKET; RAPID TECHNOLOGICAL CHANGE. The market for digital imaging software and, in particular, for our products, is new and rapidly evolving. It is dependent on market demand for color sheetfed and flatbed scanners, as well as for other paper input systems. It is characterized by transforming technology and frequent new product introductions. Developing new products and product enhancements is a complex and uncertain process requiring high levels of innovation, as well as the accurate anticipation of technological and market trends. Our PaperPort, Pagis and TextBridge software products account for most of our revenues. We expect that these products will continue to account for most of our revenues for the foreseeable future. Broad market acceptance of these products is therefore critical to our future success and will depend in part on the following:
o Our ability and that of our distributors and other industry suppliers to convince end users to adopt paper input systems and digital imaging software for the desktop.
o Our ability to educate end users about the benefits of digital imaging products generally and the specific benefits of our products.
o Our ability to adapt to emerging industry standards and respond to our competitors' product announcements.
o Our ability to develop, introduce, upgrade and support competitive, new products and product enhancements that meet changing customer requirements and emerging industry standards.
o Our ability to maintain current market share for our products and increase brand-name recognition.
If we are not successful in meeting the goals listed above, we may not be able to gain broad market acceptance for our products. Further, a decline in demand for digital imaging products generally, or for PaperPort, Pagis or TextBridge products, in particular, could occur as a result of competitive technological change or other factors and would have a material adverse effect on our business, operating results and financial condition.
DIFFICULTIES ASSOCIATED WITH TIMING OF NEW PRODUCT INTRODUCTION. The digital imaging software market is characterized by rapid technological change, evolving customer needs, frequent new product introductions and evolving industry standards. Rapid product advancements could erode the market position of our products or render those products obsolete. Our success depends on how well we are able to manage the transition to new products and new versions of existing products. The life cycles of our products are difficult to estimate. Further, it is not unusual in personal computer software life cycles for the sales volume of new products to increase in the first few months after their introduction because distributors and resellers purchase initial inventory during that time. As a product reaches the end of its life cycle, however, demand for that product tends to fall in anticipation of new replacement products. Consequently, announcements about new products at the end of a product life cycle may cause our customers to defer purchasing existing products, and we may be forced to lower the prices of older products in anticipation of new releases. This may result in distributors claiming price protection credits or returning older products to us, and as a result, our revenues may decline. We cannot accurately predict the exact timing in which a new product or version will be ready to ship. Moreover, in order to maintain competitiveness, we must make substantial investments in product development and testing. We cannot guarantee that we will have sufficient resources to make the necessary investments or that we will be able to develop new products or new product features quickly enough to meet market demand. Any delay in the scheduled release of new products or features, or lack of market acceptance for such new products or features, may have a material adverse impact on our business, results of operations and financial condition.
DISPOSITION OF HARDWARE BUSINESS; NEED FOR REBRANDING OF PRODUCTS; NEED FOR SERVICES AGREEMENT WITH PRIMAX. In January 1999, we sold our hardware business to Primax, which was a principal manufacturer of our flatbed and sheetfed scanners and other hardware products. In this transaction, Primax purchased substantially all of our hardware business (including the "Visioneer" brand and company name), and it assumed all known liabilities associated with the hardware business. We intend to take steps to rebrand all software products carrying the Visioneer name so that in the future all such products will be identified with a new software brand name, such as ScanSoft or PaperPort. In the same way, Primax will rebrand any hardware products that carry the PaperPort name so that in the future such products will be identified with a different name. This rebranding may create confusion for our customers, including OEM distributors and end-users, and there will necessarily be an adjustment period during which time new brands will need to be established.
DEPENDENCE ON RELATIONSHIPS WITH XEROX, PRIMAX AND OTHER OEMS. ScanSoft and Visioneer each had OEM relationships with Xerox prior to the merger, which relationships remain in effect following the merger. In connection with the sale of the hardware business to Primax, Visioneer entered into a software license agreement granting Primax certain rights to "bundle" and sell Visioneer's software products with certain Primax hardware products. Under the license, Primax must pay us certain minimum annual royalties during the license term. Primax, however, is not obligated to bundle or sell our software products with its hardware products. Other risks include whether Primax will give sufficient priority to marketing our products, whether Primax will continue to offer our products at all, and whether Primax will elect instead to bundle software products of our competitors with its hardware products. Any of the foregoing actions could adversely impact our future business, results of operations and financial condition since we expect Primax to become an important OEM partner.
We also rely on other OEM partners to bundle, market and sell our products with their products. However, there are certain risks associated with such relationships, including whether sufficient priority will be given by such OEM partners to marketing our products. In addition, our OEM partners may not continue to offer our products. If we do not maintain and build our OEM relationships, our business, operating results and financial condition may suffer.
COMPETITION. The digital imaging market is highly competitive and subject to rapid change, with frequent new product introductions and enhancements, and constant pressure to reduce prices. We believe that the principal competitive factors in the digital imaging software market include:
o OCR accuracy;
o ease of understanding and use,
o product reliability;
o tolerance for poor media;
o product features and functions;
o price/performance characteristics;
o brand recognition; and
o quality of product support.
Our current competitors include developers of digital image processing software (including photo-editing software), personal document management software and scanning software suites and manufacturers of scanners and multi-function peripheral devices. We also face competition in the market for packaged OCR application programs and bundled OCR products, both in the retail channel and in the OEM market. We experience significant price competition in both the retail channel and the OEM market and expect this to continue. In addition, our "bundled" OCR products themselves compete with our fully featured shrinkwrap products. In addition to our
current competitors, Microsoft Corporation and MGI Software offer photo-editing products and could offer products in this market segment in the future. Increased competition may force us to lower our prices, experience decreased gross margins or lose market acceptance. We face the following challenges from our competitors:
o Certain of our competitors offer products comparable to ours at retail prices that are lower than ours.
o Many of our current and potential competitors have longer operating histories and significantly greater financial, technical, support, sales, marketing, recruiting and other resources.
o Certain of our competitors have greater name recognition and larger customer bases than we do.
o Certain of our competitors may be better able to withstand significant price decreases or devote greater resources to the development, promotion, sale and support of their products than we can.
o Certain of our competitors may be able to develop digital image processing software with superior OCR accuracy, ease of understanding and use, product reliability, tolerance for poor media, product features and functions and price/performance characteristics.
We may not be able to compete successfully against current and future competitors, especially those with greater financial, technical, support, sales, marketing, recruiting and other resources. If we are not successful in meeting the challenges listed above, we may not be able to gain broad market acceptance for our products and our business, financial condition and operating results may suffer. Competitive pressures may materially affect our business, operating results, and financial condition.
Further, we expect that some consolidation in the digital imaging software industry will occur over the next few years through strategic acquisitions or alliances. We expect increased competition from new entrants, including the possibility that Microsoft will add digital imaging components to the Windows operating system. In addition, according to PC Data, Inc., the average retail price of scanners dropped by 47% for the nine months ending September 30, 1998, as compared to the same period in 1997. Based on this historical trend, we expect that scanner prices will continue to decline in the future. We believe that the downward price trend of scanners may reduce prices for digital imaging software products. These changes in the market could result in price erosion, reduced gross margins or loss of market share, any of which could have a material adverse effect on our business, operating results and financial condition.
PRESSURE ON GROSS MARGIN. We may suffer adverse operating results if our gross margin fluctuates. Retail prices on software products drop quickly. In addition, our competitors will attempt to offer products which meet or exceed our products' performance and capabilities. We intend to introduce new software products, software upgrades and software features in response to anticipated competitive price pressures and new product introductions. If prices fall faster than we expect or if we must reduce our prices for any reason, we may experience pressure on our gross margin. In addition, our gross margin will depend in part on certain factors listed below:
o Our success in introducing new products to the market and easing out old ones.
o Our competitors prices, products and market share.
o The amount of royalties we receive under our OEM arrangements.
o General economic conditions.
If we are not successful in meeting these challenges, our business, operating results and financial condition may suffer.
DEPENDENCE ON DISTRIBUTORS AND RESELLERS. We expect to continue to receive a substantial portion of our revenues from sales through our independent distributors and resellers, but we anticipate that our dependence on
any one independent distributor or reseller will decrease in the future as we expand distribution channels. Our agreements with distributors and resellers are not exclusive; many of our distributors and resellers offer competitive products and are not required to give our products priority. Each of our distributors and resellers can cease marketing our products with limited notice and with little or no penalty. If we lose any one of our independent distributors or resellers, we may not be able to recruit replacements. If our distributors or resellers reduce or cease their marketing and sales efforts on our behalf, our business, operating results and financial condition may suffer.
INTERNATIONAL SALES RISKS. We plan to expand our international sales by establishing a more extensive network of international distributors and resellers. We also plan to develop versions of our products suitable to the market requirements of particular foreign countries, such as different languages. We have limited experience in developing international versions of our products and marketing, distributing, servicing and supporting such products. We may not be able to develop new or additional versions of our existing products or successfully market, sell, deliver, service or support our products in international markets. In conducting business outside of the United States, we are exposed to the risks listed below:
o Unexpected changes in regulatory requirements.
o Import and export duties and restrictions.
o Tariffs and other trade barriers.
o Difficulties in staffing and managing foreign operations.
o Longer payment cycles.
o Uncertainties in connection with collecting accounts receivable.
o Political instability.
o Fluctuations in currency exchange rates.
o Logistical difficulties in managing multinational operations.
o Seasonal reductions in business activity during summer months in Europe and certain other parts of the world.
o Potentially adverse tax consequences, including our inability to recover withholding taxes.
If we are not successful in managing the risks listed above, our business, operating results and financial condition may suffer. One or more of these factors could have a material adverse effect on our international operations and, consequently, on our business, operating results and financial condition.
QUALITY CONTROL RISKS. Our products are complex and may contain certain software errors or failures which are detected only after we begin to ship a product, especially when first introduced as new versions or when enhancements are released. Although we conduct testing during product development, we have at times been forced to delay commercial release of software until problems were corrected and, in some cases, have provided enhancements to correct errors in released software. If we do detect any errors before we ship a product, we might have to limit product shipment for an extended period of time while we address the problem. Delay in commercial release, correction of errors or limiting product shipment could lead to loss of revenues, credibility with customers and market acceptance of our products. We would also be exposed to additional warranty and engineering expenses. Despite our testing and testing by current and potential customers, errors may be found in software or releases after commencement of commercial shipments, resulting in loss or delay of revenue or delay in market acceptance, diversion of development resources, damage to our reputation, or increased service and warranty costs. If we do not successfully manage our quality control, our business, operating results and financial condition may suffer.
DEPENDENCE ON THIRD-PARTY LICENSES. We rely on certain technology which we license from third parties, including software which is integrated with our own software and used in our products to perform key functions and provide additional functionality. Because our products incorporate software developed and maintained by third parties, we are, to a certain extent, dependent upon such third parties' ability to maintain or enhance their current products, to develop new products on a timely and cost-effective basis, and to respond to emerging industry standards and other technological changes. Further, these third-party technology licenses may not always be available to us on commercially reasonable terms or at all.
In the event that our agreements with third-party vendors should fail to be renewed or the products licensed from such vendors should fail to address the requirements of our software products, we would be required to find alternative software products or technologies of equal performance or functionality. There can be no assurance that we would be able to replace such functionality provided by software that we currently license from third parties in the event that we lose the license to such software, such software becomes obsolete or incompatible with future versions of our products or is otherwise not adequately maintained or updated. The absence of or any significant delay in the replacement of that functionality could have a material adverse effect on our business, operating results and financial condition. Moreover, if we were to lose any of these technology licenses we might experience product shipment delays or reductions until equivalent technology were identified, licensed and used. If we do experience product shipping delays and reductions due to licensing problems, our business, operating results and financial condition would suffer.
RISKS ASSOCIATED WITH PROTECTION OF CONFIDENTIAL INFORMATION AND PROPRIETARY RIGHTS. We generally enter into confidentiality or license agreements with our employees, consultants and vendors. We also generally control access to and distribution of our software, documentation and other proprietary information. We primarily rely on "shrink wrap" licenses that are not signed by the end-user customer and, therefore, may not be enforceable under the laws of certain jurisdictions. Unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. Policing unauthorized use of our products is difficult and we may not be able to protect our technology from unauthorized use. Additionally, our competitors may independently develop technologies that are substantially the same or superior to ours. In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as the laws of the United States. Although the source code for our proprietary software is protected both as a trade secret and as a copyrighted work, litigation may be necessary to enforce our intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Litigation, regardless of the outcome, can be very expensive and can divert management efforts. These risks, if not managed successfully, could have a material adverse effect on our business, operating results or financial condition.
DEPENDENCE ON KEY PERSONNEL; RISKS ASSOCIATED WITH HIRING AND RETENTION OF EMPLOYEES. We rely to a significant extent upon our senior management team and other key employees. Competition for such employees is intense. We cannot guarantee that we will be able to retain our key employees following the merger. Our operations could be materially and adversely affected if we were unable to retain such key employees, or attract new ones. From time to time, we will need to hire additional or replacement employees. We may not be successful in hiring, integrating or retaining new employees. If we are not successful in attracting or retaining qualified personnel, our business, financial condition and operating results could suffer.
HISTORY OF LOSSES; FLUCTUATIONS IN OPERATING RESULTS. ScanSoft had net losses for 1996, 1997 and 1998. Visioneer also had net losses for its fiscal 1996, 1997 and 1998, although a substantial portion of those losses were attributable to the hardware business that was sold to Primax. On a pro forma basis, the combined companies had a net loss for 1997 and 1998. We may never become profitable or sustain profitability.
Our revenues frequently fluctuate from quarter to quarter due, to a large extent, on the following:
o volume, timing and filling of customer orders;
o reduction in prices in response to competition;
o increased expenditures to pursue new product or market opportunities;
o fluctuation in sales orders, juxtaposed with a significant portion of our operating expenses being fixed in advance, based in large part on forecasts of future sales;
o inability to adjust operating expenses to compensate for shortfalls in sales orders against forecast;
o price protection charges in excess of recorded allowances;
o demand for products;
o seasonality;
o customer deferrals in anticipation of new versions of products;
o introduction of new products by us or our competitors;
o timing of new product acquisitions; and
o timing of significant marketing and sales promotions.
Further, backlog early in a quarter is generally not large enough to assure than we will meet our revenue target for any particular quarter. A shortfall in shipments at the end of any quarter may cause operating results for that quarter to fall significantly short of anticipated levels.
In addition, if we need to reduce our prices in response to price competition, we will therefore be at a significant disadvantage with respect to our competitors that have substantially greater resources. Such competitors may more readily withstand an extended period of downward pricing pressure. In such event, we may also incur price protection charges from our distributors and resellers. Any price protection charges in excess of recorded allowances would have a material adverse effect on our business, operating results and financial condition.
Due to the foregoing factors, among others, our revenues are difficult to forecast. We intend to base our expense levels in significant part on our expectations of future revenue. As a result, we expect our expense levels to be relatively fixed in the short term. Our failure to meet revenue expectations would have a material adverse affect on our business, operating results and financial condition. Further, an unanticipated decline in revenue for a particular quarter may disproportionately affect our net income because a relatively small amount of our expenses are intended to vary with our revenue in the short term. As a result, we believe that period-to-period comparisons of our results of operations are not and will not necessarily be meaningful, and you should not rely upon them as an indication of future performance.
XEROX AS A SIGNIFICANT STOCKHOLDER. Xerox Imaging Systems, Inc., a wholly owned subsidiary of Xerox, owns approximately 45% of our outstanding common stock and all of our outstanding Series B Preferred Stock. In addition, Xerox has the opportunity to acquire additional shares of our common stock pursuant to a warrant. Xerox is currently our largest stockholder. Although Xerox does not control us and is restricted for at least two years after the merger from holding more than 50% of the voting power of our capital stock, Xerox will have a strong influence over matters requiring approval by our stockholders. In addition, Xerox has two designees on the board of directors, including Paul A. Ricci, the new Chairman of the Board.
Xerox has advised us that its current intent is to hold all of its shares of common stock. However, there can be no assurance concerning the periods of time during which Xerox will maintain its ownership of our common stock.
YEAR 2000 RISKS. We have a number of installed computer systems and software products that are coded to accept only two digit entries in the date code field. These date code fields will need to distinguish 21st century
dates from 20th century dates (the "Year 2000 bug"). The Year 2000 bug could lead to system failures or miscalculations causing disruptions of operations including, among other things, a temporary inability to process transactions, send invoices, or engage in similar normal business activities. We are currently in the process of establishing procedures for evaluating and managing the risks and costs associated with this problem. See, "Management's Discussion and Analysis of Financial Condition and Results of Operations--Year 2000." Finally, many of our customers' and suppliers' operations may be affected by Year 2000 complications. As such, the failure of these customers and suppliers to ensure that their systems are Year 2000 compliant could have a material adverse effect on our customers and suppliers, resulting in a material adverse effect on our business, operating results and financial condition.
ITEM 2.
ITEM 2. PROPERTIES
On January 6, 1999, Primax assumed the lease on our former headquarters in Fremont, California. Following the completion of the merger with ScanSoft, Inc., the combined company relocated its headquarters, administrative, sales, marketing and support functions to our leased headquarters facility in Peabody, Massachusetts. We currently occupy 37,636 square feet of space at this facility, and the lease will expire in July 2001. We also lease warehouse space in Topsfield, Massachusetts and research and development space at a Xerox facility in Palo Alto, California. In addition, our subsidiary, ScanSoft Europe Ltd., leases a sales and support office in Reading, England.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
From time to time, we are parties to various legal proceedings or claims, either asserted or unasserted, which arise in the ordinary course of business. In addition, during 1998, we were involved in separate legal matters with Caere Corporation, Flashpix, Incorporated and Storm Technology, Inc.
(1) We were named as the defendant in a complaint filed by Caere Corporation on August 10, 1998, in the United States District Court for the Northern District of California. Caere Corporation alleged that we engaged in false and misleading advertising concerning our software product, ProOCR100. Pursuant to a settlement agreement, we agreed to pay Caere the sum of $75,000, and the lawsuit was dismissed with prejudice.
(2) We were named as a defendant as part of the Digital Imaging Group, in a complaint filed by Flashpix, Incorporated on July 16, 1998, in the United States District Court for the Eastern District of Louisiana. The complaint alleged, among other things, trademark infringement, unfair competition, unfair trade practices, and dilution of trademark. Subsequent to December 31, 1998, we have, along with the Digital Imaging Group, settled this matter.
(3) We were named as the defendant in a complaint filed by Storm Technology, Inc. on June 2, 1998, in the United States District Court for the Northern District of California, alleging patent infringement of specified scanner technology. Subsequently, the parties settled the matter and executed an updated Patent Cross License Agreement. Primax assumed this matter when it purchased our hardware business.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET FOR COMMON STOCK
Our Common Stock commenced trading on the Nasdaq National Market on December 11, 1995 under the symbol "VSNR," and traded under that symbol until March 3, 1999. Our Common Stock is now traded under the symbol "SSFT." The following table sets forth for the periods indicated the high and low sale prices for our common stock as reported on the Nasdaq National Market.
HOLDERS OF RECORD
As of March 26, 1999, there were approximately 244 holders of record of our common stock.
DIVIDENDS
To date, we have not paid any cash dividends on shares of our common stock. We presently intend to retain all future earnings for our business and do not anticipate paying cash dividends on our common stock in the foreseeable future.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The information set forth below is not necessarily indicative of the results of future operations and should be read in conjunction with the information contained in Item 7
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE FINANCIAL STATEMENTS AND THE NOTES THERETO CONTAINED IN ITEM 8 OF THIS REPORT. EXCEPT FOR THE HISTORICAL INFORMATION CONTAINED HEREIN, THE FOLLOWING DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES, SUCH AS STATEMENTS OF OUR PLANS, OBJECTIVES, EXPECTATIONS AND INTENTIONS. OUR ACTUAL RESULTS MAY DIFFER MATERIALLY AS A RESULT OF CERTAIN FACTORS, INCLUDING THOSE DISCUSSED IN THIS REPORT AND OTHER RISKS DETAILED FROM TIME TO TIME IN OUR PERIODIC REPORTS.
OVERVIEW
ScanSoft, Inc. was incorporated as Visioneer, Inc. in California in March 1992, and commenced shipment of our initial product in the first quarter of 1994. Through September 1995, we financed our operations primarily through private placements of equity securities, from which we raised an aggregate of approximately $33 million, net of issuance costs. In December 1995, we reincorporated in Delaware in conjunction with our initial public offering and raised $43.5 million, net of issuance costs. In January 1996, the over allotment option granted to the underwriters in the initial public offering was exercised, resulting in additional net proceeds of approximately $6.4 million. We have experienced sequential growth in annual net revenues since the first year of product shipments. The annual growth rates between 1994 and 1996 were directly attributable to the growth of the sheetfed scanner and document management software markets, the development of OEM relationships and new product introductions. In contrast, the single digit growth rate from 1996 to 1997 was attributed to several factors. First, the grayscale sheetfed scanner market declined sharply with the advent of color sheetfed scanners. The transition of the market from grayscale to color occurred at a much faster rate than we had anticipated, and as a result, we recorded significant charges relating to grayscale inventory reserves, purchase order commitments and price protection charges in the first half of 1997. Second, we were late in introducing a color scanner product, and as a result, did not capture planned market share. Third, increased competition caused overall sheetfed scanner average selling prices to drop significantly. Finally, the growth of the sheetfed scanner market has leveled off, and, in fact, may be decreasing in size.
A key component of our business strategy in 1997 and 1998 was to penetrate the much larger and growing flatbed market by leveraging off of our software. Historically, we have bundled our PaperPort software with our scanner products, which has provided significant product differentiation. The PaperPort flatbed scanner line was introduced in September 1997. This line was enhanced with the introduction of additional 30-bit products as well as the entire 36-bit and One Touch line of flatbed scanners in 1998. In addition, our focus over time has shifted from the hardware business to the software business. During 1997 we implemented a strategy to focus our research and
development efforts on software development rather than hardware development and to leverage the engineering resources of our manufacturing partners to design future hardware products. In furtherance of this strategy, on December 3, 1998, we entered into an agreement to sell our hardware business and the Visioneer brand name to Primax, and to merge with ScanSoft. Following the sale to Primax and the merger with ScanSoft, our business will focus on software products in the PaperPort line, and the TextBridge and Pagis line of software products.
Our success in the future will depend on our ability to maintain software gross margins and increase sales of our software products. This will depend in part on our ability and the ability of our distributors, resellers and OEM partners to convince end-users to adopt paper and image input systems for the desktop and to educate end-users about the benefits of our products. There can be no assurance that the market for our products will develop or that we will achieve market acceptance of our products. Despite experiencing several quarters of minor levels of profitability throughout our history, we have incurred annual net losses since inception. There can be no assurance that we will be able to reach quarterly profitability or attain annual profitability in the near future. As of December 31, 1998, we had an accumulated deficit of $80.4 million.
As a result of the sale of our hardware business in January, our revenues will decline significantly in the first quarter of 1999. We expect our revenues to start improving gradually from the quarter ended June 1999, as revenues from ScanSoft start impacting our operating results.
RESULTS OF OPERATIONS
The following table presents, as a percentage of total net revenues, certain selected financial data for each of the three years in the period ended December 31, 1998:
TOTAL NET REVENUES
We derived our revenue primarily from three sources, the sale of PaperPort hardware products, PaperPort software products, and royalties and custom software development revenue earned pursuant to arrangements with certain OEM customers. Through the end of 1998, approximately 86% of our product revenues have been derived from sales of our PaperPort products to authorized resellers and independent distributors in North America and, to a lesser extent, in Europe and the Asia-Pacific regions. Revenues from all sales to distributors and authorized resellers are subject to agreements allowing price protection and certain rights of return. Under the price protection rights granted by us, if we lower our selling price, we are then obligated to issue credit to our distributors and resellers equal to the difference between the new selling price and the price paid for all unsold inventory held by the distributor and reseller. Accordingly, reserves for estimated future returns, exchanges and price protection are provided upon revenue recognition.
Total net revenues increased 37% to $79.1 million in 1998 from $57.6 million in 1997, despite a 38% reduction in royalty and development revenues from $7.1 million in 1997 to $4.4 million in 1998. The decline in royalty revenues in 1998 was due to the termination, in the third quarter of 1996, of royalties under an OEM agreement with Hewlett-Packard and the termination of royalties under our OEM agreement with Compaq in the first quarter of 1997. In regards to another OEM agreement with Hewlett-Packard, which involved the licensing of our software for Hewlett-Packard scanners, Hewlett-Packard informed us, in the fourth quarter of 1997, that commencing January 1, 1998, it would no longer be building new scanner products incorporating our software. We experienced declining royalties from this agreement in 1998 as Hewlett-Packard sold existing inventory of products incorporating our software which it held at December 31, 1997. Net revenues from hardware product sales increased to $66.0 million in 1998 compared to $41.5 million in 1997. As a result of the addition of the PaperPort 36-bit and OneTouch flatbed color scanner lines in 1998, overall scanner unit sales in 1998 increased by approximately 248% over 1997, despite a 79% decrease in grayscale scanner unit sales. Revenues did not increase at the same rate as unit increases because of the sharp decline in average retail prices offset the net revenue from the increased hardware unit sales from 1997 to 1998. Software revenues increased 4.3% to $8.7 million in 1998 from $8.3 million in 1997. The increase was primarily attributable to the commencement of sales of new PaperPort software products that included ProOCR 100, PaperPort ScannerSuite, Visual Explorer, and PaperPort Deluxe 5.3 released in the second quarter of 1998.
Total net revenues increased 3% to $57.6 million in 1997 from $56.1 million in 1996, despite a 40% reduction in royalty and development revenues from $11.8 million in 1996 to $7.1 million in 1997. The decline in royalty revenue in 1997 was due to the termination of the royalties associated with our OEM agreement with Hewlett-Packard and our OEM agreement with Compaq Computers. Our second OEM agreement with Hewlett-Packard, which related to the licensing of our software for Hewlett-Packard scanners, was terminated in the fourth quarter of 1997.
Our ability to increase our revenues will depend upon our ability to attain wider market acceptance for our software products and our ability to introduce new products with enhanced end-user features on a timely basis. As a result of the sale of our hardware assets, liabilities and intellectual property to Primax Electronics, Ltd., our revenues will be substantially reduced in 1999, even taking into consideration the addition of revenues from the merger with ScanSoft.
Our four largest resellers for 1998 were Sam's Club, Office Depot, Inc., Best Buy Company, Inc. and CompUSA, Inc. for distribution of our products in North America. Sales to these top four independent resellers accounted for 46% of our total net revenues in 1998 in the aggregate, or 18%, 12%, 9% and 7%, respectively. Our four largest resellers and distributors of our products in 1997 were Ingram, Best Buy, Office Depot and Micro Warehouse. Sales to these independent distributors and resellers, in the aggregate, accounted for approximately 38% of total net revenues in 1997. The four largest distributors and resellers in 1996 were Ingram, Best Buy, Tech Data and Merisel. Sales to these independent distributors, in the aggregate, accounted for approximately 52% of our total net revenues in 1996. In 1998, all four of our top customers were resellers compared to 1997, when three out of four of our largest customers, excluding OEMs, were resellers. In contrast in 1996, three out of four of our customers were distributors. We have focused on establishing direct relationships with major resellers, thus
bypassing distributors. This strategy, to a limited extent, reduces a layer of our inventory in the retail channel, thereby reducing inventory risk and increasing channel inventory visibility.
Total net revenues from independent distributors outside North America, primarily in Europe and the Asia-Pacific regions, were approximately 7%, 10% and 13% of total net revenues in 1998, 1997 and 1996, respectively. Net revenues from international sales increased from $5.6 million in 1997 to $5.9 million in 1998, whereas sales decreased from $7.1 million in 1996 to $5.6 million in 1997. The reduction in international revenues from 1996 to 1997 was primarily due to the delayed introduction of Japanese localized PaperPort Strobe products, the first of which were shipped in February 1998, and our decision to restructure our international sales and marketing operations in May 1997. Although our international sales are all denominated in U.S. dollars, these sales are subject to a number of risks inherent in doing business on an international level, such as unexpected changes in regulatory requirements, import and export duties and restrictions, fluctuations in currency exchange rates, and the logistical difficulties of managing multinational operations, any of which could adversely impact the success of our international operations. The growth of our international business will depend, in part, on our ability to increase awareness of our products in international markets. See "Item 1 - -Business-- Marketing, Sales and Distribution."
The introduction of major new software products and enhancements of existing products, such as PaperPort Deluxe, as well as potential OEM agreements, are expected to have a significant impact on our quarterly and annual revenues. As is characteristic of the initial stages of personal computer product life cycles, we expect that sales volumes of any new software product may increase in the first few months following introduction due to the purchase of initial inventory by our distribution channel. Thereafter, revenues may stabilize or decline until the end of a product life cycle, at which time revenues are likely to decline significantly, as a result of unit sales and price reductions. At the end of a product life cycle we may experience higher rates of return and/or increased price protection charges as a result of price reductions. This could have a material adverse impact on our total net revenues and operating results. Although we have sought to mitigate the effect of such transition by controlling inventory levels of our distributors and resellers, channel inventory levels are very difficult to quantify accurately, and we may experience higher than normal rates of return on our older version products and may incur significant price protection charges in connection with our planned release of new PaperPort products and price reductions in 1999. In this regard, receivable allowances were $4.2 million and $5.3 million at December 31, 1998 and 1997, respectively. A substantial portion of these reserves related to the hardware business and were eliminated as part of the sale to Primax on January 6, 1999. Due to the inherent uncertainties of product development and new product introductions, we cannot accurately predict the exact quarter in which a new product or version will be ready to ship. Any delay in the scheduled release of major new products would have a material adverse impact on our total net revenues and operating results.
We have experienced and may continue to experience significant fluctuations in revenues and operating results from quarter to quarter and from year to year due to a combination of factors, many of which are outside of our direct control. After taking into consideration the sale of our hardware business in January 1999, and the merger with ScanSoft in March 1999, these factors include the integration of the Visioneer and ScanSoft businesses, development of the paper input systems market, demand for our products, our success in developing, introducing and shipping new products and product enhancements, the market acceptance of such products, our ability to respond to new product introductions and price reductions by our competitors, the timing, cancellation or rescheduling of significant orders, the purchasing patterns and potential product returns from our distribution channels, our relationships with our OEM partners and distributors, our ability to attract, retain and motivate qualified personnel, the timing and amount of research and development and selling, general and administrative expenditures, and general economic conditions.
Revenues and operating results in any quarter depend, to a large extent, on the volume, timing and ability to fulfill customer orders, which is difficult to forecast. A significant portion of our operating expenses are relatively fixed, based in large part on our forecasts of future sales. If sales are below expectations in any given period, the adverse effect of a shortfall in sales on our operating results may be magnified by our inability to adjust operating expenses to compensate for such shortfall. Accordingly, any significant shortfall in revenues relative to our expectations would have an immediate material adverse impact on our business, operating results and financial condition. We may also be required to reduce prices in response to competition or to increase our spending to
pursue new product or market opportunities. In the event of significant price competition in the market for our products, which is anticipated, we will be required to decrease costs at least proportionately and we will be at a significant disadvantage with respect to our competitors that have substantially greater resources. Such competitors may more readily withstand an extended period of downward pricing pressure. In such event, we will also incur price protection charges from our distributors. Any price protection charges in excess of recorded allowances would have a material adverse effect on our business, operating results and financial condition.
Due to all of the foregoing factors, it is likely that at some point in the future our operating results will be below the expectations of public market analysts and investors. In such event, the price of our common stock would likely be materially adversely affected. Accordingly, our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies participating in new and rapidly evolving markets. There can be no assurance that we will be successful in addressing such risks.
TOTAL COST OF REVENUES
Total cost of revenues consists primarily of the costs associated with the purchase of PaperPort products and related costs of freight, inventory rework, inventory obsolescence and warranty. For 1998, our PaperPort hardware products were manufactured, assembled and tested by five manufacturing partners, Avision, Primax, Flextronics, NMB and Orient SemiConductor. Grayscale sheetfed scanners were manufactured by Flextronics. Our scanning keyboard, PaperPort ix, and the color sheetfed scanner, the PaperPort Strobe, were manufactured by NMB and Orient SemiConductor; and the PaperPort flatbed scanners were manufactured by Primax and Avision. We sold our hardware business to Primax in January 1999. Our software products are manufactured by DCL, which also package and ships the majority of our hardware and software products to our customers. See "Item 1 - -Business--Manufacturing."
Total cost of revenues, as a percentage of total net revenues, decreased in 1998 to 75% as compared to 88% in 1997. The decrease was primarily a result of approximately $9.5 million of charges taken in the first quarter of 1997 for write-offs and increased reserves relating to excess and obsolete grayscale inventory and cancellation charges relating to adverse purchase commitments for grayscale products. Total cost of revenues as a percentage of total net revenues was 88% in 1997 as compared to 81% in 1996. The increase was primarily a result of the charges taken in 1997 as described above.
As a result of the sale of our hardware business, we expect our total cost of revenues, as a percentage of revenue, to decline significantly from the historical levels reported in the statement of operations.
RESEARCH AND DEVELOPMENT EXPENSES
Research and development expenses consist principally of personnel costs, costs of contractors and outside consultants, supplies and material expenses, equipment depreciation and overhead costs relating to occupancy. As of December 31, 1998, we employed 21 full-time and 3 contract software design engineers, technicians and support staff. Upon the completion of the merger on March 2, 1999, we employed 67 full-time technicians and support staff.
Research and development expenses were 6%, 14% and 20% of total net revenues for 1998, 1997 and 1996, respectively. Research and development expenses decreased 46% in absolute dollars to $4.4 million in 1998 from $8.1 million in 1997. Due to our strategy to concentrate our engineering efforts on software development, all of our flatbed scanner lines that were introduced in 1997 and 1998 were designed in cooperation with our manufacturing partners, Primax and Avision.
Research and development expenses decreased 26% in absolute dollars to $8.19 million in 1997 from $10.6 million in 1996. The decrease was primarily the result of the restructuring of the engineering group in May 1997.
We believe that the development of new products and the enhancement of existing products are essential to our success. Accordingly, we will continue to invest in research and development activities. However, such expenses may fluctuate from quarter to quarter depending on a wide range of factors including the status of various development projects. To date, we have not capitalized any development costs and do not anticipate capitalizing any such costs in the foreseeable future.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses include personnel and related overhead costs for sales, marketing, customer support, finance, human resources and general management. Such costs also include advertising, commissions to manufacturers' representative organizations, co-op paid to our distributors and resellers, trade shows and other marketing and promotional expenses.
Selling, general and administrative expenses decreased 14% in absolute dollars to $19.2 million in 1998 from $22.4 million in 1997, and also declined as a percentage of total net revenues, to 24% in 1998 from 39% in 1997. The decrease was the direct result of a Company-wide restructuring plan implemented in May 1997, in which we reduced overall headcount and spending by approximately 40% of first quarter 1997 levels, as well as an additional restructuring in August 1998 which cut existing headcount by an additional 20%. We believe that these spending reductions were necessary in order to reduce our cost structure to allow us to compete more effectively. As noted below, the May 1997 restructuring resulted in a $675,000 one-time charge. The restructuring in August 1998 did not result in a significant one-time charge.
Selling, general and administrative expenses decreased 15% in absolute dollars to $22.4 million in 1997 from $26.3 million in 1996. As a percentage of total net revenues, selling, general and administrative expenses decreased to 39% in 1997 from 47% in 1996. The decrease in spending was primarily attributed to the restructuring plan implemented in May 1997, described above.
We will continue to attempt to control selling, general and administrative expenses. However, if net revenues continue to grow, in order to support our growing operations, selling, general and administrative expenses may increase in absolute terms. Such expenses may fluctuate from quarter to quarter depending on a variety of factors, including the timing of the introduction of any new products, expansion of our distribution channels, general advertising not related to product introductions and expansion into international markets.
NON-RECURRING ITEM
The non-recurring item in 1997 represents expenses incurred for severance and other charges related to the termination of approximately 40 employees and 20 contract employees in connection with the Company-wide restructuring plan implemented in May 1997. The restructuring actions were fully completed as of December 1997.
OTHER INCOME, NET
Other income, net, consists primarily of interest earned on cash equivalents and short-term investments. Other income, net, was $53,000, $940,000, and $2.3 million for the years ended December 31, 1998, 1997 and 1996, respectively. The decrease in other income, net from 1997 to 1998, and 1996 to 1997 was a result of decreased interest income from significantly lower cash, cash equivalents and short-term investments, which were used primarily to fund our operating losses.
TAXATION
At December 31, 1998, we had federal net operating loss carryforwards of approximately $61 million, of which approximately $900,000 related to tax deductions from stock compensation. The tax benefit related to the stock compensation benefit, when realized, will be accounted for as an addition to additional paid in capital rather than as a reduction of the provision for income tax. Research and development credit carryforwards as of December 31, 1998 were approximately $2.0 million. The net operating loss and credit carryforwards will expire at
various dates beginning in 2007, if not utilized. Utilization of the net operating losses and credits may be subject to a substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code of 1986 and similar state provisions. The annual limitation may result in the expiration of net operating losses and credits before utilization. As a result of the new stock issued in conjunction with the merger with ScanSoft, we are not certain whether we will be able to utilize our net operating loss and credit carryforwards without limitations. (See Note 6 of Notes to Financial Statements).
LIQUIDITY AND CAPITAL RESOURCES
Through September 30, 1995, we financed our operations primarily through private placements of equity securities, from which it raised an aggregate of approximately $33 million, net of issuance costs. In December 1995, we completed our initial public offering, and raised approximately $43.5 million, net of issuance costs. In January 1996, the over allotment option granted to the underwriters in the initial public offering was exercised, resulting in proceeds of approximately $6.4 million, net of issuance costs. As of December 31, 1998, we had cash, cash equivalents and short-term investments of $7.9 million and working capital of $6.6 million, as compared to $14.5 million in cash, cash equivalents and short-term investments and $8.4 million of working capital at December 31, 1997.
We used $9.5 million of cash for our operating activities for 1998, as compared to $20.0 million for 1997 and $18.9 million for 1996. Negative cash flows from operating activities for these periods were attributed primarily to net losses incurred of $3.8 million, $23.4 million and $24.4 million for 1998, 1997 and 1996, respectively, offset by non-cash charges and changes in working capital.
Cash provided by investing activities during 1998 was $2.3 million as we decreased short-term investments by $2.6 million and made capital expenditures of $0.3 million. Capital expenditures for 1998 consisted primarily of purchases of manufacturing tools and molds, computer equipment and software tools.
Cash provided by financing activities was $3.5 million during 1998. At December 31, 1998, we had short-term bank borrowings of $3.2 million, and $0.3 million was provided by proceeds from the issuance of Common Stock in connection with our employee stock purchase plan and the exercises of stock options.
On March 19, 1998, we amended our $7.5 million line of credit, increasing the line to $12.5 million and extending the expiration date to March 1999. The line bore an interest rate of 0.25% over the Prime Rate, and was collateralized by a security interest in our assets. As of December 31, 1998, we had $6.0 million of short-term borrowings and $0.3 million of letters of credit outstanding under the line of credit, and we were not in compliance with all financial covenants under the agreement. As a result of the sale of our hardware business to Primax, we paid all amounts owed on the line, cancelled the line and obtained a waiver of covenant default for the period ended December 31, 1998.
Our principal sources of liquidity as of December 31, 1998 consisted of approximately $7.9 million of cash, cash equivalents and short-term investments. Subsequent to our year end, we sold our hardware business to Primax for $7 million. In addition, the merger with ScanSoft provided additional cash of $0.8 million with no associated long- or short-term debt. Based upon these events and existing cash balances, we believe that our existing sources of liquidity will provide adequate cash to fund our operations for at least the next twelve months. Thereafter, if cash generated by operations is insufficient to satisfy our liquidity requirements, we may be required to sell additional equity or debt securities, or increase or obtain additional lines of credit. The sale of additional equity or convertible debt securities may result in additional dilution to our stockholders.
PRO FORMA RESULTS AND RELATED MANAGEMENT DISCUSSION AND ANALYSIS
The following two tables present, as dollar amounts and as a percentage of total net revenues, the condensed unaudited pro forma total net revenues, and certain selected financial data for each of the two years in the period ended December 31, 1998, assuming the sale of the hardware business and the merger with ScanSoft
occurred at the beginning of the periods presented and after excluding the impact of non-recurring charges resulting from the merger, such as in process research and development:
UNAUDITED PRO FORMA TOTAL NET REVENUES
The pro forma net revenues represent revenues from the combination of our software business with that of ScanSoft's and comes primarily from two sources, the sale of PaperPort, TextBridge, and Pagis software products, and royalties and custom software development revenue earned pursuant to arrangements with certain OEM customers. To date, a vast majority of our product revenues have been derived from sales of our software products to authorized resellers and independent distributors.
Total net revenues increased in 1998 from 1997, due primarily to the increase in unit shipments of products offset partially by a decline in royalty revenues.
The decline in royalty revenues in 1998 was due to the termination, in the third quarter of 1996, of royalties under our OEM agreement with Hewlett-Packard.
The introduction of major new software products and enhancements of existing products, as well as potential OEM agreements, are expected to have a significant impact on our quarterly and annual revenues.
UNAUDITED PRO FORMA TOTAL COST OF REVENUES
The pro forma cost of revenues consists primarily of the costs associated with the purchase of software products and related costs of freight, inventory obsolescence and warranty.
The pro forma cost of revenues, as a percentage of total net revenues, increased in 1998 to 28% as compared to 25% in 1997. The increase was attributable primarily to the reduction in royalty revenues, which carry minimal or no cost of revenues.
UNAUDITED PRO FORMA RESEARCH AND DEVELOPMENT EXPENSES
Pro forma research and development expenses consist principally of personnel costs, costs of contractors and outside consultants, supplies and material expenses, equipment depreciation and overhead costs relating to occupancy.
Pro forma research and development expenses decreased 13% in absolute dollars to $9.8 million in 1998 from $11.3 million in 1997. The decrease was primarily the result of the restructuring of the engineering group in May 1997 and the focus on software development rather than hardware development.
UNAUDITED PRO FORMA SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Pro forma selling, general and administrative expenses include personnel and related overhead costs for sales, marketing, customer support, finance, human resources and general management. Such costs also include advertising, commissions to manufacturers' representative organizations, co-op paid to our distributors and resellers, trade shows and other marketing and promotional expenses.
Pro forma selling, general and administrative expenses decreased 5% in absolute dollars to $15.0 million in 1998 from $15.7 million in 1997, and also declined as a percentage of total net revenues, to 43% in 1998 from 46% in 1997. The decrease was the direct result of a Company-wide restructuring plan implemented in May 1997, in which we reduced overall headcount and spending, as well as an additional restructuring in August 1998 which cut existing headcount.
We anticipate that selling, general and administrative expenses as a percentage of net revenues, and absolute dollars will decrease in the future due to the merger.
UNAUDITED PRO FORMA OTHER OPERATING EXPENSES
Pro forma other operating expense contains the amortization of goodwill and other identified intangible assets arising from the merger that have estimated useful lives ranging from three to seven years.
UNAUDITED PRO FORMA OTHER INCOME, NET
Pro forma other income, net, consists primarily of interest earned on cash equivalents and short-term investments. Other income, net, was $28,000 and $198,000 for the years ended December 31, 1998 and 1997, respectively. The decrease from 1997 to 1998 was a result of decreased interest income from significantly lower cash, cash equivalents and short-term investments, which were used primarily to fund our operating losses.
YEAR 2000 COMPLIANCE
We are aware of the potential business risks associated with the "Year 2000" millennium issue. Based upon this potential business risk, we have developed a strategy to examine the potential effect of this issue. The following strategy outlines the process by which we are trying to minimize the potential risk associated with the "Year 2000" millennium issue.
We are in the process of assessing the potential effects of the "Year 2000" millennium change on our business systems and processes, including facilities, software and components used by our employees, as well as our outsourcing vendors and critical suppliers. Our Year 2000 project is proceeding on schedule. The project goal is to ensure that our business is not impacted by the date transitions associated with the Year 2000.
Our Year 2000 project plan is coordinated by a team that reports to senior management. The project team is evaluating the Year 2000 compliance of our business systems and processes, including facilities, software and components used by our employees, as well as our outsourcing vendors and critical suppliers who provide services relating to our business. Our Year 2000 project is comprised of the following phases:
o Phase 1 - Inventory all business systems and processes, including facilities, software and components used by our employees, in order to assign priorities to potentially impacted systems and services. This phase was completed by January 31, 1999 and a complete inventory was compiled.
o Phase 2 - Assess the Year 2000 compliance of all inventoried business systems and processes, including facilities, software and components used by our employees, and determine whether to renovate or replace any non-Year 2000 compliant systems and services. This phase was completed by March 31, 1999.
o Phase 3 - Complete remediation, if any is required, of any non-compliant business systems and processes, including facilities, software and components used by our employees and outsourcing vendors. Conduct procurements to replace any other non-Year 2000 compliance business systems and processes, including facilities, software and components used by our employees and outsourcing vendors that won't be remediated. We expect to complete all remediation efforts, if any are required, by June 30, 1999.
o Phase 4 - Test and validate remediated and replacement systems, if any such remediation or replacement is required, to ensure inter-system compliance and mission critical system functionality. We expect to complete testing and validation efforts, if any are required, by July 31, 1999.
o Phase 5 - Deploy and implement remediated and replacement systems, if any deployment or implementation is required, after the completion of successful testing and validation. We expect to complete the deployment and implementation of the remediated or replacement systems, if any is required, by September 30, 1999.
o Phase 6 - Design contingency plan and business continuation plans in the event of the failure of business systems and processes, facilities, data networking infrastructure, software and components used by our employees due to the Year 2000 millennium change. We expect that the initial contingency and business continuation plan will be in place by November 30, 1999.
Based on our inventory and assessment to date, we believe that our internal mission critical systems are Year 2000 compliant and that our facilities can be Year 2000 compliant. In addition, we are seeking assurances from our facilities' landlords and equipment vendors and data circuit providers regarding the Year 2000 compliance of their facilities and equipment.
At this time, we believe that our incremental remediation costs, if any, needed to make our current business systems and processes, including facilities, software and components used by our employees and outsourcing vendors, are not material. While we are incurring some incremental costs, our incurred costs through December 31, 1998 were less than $60,000. Our expected total costs, including remediation and replacement costs, if any, are estimated to be between $100,000 and $200,000 over the life of the Year 2000 project.
We are contacting our hardware and software vendors, other significant suppliers, manufacturers, outsourcing service providers and other contracting parties to determine the extent to which we are vulnerable to any one of their failures to achieve Year 2000 compliance for their own systems. At the present time, we do not expect Year 2000 issues of any such third parties to materially affect our business.
Should we fail to solve a Year 2000 compliance problem to our critical business systems and processes, the result could be a failure or interruption to normal business operations.
Despite the assurances of our third-party suppliers, hardware and software vendors, and outsourcing service providers regarding Year 2000 compliance of their products and services, the potential exists that a Year 2000 problem relating to such third-party suppliers, vendors and outsourcing service providers products and services could have a material impact on our business. We are conducting monthly discussions with our critical outsourcing service providers to determine the progress of their Year 2000 compliance programs.
Despite extensive preparation and effort to ensure Year 2000 compliance, implementation of our business continuation contingency plan for a very short time may be required while we remediate the Year 2000 problem.
Despite our belief that our mission critical computer software applications and systems are Year 2000 compliant and our expectation that our enhancement effort will result in Year 2000 compliant systems, we are currently developing a business continuation contingency plan. We expect to finalize our initial contingency plan to complete the testing of all existing systems by November 30, 1999.
The Foregoing Year 2000 discussion contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements, including without limitation, anticipated costs and the dates by which certain actions are expected to be completed, are based on management's best current estimates, which were derived utilizing numerous assumptions about future events, including the continued availability of certain resources, representations received from third parties and other factors. However, there can be no guarantee that these estimates will be achieved, and actual results could differ materially from those anticipated. Specific factors that might cause such material differences include, but are not limited to, the ability to identify and remediate all relevant systems, results of Year 2000 testing, adequate resolution of Year 2000 issues by governmental agencies, businesses and other third parties who are outsourcing service providers suppliers and vendors, unanticipated system costs, the adequacy of and ability to implement contingency plans and similar uncertainties. The "forward-looking statements" made in the foregoing Year 2000 discussion speak only as of the date on which such statements are made, and management does not undertake any obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
INVESTMENT RISK
As of December 31, 1998, our investment portfolio consisted of fixed income securities. These securities, like all fixed income instruments, carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Page ---- Financial Statements:
Report of Independent Accountants...................................... 33
Balance Sheets......................................................... 34
Statements of Operations .............................................. 35
Statements of Cash Flows............................................... 36
Statements of Stockholders' Equity..................................... 37
Notes to Financial Statements.......................................... 38
Financial Statement Schedules:
Report of Independent Accountants on Financial Statement Schedules..... 50
Schedule II -Valuation and Qualifying Accounts and Reserves............ 51
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of ScanSoft, Inc.
In our opinion, the accompanying balance sheets and the related statements of operations, of stockholders' equity and of cash flows present fairly, in all material respects, the financial position of ScanSoft, Inc. (formerly Visioneer, Inc.) at December 31, 1998, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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 the opinion expressed above.
PricewaterhouseCoopers LLP
San Jose, California January 27, 1999, except for Note 3, which is as of March 2, 1999
SCANSOFT, INC.
NOTES TO FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
ORGANIZATION AND PRESENTATION
ScanSoft, Inc. (the "Company") was incorporated as Visioneer, Inc. in the state of California on March 10, 1992 and was reincorporated in the state of Delaware on December 5, 1995. The Company develops and markets scanner hardware and software for sale primarily through retail distributors or directly to retailers. The Company began primarily as a scanner hardware company and spent most of its research and development time on the development of scanner products and related bundled software for this market. In 1997, the Company decided to leverage off the merits of its software in an attempt to penetrate the flatbed scanner market and to introduce stand alone software products. The Company's focus over time has shifted from the hardware business to the software business and during 1997, the Company implemented a strategy to focus its research and development efforts on software development rather than hardware development and to leverage the engineering resources of its manufacturing partners to design future hardware products. As a follow on to this strategy, the Company negotiated an agreement with Primax Electronics, Ltd. ("Primax") to sell the hardware business of the Company which was completed on January 6, 1999. (See Note 2). As part of the sale to Primax, the name "Visioneer" was also sold and a majority of the Company's employees, including its president and selected vice presidents, became employees of Primax.
As a result of the change in business strategy, the Company also entered into an agreement to purchase the business of ScanSoft, Inc., an indirect wholly owned subsidiary of Xerox. This transaction was consummated on March 2, 1999. (See Note 3). In connection with this acquisition, the Company changed its name to ScanSoft, Inc.
The Company's fiscal year ends on the Sunday closest to December 31. Accordingly, fiscal 1998 ended January 3, 1999 and contained 53 weeks. Fiscal years 1997 and 1996 each had 52 weeks. The Company reports quarterly results generally on thirteen-week quarterly periods, each ending on the Sunday closest to month-end. For purposes of presentation, the Company has indicated its accounting year as ending on December 31 or our interim quarterly periods as ending on the respective calendar month-end.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities on the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.
REVENUE RECOGNITION
Revenue from product sales to customers is generally recognized when the product is shipped, provided no significant obligations remain and collectibility is probable. Revenues from sales to distributors and authorized resellers are subject to agreements allowing price protection and certain rights of return. Accordingly, reserves for estimated future returns, exchanges and credits for price protection are provided for upon revenue recognition. The Company has limited control over the extent to which products sold to distributors and resellers are sold through to end users. Accordingly, a portion of the Company's sales may from time to time result in increased inventory at its distributors and resellers. The Company provides sales returns reserves for distributor and reseller inventories. These reserves are based on the Company's estimates of inventory held by its distributors and resellers and the expected sell through of its products by its distributors and resellers. Actual results could differ from these estimates.
The Company earns royalty and custom software development revenue pursuant to certain license agreements and records revenue when earned. Payments received from customers prior to revenue recognition and gross profits on shipments to customers prior to related revenue recognition are reported as "deferred revenues" and are included in other accrued liabilities in the balance sheet.
CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS
Cash equivalents are short-term, highly liquid instruments with original maturities of 90 days or less. The Company has classified all its securities as "available for sale." These securities are comprised primarily of commercial paper with maturities within one year. At December 31, 1998 and 1997 the fair market value of these securities approximated cost.
INVENTORY
Inventory is stated at the lower of cost or market, cost being determined on a first-in, first-out basis.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, which is generally one to five years. Leasehold improvements are amortized over the term of the related lease or the useful life, if shorter.
SOFTWARE DEVELOPMENT COSTS
Software development costs incurred prior to establishment of technological feasibility are expensed as incurred. The Company defines establishment of technological feasibility as the completion of a working model. Software development costs incurred subsequent to the establishment of technological feasibility through the period of general market availability of products will be capitalized, if material. To date, all software development costs have been expensed.
WARRANTY COSTS
The Company provides for the estimated cost which may be incurred under its product warranties upon product shipment.
INCOME TAXES
The Company accounts for income taxes utilizing an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's Financial Statements or income tax returns. In estimating future tax consequences, the Company generally considers all expected future events other than enactments of changes in the tax laws or rates.
COMPREHENSIVE INCOME (LOSS)
In 1998, the Company adopted SFAS No. 130, "Reporting Comprehensive Income." Comprehensive income is defined as the change in equity of a company during a period from transactions and other events and circumstances excluding transactions resulting from investments by owners and distributions to owners. The Company's comprehensive loss for 1996, 1997 and 1998 is the same as its reported net loss.
CONCENTRATION OF CREDIT RISK
Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of cash equivalents, short-term investments and trade accounts receivable. The Company invests
in a wide variety of financial instruments, such as certificates of deposits, commercial paper, municipal debt and U.S. government agency debt. The Company, by policy, limits the amount of credit exposure to any one financial institution. The Company performs ongoing credit evaluations of its customers' financial condition and maintains an allowance for uncollectible receivables based upon expected collectibility of accounts receivable. At December 31, 1998, 1997 and 1996 the Company's top two customers in aggregate accounted for 30%, 42% and 40% respectively, of accounts receivable.
FAIR VALUE DISCLOSURES OF FINANCIAL INSTRUMENTS
The estimated fair value of financial instruments at December 31, 1998 and 1997 was not significantly different than the values presented in the balance sheets.
NET LOSS PER SHARE
Basic loss per share is based on the weighted average number of common shares outstanding, and diluted loss per share is based on the weighted average number of common shares outstanding and dilutive potential common shares outstanding. However, because the Company has been in a net loss position on an annual basis since 1995, the effects of potential common shares outstanding have been excluded as they would be anti-dilutive in the loss per share calculation. All options outstanding during 1998, 1997 and 1996 were excluded from diluted loss per share calculations because they were anti-dilutive in view of the losses incurred by the Company.
EMPLOYEE STOCK PLANS
In October 1995, the Financial Accounting Standards Board issued SFAS No. 123, "Accounting for Stock Compensation." SFAS 123 establishes an accounting method based on the fair value of equity instruments awarded to employees as compensation. The Company has elected to retain its current application of Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees." The Company has adopted, as required, the disclosure provisions of SFAS No. 123.
RECENTLY ISSUED ACCOUNTING STANDARDS
In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133 (SFAS 133), "Accounting for Derivative Instruments and Hedging Activities." SFAS 133 requires that all derivatives be recognized at fair value in the statement of financial position, and that corresponding gains or losses be reported either in the statement of operations or as a component of comprehensive income, depending on the type of hedging relationship that exists. The Company is currently assessing the disclosure effects of adopting SFAS 133, which will be effective for the Company's fiscal 2000 financial statements.
NOTE 2. SALE OF HARDWARE BUSINESS:
On December 3, 1998, the Company entered into an agreement to sell its hardware assets, liabilities and intellectual property to Primax for approximately $7 million in cash. The terms of the agreement also grant to Primax a software license agreement that allows them to "bundle," market and sell the Company's PaperPort software with Primax hardware products. The agreement requires the payment of certain royalties by Primax to the Company.
On January 6, 1999 the agreement with Primax was consummated. Accordingly, in the quarter ending March 31, 1999, the Company will report a non-operating gain related to the sale of the hardware business, less costs and expenses of disposing of the business. The most significant assets and liabilities at December 31, 1998 of the hardware business were receivables, inventories and accounts payable in the approximate amounts of $12.7 million, $4.4 million and $10.7 million, respectively. In addition, Primax assumed the lease of the Company's current corporate facilities. The Company entered into an agreement with Primax to pay Primax rent for their use of this facility until the move of the corporate offices to Peabody, Massachusetts after the acquisition of ScanSoft in March 1999.
HARDWARE BUSINESS PRO FORMA INFORMATION (UNAUDITED)
As a result of the sale of the hardware business on January 6, 1999, the revenues and other operating expenses related to the hardware business will not continue. The following summarizes the unaudited pro forma operating information for the hardware business and the remaining software business for the year ended December 31, 1998:
NOTE 3. ACQUISITION OF SCANSOFT:
The Company acquired ScanSoft, a company that develops, markets, distributes and supports systems and software that capture, communicate and print documents at the desktop, effective March 2, 1999 for approximately 6.8 million shares of Common Stock of the Company, 3.6 million shares of non-voting Preferred Stock of the Company and exchange of 1.7 million employee stock options to purchase Common Stock of the Company in exchange for outstanding employee stock options of ScanSoft. Additionally, in conjunction with the acquisition, the Company incurred approximately $1.5 million of acquisition related costs.
This acquisition is being accounted for under the purchase method of accounting. Based on a preliminary appraisal, the Company expects to record a one time write-off of approximately $4 million in the quarter ending March 31, 1999 related to the estimated value of in-process research and development acquired as part of the purchase. For its year ended December 31, 1998, ScanSoft had net revenues of $21.7 million (unaudited) and a net loss of $1.9 million (unaudited). Also at December 31, 1998 ScanSoft had total assets of approximately $6.8 million (unaudited).
NOTE 4. BALANCE SHEET COMPONENTS:
The following table summarizes key balance sheet components:
NOTE 5. BANK LINE OF CREDIT:
At December 31, 1998, the Company had a $12.5 million line of credit with a bank with an expiration date in March 1999. The line of credit was collateralized by a security interest in the Company's assets and carried an interest rate of 8.25%. At December 31, 1998, the Company had bank borrowings of $6.0 million under this line of credit and the Company was not in compliance with certain covenants, for which the bank issued a waiver. In connection with the sale of the hardware business in January 1999 (see Note 2), the outstanding borrowings were paid and the line of credit was terminated.
NOTE 6. INCOME TAXES:
No provision for federal or state income taxes has been recorded as the Company has incurred net operating losses through December 31, 1998.
Management believes that based on a number of factors, the available objective evidence creates sufficient uncertainty regarding the realizability of the deferred tax assets such that full valuation allowance has been recorded. These factors include the lack of significant history of profits, the fact that the market in which the Company competes is intensely competitive and characterized by rapidly changing technology, and lack of carryback capacity to realize these assets.
At December 31, 1998, the Company had federal net operating loss carryforwards of approximately $61 million, of which approximately $900,000 related to tax deductions from stock compensation. The tax benefit related to the stock compensation benefit, when realized, will be accounted for as an addition to additional paid in capital rather than as a reduction of the provision for income tax. Research and development credit carryforwards as of December 31, 1998 were approximately $2.0 million. The net operating loss and credit carryforwards will expire at various dates beginning in 2007, if not utilized. Utilization of the net operating losses and credits may be subject to a substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code of 1986 and similar state provisions. The annual limitation may result in the expiration of net operating losses and credits before utilization. At December 31, 1998 the federal net operating loss and credit carryforwards of the Company were not subject to any material limitations. The federal net operating loss carryforwards differ from the accumulated deficit principally due to temporary differences in the recognition of certain expense items for financial statement and federal tax reporting purposes, consisting primarily of certain reserves and allowances not currently deductible for tax and start-up and development costs capitalized for tax purposes.
NOTE 7. STOCKHOLDERS' EQUITY:
RESTRICTED COMMON STOCK
In February 1993, the Company's board of directors adopted the 1993 Restricted Stock Purchase Plan (the "Purchase Plan") which provided for the sale of Common Stock to employees and consultants. Restricted shares purchased under the Purchase Plan are subject to a repurchase right by the Company. This repurchase right generally lapses over a 48-month period. This plan was terminated on October 16, 1995. As of December 31, 1998, no shares were subject to repurchase under the Purchase Plan.
COMMON STOCK WARRANTS
At December 31, 1994, the Company had 101,500 Series C Convertible Preferred Stock warrants outstanding which were exercisable at $4 per share. In conjunction with its initial public offering, 85,000 of these warrants were exercised on a net issuance basis for 65,000 Common shares. The remaining 16,500 warrants automatically converted into Common Stock warrants upon the completion of the Company's initial public offering. These warrants will expire on June 30, 2004.
During the quarter ended December 31, 1995 the Company issued a warrant to purchase 110,000 shares of its Series C Convertible Preferred Stock in connection with a technology licensing arrangement. The warrant expires on November 1, 1999 and is exercisable at $9 per share. The Company assigned a value of $300,000 to this warrant. The warrant automatically converted into a Common Stock warrant upon the completion of the Company's initial public offering.
DEFERRED COMPENSATION RELATING TO STOCK OPTIONS
Based on an independent consultant's valuation report, management believes that the exercise price for certain options granted during 1995 was below the estimated fair value of the Company's Common Stock at the dates of the grants. The Company recorded deferred compensation expense of $400,000 related to these grants which is being amortized over related vesting periods of the options. As of December 31, 1998, the Company has recorded an expense of $350,000 related to this compensation.
NOTES RECEIVABLE FROM STOCKHOLDERS
In exchange for the issuance of Common Stock in fiscal 1995 and 1994 under the 1993 Restricted Stock Purchase Plan, the Company received notes receivable from certain stockholders that bore interest at rates varying from 4.86% to 7.2% per annum. During 1998, all loan balances were fully settled.
NOTE 8. STOCK COMPENSATION PLANS:
1993 INCENTIVE STOCK OPTION PLAN
In February 1993, the Company's board of directors adopted the 1993 Incentive Stock Option Plan (the "Option Plan"). Under the Option Plan, the Board of Directors are authorized to issue options for up to 3,870,000 shares of Common Stock to employees and consultants of the Company at grant prices determined by the Board of Directors on the date of grant. The Option Plan allows for incentive stock options to be granted to employees and non-statutory stock options to be granted to employees and consultants.
Options granted under the Option Plan expire no later than ten years from the date of grant (no later than five years for 10% shareholders). The exercise price will be at least 100% and 85% of the fair value of the stock subject to the option on the date the option is granted as determined by the Board of Directors for incentive stock options and non-statutory stock options, respectively (110% of the fair value for 10% shareholders). The options generally become exercisable in increments over a period of four years from the date of grant, with the first increment vesting after one year. At the discretion of the Board of Directors, options may be granted with different vesting terms.
1995 DIRECTORS' STOCK OPTION PLAN
In October 1995, the Company instituted a directors' stock option plan and reserved a total of 200,000 shares of the Company's Common Stock for issuance of stock options thereunder. On October 3, 1997, at the Company's Annual Meeting of Stockholders, an amendment was approved to increase the options available in this plan by 120,000 to an aggregate of 320,000. The Plan allows for granting of stock options to members of the Board of Directors who are not employees of the Company. The options generally become exercisable in increments over
a period of four years from the date of grant, with the first increment vesting after one year. The price of the options are equal to the fair market value of the Company's Stock on the date of the grant.
1997 EMPLOYEE STOCK OPTION PLAN
In February 1997, the Board of Directors adopted the 1997 Employee Stock Option Plan (the "1997 Option Plan") to provide for the granting of non-statutory stock options only to eligible employees and consultants who are not officers or directors of the Company, with the exception of officers who were not previously employed by the Company and for whom an option grant is an inducement essential to such officers' entering into an employment relationship or contract with the Company. The 1997 Option Plan was adopted in response to the non-availability of options for future grant under the Option Plan. The Company has reserved a total of 1,300,000 shares under this plan.
Options granted under the 1997 Option Plan expire no later than ten years from the date of grant (no later than five years for 10% shareholders). The exercise price will be at least 100% and 85% of the fair value of the stock subject to the option on the date the option is granted as determined by the Board of Directors for incentive and non-statutory stock options, respectively (110% of the fair value for 10% shareholders). The options generally become exercisable in increments over a period of four years from the date of grant. At the discretion of the Board of Directors, options may be granted with different vesting terms.
NON-STATUTORY OPTION GRANT TO A DIRECTOR
On April 9, 1997, the Company's Board of Directors granted non-statutory stock options for 30,000 shares of Common Stock to Mr. Jeffrey Heimbuck, in conjunction of him becoming a member of the Company's Board of Directors. The option grants were made outside of the 1995 Directors' Stock Option Plan at an exercise price of $3.50 per share. All such options become exercisable in annual installments of 25% of the total number of shares subject to each option on each anniversary of the date of grant. On October 15, 1998, Mr. Heimbuck resigned as a member of the Company's Board of Directors and the Non-Statutory Option Grant was canceled.
REPRICING OF STOCK OPTIONS
In January 1998, the Company allowed all holders of outstanding options to exchange higher priced options for new options at $1.75 per share, the fair market value at the time of the exchange. The repricing terms provided that for each seven shares of options exchanged, six new options would be granted. The repriced options maintained the same vesting schedule. Options for 2,656,449 shares were exchanged for new options for 2,276,956 shares and are included in the summary stock option table in the options cancelled and options granted categories.
1995 EMPLOYEE STOCK PURCHASE PLAN
In October 1995, the Company instituted an employee stock purchase plan (the "1995 Purchase Plan") and reserved a total of 300,000 shares of the Company's Common Stock for issuance thereunder. On October 3, 1997, at the Company's Annual Meeting of Stockholders, an amendment was approved to increase the shares available in this plan by 400,000 to an aggregate of 700,000. The 1995 Purchase Plan permits employees to acquire shares of the Company's Common Stock through payroll deductions. During 1996, 1997, and 1998 shares issued under this plan aggregated 110,996, 188,797, and 116,969 respectively.
PRO FORMA INFORMATION
As of December 31, 1998, the Company had five stock-based compensation plans as described above. The Company applies APB Opinion No. 25 and related Interpretations in accounting for its plans. Accordingly, no compensation cost has been recognized for these stock option plans. Had compensation cost for options granted in 1998, 1997 and 1996 under the Company's option plans been determined based on fair market value at the grant dates, as prescribed by SFAS No. 123, the Company's net loss and pro forma net loss (in thousands) and the Company's net loss and pro forma net loss per share would have been as follows:
The weighted average fair market value of options granted was $ 1.16 per share, $3.87 per share and $3.80 per share for the years ended December 31, 1998, 1997 and 1996, respectively.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants during the applicable period: expected volatility of 70% for all periods, risk-free interest rate of 5.12% for options granted in 1998, 5.71% for options granted in 1997 and 6.19% for options granted in 1996, and a weighted average expected option term of 5.0 years for all periods. The Company has not paid dividends and assumed no dividend yield.
The following table summarizes information about stock options outstanding under the 1993 Incentive Stock Option Plan, the 1997 Employee Stock Option Plan, the 1995 Directors' Stock Option Plan and the Non-Statutory Option Grant to Director at December 31, 1998:
For the Employee Stock Purchase Plan, the fair value of each purchase right is estimated at the beginning of the offering period using the Black-Scholes option-pricing model with the following weighted-average assumptions used in 1998, 1997 and 1996: expected volatility of 70% for all three years; risk-free interest rate of 5.12%, 5.71% and 5.17% for 1998, 1997 and 1996, respectively; and expected lives of six months for all three years. The Company has not paid dividends and assumed no dividend yield. The weighted-average fair value of all purchase rights granted in 1998, 1997 and 1996, were $0.70, $2.14 and $2.89, respectively.
NOTE 9. COMMITMENTS AND CONTINGENCIES:
OPERATING AND CAPITAL LEASES
The Company leases its facility in California and certain equipment under noncancelable operating leases. Total rent expense under these operating leases for the years ended December 31, 1998, 1997 and 1996 was $339,000, $657,000, and $546,000, respectively.
In August 1997, the Company entered into an agreement with a third party to sublease 17,928 square feet within the Company's leased facility in Fremont, California. The term of the sublease is forty-six months. The income is used to offset the Company's rent expense. As indicated in Note 2, as part of the sale of its hardware business, the Company's leases were included in the sale and therefore the Company's lease and sublease commitments outstanding at December 31, 1998, were assumed by Primax.
LETTERS OF CREDIT
As of December 31, 1998, the Company had two letters of credit outstanding totaling $0.3 million. The letters of credit were secured by the Company's line of credit. The letters of credit are secured by certificates of deposit which are presented as restricted cash at December 31, 1998. As indicated in Note 2, as part of the sale of its hardware business all of the Company's commitments associated with the letters of credit were included in the sale.
LITIGATION AND OTHER CLAIMS
The Company is a party to litigation and patent infringement matters and claims which arose in the course of the Company's operations. While the results of such litigation and claims cannot be predicted with certainty, the Company believes that the final outcome of such matters will not have a significant adverse effect on the Company's financial position and results of operations. However, should the Company not prevail in any such litigation, its operating results and financial position could be adversely impacted.
NOTE 10. NON-RECURRING ITEM:
The Company implemented a restructuring plan of all its organizations in May 1997 which included a decrease of approximately 40% of total employee and consultant headcount. A one-time restructuring charge of $675,000 was recorded in the three month period ended June 30, 1997, representing severance paid to terminated employees.
NOTE 11. SEGMENT, GEOGRAPHIC AND SIGNIFICANT CUSTOMER INFORMATION
In 1998, the Company adopted Statement of Financial Accounting Standards (FAS) 131, "Disclosures about Segments of an Enterprise and Related Information." FAS 131 supersedes FAS 14, "Financial Reporting for Segments of a Business Enterprise," replacing the "industry segment" approach with the "management" approach. The management approach designates the internal organization that is used by management for making operating decisions and assessing performance as the source of the Company's reportable segments. FAS 131 also requires disclosures about products and services, geographic areas and major customers. The adoption of FAS 131 did not affect results of operations or financial position or the segment information reported in 1997. Based on its management structure, the Company has one reporting segment.
During 1998, two customers accounted for 18% and 12% of total net revenues, respectively. One customer accounted for 21% of total net revenues in 1997. In 1996, one customer accounted for 37% of total net revenues.
REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES
To the Board of Directors and Stockholders of ScanSoft, Inc.
Our audits of the financial statements referred to in our report dated January 27, 1999, except for Note 3, which is as of March 2, 1999, appearing on page 33 in the 1998 Annual Report on Form 10-K also included an audit of the Financial Statement Schedule listed in Item 14(a) of this Form 10-K. In our opinion, the Financial Statement Schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related financial statements.
PricewaterhouseCoopers LLP
San Jose, California January 27, 1999
Schedule II
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not Applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth certain information regarding our executive officers and directors as of March 26, 1999.
Name Age Position ---- --- --------
Michael K. Tivnan 46 President, Chief Executive Officer, and Director Paul A. Ricci(1)(2) 42 Chairman of the Board of Directors Wayne S. Crandall 40 Vice President Sales and Channel Marketing Steven C. Ricketts 36 Vice President Marketing Stanley E. Swiniarski 41 Vice President Development J. Larry Smart(1) 51 Director William J. Harding(1)(2) 51 Director David F. Marquardt(2) 50 Director Mark B. Myers 59 Director
- ----------
(1) Member of the Audit Committee of the Board of Directors. (2) Member of the Compensation Committee of the Board of Directors.
Mr. Tivnan has served as the President and Chief Executive Officer of the Company since March 2, 1999. From February 1998 until March 2, 1999, Mr. Tivnan served as the President of ScanSoft, Inc., which was then operating as an indirect wholly owned subsidiary of Xerox. From November 1993 until February 1998, Mr. Tivnan served as General Manager and Vice President of ScanSoft. From January 1991 until November 1993, Mr. Tivnan served as Chief Financial Officer of ScanSoft.
Mr. Ricci has served as the Chairman of the Board of Directors since March 2, 1999. Mr. Ricci joined Xerox in 1992 and is currently the Vice President, Corporate Business Development, a position he has held since January 1998. Prior to assuming his current position, Mr. Ricci has held several positions within Xerox, including serving as President, Software Solutions, in Xerox's Document Services Group, and as President of the Desktop Document Systems Division. Mr. Ricci has served as Chairman of the Board of Directors of ScanSoft since June 1997 and has served as the sole director of ScanSoft since September 1996. From September 1996 until February 1998, Mr. Ricci served as President of ScanSoft.
Mr. Crandall has served as the Vice President Sales and Channel Marketing of the Company since March 2, 1999. From December 1989 until March 2, 1999, Mr. Crandall oversaw all domestic and international sales activity of ScanSoft, Inc., which was then operating as an indirect wholly owned subsidiary of Xerox. Mr. Crandall originally joined ScanSoft in November 1988 as the Director of North America Sales.
Mr. Ricketts has served as Vice President Marketing of the Company since March 2, 1999. Mr. Ricketts joined ScanSoft, Inc., which was then oeprating as an indirect wholly owned subsidiary of Xerox, in December 1992 as the Manager of OEM Marketing and held roles that include leadership over the program management teams and worldwide product marketing function. Mr. Ricketts served as Director of Marketing of ScanSoft for three years before being promoted to Vice President in August 1998.
Mr. Swiniarski has served as Vice President Development of the Company since March 2, 1999. From November 1991 until March 2, 1999, Mr. Swiniarski served as the Director of Product Development. From 1988 until 1991, Mr. Swiniarski served as the Director of Technology Development and Marketing for Siemens Nixdorf Information Systems, Inc. and held a number of engineering positions with software companies that include Apollo Computer, High Order Software, Inc. and Systems Architects, Inc.
Mr. Smart has served as a director of the Company since March 2, 1999. From April 1997 until March 2, 1999, Mr. Smart served as President and Chief Executive Officer of Visioneer. Mr. Smart served as Chairman of the Board of Directors of Visioneer from February 1997 until April 1997. From April 1996 to March 1997, Mr. Smart was Chairman, President and Chief Executive Officer of StreamLogic Corporation, a network storage company. From July 1995 to March 1996, Mr. Smart was President and CEO of Micropolis Corporation, a disk drive design and manufacturing company. From March 1994 to February 1995, Mr. Smart was President and Chief Executive Officer of Maxtor Corporation, a disk drive development and manufacturing company. Mr. Smart currently serves as Chairman of the Board of Southwall Technologies Inc., a thin film technology company, and is a director of Savoir Technology Group, Inc., a distributor of electronic components and systems, and Midisoft Corp., a developer of music and sound software for personal computers.
Dr. Harding has served as a director of the Company since May 1995. Since 1994, Dr. Harding has been a general partner of Morgan Stanley Venture Partners II, L.P., which manages the Morgan Stanley Venture Capital Funds. During 1994, Dr. Harding was a private investor. From 1985 through 1993, Dr. Harding was a general partner of J.H. Whitney & Co., a venture capital firm.
Mr. Marquardt has served as a director of the Company since November 1992. Since August 1980, Mr. Marquardt has been a general partner of Technology Venture Investors, a venture capital firm. Mr. Marquardt currently serves as a director of Auspex Systems, Inc., a provider of network server hardware and software.
Dr. Myers has served as a director of the Company since March 2, 1999. Since February 1992, Dr. Myers has served as Senior Vice President, Xerox Research and Technology, responsible for worldwide research and technology. Dr. Myers earned an A.B. degree from Earlham College, Richmond, Indiana in 1960, and a Ph.D. in material sciences from Pennsylvania State University in 1964.
ITEM 11.
ITEM 11.EXECUTIVE COMPENSATION
The following table provides certain summary information for the fiscal years 1996, 1997 and 1998 concerning compensation paid to the Company's Chief Executive Officer and to the Company's four other named executive officers whose compensation exceeded $100,000 in 1998 (the "Named Executive Officers").
RECENT OPTION GRANTS
The following table sets forth certain information regarding options granted during the fiscal year ended January 3, 1999 to the Named Executive Officers.
The following table shows the number of shares of common stock represented by outstanding stock options held by each of the Named Executive Officers as of January 3, 1999.
In January 1998, the Company allowed all holders of outstanding options to exchange higher priced options for new options at $1.75 per share, the fair market value at the time of the exchange. The repricing terms provided that for each seven shares of options exchanged, six new options would be granted. The repriced options maintained the same vesting schedule. Options for 2,656,449 shares were exchanged for new options for 2,276,956 shares.
BOARD MEETINGS AND COMMITTEES
The Board of Directors held a total of 15 meetings during the fiscal year ended January 3, 1999. Each director attended at least 75% of the aggregate number of meetings of (i) the Board of Directors and (ii) the committees of the Board of Directors on which he served, except David F. Marquardt, who attended 66.6% of the meetings.
The Board of Directors has an Audit Committee and a Compensation Committee. It does not have a nominating committee or a committee performing the functions of a nominating committee.
The Audit Committee of the Board of Directors, which currently consists of directors Paul A. Ricci, J. Larry Smart and William J. Harding, held one meeting during 1998. The Audit Committee, which meets periodically with management and our independent public accountants, recommends engagement of our independent public accountants and is primarily responsible for approving the service performed by our independent public accountants and reviewing and evaluating our accounting principles and the adequacy of our internal auditing procedures and controls.
The Compensation Committee of the Board of Directors, which currently consists of directors Paul A. Ricci, William J. Harding and David F. Marquardt, held three meetings during 1998. The Compensation Committee, in conjunction with the Board of Directors, establishes salaries, incentives and other forms of compensation for directors, officers and other employees, administers the various incentive compensation and benefit plans (including our stock purchase and stock option plans) and recommends policies relating to such plans.
COMPENSATION OF DIRECTORS
Nonemployee directors of the Company are automatically granted options to purchase shares of the Company's Common Stock pursuant to the terms of the Company's 1995 Directors' Stock Option Plan (the "Directors' Option Plan"). Under such plan, each person who was a nonemployee director of the Company on the date of the Company's initial public offering, which was December 11, 1995, was granted an option to purchase 20,000 shares of Common Stock on the date of such offering and each person who thereafter first becomes a nonemployee director will be granted an option to purchase 20,000 shares of Common Stock on the date on which he or she first becomes a nonemployee director (the "First Option"). Thereafter, on January 1 of each year, commencing January 1, 1997, each nonemployee director shall be automatically granted an additional option to purchase 5,000 shares of Common Stock (a "Subsequent Option") if, on such date, he or she shall have served on the Company's Board of Directors for at least six (6) months. The Directors' Plan provides that the First Option shall become exercisable in installments as to twenty-five percent (25%) of the total number of shares subject to the First Option on each anniversary of the date of grant of the First Option and each Subsequent Option shall become exercisable in full on the first anniversary of the date of grant of that Subsequent Option. Options granted under the Directors' Option Plan have an exercise price equal to the fair market value of the Company's Common Stock on the date of grant, and a term of ten (10) years. Pursuant to the Directors' Option Plan, on January 1, 1998, each nonemployee director was granted an option to purchase 5,000 shares of Common Stock. The terms of such options, including vesting terms, are substantially similar to the terms of the First Option.
CHANGE IN CONTROL AND EMPLOYMENT AGREEMENTS
AGREEMENTS WITH VISIONEER'S EXECUTIVE OFFICERS
Two executive officers of Visioneer prior to the merger, J. Larry Smart, President and Chief Executive Officer and a director, and Murray Dennis, Vice President of Sales and Marketing, executed employment and non-compete agreements with Primax V Acquisition Corp., a wholly owned subsidiary of Primax Electronics Ltd. After the sale of the hardware business to Primax in January 1999, Mr. Dennis became employed by Primax, and received a signing bonus paid by Primax equal to six months of his Visioneer salary as part of his new employment compensation package. He also released Visioneer from its obligations under his existing employment agreement with Visioneer. Mr. Smart is entitled to receive payment of six months additional salary by Visioneer since his termina-
tion of employment. Michael T. Burt, Vice President of Operations, received a payment of four months additional salary upon termination of employment. Pursuant to an engagement letter dated August 11, 1998 between Visioneer and The Brenner Group LLC, Richard Brenner serves as the Company's Chief Financial Officer. Visioneer paid The Brenner Group hourly fees for Mr. Brenner's services and paid a success fee of 90,000 for completion of the hardware sale and the merger with ScanSoft. The total amount of payments to Messrs. Smart and Brenner will be approximately 325,000.
In November 1998, Visioneer's Board of Directors approved the acceleration of vesting of 50% of unvested options held by Messrs. Dennis and Burt upon each individual's termination of employment with Visioneer. Visioneer also accelerated the vesting of certain options held by Mr. Smart in accordance with the vesting schedules set forth in letter agreements between Visioneer and Mr. Smart dated April 9, 1997, July 7, 1997 and October 6, 1997. Options to purchase a total of approximately 151,787 shares held by Mr. Smart have also been accelerated.
In November 1998, Visioneer's Board of Directors also approved offering to employees, including executive officers, whose employment was terminated by Visioneer prior to the effective time of the merger the right to receive 0.20 per share for each option share held by such employee that is or would have vested as of the effective time of the merger (including options that will be accelerated prior to such time), provided that the employee agreed to terminate all additional outstanding unvested options held by such employee. Accordingly, Mr. Dennis received approximately 30,500 for options exercisable as of the date of the hardware sale to Primax and options accelerated as a result of their termination of employment. Similarly, Messrs. Smart and Burt received approximately 134,000 and 17,400, respectively, for options that would be exercisable as of the closing of the merger and for options accelerated in connection with the closing of the merger or their termination of employment.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth certain information with respect to the beneficial ownership of our common stock as of March 26, 1999, as to (1) each person (or group of affiliated persons) who is known by us to own beneficially more than 5% of our common stock; (2) each of our directors; (3) each of our executive officers; and (4) all directors and executive offices as a group.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
(a) Transactions with Management and Others
The following is a summary of certain agreements we have entered into with Xerox, which currently owns approximately 45% of our outstanding common stock. The following summaries of these agreements are qualified in their entirety by reference to each of the agreements, copies of which are included as exhibits to this Report.
VOTING AGREEMENT. Xerox, Xerox Imaging Systems, Inc., Visioneer and several holders of Visioneer common stock entered into a voting agreement effective at the close of the merger with ScanSoft, pursuant to which they agreed to vote to elect certain nominees to the Board of Directors, including up to two persons designated by Xerox (the "Voting Agreement").
At each annual meeting of stockholders during the term of the Voting Agreement, or at any special meeting of stockholders at which board members are to be elected, the parties to the Voting Agreement will vote their shares so as to elect the following directors:
(i) so long as Xerox owns at least 20% of our outstanding voting stock: two persons designated by Xerox, two individuals designated by the four members of the Board of Directors who were not nominated by Xerox and who are not our Chief Executive Officer or our then-current Chief Executive Officer, and two independent members with relevant industry experience who are to be designated by at least four out of the five directors who are not considered to be independent directors; or
(ii) so long as Xerox owns at least 10% of our outstanding voting stock: one person designated by Xerox, two individuals designated by the five members of the board who were not nominated by Xerox and who are not our Chief Executive Officer or our then-current Chief Executive Officer, and three independent members with relevant industry experience who are designated by at least three out of the four directors who are not considered to be independent directors.
The Voting Agreement will terminate upon the earliest to occur of: (1) the sale of all or substantially all of our property or business or our merger into or consolidation with any other corporation or if we effect any other transaction(s) in which more than 50% of our voting power is disposed of; (2) such time as Xerox owns less than 10% of our outstanding voting stock; or (3) such time as the non-reporting person parties to the Voting Agreement own, in the aggregate, less than 7% of our outstanding voting stock; provided, however, that if such time occurs prior to March 2, 2001 and Xerox holds at such time shares of our Series B Preferred Stock, the Voting Agreement will not terminate until the earlier of (x) March 2, 2001 or (y) the date on which Xerox (together with its affiliates) no longer holds any shares of our Preferred Stock.
THE SERIES B PREFERRED STOCK. In connection with the merger, Xerox Imaging Systems, Inc. was issued 3,562,238 shares of our nonvoting Series B Preferred Stock. The Series B Preferred Stock is convertible into shares of common stock on a share-for-share basis at the option of Xerox Imaging Systems, Inc. at any time after March 2, 2001; provided, however, that the Series B Preferred Stock becomes convertible immediately if Xerox Imaging Systems, Inc.'s ownership of our outstanding common stock is less than 30%, unless such conversion would result in Xerox Imaging Systems, Inc. owning more than 50% of our outstanding common stock. The Series B Preferred Stock is entitled to noncumulative dividends at the rate of 0.065 per annum only if and to the extent declared by our Board of Directors. The Series B Preferred Stock has a liquidation preference of 1.30 per share plus all declared but unpaid dividends. The Series B Preferred Stock does not have any voting rights, except for such rights as are provided under Delaware law.
COMMON STOCK WARRANT. At the closing of the merger, we issued to Xerox Imaging Systems, Inc. a ten-year warrant (the "Warrant") that allows Xerox Imaging Systems, Inc. to acquire a number of shares of common stock equal to the number of options to purchase common stock (whether vested or unvested) that remain unexercised at the termination of any ScanSoft option assumed by us in the merger. The exercise price for each warrant share is the same as the exercise price of each assumed ScanSoft option, as adjusted by the exchange ratio in the merger. If all of the assumed ScanSoft options terminate without being exercised, Xerox Imaging Systems, Inc. would be entitled to purchase approximately 1,738,552 additional shares of our common stock. The Warrant is exercisable at any time that shares are available for acquisition under the Warrant; provided, however, Xerox Imaging Systems, Inc. may not exercise the Warrant prior to two years from the date of its initial issuance unless, immediately after such exercise, Xerox Imaging Systems, Inc. owns directly or indirectly a number of outstanding shares of our common stock that represents less than 45% of the total number of shares of our common stock outstanding immediately after such exercise.
REGISTRATION RIGHTS AGREEMENT. We have entered into a registration rights agreement (the "Registration Rights Agreement") with Xerox and Xerox Imaging Systems, Inc. in connection with the merger with ScanSoft. Pursuant to the Registration Rights Agreement, Xerox may demand registration under the Securities Act of some or all of the shares of common stock owned by Xerox (including upon conversion of the Series B Preferred Stock or pursuant to the exercise of the Warrant). Each such registration will be at our expense. We may postpone such a demand under certain circumstances. In addition, Xerox may request that we include shares of common stock held by Xerox in any registration proposed by us of our common stock.
(b) Certain Business Relationships
Not applicable.
(c) Indebtedness of Management
Not applicable.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as a part of this Report:
(1) Financial Statements - See Index to Financial Statements in Item 8 of this Report.
(2) Financial Statement Schedule - The following financial statement schedule for our fiscal years ended December 31, 1998, 1997 and 1996 is contained in Item 8 of this Report:
II - Valuation and Qualifying Accounts and Reserves
Report of PricewaterhouseCoopers LLP, Independent Accountants. Refer to Item 8 above.
All other schedules have been omitted as the requested information is inapplicable or the information is presented in the financial statements or related notes included as part of this Report.
(3) Exhibits -Refer to Item 14(c) below.
(b) Reports on Form 8-K.
(1) On December 8, 1998, the Registrant filed a current report on Form 8-K, dated December 3, 1998, to report under Item 5 the signing of the agreement to acquire ScanSoft and to sell its hardware business to Primax Electronics, Ltd., and to file, under Item 7, the press releases associated therewith.
(c) Exhibits.
Exhibits (numbered in accordance with Item 601 of Regulation S-K)
Exhibit No. Description of Exhibits ----------- -----------------------
2.1(1) Agreement and Plan of Merger dated December 2, 1998, between Visioneer, Inc., a Delaware corporation, and ScanSoft, Inc., a Delaware corporation.
3.1(2) Bylaws of Registrant.
3.2(3) Amended and Restated Certificate of Incorporation of Registrant.
4.1(3) Specimen Common Stock Certificate.
4.2(4) Preferred Shares Rights Agreement, dated as of October 23, 1996, between the Registrant and U.S. Stock Transfer Corporation, including the Certificate of Designation of Rights, Preferences and Privileges of Series A Participating Preferred Stock, the form of Rights Certificate and Summary of Rights attached thereto as Exhibits A, B and C, respectively.
4.3 Voting Agreement dated March 2, 1999 between Xerox, Xerox Imaging Systems, Inc., Visioneer, Inc. and several holders of Visioneer common stock.
Exhibit No. Description of Exhibits ----------- -----------------------
10.1(2) Form of Indemnification Agreement.
10.2(2)** 1993 Incentive Stock Option Plan and form of Option Agreement.
10.3(2)** 1995 Employee Stock Purchase Plan and form of Subscription Agreement.
10.4(2)** 1995 Directors' Option Plan and form of Option Agreement.
10.5(5)** 1997 Employee Stock Option Plan.
10.6(5)** Director 1997 Compensation Plan.
10.7(2) LZW Paper Input System Patent License Agreement dated October 20, 1995 between the Registrant and Unisys Corporation.
10.8(2) Patent License agreement dated November 13, 1995 between the Registrant and Wang Laboratories, Inc.
10.9(2) Building Lease dated May 21, 1996 between the Registrant and John Arrillaga, Trustee, or his Successor Trustee, UTA dated 7/20/77 (Arrillaga Family Trust) as amended, and Richard T. Peery, Trustee, or his Successor Trustee, UTA dated 7/20/77 (Richard T. Peery, Separate Property Trust) as amended.
10.10(2) Software License Agreement dated August 14, 1996 between the Registrant and Hewlett-Packard Company.
10.11(6) Form of Employment Agreement between the Registrant and each individual who was an executive officer prior to the merger with ScanSoft and the sale of the hardware business.
10.12+ Software Distribution Agreement dated April 26, 1995 between Xerox Imaging Systems, Inc. and Tech Data Corporation.
10.13 Assignment, Assumption, Renewal and Modification Agreement dated June 18, 1997 between Xerox Imaging Systems, Inc., ScanSoft, Inc. and Tech Data Product Management, Inc.
10.14+ Distribution Agreement dated September 22, 1993 between Ingram Micro, Inc. and Xerox Imaging Systems, Inc., as amended.
10.15+ Gold Disk Bundling Agreement: Pagis SE & Pagis Pro, dated June 29, 1998 between Xerox Corporation, through its Channels Group and ScanSoft, Inc., as amended.
10.16+ Gold Disk Bundling Agreement dated March 25, 1998 between Xerox Corporation, Office Document Products Group and ScanSoft, Inc.
23.1 Consent of PricewaterhouseCoopers LLP.
24.1 Power of Attorney. (See page 66)
27.1 Financial Data Schedule.
- ----------
** Denotes Management compensatory plan or arrangement.
+ Confidential Treatment requested pursuant to a request for confidential treatment filed with the Commission on April 2, 1999. The portions of the exhibit for which confidential treatment has been requested have been omitted from the exhibit. The omitted information has been filed separately with the Commission as part of the confidential treatment request.
(1) Incorporated by reference from the Registrant's Registration Statement on From S-4 (No. 333-70603) filed with the Commission on January 14, 1999.
(2) Incorporated by reference from the Registrant's Registration Statement on Form S-1 (No. 333-98356) filed with the Commission on October 19, 1995.
(3) Incorporated by reference from the Registrant's Registration Statement on Form S-8 (No. 333-74343) filed with the Commission on March 12, 1999.
(4) Incorporated by reference from the Registrant's current Report on Form 8-K dated October 30, 1996.
(5) Incorporated by reference from the Registrant's Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 1997.
(6) Incorporated by reference from the Registrant's Annual Report on Form 10-K/A-2 for the fiscal year ended December 31, 1996.
SIGNATURES
Pursuant to the requirements of the Securities Act of 1934, the Registrant has duly caused this Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Peabody, State of Massachusetts, on March 29th, 1999.
SCANSOFT, INC.
By: /s/ MICHAEL K. TIVNAN --------------------------------------- Michael K. Tivnan President and Chief Executive Officer
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Michael K. Tivnan and Richard M. Brenner, and each of them, his attorneys-in-fact and agents, each with the power of substitution, for him in any and all capacities, to sign any and all amendments to this Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therein, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Act of 1933, this Amendment to Registration Statement has been signed by the following persons in the capacities and on the dates indicated: | 25,994 | 170,285 |
910721_1999.html | 910721_1999 | 1999 | 910721 | Item 1. Business
The Company
The J. Jill Group, Inc. (together with its wholly owned consolidated subsidiary, the "Company" or "The J. Jill Group"), formerly known as DM Management Company, is a specialty marketer of high quality women's apparel, accessories and gifts. The Company was incorporated under the laws of the State of Delaware in 1987. During the fiscal year ended December 25, 1999 ("fiscal 1999") the Company began its transition from a multi-catalog concept direct mail retailer to a single brand retailer with multiple distribution channels. The Company previously marketed its products through two catalog concepts, J. Jill and Nicole Summers. During fiscal 1999, the Company decided to discontinue its Nicole Summers catalog concept to concentrate its resources on the J. Jill brand. The Company is currently in the process of winding down its Nicole Summersoperations and liquidating the related merchandise.
As part of its new strategy, the Company launched its e-commerce website, jjill.com during fiscal 1999, and began opening upscale retail stores as additional distribution channels to market its J. Jill merchandise. The Company opened two new retail stores in the fourth quarter of fiscal 1999, one located in Natick, Massachusetts and the other in Providence, Rhode Island, and plans to open ten to fifteen more by the end of fiscal year 2000. The new e-commerce website and retail stores carry the same relaxed career and casual merchandise that can be found in the J. Jill catalog. They are also specifically designed to capture the very same J. Jill lifestyle imagery which the Company has successfully established through its catalog.
The J. Jill Brand
J. Jill is characterized by the simple, comfortable, versatile style of its apparel offerings, which range from relaxed career wear to weekend wear. These apparel offerings are almost entirely private label, with emphasis on natural fibers and unique details. J. Jill's target customers are active, affluent women age 35 to 55. During fiscal 1999, net sales for J. Jill merchandise accounted for approximately 87% of the Company's total net sales, up from approximately 75% for the twelve months ended December 26, 1998 ("fiscal 1998"). During fiscal 1999 net sales for J. Jill merchandise increased by 31% as compared to fiscal 1998. The Company believes that this growth was being driven by J. Jill's distinctive merchandising, marketing and creative strategies, as well as the emerging market for more casual apparel, particularly for the workplace, and the need active, working women have for comfortable, versatile clothing. The Company experienced a net sales growth rate decline during the latter half of fiscal 1999. The Company believes the factors contributing to this decline include less than optimal creative presentation in the Company's catalogs, intensifying competition in the J. Jill apparel sector, maturation of the core J. Jill catalog business and a difficult environment for direct marketers.
Nicole Summers
The Company's Nicole Summers concept had been experiencing declining net sales and the Company believed it was operating in a mature marketplace. In an effort to revive the concept, the Company attempted to refocus the merchandise assortment during fiscal 1999. However, as a result of lower than expected performance of the new merchandise assortment, the Company decided to discontinue Nicole Summers during fiscal 1999 and concentrate its resources on the J. Jill brand.
Business Strategy
The J. Jill Group's objective is to build the J. Jill brand into a premier national brand. The Company believes that, by utilizing multiple distribution channels including catalog, retail and e-commerce, it will reach a broader audience and be able to introduce the J. Jill lifestyle concept to untapped markets. Historically the Company has sought through its J. Jill catalogs to combine the personal experience of
shopping at an upscale specialty retailer with the ease and convenience of shopping at home by offering an edited assortment of high quality products in vibrant, easy-to-read catalogs. During fiscal 1999, the Company introduced its e-commerce website, jjill.com, and began opening new retail stores. The key elements of the Company's current business strategy are set forth below:
Brand building. The Company believes that it has a significant opportunity to build J. Jill's brand identity within its target market. The Company seeks to enhance brand identity by developing strong relationships with its customers that foster loyalty and increase repeat purchases. The consistent application of unique creative and merchandising techniques tailored to create a signature style for J. Jillmerchandise is a central element of this effort, as is an emphasis on superior customer service. The recent additions of jjill.com and the Company's new retail stores are geared to increase awareness of the J. Jill brand.
Well differentiated merchandise offerings. The Company seeks to offer a highly focused and edited product assortment that will provide the best selection of current casual lifestyle clothing, accessories and gifts with a unique flair for a natural, relaxed and fashionable 35 to 55 year old woman. Key components of this strategy include:
•Private label program. Almost all of the Company's merchandise offerings are private label merchandise (i.e., merchandise sold under the J. Jill brand name). Many of the Company's private label offerings are designed by the Company and most are not available in other catalogs or retail stores. The Company believes that its exclusive private label merchandise offerings enhance the brand identity of the J. Jill name.
•Extended sizes. In addition to offering regular sizes from 4 to 20, the Company offers a broad assortment of apparel in petite, tall and large sizes in the same styles as its regular size offerings. Management believes that the Company has particular expertise in scaling fashionable regular size merchandise to be attractively worn by extended size customers, and that these hard to fit customers currently have few attractive catalog or retail shopping alternatives. In fiscal 1999 extended size apparel offerings accounted for 47% of total J. Jill apparel offerings.
Distinctive creative presentation. The Company's catalogs are currently its primary vehicles for communicating with its customers. In its catalogs the Company attempts to provide photography and text that forges an emotional bond between the customer and the J. Jillbrand. The J. Jill Group utilizes lifestyle imagery that is both believable and aspirational. The photographic style evokes a relaxed, natural feeling, providing the customer with at least a temporary escape from her hectic everyday life.
The Catalogs and E-Commerce Website
Creative Presentation and Catalog Production
The objective of the Company's creative approach is to capture and communicate the lifestyle element of the J. Jill brand. This is done through photography and text designed to forge an emotional bond between the customer and the J. Jillbrand. The Company attempts to provide its customer with a peaceful, relaxing and natural experience through its photographic style. Outdoor backgrounds are chosen to reinforce the brand positioning towards natural fibers and neutral color palettes. Model faces are chosen that reflect imperfect beauty that a 35 to 55 year old woman can relate to-more like real people than professional models. Covers, opening spreads and full-page photos utilize lifestyle photography as opposed to traditional product shots. The Company's catalogs are also designed to enhance customer convenience through easy-to-read layouts and coordinated merchandise placement.
The Company devotes substantial resources to the design and production of each edition of its catalogs. After an initial conceptualization meeting, the creative and merchandising teams work closely together on catalog design, merchandise presentation and catalog print production. The materials and
direction necessary to produce each catalog are then delivered to the Company's production team approximately eight weeks before the initial mailing date of the catalog. The production team creates the electronic files used to print the catalog and plans and manages the printing and catalog distribution processes. The production team ensures that photographs appearing in the Company's catalogs accurately depict merchandise characteristics such as color and texture. Catalog production takes place in-house using desktop publishing systems. As a result, the Company can adjust catalog layout until approximately two weeks before the planned initial mailing date, allowing the Company to react to current market and sales trends by adjusting content and presentation of catalogs while they are in production. All of the Company's catalogs are printed commercially under the Company's supervision.
Marketing and Customer Database Management
At December 25, 1999, the Company's J. Jill catalog customer database contained approximately 2.6 million individual customer names, including approximately 1.0 million individuals who had made a purchase from the J. Jill catalog within the previous 12 months. The Company estimates that approximately two-thirds of these active customers have made multiple purchases from the Company. The J. Jill Group stores detailed information on each of its catalog customers, including demographic data and purchase history. The database is updated on a weekly basis. To determine which of its customers will receive a particular catalog mailing, the Company analyzes this information using sophisticated statistical modeling techniques. The Company's customer database is maintained off-site by a service bureau which sorts and processes the information in accordance with instructions from the Company. The Company's agreement with the service bureau requires the service bureau to safeguard the confidentiality of the Company's database.
The Company acquires lists of prospective customers by rental or exchange, and from a database cooperative and other sources. The Company also purchases lists of prospective customers. The most productive prospects tend to come from the customer lists of other women's apparel catalogs, including direct competitors. The Company rents its list of customers to and exchanges it with others, including direct competitors. To determine which prospective customers will receive a particular catalog mailing, the Company analyzes available information concerning such prospects using the same types of sophisticated statistical modeling techniques used to target mailings to the Company's own customers.
Merchandising and Product Development
The Company provides an edited assortment of high quality merchandise designed to meet the tastes and serve the lifestyle needs of its target customers. The Company has its own product development team and a merchandise selection staff. In addition to apparel and accessories, the Company's merchandise assortment also offers a selection of gifts selected with the specific lifestyle profiles of the J. Jill customer in mind.
The Company offers both brand name and private label merchandise. In fiscal 1999 approximately 99% of the apparel styles offered in the J. Jill catalogs were private label. Private label apparrel is manufactured to the Company's detailed specifications by foreign and domestic vendors. The brand name products, mainly within the accessories offerings, are selected from the regular offerings of the Company's vendors.
The J. Jill brand offers merchandise in petite, tall and large sizes, in the same styles as its regular sized offerings. In fiscal 1999 extended size apparel offerings accounted for 47% of total merchandise offerings.
Inventory Management and Purchasing
The Company's inventory management systems are designed to maintain inventory levels that provide optimum in-stock positions and maximum inventory turnover rates at its operations and fulfillment center while minimizing the amount of unsold merchandise at the end of each selling season. To achieve this goal,
the Company seeks to schedule merchandise deliveries and inventory amounts to coincide with expected sales levels.
The Company follows an interdepartmental approach to the inventory planning process. Conceptual planning for each selling season begins approximately nine months in advance of the beginning of the season. Early in the process, the Company's inventory control, marketing, creative and merchandising teams meet to present key strategies and opportunities for specific merchandise items in the Company's catalog editions and e-commerce website. The inventory control group then applies inventory coverage models to plan inventory levels for each stock keeping unit ("sku"), taking into account projected sales, the cost of being out of stock and ease of reordering. Preliminary commitments with the Company's private label merchandise vendors typically are made five to seven months in advance of each planned offering date. To the extent feasible, the Company seeks to retain flexibility in these commitments in order to be able to react to market and sales trends. Initial merchandise commitments for branded merchandise typically are made four to six months before the planned offering date. Initial deliveries generally are scheduled to be received two to three weeks before the planned offering date.
The inventory control group utilizes a forecasting system that analyzes catalog and e-commerce sales and returns by sku throughout the selling season to permit purchasing adjustments based on forecasted sales and returns. The Company attempts to minimize overstocks through a variety of promotional efforts, including telemarketing to customers at the time they place orders for other merchandise and seasonal clearance sales in the Company's catalogs and on its e-commerce website. The Company also sells excess inventory through its outlet stores and to "jobbers." The Company's outlet stores are run solely for the purpose of liquidating overstocks.
The Company sells both domestically produced and imported merchandise, which it purchases in the open market. In fiscal 1999 the Company purchased merchandise from approximately 630 vendors. The Company expects the number of vendors used during fiscal year 2000 to decrease significantly due to the discontinuance of the Nicole Summers concept. In fiscal 1999 the Company purchased approximately 32% of its merchandise directly from foreign vendors and buying agents primarily located in Hong Kong, Singapore and Israel. The Company expects that it will continue to purchase merchandise from foreign sources in the future. In addition, goods purchased by the Company from domestic vendors may be sourced abroad by such vendors. The Company seeks to establish long-term relationships with its merchandise vendors and works closely with them to ensure high standards of merchandise quality.
E-Commerce Website
The Company's e-commerce website, jjill.com, reflects the J. Jilllifestyle imagery through an easy-to-navigate virtual retail store consistent with the J. Jill catalog, and utilizes the latest interactive and customer friendly features. Virtually all current J. Jill catalog merchandise is accessible for viewing and purchase at jjill.com. Customers can use jjill.com to enter catalog orders, shop online, check order status and check inventory availability. As the internet has become a powerful medium that is increasingly important in its customers' everyday lives, the extension to an online channel is a natural evolution of the Company's business. By launching jjill.com, the Company can communicate more frequently with its existing customers, leverage its extensive database and introduce the J. Jill brand to previously untapped markets.
Contact Center and Customer Service
The J. Jill Group believes that an emphasis on superior customer service is important to its ability to expand its customer base and build customer loyalty. At December 25, 1999, the Company employed approximately 390 contact center representatives. Customer orders are taken 24 hours a day, 365 days a year, primarily by the Company's contact center representatives at the operations and fulfillment center in Tilton, New Hampshire. The Company also accepts orders over its e-commerce website, by mail or by
facsimile. Customer orders received over the e-commerce website are interfaced directly into the Company's data processing system. All other orders are input by the Company's contact center representatives into the Company's on-line data processing system, which provides, among other things, customer historical information, merchandise availability, product specifications, available substitutes and accessories and expected shipment date. The Company trains its contact center representatives to be knowledgeable in merchandise specifications and features. These representatives have ready access to samples of the current season's merchandise assortment, which enables them to answer detailed merchandise inquiries from customers promptly.
The J. Jill Group offers an unconditional merchandise guarantee. If a customer is not completely satisfied with any item for any reason, the customer may return it for an exchange or a full refund. To simplify the return process, the Company includes a self-addressed return label with every catalog and e-commerce order shipment, which customers can use to return any item to the Company through the United States Postal Service without paying postage fees in advance. Management believes that the Company's return rates are consistent with industry standards for comparable merchandise. Returns experience is closely monitored to identify any product quality or fit issues. Returned merchandise is inspected carefully and, unless damaged, is cleaned, pressed and returned to inventory. Approximately 94% of returned merchandise is recycled into inventory.
Order Fulfillment
The J. Jill Group believes that the prompt delivery of merchandise purchased through the Company's catalogs or e-commerce website promotes customer loyalty and repeat buying. To achieve this goal, the Company uses an integrated picking, packing and shipping system. The system monitors the in-stock status of each item ordered, processes the order and generates all related packing and shipping materials, taking into account the location of items within the fulfillment center. The Company's catalog and e-commerce website customers normally receive their orders within three to five business days after shipping, although customers may request overnight delivery for an extra charge.
The Company's significant growth during fiscal years 1997 and 1998 and the corresponding operating infrastructure investment required to support this growth resulted in the construction of a 400,000 square foot, state-of-the-art operations and fulfillment center in Tilton, New Hampshire (the "Tilton facility"). Approximately 370,000 square feet of the Tilton facility is dedicated to fulfillment operations, including catalog and e-commerce order fulfillment and retail store replenishment.
The Company is actively marketing its previous operations and fulfillment center in Meredith, New Hampshire (the "Meredith Facility") for sale. The Company leased the Meredith Facility in December of 1999 to a third party and plans to sell the property during fiscal 2000.
Retail Stores
The linchpin of the Company's new multiple distribution channel strategy is its retail store initiative. On November 17, 1999, the Company opened its first retail store in Natick, Massachusetts, followed two weeks later by its store in Providence, Rhode Island. The Company's strategy with retail stores, as it is with catalogs and e-commerce, is to reinforce the creative and sensory attachment it has established with its customers while continuing to significantly differentiate the J. Jill brand from the competition. For example, unlike its competitors, the Company does not use mannequins in either the storefront windows or the store interiors. In addition, the Company's stores include an entry area, twelve feet deep, to establish a comfort zone between the mall and the store interior. Ambient lighting through wall sconces, chandeliers and table lamps creates a comforting home-like atmosphere. The Company's retail stores include a fountain designed to appeal to both the visual and auditory senses of its customers. Organic materials such as quarry stone, bamboo and mahogany are used in floorings, tables and facades to reinforce the unique and natural elements indicative of the J. Jilllifestyle brand.
The Company's customer service strategy at its retail stores centers on a concierge desk that allows customers to order the petite, tall and large size options that may not be available in the store through a direct link to the operations and fulfillment facility in Tilton, New Hampshire.
The Company's current plans are to open between ten and fifteen stores in fiscal 2000 and an additional thirty to fifty stores in fiscal 2001. The Company believes there is a market potential for three hundred to three hundred and fifty of its stores located in upscale malls and freestanding locations. The current strategy is to target the most productive malls in the United States, focusing on those areas that have a high concentration of J. Jill catalog customers.
The merchandise available for sale in the retail stores will come almost exclusively from the merchandise assortment prepared for the catalog. Approximately 64% of the merchandise styles found in the 1999 Holiday season catalogs were also available for purchase in the retail stores.
Private Label Credit Card
As part of its customer retention program and brand building strategy, The J. Jill Group offers its own private label credit card. The J. Jill credit card can be used to purchase J. Jill merchandise through any of the Company's distribution channels. The Company believes that this credit card reinforces the Company's relationship with existing customers and promotes additional purchases by these customers. In fiscal 1999 approximately 9% of net sales were attributable to purchases made using the Company's private label credit card. At December 25, 1999 there were approximately 144,000 holders of the Company's private label credit card. The credit card program is currently administered by a fee-based outside vendor who bears the credit risk associated with the credit card without recourse to the Company.
Information Systems and Technology
The Company is committed to making ongoing investments in its information systems to increase operating efficiency, provide superior customer service and support its anticipated growth. The Company believes that the ability to capture and analyze operational and financial data and relevant information about its customers and their purchasing history is critical to its success.
The Company has made, and continues to make, significant investments in systems to support order taking and customer service, fulfillment, marketing, merchandising, inventory control, the Company's new retail store initiative, financial control and reporting and forecasting. During fiscal 1998 The J. Jill Group implemented a new automated warehouse management system that has enabled it to efficiently support its warehouse processes and provide additional flexibility to support the Company's growth plans. The Company also implemented a new order management system in fiscal 1998 that provides significant processing enhancements and flexibility as compared to the Company's previous system.
In addition to its in-house data processing and information systems resources, the Company also uses several outside vendors for key services such as list processing and credit card administration and approval.
Competition
The market for the Company's merchandise is highly competitive. The Company competes with other direct marketers, specialty apparel and accessory retailers and traditional department store retailers. The Company believes that the net sales growth rate decline experienced during the latter half of fiscal 1999 was attributable in part to the intensifying competition in the J. Jill apparel sector. Many of the Company's competitors are larger and have substantially greater financial, marketing and other resources. The J. Jill Group believes that it competes principally on the basis of its lifestyle brand, including its unique private label merchandise assortment and distinctive creative execution. The Company also believes that its strategy to expand into multiple distribution channels, including catalog, retail and e-commerce, will allow
it to reach a broader audience, introduce its lifestyle concept to untapped markets and build J. Jill into a premier national brand.
Employees
As of March 7, 2000, the Company employed 827 individuals, of whom 701 were full-time (those employees scheduled to work 30 hours or more per week). None of the Company's employees are represented by a union. The Company considers its employee relations to be good.
Trademarks and Service Marks
The Company has registered various trademarks and service marks with the United States Patent and Trademark Office, including J. Jill.
Government Regulation
The catalog sales business conducted by the Company is subject to the Mail or Telephone Order Merchandise Rule and related regulations promulgated by the Federal Trade Commission, which prohibit unfair methods of competition and unfair or deceptive acts or practices in connection with mail and telephone order sales and require sellers of mail and telephone order merchandise to conform to certain rules of conduct with respect to shipping dates and shipping delays. The Company believes it is in compliance with the Rule and such regulations.
The Company currently collects sales taxes only on sales to its Massachusetts, Pennsylvania and Rhode Island customers. Many states have attempted to require that out-of-state direct marketers collect use taxes on sales of products shipped to their residents. In 1992, the United States Supreme Court held unconstitutional a state's imposition of use tax collection obligations on an out-of-state mail order company whose only significant contacts with the state were the distribution of catalogs and other advertising materials through the mail and subsequent delivery of purchased goods by mail or common carriers, but stated that Congress could enact legislation authorizing the states to impose such obligations. In 1995, however, the United States Supreme Court let stand a decision of New York's highest state court requiring an out-of-state catalog company to collect use tax (including a retroactive assessment and penalties) on its mail order sales in the state, where the catalog company's reported contact with New York included a limited number of visits by sales force employees. If Congress enacts legislation permitting states to impose use tax collection obligations on out-of-state mail order businesses, or if the Company otherwise is required to collect additional sales or use taxes, such tax collection obligations would make it more expensive to purchase the Company's products and increase the Company's administrative costs, and therefore could have a material adverse effect on the Company's financial condition and results of operations.
Item 1A.
Item 1A. Risk Factors
The Retail Store Initiative
The Company's current growth strategy is based primarily on its retail store initiative. The Company is currently devoting significant financial resources, and significant operational efforts, to the opening of its new retail stores. The Company opened two retail stores in 1999, and is planning to open ten to fifteen more by the end of fiscal 2000 and an additional thirty to fifty during fiscal 2001. The operation of retail stores presents a number of risks not present in the Company's catalog operations, including the following:
•The Company must make substantial investments in store design, leasehold improvements and other areas prior to the opening of each store.
•The Company must frequently make long-term financial commitments when leasing retail store locations.
•The success of individual stores may depend significantly on the success of the shopping malls in which they are located.
•The Company will compete directly with other retail stores, and may be required to adopt different pricing strategies to respond to their actions.
•The Company must hire and retain retail sales and management personnel in the areas in which stores are located.
To date, the Company has limited experience in operating retail stores, and may not be able to successfully address the risks that they entail. There can be no assurance that the retail store initiative will be successful, and if not, the Company's business and financial condition would be adversely affected. In addition, continued growth could result in a strain on the Company's management, financial, merchandising, marketing, distribution and other resources. There can be no assurance that the Company will be able to manage growth effectively, and any failure to do so could have a material adverse effect on the Company's financial condition and results of operations. The Company may also need to raise additional funds in order to support its growth strategy, including the retail store strategy. The Company cannot assure that funds will be available on acceptable terms when needed, or at all.
Catalog Operations
The Company's catalog operations involve a number of inherent financial risks. Each edition of a catalog requires substantial investments in layout and design, paper, printing, postage and inventory prior to mailing. As a result, the Company is not able to adjust these costs in connection with a particular mailing in response to the actual performance of the catalog. The Company's marketing programs rely on a high level of prospect mailings and as a result involve additional risks, including potentially lower and less predictable response rates and the possibility that third parties who provide customer lists may stop making them available. If for any reason the Company experienced a significant shortfall in anticipated revenue from a particular mailing, the Company's financial condition, results of operations and cash flows would be materially and adversely affected. In addition, customer response to the Company's mailings and, as a result, revenues generated by mailings can be affected by factors that are outside the Company's control, such as consumer preferences, economic conditions and vendor work stoppages. The Company has historically experienced fluctuations in customer response to its mailings. If the Company is unable to achieve anticipated customer response to these mailings in the future, the Company's revenues could decline.
The operation of the Company's direct marketing business is dependent on its ability to prepare catalogs in a timely manner and to maintain the efficient and uninterrupted operation of order processing and fulfillment systems. Preparation of the Company's catalogs requires the involvement of many different groups within the Company as well as certain outside vendors. Any delay in the completion of a catalog could cause customers to forego or defer purchases from the Company. Any material disruption or slowdown in the Company's order processing or fulfillment systems, including any resulting from:
•strikes or labor disputes;
•disruptions in telephone service or electrical outages;
•mechanical problems;
•human error or accidents;
•fire, natural disasters or adverse weather conditions; or
•inadequate order taking or order fulfillment capacity
could cause orders to be lost or delayed and could damage the Company's reputation with its customers or cause customers to cancel orders. These problems could result in a reduction in net sales, as well as
increased administrative and shipping costs. If the Company fails to manage its catalog operations effectively, the Company's business and financial condition could be adversely affected.
Private Label Branding Strategy
In fiscal 1999, private label merchandise represented approximately 98% of the apparel styles offered in the J. Jill catalog. The use of private label merchandise requires the Company to incur costs and risks relating to the design and purchase of products, including longer lead times for orders and higher initial purchase commitments, and limits the Company's ability to offer other brands that customers may seek. If the Company fails to successfully execute its private label merchandise strategy, the Company's business and financial condition could be adversely affected.
Consumer Preferences and Fashion Trends
The Company's future success depends in part on its ability to anticipate and respond to changes in consumer preferences and fashion trends in the Company's target market. The Company begins to make merchandise commitments as early as nine months before the merchandise is available to customers through the J. Jill catalogs and any changes in consumer preferences or fashion trends after merchandise commitments are made could materially and adversely affect the performance of the Company's catalogs. There can be no assurance that the Company will be able to continue to identify and offer merchandise that appeals to the J. Jillcustomer base or that any introduction of new merchandise categories will be successful or profitable. Failure to anticipate and respond to changing consumer preferences and fashion trends would have a material adverse effect on the Company's business.
Information Systems
The Company depends on information systems to process orders, respond to customer inquiries, manage inventory, purchase, sell and ship goods on a timely basis and maintain cost-efficient operations. There can be no assurance that the Company will not experience operational problems with its information systems as a result of system failures, computer "hackers" or other causes or that the systems will be adequate to support future growth. Any interruption in the availability or use of these information systems could harm the Company's business.
Operating Results
The Company's annual and quarterly operating results have fluctuated and it expects these fluctuations to continue. Among the factors that may cause the Company's operating results to fluctuate are:
•the timing and size of catalog mailings;
•the costs of producing and mailing catalogs;
•customer response to catalog mailings;
•the timing of merchandise receipts;
•the level of merchandise returns;
•changes in merchandise mix and presentation; and
•the incurrence of other operating costs and factors beyond the Company's control, such as general economic conditions and actions of competitors.
The Company's current expense levels are based in part on expectations of future net sales and, as a result, net income for a given period could be disproportionately affected by any reduction in net sales for that period.
As a result of the foregoing factors, the Company believes that period-to-period comparisons of its historical and future results will not necessarily be meaningful, and that investors should not rely on them as an indication of future performance. To the extent the Company experiences the factors described above, its future operating results may not meet the expectations of securities analysts or investors from time to time, which may cause the market price of our common stock to decline.
Key Personnel
The Company's success depends to a significant extent upon Gordon R. Cooke, President and Chief Executive Officer and the Chairman of the Company's Board of Directors, and certain other current members of senior management. The loss of the services of one or more of these key employees could have a material adverse effect on the Company's business. The Company does not have employment contracts with any members of its senior management that would prohibit them from competing with the Company following the termination of their employment and does not maintain "key man" life insurance on the lives of any members of its senior management.
Foreign Inventory Purchases
During fiscal 1999, the Company purchased approximately 32% of its merchandise either directly from foreign suppliers or through foreign buying agents, and it expects that it will continue to purchase merchandise from foreign suppliers and through foreign buying agents in the future. In recent periods, these foreign suppliers have been primarily located in Hong Kong, Singapore and Israel. In addition, the Company believes that domestic suppliers purchase a portion of the goods they sell to the Company from foreign suppliers. Accordingly, the Company's operations are subject to the customary risks of purchasing merchandise abroad, including:
•fluctuations in the value of currencies;
•export duties or restrictions;
•work stoppages; and
•in certain parts of the world, political and economic instability.
Third Parties
The Company's ability to distribute catalogs and fulfill orders depends on the performance of third parties such as:
•manufacturers;
•printers;
•shipping companies, including the United States Postal Service;
•mailing list vendors;
•list processing and credit card processing companies; and
•foreign buying agents.
Any interruptions or delays in these services could result in delays in catalog or order shipments or an inability to process orders, which could materially and adversely affect the Company's business and financial condition. In addition, if customers perceive that the Company might be unable to fulfill orders, demand for the Company's products could decline and result in a reduction in net sales. Although the Company believes that in general the goods and services it obtains from third parties could be purchased from other sources, identifying and obtaining substitute goods and services could result in delays in shipments and increased costs. The Company does not maintain supply contracts with any of its private
label or other merchandise vendors. Rather, it acquires merchandise via purchase orders that terminate upon completion of the order. If any significant vendor were to suddenly discontinue its relationship with the Company, the Company could experience temporary delivery delays until such time as a substitute supplier could be found.
External Costs
The Company's business is subject to a number of costs that it cannot control, including:
•paper and postage expenses associated with mailing catalogs, which have historically been volatile;
•shipping charges associated with distributing merchandise to customers and stores, which have increased significantly in the past and may increase in the future; and
•labor costs, which are particularly significant in the labor-intensive retail, order processing and fulfillment center operations, and could increase as a result of changes in prevailing wages, labor shortages or other factors.
Any increase in paper, postage, shipping, labor or other external costs could adversely effect the Company's financial position, results of operations and cash flows.
General Economic Conditions
The Company's success is influenced by a number of economic conditions affecting disposable consumer income, such as employment levels, business conditions, interest rates and taxation rates. Adverse changes in these economic conditions may restrict consumer spending, thereby negatively affecting the Company's growth and profitability.
Market Value of Common Stock
The Company's stock price has fluctuated substantially since its initial public offering in 1993. The Company believes factors such as quarterly operating results, changes in market conditions, securities analysts' estimates of future operating results, and the overall performance of the stock market may cause the market price of the common stock to fluctuate significantly. The Nasdaq National Market has experienced a high level of price and volume volatility and the market prices of the stock of many companies have experienced wide price fluctuations not necessarily related to the operating performance of those companies.
State Sales Tax
The Company currently collects sales taxes only on sales to customers located in Massachusetts, Pennsylvania and Rhode Island. Many states have attempted to require that out-of-state direct marketers and internet retailers collect sales taxes on sales of products shipped to their residents, but the legality of such taxes is unsettled. If Congress enacts legislation permitting states to impose sales tax collection obligations on out-of-state mail order or e-commerce businesses, or if the Company is otherwise required to collect additional sales or use taxes on its catalog and e-commerce sales, such tax collection obligations would make it more expensive to purchase the Company's products and increase administrative costs, and could therefore have a material adverse effect on the Company's financial position, results of operations and cash flows.
Delaware Corporation Laws
Provisions of the Company's certificate of incorporation and by-laws and of the Delaware General Corporation Law may make it more difficult for a third party to acquire the Company, even if doing so would allow the Company's stockholders to receive a premium over the prevailing market price of its stock.
Those provisions of the certificate of incorporation and by-laws and Delaware law are intended to encourage potential acquirers to negotiate with the Company and allow its board of directors the opportunity to consider alternative proposals in the interest of maximizing stockholder value. However, such provisions may also discourage acquisition proposals or delay or prevent a change in control, which could negatively affect the Company's stock price.
Item 2.
Item 2. Properties
The following table sets forth certain information relating to the Company's facilities as of December 25, 1999:
(1)The Tilton operations and fulfillment center is owned by Birch Pond Realty Corporation, a wholly owned subsidiary of the Company. (See Note E to the accompanying consolidated financial statements.)(2)Subsequent to December 25, 1999 the Company moved its corporate headquarters from Hingham, Massachusetts to Quincy, Massachusetts.(3)As part of the discontinuance of Nicole Summers the Company is planning to close one of its outlet stores.
The Company believes that it currently has adequate capacity in its corporate offices and operations and fulfillment center to accommodate its planned growth for the foreseeable future.
There were two leased retail stores in operation at the close of fiscal 1999. Subsequent to December 25, 1999, the Company entered into leases for five additional retail stores that the Company expects to open during the first half of fiscal 2000. The Company plans to have a total of twelve to seventeen retail stores open by the end of fiscal 2000 and an additional thirty to fifty J. Jill stores open by the end of fiscal 2001. The Company believes there is a market potential for opening between three hundred and three hundred and fifty retail stores located in upscale malls and freestanding locations. The retail store leases in effect at December 25, 1999, and those five additional retail store leases entered into subsequent to December 25, 1999, expire between 2009 and 2010.
During December 1999, the Company entered into a five year lease agreement to lease its previous operations and fulfillment center in Meredith, NH (the "Meredith facility") to a third party. The Meredith facility is subject to certain encumbrances (see Note E to the accompanying consolidated financial statements).
Item 3.
Item 3. Legal Proceedings
From time to time the Company is party to various legal proceedings, primarily arising in the Company's ordinary course of business. The Company believes that the outcome of legal proceedings pending at December 25, 1999, will not have a material impact to its financial position, results of operations or cash flow.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
None
PART II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
The Company's common stock trades on The Nasdaq Stock Market under the symbol "JILL." As of March 10, 2000, the number of holders of record of common stock of the Company was approximately 410.
On May 29, 1998, the Company announced a three-for-two stock split to be effected in the form of a stock dividend payable on June 30, 1998 to shareholders of record on June 12, 1998.
The following table sets forth, for the periods indicated the high and low sales prices for the Company's common stock as reported on The Nasdaq Stock Market. All sales price information below has been restated, if necessary, to reflect the effects of the three-for-two stock split.
The Company has never declared or paid any cash dividends on its common stock. The Company currently intends to retain any earnings for use in the operation and expansion of its business and therefore does not anticipate paying any cash dividends in the foreseeable future.
Item 6.
Item 6. Selected Consolidated Financial Data
The selected consolidated financial data of the Company as set forth below has been derived from the Company's consolidated financial statements for the periods indicated and should be read in conjunction with the discussion under "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Company's consolidated financial statements and footnotes.
The Company's fiscal year ends on the last Saturday in December. Prior to December 28, 1996, the Company's fiscal year had ended on the last Saturday in June. The Company's change in fiscal year end resulted in a six-month transition period ended December 28, 1996 (the "transition period"). Financial information for the twelve months ended December 28, 1996 has been presented for comparative purposes and is unaudited. On May 29, 1998, the Company announced a three-for-two stock split to be effected in
the form of a stock dividend payable on June 30, 1998 to shareholders of record on June 12, 1998. All share and per share information below has been restated to reflect the effects of the three-for-two stock split.
(1)During the twelve-month period ended December 25, 1999, the Company recorded charges totaling $5,987,000, primarily associated with its decision to discontinue Nicole Summers. See Note B to the accompanying consolidated financial statements.
(2)During the six-month and twelve-month periods ended December 28, 1996, the Company determined that, based on the Company's profitability trends and anticipated future profitability, it was more likely then not that sufficient book and taxable income would be generated to fully realize the benefit of its net deferred tax asset. This determination required the Company to remove the valuation allowance and recognize the deferred tax benefit of $10,598,000 at December 28, 1996 in its entirety.
(3)In December 1994 the Company purchased certain assets and assumed certain liabilities of Carroll Reed, Inc. and Carroll Reed International Limited. In connection with the purchase, the Company paid $5,031,000 and established accruals totaling $1,180,000. On May 20, 1996, the Company announced its plan to divest its Carroll Reed segment and recorded a charge of $8,511,000 for the loss on disposal of discontinued operations. The results of the Carroll Reed operations through May 20, 1996 have been classified as income (loss) from discontinued operations.
(4)In order to more closely match net sales to catalog circulation, the Company calculates catalog circulation on a percentage of completion basis. This calculation takes into account the total number of catalogs mailed during all periods and the Company's estimate of the expected sales life of each catalog edition. As used throughout this Form 10-K, the term "catalog circulation" refers to circulation of the Company's catalogs calculated in such fashion.
(5)As used throughout this Form 10-K, the term "twelve-month buyers" means customers who have made a purchase from the Company through its catalogs within the previous 12 months.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
This Form 10-K, including the following discussion, contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, which involve risks and uncertainties. For this purpose, any statements contained herein or incorporated herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the generality of the foregoing, the words "anticipates," "plans," "expects" and similar expressions are intended to identify forward-looking statements. The Company's actual results, performance or achievements may differ significantly from the results discussed in or implied by the forward-looking statements. Factors that might cause such a difference include, but are not limited to the following: the success or failure of the J. Jill retail store and e-commerce
initiatives; the success or failure of the Nicole Summers wind-down strategy; the success or failure of new customer acquisition efforts; significant changes in customer response rates; changes in competition in the apparel industry; general economic and business conditions; success or failure of operating initiatives; the ability of the Company to effectively liquidate its overstocked merchandise; changes in consumer spending and consumer preferences; changes in business strategy; possible future increases in expenses; the existence or absence of brand awareness; the existence or absence of publicity, advertising and promotional efforts; availability, terms and deployment of capital; quality of management; business abilities and judgment of personnel; availability of qualified personnel; labor and employee benefit costs; changes in, or the failure to comply with federal and state tax and other government regulations, and other factors. See also Item 1A, Risk Factors.
Overview
The J. Jill Group, Inc. (together with its wholly owned consolidated subsidiary, the "Company" or "The J. Jill Group"), formerly known as DM Management Company, is a specialty marketer of high quality women's apparel, accessories, and gifts. During the fiscal year ended December 25, 1999 ("fiscal 1999") the Company began its transition from a multi-catalog concept direct mail retailer to a single brand retailer with multiple distribution channels. The Company previously marketed its products through two catalog concepts, J. Jill and Nicole Summers. During fiscal 1999, the Company decided to discontinue its Nicole Summers catalog concept to concentrate its resources on the J. Jill brand. The Company is currently in the process of winding down the Nicole Summers operations and liquidating the related merchandise. During fiscal 1999 the Company launched its e-commerce website, jjill.com, and began opening upscale retail stores as additional distribution channels to market its J. Jill merchandise. The Company opened two new retail stores in the fourth quarter of fiscal 1999, one located in Natick, Massachusetts and the other in Providence, Rhode Island, and plans to open ten to fifteen more by the end of fiscal year 2000.
Significant Event
The Company's Nicole Summers concept had been experiencing declining net sales and the Company believed it was operating in a mature marketplace. In an effort to revive the concept, the Company attempted to refocus the merchandise assortment during fiscal 1999. However, as a result of lower than expected performance of the new merchandise assortment, the Company decided to discontinue Nicole Summers during fiscal 1999 and concentrate its resources on the J. Jill brand.
During fiscal 1999 the Company recorded charges totaling approximately $6.0 million primarily associated with its decision to discontinue its Nicole Summers catalog concept. These charges included $2.4 million of inventory markdown charges, included in cost of products and merchandising, and a $3.6 million special charge shown separately in the accompanying consolidated statements of operations. The inventory markdown charge includes a write-down of inventory, expected to be liquidated through outlet stores and other liquidation vehicles, to the lower of cost or market as well as costs to exit certain purchase commitments made in the ordinary course of business. The Company believes the inventory liquidation plan will be substantially complete during fiscal 2000. The following is a summary of costs included in the $3.6 million special charge (in thousands):
As a result of the Company's third quarter 1999 decision to discontinue its Nicole Summers catalog concept, the Company expects that the operations and fulfillment center in Tilton, New Hampshire (the "Tilton facility") will now have enough warehousing and distribution capacity to house its future retail operations center. Based on the Tilton facility's ability to house the new retail operations center, the Company has decided to no longer hold its operations and fulfillment center in Meredith, New Hampshire (the "Meredith facility") for that purpose. As a result, the Company reclassified the property and equipment and the related accumulated depreciation to assets held for sale and recognized fixed asset impairments of $2.1 million to write-down these assets to their estimated fair market value, net of estimated costs of disposal. The Company expects to dispose of these assets during fiscal 2000. During December 1999 the Company entered into a five-year lease agreement to lease the Meredith facility to a third party. The Company believes this lease commitment increases its ability to dispose of the property.
In connection with the decision to discontinue Nicole Summers, the Company decided not to circulate certain previously planned Nicole Summers catalogs. Prepaid catalog costs incurred or committed for these catalogs were charged to expense as part of the special charge. Severance costs relate to five terminated employees previously associated with Nicole Summers. Lease commitment costs are primarily comprised of costs to close an existing Nicole Summers outlet store.
At December 25, 1999, accrued expenses included $0.5 million of accrued special charges. This amount was comprised of the lease commitment costs, severance costs and certain other miscellaneous costs. The Company expects to complete paying for a majority of these items during fiscal 2000.
Results of Operations
The following table sets forth, for the fiscal periods indicated, certain items from the Company's consolidated statements of operations expressed as a percentage of net sales. Certain prior year financial statement amounts have been reclassified to be consistent with the presentation for fiscal 1999. During fiscal 1999 the Company changed its income statement presentation to be more in line with the way the Company reviews its operations and to be more consistent with the presentation used by other companies in the industry. The most significant of these changes included combining the prior year classifications of product costs and operations expense into cost of product and merchandising and combining prior year classifications of selling expense and general and administrative expense into selling, general and administrative expenses.
(1)Cost of products and merchandising for the twelve months ended December 25, 1999 includes markdowns associated with the discontinuance of Nicole Summers which represent 0.9% of net sales.
Comparison of fiscal 1999 to fiscal 1998
In fiscal 1999 total Company net sales increased by 14.4%, or $31.6 million, to $250.3 million from $218.7 million in fiscal 1998. The increase in net sales was attributable to sales volume increases from J. Jill. In fiscal 1999 J. Jillnet sales and catalog circulation increased by 31.5% and 40.8%, respectively, as compared to fiscal 1998. J. Jill net sales growth was attributable to the aforementioned increase in circulation partially offset by a decrease in response rates and average order size. Net sales for J. Jill during fiscal 1999 also included approximately $2.9 million in net sales from the Company's two new retail stores and e-commerce website. In fiscal 1999 net sales and circulation for Nicole Summers decreased by 37.8% and 10.4%, respectively, as compared to fiscal 1998. This decrease in Nicole Summers net sales was primarily attributable to a decrease in response rates and average order size as well as the aforementioned decrease in circulation. Total Company catalog circulation increased by 27.4% to 94.0 million in fiscal 1999 from 73.8 million in fiscal 1998. The number of total Company twelve-month buyers grew to 1,206,000 at December 25, 1999 from 1,022,000 at December 26, 1998, an increase of 18.0%. The number of J. Jill twelve-month buyers grew to 1,043,000 at December 25, 1999 from 833,000 at December 26, 1998, an increase of 25.2%.
Cost of products and merchandising consists primarily of merchandise development, control and acquisition costs, provisions for markdowns, order processing and customer service costs, and distribution facility costs. In fiscal 1999 cost of products and merchandising increased by $27.7 million, or 19.3%, to $171.5 million (including special inventory markdown charges of $2.4 million) from $143.8 million in fiscal 1998. As a percentage of net sales, cost of products and merchandising increased to 68.5% (67.6% before special inventory markdown charges) in fiscal 1999 from 65.7% in fiscal 1998. This increase primarily related to increased costs associated with excess capacity at the Tilton facility as well as an increase in costs to service the customer. The Company also increased its promotional sales activity resulting in increased product cost as a percentage of net sales offset by a reduction in required markdowns (excluding special charges) during fiscal 1999 as compared to fiscal 1998. The Company expects costs of products and merchandising as a percentage of net sales (excluding special inventory markdown charges) to increase slightly during the first half of fiscal 2000.
Selling, general and administrative expenses consist of costs to produce, print and distribute catalogs, and certain administrative, e-commerce website, and retail store costs. In fiscal 1999 selling, general and administrative costs increased by $12.9 million, or 20.9%, to $74.6 million from $61.7 million in fiscal 1998. As a percentage of net sales, selling, general and administrative expenses increased to 29.8% in fiscal 1999 from 28.2% in fiscal 1998. This increase primarily resulted from decreased catalog productivity as well as start up costs attributable to the Company's new e-commerce website and retail stores. The Company expects selling, general and administrative expenses as a percentage of net sales to decrease slightly during the first half of fiscal 2000.
The special charge, as discussed above, consists of costs primarily related to the Company's decision during fiscal 1999 to discontinue Nicole Summers and is comprised of fixed asset impairments, prepaid catalog costs, lease commitment costs, employee severance costs and other miscellaneous costs.
Interest income decreased to $0.4 million in fiscal 1999 from $1.1 million in fiscal 1998, primarily as a result of lower cash and cash equivalent balances in fiscal 1999 due to cash used to finance the Tilton facility. Interest expense increased to $2.0 million in fiscal 1999 as compared to $0.6 million in fiscal 1998 primarily due to higher long-term debt levels associated with the Tilton facility financing. Interest expense does not include capitalized interest of $1.0 million in fiscal 1998. The Company does not expect a significant change in net interest expense during fiscal 2000.
Comparison of fiscal 1998 to fiscal 1997
In fiscal 1998 net sales increased by 61.4%, or $83.2 million, to $218.7 million from $135.5 million in fiscal 1997. The increase in net sales was attributable to significant sales volume increases from J. Jill. In
fiscal 1998 J. Jill net sales and circulation increased by 123.7% and 101.5%, respectively, as compared to fiscal 1997. J. Jill net sales growth was attributable to the aforementioned circulation growth, as well as improved response rates and increased units per order. In fiscal 1998 net sales and circulation for Nicole Summers decreased by 12.9% and 17.8%, respectively, as compared to fiscal 1997. Total Company catalog circulation increased by 46.1% to 73.8 million in fiscal 1998 from 50.5 million in fiscal 1997. The number of twelve-month buyers grew to 1,022,000 at December 26, 1998 from 681,000 at December 27, 1997, an increase of 50.1%.
In fiscal 1998 cost of products and merchandising increased by $57.1 million, or 65.8%, to $143.8 million from $86.7 million in fiscal 1997. As a percentage of net sales, cost of products and merchandising increased to 65.7% in fiscal 1998 from 64.0% in fiscal 1997. During fiscal 1998 the Company operated out of three distribution facilities while awaiting the completion of the Tilton facility. Reduced productivity from operating out of these multiple facilities, inefficiencies attributable to implementing new order taking and warehouse management systems, increased costs associated with third party call center usage and growth in the product development division of merchandising all contributed to increased cost of products and merchandising as a percentage of net sales over the prior year. Also contributing to the increase was an increased use of strategically designed promotional pricing in fiscal 1998 combined with increased markdown charges associated with Nicole Summers. These increases in costs as a percentage of net sales were partially offset by the shift in the mix of the business toward J. Jill, which experienced lower product costs as a percentage of net sales than Nicole Summers due to its higher concentration of private label merchandise.
In fiscal 1998 selling, general and administrative costs increased by $19.2 million, or 45.4%, to $61.7 million from $42.4 million in fiscal 1997. As a percentage of net sales, selling, general and administrative expenses decreased to 28.2% in fiscal 1998 from 31.3% in fiscal 1997. This decrease was primarily a result of improved catalog productivity, offset by an increase in paper costs in fiscal 1998 as compared to fiscal 1997. The Company also experienced an increase in leverage of general and administrative expenses in fiscal 1998 as compared to fiscal 1997.
Interest income increased to $1.1 million in fiscal 1998 from $0.5 million in fiscal 1997, primarily due to higher cash and cash equivalent balances in fiscal 1998 due to proceeds from the Company's fiscal 1997 secondary public offering. Interest expense increased to $0.6 million in fiscal 1998 as compared to $0.5 million in fiscal 1997 primarily as a result of increased use of the Company's credit facilities. Interest expense does not include capitalized interest of $1.0 million and $0.1 million in fiscal 1998 and fiscal 1997, respectively.
Income Taxes
The Company provides for income taxes at an effective tax rate that includes the full federal and state statutory tax rates. The Company's effective tax rate for fiscal 1999, fiscal 1998, and fiscal 1997 was 36.9%, 39.0% and 39.0%, respectively. The decreased effective tax rate during fiscal 1999 reflects the effect of a decreased federal statutory tax rate due to expected annual taxable income levels.
Liquidity and Capital Resources
The J. Jill Group's principal working capital needs arise from the need to support costs incurred in advance of revenue generation, primarily inventory acquisition, catalog development, production and mailing costs incurred prior to the beginning of each selling season. The Company has two selling seasons which correspond to the fashion seasons. The Spring season begins in January and ends in July. The Fall season begins in July and ends in January. Capital needs arise from capital expenditures necessary to support the growth of the Company, including the new retail store initiative, and improvements to the Company's physical and operating infrastructure. During fiscal 1999 the Company funded its operating and
capital needs through its bank credit facilities, a new loan from a financial institution, cash generated from operations, and the remaining proceeds from its 1997 secondary public offering.
The Company's operating activities provided net cash of $3.2 million during fiscal 1999 primarily from net income before depreciation and amortization. Inventory decreased 19.2% to $21.7 million at December 25, 1999 from $26.8 million at December 26, 1998 primarily as a result of lower inventory balances related to the discontinuance of Nicole Summers. The Company's operating activities provided net cash of $7.7 million during fiscal 1998 primarily from net income before depreciation and amortization, which was partially offset by increased inventory balances.
The Company's investing activities used net cash of $10.0 million and $31.4 million during fiscal 1999 and fiscal 1998, respectively, primarily related to capital expenditures. During fiscal 1999 these capital expenditures related mainly to costs of completing the construction of the Tilton facility, the construction and furniture costs for the new corporate headquarters in Quincy, Massachusetts, and costs of the two new retail stores. During fiscal 1998 capital expenditures primarily related to the construction of the new Tilton facility.
The Company's financing activities used net cash of $7.8 million during fiscal 1999. This usage was primarily the result of a paydown of debt. During fiscal 1998, financing activities provided net cash of $24.4 million primarily from borrowings used to finance the Tilton facility construction.
The Company's credit facilities at December 25, 1999 consisted of (i) a $12.0 million real estate loan (the "Tilton Facility Loan"); (ii) a $9.5 million equipment loan (the "Equipment Loan"); (iii) a $1.0 million furniture loan (the "Furniture Loan"); (iv) a $1.7 million real estate loan (the "Meredith Facility Loan"); and (v) a $30.0 million revolving line of credit (the "Revolver"). At December 25, 1999 there were $10.6 million of letters of credit outstanding under the Revolver and no borrowings, leaving $19.4 million available under the Revolver. The weighted average interest rate for amounts outstanding under the Company's credit facilities during fiscal 1999 was 7.14%. The Tilton Facility Loan is collateralized by a mortgage lien on the Tilton facility. The Tilton facility is owned by The J. Jill Group's wholly owned subsidiary, Birch Pond Realty Corporation ("Birch Pond"), and leased to The J. Jill Group. During the first quarter of 1999, Birch Pond entered into the Tilton Facility Loan with a third party financial institution. The Equipment Loan is collateralized by substantially all of the Company's materials handling equipment. The Furniture Loan is collateralized by certain workstations and office furniture. The remaining credit facilities are collateralized by substantially all of the Company's remaining assets. All of these credit facilities contain various lending conditions and covenants including restrictions on permitted liens. Certain credit facilities also require compliance with certain debt service coverage ratios. During fiscal 1999 the Company obtained an amendment to the Revolver allowing the exclusion of the special charge and related inventory markdown charges recorded during fiscal 1999 from the debt service coverage ratio calculation.
The Company moved its corporate headquarters to Quincy, Massachusetts during February 2000. The Company plans to spend approximately $4.5 million, of which $2.3 million had been incurred as of December 25, 1999, for leasehold improvements and furniture for the new corporate headquarters. The Company opened two retail stores in the fourth quarter of fiscal 1999, one located in Natick, Massachusetts, and one in Providence, Rhode Island. The Company plans to have a total of twelve to seventeen retail stores open by the end of fiscal year 2000. Cash requirements, primarily comprised of leasehold improvements and initial inventory acquisition, for these new retail stores are currently estimated at an average of between $0.8 million and $1.2 million per retail store.
During December 1999, the Company leased its previous warehouse and distribution center located in Meredith, New Hampshire to a third party. The Company is planning to dispose of this property during fiscal 2000.
The Company expects that its cash and cash equivalents, existing credit facilities, and cash flows from operations will be sufficient to support the Company's capital and operating needs during fiscal 2000.
Year 2000
The Year 2000 issue involves the computer software and hardware changes necessary to handle the transition from the year 1999 to the year 2000. The Company formulated a plan to address the Year 2000 issue in 1997. The Company did not experience any significant problems as a result of the transition from the year 1999 to the year 2000.
As part of the Company's strategic business plan, the Company's internal information technology and non-information technology systems were replaced or upgraded. Because these system improvements were primarily motivated by the Company's growth and technology needs, they were not considered to be costs directly attributable to the Year 2000 issue.
The Company incurred less than $100,000 in costs directly attributable to the Year 2000 issue. Although the Company is not aware that any significant problems as a result of the Year 2000 issue occurred, there can be no assurance that similar issues may not arise in the future. Any significant problems resulting from the Year 2000 may have a material adverse effect on the Company's financial condition, results of operations or cash flow.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The Company's objective in managing its exposure to interest rate changes and foreign currency rate changes is to limit the material impact of the changes on cash flows and earnings and to lower its overall borrowing costs. To achieve its objectives, the Company identifies these risks and manages them through its regular operating and financing activities, including periodic refinancing of debt obligations to lower financing costs and adjust fixed and variable rate debt positions. The Company does not currently use derivative financial instruments or enter into foreign currency denominated contracts. Management has calculated the effect of a 10% change in interest rates over a month and determined the effect to be immaterial. Management does not foresee or expect any significant changes in the management of foreign currency or interest rate exposures or in the strategies it employs to manage such exposures in the near future.
Item 8.
Item 8. Consolidated Financial Statements and Supplementary Data
THE J. JILL GROUP, INC.
(FORMERLY DM MANAGEMENT COMPANY)
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of
The J. Jill Group, Inc.:
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, stockholders' equity and cash flows present fairly, in all material respects, the financial position of The J. Jill Group, Inc. and its subsidiary at December 25, 1999 and December 26, 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 25, 1999 in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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 the opinion expressed above.
PricewaterhouseCoopers LLP
Boston, Massachusetts
February 14, 2000
THE J. JILL GROUP, INC.
(FORMERLY DM MANAGEMENT COMPANY)
CONSOLIDATED BALANCE SHEETS
(in thousands)
The accompanying notes are an integral part of the consolidated financial statements.
THE J. JILL GROUP, INC.
(FORMERLY DM MANAGEMENT COMPANY)
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
The accompanying notes are an integral part of the consolidated financial statements.
THE J. JILL GROUP, INC.
(FORMERLY DM MANAGEMENT COMPANY)
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(in thousands, except share data)
The accompanying notes are an integral part of the consolidated financial statements.
THE J. JILL GROUP, INC.
(FORMERLY DM MANAGEMENT COMPANY)
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
The accompanying notes are an integral part of the consolidated financial statements.
THE J. JILL GROUP, INC.
(FORMERLY DM MANAGEMENT COMPANY)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A. Summary of significant accounting policies:
Nature of business
The J. Jill Group, Inc. (together with its wholly owned consolidated subsidiary, the "Company" or "The J. Jill Group"), formerly known as DM Management Company, is a specialty marketer of high quality women's apparel, accessories, and gifts. During the fiscal year ended December 25, 1999 the Company began its transition from a multi-catalog concept direct mail retailer into a single brand retailer with multiple distribution channels. The Company previously marketed its products through two catalog concepts, J. Jill and Nicole Summers. During fiscal 1999, the Company decided to discontinue its Nicole Summers catalog concept (see Note B). During 1999 the Company launched its e-commerce website, jjill.com, and opened two new retail stores to provide additional channels of distribution to market its J. Jill merchandise.
Principles of consolidation
The consolidated financial statements include the accounts of the Company, including its wholly owned subsidiary. Intercompany balances and transactions have been eliminated.
Fiscal year
The Company's fiscal year ends on the last Saturday in December. The twelve months ended December 25, 1999 ("fiscal 1999"), December 26, 1998 ("fiscal 1998") and December 27, 1997 ("fiscal 1997") were all 52-week periods.
Stock split
On May 29, 1998, the Company announced a three-for-two stock split to be effected in the form of a stock dividend payable on June 30, 1998 to shareholders of record on June 12, 1998. All historical earnings per share information has been restated to include the effects of the stock split. The consolidated statements of changes in stockholders' equity for dates prior to the stock split have not been restated to include the effects of the stock split. All common stock amounts and activity after the date of the stock split reflect the three-for-two split.
Use of estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Revenue recognition
The Company recognizes sales and the related cost of sales at the time the products are shipped to customers. The Company provides an allowance based on projected merchandise returns. Shipping and handling fees charged to the customer are recognized at the time the products are shipped to the customer and are included in net sales. The cost of shipping products to the customer is recognized at the time the products are shipped to the customer and are included in cost of products and merchandising.
Cash and cash equivalents
Cash and cash equivalents consist primarily of cash on deposit in banks and may also include cash invested in money market mutual funds and overnight repurchase agreements. The Company considers all highly liquid instruments, including certificates of deposit, with remaining maturity at time of purchase of three months or less to be cash equivalents.
Cash held in escrow
Cash held in escrow consists of amounts The J. Jill Group's wholly owned subsidiary, Birch Pond Realty Corporation ("Birch Pond"), is required to keep in escrow associated with the outstanding loan on the operations and fulfillment center in Tilton, New Hampshire (the "Tilton facility"). These amounts will be used to pay real estate taxes, insurance and various costs for repairs and replacements related to the Tilton facility.
Inventory
Inventory, consisting of merchandise for sale, is stated at the lower of cost or market, with cost determined using the weighted average first-in, first-out method. The Company provides for markdown reserves based on expected net realizable market value.
Selling expenses
Selling expenses consist primarily of the cost to produce, print and distribute catalogs. These costs are considered direct-response advertising and as such are capitalized as incurred and amortized over the expected sales life of each catalog, which is generally a period not exceeding six months. Creative and production costs associated with the Company's e-commerce website are considered direct response advertising and as such are capitalized as incurred and amortized over the respective selling season, which is generally a period not to exceed six months.
Property and equipment
Property and equipment are stated at cost. Depreciation expense is computed using the straight-line method over the estimated useful lives of the assets, which are 30 years for buildings and 1-7 years for computers, computer software, equipment, furniture and fixtures. Improvements to leased premises are amortized on a straight-line basis over the shorter of the estimated useful life or the lease term. Maintenance and repairs are charged to expense as incurred. Upon retirement or sale, the cost of the assets disposed of and the related accumulated depreciation are removed from the accounts and any resulting gain or loss is credited or charged to income. Pre-opening costs for the Company's new retail stores, including primarily payroll costs and manager training costs incurred prior to store opening, are expensed as incurred and are included in selling, general and administrative expenses.
The Company accounts for its internal use software in accordance with American Institute of Certified Public Accountants issued Statement of Position No. 98-1 ("SOP 98-1"), "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." SOP 98-1 requires that certain costs related to the development or purchase of internal-use software be capitalized and amortized over the estimated useful life of the software. SOP 98-1 also requires that costs related to the preliminary project
stage and the post-implementation/operations stage of an internal-use computer software development project be expensed as incurred.
Long-lived assets
Management periodically considers whether there has been a permanent impairment in the value of its long-lived assets, primarily property and equipment, by evaluating various factors, including current and projected future operating results and undiscounted cash flows. During fiscal 1999 the Company determined that certain long-lived assets were impaired. See footnotes B and C.
Fair value of financial instruments
The Company periodically assesses the fair value of its financial instruments. Based on such an analysis, the Company's long-term debt, including current maturities, approximates fair value.
Risks and Uncertainties
Financial instruments, which potentially subject the Company to significant concentrations of credit risk, consist principally of cash investments. The Company maintains cash and cash equivalents with various major financial institutions. The Company performs periodic evaluations of the relative credit standing of these financial institutions to minimize credit risk.
The Company has evaluated its operations to determine if any risks and uncertainties exist that could severely impact its operations in the near term. The Company believes that its concentration risks are limited, primarily due to the fact that it purchases its inventory through buying agents and directly from a variety of vendors. The buying agents generally purchase the Company's inventory directly from a variety of vendors. The Company does not purchase more than 10% of its inventory directly from any one vendor, however it does purchase approximately 20% of its inventory through one buying agent. Although the Company could purchase this inventory through alternative buying agents and or directly from vendors, loss of this buying agent could temporarily disrupt operations. The Company attempts to mitigate this risk by working closely with key agents and vendors.
Reclassifications
Certain prior year financial statement amounts have been reclassified to be consistent with the presentation for fiscal 1999. During fiscal 1999 the Company changed its income statement presentation to be more in line with the way the Company reviews its operations and to be more consistent with the presentation used by other companies in the industry. The most significant of these changes included combining the prior year classifications of product costs and operations expense into cost of product and merchandising and combining prior year classifications of selling expense and general and administrative expense into selling, general and administrative expenses. As part of these changes the Company reclassified approximately $4.0 million, $2.1 million and $1.3 million from selling, general and administrative expenses to cost of product and merchandising for fiscal 1999, fiscal 1998 and fiscal 1997, respectively.
B. Special Charge:
During fiscal 1999 the Company recorded charges totaling $5,987,000 primarily associated with its decision to discontinue its Nicole Summers catalog concept. These charges included a $2,359,000 inventory markdown charge included in cost of products and merchandising and a $3,628,000 special charge shown separately on the accompanying consolidated statements of operations. The inventory markdown charge includes a write-down of inventory, expected to be liquidated through outlet stores and other liquidation vehicles, to the lower of cost or market as well as costs to exit certain purchase commitments made in the ordinary course of business. The following is a summary of costs included in the $3,628,000 special charge (in thousands):
In connection with the third quarter 1999 decision to discontinue its Nicole Summers catalog concept, the Company decided not to circulate certain previously planned Nicole Summers catalogs. Prepaid catalog costs incurred or committed for these catalogs were written off as part of the special charge. Severance costs relate to five terminated employees previously associated with the Nicole Summers catalog concept. Lease commitment costs are primarily comprised of costs to close an existing Nicole Summers outlet.
At December 25, 1999, accrued expenses included $532,000 of accrued special charges. This amount was comprised of the lease commitment costs, severance costs and certain of the other miscellaneous costs. The Company expects to complete paying for a majority of these items during fiscal 2000.
C. Assets held for sale:
Assets held for sale is primarily comprised of property and equipment associated with the Company's operations and fulfillment center in Meredith, New Hampshire (the "Meredith facility"). As a result of the Company's decision to discontinue its Nicole Summers catalog concept, the Company expects that the operations and fulfillment center in Tilton, New Hampshire (the "Tilton facility") will now have enough warehousing and distribution capacity to house its future retail operations center. Based on the Tilton facility's ability to house the new retail operations center, the Company has decided to no longer hold its Meredith facility for that purpose. As a result, during fiscal 1999 the Company reclassified the property and equipment and the related accumulated depreciation to assets held for sale and recognized fixed asset impairments of $2,130,000 to write-down these assets to their estimated fair market value, net of estimated costs of disposal. The Company disposed of $110,000 of these assets held for sale during fiscal 1999, leaving a remaining balance of $2,313,000 at December 25, 1999. The Company expects to dispose of the remaining assets held for sale during fiscal 2000. During December 1999 the Company entered into a five-year lease agreement to lease the Meredith facility to a third party.
D. Property and equipment:
Property and equipment consists of the following (in thousands):
At December 25, 1999 construction in progress was primarily comprised of leasehold improvement and furniture costs related to the new corporate headquarters in Quincy, Massachusetts as well as leasehold improvement costs related to new, unopened retail stores. At December 26, 1998 construction in progress was comprised primarily of construction costs related to the Tilton facility. This facility was placed in full operation in early 1999. Included in construction in progress at December 26, 1998 was $1,071,000 of capitalized interest. The Company had a balance of construction cost incurred for which payment was retained until completion and approval of $297,000 and $943,000 at December 25, 1999 and December 26, 1998, respectively.
E. Debt:
The Company's credit facilities at December 25, 1999 consisted of (i) a $12,000,000 real estate loan (the "Tilton Facility Loan"); (ii) a $9,500,000 equipment loan (the "Equipment Loan"); (iii) a $980,000 furniture loan (the "Furniture Loan"); (iv) a $1,650,000 real estate loan (the "Meredith Facility Loan"); and (v) a $30,000,000 revolving line of credit (the "Revolver").
The Tilton Facility Loan is collateralized by a mortgage lien on the Tilton facility. The Tilton facility is owned by Birch Pond and leased to The J. Jill Group. During the first quarter of 1999, Birch Pond entered into the Tilton Facility Loan with a third party financial institution. The Equipment Loan is collateralized by substantially all of the Company's materials handling equipment. The Furniture Loan is collateralized by certain workstations and office furniture. The remaining credit facilities are collateralized by substantially all of the Company's remaining assets. All of these credit facilities contain various lending conditions and covenants including restrictions on permitted liens. Certain credit facilities also require compliance with certain debt service coverage ratios. During fiscal 1999 the Company obtained an amendment to the Revolver allowing the exclusion of the special charge and related inventory markdown charges recorded in fiscal 1999 from the debt service coverage ratio calculation.
Payments of principal and interest on the Tilton Facility Loan are due monthly through March 1, 2009 with the remaining principal due on April 1, 2009. The interest rate on the Tilton Facility Loan is fixed at 7.30% per annum. The Equipment Loan requires monthly payments of principal and interest through its maturity on December 1, 2005 and has two components with different fixed interest rates, with a weighted average interest rate of 7.62% per annum. Interest on the Furniture Loan is fixed at 6.25% per annum and requires monthly payments of principal and interest through its maturity on March 30, 2002. Payments of
principal and interest on the Meredith Facility Loan are due monthly, based on a 15-year amortization, with the remaining balance payable on July 30, 2002. Interest on the Meredith Facility Loan is currently locked in for 3 years based on the 3-year United States Treasury rate plus 1.5% which resulted in a rate of 6.74% per annum at December 25, 1999. The availability under the Revolver is reduced by outstanding borrowings and outstanding letters of credit and matures on June 1, 2001. At December 25, 1999 and December 26, 1998 there were no borrowings under the Revolver. Outstanding import letters of credit totaled approximately $10,639,000 and $11,612,000 at December 25, 1999 and December 26, 1998, respectively. At December 25, 1999 the Revolver bore interest at 8.5% per annum. The outstanding letters of credit do not bear interest.
A summary of the Company's outstanding long-term debt follows (in thousands):
At December 25, 1999, aggregate maturities of long-term debt for the next five fiscal years and thereafter were as follows: 2000-$3,137,000; 2001-$1,848,000; 2002-$1,706,000; 2003-$1,743,000; 2004-$1,878,000; and thereafter-$11,923,000.
F. Stockholders' equity:
Common stock
In fiscal 1997 the Company completed its second offering of common stock to the public, issuing 1,412,861 shares of common stock at a price to the public of $13.50 per share. The Company received approximately $17,454,000 in net proceeds from the offering, after underwriting discounts and commissions and expenses. Expenses incurred by the Company in connection with the offering totaled approximately $567,000. Also in connection with this public offering, 1,752,404 shares of the Company's common stock were sold by selling stockholders. The Company did not receive any of the proceeds from the sale of shares by selling stockholders. The information in this paragraph has not been restated to reflect the effects of the three-for-two stock split.
Special preferred stock
The Company has 1,000,000 shares of special preferred stock, $0.01 par value per share, authorized. No special preferred stock was outstanding at either of the reported balance sheet dates.
Earnings (loss) per share
A reconciliation of the numerators and denominators of the basic and diluted per share computation for net income (loss) per share ("EPS") follows (in thousands, except per share data). All share and per share information below has been restated to reflect the effects of the three-for-two stock split.
Options to purchase 1,806,621, 40,000 and 129,000 shares of common stock were outstanding at December 25, 1999, December 26, 1998, and December 27, 1997, respectively, but were not included in the computation of diluted EPS since the options were antidilutive.
Comprehensive income (loss)
The Company calculates comprehensive income in accordance with Financial Accounting Standards Board issued Statement No. 130 ("SFAS 130"), "Reporting Comprehensive Income," which establishes standards for reporting and display of comprehensive income. The Company's comprehensive income (loss) includes net income (loss) as reported in the accompanying consolidated statements of operations plus the change in unrealized losses on marketable securities, net of deferred tax benefit. Comprehensive income (loss) totaled ($684,000) in fiscal 1999, $8,507,000 in fiscal 1998, and $3,909,000 in fiscal 1997. The unrealized loss on marketable securities represents accumulated other comprehensive income. There was no accumulated other comprehensive income at December 25, 1999 or December 26, 1998.
G. Stock-based plans:
At December 25, 1999, the Company had three stock-based plans: the 1988 Incentive Stock Option Plan (the "1988 Stock Option Plan"), the 1993 Incentive and Nonqualified Stock Option Plan (the "1993 Stock Option Plan") and the 1998 Employee Stock Purchase Plan (the "1998 Stock Purchase Plan"). The Company applies Accounting Principles Board Opinion No. 25 ("APB 25"), "Accounting for Stock Issued to Employees," and related interpretations to account for its stock option plans and employee stock purchase plans. No compensation cost has been recognized for these plans.
Stock option plans
The 1988 Stock Option Plan provides for the grant of options to purchase common stock intended to qualify as incentive stock options as defined in Section 422 of the Internal Revenue Code of 1986, as amended ("ISO's"). During fiscal 1994, the Board of Directors voted not to issue any additional options under the 1988 Stock Option Plan. The maximum term of options granted under the 1988 Stock Option Plan is ten years. At December 25, 1999 there were no remaining options outstanding under the 1988 Stock Option Plan.
The 1993 Stock Option Plan authorizes (i) the grant of options to purchase common stock intended to qualify as ISO's, and (ii) the grant of options that do not so qualify. At December 25, 1999, the 1993 Stock Option Plan authorized the issuance of options to purchase up to 2,400,000 shares of common stock (as adjusted to reflect the effects of the three-for-two stock split). The Compensation Committee of the Board of Directors administers the 1993 Stock Option Plan and within certain limits has discretion to determine the terms and conditions of options granted under the plan. The 1993 Stock Option Plan also provides for the automatic grant of options to purchase a specified number of shares to non-employee directors. The maximum term of options granted under the 1993 Stock Option Plan is ten years.
Stock purchase plans
Under the Company's stock purchase plans, eligible employees may be granted the opportunity to purchase common stock of the Company at 85% of market value on the first or last business day of the calendar year, whichever is lower. The 1993 Stock Purchase Plan and the 1998 Stock Purchase Plan each authorized the issuance of up to 150,000 shares (as adjusted to reflect the effects of the three-for-two stock split) of the Company's common stock to eligible employees. Issuances of common stock under the 1993 Stock Purchase Plan and the 1998 Stock Purchase Plan have been made as follows. All share information below has been restated to reflect the effects of the three-for-two stock split.
Immediately following the December 31, 1997 issuance, the 1993 Stock Purchase Plan was terminated.
THE J. JILL GROUP, INC.
(FORMERLY DM MANAGEMENT COMPANY)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
G. Stock-based plans: (Continued)
The following table reflects the activity under the 1988 Stock Option Plan and the 1993 Stock Option Plan. All amounts have been restated to reflect the effects of the three-for-two stock split:
Options exercisable under the 1988 Stock Option Plan and the 1993 Stock Option Plan were as follows.
The following table summarizes information about options outstanding under the 1988 Stock Option Plan and the 1993 Stock Option Plan at December 25, 1999:
The Company discloses stock-based compensation information in accordance with Financial Accounting Standards Board issued Statement No. 123 ("SFAS 123"), "Accounting for Stock-Based Compensation," which requires disclosure of pro forma net income, EPS and other information as if the fair value method of accounting for stock options and other equity instruments described in SFAS 123 had been adopted. Pro forma disclosures include the effects of all options granted after December 25, 1994. The effects of applying SFAS 123 in this pro forma disclosure are not indicative of future amounts. SFAS 123 does not apply to awards made prior to December 25, 1994. Additional awards in future years are anticipated.
Had compensation cost for the Company's stock-based plans been based on the fair value at the grant dates for awards made under these plans consistent with SFAS 123, the Company's net income (loss) and EPS would have been as follows (in thousands, except per share data). EPS amounts have been restated where applicable to reflect the effects of the three-for-two stock split:
The Black-Scholes option-pricing model is used to estimate the fair value on the date of grant of each option granted after December 25, 1994. The Black-Scholes model is also used to estimate the fair value of
the employees' purchase rights. In each case, the following assumptions were used for stock option grants and employee purchase right grants in fiscal 1999:
The weighted average fair value of stock options granted and the average fair value of the employee purchase rights granted were as follows. Amounts have been restated where applicable to reflect the effects of the three-for-two stock split.
H. Benefit plans:
The Company offers a savings plan (the "Savings Plan") to its employees, which permits participants to make contributions by salary reduction pursuant to Section 401(k) of the Internal Revenue Code. At the discretion of the Board of Directors, the Company may also make contributions for the benefit of all eligible employees under the Savings Plan. Employee eligibility is based on minimum age and employment requirements. The Company plans to contribute $250,000 to the Savings Plan for fiscal 1999 and has contributed approximately $200,000, and $100,000 to the Savings Plan for fiscal 1998, and fiscal 1997 respectively.
I. Income taxes:
The Company accounts for income taxes in accordance with Financial Accounting Standards Board issued Statement No. 109 ("SFAS 109"), "Accounting for Income Taxes." Under SFAS 109, deferred tax assets and liabilities are recognized based on temporary differences between the financial statement and tax basis of assets and liabilities using tax rates enacted to be in effect in the years in which the differences are expected to reverse. SFAS 109 requires current recognition of net deferred tax assets to the extent that it is more likely than not that such net assets will be realized. To the extent that the Company believes that its net deferred tax assets will not be realized, a valuation allowance must be placed against those assets.
Significant components of the Company's deferred tax assets and liabilities are as follows (in thousands):
At December 25, 1999, the Company had available net operating loss ("NOL") carryforwards of approximately $10,950,000, of which $6,037,000 expires in 2004, $2,530,000 expires in 2005 and $2,383,000 expires in 2006.
Section 382 of the Internal Revenue Code of 1986, as amended, restricts a corporation's ability to use its NOL carryforwards following certain "ownership changes." The Company determined that such an ownership change occurred as a result of its initial public offering ("IPO") and accordingly the amount of the Company's pre-IPO NOL carryforwards available for use in any particular taxable year is limited to approximately $1.5 million annually. To the extent that the Company does not utilize the full amount of the annual NOL limit, the unused amount may be used to offset taxable income in future years. At December 25, 1999 the Company had $1.1 million of NOL carryforwards available for this purpose. NOL carryforwards expire 15 years after the tax year in which they arise, and the last of the Company's current NOL carryforwards will expire in its 2006 tax year.
The components of the Company's provision (benefit) for income taxes from continuing operations are as follows (in thousands):
The difference in income taxes at the U. S. federal statutory rate and the income tax provision (benefit) reported in the accompanying consolidated statements of operations is as follows (in thousands):
At December 25, 1999 approximately $4,051,000 of federal and state income tax receivables were included in other assets. At December 26, 1998, approximately $1,089,000 of federal and state income tax payables were included in accrued expenses.
J. Commitments:
The Company leases certain of its facilities under noncancellable operating leases having initial or remaining terms of more than one year. The majority of these real estate leases require the Company to pay maintenance, insurance and real estate taxes. Total rent expense, including these costs, amounted to approximately $1,896,000 in fiscal 1999, $1,622,000 in fiscal 1998, and $1,052,000 in fiscal 1997.
At December 25, 1999, future minimum lease payments for operating leases having a remaining term in excess of one year at such date totaled $23,848,000 and for the next five fiscal years and thereafter were as follows: 2000-$2,351,000; 2001-$2,393,000; 2002-$2,414,000; 2003-$2,412,000; 2004-$2,408,000; and thereafter-$11,870,000.
At December 25, 1999, future minimum lease receipts under operating leases having a remaining term in excess of one year at such date totaled $1,906,000 and for the next five fiscal years were as follows:
2000-$238,000; 2001-$411,000; 2002-$431,000; 2003-$431,000; and 2004-$395,000. The Company does not expect to fully realize these future minimum lease receipts as the related Meredith facility is held for sale.
K. Quarterly financial data (unaudited): (in thousands, except per share data)
(1)During the quarter ended September 25, 1999 the Company recognized charges totaling $5,276,000 associated with its decision to discontinue its Nicole Summers concept. (See Note B).(2)During the quarter ended December 25, 1999 the Company recognized an additional $711,000 of inventory markdown charges associated with its decision to discontinue the Nicole Summers concept. These additional charges were a result of a higher than expected rate of return on the Nicole Summers merchandise.
On May 29, 1998, the Company announced a three-for-two stock split to be effected in the form of a stock dividend payable on June 30, 1998 to shareholders of record on June 12, 1998. All per share information above has been restated to reflect the effects of the three-for-two stock split.
The sum of the quarterly EPS amounts may not equal the full year amount since the computations of the weighted average shares outstanding for each quarter and the full year are made independently.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of
The J. Jill Group, Inc.:
Our audits of the consolidated financial statements referred to in our report dated February 14, 2000, appearing in the 1999 Annual Report to Shareholders of The J. Jill Group, Inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the financial statement schedule listed in Item 14(a)(2) of this Form 10-K. In our opinion, this financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements.
PricewaterhouseCoopers LLP
Boston, Massachusetts
February 14, 2000
THE J. JILL GROUP, INC.
(FORMERLY DM MANAGEMENT COMPANY)
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
(in thousands)
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Consolidated Financial Disclosure
Not applicable.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The information set forth under the captions "Directors and Executive Officers" and "Section 16(a) Beneficial Ownership Reporting Compliance" appearing in the Company's definitive Proxy Statement to be delivered to stockholders in connection with the Annual Meeting of Stockholders to be held on June 1, 2000, which will be filed with the Securities and Exchange Commission not later than 120 days after December 25, 1999, is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation
The information set forth under the caption "Remuneration of Executive Officers and Directors" appearing in the Company's definitive Proxy Statement to be delivered to stockholders in connection with the Annual Meeting of Stockholders to be held on June 1, 2000, which will be filed with the Securities and Exchange Commission not later than 120 days after December 25, 1999, is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information set forth under the caption "Security Ownership of Certain Beneficial Owners and Management" appearing in the Company's definitive Proxy Statement to be delivered to stockholders in connection with the Annual Meeting of Stockholders to be held on June 1, 2000, which will be filed with the Securities and Exchange Commission not later than 120 days after December 25, 1999, is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions
None.
PART IV
Item 14.
Item 14. Exhibits, Consolidated Financial Statement Schedules, and Reports on Form 8-K
(1) Financial Statements
The financial statements filed as part of this report are listed on the Index to Consolidated Financial Statements on Page 23.
(2) Financial Statement Schedule
(3) Exhibits
Exhibits 10.11 through 10.25 include the Company's compensatory plans or arrangements required to be filed as exhibits pursuant to Item 14(c) of Form 10-K.
Certificate of Incorporation and By-Laws
3.1
Restated Certificate of Incorporation of the Company (included as Exhibit 4.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 25, 1993, File No. 0-22480, and incorporated herein by reference)
3.2
By-Laws of the Company, as amended (included as Exhibit 99.1 to the Company's Current Report on Form 8-K dated November 24, 1999, File No. 0-22480, and incorporated herein by reference)
Material Contracts
10.1
Lease Agreement dated September 14, 1989, between the Company and Richard D. Matthews and Richard J. Valentine, Trustees of Bare Cove Realty Trust established u/d/t dated January 10, 1984, as amended (included as Exhibit 10.13 to the Company's Registration Statement on Form S-1, Registration No. 33-67512, and incorporated herein by reference)
10.2
Third Amendment to Lease Agreement dated September 14, 1989, between the Company and Richard D. Matthews and Richard J. Valentine, Trustees of Bare Cove Realty Trust established u/d/t dated January 10, 1984, as previously amended (included as Exhibit 10.3 to the Company's Transition Report on Form 10-K for the transition period from June 30, 1996 to December 28, 1996, File No. 0-22480, and incorporated herein by reference)
10.3
Fourth Amendment to Lease Agreement dated September 14, 1989, between the Company and Richard D. Matthews and Richard J. Valentine, Trustees of Bare Cove Realty Trust established u/d/t dated January 10, 1984, as previously amended (included as Exhibit 10.4 to the Company's Transition Report on Form 10-K for the transition period from June 30, 1996 to December 28, 1996, File No. 0-22480, and incorporated herein by reference)
10.4
Fifth Amendment to Lease Agreement dated August 27, 1998, between the Company and Richard D. Matthews and Richard J. Valentine, as Trustees of Bare Cove Realty Trust established u/d/t dated January 10, 1984, as amended (included as Exhibit 10.4 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.5
Lease dated August 15, 1997 between the Company and Central NH Realty, Inc.(included as Exhibit 10.27 to the Company's Registration Statement on Form S-2 dated September 10, 1997, File No. 0-22480, and incorporated herein by reference)
10.6
Lease Agreement dated September 18, 1998, between the Company and National Fire Protection Association (included as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.7
First Amendment to Lease Agreement, dated June 10, 1999, between the Company and National Fire Protection Association (included as Exhibit 10.1 to the Company's Quarterly report on form 10-Q for the quarter ended June 26, 1999, File No. 0-22480, and incorporated herein by reference)
10.8
Second Amendment to Lease Agreement, dated October 29, 1999, between the Company and National Fire Protection Association
10.9
Lease dated March 1, 1999 between the Company and Birch Pond Realty Corporation (included as Exhibit 10.10 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.10
Lease dated December 21, 1999, between the Company and iDolls Corporation
10.11
Amended and Restated 1993 Incentive and Nonqualified Stock Option Plan (included as Exhibit 10.12 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.12
1998 Employee Stock Purchase Plan (included as Appendix B to the Company's definitive Proxy Statement for its annual meeting of stockholders held on May 28, 1998, File No. 0-22480, and incorporated herein by reference)
10.13
1999 Incentive Compensation Plan (included as Exhibit 10.15 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.14
Employment Letter Agreement dated December 21, 1995, between the Company and Gordon R. Cooke (included as Exhibit 10.4 to the Company's Quarterly Report on Form 10-Q for the quarter ended December 30, 1995, File No. 0-22480, and incorporated herein by reference)
10.15
Employment Letter Agreement dated May 7, 1996, between the Company and John J. Hayes (included as Exhibit 10.12 to the Company's Annual Report on Form 10-K for the year ended June 29, 1996, File No. 0-22480, and incorporated herein by reference)
10.16
Employment Letter Agreement between the Company and Kevin E. Burns (included as Exhibit 10.7 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 27, 1997, File No. 0-22480, and incorporated herein by reference)
10.17
Employment Letter Agreement dated March 11, 1999, between the Company and Dennis J. Adomaitis (included as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 27, 1999, File No. 0-22480, and incorporated herein by reference)
10.18
Split Dollar Agreement and Assignment of Life Insurance Policy as Collateral dated October 1, 1998 between the Company and Gordon R. Cooke (included as Exhibit 10.12 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.19
Split Dollar Agreement and Assignment of Life Insurance Policy as Collateral dated February 22, 1999 between the Company and Kevin Burns (included as Exhibit 10.20 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.20
Split Dollar Agreement and Assignment of Life Insurance Policy as Collateral dated February 24, 1999 between the Company and Olga Conley (included as Exhibit 10.21 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.21
Split Dollar Agreement and Assignment of Life Insurance Policy as Collateral dated February 24, 1999 between the Company and Gordon Cooke (included as Exhibit 10.22 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.22
Split Dollar Agreement and Assignment of Life Insurance Policy as Collateral dated February 24, 1999 between the Company and John Hayes (included as Exhibit 10.23 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.23
Split Dollar Agreement and Assignment of Life Insurance Policy as Collateral dated February 24, 1999 between the Company and Patricia Lee (included as Exhibit 10.24 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.24
Split Dollar Agreement and Assignment of Life Insurance Policy as Collateral dated February 24, 1999 between the Company and Peter Tulp (included as Exhibit 10.25 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.25
Split Dollar Agreement and Assignment of Life Insurance Policy as Collateral dated November 18, 1999 between the Company and Dennis Adomaitis
10.26
Merchant Services Agreement between the Company and Hurley State Bank, dated July 18, 1995 (included as Exhibit 10.21 to the Company's Annual Report on Form 10-K for the fiscal year ended June 24, 1995, File No. 0-22480, and incorporated herein by reference)
10.27
Grant of Security Interest in Trademarks dated June 5, 1997 between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.6 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 28, 1997, File No. 0-22480, and incorporated herein by reference)
10.28
Real Estate Note dated July 30, 1997 between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.8 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 28, 1997, File No. 0-22480, and incorporated herein by reference)
10.29
Mortgage dated July 30, 1997 between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.9 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 28, 1997, File No. 0-22480, and incorporated herein by reference)
10.30
Mortgage (Bridge Mortgage) dated October 31, 1997 between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.3 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 27, 1997, File No. 0-22480, and incorporated herein by reference)
10.31
First Amendment to Security Agreement dated October 31, 1997 between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.4 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 27, 1997, File No. 0-22480, and incorporated herein by reference)
10.32
First Amendment to Mortgage dated October 31, 1997 between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.5 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 27, 1997, File No. 0-22480, and incorporated herein by reference)
10.33
Replacement Revolving Note dated October 31, 1997 between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.6 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 27, 1997, File No. 0-22480, and incorporated herein by reference)
10.34
Second Amended and Restated Loan Agreement dated March 5, 1998 between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.27 to the Company's Annual Report on Form 10-K for the fiscal year ended December 27, 1997, File No. 0-22480, and incorporated herein by reference)
10.35
New Bridge Note dated March 5, 1998 between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.28 to the Company's Annual Report on Form 10-K for the fiscal year ended December 27, 1997, File No. 0-22480, and incorporated herein by reference)
10.36
Short Term Revolving Note dated March 5, 1998 between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.29 to the Company's Annual Report on Form 10-K for the fiscal year ended December 27, 1997, File No. 0-22480, and incorporated herein by reference)
10.37
Second Amendment to Security Agreement dated March 5, 1998 between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.30 to the Company's Annual Report on Form 10-K for the fiscal year ended December 27, 1997, File No. 0-22480, and incorporated herein by reference)
10.38
Assignment of Certificate of Deposit dated March 5, 1998 between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.31 to the Company's Annual Report on Form 10-K for the fiscal year ended December 27, 1997, File No. 0-22480, and incorporated herein by reference)
10.39
Amended Bridge Mortgage dated March 5, 1998 between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.32 to the Company's Annual Report on Form 10-K for the fiscal year ended December 27, 1997, File No. 0-22480, and incorporated herein by reference)
10.40
Second Amendment to Mortgage (Meredith) dated March 5, 1998 between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.33 to the Company's Annual Report on Form 10-K for the fiscal year ended December 27, 1997, File No. 0-22480, and incorporated herein by reference)
10.41
First Amendment to Second Amended and Restated Loan Agreement dated June 30, 1998 between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 27, 1998, File No. 0-22480, and incorporated herein by reference)
10.42
Second Amendment to Second Amended and Restated Loan Agreement dated September 4, 1998, between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.43
Third Amendment to Second Amended and Restated Loan Agreement dated September 4, 1998, between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.3 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.44
First Amendment to Assignment of Certificate of Deposit dated September 4, 1998, between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.4 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.45
Second Amendment to Bridge Mortgage dated September 4, 1998, between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.5 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.46
Third Amendment to Mortgage (Meredith) dated September 4, 1998, between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.6 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.47
Replacement New Bridge Note dated September 4, 1998, between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.7 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.48
Replacement Short Term Revolving Note dated September 4, 1998, between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.8 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.49
Second Replacement Revolving Note dated September 4, 1998, between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.9 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.50
Third Amendment to Security Agreement dated September 4, 1998, between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.10 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.51
Fourth Amendment to Second Amended and Restated Loan Agreement, dated as of December 31, 1998, by and between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.55 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.52
Second Amendment to Assignment of Certificate of Deposit, dated as of December 31, 1998, by and between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.56 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.53
Second Replacement New Bridge Note, dated as of December 31, 1998, by and between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.57 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.54
Second Replacement Short Term Revolving Note, dated as of December 31, 1998, by and between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.58 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.55
Fifth Amendment to Second Amended and Restated Loan Agreement, dated March 30, 1999, by and between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.2 to the Company's Quarterly report on Form 10-Q for the quarter ended March 27, 1999, file No. 0-22480, and incorporated herein by reference)
10.56
Third Amended and Restated Loan Agreement, dated May 4, 1999, between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.8 to the Company's Quarterly report on Form 10-Q for the quarter ended March 27, 1999, file No. 0-22480, and incorporated herein by reference)
10.57
Third Replacement Revolving Note, dated May 4, 1999, between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.9 to the Company's Quarterly report on Form 10-Q for the quarter ended March 27, 1999, file No. 0-22480, and incorporated herein by reference)
10.58
First Amendment to Third Amended and Restated Loan Agreement between the Company and Citizens Bank of Massachusetts
10.60
Master Security Agreement, dated as of December 23, 1998, by and between the Company and Citizens Leasing Corporation (included as Exhibit 10.59 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.61
Amendment No. 1 to the Master Security Agreement, dated as of December 23, 1998, by and between the Company and Citizens Leasing Corporation (included as Exhibit 10.60 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.62
Secured Promissory Note, dated as of December 23, 1998, by and between the Company and Citizens Leasing Corporation (included as Exhibit 10.61 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.63
Secured Promissory Note, dated as of December 23, 1998, by and between the Company and Citizens Leasing Corporation (included as Exhibit 10.62 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.64
Secured Promissory Note, dated March 30, 1999, between the Company and Citizens Leasing Corporation (included as Exhibit 10.3 to the Company's Quarterly report on Form 10-Q for the quarter ended March 27, 1999, file No. 0-22480, and incorporated herein by reference)
10.65
Secured Promissory Note, dated March 30, 1999, between the Company and Citizens Leasing Corporation (included as Exhibit 10.4 to the Company's Quarterly report on Form 10-Q for the quarter ended March 27, 1999, file No. 0-22480, and incorporated herein by reference)
10.66
Mortgage Note dated March 1, 1999 between Birch Pond Realty Corporation and John Hancock Real Estate Finance, Inc. (included as Exhibit 10.63 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.67
Assignment of Leases and Rents dated March 1, 1999 between Birch Pond Realty Corporation and John Hancock Real Estate Finance, Inc. (included as Exhibit 10.64 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.68
Mortgage, Assignment of Leases and Rents and Security Agreement dated March 1, 1999 between Birch Pond Realty Corporation and John Hancock Real Estate Finance, Inc. (included as Exhibit 10.65 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.69
Assignment of Agreements, Permits and Contracts dated March 1, 1999 between Birch Pond Realty Corporation and John Hancock Real Estate Finance, Inc. (included as Exhibit 10.66 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.70
Indemnification Agreement dated March 1, 1999 between the Company, Birch Pond Realty Corporation and John Hancock Real Estate Finance, Inc. (included as Exhibit 10.67 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.71
Guaranty Agreement dated March 1, 1999 between the Company and John Hancock Real Estate Finance, Inc. (included as Exhibit 10.68 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.72
Replacement Reserve Agreement dated March 1, 1999 by and between Birch Pond Realty Corporation and John Hancock Real Estate Finance, Inc. (included as Exhibit 10.69 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.73
Tenant Improvement and Leasing Commissions Agreement dated March 1, 1999 between Birch Pond Realty Corporation and John Hancock Real Estate Finance, Inc. (included as Exhibit 10.70 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.74
Subordination of Mortgage, dated June 28, 1999, between Birch Pond Realty Corporation and John Hancock Real Estate Finance, Inc. (included as Exhibit 10.2 to the Company's Quarterly report on form 10-Q for the quarter ended June 26, 1999, File No. 0-22480, and incorporated herein by reference)
10.75
First Modification of Mortgage, Assignment of Leases and Rents and Security Agreement, dated June 28, 1999, between Birch Pond Realty Corporation and John Hancock Real Estate Finance, Inc. (included as Exhibit 10.3 to the Company's Quarterly report on form 10-Q for the quarter ended June 26, 1999, File No. 0-22480, and incorporated herein by reference)
10.76
Partial Release, dated June 28, 1999, between Birch Pond Realty Corporation and John Hancock Real Estate Finance, Inc. (included as Exhibit 10.4 to the Company's Quarterly report on form 10-Q for the quarter ended June 26, 1999, File No. 0-22480, and incorporated herein by reference)
10.77
Reaffirmation of Guaranty and Indemnity Agreements, dated June 28, 1999, between the Company and Birch Pond Realty Corporation in favor or John Hancock Real Estate Finance, Inc. (included as Exhibit 10.5 to the Company's Quarterly report on form 10-Q for the quarter ended June 26, 1999, File No. 0-22480, and incorporated herein by reference)
10.78
Consent Agreement dated March 1, 1999 between the Company and Citizens Bank of Massachusetts (included as Exhibit 10.71 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1998, File No. 0-22480, and incorporated herein by reference)
10.79
Loan Agreement, dated March 30, 1999, between the Company and Belknap County Economic Development Council, Inc. (included as Exhibit 10.5 to the Company's Quarterly report on Form 10-Q for the quarter ended March 27, 1999, file No. 0-22480, and incorporated herein by reference)
10.80
Security Agreement, dated March 30, 1999, between the Company and Belknap County Economic Development Council, Inc. (included as Exhibit 10.6 to the Company's Quarterly report on Form 10-Q for the quarter ended March 27, 1999, file No. 0-22480, and incorporated herein by reference)
10.81
Note, dated March 30, 1999, between the Company and Belknap County Economic Development Council, Inc. (included as Exhibit 10.7 to the Company's Quarterly report on Form 10-Q for the quarter ended March 27, 1999, file No. 0-22480, and incorporated herein by reference)
List of Subsidiaries of the registrant
21.1
List of Subsidiaries of the registrant at December 25, 1999
Consent of Experts and Counsel
23.1
Consent of PricewaterhouseCoopers LLP dated March 23, 2000
Financial Data Schedules
27.1
Financial Data Schedule for the year ended December 25, 1999
27.2
Restated Financial Data Schedule for the quarter ended September 25, 1999
27.3
Restated Financial Data Schedule for the quarter ended June 26, 1999
27.4
Restated Financial Data Schedule for the quarter ended March 27, 1999
27.5
Restated Financial Data Schedule for the year ended December 26, 1998
27.6
Restated Financial Data Schedule for the quarter ended September 26, 1998
27.7
Restated Financial Data Schedule for the quarter ended June 27, 1998
27.8
Restated Financial Data Schedule for the quarter ended March 28, 1998
27.9
Restated Financial Data Schedule for the year ended December 27, 1997
(4) Reports on Form 8-K
The Company filed the following reports on Form 8-K during the quarter ended December 25, 1999.
1)A report dated October 4, 1999 to file a copy of a press release issued by the Company regarding expected third quarter 1999 results, updates to its retail and internet strategies, announcing a new strategic alliance, and announcing its plan to discontinue its Nicole Summers concept.2)A report dated November 19, 1999 disclosing the Company's by-laws as amended.
SIGNATURES
Pursuant to the requirements of Section 13 of 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
THE J. JILL GROUP, INC.
Dated: March 23, 2000
By:
/s/ GORDON R. COOKE Gordon R. Cooke
President, Chief Executive Officer,
Chairman of the Board of Directors and
Director (Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature
Title
Date
/s/ GORDON R. COOKE Gordon R. Cooke
President, Chief Executive Officer, Chairman of the Board of Directors and Director (Principal Executive Officer)
March 23, 2000
/s/ OLGA L. CONLEY Olga L. Conley
Senior Vice President-Finance, Chief Financial Officer and Treasurer (Principal Financial Officer)
March 23, 2000
/s/ PETER J. TULP Peter J. Tulp
Vice President-Finance and Corporate Controller (Principal Accounting Officer)
March 23, 2000
/s/ WILLIAM E. ENGBERS William E. Engbers
Director
March 23, 2000
/s/ THOMAS J. LITLE Thomas J. Litle
Director
March 23, 2000
/s/ RUTH M. OWADES Ruth M. Owades
Director
March 23, 2000
/s/ SAMUEL L. SHANAMAN Samuel L. Shanaman
Director
March 23, 2000
THE J. JILL GROUP, INC.
(FORMERLY DM MANAGEMENT COMPANY)
FORM 10-K
FOR THE FISCAL YEAR ENDED DECEMBER 25, 1999
EXHIBIT INDEX
Exhibit
No.
Description
Material Contracts
10.8
Second Amendment to Lease Agreement, dated October 29, 1999, between the Company and National Fire Protection Association
10.10
Lease dated December 21, 1999, between the Company and iDolls Corporation
10.25
Split Dollar Agreement and Assignment of Life Insurance Policy as Collateral dated November 18, 1999 between the Company and Dennis Adomaitis
10.58
First Amendment to Third Amended and Restated Loan Agreement between the Company and Citizens Bank of Massachusetts
List of Subsidiaries of the registrant
21.1
List of Subsidiaries of the registrant at December 25, 1999
Consent of Experts and Counsel
23.1
Consent of PricewaterhouseCoopers LLP dated March 23, 2000
Financial Data Schedule
27.1
Financial Data Schedule for the year ended December 25, 1999
27.2
Restated Financial Data Schedule for the quarter ended September 25, 1999
27.3
Restated Financial Data Schedule for the quarter ended June 26, 1999
27.4
Restated Financial Data Schedule for the quarter ended March 27, 1999
27.5
Restated Financial Data Schedule for the year ended December 26, 1998
27.6
Restated Financial Data Schedule for the quarter ended September 26, 1998
27.7
Restated Financial Data Schedule for the quarter ended June 27, 1998
27.8
Restated Financial Data Schedule for the quarter ended March 28, 1998
27.9
Restated Financial Data Schedule for the year ended December 27, 1997
PART I
PART II
REPORT OF INDEPENDENT ACCOUNTANTS
REPORT OF INDEPENDENT ACCOUNTANTS
PART III
PART IV
SIGNATURES
THE J. JILL GROUP, INC. (FORMERLY DM MANAGEMENT COMPANY) FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 25, 1999 EXHIBIT INDEX | 20,416 | 134,036 |
868825_1999.txt | 868825_1999 | 1999 | 868825 | ITEM 1. BUSINESS
INTRODUCTION
Rx Medical Services Corp. (the "Company") is a holding company, which through its subsidiaries, is a provider of healthcare services in the United States. At December 31, 1999, the Company was engaged in two healthcare businesses: the operation of hospitals and clinics located in rural markets in the southeast, and the distribution of biological products.
The hospital management operation is conducted through the Company's wholly-owned subsidiary, Consolidated Health Corporation of Mississippi, Inc., a Mississippi corporation which the Company acquired in July 1995 through a merger transaction, and its subsidiaries ("CHC"). At December 31, 1999, CHC, via a wholly owned subsidiary, operated one hospital and one medical clinic in Virginia, with 50 licensed hospital beds.
The biological product distribution operation, is conducted through BioSource Corporation ("BSC"), which is majority owned by a Florida corporation that is a wholly-owned subsidiary of the Company. BSC is engaged in the business of distributing, on a wholesale basis, biological and biotech products. The Company intends to wind down this line of business as a result of not being able to obtain a steady supply of product from manufacturers.
The Company was incorporated in Nevada in 1985. The Company's principal executive offices are located at 888 East Las Olas Boulevard, Suite 210, Fort Lauderdale, Florida 33301 and its telephone number is (954) 462-1711.
BUSINESS STRATEGY
The Company, through asset sales and a bankruptcy proceeding, has divested itself of substantially all of the assets that were acquired and used initially in its business. Since July 1995, the Company has acquired all of the assets that are used in its current operations.
Effective August 31, 1999, CHC ceased operations at the Smith County General Hospital due to continued lack of financial performance.
Effective December 30, 1999, CHC sold the assets of Pittsburgh Specialty Hospital.
RECENT DEVELOPMENTS: The Company's strategy is to continue to reorganize the hospital ownership and management business.
With respect to its hospital ownership and management business, it is the Company's intention to continue reorganizing this line of business. This line of business has and currently is incurring significant operating losses due to a reduction in patient services eligible for reimbursement and reimbursement rates from third party payors, such as Medicare and Medicaid. The Company anticipates entering into an individual agreement to sell or to close the hospital it currently operates while looking to expand its presence, through joint ventures and/or acquisitions, into new markets with perceived potential. There can be no assurance that a suitable candidate can be found to acquire the Company's hospital or that a sale can be negotiated on terms acceptable or economically feasible to the Company. If the Company can not find a suitable candidate to acquire its hospital, the Company may have to or could be forced to close the remaining hospital it operates. There also can be no assurance that suitable joint venture and/or acquisition candidates can be found, that joint ventures and/or acquisitions can be negotiated on acceptable terms, that adequate financing can be obtained or that the operations of acquired businesses can be effectively or profitably integrated into the Company's existing operations.
BUSINESS SEGMENTS
HOSPITAL MANAGEMENT
On April 30, 1996, one month following the acquisition of Dickenson County Medical Center by the Financing Source - National Century Financial Enterprises, Inc. ("Related Party"), the bankruptcy court entered an order rejecting all executory contracts, including Dickenson County Medical Center's Medicare provider contract. This occurred without the knowledge or consent of CHC or the purchaser of the facility, and has resulted in the denial of Medicare claims from that facility for the period from March 30, 1996 through June 2, 1996, amounting to $793,856. CHC requested the Health Care Financing Administration ("HCFA") to reconsider its decision to issue a new provider agreement effective June 3, 1996 and to revise the effective date of the agreement to March 30, 1996, or, alternatively, May 1, 1996. In June 1999, a settlement agreement was reached between the parties that revised the effective date of the provider agreements to May 1, 1996, and this allowed the Dickenson County Medical Center to re-bill and collect on the claims previously submitted and rejected by the HCFA during the time period mentioned above.
Effective August 31, 1999, CHC ceased operations at the Smith County General Hospital due to continued lack of financial performance.
Effective December 30, 1999, CHC sold the assets of Pittsburgh Specialty Hospital.
The following table sets forth the name of each of CHC's hospitals and its locations, number of licensed beds and whether the hospital is owned, leased or managed as of December 31, 1999:
Leased hospitals are operated by CHC under operating lease agreements pursuant to which CHC pays the owner a stipulated rental and assumes the risk of the hospital not generating sufficient revenues to pay all operating expenses. Any net revenues belong to CHC under these operating agreements. Managed hospitals are operated by CHC under management agreements pursuant to which the owners of the hospitals pay a stipulated management fee to CHC for the services performed by CHC in managing the hospitals. The risk of loss remains with the hospital owners in such instances.
The Company believes that rural acute care hospitals generally face less direct competition than similar urban facilities from specialty healthcare providers such as outpatient surgery and diagnostic treatment centers, and rehabilitation, psychiatric and chemical dependency hospitals. The Company sought to develop its acute care hospitals as the providers of primary care services in their respective markets and to reduce the migration of the local population to larger urban hospitals and other rural hospitals. This is based on the Company's belief that the delivery of healthcare services is local in nature.
The Company employs experienced administrators and controllers at each of the hospitals operated or managed by CHC who have responsibility for carrying out the strategic plan established for their respective hospital. The Company's management works closely with its local administrators to review hospital performance and provide operating and financial guidance.
SOURCES OF REVENUES
Hospital revenues are received primarily from three categories of payors: private payors (primarily private insurance), the federal government under the Medicare program and state governments under their respective Medicaid programs. The following table sets forth the percentages of net operating revenues received by CHC's hospitals from each category of payor for the year ended December 31, 1999:
Medicare and Medicaid......................................... 56% Private and other sources..................................... 44%
The Medicare and Medicaid reimbursement programs have been changed by legislative and regulatory actions many times since their inception. The changes have usually reduced the rate of growth in reimbursement payments and placed a greater administrative burden on hospitals and other providers of healthcare services. Although the Company will attempt to offset the reduction in reimbursement rates under Medicare and Medicaid and the additional administrative burdens imposed by applicable laws and regulations there can be no assurance that the Company's profitability will not be adversely affected. (see "Business Segments - Hospital Management" above for a description of a Medicare denial of claims at CHC's hospital).
EMPLOYEES AND MEDICAL STAFFS
CHC, at December 31, 1999, has approximately 202 full-time and part-time employees at its hospital, of which approximately 34% are nursing personnel (i.e. registered nurses, licensed vocational nurses and licensed practical nurses). Only the employees of the Dickenson County Medical Center in Clintwood, Virginia, are represented by a labor union. The union agreement pertaining to Dickenson County Medical Center has an anniversary date of September 20th and is renewable on a year-to-year basis thereafter unless either party, after due notice, desires to modify or terminate the agreement.
Physicians on the medical staff of CHC's hospital are generally not employees of CHC or its hospital; however, they utilize the hospital to serve and treat their patients. Physician staff members may also serve on the medical staffs of other hospitals and each may terminate his or her affiliation with CHC's hospital at any time.
DEPENDENCE ON HEALTHCARE PROFESSIONALS
CHC's hospital is dependent upon the physicians practicing in the communities served by CHC's hospital. A small number of physicians account for a significant portion of patient admissions at CHC's hospital. Changes in the healthcare industry may increase the competition for physicians specializing in primary care. There can be no assurance that, despite vigorous physician recruitment efforts, CHC's hospital will be able to recruit physicians successfully or to retain the loyalty of the physicians whose patient admissions are important to the hospital.
COMPETITION
Competition for patients among hospitals and other healthcare providers has intensified in recent years. During this period, hospital occupancy rates in the United States have declined as a result of cost containment pressures, changing technology, changes in regulations and reimbursement, the advent of managed care, changes in practice patterns from inpatient to outpatient treatment and other factors. The market in which CHC operates, there are other hospitals or facilities that provide inpatient
and outpatient services comparable to those offered by CHC's hospital. Certain of these facilities may have greater financial resources and may offer a wider range of services than CHC's hospital. Even in the community in which CHC's hospital is the sole or dominant provider of acute care hospital services, CHC may face competition from hospitals and other healthcare providers in nearby communities. The competitive position of CHC's hospital will, in all likelihood, be affected by cost containment strategies imposed by the federal and state governments and other major purchasers of healthcare services.
HOSPITAL ACCREDITATION AND LICENSING
The Dickenson County Medical Center, at December 31, 1999, is accredited by the Joint Commission on Accreditation of Healthcare Organizations ("JCAHO"). With regard to accreditation by JCAHO, or the American Osteopathic Association, another accrediting body, it is CHC's intention to meet the requirements of the managed care contract providers for each of its hospitals. All hospitals, and the healthcare industry generally, are subject to extensive federal, state and local regulation relating to licensure, conduct of operations, billing and reimbursement, relationships with physicians, construction of new facilities, expansion or acquisition of existing facilities and the offering of new services. CHC's hospital is licensed by the department in the state in which the hospital is located. Federal and state agencies conduct periodic inspections to ensure that a hospital maintains adequate standards of medical care, equipment and cleanliness. Failure to comply with applicable laws and regulations could result in, among other things, the imposition of fines, temporary suspension of the ability to admit new patients to the facility or, in extreme circumstances, exclusion from participation in government healthcare reimbursement programs such as Medicare and Medicaid (from which the Company derives substantial revenues) or the revocation of facility licenses. The Company believes that it is in substantial compliance with all material regulations, although there is no assurance that CHC's hospital will be able to comply in the future and there can be no assurance that future regulatory changes will not have an adverse impact on the Company.
CERTIFICATE OF NEED. Certificate of need regulations continue to control the development and expansion of healthcare services and facilities in the state in which CHC's hospital operates. These regulations generally require proper government approval for the expansion or acquisition of existing facilities, the construction of new facilities, the addition of new beds, the acquisition of major items of equipment and the introduction of new healthcare services. Failure to obtain necessary approval can result in the inability to complete a project, the imposition of civil and, in some cases, criminal sanctions, the inability to receive Medicare and Medicaid reimbursement and/or revocation of a facility's license.
FINANCIAL INFORMATION
The Company's net revenues from continuing operations, by business segment during the past three fiscal years, were as follows (in thousands):
Revenue from hospitals and medical clinics is recognized upon completion of patient services and is recorded at amounts estimated to be received under reimbursement arrangements with third party payors.
GOVERNMENTAL REGULATION
GENERAL. The health care industry is subject to extensive federal, state and local regulation relating to licensure, conduct of operations, ownership of facilities, addition of facilities and services and prices for services, as described below. The Company is unable to predict the future course of federal, state and local regulation or legislation, including Medicare and Medicaid statutes and regulations. Further changes in the regulatory framework could have a material adverse effect on the financial results of the Company's operations.
FEDERAL AND STATE ANTI-FRAUD AND ANTI-REFERRAL LEGISLATION.
MEDICARE ANTI-KICKBACK STATUTE. Section 1128B(b) of the Social Security Act (the "Antikickback Statute") prohibits offering, paying, soliciting, or receiving remuneration to induce, or in exchange for, the referral of business that is reimbursable under the Medicare or Medicaid program. A person who violates the Antikickback Statute may be subject to fines of up to $25,000, imprisonment for up to five years, civil monetary penalties, and exclusion from participation in the Medicare and Medicaid programs. The Antikickback Statute has been interpreted broadly by federal courts and enforcement agencies. Many common kinds of business arrangements, including joint ventures, investment interests, leases, and service or supply contracts, can violate the Antikickback Statute if they involve the payment of any remuneration that is intended to induce the referral of Medicare or Medicaid business. The federal government encourages the public to report persons believed to be in violation of the Antikickback Statute.
"STARK" SELF-REFERRAL STATUTE. If a physician has a financial relationship with an entity (including any ownership or investment interest in, or any compensation arrangement with, an entity), Section 1877 of the Social Security Act (the "Stark Law") prohibits the physician from referring patients to the entity for the provision of any "designated health service" for which reimbursement is available under Medicare or Medicaid. The Stark Law also prohibits the entity from billing Medicare, Medicaid, or any other payer for services provided pursuant to a prohibited referral. "Designated health services" include (among others) clinical laboratory services, physical and occupational therapy services, radiology services, durable medical equipment, home health services, and inpatient and outpatient hospital services. Sanctions for violating the Stark Law include civil money penalties of up to $15,000 per prohibited service provided, assessments equal to 200% of the dollar value of each such service provided, and exclusion from the Medicare and Medicaid programs. The Stark Law contains certain exceptions to the self-referral prohibition.
FALSE CLAIMS. The Social Security Act also imposes criminal and civil penalties for making false claims to Medicare and Medicaid for services not rendered or for misrepresenting actual services rendered in order to obtain higher reimbursement. Like the Antikickback Statute, the false claims statute is very broad. The false claims statute requires careful and accurate coding of claims for reimbursement.
STATE ANTIKICKBACK LAWS. Many states in which the Company operates also have laws that prohibit payments to physicians for patient referrals. Although some of these statutes are similar to the federal Antikickback Statute, they are broader in the sense that they apply regardless of the source of the payment for the care. These statutes typically provide for criminal and civil penalties as well as loss of licensure. Many states also have passed legislation similar to the Stark Law, but also with broader effect because the legislation applies regardless of the source of the payment for the care.
CERTAIN COMPANY TRANSACTIONS. The Company's future development of joint ventures and other financial arrangements with physicians also could be adversely affected by the failure of such arrangements to comply with Antikickback Stautue, Stark Law, State Laws or similar laws adopted in the future. The Company has not been the subject of, and is not currently the subject of, any legal proceedings concerning violations of federal or state anti-kickback or self-referral laws.
As of January 1, 1995, the Company was unable to comply with certain provisions of the Stark Law, as well as certain similar state self-referral statutes, as they applied to the medical diagnostic business of the Company's Manatee subsidiary. The Company took steps during 1995, before the Company's medical diagnostic business ceased operations, to notify its physician shareholders of its intent not to accept referrals that would be prohibited under the Stark Law. The Company has determined that, based on prohibited referrals to the Company's medical diagnostic business (before it ceased operations), the Company could be subject to penalties and the return of monies collected on certain services provided in an aggregate amount of up to approximately
$50 million. The Company believes, however, that enforcement action is unlikely, because of the filing of the Chapter 7 bankruptcy petition by Manatee and the cessation of the Company's medical diagnostic operations. Nevertheless, the Company cannot be certain concerning the probability of an enforcement action.
MEDICARE AND MEDICAID REIMBURSEMENT. The Company is dependent upon reimbursement from the Medicare and Medicaid programs. Future legislation adopted or proposed in Congress in connection with efforts to reduce the federal budget deficit could potentially have the effect of reducing, or limiting increases in, federal expenditures on the Medicare and Medicaid programs. Such legislation could have a material adverse effect on the Company.
DISCONTINUED OPERATIONS
Following the sale of its California clinical laboratory operations in August 1995, the Company, through its Manatee subsidiary, owned and operated eight clinical laboratories which analyzed human tissue, blood and other bodily fluids for the medical community. The Company's clinical laboratories serviced clients in the metropolitan areas surrounding Tampa, Miami, Orlando and Jacksonville, Florida and New Orleans, Louisiana. In addition, Manatee owned and operated an imaging center in Pinole, California which performed MRI's. Due to continuing unprofitability of Manatee, and intense pressure from certain of Manatee's creditors who were in the process of executing on previously obtained judgments, on April 4, 1996, Manatee filed a voluntary petition under Section 301 of Chapter 7 of Title 11 of the United States Code, 11 U.S.C. Sections 101 et. seq. in the Bankruptcy Court for the Southern District of Florida (Case No. 96-21552 BKC-RBR). On April 10, 1996, John P. Barbee of Fort Lauderdale, Florida was appointed Trustee of the bankrupt estate. The bankruptcy filing forced the closing of all the Company's remaining clinical laboratory facilities in Florida (the assets of the New Orleans lab had been sold in January 1996 to another laboratory company in an arms-length transaction). The trustee in bankruptcy has assumed Manatee's position as general partner of the partnership that owns and operates the Pinole, California MRI center. The bankruptcy trustee is currently proceeding through the administrative process.
EMPLOYEES.
The Company has a total of approximately 202 employees, of whom approximately 195 are engaged in the operation of the Company's hospital management and biological product distribution businesses, and the remainder are engaged in administrative functions at the Company's Fort Lauderdale, Florida corporate headquarters.
ITEM 2.
ITEM 2. PROPERTIES
The Company's corporate headquarters are located in Fort Lauderdale, Florida, where it leases approximately 3,200 square feet at a monthly rental of $8,899 through September 2001. The Company renewed the lease at a monthly rental of $9,357 through September 2002. BSC leases premises, on a month-to-month basis, in Clearwater, Florida (1,000 square feet) for a monthly rental of $862. Dickenson County Medical Center also leases approximately 33,000 square feet at a monthly rental of $95,465 from the Related Party.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company, in March 1995, received from the U.S. Securities and Exchange Commission (the "Commission") a Formal Order Directing Private Investigation And Designating Officers To Take Testimony In The Matter of Rx Medical Services Corp., dated March 8, 1995. The Company has been advised by the Commission that the investigation is confidential and should not be construed as an indication by the Commission or its staff that any violation of law has occurred. No proceedings in furtherance of this investigation have occurred; however, no assurance can be given that this investigation will not be activated in the future.
In July 1998, an action was commenced against the Company in the Superior Court of California, County of Contra Costa, under the title NORTH BAY MRI ASSOCIATES V. RX MEDICAL SERVICES CORP. (Case No. C 98-02610). The complaint stated many issues though the primary issue was that Rx Medical Services Corp. guaranteed the performance of a lease agreement entered into by a partnership of which a subsidiary of Manatee was a general partner. This subsidiary was included in voluntary bankruptcy petition of Manatee filed on April 4, 1996. The Company chose not to defend against this action and on October 20, 1998 a judgment by default was entered against the Company in the amount of $1,432,900. The Company has established a liability account for the full amount of the judgment. In February 2002, the Company settled with the plaintiffs in the amount of $80,000 cash and 210,000 shares of common stock from the Chief Executive Officer. The settlement is contingent upon the Company remaining solvent for 120 days subsequent to the settlement date.
In November 1998, an action was commenced against Biologic Health Care, which the Company's wholly owned subsidiary RxMIC was a 25% general partner, in the Superior Court of California, County of Santa Clara, under the title of CENTEON LLC V. BIOLOGIC HEALTH (Case No. CV775830). The complaint stated that BHC owed Centeon LLC for biological and other medical products purchased but not paid for. The partnership was subsequently dissolved and Centeon LLC on January 8, 1999, entered and was granted a default judgment against RxMIC, who was the 25% general partner in BHC, and Biologic Health Resources, who was the 75% general partner in BHC, in the amount of $437,343. This default judgment as of May 22, 2000, had increased to $472,245. The Company has not established a liability account for this judgment as the only asset of RxMIC was the investment in the BHC partnership, which was written off in a previous year, and the Company did not guarantee the performance of BHC or RxMIC. Therefore, Centeon LLC, in the Company's opinion, has no viable way to collect on the default judgment granted to them.
In March 1997, the Company learned that the principals of BHR had conspired to violate the BHC agreements by entering into direct competition with the BSC and BHC-SC operations in Florida and California. In April 1997, the Company commenced an action in the Florida Circuit Court (Dade County) against BHR's new Florida operation seeking to enjoin BHR from stealing BSC's patients and for damages in an unspecified
amount for breach of contract and tortious interference with BSC's business. In addition, in June 1997, the Company commenced an action in the Superior Court of California (Santa Clara County) seeking a dissolution of the BHC general partnership, an accounting of monies alleged to have been diverted by BHR from BHC for BHR's own use, and for damages for breach of contract. The actions of BHR that are the subject of the lawsuit in Florida significantly weakened the BSC operation in Florida. BHC ceased operations in the last quarter of 1997 as a result of the dispute between the BHC partners. This action was dismissed in connection with a global settlement reached between the parties effective May 1999. Based on the above facts the Company has provided a reserve equal to 100% of its investment in BHC.
On April 4, 1996, Manatee filed a voluntary petition under Section 301 of Chapter 7 of Title 11 of the United States Code, 11 U.S.C. Sections 101 et. seq. in the Bankruptcy Court for the Southern District of Florida (Case No. 96-21552 BKC-RBR). On April 10, 1996, John P. Barbee of Fort Lauderdale, Florida was appointed trustee of the bankrupt estate. The bankruptcy trustee is currently proceeding through the administrative process.
On April 8, 1997, the Company commenced an action against Biologic Health Resources (Florida) LLC ("BHR LLC") and five individuals, in the Circuit Court for Dade County, Florida, under the title BIOLOGIC HEALTH CARE - FLORIDA, INC. V. BIOLOGIC HEALTH RESOURCES (FLORIDA) LLC, ET. AL. (Case No. 97-07747 CA 25). The complaint alleges that the principals of BHR conspired to violate the BHC agreements by entering into direct competition with the BSC operation, and seeks injunctive relief and damages against two former BHC employees for violations of restrictive covenants contained in their employment agreements, and damages against BHR LLC and its principals for tortious interference with the business of BSC. A motion by the Company for a temporary injunction against one of the former BSC employees was granted in August 1997. In May 1999, this action, along with the California action described below was settled.
On June 10, 1997, the Company commenced an action against BHR in the Superior Court of California, County of Santa Clara, under the title RX MEDICAL IMAGING CORP V. BIOLOGIC HEALTH RESOURCES, ET. AL. (Case No. CV-766768). The complaint alleges that the defendants violated the partnership agreement of BHC in a number of respects, including misappropriation of partnership assets and diverting partnership customers, and seeks a dissolution of BHC, an accounting of BHC's affairs, and damages. On August 7, 1997, the defendants filed a cross-complaint in the pending action against the Company, RxMIC, the Financing Source ("Related Party"), the Company's president and general counsel, and Bay Cities Pharmaceutical Services and its two principals, seeking a dissolution of the partnership and an accounting, and damages for breach of contract, breach of fiduciary duty, fraud, recission, conversion, constructive trust, and conspiracy to defraud. The action was dismissed in connection with a global settlement reached between the parties, effective May 1999.
In addition to the foregoing, the Company is involved in routine litigation arising in the ordinary course of its business which the Company believes would not have a material adverse effect on its financial position.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company did not hold an annual meeting of its stockholders in 1999, 2000, or 2001.
EXECUTIVE OFFICERS
The executive officers of the Company as of December 31, 1999, are as follows:
Name Age Position ---- --- --------
Michael L. Goldberg 50 Chairman of the Board and Chief Executive Officer
Randolph H. Speer 49 Director, President, and Chief Operating Officer
Dennis A. Dolnick 36 Chief Financial Officer
Greg A. Berube 51 Controller
MICHAEL L. GOLDBERG, 50 (a director since 1990). Mr. Goldberg was an Assistant District Attorney in the Philadelphia District Attorney's office from 1974 to 1977 before entering private practice with a specialty in complex commercial litigation. Mr. Goldberg joined the Company in May 1990. He was Chairman, President and Chief Executive Officer of the Company from November 1991 to June 1994 at which time he relinquished the position of President.
RANDOLPH H. SPEER, 48 (a director since 1994). Mr. Speer was named President and Chief Operating Officer of the Company in July 1994. On August 2, 1994, Mr. Speer was appointed to the Board of Directors. Previously, he was Senior Vice President, Treasurer and Chief Financial Officer of Summit Health Ltd. from April 1989 through April 1994. In April 1994, Summit Health Ltd. was merged into OrNda HealthCorp. Previous to Summit Health Ltd., from January 1981 until April 1989, Mr. Speer was Vice President and Chief Financial Officer of Sierra Land Group, Inc. which, prior to the merger with OrNda HealthCorp., was the largest shareholder of Summit Health Ltd. Mr. Speer is a CPA, licensed in the State of California. Mr. Speer resigned from the Company in September, 1999.
DENNIS A. DOLNICK, 36. Mr. Dolnick joined the Company in 1997 as Chief Financial Officer. Previously, Mr. Dolnick was Controller of SII Pak-Tek, Ltd. and SII Cassettes, Ltd. manufacturers of plastic injected molding supplies used primarily by the entertainment industry. Previous to SII Pak-Tek, Ltd. and SII Cassettes, Ltd., Mr. Dolnick was a manager in the audit department of the accounting and management
consulting firm of Grant Thornton LLP. Mr. Dolnick is a CPA, licensed in the State of Florida. Mr. Dolnick resigned from the Company in September, 2001.
GREG A. BERUBE, 51. Mr. Berube joined the Company in January 1996 as Assistant to the Controller. Previously, Mr. Berube was Operations Manager of Water Taxi, Inc. where he installed and maintained a network and database computer system. Previously to Water Taxi, Mr. Berube worked for Aero-Flite Distributing, Inc., a manufacturer and distributor of toy products sold exclusively in temporary kiosks.
The executive officers hold office at the pleasure of the Board of Directors.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
Effective December 3, 1996, shares of the Company's Common Stock were formally delisted from the American Stock Exchange (the "Exchange"). Prior to that date, there had been no trading of the Company's Common Stock since April 1, 1996. The Company's Common Stock is qualified for trading on the OTC Electronic Bulletin Board (the "OTC Bulletin Board"). Trading of the Company's Common Stock on the OTC Bulletin Board commenced in mid-December, 1996; however, such trading has been limited due to the Company's inability to comply with the filing requirements of the Securities Exchange Act of 1934 since April 1, 1996. The following table sets forth the high and low closing prices on the OTC Bulletin Board for 1997, 1998, 1999, 2000 and 2001:
High Low ---- ---
1997 First Quarter .56 .06 Second Quarter .38 .13 Third Quarter .22 .09 Fourth Quarter .44 .10
1998 First Quarter .31 .19 Second Quarter .25 .17 Third Quarter .23 .15 Fourth Quarter .14 .06
1999 First Quarter .09 .06 Second Quarter .07 .06 Third Quarter .31 .06 Fourth Quarter .31 .07
2000 First Quarter .10 .01 Second Quarter .02 .01 Third Quarter .14 .01 Fourth Quarter .07 .01
2001 First Quarter .01 .01 Second Quarter .01 .01 Third Quarter .07 .01 Fourth Quarter .07 .01
On February 19, 2002, the closing price of the Company's Common Stock on the OTC Bulletin Board was $0.03 per share. As of February 19, 2002, based on the records of the Company's transfer agent, there were 744 holders of record of the Company's Common Stock, excluding the number of beneficial owners whose shares are held in street name.
Although the Company's Common Stock is qualified for trading on the OTC Bulletin Board, there can be no assurance that an active trading market will develop for such common stock.
Effective December 31, 1999, the remaining 63,836 shares of the Company's Series C Preferred Stock were automatically fully converted into 4,605,311 shares of the Company's Common Stock, as specified in the preferences and rights of the Series C Preferred Stock. Pursuant to the terms of the Series C Preferred Stock, the Company was not required to pay dividends.
On October 1, 1998 and on a quarterly basis thereafter (January 1, April 1, and July 1) until the shares of the Company's Series G Preferred Stock are fully converted (on or before July 1, 2002), as specified in the preferences and rights of the Series G Preferred Stock, the Company is required to make quarterly dividend payments, at the rate of $.15 per annum per share payable at the Company's discretion in cash or the Company's Common Stock, payable in arrears (see Note 6(a) to the Notes to Consolidated Financial Statements). At December 31, 1999, the Company had dividends in arrears, for this series of preferred stock, in the amount of $30,000.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
Rx Medical Services Corp. Summary of Financial Information (Dollar amounts in thousands, except per share amounts)
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
From inception, the Company was unable to achieve profitability in its medical diagnostic business. Commencing in 1995, and continuing to the present, management embarked on a plan to reorganize the Company.
As a result of this decision, for all years presented, the medical diagnostic services business segment has been accounted for as discontinued operations in accordance with Accounting Principles Board Opinion No. 30, which provides for the reporting of operating results of discontinued operations separately from continuing operations. Gains from discontinued operations amounted to $136,000 and $181,000 for the years ended December 31, 1998, and 1997, respectively.
Also, gains and losses on the settlement of liabilities, indebtedness and on the purchase of accounts receivable have been accounted for as extraordinary items in accordance with Accounting Principles Board Opinion No. 30, which provides for the reporting of such material, non-recurring events separately from continuing operations. Gains from extraordinary items amounted to $3,195,000 for the year ended December 31, 1998.
Effective December 30, 1999, the Company sold the Pittsburgh Specialty Hospital, resulting in an increase to additional paid in capital of $1,650,000.
Including losses from continuing operations, net losses of the Company were $(13,424,000), $(9,240,000) and $(8,993,000) for the years ended December 31 1999, 1998 and 1997 respectively.
RESULTS OF OPERATIONS
1999 VS. 1998
Revenues from hospitals and medical clinics for the year ended December 31, 1999 were $12.1 million compared to $15.5 million for the year ended December 31, 1998. The decrease in revenues from hospitals and medical clinics is primarily the result of (a) a decrease in patient services provided at the Dickenson County Medical Center located in Clintwood, Virginia ("DCMC") which resulted in a decrease in revenues of approximately $1.7 million; (b) a decrease in patient services provided at the Pittsburgh Specialty Hospital ("PSH") in Pittsburgh, Pennsylvania which resulted in a decrease in revenues of $0.7 million; (c) a decrease in patient revenue and the closing of the Smith County Hospital, in Raleigh, Mississippi ("SCH") which resulted in a decrease in revenues of approximately $0.8 million, and (d) a cumulative decrease of revenues at other Company hospital and medical clinics of approximately $0.2 million.
Revenues from biological product distribution for the year ended December 31, 1999 were $0.7 million compared to $1.0 million for the year ended December 31, 1998. This decrease in revenues is primarily due to the Company facing challenges in securing reliable suppliers of biological products in which to distribute. As a result of the Company's inability to secure reliable suppliers, it made the decision to wind down operations in 2001.
Costs and expenses decreased 18% to $17.3 million for the year ended December 31, 1999 from $20.4 million for the year ended December 31, 1998. Of these 1999 expenses, hospital management operations accounted for $15.7 million, biological product distribution accounted for $0.7 million, and the corporate expenses of the Company were $0.9 million. The decrease in costs and expenses is primarily the result of (a) a decrease in patient services provided at DCMC which resulted in a decrease in costs and expenses of approximately $1.5 million; (b) a decrease in patient services provided at Pittsburgh Specialty Hospital which resulted in a decrease in costs and expenses of $0.5 million; (c) a decrease in patient revenue and the closing of the SCH which resulted in a decrease in cost and expenses of approximately $1.1 million; (d) an decrease in biological product sales which resulted in an decrease in costs and expenses of $0.1 million, and (e) a cumulative increase of costs and expenses at other Company hospital and medical clinics and the Company's corporate headquarters of approximately $0.1 million.
Interest expense increased 15% to $8.8 million for the year ended December 31, 1999 from $7.6 million for the year ended December 31, 1998. This increase is due primarily to a higher level of borrowings from the Financing Source ("Related Party"). (See "Financial Condition, Liquidity, and Capital Resources").
RESULTS OF OPERATIONS
1998 VS. 1997
Revenues from hospitals and medical clinics for the year ended December 31, 1998 were $15.5 million compared to $19.6 million for the year ended December 31, 1997. The decrease in revenues from hospitals and medical clinics is primarily the result of (a) a decrease in patient services provided at DCMC which resulted in a decrease in revenues of approximately 3.2 million; (b) termination of two hospital management agreements which resulted in a decrease in revenues of approximately $0.4 million; and (c) a cumulative decrease of revenues at other Company hospital and medical clinics of approximately $0.5 million.
Revenues from biological product distribution for the year ended December 31, 1998 were $1.0 million compared to $0.3 million for the year ended December 31, 1997. This increase in revenues is primarily due to the current biological product mix being in high demand and commanding higher sales prices.
Costs and expenses decreased 15% to $20.4 million for the year ended December 31, 1998 from $22.8 million for the year ended December 31, 1997. Of these 1998 expenses, hospital management operations accounted for $18.4 million, biological product distribution accounted for $0.8 million, and the corporate expenses of the Company were $1.2 million. The decrease in costs and expenses is primarily the result of (a) a decrease in patient services provided at DCMC which resulted in a decrease in costs and expenses of approximately $1.6 million; (b) an increase in biological product sales which resulted in an increase in costs and expenses of $0.2 million; and (c) a cumulative decrease in costs and expenses at other Company hospital and medical clinics and the Company's corporate headquarters of approximately $1.0 million.
Interest expense increased 20% to $7.7 million for the year ended December 31, 1998 from $6.4 million for the year ended December 31, 1997. This increase is due primarily to a higher level of borrowings from the Financing Source ("Related Party"). (See "Financial Condition, Liquidity, and Capital Resources").
No provision for income taxes is required on the gain from discontinued operations.
FINANCIAL CONDITION, LIQUIDITY, AND CAPITAL RESOURCES
At December 31, 1999 and 1998, the Company's working capital deficit was $62.4 million and $51.6 million, respectively. This increase in the working capital deficit was primarily due to a $9.4 million increase in the level of funding from the Financing Source ("Related Party") and operating losses. Through December 31, 1999, the Company's ability to continue as a going concern is dependent on the continued funding of its operations by the Financing Source ("Related Party"). Without this funding, the Company's ability to operate its business would be adversely impacted. However, until the Company's revenues increase so as to exceed the Company's operating expenses, the Company will continue to utilize funding from the Financing Source ("Related Party"), or other alternative sources of funding, to the extent available. To the extent fundings from the Financing Source ("Related Party") are insufficient to pay the Company's operating expenses, the Company will require alternative sources of funding. There can be no assurance that any alternative sources of financing will be available to the Company at such point in time, or if obtainable, on terms that are commercially feasible.
The Company's current operations (i.e. hospital management and biological product distribution) are presently being funded through financing agreements with the Financing Source ("Related Party") and the Company's various operating facilities. Financing agreements exist between the Financing Source ("Related Party"), the Company and five of the Company's operating subsidiaries.
While the Company has not yet reached profitability operationally, it has several plans of action in progress designed to improve profitability, as well as, cash flow.
The Company intends to continue reorganizing the hospital ownership and management business.
GOING CONCERN
The report of the independent certified public accountants of the Company on its 1999, 1998 and 1997 consolidated financial statements express substantial doubt about the Company's ability to continue as a going concern. Factors contributing to this substantial doubt include recurring operating losses, a working capital deficiency, delinquencies and defaults on its accounts payable and other outstanding liabilities, litigation, as well as, to the uncertainty of the Company's compliance with certain Medicare and state statutes and regulations. As of January 1, 1995, the Company was unable to comply with certain provisions of the OBRA 1993 amendments to the Stark Act, as well as, certain similar state statutes. Although the Company has not been the subject of, and is not currently the subject of, any administrative proceedings concerning violations of federal or state self-referral statutes or regulations, in the event that the Company is found to have violated such statutes and regulations, it could be subject to cumulative fines and penalties and could also be required to make refunds, which may aggregate up to approximately $50.0 million. The Company believes, however, that due to the filing of the Chapter 7 bankruptcy petition for Manatee, the likelihood of such enforcement actions occurring is remote.
As mentioned in the Financial Condition section, the Company is dependent on the continued funding currently being received from the Financing Source ("Related Party") to continue operations. The discontinuance of such funding, and the unavailability of financing to replace such funding, could result in the Company ceasing its operations.
OUTLOOK
The Company views its decisions to discontinue the operation of its medical diagnostic services business segment, to continue reorganizing the hospital ownership and management business as positive from a strategic standpoint. In the hospital operation and management business, the Company anticipates entering into an agreement to sell or closing the hospital it currently operates while looking to expand its presence, through joint ventures and/or acquisitions, into new markets with perceived potential. There can be no assurance, however, that the Company will achieve its strategic objectives.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the potential loss arising from adverse changes in market rates and prices, such as foreign currency exchange, interest rates and a decline in the stock market. The Company does not enter into derivatives or other financial instruments for trading or speculative purposes. The Company is not exposed to market risk as it relates to changes in foreign currency exchange rates though the Company is exposed to immaterial levels of market risk as it relates to changes in interest rates. The Company's objectives in managing its exposure to stock market fluctuations is to minimize the impact of stock market declines to the Company's earnings and cash flows. Beyond the control of the Company, however, continued market volatility, as well as mergers and acquisitions, have the potential to have material non-cash impact on the operating results of the Company in future periods.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Refer to the index of financial statements and schedules as presented on page 37. Information on selected quarterly financial data is not required for the Registrant pursuant to the rules of the Commission.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS OF THE REGISTRANT
DIRECTORS
The Company's by-laws provide that the number of directors shall be not less than three nor more than ten. The actual number of directors is determined by resolution of the Board from time to time. The Company's by-laws also provide that directors are elected at the annual meeting of shareholders for a term of office of one year or until their successors are elected and qualify. The last annual meeting of shareholders was held on November 20, 1997. All of the current directors were elected at that meeting. The Company anticipates that the next annual meeting of shareholders will be held in the year 2002. The number of directors is currently set at nine. Only three persons, however, are currently serving as directors. Following is information concerning each of the current directors of the Company:
MICHAEL L. GOLDBERG, 50 (a director since 1990). Mr. Goldberg was an Assistant District Attorney in the Philadelphia District Attorney's office from 1974 to 1977 before entering private practice with a specialty in complex commercial litigation. Mr. Goldberg joined the Company in May 1990. He was Chairman, President and Chief Executive Officer of the Company from November 1991 to June 1994 at which time he relinquished the position of President.
PHILLIP E. PEARCE, 71 (a director since 1992). Mr. Pearce has been in the investment banking and securities business since receiving his Graduate Degree from the Wharton School in 1954. From 1969 to 1983, he served as Senior Vice President and a Director of E.F. Hutton of New York City, served on the Board of Governors of the New York Stock Exchange and was Chairman of the Board of Governors of the National Association of Securities Dealers, Inc. From 1983 to 1988, Mr. Pearce served as President of Phillip E. Pearce & Co., and since 1988 has been a partner in Pearce-Henry Capital Corp. of Charlotte, North Carolina, an investment banking firm. Mr. Pearce was also a contributing author and editor of the Dow Jones publication of the Stock Market Handbook, and sat on the advisory council to the Securities and Exchange Commission on THE INSTITUTIONAL STUDY OF THE STOCK MARKETS.
MICHAEL J. PICKERING, M.D., 69 (a director since 1990). Dr. Pickering has practiced as a medical doctor specializing in nephrology since receiving his medical degree from the University of Florida in 1961. He has certifications from the American Board of Internal Medicine and the American Board of Internal Medicine in the Subspecialty of Nephrology and is a member of the American and Florida Medical Associations, is a Fellow, American College of Physicians, and is a member of the American Society of Artificial Internal Organs, American Society of Internal Medicine, the American Society of Nephrology, the Florida Society of Internal Medicine, the Florida Society of Nephrology, the Hillsborough County Medical Association, the International Society of
Nephrology, the National Kidney Foundation, the Southeastern Dialysis and Transplantation Association, the South-Eastern Organ Procurement Foundation, the Royal Society of Health and the American Board of Quality Assurance & Utilization Review Physicians. Dr. Pickering currently practices medicine, serves as an Associate Professor of Medicine at the University of Florida and is a frequent speaker and lecturer on his area of specialty throughout the country. He also has had articles and abstracts published in more than one hundred medical journals and medical conferences.
EXECUTIVE OFFICERS
Information concerning the executive officers of the Company is contained in Part I, on page 14 of this annual report.
COMPLIANCE WITH SECTION 16(a) OF THE SECURITIES EXCHANGE ACT OF 1934
Ownership of and transactions in the Company's securities by executive officers and directors of the Company and owners of ten percent or more of the Company's Common Stock are required to be reported to the Securities and Exchange Commission pursuant to Section 16(a) of the Securities Exchange Act of 1934 (the "Exchange Act").
The Company does not have knowledge of any failure to file a required form to report such ownership and transactions.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
SUMMARY COMPENSATION TABLE
The following table provides a summary of cash and non-cash compensation for each of the fiscal years ended December 31, 1999, 1998 and 1997 with respect to the Company's Chief Executive Officer and the only other executive officer whose compensation exceeded $100,000 in the fiscal year ended December 31, 1999 (the "Named Officers").
(*) Randolph H. Speer resigned his positions with the Company in the year ended December 31, 1999.
STOCK OPTIONS
There were no grants of stock options by the Company to the Named Officers during 1999.
AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FY-END
OPTION VALUES
The following table sets forth the information with respect to the Named Officers concerning the exercise of options during 1999 and unexercised options held as of December 31, 1999:
COMPENSATION OF DIRECTORS
It has been the policy of the Company not to compensate its directors for their services as directors. It is the policy of the Company not to pay its directors for attending Board or committee meetings, but the Company reimburses directors for travel expenses incurred in attending such meetings.
BOARD COMPENSATION COMMITTEE REPORT ON EXECUTIVE COMPENSATION
The Board of Directors of Rx Medical Services Corp. does not have a Compensation Committee and, as a result, the Board of Directors makes determinations as to executive officer compensation. As of December 31, 1999, the Company had two executive officers.
PERFORMANCE GRAPH
COMPARISON OF FIVE YEAR CUMULATIVE TOTAL RETURN * AMONG RX MEDICAL SERVICES CORP., THE NASDAQ STOCK MARKET (U.S.) INDEX AND THE S & P HEALTH CARE (HOSPITAL MANAGEMENT) INDEX
- --------------------------- * $100 invested on 12/31/94 in stock or index - including reinvestment of dividends. Fiscal year ending December 31.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Each share of Preferred Stock of the Company contains voting rights equivalent to one share of the Company's Common Stock. The Company currently has one series of preferred stock outstanding, designated Series G. For a description of the relative rights and preferences of this series, see Note 5(a) to the Notes to Consolidated Financial Statements. On all matters submitted for vote by the stockholders of the Company, including the election of directors, the shares of the Company's Preferred Stock and Common Stock vote together as a single class except as may otherwise be required by law.
The following table sets forth information as of February 19, 2002, with respect to all stockholders known by the Company to be the direct or indirect beneficial owners of 5% or more of the Company's voting securities and by the executive officers and directors of the Company as a group. Each percentage is calculated by assuming that the named stockholder converted or exercised all of such stockholder's securities convertible within the next 60 days into, or exercisable for, shares of the Company's Common Stock at a time when no other stockholder did so, irrespective of the conversion or exercise price thereof. Except as otherwise noted, all persons and entities have sole voting and investment power with respect to their shares.
- -----------------
1) As of February 19, 2002, there were 23,194,985 shares of the Company's Common Stock and 800,000 shares of the Company's Preferred Stock issued and outstanding.
2) Includes 25,000 shares representing stock options exercisable within 6 months.
3) Represents 1,000,0000 shares of the Company's Common Stock registered in the name of Gulf Coast Medical, Inc., a company controlled by Mr. Behar.
4) In July 1996, an entity distributed, in equal amounts, 750,000 shares to Lance K. Poulsen, Donald H. Ayers, Rebecca S. Parrett and Barbara C. Larson. These individuals are officers, directors and the majority shareholders of the Financing Source ("Related Party") and Healthcare Capital, LLC ("HCC") (formerly known as Intercontinental Investment Associates, LLP) may be deemed to be the beneficial owners of the shares, of the Company's Common Stock, owned by HCC.
5) Represents 800,000 shares of the Company's Common Stock that may be obtained by the conversion of the Company's Series G Preferred Stock.
6) Includes 3,182 shares representing stock options exercisable within 6 months.
7) Includes 28,182 shares representing stock options exercisable within 6 months.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
In consideration of the funding of $1.0 million by the Financing Source ("Related Party") to facilitate the acquisition by the Company of CHC (see Item 1. "Business"), the Company pledged to the Financing Source ("Related Party") all of the issued and outstanding common and preferred stock of CHC as collateral for the repayment of the loan.
On May 27, 1999, the Company paid $55,644 of dividends in arrears to HCC on the Company's Series G Preferred Stock via the issuance of 650,960 shares of the Company's Common Stock.
On December 15, 1999, the Company paid $90,000 of dividends in arrears to HCC on the Company's Series G Preferred Stock via the issuance of 512,835 shares of the Company's Common Stock.
On December 31, 1999, the remaining 63,836 issued and outstanding shares of the Company's Series C Preferred Stock, held by Michael L. Goldberg, were automatically converted into 4,605,311 shares of the Company's Common Stock.
HCC is affiliated with the Financing Source ("Related Party") via common owners. At December 31, 1999, HCC is the Company's major shareholder. HCC owns directly and/or indirectly 46.4% or 11,028,717 of the 23,751,920 shares of the issued and outstanding shares of the Company's $.002 par value Common Stock as of December 31, 1999. The ownership percentage and the number of shares owned do not take into account following:
a) the 800,000 shares of the Company's Series G Preferred Stock, which are convertible into the Company's Common Stock, owned by HCC,
b) dividends in arrears of $30,000 on the Company's Series G Preferred Stock as of December 31, 1999, which are anticipated to be paid by the issuance of a yet to be determined number of shares of the Company's Common Stock, or
c) shares of the Company's Common Stock issued and held in street name.
Effective December 30, 1999, the Company entered into an Agreement For The Sale And Purchase of Assets of Consolidated Health Corporation of Pittsburgh, Inc. (PSH) to ACCI/AllCare of Pennsylvania, Inc. (AllCare). AllCare assumed none of the liabilities of PSH. In consideration for the sale of the assets, the purchaser shall enter into a mortgage payable for $3,300,000.
In connection with the sale agreement described above, a second agreement, Agreement Regarding Acquisition of Assets of Pittsburgh Specialty Hospital was entered into by and among The Financing Source, Allcare and another party. The agreement called for the following:
o The Financing Source to settle certain debts of PSH.
o AllCare will enter into a $3,300,000 mortgage payable (described in the above paragraph) with Financing Source.
o The Financing Source will provide AllCare with 12 monthly payments of $200,000 commencing on the Closing date in return for a $2,400,000 mortgage.
In addition, the Financing Source engaged AllCare as an agent to attempt to settle the trade debts of Consolidated Health Corporation of Pittsburgh, Inc, except for approximately $250,000 that was separately identified as the exclusive responsibility of PSH. PSH's trade debts were $1,364,000 at December 31, 1999. As this agreement did not relieve PSH of its legal obligation to pay its trade debts, the accounts payable balance was not adjusted.
A summary of the assets sold to AllCare and liabilities paid off by The Financing Source are as follows:
Accounts receivable, net $ (355) Inventories (50) Land and buildings (653) Equipment, net (284) Notes payable - related party 2,758 Accrued liabilities 7 Accrued liabilities - related party 14 Long-term debt 197 Obligations under capital leases - related party 16 --
Net adjustment to paid in capital $1,650
No gain or loss was recorded for the sale of the PSH assets to Allcare or the PSH liabilities being settled by The Financing Source. The Company recorded the net adjustment to paid in capital due to the substance and the related party aspects of the transaction.
NOTES PAYABLE - RELATED PARTY
At December 31, 1999 and 1998, notes payable-related party included amounts due to the Financing Source, through which the Company has obtained financing collateralized by certain accounts receivable, real estate and equipment.
Certain financing agreements with the Financing Source provide that the Company will periodically sell certain eligible accounts receivable to the Financing Source. However, the terms of the agreements specify certain items of limited recourse, including the ability to resell receivables which have aged beyond 150 days back to the Company. While the Company believes that legally a sale of its receivables has occurred, due to the existence of the terms of limited recourse, this transaction does not qualify for treatment as a sale for accounting purposes and, accordingly, such activity has been recorded as notes payable at December 31, 1999 and 1998.
The notes payable due to the Financing Source at December 31, 1999 and 1998 consisted of the following (in thousands):
In 1999, the notes payable collateralized by real estate were settled by the Financing Source.
LONG-TERM DEBT - RELATED PARTY
Long-term debt - related party consists of an unsecured promissory note, interest at 14%, due in monthly installments of principal and interest of $13,232, and matures on September 1, 2003. Scheduled principal maturities for each of the five years subsequent to December 31, 1999, and thereafter are estimated as follows (in thousands): 2000 - $100; 2001 - $116; 2002 - $132; and 2003 - $113.
The Financing Source is being categorized as a related party due to the Financing Source's stock ownership in and its ability to exercise control over the operations of the Company.
During the year ended December 31, 1999, the Company paid $145,644 of dividends in arrears to HHC on the Company's Series G Preferred Stock via the issuance of 1,163,795 shares of the Company's Common Stock.
At December 31, 1999, the Company is indebted to the Financing Source in the amount of $57.4 million.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) LIST OF FINANCIAL STATEMENTS
The following Consolidated Financial Statements of Rx Medical Services Corp. and Report of Independent Accountants are filed as a part of this annual report:
Schedules other than those listed above are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto.
(a)(2) List of Exhibits: (numbered in accordance with Item 601 of Regulation S-K)
Explanation of Incorporation by Reference:
* Form 10 of Registrant, dated October 10, 1990, as amended by Form 8, dated March 15, 1991
** Amendment No. 2 to Form S-1 of Registrant, dated January 31, 1994
*** Current Report of Registrant on Form 8-K, dated January 7, 1994
**** Current Report of Registrant on Form 8-K, dated December 23, 1991, as amended on December 29 and 31, 1991, and January 14 and March 14, 1992
+ Amendment No. 1 to Form S-1 of Registrant, dated October 28, 1993
++ Current Report of Registrant on Form 8-K, dated April 20, 1994
+++ Current Report of Registrant on Form 8-K, dated September 20, 1994
++++ Current Report of Registrant on Form 8-K, dated August 10, 1995
o Annual Report of Registrant on Form 10-K for fiscal year ended December 31, 1995
oo Current Report of Registrant on Form 8-K, dated April 3, 1997
ooo Current Report of Registrant on Form 8-K, dated January 29, 1998
(b) REPORTS ON FORM 8-K
None.
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
Board of Directors Rx Medical Services Corp.
We have audited the accompanying consolidated balance sheets of Rx Medical Services Corp. as of December 31, 1999 and 1998, and the related consolidated statements of operations, shareholders' deficit, and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Rx Medical Services Corp. at December 31, 1999 and 1998, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States of America.
The accompanying financial statements have been prepared assuming that Rx Medical Services Corp. will continue as a going concern. However, as more fully described in Note 1, the Company has incurred recurring operating losses, has a working capital deficiency, is delinquent in payments due to debt holders, taxing authorities and others, is in default of certain loan covenants and is dependent on the settlement of various lawsuits, the SEC investigation and on continued funding by the senior lender. In addition, as described in Note 11, there are uncertainties concerning the Company's compliance with various federal and state statutes and certain provisions of the Omnibus Budget Reconciliation Act of 1993, as well as, certain similar state statutes. The forgoing matters raise substantial doubt about the Company's ability to continue as a going concern. Management's plans in regard to these matters are also described in Notes 1 and 11. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty.
Grant Thornton LLP Weston, Florida February 19, 2002
Rx Medical Services Corp.
Consolidated Statements of Operations (Dollars in thousands except per share amounts)
The accompanying notes are an integral part of these financial statements.
Rx Medical Services Corp.
Consolidated Balance Sheets (Dollars in thousands)
The accompanying notes are an integral part of these financial statements.
Rx Medical Services Corp.
Consolidated Balance Sheets (continued) (Dollars in thousands)
The accompanying notes are an integral part of these financial statements.
Rx Medical Services Corp.
Consolidated Statements of Shareholders' Deficit (Dollars and shares in thousands)
The accompanying footnotes are an integral part of these financial statements.
Rx Medical Services Corp.
Consolidated Statements of Cash Flows (Dollars in thousands)
(Continued)
Rx Medical Services Corp.
Consolidated Statements of Cash Flows (Continued) (Dollars in thousands)
On July 1, 1998, the 600,270 issued and outstanding shares of the Company's Series F Preferred Stock, were converted into 600,270 shares of the Company's Common Stock.
On December 31, 1999, the remaining 63,836 issued and outstanding shares of the Company's Series C Preferred Stock were converted into 4,605,311 shares of the Company's Common Stock.
For the years ended December 31, 1999, 1998 and 1997, interest paid, including interest on obligations under capitalized leases was $8,768, $8,552 and $5,695, respectively. No income taxes were paid during these periods.
Effective December 30, 1999, the Company sold Consolidated Health Corporation of Pittsburgh, Inc.'s (PSH)assets of $1,342,000. The Financing Source settled certain liabilites of $2,992,000. (See Note 2)
The accompanying notes are an integral part of these financial statements.
Rx Medical Services Corp. Notes to Consolidated Financial Statements
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
a. PRINCIPLES OF CONSOLIDATION
The consolidated financial statements of Rx Medical Services Corp. include the accounts of Rx Medical Services Corp. and its subsidiaries (the "Company"). The subsidiaries are four wholly-owned operating companies, Consolidated Health Corporation of Mississippi, Inc., Rx Medical Management, Inc., Rx Medical Imaging Corp. and CHC Medical Services Corp. All significant intercompany transactions have been eliminated.
b. NATURE OF OPERATIONS
The Company operates a hospital and clinic in Clintwood, Virginia. The Company's primary source of revenue is providing medical services to patients that live in and around Clintwood, Virginia. The Company also distributes biological products in Florida.
c. BASIS OF PRESENTATION
For all years presented, the medical diagnostic services business segment has been reflected as discontinued operations in accordance with Accounting Principles Board Opinion No. 30 which provides for the reporting of operating results of discontinued operations separately from the continuing operations (see Note 2).
The Company has experienced significant losses in each of the past three years, reflects a working capital deficit of $62.9 million at December 31, 1999, is in default with respect to certain indebtedness and there are uncertainties regarding the Company's compliance with federal and state self-referral regulations while operating its medical diagnostic services business segment (see Note 11c). However, the accompanying financial statements have been prepared on the basis that the Company will continue as a going concern because management believes it has an attainable plan to overcome these matters and provide sufficient capital to operate for the coming year. The Company's ability to continue as a going concern is dependent on the continued funding of its operations from its primary financing source, National Century Financial Enterprises, Inc. and its affiliates (the "Financing Source") (see Note 8) or an alternative source, without which funding the Company's ability to continue as a going concern would be adversely impacted.
While the Company has not yet reached operational profitability, it has several plans of action in progress designed to improve profitability, as well as, cash flow. The Company intends to continue reorganizing the hospital ownership and management business and attempt to sustain the biological product distribution business.
Rx Medical Services Corp. Notes to Consolidated Financial Statements
As mentioned above, the Company intends to continue reorganizing the hospital ownership and management line of business. This line of business has and currently is incurring significant operating losses due to a reduction in patient services eligible for reimbursement and reimbursement rates from third party payors, such as Medicare and Medicaid. The Company anticipates entering into an agreement to sell or to close the hospital it currently operates while looking to expand its presence, through joint ventures and/or acquisitions, into new markets with perceived potential. There can be no assurance that suitable candidates can be found to acquire the Company's hospital or that a sale can be negotiated on terms acceptable or economically feasible to the Company. If the Company can not find a suitable candidate to acquire its hospital, the Company may have to or could be forced to close the remaining hospital it operates. The Company anticipates limiting its joint ventures and/or acquisitions to those that meet certain criteria and are expected to generate positive cash flow.
d. CASH AND CASH EQUIVALENTS
For purposes of the statement of cash flows, the Company considers cash deposited with financial institutions and marketable securities with a maturity of three months or less at the date of acquisition to be cash and cash equivalents.
e. INVENTORY
Inventory, which consists primarily of patient supplies, is stated at the lower of cost or market; cost is determined using the first-in, first-out (FIFO) method.
f. PROPERTY AND EQUIPMENT
Depreciation on buildings is computed on the straight-line method over 30 years. Depreciation on equipment, furniture, fixtures and improvements is computed principally on the straight-line method over the estimated useful lives of these assets, which range from three to eight years.
g. REVENUES
Revenue from hospitals and medical clinics is recognized upon completion of patient services and is recorded net of contractual allowances and amounts estimated to be received under reimbursement arrangements with certain third party payers. Approximately 56%, 54% and 50% of the Company's revenues for the years ended December 31, 1999, 1998 and 1997, respectively, were reimbursements provided by Medicare and Medicaid.
Contractual allowances represent the difference between the Company's basic fee schedule and the estimated amount of available reimbursement from third party payers, such as Medicare, Medicaid and certain clients. Contractual allowances are deducted directly from gross revenues and accounts receivable at the time the service is
Rx Medical Services Corp. Notes to Consolidated Financial Statements
performed and recorded in the Company's financial statements at the estimated net amount to be received. These revenues are subject to audit and retroactive adjustment by the respective third party fiscal intermediaries. In the opinion of management, retroactive adjustments, if any, would not be material to the financial statements of the Company. An allowance for doubtful accounts is established based on management's estimates of the net amounts to be collected from third party payors and individuals considering past collection history and the current status of such related receivable. Accordingly, the allowance for doubtful accounts does not contain any amounts relative to contractual allowances.
h. FAIR VALUE OF FINANCIAL INSTRUMENTS
Statement of Financial Accounting Standards No. 107, "Disclosures About Fair Value of Financial Instruments," requires disclosure of estimated fair values of financial instruments. These estimated fair values are to be disclosed whether or not they are recognized in the balance sheet, provided it is practical to estimate such values. Such information, which pertains to the Company's financial instruments, is based on the requirements set forth in that Statement and does not purport to represent the aggregate net fair value of the Company. The Company estimates that the carrying amount approximates the fair value of its financial instruments at December 31, 1999 and 1998 due to the maturities of these financial instruments.
i. STOCK OPTIONS
Options granted under the Company's Stock Option Plans are accounted for under APB 25, "Accounting for Stock Issued to Employees," and related interpretations. In November 1995, the Financial Accounting Standards Board issued Statement 123, "Accounting for Stock-Based Compensation," which requires additional proforma disclosures for companies that will continue to account for employee stock options under the intrinsic value method specified in APB 25. The Company plans to continue to apply APB 25 and the only effect of this statement on the Company's financial statements are the new disclosure requirements.
j. BASIC AND DILUTED NET LOSS PER COMMON SHARE
Statement Of Financial Accounting Standards No. 128, "Earnings Per Share," requires public companies to present basic earnings (net loss) per share and, if applicable, diluted earnings (net loss) per share for all periods that statements of operations are presented.
Basic and diluted net loss per common share are the same since (a) the potential common shares of the Company would be anti-dilutive and (b) the Company has reflected net losses from continuing operations for all periods presented.
Rx Medical Services Corp. Notes to Consolidated Financial Statements
k. USE OF ESTIMATES
In preparing financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amount of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting period. Actual results could differ from those estimates.
l. CONCENTRATION OF CREDIT RISK
In connection with the Company's hospital and clinic operations, the Company extends credit to individuals, government agencies and third party payors.
The Company does not have director and officer liability insurance. The Company has agreed to indemnify all of its directors and officers from any potential liability they may have as a result of their actions in fulfilling their responsibilities as directors and officers.
m. RECLASSIFICATIONS
Certain amounts in the prior years have been reclassified to conform to the 1999 consolidated financial statement presentation.
n. RECENTLY ISSUED PRONOUNCEMENTS
In June 1998, the FASB issued Statement of Financial Accounting Standards (FAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities" which was amended by FAS No. 138. FAS No. 133 establishes standards for accounting and reporting for derivative instruments, and conforms the requirements for treatment of different types of hedging activities. These statements are effective for all fiscal years beginning after June 15, 2000. Management does not expect these standards to have a significant impact on the Company's operations.
On July 20, 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) 141, Business Combinations, and SFAS 142, Goodwill and Intangible Assets. SFAS 141 is effective for all business combinations completed after June 30, 2001. SFAS 142 is effective for fiscal years beginning after December 15, 2001; however, certain provisions of this Statement apply to goodwill and other intangible assets acquired between July 1, 2001 and the effective date of SFAS 142. Management does not expect these standards to have a significant impact on the Company's operations.
In August 2001, the Financial Accounting Standards Board issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets". This statement addresses financial accounting and reporting for the impairment or disposal of
Rx Medical Services Corp. Notes to Consolidated Financial Statements
long-lived assets. SFAS No. 144 will be effective for financial statements of fiscal years beginning after December 15, 2001. The Company expects to adopt this statement for the fiscal year ending December 31, 2002, and does not anticipate that it will have a material impact on the Company's consolidated financial results.
o. INCOME TAXES
Deferred income taxes have been provided for elements of income and expense, which are recognized for financial reporting purposes in periods different than such items are recognized for income tax purposes. The Company accounts for deferred taxes utilizing the liability method, which applies the enacted statutory rates in effect at the balance sheet date to differences between the book and tax basis of assets and liabilities. The resulting deferred tax liabilities and assets are adjusted to reflect changes in tax laws. A valuation allowance is provided against deferred income tax assets to the extent of the likelihood that the deferred tax asset may not be realized.
2. SALE OF SUBSIDIARY
Effective December 30, 1999, the Company entered into an Agreement For The Sale And Purchase of Assets of Consolidated Health Corporation of Pittsburgh, Inc. (PSH) to ACCI/AllCare of Pennsylvania, Inc. (AllCare). AllCare assumed none of the liabilities of PSH. In consideration for the sale of the assets, the purchaser shall enter into a mortgage payable for $3,300,000.
In connection with the sale agreement described above, a second agreement, Agreement Regarding Acquisition of Assets of Pittsburgh Specialty Hospital was entered into by and among The Financing Source, AllCare and another party. The agreement called for the following:
o The Financing Source to settle certain debts of PSH.
o AllCare will enter into a $3,300,000 mortgage payable (described in the above paragraph) with Financing Source.
o The Financing Source will provide AllCare with 12 monthly payments of $200,000 commencing on the Closing date in return for a $2,400,000 mortgage.
In addition, the Financing Source engaged AllCare as an agent to attempt to settle the trade debts of Consolidated Health Corporation of Pittsburgh, Inc, except for approximately $250,000 that was separately identified as the exclusive responsibility of PSH. PSH's trade debts were $1,364,000 at December 31, 1999. As this agreement did not relieve PSH of its legal obligation to pay its trade debts, the accounts payable balance was not adjusted.
Rx Medical Services Corp. Notes to Consolidated Financial Statements
A summary of the assets sold to AllCare and liabilities paid off by The Financing Source are as follows:
Accounts receivable, net $ (355) Inventories (50) Land and buildings (653) Equipment, net (284) Notes payable - related party 2,758 Accrued liabilities 7 Accrued liabilities - related party 14 Long-term debt 197 Obligations under capital leases - related party 16 ------ Net adjustment to paid in capital $1,650
No gain or loss was recorded for the sale of the PSH assets to AllCare or the PSH liabilities being settled by The Financing Source. The Company recorded the net adjustment to paid in capital due to the substance and the related party aspects of the transaction.
3. DISCONTINUED OPERATIONS
In April 1996, due to continuing losses from the Company's medical diagnostic services business and intense pressure from creditors, Manatee Medical Laboratories, Inc. ("Manatee"), a wholly-owned subsidiary of the Company which operated the medical diagnostic services business segment filed a voluntary petition under Chapter 7 of the U.S. Bankruptcy Code. This resulted in the closing of the Company's remaining medical diagnostic facilities and imaging center.
Assets and liabilities at December 31, 1998 and 1997, and the results from operations of discontinued operations for the years ended December 31, 1998 and 1997, are reflected below (in thousands):
1998 1997 ----- ----- Assets and liabilities: Reserve for future costs $ -- $(100) ----- ----- Net liabilities of discontinued operations $ -- $(100) ===== =====
Results from operations: Other income $ 136 $ 181 ----- ----- Gain from discontinued operations $ 136 $ 181 ===== =====
Rx Medical Services Corp. Notes to Consolidated Financial Statements
4. NOTES PAYABLE
a. NOTE PAYABLE
Note payable, at December 31, 1999, consists of an unsecured promissory note, due in monthly principal and interest installments, that bears interest at 8.00% per annum. This note matured on February 3, 2000. The holder of this note, as of the date of these financial statements, has not renewed this note or sought collection of the outstanding principal and accrued interest.
Note payable, at December 31, 1998, consisted of an unsecured promissory note, due in monthly principal and interest installments, that bore per interest at 8.00% annum. The holder of this note sought and obtained, on March 19, 1999, a judgment against the Company for the principal and accrued interest on the note plus other costs aggregating $25,055. Effective with the sale of Pittsburgh Specialty Hospital (see Note 2), this note was settled by the Financing Source.
b. NOTES PAYABLE - RELATED PARTY
At December 31, 1999 and 1998, notes payable-related party included amounts due to the Financing Source, through which the Company has obtained financing collateralized by certain accounts receivable, real estate and equipment.
Certain financing agreements with the Financing Source provide that the Company will periodically sell certain eligible accounts receivable to the Financing Source. However, the terms of the agreements specify certain items of limited recourse, including the ability to resell receivables which have aged beyond 150 days back to the Company. While the Company believes that legally a sale of its receivables has occurred, due to the existence of the terms of limited recourse, this transaction does not qualify for treatment as a sale for accounting purposes and, accordingly, such activity has been recorded as notes payable at December 31, 1999 and 1998.
Rx Medical Services Corp. Notes to Consolidated Financial Statements
The notes payable due to the Financing Source at December 31, 1999 and 1998 consisted of the following (in thousands):
In 1999, the notes payable collateralized by real estate were settled by the Financing Source (see Note 2).
Notes payable collateralized by accounts receivable of $56,501 and $46,166 at December 31, 1999 and December 31, 1998, respectively, are included in current liabilities because the Company has defaulted the required payments.
5. LONG-TERM DEBT
a. LONG-TERM DEBT
Long-term debt at December 31, 1998 consisted of the following (in thousands):
Rx Medical Services Corp. Notes to Consolidated Financial Statements
In 1999, the debt was settled by the Financing Source (see Note 2).
b. LONG-TERM DEBT - RELATED PARTY
Long-term debt - related party consists of an unsecured promissory note, interest at 14%, due in monthly installments of principal and interest of $13,232, and matures on September 1, 2003. Scheduled principal maturities for each of the five years subsequent to December 31, 1999, and thereafter are estimated as follows (in thousands): 2000 - $100; 2001 - $116; 2002 - $132; and 2003 - $113.
6. SHAREHOLDERS' EQUITY
a. PREFERRED STOCK
At December 31, 1999 the Company had authorized, issued and outstanding one series of preferred stock as follows:
Series G Preferred Stock, par value of $.001, conversion price is the market value of the Company's Common Stock, with voting rights equivalent to the Company's Common Stock. This series of Preferred Stock is convertible into shares of the Company's Common Stock annually, with the annual conversion being limited to twenty-five percent (25%) of the original shares issued to each shareholder. On July 1, 2002, any remaining unconverted shares automatically convert into the Company's Common Stock. This series of Preferred Stock pays annual dividends of $0.15 in arrears, payable at the Company's discretion in cash or the Company's Common Stock. At December 31, 1999 dividends in arrears on this series of Preferred Stock aggregated approximately $30,000. The Company has reserved sufficient shares of authorized and unissued Common Stock to effect the conversion of Series G Preferred Stock. At December 31, 1999, 800,000 issued and outstanding shares of Series G Preferred Stock remain unconverted.
b. REGISTRATION RIGHTS
Pursuant to several separate agreements, the Company is obligated on a best efforts basis to register shares of issued, but restricted, Common Stock, Common Stock issued upon exercise of stock warrants, and Common Stock issued upon conversion of Preferred Stock. Certain of the agreements provide the holders of the common stock with piggyback registration rights, and certain of the agreements provide for demand registration rights. In either case, the Company is obligated to pay all of the expenses associated with such registration statements.
Rx Medical Services Corp. Notes to Consolidated Financial Statements
c. STOCK ISSUANCES
On May 27, 1999, the Company paid $55,644 of dividends in arrears on the Company's Series G Preferred Stock via the issuance of 650,960 shares of the Company's Common Stock.
On December 15, 1999, the Company paid $90,000 of dividends in arrears on the Company's Series G Preferred Stock via the issuance of 512,835 shares of the Company's Common Stock.
On December 31, 1999, the remaining 63,836 issued and outstanding shares of the Company's Series C Preferred Stock were automatically converted into 4,605,311 shares of the Company's Common Stock.
d. Warrants
The Company issued warrants in conjunction with private placements of debt and the Company's Common Stock and as consideration for other expenses. Certain of these warrants were re-priced in 1996 based on the market price of the Company's Common Stock at the time they were re-priced. The following table summarizes the warrant transactions for the years ended December 31, 1997, 1998, and 1999:
Exercise Shares Grant Date Price ------- ---------- --------
Outstanding at January 1, 1997 62,500 Expired (12,500) 4/94 $ 2.63 ------- Outstanding at December 31, 1997 50,000 No Activity -- Outstanding at December 31, 1998 50,000 Expired (50,000) 4/94 $ 2.63 ------- Outstanding at December 31, 1999 -- =======
e. STOCK OPTIONS
The Company's 1992 Long-Term Incentive Stock Option Plan provides for granting of options of not more than 1,000,000 shares of Common Stock. Options granted under the plans are exercisable in one-third installments annually from the date of grant and have a term of four to ten years.
The Company has also granted stock options which are classified as non-qualified, and which are not included in the 1992 Employees' Incentive Stock Option Plan.
Rx Medical Services Corp. Notes to Consolidated Financial Statements
There were no options granted in 1999, 1998, and 1997; therefore no proforma disclosures are required pursuant to SFAS 123.
A summary of the status of the Company's fixed stock options as of December 31, 1999 1998 and 1997, and changes during the years ending on those dates is as follows:
The following information applies to options outstanding at December 31, 1999:
Rx Medical Services Corp. Notes to Consolidated Financial Statements
f. BASIC AND DILUTED NET LOSS PER COMMON SHARE
The following table reflects the computation of the basic and diluted net loss per common share:
The Company has issued potential common share securities (see Notes 5a and 5e) that could potentially dilute basic earnings per share in the future. These securities were not included in the computations of net loss per common share presented in the financial statements because they were anti-dilutive. Potentially dilutive securities not included in the loss per share calculation included 242,127 stock options and 2,857,143 common equivalent shares of convertible preferred stock.
Rx Medical Services Corp. Notes to Consolidated Financial Statements
7. INCOME TAXES
Income tax expense differs from the amounts computed by applying the statutory federal tax rate to income before income taxes. The difference is reconciled as follows (in thousands):
At December 31, 1999, the Company has a federal net operating loss carryforward of approximately $88.5 million. In addition, the Company has various state net operating loss carryforwards.
As a result of certain cumulative changes in the Company's stock ownership over the years, the use of the Company's federal net operating loss carryforward may be substantially limited. In 2005, certain portions of the federal net operating loss carryforward begin to expire.
Differences between pre-tax income for financial reporting purposes and taxable income for income tax purposes relate primarily to allowances for doubtful accounts, valuation reserves, accrued compensation and financial statement expenses recorded for certain stock option transactions.
Rx Medical Services Corp. Notes to Consolidated Financial Statements
Deferred tax assets and liabilities at December 31, 1999, and 1998, arose from the following items (in thousands):
8. RELATED PARTY TRANSACTIONS
The Financing Source is being categorized as a related party due to the Financing Source's stock ownership in and its ability to exercise control over the operations of the Company.
Healthcare Capital, LLC ("HCC"), formerly know as Intercontinental Investment Associates, Ltd., is affiliated with the Financing Source via common individual owners. At December 31, 1999, HCC is the Company's major shareholder. HCC owns directly and/or indirectly 47.54% or 11,028,717 of the 23,751,920 shares of the issued and outstanding shares of the Company's $.002 par value Common Stock as of December 31, 1999. The ownership percentage and the number of shares owned do not take into account following:
a) the 800,000 shares of the Company's Series G Preferred Stock, which are convertible into the Company's Common Stock, owned by HCC,
b) dividends in arrears of $30,000 on the Company's Series G Preferred Stock as of December 31, 1999, which are anticipated to be paid by the issuance of a yet to be determined number of shares of the Company's Common Stock, or
c) shares of the Company's Common Stock issued and held in street name.
During the year ended December 31, 1999, the Company paid $145,644 of dividends in arrears to HHC on the Company's Series G Preferred Stock via the issuance of 1,163,795 shares of the Company's Common Stock.
Rx Medical Services Corp. Notes to Consolidated Financial Statements
At December 31, 1999, the Company is indebted to the Financing Source in the amount of $57.4 million.
9. EXTRAORDINARY ITEMS
On July 23, 1998, the pending lawsuit against the Company and Manatee Medical Laboratories, Inc. by Eduardo R. Latour, as Trustee for Physicians Reference Lab Short Term Trust filed in the Circuit Court for Pinellas County, Florida (Case No. 96-00683-CI-15) was settled. A stipulation of settlement was entered into by the parties pursuant to which a voluntary dismissal with prejudice was filed with the Clerk of the Court. Pursuant to the settlement $3.1 million of long-term debt and $0.7 million of accrued interest was retired for $0.6 million in cash. The Company, due to the settlement of this lawsuit, recognized a gain on settlement of indebtedness of $3.2 million.
10. RETIREMENT PLAN
The Company has a Combined Profit Sharing/Money Purchase Plan with a Cash or Deferred Arrangement Option (the "Plan") to which both the Company and eligible employees contribute. The Plan segregates the Company's employees into two distinct participant groups (a) non-union participants and (b) union participants.
The Company, pursuant to a union contract at the Company's hospital, contributes up to $550 per Plan year for eligible union participants. Company contributions are discretionary per Plan year for eligible non-union participants.
Employees are eligible to participate in the Plan based on the number of hours worked in the Plan year and the attainment of a certain age. Company and employee contributions vest 100% in the first year.
Company contributions to the Plan for the year ended December 31, 1999, 1998 and 1997 aggregated approximately $52,000, $60,000, and $68,000, respectively.
Rx Medical Services Corp. Notes to Consolidated Financial Statements
11. COMMITMENTS AND CONTINGENCIES
a. LEASES
The Company leases its operating and other facilities, as well as certain equipment, under noncancelable leases with initial lease terms of one to ten years; also, the Company leases one of its facilities from the Financing Source with an initial lease term of twenty years. Certain of the facilities leases provide for optional renewal periods. Scheduled future minimum commitments under operating leases with remaining terms subsequent to December 31, 1999 are as follows (in thousands):
Years Ending All Related-Party December 31, Leases Leases ------------ -------- -------------
2000 $ 1,512 $ 1,146 2001 1,285 1,146 2002 1,189 1,146 2003 1,150 1,145 2004 1,146 1,145 Thereafter 12,888 12,888 ------- ------- $19,170 $18,616 ======= =======
Scheduled future minimum commitments under capital lease obligations with remaining terms subsequent to December 31, 1999 are as follows (in thousands):
Years Ending All Related-Party December 31, Leases Leases ------------ -------- -------------
2000 $ 131 $ 66 2001 92 66 2002 20 17 2003 -- -- 2004 -- -- Thereafter -- -- ------- ------- 243 149 Less amounts Representing interest (22) (14) ------- -------
Present value of remaining minimum capital lease payments 221 135
Rx Medical Services Corp. Notes to Consolidated Financial Statements
Less: Scheduled current portion (115) (57) Non-current obligations Reclassified to current (7) -- ------- ------- Long-term obligations under capital leases 99 78 ======= =======
Rent expense was approximately (in thousands) $1,584, $1,643, and $1,752, for the years ended December 31, 1999, 1998 and 1997, respectively.
b. CONTRACTS
The Company has entered into contracts with various individuals and entities to provide patient and other services for the Company. Scheduled future minimum commitments under these contracts with remaining terms subsequent to December 31, 1999 are as follows (in thousands):
------------------------------- Years Ending December 31, ------------------------------- 2000 $ 508 2001 161 2002 19 2003 -- 2004 -- Thereafter -- ------- =======
c. GOVERNMENT REGULATION
The Company's operations are subject to extensive government regulation. Industry compliance with such regulations is under constant scrutiny by regulatory authorities and legislative bodies and regulations are subject to change at any time. Certain proposed changes in regulations, if enacted, could have an adverse effect on the Company's operations and such effects could be material.
Federal and certain state regulations restrict the nature and types of financial relationships that medical service providers receiving reimbursement under the Medicare and Medicaid program may have with referring physicians (the self-referral regulations). A financial relationship is defined by the federal regulations as an ownership or investment interest through equity or debt or certain compensation
Rx Medical Services Corp. Notes to Consolidated Financial Statements
arrangements. The Company believes that there may have been violations of certain applicable statutes and regulations with respect to the operation of certain of its clinical laboratories in Florida.
The Omnibus Budget Reconciliation Act of 1989, often referred to as the "Stark Act", included restrictions on physician financial relationships with laboratories to which they refer patients but provided an exemption for publicly traded entities that have total assets in excess of $100 million. The Omnibus Budget Reconciliation Act of 1993 ("OBRA 1993") expanded these restrictions to apply beyond physician financial relationships with laboratories to physician relationships with entities that provide "Designated Health Services" (including clinical laboratory services, radiology and other diagnostic services). However, the Act deleted the previous exemption and substituted a requirement that the entity have $75 million in stockholders' equity at the end of its most recent fiscal year or on average during its prior three fiscal years. The OBRA 1993 amendments became effective on January 1, 1995.
For the period prior to January 1, 1995, should it be determined that the Company did not comply with the federal regulations the Company may be subjected to refunding a portion of Medicare and Medicaid revenues collected, in addition to paying substantial penalties. As of January 1, 1995, the Company did not meet the OBRA 1993 amendments to the Stark Act requiring $75 million in stockholders' equity. Physician/shareholder referrals since January 1, 1995 could cause penalties to be imposed of up to $15,000 for each item or service claimed, plus twice the amount billed. The Company believes, however, that due to the filing of the Chapter 7 bankruptcy petition for Manatee, the likelihood of such enforcement actions occurring is remote.
In April 1992, the Florida Legislature enacted the Patient Self-Referral Act of 1992 (the "Florida Act") which prohibits referrals for certain designated health services (including clinical laboratory testing and diagnostic imaging) by a physician to a facility in which such physician has an investment. The effective date of this prohibition was October 1, 1994 for investment interests acquired prior to May 1, 1992; otherwise, the effective date of the Florida Act was July 1, 1992. The Company's financial relationships with referring physicians in respect of its clinical laboratories in Florida since October 1, 1994 and its imaging center in Fort. Lauderdale, Florida since July 1993 did not comply with the Act and may require the Company to refund substantial revenues. The Company believes, however, that due to the filing of the Chapter 7 bankruptcy petition for Manatee, the likelihood of such enforcement actions occurring is remote.
In October 1993, the California legislature enacted legislation relating to health care referrals which has a public company exception similar in scope to the Stark Act as it
Rx Medical Services Corp. Notes to Consolidated Financial Statements
existed prior to the OBRA 1993 amendments. The major difference with the California self-referral legislation, effective January 1, 1995, is that it applies to both clinical laboratory and diagnostic imaging services subsequent to January 1, 1995. The Company could be assessed substantial fines and penalties. The Company believes, however, that due to the filing of the Chapter 7 bankruptcy petition for Manatee, the likelihood of such enforcement actions occurring is remote. Legislatures in other states are considering or have considered similar legislation which, if enacted, may have an adverse impact on the Company to the extent that the Company acquires facilities in those states.
The Company's inability to meet the OBRA 1993 amendment to the Stark Act requiring $75 million in stockholders' equity, and provisions of the Florida Act and the California self-referral legislation, could result in the imposition of penalties and the return of revenues collected for certain services provided, which may aggregate up to approximately $50.0 million. The Company believes, however, that due to the filing of the Chapter 7 bankruptcy petition for Manatee, the likelihood of such enforcement actions occurring is remote.
As of April 1996, the Company no longer operates clinical laboratories and imaging centers, thereby eliminating additional potential fines, penalties and refunds that could be imposed under the Stark Act (as amended) and the State Acts.
d. LEGAL PROCEEDINGS
The Company, in March 1995, received from the U.S. Securities and Exchange Commission (the "Commission") a Formal Order Directing Private Investigation And Designating Officers To Take Testimony In The Matter of Rx Medical Services Corp., dated March 8, 1995. The Company has been advised by the Commission that the investigation is confidential and should not be construed as an indication by the Commission or its staff that any violation of law has occurred. No proceedings in furtherance of this investigation have occurred; however, no assurance can be given that this investigation will not be activated in the future.
In July 1998, an action was commenced against the Company in the Superior Court of California, County of Contra Costa, under the title NORTH BAY MRI ASSOCIATES V. RX MEDICAL SERVICES CORP. (Case No. C 98-02610). The complaint stated many issues though the primary issue was that Rx Medical Services Corp. guaranteed the performance of a lease agreement entered into by a partnership of which a subsidiary of Manatee was a general partner. This subsidiary was included in voluntary bankruptcy petition of Manatee filed on April 4, 1996. The Company chose not to defend against this action and on October 20, 1998, a judgment by default was entered against the Company in the amount of $1,432,900. The Company has established a
Rx Medical Services Corp. Notes to Consolidated Financial Statements
liability account for the full amount of the judgment. In February 2002, the Company settled with the plaintiffs in the amount of $80,000 cash and 210,000 shares of common stock from the Chief Executive Officer. The settlement is contingent upon the Company remaining solvent fro 120 days subsequent to the settlement date.
In November 1998, an action was commenced against Biologic Health Care, which the Company's wholly owned subsidiary RxMIC was a 25% general partner, in the Superior Court of California, County of Santa Clara, under the title of CENTEON LLC V. BIOLOGIC HEALTH (Case No. CV775830). The complaint stated that BHC owed Centeon LLC for biological and other medical products purchased but not paid for. The partnership was subsequently dissolved and Centeon LLC on January 8, 1999, entered and was granted a default judgment against RxMIC, who was the 25% general partner in BHC, and Biologic Health Resources, who was the 75% general partner in BHC, in the amount of $437,343. This default judgment as of May 22, 2000, had increased to $472,245. The Company has not established a liability account for this judgment as the only asset of RxMIC was the investment in the BHC partnership, which was written off in a previous year, and the Company did not guarantee the performance of BHC or RxMIC. Therefore, Centeon LLC, in the Company's opinion, has no viable way to collect on the default judgment granted to them.
In addition to the foregoing, the Company is involved in routine litigation arising in the ordinary course of its business which the Company believes would not have a material adverse effect on its financial position.
e. UNION CONTRACT
The Company's hospital has entered into an agreement with the United Mine Workers of America and its District 28 and its Local Union 7528 (the "Union") whereby the Union acts as the sole and exclusive bargaining representative in respect to wages, hours, other working conditions for all employees affiliated with the Union. This agreement can be renegotiated annually, by either party giving the other party written notice of its desire to modify or terminate the agreement, 90 days before the agreements' anniversary date of September 20.
12. SUBSEQUENT EVENTS
On January 3, 2000, stock options to acquire 78,500 shares of the Company's Common Stock expired unexercised.
In 2000, the Company ceased operations in California and significantly curtailed operations in Florida of the biological product distribution business.
Rx Medical Services Corp. Notes to Consolidated Financial Statements
In the case of NORTH BAY MRI ASSOCIATES V. RX MEDICAL SERVICES CORP. (Case No. C 98-02610), in February 2002, the Company settled with the plaintiffs in the amount of $80,000 cash and 210,000 shares of common stock from the Chief Executive Officer. The settlement is contingent upon the Company remaining solvent for 120 days subsequent to the settlement date.
13. SEGMENT INFORMATION
The Company operates in two business segments: the operation of hospitals and medical clinics, and the distribution of biological products. The following presents information on the two business segments (in thousands):
Rx Medical Services Corp. Notes to Consolidated Financial Statements
14. FOURTH QUARTER ADJUSTMENTS
The Company recorded significant fourth quarter adjustments which effected the net losses for the following years. Following is a summary of such adjustments (unaudited, in thousands):
1999 1998 1997 ------ ------ ------ Provision for legal judgement $ -- $1,130 $ -- ====== ====== ======
15. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
The quarterly results for the years 1998 and 1999 are set forth in the following table: Diluted Net Loss Loss from Per Operating Continuing Common Revenues Loss Operations Net Loss Share -------- --------- ---------- -------- ------- (In thousands, except per share data)
1st Quarter $ 3,332 (967) (3,118) (3,118) (0.18) 2nd Quarter 3,038 (1,316) (3,374) (3,374) (0.19) 3rd Quarter 2,918 (1,335) (3,734) (3,734) (0.20) 4th Quarter 3,521 (859) (3,198) (3,198) (0.19) ------- ------- ------- ------- ---- Total $12,809 (4,477) (13,424) (13,424) (0.76) ======= ======= ======= ======= ====
1st Quarter $ 4,667 (268) (1,768) (1,725) (0.19) 2nd Quarter 4,257 (1,031) (2,937) (2,906) (0.31) 3rd Quarter 4,200 (1,038) (3,187) 39 0.00 4th Quarter 3,374 (1,577) (4,679) (4,648) (0.20) ------- ------- ------- ------- ---- Total $16,498 (3,914) (12,571) (9,240) (0.70) ======= ======= ======= ======= ====
RX MEDICAL SERVICES CORP.
Schedule II Valuation and Qualifying Accounts
(Dollars in thousands)
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
RX MEDICAL SERVICES CORP.
By: /s/ Michael L. Goldberg ------------------------------------- Michael L. Goldberg Chief Executive Officer
Dated: March 21, 2002
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. | 16,572 | 107,927 |
945792_1999.txt | 945792_1999 | 1999 | 945792 | ITEM 3. LEGAL PROCEEDINGS
There are no material legal proceedings pending involving the Partnership, any of its subsidiaries or any of their properties, and no such proceedings are known to be contemplated by governmental authorities other than claims arising in the ordinary course of the Partnership's business.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of security holders during the last fiscal quarter of the 1999 fiscal year.
PART II: SECURITIES AND FINANCIAL INFORMATION
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON UNITS AND RELATED SECURITY HOLDER MATTERS
Each common unit ("Common Unit") represents a limited partner interest. The Common Units are listed on the New York Stock Exchange, which is the principal trading market for such securities, under the symbol "APU." The following table sets forth, for the periods indicated, the high and low sale prices per Common Unit, as reported on the New York Stock Exchange Composite Transactions tape, and the amount of cash distributions paid per Common Unit.
- ------------------------------------------------------------------------------
As of December 1, 1999, there were 1,289 record holders of the Partnership's Common Units. There is no established public trading market for the Partnership's subordinated units, representing limited partner interests ("Subordinated Units"). The Partnership makes quarterly distributions to its partners in an aggregate amount equal to its Available Cash, as defined in the Amended and Restated Agreement of Limited Partnership of AmeriGas Partners, L.P., which is filed as an exhibit to this report. Available Cash generally means, with respect to any fiscal quarter of the Partnership, all cash on hand at the end of such quarter, plus all additional cash on hand as of the date of determination resulting from borrowings subsequent to the end of such quarter, less the
amount of cash reserves established by the General Partner in its reasonable discretion for future cash requirements. Certain reserves are maintained to provide for the payment of principal and interest under the terms of the Partnership's debt agreements and other reserves may be maintained to provide for the proper conduct of the Partnership's business, and to provide funds for distribution during the next four fiscal quarters. The information concerning restrictions on distributions required by Item 5 of this report is incorporated herein by reference to Notes 3 and 4 to the Partnership's Consolidated Financial Statements which are incorporated herein by reference. Distributions of Available Cash to the holders of Subordinated Units are subject to the prior rights of holders of the Common Units to receive the Minimum Quarterly Distribution ("MQD") for each quarter during the subordination period, and to receive any arrearages in the distribution of the MQD on the Common Units for prior quarters during the subordination period. The subordination period will not end earlier than April 1, 2000. See "Management's Discussion and Analysis of Financial Condition and Results of Operations."
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
N.M. - Not Meaningful.
(a) Represents financial data for the period April 19, 1995, the date the Partnership commenced operations, through September 30, 1995.
(b) EBITDA (earnings before interest expense, income taxes, depreciation and amortization) should not be considered as an alternative to net income (as an indicator of operating performance) or as an alternative to cash flow (as a measure of liquidity or ability to service debt obligations) and is not a measure of performance or financial condition under generally accepted accounting principles.
(c) Based upon national weather statistics provided by the National Oceanic and Atmospheric Administration (NOAA) for 335 airports in the continental U.S.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ANALYSIS OF RESULTS OF OPERATIONS
The following analysis compares the Partnership's results of operations for (1) the year ended September 30, 1999 ("Fiscal 1999") with the year ended September 30, 1998 ("Fiscal 1998") and (2) Fiscal 1998 with the year ended September 30, 1997 ("Fiscal 1997").
The following table provides gallon, weather and certain financial information for the Partnership:
AmeriGas Partners, L.P. (Millions, except per gallon and percentages)
(a) Revenues less related cost of sales.
(b) EBITDA (earnings before interest expense, income taxes, depreciation and amortization) should not be considered as an alternative to net income (as an indicator of operating performance) or as an alternative to cash flow (as a measure of liquidity or ability to service debt obligations) and is not a measure of performance or financial condition under generally accepted accounting principles.
(c) Based upon national weather statistics provided by the National Oceanic and Atmospheric Administration (NOAA) for 335 airports in the continental U.S.
PARTNERSHIP RESULTS OF OPERATIONS
FISCAL 1999 COMPARED WITH FISCAL 1998
Temperatures during the heating season have a significant impact on our propane retail sales volumes because many of our customers use propane for heating purposes. For the second year in a row, significantly warmer than normal weather impacted the Partnership's results. Based upon national weather data, temperatures in Fiscal 1999 were 9.9% warmer than normal and 1.3% warmer than in Fiscal 1998. Retail volumes of propane sold were slightly lower in Fiscal 1999 primarily as a result of a 7.3 million decline in agricultural gallons as a dry autumn reduced demand for crop drying. Partially offsetting the decrease in agricultural gallons were higher motor fuel sales, increased gallons sold through our PPX Prefilled Propane Xchange(R) program, and, notwithstanding the warmer weather, higher sales to residential customers. During Fiscal 1999, we targeted for growth the higher-margin residential heating customer market which resulted in residential volume growth despite the warmer weather.
Total revenues from retail propane sales declined $36.3 million in Fiscal 1999 due primarily to lower average selling prices. The lower average selling prices resulted from lower propane product costs. Wholesale propane revenues declined $13.2 million reflecting (1) a $6.9 million decrease as a result of lower average wholesale prices and (2) a $6.3 million decrease as a result of lower wholesale volumes sold. Nonpropane revenues increased $7.6 million in Fiscal 1999 reflecting higher appliance and cylinder sales, increased terminal and hauling revenues, and greater customer fee revenues. Cost of sales declined $53.0 million primarily as a result of lower propane product costs.
Total margin increased $11.2 million in Fiscal 1999 due to (1) slightly higher average retail unit margin per gallon, (2) greater total margin from our PPX Prefilled Propane Xchange(R) program, and (3) an increase in total margin from appliance sales, customer fees and hauling and terminal revenue.
EBITDA (earnings before interest expense, income taxes, depreciation and amortization) and operating income were higher in Fiscal 1999 as a result of (1) the higher total margin and (2) higher other income. These increases were partially offset by an increase in operating expenses. Other income, net, in the prior year included a $4.0 million loss from two interest rate protection agreements entered into to reduce interest rate exposure associated with an anticipated debt refinancing. When we postponed the refinancing due to volatility in the corporate debt markets, we recorded a loss on these interest rate agreements. Operating expenses of the Partnership were $329.6 million in Fiscal 1999 compared with $320.2 million in Fiscal 1998. Operating expenses in Fiscal 1998 are net of (1) $2.7 million of income from lower required accruals for environmental matters and (2) $2.0 million of income from lower required accruals for property taxes. Excluding the impact of these items in the prior year, operating expenses increased $4.7 million in Fiscal 1999 principally due to expenses associated with new business initiatives. Continued attention to controlling our operating expenses resulted in our total base business expenses, which exclude expenses associated with new business initiatives, remaining essentially unchanged.
FISCAL 1998 COMPARED WITH FISCAL 1997
Retail and wholesale volumes sold in Fiscal 1998 were lower due to warmer heating-season weather. Weather in Fiscal 1998 was 8.7% warmer than normal compared to weather that was 1.2% warmer than normal in Fiscal 1997. In particular, the critical heating-season period of January and February 1998 was the warmest in more than 100 years.
Total revenues from our retail propane sales were $746.1 million in Fiscal 1998, a decrease of $122.1 million from Fiscal 1997. The decrease includes $98.3 million from a reduction in average selling prices and $23.8 million from the lower retail volumes sold. Our wholesale propane revenues in 1998 decreased $37.5 million to $88.5 million due to lower Fiscal 1998 selling prices and lower volumes. The lower average retail and wholesale selling prices were due to significantly lower propane product costs. Other revenues were $79.8 million in Fiscal 1998, a decrease of $3.8 million, due in large part to reduced terminal and storage revenues and lower appliance sales revenues. Propane cost of sales declined in Fiscal 1998 as a result of the lower volumes sold and lower propane product costs.
Total margin declined $6.8 million in Fiscal 1998 due to the lower retail volumes sold. The decline in Fiscal 1998 total margin resulting from the lower sales was partially offset by slightly higher average retail unit margin. The higher average unit margin in Fiscal 1998 principally resulted from the lower propane product costs.
The decrease in Fiscal 1998 operating income and EBITDA reflects (1) lower other income, (2) a decrease in total propane margin, and (3) slightly higher operating expenses. Other income, net, in Fiscal 1998 includes a $4.0 million loss from two interest rate protection agreements entered into to reduce interest rate exposure associated with an anticipated refinancing of the Operating Partnership's Acquisition Facility in late Fiscal 1998. Other income in Fiscal 1997 includes (1) $4.7 million from the sale of the Partnership's 50% interest in Atlantic Energy, Inc., a storage terminal facility in Chesapeake, Virginia, (2) higher customer finance charges, and (3) higher interest income. Operating expenses of the Partnership were $320.2 million in Fiscal 1998 compared to $316.4 million in Fiscal 1997. Operating expenses in Fiscal 1998 include the benefit of (1) $2.7 million from lower required accruals for environmental matters and (2) $2.0 million from lower required accruals for property taxes. Excluding these items, operating expenses of the Partnership in Fiscal 1998 were $8.5 million higher, an increase of 2.7%, primarily due to incremental expenses associated with (1) acquisitions and (2) new business activities including start-up locations and our PPX Prefilled Propane Xchange(R) program. Excluding the impact of these new business activities, our base business total expenses were essentially unchanged.
FINANCIAL CONDITION AND LIQUIDITY
CAPITALIZATION AND LIQUIDITY
The Operating Partnership's primary cash sources since its formation in 1995 have been (1) cash generated by operations, (2) borrowings under its Bank Credit Agreement, and (3) the issuance of $70 million of long-term debt in Fiscal 1999.
The Operating Partnership's Bank Credit Agreement consists of (1) a $100 million Revolving Credit Facility and (2) a $75 million Acquisition Facility. The Revolving Credit Facility may be used for (1) working capital, (2) capital expenditures, and (3) interest and distribution payments. Revolving Credit Facility loans were $22 million at September 30, 1999 and $10 million at September 30, 1998. The Operating Partnership's borrowing needs are seasonal, and are typically greatest during the fall and early winter months due to higher working capital needs. The Operating Partnership may borrow under its Acquisition Facility to finance the purchase of propane businesses or propane business assets. The Acquisition Facility operates like a revolving facility until September 15, 2000. At that time, the total amount outstanding will convert to a quarterly amortizing four-year term loan. Loans outstanding under the Acquisition Facility at September 30, 1999 were $23 million, but the Operating Partnership had the ability to borrow an additional $47 million based upon eligible propane business and asset expenditures through that date.
The Operating Partnership also has a credit agreement with the General Partner to borrow up to $20 million on an unsecured, subordinated basis, to fund (1) working capital, (2) capital expenditures, and (3) interest and distribution payments. UGI has agreed to contribute up to $20 million to the General Partner to fund such borrowings.
The Partnership must maintain certain financial ratios in order to borrow under the Bank Credit Agreement including a minimum interest coverage ratio and a maximum debt to EBITDA ratio. The Partnership's ratios calculated as of September 30, 1999 permit it to borrow up to the maximum amount available. For a more detailed discussion of the Partnership's credit facilities, see Note 4 to Consolidated Financial Statements.
The Partnership's management believes that cash flow from operations and Bank Credit Agreement borrowings will be sufficient to satisfy its liquidity needs in fiscal 2000.
PARTNERSHIP DISTRIBUTIONS
Since our formation in 1995, we have paid the MQD on all limited partner units outstanding. The amount of Available Cash needed annually to pay the MQD on all units and the general partner interests is approximately $94 million. A reasonable proxy for the amount of cash available for distribution that is generated by the Partnership can be calculated by subtracting (1) cash interest expense and (2) capital expenditures needed to maintain operating capacity, from the Partnership's EBITDA. Distributable cash flow as calculated for Fiscal 1999, Fiscal 1998 and Fiscal 1997 is as follows:
(a) EBITDA (earnings before interest expense, income taxes, depreciation and amortization) should not be considered as an alternative to net income (as an indicator of operating performance) or as an alternative to cash flow (as a measure of liquidity or ability to service debt obligations) and is not a measure of performance or financial condition under generally accepted accounting principles.
(b) Interest expense adjusted for noncash items.
Although distributable cash flow is a reasonable estimate of the amount of cash generated by the Partnership, it does not reflect changes in working capital which can significantly affect cash available for distribution and it is not a measure of performance or financial condition under generally accepted accounting principles. Although the levels of distributable cash flow in Fiscal 1999 and 1998 were less than the full MQD, borrowings in Fiscal 1999 and cash generated from changes in the Partnership's working capital in Fiscal 1998 were more than sufficient to permit the Partnership to pay the full MQD. The ability of the Partnership to pay the MQD on all units depends upon a number of factors. These factors include (1) the level of Partnership earnings, (2) the cash needs of the Partnership's operations (including cash needed for maintaining and increasing operating capacity), (3) changes in operating working capital, and (4) the Partnership's ability to borrow under its Bank Credit Agreement and refinance maturing debt. Some of these factors are affected by conditions beyond our control including weather, competition in markets we serve, and the cost of propane.
CONVERSION OF SUBORDINATED UNITS
The AmeriGas Partners L.P. Amended and Restated Agreement of Limited Partnership dated as of September 18, 1995 (Partnership Agreement) provides that a total of 4,945,537 of its Subordinated Units may convert into Common Units on the first day after the distribution record date for any quarter ending on or after March 31, 1998, and an additional 4,945,537 Subordinated Units may convert on the first day after the distribution record date for any quarter ending on or after March 31, 1999, if as of such quarterly dates certain historical and projected cash generation-based requirements are met. Because the required cash generation-based objectives were achieved as of March 31, 1999, a total of 9,891,074 Subordinated Units held by the General Partner and a subsidiary were converted to Common Units on May 18, 1999. The remaining 9,891,072 Subordinated Units we hold are eligible to convert to Common Units on the first day after the record date for any quarter ending on or after March 31, 2000 in respect of which certain historical cash generation-based requirements are met, as defined in the Partnership Agreement. The ability of the Partnership to attain these requirements will depend upon a number of factors including highly seasonal operating results, changes in working capital, asset sales and the Partnership's ability to borrow and refinance maturing debt. Based upon projections assuming normal weather, it is reasonably possible that the remaining 9,871,072 Subordinated Units could convert to Common Units during fiscal 2000.
CASH FLOWS
OPERATING ACTIVITIES. Although Fiscal 1999 net income was greater than Fiscal 1998, cash flow from operating activities was $62.7 million lower as a result of lower cash from changes in
operating working capital. Changes in working capital in Fiscal 1999 used $19.3 million of cash while changes in working capital in Fiscal 1998 provided $51.1 million of cash (principally from reductions in accounts receivable and inventories). Cash flow from operations before changes in working capital was $7.8 million higher in 1999 reflecting the increase in operating results.
INVESTING ACTIVITIES. In Fiscal 1999 we spent $31.1 million in cash for property, plant and equipment (excluding $3.5 million in capital lease additions) compared with $31.6 million of cash expenditures in Fiscal 1998. We acquired a number of propane businesses in Fiscal 1999 for net cash consideration of $3.9 million compared with $8.1 million of such expenditures in 1998. We expect to have approximately $37.4 million of capital expenditures in fiscal 2000 which will be financed from operating cash flows and Bank Credit Agreement borrowings.
FINANCING ACTIVITIES. We paid the MQD on all Common Units and Subordinated Units, as well as the general partner interests, totaling $94.2 million in Fiscal 1999. During Fiscal 1998, we paid $94.1 million in such distributions. Net borrowings under our Revolving Credit Facility were $12 million in Fiscal 1999 compared to net repayments of $18 million in Fiscal 1998 which resulted from the strong Fiscal 1998 operating cash flow. We issued $70 million of ten-year Series D First Mortgage Notes in Fiscal 1999. The proceeds were used principally to repay Acquisition Facility and Revolving Credit Facility borrowings. We subsequently borrowed an additional $23 million under the Acquisition Facility.
YEAR 2000 MATTERS
The Year 2000 ("Y2K") issue is a result of computer programs being written using two digits (rather than four) to identify and process a year in a date field. Computer programs, computer-controlled systems and equipment with embedded software may recognize date fields using "00" as the year 1900 rather than the year 2000. If uncorrected, miscalculations and possible computer-based system failures could result which might disrupt business operations. We are designating the following information as our "Year 2000 Readiness Disclosure."
Recognizing the potential business consequences of the Y2K issue, we conducted a detailed assessment of our critical, date sensitive, computer-based systems to identify those systems that were not Y2K compliant and developed a program to modify those systems that were not otherwise scheduled for replacement prior to the year 2000. Our Y2K compliance efforts focused on our ability to continue to perform three critical operating functions: (1) obtain products to sell; (2) provide service to our customers; and (3) bill customers and pay our vendors and employees.
Those systems that we assessed included (1) our information technology ("IT") systems such as computer hardware and software we use in the operation of our business and (2) our non-IT systems that contain embedded systems with potentially date-sensitive components such as micro-controllers contained in various equipment and facilities. Among these systems are our customer information and data systems and our financial systems including payroll and our propane fuel accounting, supply and transportation system. In order to identify and modify those systems that we determined were not Y2K compliant, we used internal resources as well as outside consultants and vendor representatives. In addition to assessing, identifying and
modifying our own systems, we developed and implemented a program to attempt to determine the Y2K compliance status of third parties, including our key suppliers and vendors, and certain of our customers. The Partnership has successfully modified or replaced all of our critical IT and non-IT systems that were not Y2K compliant.
As previously mentioned, in addition to assuring our IT and non-IT systems are Y2K compliant, we developed and implemented a program to assess the readiness of our key suppliers and third-party providers. Although none of our products or services are of themselves date sensitive, as a company with operations throughout the United States, we are dependent upon other companies whose IT and non-IT systems may not be Y2K compliant. We rely on these companies for the supply and transportation of propane. Additionally, we depend on other companies to supply us with propane tanks and cylinders, fuel for our vehicles, as well as other products and services we need to operate our businesses. We have completed our program to contact and inquire of the readiness of these key suppliers and vendors. We have evaluated the responses received from our critical vendors and suppliers, and to the extent we were not satisfied with the responses, or have determined that the responses indicate a lack of Y2K readiness, we have developed contingency plans. The major elements of these contingency plans are based upon the use of manual back-up systems, alternative supply sources, higher critical inventory levels, and additional staffing. These contingency plans attempt to mitigate the potential impact of Y2K noncompliance by our key suppliers and vendors. However, these plans cannot assure that business disruptions that may be caused by key suppliers or third-party providers will not have a material adverse impact on our operations. The Partnership has completed its business contingency plans.
In addition, there are other Y2K risks which are beyond our control, any of which could have a material adverse impact on our operations. Such risks include, but are not limited to, the failure of utility and telecommunications companies to provide service and the failure of financial institutions to process transactions.
Expenses associated with our Y2K efforts during the last three fiscal years totaled approximately $2 million.
IMPACT OF INFLATION
Inflation affects the prices the Partnership pays for operating and administrative services and, to some extent, propane gas. Competitive pressures in propane markets may limit the Partnership's ability to recover fully propane product cost increases. The Partnership attempts to limit the effects of inflation on its results of operations through cost control efforts and productivity improvements.
MARKET RISK DISCLOSURES
Our primary market risk exposures are market prices for propane and changes in interest rates.
Price risk associated with fluctuations in the prices we pay for propane is principally a result of market forces reflecting changes in supply and demand. The Partnership's profitability is sensitive to changes in propane supply costs, and the Partnership generally seeks to pass on increases in such costs to customers. There is no assurance, however, that the Partnership will be able to do so. In order to manage a portion of our propane market price risk, we use contracts for the forward purchase of propane, propane fixed-price supply agreements, and derivative commodity instruments such as price swap and option contracts. Although we use derivative financial and commodity instruments to reduce market price risk associated with forecasted transactions, we do not use derivative financial and commodity instruments for trading purposes.
We have market risk exposure from changes in interest rates on borrowings under the Operating Partnership's Bank Credit Agreement. This agreement has interest rates on borrowings that are indexed to short-term market interest rates. At September 30, 1999 and 1998, borrowings outstanding under this facility totaled $45 million and $70 million, respectively. Based upon average borrowings under these agreements during Fiscal 1999 and Fiscal 1998, an increase in interest rates of 100 basis points (1%) would have increased interest expense by $0.6 million and $0.5 million, respectively. We also use long-term debt as a source of capital. This debt is typically issued at fixed rates of interest based upon market rates for debt having similar terms and credit ratings. As those long-term debt issues mature, we may refinance such debt with new debt having interest rates reflecting then-current market conditions. This debt may have an interest rate that is more or less than the refinanced debt. On occasion, we enter into interest rate protection agreements to reduce interest rate risk associated with a forecasted issuance of debt.
The following table summarizes the fair value of our market risk sensitive instruments at September 30, 1999 and 1998. It also includes the change in fair value that would result if there were an adverse change in (1) the market price of propane of 10 cents a gallon and (2) interest rates on ten-year U.S. treasury notes of 100 basis points:
We expect that any losses from market risk sensitive instruments used to manage propane price or interest rate market risk would be substantially offset by gains on the associated underlying transactions.
ACCOUNTING PRINCIPLES NOT YET ADOPTED
In March 1998, the American Institute of Certified Public Accountants issued Statement of Position No. 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" ("SOP 98-1"). SOP 98-1 requires companies to capitalize the cost of computer software developed or obtained for internal use once certain criteria have been met. We will adopt SOP 98-1 in fiscal 2000. We do not expect the adoption of SOP 98-1 will have a material effect on our financial position or results of operations.
In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). SFAS 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that an entity recognize all derivative instruments as either assets or liabilities and measure them at fair value. The accounting for changes in fair value depends upon the purpose of the derivative instrument and whether it is designated and qualifies for hedge accounting. To the extent derivative instruments qualify and are designated as hedges of forecasted transactions, changes in fair value will generally be reported as a component of other comprehensive income and be reclassified into net income when the forecasted transaction affects earnings. To the extent such derivative instrument qualifies as a hedge of a firm commitment, any gain or loss would generally be recognized in earnings when the firm commitment affects earnings. In June 1999, the FASB deferred the effective date of SFAS 133 to fiscal years beginning after June 15, 2000. Accordingly, we will adopt SFAS 133 in fiscal 2001. The impact of SFAS 133 will depend upon the extent to which we use derivative instruments and their designation and effectiveness as hedges of market risk.
FORWARD-LOOKING STATEMENTS
Information contained above in this Management's Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this Report on Form 10-K with respect to expected financial results and future events is forward-looking, based on our estimates and assumptions and subject to risk and uncertainties. For those statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.
The following important factors could affect our future results and could cause those results to differ materially from those expressed in our forward-looking statements: (1) adverse weather conditions resulting in reduced demand, (2) price volatility and availability of propane, and the capacity to transport to market areas, (3) changes in laws and regulations, including safety, tax and accounting matters, (4) competitive pressures from the same and alternative energy sources, (5) liability for environmental claims, (6) improvements in energy efficiency and technology resulting in reduced demand, (7) labor relations, (8) inability to make business acquisitions on economically acceptable terms, (9) operating hazards and risks incidental to transporting, storing and distributing propane, butane and ammonia including the risk of explosions and fires resulting in personal injury and property damage, (10) regional economic conditions, (11) the success of
the Partnership and its suppliers in achieving Year 2000 compliance, and (12) interest rate fluctuations and other capital market conditions.
These factors are not necessarily all of the important factors that could cause actual results to differ materially from those expressed in any of our forward-looking statements. Other unknown or unpredictable factors could also have material adverse effects on future results. We undertake no obligation to update publicly any forward-looking statement whether as a result of new information or future events.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
"Quantitative and Qualitative Disclosures About Market Risk" are contained in Management's Discussion and Analysis of Financial Condition and Results of Operations under the caption "Market Risk Disclosures" and are incorporated here by reference.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and financial statement schedules referred to in the index contained on pages and of this report are incorporated herein by reference.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III: MANAGEMENT AND SECURITY HOLDERS
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE GENERAL PARTNER
We do not directly employ any persons responsible for managing or operating the Partnership. The General Partner and UGI provide such services and are reimbursed for direct and indirect costs and expenses including all compensation and benefit costs. See "Certain Relationships and Related Transactions" and Note 10 to the Partnership's Consolidated Financial Statements.
The Board of Directors of the General Partner established a committee (the "Audit Committee") consisting of two individuals, currently, Messrs. Van Dyck and Vincent, who are neither officers nor employees of the General Partner or any affiliate of the General Partner. The Audit Committee has the authority to review, at the request of the General Partner, specific matters as to which the General Partner believes there may be a conflict of interest, in order to determine if the resolution of such conflict is fair and reasonable to the Partnership. In addition, the Audit Committee has the authority and responsibility for selecting the Partnership's independent public accountants, reviewing the Partnership's annual audit, and resolving accounting policy questions.
DIRECTORS AND EXECUTIVE OFFICERS OF THE GENERAL PARTNER
The following table sets forth certain information with respect to the directors and executive officers of the General Partner. Directors are elected annually by AmeriGas, Inc. as the sole shareholder of the General Partner. AmeriGas, Inc. is a wholly owned subsidiary of UGI. Executive officers are elected for one-year terms. There are no family relationships between any of the directors or any of the executive officers or between any of the executive officers and any of the directors.
Mr. Greenberg is a director (since 1994) and Chairman, President and Chief Executive Officer (since 1996) of the General Partner. He is also a director (since 1994) and Chairman (since 1996), Chief Executive Officer (since 1995), and President (since 1994) of UGI, having been Senior Vice President - Legal and Corporate Development of UGI (1989 to 1994). Mr. Greenberg previously served as Vice President and General Counsel of AmeriGas, Inc. (1984 to 1994). He also serves as a director of UGI Utilities, Inc. and Mellon PSFS Advisory Board.
Mr. Donovan was elected a director of the General Partner on April 25, 1995. He retired as Vice Chairman of Mellon Bank on January 31, 1997, a position held since 1988. He continues to serve as an advisory board member to Mellon Bank Corp. He also serves as a director of UGI Corporation, UGI Utilities, Inc., Nuclear Electric Insurance Co. and Merrill Lynch International Bank, Ltd.
Mr. Gozon was elected a director of the General Partner on February 24, 1998. He is Executive Vice President of Weyerhaeuser Company (an integrated forest products company), a position he has held since 1994. Mr. Gozon was formerly Director (1984 to 1993), President and Chief Operating Officer of Alco Standard Corporation (a provider of paper and office products) (1988 to 1993); Executive Vice President and Chief Operating Officer (1987); Vice President (1982 to 1988); and President (1979 to 1987) of Paper Corporation of America. He also serves as a director of UGI Corporation, UGI Utilities, Inc., AmeriSource Health Corporation, and Triumph Group, Inc.
Mr. Stratton was elected a director of the General Partner on April 25, 1995. He is President and Chief Executive Officer of Stratton Management Company (investment advisory and financial consulting firm) since 1972, and Chairman and Chief Executive Officer of EFI (financial services firm). Mr. Stratton is a director of UGI Corporation, UGI Utilities, Inc., Stratton Growth Fund, Stratton Monthly Dividend Shares, Inc., Stratton Small-Cap Yield Fund, and Teleflex, Inc.
Mr. Van Dyck was elected a director of the General Partner on June 15, 1995. He is Chairman of the Board and Chief Executive Officer of Maritrans Inc. (since 1987), the nations largest independent marine transporter of petroleum. He also serves as Chairman of the Board of West of England Mutual Insurance Association, and as a director of Mellon PSFS Advisory Board.
Mr. Vincent was elected a director of the General Partner on January 8, 1998. He is President of Springwell Corporation, a corporate finance advisory firm (since 1989). Mr. Vincent served in various capacities at Bankers Trust Company (1971 to 1989), including managing director (1984 to 1989). He is also a director of Tatham Offshore, Inc.
Mr. Wang was elected a director of the General Partner on April 25, 1995. Mr. Wang is retired, having formerly served as Executive Vice President - Timber and Specialty Products and a director of International Paper Company (1987 to 1991). He is also a director of UGI Corporation, UGI Utilities, Inc., BE&K Inc., Emsource Inc., and Forest Resources LLC.
Ms. Lindsay was elected Vice President - Finance and Chief Financial Officer of the General Partner on January 5, 1998. She previously served as Vice President and Treasurer (1994
to 1997) and as Treasurer (1994) of Tambrands Inc., a manufacturer of personal products. Prior to 1994, Ms. Lindsay held the positions of Director of Business Development (1987 to 1989) and Assistant Treasurer (1990 to 1993) at Tambrands Inc.
Mr. Bovaird is Vice President and General Counsel of the General Partner (since 1995). He is also Vice President and General Counsel of UGI Corporation, UGI Utilities, Inc. and AmeriGas, Inc. (since 1995). Mr. Bovaird previously served as Division Counsel and Member of the Executive and Operations Committees of Wyeth-Ayerst International Inc. (1992 to 1995) and Senior Vice President, General Counsel and Secretary of Orion Pictures Corporation (1990 to 1991).
Mr. Bissell is Senior Vice President - Sales and Marketing of the General Partner (since October 1999), having served as Vice President - Sales and Operations (1995 to 1999). Previously, he was Vice President - Distributors and Fabrication, BOC Gases (1995), having been Vice President - National Sales (1993 to 1995) and Regional Vice President Southern Region for Distributor and Cylinder Gases Division, BOC Gases (1989 to 1993).
Mr. Eynon was elected Controller and Chief Accounting Officer of the General Partner on January 5, 1998. Prior to his election, Mr. Eynon was Controller of the General Partner (March 1997 to January 1998) and Assistant Controller of UGI Corporation (1985 to 1997). Previously, he was a Senior Manager with Price Waterhouse.
Mr. Grady is Senior Vice President - Operations of the General Partner (since October 1999), having served as Vice President - Sales and Operations (1995 to 1999). Previously, he was Vice President - Corporate Development of UGI (1994 to 1995), and Director, Corporate Development (1990 to 1994). Mr. Grady was Director, Corporate Development Services of Campbell Soup Company (1985 to 1990).
Mr. Katz is Vice President - Human Resources of the General Partner (since December 1999), having served as Vice President - Corporate Development (1996 to 1999). Previously, he was Vice President - Corporate Development of UGI (1995 to 1996). Prior to joining UGI, Mr. Katz was Director of Corporate Development with Campbell Soup Company for over five years. He also practiced law for approximately 10 years, first with the firm of Jones, Day Reavis & Pogue, and later in the Legal Department at Campbell Soup Company.
Mr. Knauss is Vice President - Law and Associate General Counsel of the General Partner (since 1996), having served as Corporate Secretary (since 1994) and Group Counsel - Propane (1989 to 1996) of UGI. He joined UGI as Associate Counsel in 1985. Before joining UGI, Mr. Knauss was an associate at the firm of Ballard, Spahr, Andrews & Ingersoll in Philadelphia.
Mr. Regan is Vice President-Purchasing and Transportation of the General Partner (since May 1996). Prior to joining the General Partner, Mr. Regan was President of the Chemical Division of DSI Transports, Inc. (1995 to 1996). Previously, he served Conoco, Inc. for approximately 20 years, most recently as General Manager Business Support, Downstream-North America.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The following table shows cash and other compensation paid or accrued to the General Partner's Chief Executive Officer and each of its four other most highly compensated executive officers, (collectively, the "Named Executives") for the last three fiscal years.
SUMMARY COMPENSATION TABLE
(1) Messrs. Greenberg and Bovaird participate in the UGI Annual Bonus Plan. All other Named Executives participate in the AmeriGas Propane, Inc. Annual Bonus Plan. Awards under both Plans are for the year reported, regardless of the year paid. Awards under both Plans are based on the achievement of pre-determined business and/or financial performance objectives which support business plans and goals. Bonus opportunities vary by position and currently range from 0% to 148% of base salary for Mr. Greenberg, 0% to 91% of base salary for Mr. Bovaird 0% to 65% for Mr. Knauss, and 0% to 83% for Messrs. Bissell and Grady.
(2) Amounts represent tax payment reimbursements for certain benefits, except for Mr. Bissell. In 1997, Mr. Bissell received a tax payment reimbursement of $7,563, reimbursement of relocation expenses in the amount of $39,765, and other perquisites available to executive officers generally.
(3) (a) On June 4, 1999, the Board of Directors of UGI Corporation approved restricted UGI Common Stock awards to certain executives of UGI and AmeriGas Propane, Inc. The dollar values shown above represent the aggregate value of each award on the date of grant, determined by multiplying the number of shares awarded by the
closing stock price of UGI Common Stock on the New York Stock Exchange on June 4, 1999. Holders of restricted shares have the right to vote and to receive dividends during the restriction period.
(b) Based on the closing price of UGI Common Stock on the New York Stock Exchange on September 30, 1999, Mr. Greenberg's 30,000 share grant had a market value of $697,000; and the 7,000 share grant held by each of Messrs. Bissell, Bovaird and Grady had a market value $162,750.
(4) The amounts represent contributions by the General Partner or UGI in accordance with the provisions of the AmeriGas Propane, Inc. Employee Savings Plan (the "AmeriGas Employee Savings Plan"), the UGI Utilities, Inc. Employee Savings Plan (the "UGI Employee Savings Plan"), allocations under the UGI Corporation Senior Executive Retirement Plan (the "UGI Executive Retirement Plan"), and/or allocations under the AmeriGas Propane, Inc. Supplemental Executive Retirement Plan (the "AmeriGas Executive Retirement Plan"). During fiscal years 1999, 1998 and 1997, the following contributions were made to the Named Executives: (i) under the AmeriGas Employee Savings Plan: Mr. Bissell, $5,000, $5,148 and $4,902; Mr. Grady, $9,648, $6,394 and $7,048; and Mr. Knauss, $8,040, $5,691 and $7,098; (ii) under the UGI Employee Savings Plan: Mr. Greenberg, $3,600, $3,600 and $3,375; and Mr. Bovaird, $3,509, $3,600 and $3,375; (iii) under the UGI Executive Retirement Plan: Mr. Greenberg, $14,673, $18,554 and $10,858; and Mr. Bovaird, $1,706, $1,852 and $821; (iv) under the AmeriGas Executive Retirement Plan: Mr. Bissell, $16,900, $14,027 and $16,974; Mr. Grady, $16,629, $13,837 and $16,496; and Mr. Knauss, $15,742, $12,024 and $11,077.
(5) Compensation reported for Messrs. Greenberg and Bovaird is attributable to their respective positions of Chairman, President and Chief Executive Officer, and Vice President and General Counsel of UGI Corporation. Compensation for these individuals is also reported in the UGI Proxy Statement for the 1999 Annual Meeting of Shareholders and is not additive. The General Partner does not compensate Mr. Greenberg or Mr. Bovaird.
(6) (a) Non-qualified UGI stock options granted under the UGI Corporation 1997 Stock Option and Dividend Equivalent Plan ("1997 Plan"), without the opportunity to earn dividend equivalents described below.
(b) Non-qualified UGI stock options granted under the 1997 Plan with the opportunity to earn an amount equivalent to the dividends paid on shares covered by options, subject to a comparison of the total return realizable on a share of UGI Common Stock (the "UGI Return") with the total return achieved by each member of a group of comparable peer companies (the "SODEP Peer Group") over a three-year period beginning January 1, 1997 and ending December 31, 1999. Total return encompasses both changes in the per share market price and dividends paid on a share of UGI Common Stock.
(7) Payout under the performance-based AmeriGas Propane, Inc. Long-Term Incentive Plan ("LTIP"). The performance contingency was satisfied May 18, 1999 when fifty percent of the Partnership's Subordinated Units converted to Common Units in accordance with the Partnership Agreement, based on Partnership financial and operating performance. The awards were made partially in Common Units (approximately 60%) and partially in cash (approximately 40%). Messrs. Bissell and Grady each received 11,250 Common Units; Mr. Knauss received 7,875 Common Units.
OPTION GRANTS IN LAST FISCAL YEAR
The following table shows information on grants of options for the purchase of UGI Common Stock during fiscal year 1999 to each of the Named Executives.
UGI STOCK OPTION GRANTS IN LAST FISCAL YEAR
(1) Non-qualified UGI stock options granted on June 4, 1999 under the 1997 Plan. This grant does not include the opportunity to earn an amount equivalent to the dividends paid during the performance period on shares covered by options. The option exercise price is not less than 100% of the fair market value of UGI's Common Stock determined on the date of the grant. These options will vest at the rate of 25% per year on the anniversary of the grant date. Options granted under the Plan are nontransferable and are generally exercisable only while the optionee is employed by the Company or an affiliate. Options are subject to adjustment in the event of recapitalizations, stock splits, mergers, and other similar corporate transactions affecting UGI's Common Stock.
(2) A total of 231,806 UGI stock options were granted to employees and executive officers of UGI and its subsidiaries during fiscal year 1999 under the 1997 Plan and the 1992 Non-Qualified Stock Option Plan. Under the 1992 Non-Qualified Stock Option Plan, the option exercise price is not less than 100% of the fair market value of UGI's Common Stock on the date of grant. Generally, options granted on and after December 10, 1996 are fully vested on the date of grant. Options under the 1992 Plan are nontransferable and generally exercisable only while the optionee is employed by the Company or an affiliate. Options are subject to adjustment in the event of recapitalizations, stock splits, mergers, and other similar corporate transactions affecting UGI's Common Stock.
(3) Based on the Black-Scholes options pricing model. The assumptions used in calculating the grant date present value are as follows:
- Three years of closing monthly stock price observations were used to calculate the stock volatility and dividend yield assumptions
- Stock volatility - 22.39%
- Stock's dividend yield - 6.18%
- Length of option term - 10 years
- Annualized risk-free interest rate - 6.14%
- Discount of risk of forfeiture - 3% per year
All options were granted at fair market value. The actual value, if any, the executive may realize will depend on the excess of the stock price on the date the option is exercised over the exercise price. There is no assurance that the value realized by the executive will be at or near the value estimated by the Black-Scholes model.
UGI STOCK OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION VALUES
(1) Options granted under the 1992 Stock Option and Dividend Equivalent Plan.
(2) Value based on comparison of price per share at September 30, 1999 (fair market value $23.25) to option exercise price ($20.125) under the 1992 Stock Option and Dividend Equivalent Plan.
(3) Options granted under the 1997 Stock Option and Dividend Equivalent Plan.
(4) Value based on comparison of price per share at September 30, 1999 (fair market value $23.25) to option exercise price ($22.625) under the 1997 Stock Option and Dividend Equivalent Plan.
(5) Value based on comparison of price per share at September 30, 1999 (fair market value $23.25) to option exercise price ($20.375) under the 1997 Stock Option and Dividend Equivalent Plan
(6) Options granted under the 1992 Non-Qualified Stock Option Plan.
(7) Value based on comparison of price per share at September 30, 1999 (fair market value $23.25) to option exercise price ($20.625) under the 1992 Non-Qualified Stock Option Plan.
(8) Value based on comparison of price per share at September 30, 1999 (fair market value $23.25) to option exercise price ($20.125) under the terms of the 1992 Non-Qualified Stock Option Plan.
RETIREMENT BENEFITS
The following table shows the annual benefits payable upon retirement to Messrs. Greenberg and Bovaird under the Retirement Income Plan for Employees of UGI Utilities, Inc. and participating employers (the "UGI Retirement Plan") and the UGI Supplemental Executive Retirement Plan. The amounts shown assume the executive retires in 1999 at age 65, and that the aggregate benefits are not subject to statutory maximums.
PENSION PLAN BENEFITS TABLE
(1) Annual benefits are computed on the basis of straight life annuity amounts. These amounts include pension benefits, if any, to which a participant may be entitled as a result of participation in a pension plan of a UGI subsidiary during previous periods of employment. The amounts shown do not take into account exclusion of up to 35% of the estimated primary Social Security benefit. The UGI Retirement Plan provides a minimum benefit equal to 25% of a participant's final 12 months' earnings, reduced proportionately for less than 15 years of credited service at retirement. The minimum UGI Retirement Plan Benefit is not subject to Social Security offset. Messrs. Greenberg and Bovaird had 19 and 4 years of estimated credited service, respectively, at September 30, 1999. Mr. Grady previously accumulated more than 4 years of credited service in the UGI Retirement Plan before joining the General Partner in 1995. Mr. Knauss previously accumulated more than 11 years of credited service in the UGI Retirement Plan before joining the General Partner in 1996. Mr. Bissell previously accumulated more than 5 years of credited service with UGI and its subsidiaries before joining the General Partner in 1995.
(2) Consists of (i) base salary, commissions and cash payments under the UGI Annual Bonus Plan, and (ii) deferrals thereof permitted under the Internal Revenue Code.
(3) The maximum benefit under the UGI Retirement Plan and the UGI Supplemental Executive Retirement Plan is equal to 60% of a participant's highest consecutive 12 months' earnings during the last 120 months.
SEVERANCE PAY PLAN FOR SENIOR EXECUTIVE EMPLOYEES
Named Executives Employed by UGI Corporation. The UGI Corporation Senior Executive Employee Severance Pay Plan (the "UGI Severance Plan") assists certain senior level employees of UGI, including Messrs. Greenberg and Bovaird, in the event their employment is terminated without fault on their part. Benefits are payable to a senior executive covered by the UGI Severance Plan if the senior executive's employment is involuntarily terminated for any reason other than for cause or as a result of the senior executive's death or disability.
The UGI Severance Plan provides for cash payments equal to a participant's compensation for a period of time ranging from 3 months to 15 months (30 months in the case of Mr. Greenberg), depending on length of service. In addition, a participant receives the cash equivalent of his or her target bonus under the Annual Bonus Plan, pro-rated for the number of months served in the fiscal year. However, if the termination occurs in the last two months of the fiscal year, the Chief Executive Officer has the discretion to determine whether the participant will receive a pro-rated target bonus, or the actual annual bonus which would have been paid after the end of the fiscal year, assuming that the participant's entire bonus was contingent on meeting the applicable financial performance goal. The Plan also provides for separation pay equal to one day's pay per month of service, not to exceed 12 months' compensation. Certain employee benefits are continued under the Plan for a period of up to 15 months (30 months in the case of Mr. Greenberg). UGI has the option to pay a participant the cash equivalent of those employee benefits.
In order to receive benefits under the UGI Severance Plan, a senior executive is required to execute a release which discharges UGI and its subsidiaries from liability for any claims the senior executive may have against any of them, other than claims for amounts or benefits due to the executive under any plan, program or contract provided by or entered into with UGI or its subsidiaries. The senior executive is also required to cooperate in attending to matters pending at the time of his or her termination of employment.
Named Executives Employed by AmeriGas Propane. The AmeriGas Propane, Inc. Executive Employee Severance Pay Plan (the "AmeriGas Severance Plan") assists certain senior level employees of the General Partner including Messrs. Bissell, Grady and Knauss in the event their employment is terminated without fault on their part. Specified benefits are payable to a senior executive covered by the AmeriGas Severance Plan if the senior executive's employment is involuntarily terminated for any reason other than for cause or as a result of the senior executive's death or disability.
The AmeriGas Severance Plan provides for cash payments equal to a participant's compensation for three months (6 months in the case of the Chief Executive Officer). In addition, a participant receives the cash equivalent of his or her target bonus under the Annual Bonus Plan, pro-rated for the number of months served in the fiscal year. However, if the termination occurs in the last two months of the fiscal year, the Chief Executive Officer has the discretion to determine whether the participant will receive a pro-rated target bonus, or the actual annual bonus which would have been paid after the end of the fiscal year, assuming that the participant's entire bonus was contingent on meeting the applicable financial performance goal. The Plan also provides for separation pay equal to one day's pay per month of service, not to exceed 12 months' compensation.
Minimum separation pay ranges from six to twelve months' base salary, depending on the executive's employment grade. Certain employee benefits are continued under the Plan for a period not exceeding 15 months (30 months in the case of the Chief Executive Officer). This period is called the "Employee Benefit Period." The General Partner has the option to pay a participant the cash equivalent of those employee benefits.
In order to receive benefits under the AmeriGas Severance Plan, a senior executive is required to execute a release which discharges the General Partner and its affiliates from liability for any claims the senior executive may have against any of them, other than claims for amounts or benefits due to the executive under any plan, program or contract provided by or entered into with the General Partner or its affiliates. The senior executive is also required to cooperate in attending to matters pending at the time of his or her termination of employment.
CHANGE OF CONTROL ARRANGEMENTS
Named Executives Employed By UGI Corporation. Messrs. Greenberg and Bovaird each have an agreement with UGI Corporation (the "Agreement") which provides certain benefits in the event of a change of control. The Agreements operate independently of the UGI Severance Plan, continue through July 2004, and are automatically extended in one-year increments thereafter unless, prior to a change of control, UGI terminates an Agreement. In the absence of a change of control, each Agreement will terminate when, for any reason, the executive terminates his employment with UGI or its subsidiaries.
A change of control is generally deemed to occur if: (i) any person (other than the executive, his affiliates and associates, UGI or any of its subsidiaries, any employee benefit plan of UGI or any of its subsidiaries, or any person or entity organized, appointed, or established by UGI or its subsidiaries for or pursuant to the terms of any such employee benefit plan), together with all affiliates and associates of such person, acquires securities representing 20% or more of either (x) the then outstanding shares of common stock of UGI or (y) the combined voting power of UGI's then outstanding voting securities; (ii) individuals who at the beginning of any 24-month period constitute the Board of Directors (the "Incumbent Board") and any new director whose election by the Board, or nomination for election by UGI's shareholders, was approved by a vote of at least a majority of the Incumbent Board, cease for any reason to constitute a majority thereof; (iii) UGI is reorganized, merged or consolidated with or into, or sells all or substantially all of its assets to, another corporation in a transaction in which former shareholders of UGI do not own more than 50% of the outstanding common stock and the combined voting power, respectively, of the then outstanding voting securities of the surviving or acquiring corporation after the transaction; or (iv) UGI is liquidated or dissolved.
Upon a change of control, the Agreement provides for an immediate cash payment equal to the market value of any pending target award under UGI's long-term compensation plan.
Severance benefits are payable under the Agreements if there is a termination of the executive's employment without cause at any time within three years after a change of control. In addition, following a change of control, the executive may elect to terminate his or her
employment without loss of severance benefits in certain specified contingencies, including termination of officer status; a significant adverse change in authority, duties, responsibilities or compensation; the failure of UGI to comply with and satisfy any of the terms of the Agreement; or a substantial relocation or excessive travel requirements.
An executive who is terminated with rights to severance compensation under an Agreement will be entitled to receive an amount equal to 1.0 or 1.5 (2.5 in the case of Mr. Greenberg) times his average total cash remuneration for the preceding five calendar years. If the severance compensation payable under the Agreement, either alone or together with other payments to an executive, would constitute "excess parachute payments," as defined in Section 280G of the Internal Revenue Code of 1986, as amended (the "Code"), the executive will also receive an amount to satisfy the executive's additional tax burden.
Named Executives Employed by the General Partner. Messrs. Bissell, Grady and Knauss each have an agreement with the General Partner (the "Agreement") which provides certain benefits in the event of a change of control. The Agreements operate independently of the AmeriGas Severance Plan, continue through July 2004, and are automatically extended in one-year increments thereafter unless, prior to a change of control, the General Partner terminates an Agreement. In the absence of a change of control, each Agreement will terminate when, for any reason, the executive terminates his employment with the General Partner or any of its subsidiaries.
A change of control is generally deemed to occur if : (i) a change of control of UGI, as defined above, occurs, (ii) the General Partner, AmeriGas Partners or the Operating Partnership is reorganized, merged or consolidated with or into, or sells all or substantially all of its assets to, another corporation or partnership in a transaction in which the former shareholders of the General Partner, or former limited partners, as the case may be, do not own more than 50% of the outstanding common stock and combined voting power, or the outstanding common units of such partnership, after the transaction, (iii) the General Partner, AmeriGas Partners or the Operating Partnership is liquidated or dissolved, (iv) UGI and its subsidiaries fail to own more than fifty percent of the general partnership interests of AmeriGas Partners or the Operating Partnership, (v) UGI and its subsidiaries fail to own more than fifty percent of the combined voting power of the General Partner's then outstanding voting securities, or (vi) AmeriGas Propane, Inc. is removed as the general partner of AmeriGas Partners by vote of the limited partners, or AmeriGas Propane, Inc. is removed as the general partner of AmeriGas Partners or the Operating Partnership as a result of judicial or administrative proceedings.
Upon a change of control, the Agreement provides for an immediate cash payment equal to the market value of any pending target award under the General Partner's long-term compensation plan.
Severance benefits are payable under the Agreements if there is a termination of the executive's employment without cause at any time within three years after a change of control. In addition, following a change of control, the executive may elect to terminate his or her employment without loss of severance benefits in certain specified contingencies, including termination of officer status; a significant adverse change in authority, duties, responsibilities or
compensation; the failure of the General Partner to comply with and satisfy any of the terms of the Agreement; or a substantial relocation or excessive travel requirements.
An executive who is terminated with rights to severance compensation under an Agreement will be entitled to receive an amount equal to 1.0 times his average total cash remuneration for the preceding five calendar years. If the severance compensation payable under the Agreement, either alone or together with other payments to an executive, would constitute "excess parachute payments," as defined in Section 280G of the Code, the executive will also receive an amount to satisfy the executive's additional tax burden.
BOARD OF DIRECTORS
Officers of the General Partner receive no additional compensation for service on the Board of Directors or on any Committee of the Board. The General Partner pays an annual retainer of $22,000 to all other directors and an attendance fee of $1,000 for each Board meeting. For service on Committees, the General Partner pays an annual retainer of $2,000 to each Committee Chairman and an attendance fee of $1,000 for each Committee meeting attended. The General Partner reimburses directors for expenses incurred by them (such as travel expenses) in serving on the Board and Committees. The General Partner determines all expenses allocable to the Partnership, including expenses allocable to the services of directors.
COMPENSATION/PENSION COMMITTEE
The members of the General Partner's Compensation/Pension Committee are Richard C. Gozon (Chairman), Thomas F. Donovan and David I. J. Wang.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
OWNERSHIP OF LIMITED PARTNERSHIP UNITS BY CERTAIN BENEFICIAL OWNERS
The following table sets forth certain information regarding each person known by the Partnership to have been the beneficial owner of more than 5% of the Partnership's voting securities representing limited partner interests as of December 1, 1999. AmeriGas Propane, Inc. is the sole general partner of the Partnership.
(1) The address of each of UGI, AmeriGas, Inc., AmeriGas Propane, Inc. and Petrolane Incorporated is 460 North Gulph Road, King of Prussia, PA 19406.
(2) Based on the number of units held by its indirect, wholly owned subsidiaries, Petrolane Incorporated ("Petrolane") and AmeriGas Propane, Inc.
(3) Based on the number of units held by its direct and indirect, wholly-owned subsidiaries, AmeriGas Propane, Inc. and Petrolane.
(4) AmeriGas Propane, Inc's ownership includes 6,444,021 Common Units for which it has sole voting and investment power, and 7,839,911 Common Units held by its subsidiary, Petrolane.
(5) Petrolane has sole voting and investment power.
(6) Based on the number of units held by its indirect, wholly-owned subsidiary, AmeriGas Propane, Inc.
(7) Based on the number of units held by its wholly-owned subsidiary, AmeriGas Propane, Inc.
(8) AmeriGas Propane, Inc. has sole voting and investment power.
OWNERSHIP OF PARTNERSHIP COMMON UNITS BY THE DIRECTORS AND EXECUTIVE OFFICERS OF THE GENERAL PARTNER
The table below sets forth as of October 31, 1999 the beneficial ownership of Partnership Common Units by each director and each of the Named Executives currently serving the General Partner, as well as by the directors and all of the executive officers of the General Partner as a group. No director, Named Executive or executive officer beneficially owns (i) any Subordinated Units, or (ii) more than 1% of the Partnership's Common Units. The total number of Common Units beneficially owned by the directors and executive officers of the General Partner as a group represents less than 1% of the Partnership's outstanding Common Units.
(1) Sole voting and investment power unless otherwise specified.
(2) Units shown are held by Mr. Greenberg's adult children.
(3) Mr. Bissell's Units are held jointly with his spouse.
(4) Mr. Bovaird's Units are held jointly with his spouse.
The General Partner is a wholly owned subsidiary of AmeriGas, Inc. which is a wholly owned subsidiary of UGI. The table below sets forth, as of October 31, 1999, the beneficial ownership of UGI Common Stock by each director and each of the Named Executives, as well as by the directors and the executive officers of the General Partner as a group. Including the number of shares of stock underlying exercisable options, Mr. Greenberg is the beneficial owner of approximately 1.5% of UGI's Common Stock. All other directors, Named Executives and executive officers own less than 1% of UGI's outstanding shares. The total number of shares beneficially owned by the directors and executive officers as a group (including 385,466 shares subject to exercisable options), represents approximately 2.5% of UGI's outstanding shares.
(1) Sole voting and investment power unless otherwise specified.
(2) Included in the number of shares shown are Deferred Units ("Units") acquired through the UGI Corporation 1997 Directors' Equity Compensation Plan. Units are neither actual shares nor other securities, but each Unit will be converted to one share of UGI common stock and paid out to directors upon their retirement or termination of service. The number of Units included for the directors is as follows: Messrs. Donovan (1,298), Gozon (10,970), Stratton (9,478) and Wang (8,494).
(3) Mr. Greenberg holds 88,220 shares jointly with his spouse and 5,178 shares represented by units held in the UGI Stock Fund of the 401(k) Employee Savings Plan.
(4) Mr. Bissell holds these shares jointly with his spouse.
(5) Mr. Bovaird holds 12,993 shares jointly with his spouse and 3,061 shares represented by units held in the UGI Stock Fund of the 401(k) Employee Savings Plan.
(6) Mr. Grady's ownership includes 6,942 shares represented by units held in the UGI Stock Fund of the 401(k) Employee Savings Plan based on September 30, 1999 Savings Plan statements.
(7) Mr. Knauss's ownership includes 4,315 shares represented by units held in the UGI Stock Fund of the 401(k) Employee Savings Plan based on September 30, 1999 Savings Plan statements.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The General Partner employs persons responsible for managing and operating the Partnership. The Partnership reimburses the General Partner for the direct and indirect costs of providing these services, including all compensation and benefit costs.
The Operating Partnership has a revolving line of credit up to a maximum of $20 million from the General Partner available until September 15, 2002, the termination date of the Revolving Credit Facility. Any loans under this agreement will be unsecured and subordinated to all senior debt of the Operating Partnership. The commitment fees for this line of credit are computed on the same basis as the facility fees under the Revolving Credit Facility, and totaled $70,777 in fiscal year 1999. Interest rates are based on one-month offshore interbank borrowing rates. The interest rate for a recent Credit Facility borrowing from October 20, 1999 to November 22, 1999 was 6.0625%, representing a 5.4375% one-month Offshore Rate, plus an Applicable Margin of .625%. See Note 4 to the Partnership's Consolidated Financial Statements, which are filed as an exhibit to this report.
The Partnership and the General Partner also have extensive, ongoing relationships with UGI and its affiliates. UGI performs certain financial and administrative services for the General Partner on behalf of the Partnership. UGI does not receive a fee for such services, but is reimbursed for all direct and indirect expenses incurred in connection with providing these services, including all compensation and benefit costs. A wholly owned subsidiary of UGI provides the Partnership with general liability, automobile and workers' compensation insurance for up to $500,000 over the Partnership's self-insured retention. Another wholly owned subsidiary of UGI leases office space to the General Partner for its headquarters staff. In addition, a UGI master policy provides accidental death and business travel and accident insurance coverage for employees of the General Partner. The General Partner is billed directly by the insurer for this coverage. As discussed under "Business --Trade Names; Trade and Service Marks," UGI, Petrolane and the General Partner have licensed the trade names "AmeriGas," "America's Propane Company" and "Petrolane" and the related service marks and trademark to the Partnership on a royalty-free basis. Finally, the Partnership obtains management information services from the General Partner, and reimburses the General Partner for its direct and indirect expenses related to those services. The rental payments and insurance premiums charged to the Partnership by UGI and its affiliates are comparable to amounts charged by unaffiliated parties. In fiscal year 1999, the Partnership paid UGI and its affiliates $9,297,946 for the services and expense reimbursements referred to in this paragraph.
PART IV: ADDITIONAL EXHIBITS, SCHEDULES AND REPORTS
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) DOCUMENTS FILED AS PART OF THIS REPORT:
(1) and (2) FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES
The financial statements and financial statement schedules incorporated by reference or included in this report are listed in the accompanying Index to Financial Statements and Financial Statement Schedules set forth on pages and of this report, which is incorporated herein by reference.
(3) LIST OF EXHIBITS:
The exhibits filed as part of this report are as follows (exhibits incorporated by reference are set forth with the name of the registrant, the type of report and registration number or last date of the period for which it was filed, and the exhibit number in such filing):
INCORPORATION BY REFERENCE
INCORPORATION BY REFERENCE
INCORPORATION BY REFERENCE
INCORPORATION BY REFERENCE
INCORPORATION BY REFERENCE
* Filed herewith.
** As required by Item 14(a)(3), this exhibit is identified as a compensatory plan or arrangement.
(b) Reports on Form 8-K.
During the last quarter of the 1999 fiscal year, neither the Partnership nor AmeriGas Finance Corp. filed any Current Reports on Form 8-K.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
AMERIGAS PARTNERS, L.P.
Date: December 13, 1999 By: AmeriGas Propane, Inc. its General Partner
By: Martha B. Lindsay ---------------------------------- Martha B. Lindsay Vice President - Finance and Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below on December 13, 1999 by the following persons on behalf of the Registrant and in the capacities with AmeriGas Propane, Inc., General Partner, indicated.
SIGNATURE TITLE
Lon R. Greenberg President, Chairman and Chief - -------------------------------- Executive Officer Lon R. Greenberg (Principal Executive Officer) and Director
Martha B. Lindsay Vice President - Finance - -------------------------------- and Chief Financial Officer Martha B. Lindsay (Principal Financial Officer)
Richard R. Eynon Controller and - -------------------------------- Chief Accounting Officer Richard R. Eynon (Principal Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below on December 13, 1999 by the following persons on behalf of the Registrant and in the capacities with AmeriGas Propane, Inc., General Partner, indicated.
SIGNATURE TITLE --------- ----- Thomas F. Donovan Director - ----------------------------------- Thomas F. Donovan
Richard C. Gozon Director - ----------------------------------- Richard C. Gozon
James W. Stratton Director - ----------------------------------- James W. Stratton
Stephen A. Van Dyck Director - ----------------------------------- Stephen A. Van Dyck
Roger B. Vincent Director - ----------------------------------- Roger B. Vincent
David I. J. Wang Director - ----------------------------------- David I. J. Wang
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
AMERIGAS FINANCE CORP.
Date: December 13, 1999 By: Martha B. Lindsay ---------------------------- Martha B. Lindsay Vice President - Finance and Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below on December 13, 1999 by the following persons on behalf of the Registrant and in the capacities indicated.
SIGNATURE TITLE --------- -----
Eugene V.N. Bissell President (Principal Executive - ------------------------------ Officer) and Director Eugene V.N. Bissell
Martha B. Lindsay Vice President - Finance - ------------------------------ and Chief Financial Officer Martha B. Lindsay (Principal Financial Officer) and Director
Richard R. Eynon Controller and Chief Accounting Officer - ------------------------------ (Principal Accounting Officer) Richard R. Eynon
Brendan P. Bovaird Director - ------------------------------ Brendan P. Bovaird
AMERIGAS PARTNERS, L.P AMERIGAS FINANCE CORP.
FINANCIAL INFORMATION
FOR INCLUSION IN ANNUAL REPORT ON
FORM 10-K FOR THE FISCAL
YEAR ENDED SEPTEMBER 30, 1999
AMERIGAS PARTNERS, L.P. AND SUBSIDIARIES
INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES
The consolidated financial statements of AmeriGas Partners, L.P. and subsidiaries, together with the report thereon of Arthur Andersen LLP dated November 12, 1999, listed in the following index, are included in AmeriGas Partners' 1999 Annual Report to Unitholders and are incorporated herein by reference. With the exception of the pages listed in this index and information incorporated in Items 5 and 8, the 1999 Annual Report to Unitholders is not to be deemed filed as part of this Report.
AMERIGAS PARTNERS, L.P. AND SUBSIDIARIES
INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES (continued)
We have omitted all other financial statement schedules because the required information is either (1) not present; (2) not present in amounts sufficient to require submission of the schedule; or (3) the information required is included elsewhere in the financial statements or related notes.
AMERIGAS FINANCE CORP.
FINANCIAL STATEMENTS for the years ended September 30, 1999, 1998 and 1997
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To AmeriGas Finance Corp.:
We have audited the accompanying balance sheets of AmeriGas Finance Corp. (a Delaware corporation and a wholly owned subsidiary of AmeriGas Partners, L.P.) as of September 30, 1999 and 1998, and the related statements of stockholder's equity for each of the three years in the period ended September 30, 1999. These financial statements are the responsibility of the management of AmeriGas Propane, Inc. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the balance sheets and statements of stockholder's equity referred to above present fairly, in all material respects, the financial position of AmeriGas Finance Corp. as of September 30, 1999 and 1998, in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Chicago, Illinois November 12, 1999
AMERIGAS FINANCE CORP. (A WHOLLY OWNED SUBSIDIARY OF AMERIGAS PARTNERS, L.P.)
BALANCE SHEETS
The accompanying note is an integral part of these financial statements.
AMERIGAS FINANCE CORP. (A WHOLLY OWNED SUBSIDIARY OF AMERIGAS PARTNERS, L.P.)
STATEMENTS OF STOCKHOLDER'S EQUITY
The accompanying note is an integral part of these financial statements.
AMERIGAS FINANCE CORP. (A WHOLLY OWNED SUBSIDIARY OF AMERIGAS PARTNERS, L.P.)
NOTE TO FINANCIAL STATEMENTS
SEPTEMBER 30, 1999 AND 1998
AmeriGas Finance Corp. (AmeriGas Finance), a Delaware corporation, was formed on March 13, 1995 and is a wholly owned subsidiary of AmeriGas Partners, L.P. (AmeriGas Partners).
On April 19, 1995, AmeriGas Partners issued $100,000,000 face value of 10.125% Senior Notes due April 2007. AmeriGas Finance serves as a co-obligor of these notes.
AmeriGas Partners owns all 100 shares of AmeriGas Finance common stock outstanding.
AMERIGAS PARTNERS, L.P. AND SUBSIDIARIES SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY)
BALANCE SHEETS (Thousands of dollars)
S-1 AMERIGAS PARTNERS, L.P. AND SUBSIDIARIES SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY)
STATEMENTS OF OPERATIONS (Thousands of dollars)
S-2 AMERIGAS PARTNERS, L.P. AND SUBSIDIARIES SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY)
STATEMENTS OF CASH FLOWS (Thousands of dollars)
S-3 AMERIGAS PARTNERS, L.P. AND SUBSIDIARIES
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS (Thousands of dollars)
S-4 AMERIGAS PARTNERS, L.P. AND SUBSIDIARIES
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS (CONTINUED) (Thousands of dollars)
(1) Uncollectible accounts written off, net of recoveries. (2) Payments, net of any refunds (3) Other adjustments.
S-5 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Partners of AmeriGas Partners, L.P. and the Board of Directors of AmeriGas Propane, Inc.:
We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements included in the AmeriGas Partners, L.P. annual report to unitholders for the year ended September 30, 1999, incorporated by reference in this Form 10-K, and have issued our report thereon dated November 12, 1999. Our audits were made for the purpose of forming an opinion on those consolidated financial statements taken as a whole. The schedules listed in the index on page are the responsibility of the management of AmeriGas Propane, Inc. and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
ARTHUR ANDERSEN LLP
Chicago, Illinois November 12, 1999
S-6 EXHIBIT INDEX
EXHIBIT NO. DESCRIPTION - ----------- -----------
10.17 AmeriGas Propane, Inc. Annual Bonus Plan effective October 1,
10.31 Description of Change of Control arrangements for Messrs. Bissell, Grady and Knauss
13 Pages 9 through 23 of the AmeriGas Partners, L.P. 1999 Annual Report
27.1 Financial Data Schedule of AmeriGas Partners, L.P.
27.2 Financial Data Schedule of AmeriGas Finance Corp. | 12,422 | 80,747 |
729502_1999.txt | 729502_1999 | 1999 | 729502 | ITEM 1. BUSINESS
General: - -------
First Financial Bancorp (the "Company") was incorporated under the laws of the State of California on May 13, 1982, and operates principally as a bank holding company for its wholly owned subsidiary, Bank of Lodi, N.A. (the "Bank"). The Company is registered under the Bank Holding Company Act of 1956, as amended. The Bank is the principal source of income for the Company. The Bank owns the office building where the Bank's Lodi Branch and administrative offices are located, and the Company owns the land upon which the Bank's Woodbridge Branch is located. The Company receives income from the Bank under the lease associated with the Woodbridge property. The Company also holds all of the capital stock of Western Auxiliary Corporation (WAC), a California Corporation which functions as trustee on deeds of trust securing mortgage loans originated by the Bank. All references herein to the "Company" include the Bank and WAC, unless the context otherwise requires.
The Bank: - --------
The Bank was organized on May 13, 1982 as a national banking association. The application to organize the Bank was accepted for filing by the Comptroller of the Currency (the "OCC") on September 8, 1981, and preliminary approval to organize was granted on March 27, 1982. On July 18, 1983 the Bank received from the OCC a Certificate of Authority to Commence the Business of Banking. Subsequently, the Bank opened branch offices in Woodbridge and Lockeford, California. Effective February 22, 1997, the Bank acquired the Galt, Plymouth and San Andreas offices of Wells Fargo Bank. A loan production office in Folsom, California was opened in January, 1998, and was approved to operate as a full- service branch in July, 1999. In addition, a full-service branch was opened in Elk Grove, California in August, 1998.
The Bank's headquarters is located at 701 South Ham Lane, Lodi, California. Branch offices are located in Woodbridge, Lockeford, Galt, Plymouth, San Andreas, Elk Grove and Folsom, California. The Bank's primary service area, from which the Bank attracts 75% of its business, is the city of Lodi and the surrounding area. This area is estimated to have a population approaching 70,000 persons, with a median annual family income of approximately $30,000. The area includes residential developments, neighborhood shopping centers, business and professional offices and manufacturing and agricultural concerns.
Bank Services: - -------------
The Bank offers a wide range of commercial banking services to individuals and business concerns located in and around its primary service area. These services include personal and business checking and savings accounts (including interest- bearing negotiable order of withdrawal ("NOW") accounts and/or accounts combining checking and savings accounts with automatic transfers), and time certificates of deposit. The Bank also offers extended banking hours at its drive-through window, night depository and bank-by-mail services, and travelers' checks (issued by an independent entity). Each branch location has a 24 hour ATM machine, and the Bank has 24 hour telephone banking and bill paying services. The Bank issues MasterCard credit cards and acts as a merchant depository for cardholder drafts under both VISA and MasterCard. In addition, it provides note and collection services and direct deposit of social security and other government checks.
During 1998, the Bank entered into an agreement with Investment Centers of America to offer stocks, bonds, mutual funds, annuities and insurance products through offices located on-site at Bank branches. The first Investment Centers of America office was established at the Lodi branch location, and additional offices are planned for Elk Grove and Folsom.
The Bank engages in a full complement of lending activities, including commercial, Small Business Administration (SBA), residential mortgage, consumer/installment, and short-term real estate loans, with particular emphasis on short and medium-term obligations. Commercial lending activities are directed principally toward businesses whose demand for funds falls within the Bank's lending limit, such as small to medium-sized professional firms, retail and wholesale outlets and manufacturing and agricultural concerns. Consumer lending is oriented primarily to the needs of the Bank's customers, with an emphasis on automobile financing and leasing. Consumer loans also include loans for boats, home improvements, debt consolidation, and other personal needs. Real estate loans include short-term "swing" loans and construction loans. Residential mortgages are generally sold into the secondary market for these loans. SBA loans are made available to small to medium-sized businesses. The Bank generates noninterest income through premiums received on the sale of guaranteed portions of SBA loans and the resulting on-going servicing income on its SBA portfolio.
Sources of Business: - --------------------
Management seeks to obtain sufficient market penetration through the full range of services described above and through the personal solicitation of the Bank's officers, directors and shareholders. All officers are responsible for making regular calls on potential customers to solicit business and on existing customers to obtain referrals. Promotional efforts are directed toward individuals and small to medium-sized businesses. The Bank's customers are able in their dealings with the Bank to be served by bankers who have commercial loan experience, lending authority, and the time to serve their banking needs quickly and competently. Bankers are assigned to customers and not transferred from office to office as in many major chain or regional banks. In order to expedite decisions on lending transactions, the Bank's loan committee meets on a regular basis and is available where immediate authorization is important to the customer.
The risk of non-payment (or deferred payment) of loans is inherent in commercial banking. Furthermore, the Bank's marketing focus on small to medium-sized businesses may involve certain lending risks not inherent in loans to larger companies. Smaller companies generally have shorter operating histories, less sophisticated internal record keeping and financial planning capabilities, and greater debt-to-equity ratios. Management of the Bank carefully evaluates all loan applicants and attempts to minimize its credit risk through the use of thorough loan application and approval procedures.
Consistent with the need to maintain liquidity, management of the Bank seeks to invest the largest portion of the Bank's assets in loans of the types described above. Loans are generally limited to less than 75% of deposits and capital funds. The Bank's surplus funds are invested in the investment portfolio, made up of both taxable and non-taxable debt securities of the U.S. government, U.S. government agencies, states, and municipalities. On a day to day basis, surplus funds are invested in federal funds and other short-term money market instruments.
Competition: - -----------
The banking business in California generally, and in the northern portion of central California where the Bank is located, is highly competitive with respect to both loans and deposits and is dominated by a relatively small number of major banks with branch office networks and other operating affiliations throughout the State. The Bank competes for deposits and loans with these banks, as well as with savings and loan associations, thrift and loan associations, credit unions, mortgage companies, insurance companies and other lending institutions. Among the advantages certain of these institutions have over the Bank are their ability (i) to finance extensive advertising campaigns, (ii) to allocate a substantial portion of their investment assets in securities with higher yields (not available to the Bank if its investments are to be diversified) and (iii) to make funds available for loans in geographic regions with the greatest demand. In competing for deposits, the Bank is subject to the same regulations with respect to interest rate limitations on time deposits as other depository institutions. See "Supervision and Regulation" below.
Many of the major commercial banks operating in the Bank's service area offer certain services, such as international banking and trust services, which are not offered directly by the Bank, and such banks, by virtue of their greater capitalization, have substantially higher lending limits than the Bank. In addition, other entities, both public and private, seeking to raise capital through the issuance and sale of debt and equity securities compete with the Bank for the acquisition of funds for deposit.
In order to compete with other financial institutions in its primary service area, the Bank relies principally on local promotional activities, personal contacts by its officers, directors, employees and shareholders, extended hours and specialized services. The Bank's promotional activities emphasize the advantages of dealing with a locally-owned and headquartered institution sensitive to the particular needs of the community. The Bank also assists customers in obtaining loans in excess of the Bank's lending limit or services not offered by the Bank by arranging such loans or services in participation with or through its correspondent banks.
The State Bank Parity Act, effective January 1, 1996, eliminated certain existing disparities between California state chartered banks and national banking associations, such as the Bank, by authorizing the California Commissioner of Financial Institutions (the "Commissioner") to address such disparities through a streamlined rule-making process.
Employees: - ---------
As of December 31, 1999, the Company employed 101 full-time equivalent employees, including four executive officers. Management believes that the Company's relationship with its employees is good.
Supervision and Regulation
The Company - -----------
The common stock of the Company is subject to the registration requirements of the Securities Act of 1933, as amended, and the qualification requirements of the California Corporate Securities Law of 1968, as amended. The Company is also subject to the periodic reporting requirements of Section 13(d) of the Securities Exchange Act of 1934, as amended, which include, but are not limited to, annual, quarterly and other current reports with the Securities and Exchange Commission.
The Company is a bank holding company registered under the Bank Holding Company Act of 1956 (the "Act") and is subject to supervision by the Board of Governors of the Federal Reserve System (the "Board"). As a bank holding company, the Company must file with the Board quarterly reports, annual reports, and such other additional information as the Board may require pursuant to the Act. The Board may also make examinations of the Company and its subsidiaries.
The Act requires prior approval of the Board for, among other things, the acquisition by a bank holding company of direct or indirect ownership or control of more than 5% of the voting shares, or substantially all the assets, of any bank, or for a merger or consolidation by a bank holding company with any other bank holding company. The Act also prohibits the acquisition by a bank holding company or any of its subsidiaries of voting shares, or substantially all the assets, of any bank located in a state other than the state in which the operations of the bank holding company's banking subsidiaries are principally conducted, unless the statutes of the state in which the bank to be acquired is located expressly authorize such acquisition.
With certain limited exceptions, a bank holding company is prohibited from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company that is not a bank or bank holding company and from engaging directly or indirectly in any activity other than banking or managing or controlling banks or furnishing services to, or performing services for, its authorized subsidiaries. A bank holding company may, however, engage in or acquire an interest in a company that engages in activities that the Board has determined to be so closely related to banking or to managing or controlling banks as to be properly incident thereto. In making such a determination, the Board is required to consider whether the performance of such activities reasonably can be expected to produce benefits to the public, such as greater convenience, increased competition, or gains in efficiency, which outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. The Board is also empowered to differentiate between activities commenced de novo and activities commenced by the acquisition, in whole or in part, of a going concern.
Additional statutory provisions prohibit a bank holding company and any subsidiary banks from engaging in certain tie-in arrangements in connection with the extension of credit, sale or lease of property or furnishing of services. Thus, a subsidiary bank may not extend credit, lease or sell property, or furnish any services, or fix or vary the consideration for any of the foregoing on the condition that: (i) the customer must obtain or provide some additional credit, property or service from or to such bank other than a loan, discount, deposit or trust service; or (ii) the customer must obtain or provide some additional credit, property or service from or to the company or any other subsidiary of the company; or (iii) the customer may not obtain some other credit, property to service from competitors, except reasonable requirements to assure soundness of the credit extended. These anti-tying restrictions also apply to bank holding companies and their non-bank subsidiaries as if they were banks.
The Company's ability to pay cash dividends is subject to restrictions set forth in the California General Corporation Law. The Bank is a legal entity separate and distinct from the Company, and is subject to various statutory and regulatory restrictions on its ability to pay dividends to the Company. See Note 14(c) to the financial statements for further information regarding the payment of cash dividends by the Company and the Bank.
The Company is a bank holding company within the meaning of Section 3700 of the California Financial Code. As such, the Company and its subsidiaries are subject to examination by, and may be required to file reports with, the Commissioner. Regulations have not yet been proposed or adopted to implement the Commissioner's powers under this statute.
The Bank: - --------
The Bank, as a national banking association whose deposit accounts are insured by the Federal Deposit Insurance Corporation (the "FDIC") up to the maximum legal limits and the Bank is subject to regulation, supervision, and regular examination by the OCC. The Bank is a member of the Federal Reserve System, and, as such, is subject to certain provisions of the Federal Reserve Act and regulations issued by the Board. The Bank is also subject to applicable provisions of California law, insofar as they are not in conflict with, or preempted by, federal law. The regulations of these various agencies govern most aspects of the Bank's business, including reserves against deposits, interest rates payable on deposits, loans, investments, mergers and acquisitions, borrowings, dividends and location of branch offices.
Officers: - --------
Leon Zimmerman, age 57, is President and Chief Executive Officer of the Bank and of the Company; Robert H. Daneke, age 46, is Executive Vice President and Chief Credit Officer of the Bank and of the Company; Allen R. Christenson, age 42, is Senior Vice-President, Chief Financial Officer and Secretary of the Bank and of the Company and; Lance Gallagher, age 55, is Senior Vice President and Operations Administrator of the Bank and the Company.
Mr. Zimmerman joined the Company in April, 1990. He was promoted from Executive Vice President and Chief Credit Officer of Bank of Lodi to President and CEO in August of 1994. Mr. Zimmerman became President and CEO of the Company effective August 1995. He lives in Lodi with his wife and has resided and worked in the San Joaquin-Sacramento Valley since 1960, serving in various banking capacities since 1962. Mr. Zimmerman serves on many community boards and committees, including the Lodi Police Chaplaincy Association, San Joaquin County Education Foundation, Chamber of Commerce - Economic Development Task Force & Agribusiness Committees, LEED - Sacramento Steering Committee and Lodi Grape Festival and Harvest Fair. He is an active member of Rotary, Sutter Club, Independent Order of Odd Fellows and several other community groups.
Mr. Daneke joined the Company in December, 1999 bringing on board 22 years of banking experience. Prior to joining the Company, Mr. Daneke was employed at Clovis Community Bank for the past eight years and was promoted to Senior Vice President/Senior Credit Officer in 1997. In addition, his career has included: seven years with the Correspondent Bank Division of Community Bank in Redwood City and seven years with Bank of America Technology Banking Group. Mr. Daneke holds a B.B.A. Degree in Finance from the University of Iowa. He is also a graduate of Pacific Coast Banking School at the University of Washington and the California Intermediate Banking School at the University of San Diego. He has been President and Chairman of the Board for the Clovis District Chamber of Commerce and has served on the Board of Directors for both the Clovis Kiwanis Club and the Sequoia Council of Boy Scouts of America. Mr. Daneke has recently purchased a home in the Lodi area where he will reside with his wife and two children.
Mr. Christenson joined the Company in August, 1999. Prior to joining the Company, Mr. Christenson was Senior Vice President and Chief Financial Officer of River City Bank, located in Sacramento, California (1994-1999). Prior to joining River City Bank, Mr. Christenson was Senior Vice President and Chief Financial Officer of CapitolBank Sacramento which was acquired by another Bank (1993-1994). Prior to joining CapitolBank Sacramento, Mr. Christenson was in public accounting for over eight years, specializing in financial audits and consulting within the financial services industry. Mr. Christenson is a Certified Public Accountant and has a Bachelors degree from California State University, Sacramento. He resides in South Sacramento with his wife and five children. He is a life-long resident of the greater Sacramento area and continues to serve in various community and civic organizations.
Mr. Gallagher joined the Bank in February, 1991. He was promoted from Vice President of Compliance to Senior Vice President and Operations Administrator in January, 1997. As a graduate of the American Bankers Associations Graduate School of Compliance, he is responsible for the Bank's regulatory compliance program in addition to Bank operations and item processing. Prior to joining the Company, Mr. Gallagher was with Wells Fargo Bank for 22 years in various customer service, operations, and human resource capacities of increasing responsibility. He lives in San Joaquin County with his wife and has four boys and a grandson. Mr. Gallagher is a banking instructor for The American Institute of Banking and Delta Community College, serves as a member of the Colleges Banking Advisory Board, a member of the Heald College Employer Advisory Committee, and is the Initiation Coaching Program Director with U. S. Hockey Pacific District.
Recent Legislation and Regulations Affecting Banking: - ----------------------------------------------------
From time to time, new laws are enacted which increase the cost of doing business, limit permissible activities, or affect the competitive balance between banks and other financial institutions. Proposals to change the laws and regulations governing the operations and taxation of bank holding companies, banks and other financial institutions are frequently made in Congress, in the California legislature and before various bank holding company and bank regulatory agencies. The likelihood of any major changes and the impact such changes might have are impossible to predict. Certain significant recently proposed or enacted laws and regulations are discussed below.
Interstate Banking. Since 1986, California has permitted California banks and bank holding companies to be acquired by banking organizations based in other states on a "reciprocal" basis (i.e., provided the other state's laws permit California banking organizations to acquire banking organizations in that state on substantially the same terms and conditions applicable to local banking organizations). Since October 2, 1995, California law implementing certain provisions of prior federal law have (1) permitted interstate merger transactions; (2) prohibited interstate branching through the acquisition of a branch business unit located in California without acquisition of the whole unit of the California bank; and (3) prohibited interstate branching through
de novo establishment of California branch offices. Initial entry into California by an out-of-state institution must be accomplished by acquisition of or merger with an existing whole bank which has been in existence for at least five years.
Capital Requirements. Federal regulation imposes upon all FDIC-insured financial institutions a variable system of risk-based capital guidelines designed to make capital requirements sensitive to differences in risk profiles among banking organizations, to take into account off-balance sheet exposures and to aid in making the definition of bank capital uniform internationally. Under the OCC's risk-based capital guidelines, the Bank is required to maintain capital equal to at least 8 percent of its assets, weighted by risk. Assets and off-balance sheet items are categorized by the guidelines according to risk, and certain assets considered to present less risk than others permit maintenance of capital below the 8 percent level. The guidelines established two categories of qualifying capital: Tier 1 capital comprising core capital elements, and Tier 2 comprising supplementary capital requirements. At least one-half of the required capital must be maintained in the form of Tier 1 capital. For the Bank, Tier 1 capital includes only common stockholders' equity and retained earnings, but qualifying perpetual preferred stock would also be included without limit if the Bank were to issue such stock. Tier 2 capital includes, among other items, limited life (and in the case of banks, cumulative) preferred stock, mandatory convertible securities, subordinated debt and a limited amount of the allowance for loan and lease losses.
The guidelines also require all insured institutions to maintain a minimum leverage ratio of 3 percent Tier 1 capital to total assets (the "leverage ratio"). The OCC emphasizes that the leverage ratio constitutes a minimum requirement for the most well-run banking organizations. All other banking organizations are required to maintain a minimum leverage ratio ranging generally from 4 to 5 percent. The Bank's required minimum leverage ratio is 4 percent.
The federal banking agencies during 1996 issued a joint agency policy statement regarding the management of interest-rate risk exposure (interest rate risk is the risk that changes in market interest rates might adversely affect a bank's financial condition) with the goal of ensuring that institutions with high levels of interest-rate risk have sufficient capital to cover their exposures. This policy statement reflected the agencies' decision at that time not to promulgate a standardized measure and explicit capital charge for interest rate risk, in the expectation that industry techniques for measurement of such risk will evolve.
However, the Federal Financial Institutions Examination Council ("FFIEC") on December 13, 1996, approved an updated Uniform Financial Rating System ("UFIRS"). In addition to the five components traditionally included in the so- called "CAMEL" rating system which has been used by bank examiners for a number of years to classify and evaluate the soundness of financial institutions (including capital adequacy, asset quality, management, earnings and liquidity), UFIRS includes for all bank regulatory examinations conducted on or after January 1, 1997, a new rating for a sixth category identified as sensitivity to market risk. Ratings in this category are intended to reflect the degree to which changes in interest rates, foreign exchange rates, commodity prices or equity prices may adversely affect an institution's earnings and capital. The rating system henceforth will be identified as the "CAMELS" system.
As of December 31, 1999, the Bank's total risk-based capital ratio was approximately 10.51 percent and its leverage ratio was approximately 7.82 percent. The Bank does not presently expect that compliance with the risk-based capital guidelines or minimum leverage requirements will have a materially adverse effect on its business in the reasonably foreseeable future. Nor does the Bank expect that its sensitivity to market risk will adversely affect its overall CAMELS rating as compared with its previous CAMEL ratings by bank examiners.
Deposit Insurance Assessments. In 1995, the FDIC, pursuant to Congressional mandate, reduced bank deposit insurance assessment rates to a range from $0 to $.27 per $100 of deposits, dependent upon a bank's risk. The FDIC has continued these reduced assessment rates through 1999. Based upon the above risk-based assessment rate schedule, the Bank's current capital ratios, the Bank's current level of deposits, and assuming no further change in the assessment rate applicable to the Bank during 1999, the Bank estimates that its annual noninterest expense attributed to the regular assessment schedule will not increase during 1999.
Prompt Corrective Action. Prompt Corrective Action Regulations (the "PCA Regulations") of the federal bank regulatory agencies established five capital categories in descending order (well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized), assignment to which depends upon the institution's total risk-based capital ratio, Tier 1 risk-based capital ratio, and leverage ratio. Institutions classified in one of the three undercapitalized categories are subject to certain mandatory and discretionary supervisory actions, which include increased monitoring and review, implementation of capital restoration plans, asset growth restrictions, limitations upon expansion and new business activities, requirements to augment capital, restrictions upon deposit gathering and interest rates, replacement of senior executive officers and directors, and requiring divestiture or sale of the institution. The Bank has been classified as a well-capitalized bank since adoption of the PCA Regulations.
Community Reinvestment Act. Community Reinvestment Act ("CRA") regulations effective as of July 1, 1995 evaluate banks' lending to low and moderate income individuals and businesses across a four-point scale from "outstanding" to "substantial noncompliance," and are a factor in regulatory review of applications to merge, establish new branches or form bank holding companies. In addition, any bank rated in "substantial noncompliance" with the CRA regulations may be subject to enforcement proceedings. The Bank has a current rating of "satisfactory" CRA compliance.
Safety and Soundness Standards. Federal bank regulatory agency safety and soundness standards for insured financial institutions establish standards for (1) internal controls, information systems and internal audit systems; (2) loan documentation; (3) credit underwriting; (4) interest rate exposure; (5) asset growth; and (6) compensation, fees and benefits. In addition, the standards prohibit the payment of compensation which is excessive or which could lead to material financial loss. If an agency determines that an institution fails to meet any standard established by the guidelines, the agency may require the financial institution to submit to the agency an acceptable plan to achieve compliance with the standard. Agencies may elect to initiate enforcement action in certain cases where failure to meet one or more of the standards could threaten the safe and sound operation of the institution. The Bank has not been and does not expect to be required to submit a safety and soundness compliance plan because of a failure to meet any of the safety and soundness standards.
Permitted Activities. In recent years, the Federal banking agencies, especially the OCC and the Board, have taken steps to increase the types of activities in which national banks and bank holding companies can engage, and to make it easier to engage in such activities. On November 20, 1996, the OCC issued final regulations permitting national banks to engage in a wider range of activities through subsidiaries. "Eligible institutions" (those national banks that are well capitalized, have a high overall rating and a satisfactory CRA rating, and are not subject to an enforcement order) may engage in activities related to banking through operating subsidiaries after going through a new expedited application process. In addition, the new regulations include a provision whereby a national bank may apply to the OCC to engage in an activity through a subsidiary in which the bank itself may not engage. Although the Bank in not currently intending to enter into any new type of business, this OCC regulation could be advantageous to the Bank if the Bank determines to expand its operations in the future, depending on the extent to which the OCC permits national banks to engage in new lines of business and whether the Bank qualifies as an "eligible institution" at the time of making application.
Monetary Policies. Banking is a business in which profitability depends on rate differentials. In general, the differences between the interest rate received by a bank on loans extended to its customers and securities held in that bank's investment portfolio and the interest rate paid on its deposits and its other borrowings constitute the major portion of the bank's earnings. To the extent that a bank is not able to compensate for increases in the cost of deposits and other borrowings with greater income from loans, securities and fees, the net earnings of that bank will be reduced. The interest rates paid and received by any bank are highly sensitive to many factors which are beyond the control of that bank, including the influence of domestic and foreign economic conditions. See Item 7 herein, Management's Discussion and Analysis of Financial Condition and Results of Operations.
The earnings and growth of a bank are also affected by the monetary and fiscal policy of the United States Government and its agencies, particularly the Board. These agencies can and do implement national monetary policy, which is used in part to curb inflation and combat recession. Among the instruments of monetary policy used by these agencies are open market transactions in United States Government securities, changes in the discount rates of member bank borrowings, and changes in reserve requirements. The actions of the Board have had a significant effect on banks' lending, investments and deposits, and such actions are expected to continue to have a substantial effect in the future. However, the nature and timing of any further changes in such policies and their impact on banks cannot be predicted.
Financial Services Modernization Legislation. On November 12, 1999 President Clinton signed into law the Gramm-Leach-Bliley Act of 1999 (the "Modernization Act"). The Modernization Act repeals the two affiliation provisions of the Glass-Steagall Act: Section 20, which restricts the affiliation of Federal Reserve Member banks with firms "engaged principally" in specified securities activities; and Section 32, which restricts officer, director, or employee interlocks between a member bank and any company or person "primarily engaged" in specified securities activities. In addition, the Modernization Act also expressly preempts any state law restricting the establishment of financial affiliations, primarily related to insurance. The law establishes a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms, and other financial service providers by revising and expanding the BHC Act framework to permit a holding company system to engage in a full range of financial activities through a new entity known as a Financial Holding Company. "Financial activitities" is broadly defined to include not only banking, insurance, and securities activities, but also merchant banking and additional activities that the nature, incidental to such financial activities, or complementary activities that do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally.
In order for the Company to take advantage of the ability provided by the Modernization Act to affiliate with other financial service providers, it must become a "Financial Holding Company." To do so, the Company would file a declaration with the Federal Reserve, electing to engage in activities permissible for Financial Holding Companies and certifying that it is eligible to do so because its insured depository institution subsidiary (the Bank) is well-capitalized and well-managed. In addition, the Federal Reserve must also determine that an insured depository institution subsidiary has at least a "satisfactory" rating under the Community Reinvestment Act. [The Company currently meets the requirements for Financial Holding Company status.] The Company will continue to monitor its strategic business plan to determine whether, based on market conditions and other factors, the Company wishes to utilize any of its expanded powers provided in the Modernization Act.
Under the Modernization Act, securities firms and insurance companies that elect to become Financial Holding Companies may acquire banks and other financial institutions. The Company does not believe that the Modernization Act will have a material adverse effect on its operations in the near-term. However, to the extent that it permits banks, securities firms, and insurance companies to affiliate, the financial services industry may experience further consolidation. The Modernization Act is intended to grant to community banks certain powers as a matter of right that larger institutions have accumulated on an ad hoc basis. Nevertheless, this act may have the result of increasing the amount of competition that the Company and the Bank face from larger institutions and other types of companies offering financial products, many of which may have substantially more financial resources that the Company and the Bank.
Proposed Legislation and Regulation. Certain legislative and regulatory proposals that could affect the Bank and the banking business in general are pending or may be introduced before the United States Congress, the California State Legislature and Federal and state government agencies. The United States Congress is considering numerous bills that could reform banking laws substantially.
It is not known whether any of these current legislative proposals will be enacted and what effect such legislation would have on the structure, regulation and competitive relationships of financial institutions. It is likely, however, that many of these proposals would subject the Bank to increased regulation, disclosure and reporting requirements and would increase competition to the Bank and its cost of doing business.
In addition to pending legislative changes, the various banking regulatory agencies frequently propose rules and regulations to implement and enforce already existing legislation. It cannot be predicted whether or in what form any such rules or regulations will be enacted or the effect that such rules and regulations may have on the Bank's business.
The above description of the business of the Bank should be read in conjunction with Item 7 herein, Management's Discussion and Analysis of Financial Condition and Results of Operations.
ITEM 2.
ITEM 2. PROPERTIES
The Bank owns a 0.861 acre lot located at the corner of Ham Lane and Tokay Street, Lodi, California. A 34,000 square foot, tri-level commercial building for the main branch and administrative offices of the Company and the Bank was constructed on the lot. The Company and the Bank use approximately 75% of the leasable space in the building and the remaining area is either leased or available for lease as office space to other tenants. The construction of this building in 1991 has enabled the Bank to better serve its customers with more teller windows, four drive-through lanes and expanded safe deposit box capacity.
The Company owns a 10,000 square foot lot located on Lower Sacramento Road in the unincorporated San Joaquin County community of Woodbridge, California. The entire parcel has been leased to the Bank on a long term basis at market rates. The Bank has constructed, furnished and equipped a 1,437 square foot branch office on the parcel and commenced operations of the Woodbridge Branch on December 15, 1986.
The Bank assumed a long-term ground lease on 1.7 acres of land at 19000 North Highway 88, Lockeford, California. The building previously occupying the Lodi site at 701 South Ham Lane was moved to Lockeford, California, and has become the permanent branch office of the Bank at that location. A temporary 1,000 square foot office had been used by the Bank at the Lockeford location. The permanent office was opened on April 1, 1991. The temporary office, along with a portion of the permanent building, are leased by the Bank to two tenants.
On February 22, 1997, the Bank acquired the Galt, Plymouth and San Andreas branches of Wells Fargo Bank. The transaction included the assumption of the 6,000 square foot branch building lease in Galt with a remaining term of two years, and the purchase of the branch building and land for the Plymouth and San Andreas offices. The Plymouth and San Andreas offices are approximately 1,200 and 5,500 square feet, respectively. In November, 1998, upon expiration of the Galt lease, the Galt branch was relocated to a new 3,000 square foot leased facility one block west of the old location. The new Galt location is leased under a five year lease with three successive five-year renewal options.
In January, 1998, the Bank opened a 1,220 square foot loan production office in Folsom, California. The office was leased for one year with a one year renewal option which has been exercised by the Bank. In July, 1999 the Bank received approval to operate the Folsom office as a full-service branch. In December 1999, the lease was extended for one year to allow the Bank time identify a permanent location within the Folsom community. In August, 1998, the Bank opened a 4,830 square foot full service branch in Elk Grove, California. The office is leased under a three year lease with two successive three-year renewal options.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Not Applicable
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not Applicable
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
There is no established public trading market for the common stock of the Company. The Company's common stock is traded in the over-the-counter market and is not presently listed on a national exchange or reported by the NASDAQ Stock Market. Trading of the stock has been limited and has been principally contained within the Company's general service area. As of March 1, 2000, there were 1,033 shareholders of record of the Company's common stock. Set forth below is the range of high and low bid prices for the common stock during 1999 and 1998.
1999 1998 Bid Price of Common Shares High Low High Low
First Quarter $12.25 11.00 13.25 13.00 Second Quarter 12.50 11.00 14.50 13.63 Third Quarter 12.50 10.63 14.63 13.25 Fourth Quarter 11.00 9.12 13.38 12.00
The foregoing prices are based on trades of which Company is aware and reflect inter-dealer prices, without retail mark-up, mark-down or commissions, and may not necessarily represent actual transactions.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Certain statements in this Annual Report on Form 10-K include forward-looking information within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are subject to the "safe harbor" created by those sections. These forward- looking statements involve certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Such risks and uncertainties include, but are not limited to, the following factors: competitive pressure in the banking industry; changes in the interest rate environment; general economic conditions, either nationally or regionally becoming less favorable than expected and resulting in, among other things, a deterioration in credit quality and an increase in the provision for possible loan losses; changes in the regulatory environment; changes in business conditions; volatility of rate sensitive deposits; operational risks, including data processing system failures or fraud; asset/liability matching risks and liquidity risks; and changes in the securities markets.
The following discussion addresses information pertaining to the financial condition and results of operations of the Company that may not be otherwise apparent from a review of the consolidated financial statements and related footnotes. It should be read in conjunction with those statements and notes found on pages 33 through 55, as well as other information presented throughout this report.
Summary of Earnings Performance - --------------------------------------------------------------------------------
For the Year Ended December 31: ------------------------------------------ 1999 1998 1997
Earnings (in thousands) $ 1,159 1,052 1,015 - --------------------------------------------------------------------------------
Basic earnings per share $ .83 .76 .74 Diluted earnings per share $ .80 .72 .71 Return on average assets 0.69% 0.68% 0.75% Return on average equity 8.19% 7.90% 8.18% Dividend payout ratio 24.19% 26.26% 26.86% - --------------------------------------------------------------------------------
Average equity to average assets 8.40% 8.64% 9.12% - --------------------------------------------------------------------------------
Basic earnings per share in 1999 were $.83, compared to $.76 and $.74 in 1998 and 1997, respectively. During 1999, the Company benefited from a 21.1% increase in gross loans which resulted in an increase in net interest income. Net interest income was also impacted by the shift in earning assets combined with a general decline in rates. As a result of the increase in loans, the Company did increase the provision for loan losses. Furthermore, the Company experienced a 31% increase in noninterest income and a 14% increase in noninterest expense during the year. Included in noninterest income is a $287,000 gain resulting from stock received from an insurance company which converted from a mutual to a stock based company during 1999. The Company purchased a policy from the insurance company and the stock was received as part of the demutualization. Earnings of the Company continue to be negatively impacted by the amortization of the premium associated with the acquisition of three branches from Wells Fargo Bank on February 22, 1997. Additionally, the Company incurred $152,000 in one time expenses during 1999 in preparation for the year 2000 date change.
During 1998, loans and deposits increased 45% and 12%, respectively from 1997. In addition the company experienced record levels of mortgage loan origination and sales volumes. Deposits grew in connection with business development efforts in both 1998 and 1997 as well as the acquisition of three branches from Wells Fargo Bank on February 22, 1997. The acquisition increased deposits by $34 million as of the closing date of the transaction.
Branch Expansion and Acquisitions
In August, 1998, the Bank opened a full-service branch in the Elk Grove, California market. The Elk Grove office is approximately 30 miles North of the Bank's corporate headquarters in Lodi, California and it effectively expands the Bank's trade area into South Sacramento County.
In January, 1998, the Bank opened a loan production office in the growing market of Folsom, California. The location was converted to a full-service branch in July, 1999. The Folsom office is approximately 45 miles Northeast of the Bank's corporate headquarter's in Lodi, California and effectively expanded the Bank's trade area into the greater Sacramento area.
On February 22, 1997, the Bank completed the acquisition of the Galt, Plymouth, and San Andreas, California, branches of Wells Fargo Bank. The Bank purchased the premises and equipment of the Plymouth and San Andreas branches and assumed the building lease for the Galt branch. The Bank also purchased the furniture and equipment of all three branches and paid a premium for the deposits of each branch. The total cost of acquiring the branches, including payments to Wells Fargo Bank as well as other direct costs associated with the purchase, was $2.86 million. The transaction was accounted for using the purchase method of accounting. Accordingly, the purchase price was allocated first to identifiable tangible assets based upon those assets' fair value and then to identifiable intangible assets based upon the assets' fair value. The excess of the purchase price over identifiable tangible and intangible assets was allocated to goodwill. Allocations to identifiable tangible assets, identifiable intangible assets, and goodwill were $856 thousand, $1.98 million, and $24 thousand, respectively. Deposits totaling $34 million were acquired in the transaction.
Net Interest Income
The following table provides a detailed analysis of net interest spread and net interest margin for the years ended December 31, 1999, 1998, and 1997, respectively:
(1) Income on tax-exempt securities has not been adjusted to a tax equivalent basis. (2) Nonaccrual loans are included in the loan totals for each year.
Net interest income increased by 18% in 1999 after increasing by 10% in 1998. The increase in 1999 was the result of a 9.3% increase in average earning assets combined with an 8.6% increase in average deposits in addition to a decrease in overall deposit costs. The increase in 1998 was also the result of both growth in earning assets and deposits as well as decreased earning asset yields and decreased deposit costs.
Average earning assets increased by 9% in 1999 compared to 1998 and 11% in 1998 compared to 1997. The increase in average earning assets was driven by growth in average deposits during both years. Average deposits increased by 9% in 1999 compared to 1998 and 15% in 1998 compared to 1997.
The mix of earning assets in 1999 changed as a result of year-over-year loan growth of 21% compared to 45% in 1998. Average loans in 1999 increased 37% compared to 1998. The increase absorbed the liquidity created by the growth in deposits during 1999 and offset the impact of falling interest rates in all asset categories. The loan growth also increased the average loan-to-deposit ratio to 66% in 1999 compared to 52% in 1998. Average investments decreased 23% in 1999 as compared to 1998 as a result of the increase in loans. Average investments were nearly unchanged in 1998 compared to 1997.
Net interest margin increased by 44 basis points in 1999 after declining by 6 basis points in 1998. This increase in 1999 was the result of several key items:
. The impact on average earning asset yields of declining interest rates was overcome by the growth in loans that had higher yields than investments and federal funds sold. While the yields on federal funds and investments declined by 27 and 55 basis points, respectively, earning asset yields decreased by 4 basis points.
. The general decline in interest rates helped to bring down the cost of average NOW, money market, savings and certificates of deposit by 17, 90, 60, and 48 basis points, respectively.
. The mix of noninterest bearing deposits increased to 13% of average deposits in 1999 from 12% in 1998.
Net interest margin declined by 6 basis points in 1998 after increasing by 50 basis points in 1997. Excluding the impact of interest from the recovery of loan losses in 1997, net interest margin would have increased by 31 basis points in 1998. This adjusted increase in 1998 was the result of several key items:
. The impact on average earning asset yields of declining interest rates was overcome by the growth in loans that had higher yields than investments and federal funds sold. While the yields on federal funds and investments declined by 36 and 14 basis points, respectively, earning asset yields decreased by 18 basis points.
. The general decline in interest rates helped to bring down the cost of average NOW, savings and certificates of deposit by 32, 26, and 3 basis points, respectively.
. The mix of noninterest bearing deposits increased to 12% of average deposits in 1998 from 11% in 1997.
The following table presents the monetary impact of the aforementioned changes in earning asset and deposit volumes, yields and mix for the two years ended December 31, 1999 and 1998.
The volume, rate, and mix variances for net interest income in 1999 compared to 1998 indicate that the 37% increase in average loans was offset by a negative mix variance combined with a decrease in rates. During 1999, average earning assets increased 9%. Average loans, the primary component of earning assets, comprised 69% and 55% of total earning assets during 1999 and 1998, respectively. Average investment securities and federal funds sold decreased 23% and 39%, respectively. While average deposits increased 9% during 1999, the average rate paid on deposit accounts declined 16% resulting in a reduction in total interest expense.
The volume, rate, and mix variances for net interest income in 1998 compared to 1997 indicate that a negative rate variance driven by falling interest rates was offset by a positive mix variance driven by a 26% increase in average loans. That left the net increase in net interest income approximately equal to the positive volume variance from the 11% growth in average earning assets. The net interest income rate variance is significantly impacted by $445 thousand in 1997 resulting from interest income recognized in connection with the recovery of loans which had been previously charged off. Excluding the recovered interest
from 1997, the rate variance would have been a positive $87 thousand despite falling earning asset yields. The benefit from declining deposit rates more than offsets declines in interest income that resulted from falling earning asset yields.
Allowance for Loan Losses
The following table reconciles the beginning and ending allowance for loan losses for the previous five years. Reconciling activity is broken down into the three principal items that impact the reserve: (1) reductions from charge- offs; (2) increases from recoveries; and (3) increases or decreases from positive or negative provisions for loan losses.
Footnote 1(g) to the consolidated financial statement discusses the factors used in determining the provision for loan losses and the adequacy of the allowance for loan losses.
Charge-off activity declined by 17% in 1999 compared to 1998, and 54% in 1998 compared to 1997, while recoveries declined by 44% and 71%, respectively, during the same period. The decline in charge-offs is consistent with the asset quality statistics discussed below in the Asset Quality section. The Bank has not modified or significantly excepted its underwriting standards despite growing competition within the industry.
The loan loss provision for 1999 totaled $1,051,000 and represents an increase of $801,000 (320%) over 1998. The reason for the increase is attributable primarily to two factors; the primary factor being the continued year-over-year increase in the loan portfolio. Secondly, during the fourth quarter of 1999, the Company became aware of the deteriorating condition in the credit quality of a few specific loans. As a result, the provision for loan losses totaled $650,000 during the fourth quarter of 1999.
The loan loss provision for 1998 increased $310,000 relative to 1997. The increase was attributable to two factors; loan growth in 1998 and recoveries during 1997. With year-over-year increase in the loan portfolio totaling 45%, a larger provision was deemed necessary as a result of the significant growth in lending volume and the losses inherent in that volume. In addition, the 1997 provision was negative as a result of the significant recoveries that effectively amplified the year-to-year change in the provision with respect to both 1998 and 1996. The declining charge-offs and larger recoveries during 1997 increased the loan loss reserve by more than management believed was necessary to provide for loss potential in the loan portfolio. Accordingly, a negative provision resulted from the reversal of a portion of the reserve. The loan loss provision for 1996 exceeded the provision for 1995 by 170%. Although net charge-offs declined from 1995 to 1996, management determined that the loan loss provision of $310 thousand was necessary to provide for the loss potential with respect to a specific group of loan relationships that exhibited increased credit risk at that time.
Noninterest Income
Noninterest income increased by 31% and 32% in 1999 and 1998, respectively. The primary components of noninterest income consist of: service charges, SBA and mortgage income, and other noninterest income. The following table summarizes the significant elements of service charge, SBA, mortgage and Farmer Mac revenue for the three years ending 1999, 1998, and 1997:
Service charge revenue increased by 27% in 1999 compared to 1998 and 10% in 1998 compared to 1997. The growth in service charge income for 1999 was driven by deposit growth combined with changes to the fee structure of certain deposit products. While average deposits grew 9% in 1999, noninterest-bearing demand deposits and NOW accounts increased 16% and 11%, respectively. The growth in service charge income for 1998 was driven by average deposit growth of 15%.
SBA and mortgage revenue declined 8% and 24%, respectively, during 1999 and 1998 while Farmer Mac revenue increased 31% during 1999 as compared to 1998.
During 1999, the Company experienced increased competition in the SBA origination market, the result of which was a decline in production and relating gains on the sale of SBA loans. Additionally, the mortgage department experienced a decline in sales volume and the related margins on mortgage loans sold.
Revenue from SBA loan sales during 1998 was nearly comparable to the record level set in 1997, when SBA loan sales revenue increased by 33% over 1996. While SBA loan originations increased in 1998 relative to 1997, the production cycle for many of these loans extended relative to 1997, and fewer loans were sold. Partially disbursed SBA loans at December 31, 1998 were $6.4 million compared to $1.1 million at December 31, 1997. The 33% increase in 1997 was the result of both increases in the volume of loans originated and sold as well as a general increase in the loan sale premiums realized in the secondary market for SBA loan sales. During 1996, a new incentive compensation program was put into place. The program was designed to provide incentives for increasing levels of production. As production increased, the SBA servicing portfolio increased and resulted in the 13% and 9% increases in SBA servicing revenue for 1998 and 1997, respectively.
Revenue from mortgage loan sales reached a new record in 1998, surpassing the previous record by 216%. Mortgage operations were reorganized in 1994, and part of the annual increases since that time are the result of the relationships that have been developed with builders, realtors, and title companies. In addition to reorganized operations, housing activity in the Bank's trade area continued to improve in 1998, building on the improvements in 1997. The Bank continues to package home construction and mortgage take-out loans in a competitive manner and has successfully marketed this product in the new trade areas that were opened as a result of the acquisition of branches from Wells Fargo Bank in early 1997 (see "Branch Acquisition" above). Finally, declining mortgage rates during 1998 and 1997 had a favorable impact on mortgage loan refinance volumes.
The Bank began to participate in the Federal Agricultural Mortgage Corporation ("Farmer Mac") lending program in late 1994, whereby qualifying mortgage loans on agricultural property are originated and sold.
During 1998, the Company purchased single-premium life insurance policies written on the lives of certain officers and the directors of the Company and the Bank. During 1999, one of the insurance companies converted from a mutual to a stock based company, which process is referred to as "demutualization." As a result of the demutualization, policyholders of the insurance company received shares of common stock of the insurance company. The number of shares of stock received by policyholders was based upon the cash surrender value of the individual policies. The Company received and subsequently sold the stock in December, 1999. The gain recognized upon the receipt of the stock totaled $287,000.
Noninterest Expenses
Noninterest expenses increased by 14% in 1999 compared to 1998 and 13% in 1998 compared to 1997. Several events had a significant impact on year-to-year comparability. During 1999, the primary events related to expenses associated with the year 2000 date change. In 1998 and 1997, the Company expanded its branch network, opening two new branches in 1998 and purchasing three branches from Wells Fargo in 1997.
Noninterest expense is broken down into four primary categories each of which is discussed in this section.
Salaries and Employee Benefits - ------------------------------
The following table provides the detail for each major segment of salaries and employee benefits together with relevant statistical data:
The number of full-time equivalent employees increased 9% in 1999 compared to 1998 and 16% in 1998 compared to 1997. Regular payroll, contract labor and overtime increased 12% in 1999 compared to 1998 and 15% in 1998 compared to 1997. Total salaries and benefits expense increased by 13% in 1999 compared to 1998 and 15% in 1998 compared to 1997. The average regular payroll per full- time equivalent employee increased 2% in 1999 compared to 1998 and decreased 1% in 1998 compared to 1997.
Incentive compensation includes bonus awards under the Incentive Compensation Plan, contributions to the Employee Stock Ownership Plan and matching contributions to the 401(k) Stock Ownership Plan. The Incentive Compensation Plan pays bonuses to officers based upon the actual results of departmental and Bank-wide performance in comparison to predetermined targets. Contributions to the Employee Stock Ownership Plan are made at the discretion of the board of directors based upon profitability. Matching contributions to the 401(k) Stock Ownership Plan are made at the rate of 50% of the first 4% of compensation contributed by employees.
Payroll taxes and employee benefits per full-time equivalent increased 4% in 1999 as compared to 1998 and 8% as compared to 1997. The increases are related primarily to a 28% increase in the Company's contribution to the Employee Stock Ownership Plan combined with general increases in the cost of medical and other related insurance benefits, education and training expenses and supplemental compensation accruals made pursuant to the agreements summarized in Footnote 9 to the 1999 Consolidated Financial Statements. The increase to the Company's Employee Stock Ownership Plan comes as a result of the increased number of employees becoming eligible for participation in the plan.
Occupancy Expense - -----------------
The following table provides the detail for each major segment of occupancy expense:
Occupancy expenses increased by 13% in 1999 compared to 1998 and 21% in 1998 compared to 1997.
The primary reason for the increases in 1999 and 1998 are the expansion into new offices opened in 1998. In January 1998 the Company opened a loan production office in Folsom, California and the August 1998 opening of a full service branch in Elk Grove, California. The Folsom office was converted to a full service branch in July, 1999. In addition, the Galt branch was relocated in November, 1998. While the new rental expense in Galt is lower than it would have been absent a relocation, it is higher per month than it was in 1997. With respect to the three branches acquired from Wells Fargo Bank in 1997, 1998 includes two additional months of occupancy expenses compared to 1997.
Equipment Expense - -----------------
The following table provides the detail for each major segment of equipment expense:
Equipment expense increased by 28% in 1999 compared to 1998 and increased by 18% in 1998 compared to 1997.
The increase in 1999 is primarily attributable to investments made in the Company's computer hardware and software systems. Additionally, the 1999 expense reflects an entire year's deprecation expense for equipment placed in service at the two new branches in 1998.
The increase in 1998 was driven by two additional months of costs in 1998 for the three branches acquired from Wells Fargo Bank in 1997 and the loan production office and full service branch opened in the communities of Folsom and Elk Grove California, respectively, in January and August of 1998, respectively. The Galt branch was also relocated in November, 1998, and some equipment was replaced.
Other Noninterest Expense - -------------------------
Other noninterest expenses increased by 13% in 1999 compared to 1998 and 9% in 1998 compared to 1997. The following table provides the detail for each major segment of other noninterest expense:
Professional fees increased during 1999 as a result of the Company increasing its use of third parties in the development and implementation of specific strategic initiatives. The two primary initiatives included enhancing the Company's use of technology and opportunities to increase noninterest income.
During 1998 the Company substantially enhanced its marketing efforts to include the hiring of a full time marketing director in September, 1998. As a result of the increased focus on marketing, marketing expenses increased 52% in 1999 as compared to 1998. Furthermore, during 1999 the size of the Board of Directors was reduced and reduction were made to the number of meetings, the result of which was to reduce the amount paid to directors for services rendered on behalf of the Company. The remainder of the increases are driven primarily by volume related costs. Average loans and deposit volumes increased by 37% and 9% during 1999, respectively.
The amortization of the core deposit and goodwill intangible assets purchased in the acquisition of the Wells Fargo Branches in 1997 declined 24% in 1999 as compared to 1998 and 22% in 1998 as compared to 1997. The Bank is using an accelerated method of amortization for these assets over an eight year period. Accordingly, the amortization expense is expected to continue to decline over the remaining amortization period.
During 1999 the Company expensed $152,000 in one time costs associated with the Year 2000 date change. Additional expense was incurred by the Company as part of the Year 2000 date change. Such additional expense relate to the allocation of human resources and other capital expenditures.
Approximately 3% out of the 9% increase in 1998 compared to 1997 is the result of the new branches in 1998 and the inclusion of the three branches acquired in 1997 for twelve months in 1998 compared to 10 months for 1997. The remainder of the increase is driven primarily by volume related costs. Average loans and deposit volumes increased by 26% and 15%, respectively.
Income Taxes
The provision for income taxes as a percentage of pretax income for 1999, 1998, and 1997 was 19%, 25%, and 32%, respectively. The effective rate is lower than the combined marginal rate for state and federal taxes due primarily to the level of tax exempt income relative to total pre-tax income combined with a decrease in the tax asset valuation allowance. Tax exempt income increased in 1999 compared to 1998 and 1998 compared to 1997 due to an investment of $8.7 million and $4.2 million, respectively in the cash surrender value of life insurance as discussed below under Balance Sheet Review. The tax asset valuation allowance declined $85,000 and $45,000 in 1999 and 1998, respectively. Footnote 13 to the Consolidated Financial Statements contains a detailed presentation of the income tax provision and the related current and deferred tax assets and liabilities.
Balance Sheet Review
The following table presents average balance sheets for the years ended December 31, 1999, 1998 and 1997.
Average total assets increased by 9% in 1999 compared to 1998 and 14% in 1998 compared to 1997. Year-end asset totals at December 31, 1999 reached $176.3 million and represented an increase of 7% over December 31, 1998. The increase in 1999 and 1998 is a function of deposit growth throughout the Bank's branch network, as average deposits increased by 9% and 15%, respectively.
During 1999 average gross loans increased 39%. This increase was funded by the growth in deposits combined with a 16% reduction in fed funds sold and investment securities. During 1998 average gross loans increased 26% which was funded by the increase in deposits.
Other assets at December 31, 1999 increased 71% as compared to December 31, 1998. The increase is primarily attributable to an increase in the cash surrender value of life insurance of $8,674,000 and $4,274,000 at December 31, 1999 and 1998, respectively. The cash surrender value of life insurance consists primarily of the Bank's contractual rights under single-premium life insurance policies written on the lives of certain officers and the directors of the Company and the Bank. The policies were purchased in order to indirectly offset anticipated costs of certain benefits payable upon the retirement, and the death or disability of the directors and officers pursuant to deferred compensation agreements. The cash surrender value accumulates tax-free based upon each policy's crediting rate which is adjusted by the insurance company on an annual basis.
Investment Securities
The following table presents the investment portfolio at December 31, 1999, 1998 and 1997 by security type, maturity, and yield:
(a) The yields on tax-exempt obligations have not been computed on a tax- equivalent basis.
The investment portfolio at December 31, 1999 and 1998 declined by 21% and 26%, respectively, compared to the prior year-end totals. The decline in the portfolio during 1999 and 1998 funded increases in loan volume. With the exception of the sale of money market mutual fund shares, the decline in the portfolio during 1999 and 1998 came solely from maturities and calls. The general decline in interest rates during 1999 and 1998 led to the call of several agency securities that were purchased subsequent to the acquisition of the Wells Fargo Branches in 1997. Maturities and calls during 1999 and 1998 were approximately $9.2 million and $20.9 million, respectively.
Loans
The following table summarizes gross loans and the components thereof as of December 31, for each of the last five years:
Gross loans outstanding as of December 31, 1999 and 1998 exceeded the comparable prior year-end totals by 21% and 45%, respectively. Improving economic conditions combined with increased business development efforts were the foundation for the growth in both years. With the acquisition of the Wells Fargo Branches in 1997, the Company entered into new market areas which substantially enhanced their marketing capabilities.
The most significant segment of the loan portfolio is commercial loans, which represented 85% and 84% of the total portfolio at December 31, 1999 and 1998, respectively. Commercial loans include agricultural loans, working capital loans to businesses in a number of industries, and loans to finance commercial real estate. Agricultural loans represented approximately 15% and 14% of the commercial loan portfolio at December 31, 1999 and 1998, respectively. Agricultural loans are diversified throughout a number of agricultural business segments, including dairy, orchards, row crops, vineyards, cattle and contract harvesting. Agricultural lending risks are generally related to the potential for volatility of agricultural commodity prices. Commodity prices are affected by government programs to subsidize certain commodities, weather, and overall supply and demand in wholesale and consumer markets. Excluding agricultural loans, the remaining portfolio is principally dependent upon the health of the local economy and related to the real estate market.
The maturity and repricing characteristics of the loan portfolio at December 31, 1999 are as follows:
(1) Scheduled repayments are reported in the maturity category in which the payment is due.
Approximately 36% of the loan portfolio carries a fixed rate of interest as of December 31, 1999, while approximately 86% of the portfolio matures within five years.
Deposits
The following table summarizes average deposit balances and rates for the years ended December 31, 1999, 1998, and 1997:
Average deposits increased by approximately 9% and 15% in 1999 and 1998, respectively. Due to a declining rate environment, the average rate declined by 45 basis points when comparing 1999 to 1998 and 22 basis points when comparing 1998 to 1997. The deposit growth in 1999 and 1998 came from account growth at all branches throughout the Bank's network. The growth was the result of business development efforts in the lending area as well as a continued influx of "large" bank customers that have grown tired of merger activity among large institutions.
The reduced rates on the deposit portfolio in 1999 and 1998 are a function of changes in mix, pricing, and the general level of interest rates. The mix of deposits has become more cost efficient over the past three years. The mix of noninterest bearing deposits was 13%, 12%, and 11% for 1999, 1998, and 1997, respectively.
Certificates of deposit contain regular and individual retirement account balances and deposits received under the State of California Time Certificate of Deposit Program. There are no brokered certificates of deposit in the portfolio. At December 31, 1999 the Company had $3 million in deposits with the State of California under the Time Certificate of Deposit Program. It is the intent of the Company to increase total deposits under this program to approximately $7 million. The Certificates with the State of California have maturities of one year or less and are collateralized by loans or investment securities. The deposit program provides the Company with an additional source of funds at a relatively low cost. The deposits are used to fund loans and investments.
Certificates of $100,000 or more represent approximately 38% of the certificate of deposit portfolio at December 31, 1999. Excluding the Certificates of Deposit with the State of California, certificates of $100,000 or more represent approximately 34% of the certificate of deposit portfolio at December 31, 1999. The following table summarizes the maturities of those certificates of $100,000 or more:
Asset Quality
The following table contains asset quality information with respect to the loan portfolio and other real estate owned:
The Company's nonaccrual policy is discussed in note 1(c) to the consolidated financial statements. Interest income recorded on these nonaccrual loans was approximately $138,000 $2,000, $8,000, $7,000, and $13,000 in 1999, 1998, 1997, 1996, and 1995, respectively. Interest income foregone or reversed on these loans was approximately $76,000, $43,000, $45,000, $149,000, and $161,000 in 1999, 1998, 1997, 1996, and 1995, respectively. At December 31, 1999, there were no individually material or a material amount of loans in the aggregate for which management had serious doubts as to the borrower's ability to comply with present loan repayment terms and which may result in the subsequent reporting of such loans as nonaccrual.
Nonperforming loans increased by $2.2 million in 1999 after having increased $34 thousand in 1998 which followed declines in 1997 and 1996. Portfolio delinquency also increased to 3.32% after having increased to 1.40% in 1998 following a decline in 1997 and 1996. The dollar amount of the allowance for loan losses has increased in each of the last four years. During 1999, the allowance increased as a result of three factors; growth, expansion into new market areas and declining credit quality of a few borrowers. During 1999, average gross loans increased 37% compared to the prior year. The growth in 1999 included expansion into markets within Northern and Central California to include commercial, agricultural and real estate loans. Furthermore, during the fourth quarter of 1999, the Company experienced a decline in the credit quality in loans to four individual borrowers. The loans to two of the borrowers, which were placed on nonaccrual during the fourth quarter of 1999, totaled $1.9 million and represent 1.69% of gross loans at December 31, 1999. The loans to the other two borrowers totaled $2.2 million, represent 1.95% of gross loans and were not delinquent with regard to principal or interest at December 31, 1999.
The following table summarizes the allocation of the allowance for loan losses at December 31, for each of the last five years:
Please also see "Allowance for Loan Losses".
Market Risk
While there are several varieties of market risk, the market risk material to the Company and the Bank is interest rate risk. Within the context of interest rate risk, market risk is the risk of loss due to changes in market interest rates that have an adverse effect on net interest income, earnings, capital or the fair value of financial instruments. Exposure to this type of risk is a regular part of a financial institution's operations. The fundamental activities of making loans, purchasing investment securities, and accepting deposits inherently involve exposure to interest rate risk. As described in "Asset Liability Management," the Company monitors the repricing differences between assets and liabilities on a regular basis and estimates exposure to net interest income, net income, and capital based upon assumed changes in the market yield curve. The following tables summarize the expected maturity, principal repayment and fair value of the financial instruments that are sensitive to changes in interest rates as of December 31, 1999 and 1998. See further discussion regarding interest rate risk under "Asset Liability Management."
As of December 31, 1999:
As of December 31, 1998:
(1) Expected maturities for investment securities are based upon anticipated prepayments as evidenced by historical prepayment patterns. (2) Expected maturities for loans are based upon contractual maturity dates. (3) NOW, money market and savings deposits do not carry contractual maturity dates; therefore, the expected maturities reflect estimates applied in evaluating the Company's interest rate risk. The actual maturities of NOW, money market, and savings deposits could vary substantially if future prepayments differ from the Company's historical experience.
The majority of the loan growth during 1999 was in the area of floating rate commercial loans. In addition, during 1999, the Company invested a significant portion of its short term investments (i.e., fed funds and money market mutual funds) in longer term fixed rate agency and municipal securities with average maturities in excess of five years. The purchase of the
longer term investments provided the Company with an increase in interest income while providing interest rate protection in the event of a declining interest rate environment.
Asset Liability Management
The primary goal of the Company's asset and liability management system is to maximize net interest margin within reasonable risk parameters with respect to the maturity and pricing structure of assets and liabilities. The Company monitors the repricing differences between assets and liabilities on a regular basis and estimates exposure to net interest income, net income, and capital based upon assumed changes in the market yield curve. The following tables summarize the repricing intervals for the balance sheet at December 31, 1999 and 1998:
As of December 31, 1999:
As of December 31, 1998
The interest rate gaps reported in the table arise when assets are funded with liabilities having different repricing intervals. Since these gaps are actively managed and change daily as adjustments are made in interest rate forecasts and market outlook, positions at the end of any period may not be reflective of the Company's interest rate sensitivity in subsequent periods. Active management dictates that longer-term economic views are balanced against prospects for short-term interest rate changes in all repricing intervals. For purposes of the above analysis, repricing of fixed-rate instruments is based upon the contractual maturity of the applicable instruments. In addition, repricing of assets and liabilities is assumed in the first available repricing period. Actual payment patterns may differ from contractual payment patterns, and it has been management's experience that repricing does not always correlate directly with market changes in the yield curve.
Fluctuations in interest rates can also impact the market value of assets and liabilities either favorably or adversely depending upon the nature of the rate fluctuations as well as the maturity and repricing structure of the underlying financial instruments. To the extent that financial instruments are held to contractual maturity, market value fluctuations related to interest rate changes are realized only to the extent that future net interest margin is either higher or lower than comparable market rates for the period. To the extent that liquidity management dictates the need to liquidate certain assets prior to contractual maturity, changes in market value from fluctuating interest rates will be realized in income to the extent of any gain or loss incurred upon the liquidation of the related assets.
Liquidity
The Company's primary source of liquidity is dividends from the Bank. The Company's primary uses of liquidity are associated with dividiend payments made to shareholders and operating expenses.
Liquidity is managed on a daily basis by maintaining cash, federal funds sold, and short-term investments at levels commensurate with the estimated requirements for loan demand and fluctuations in deposits. Loan demand and deposit fluctuations are affected by a number of factors, including economic conditions, seasonality of the borrowing and deposit bases, and the general level of interest rates. The Bank maintains two lines of credit with correspondent banks as a supplemental source of short-term liquidity in the event that saleable investment securities and loans or available new deposits are not adequate to meet liquidity needs. The Bank has also established reverse repurchase agreements with two brokerage firms which allow for short term borrowings that are secured by the Bank's investment securities. Furthermore, the Bank may also borrow on a short-term basis from the Federal Reserve in the event that other liquidity sources are not adequate.
At December 31, 1999 liquidity was considered adequate, and funds available in the local deposit market and scheduled maturities of investments are considered sufficient to meet long-term liquidity needs. Compared to 1998 liquidity declined in 1999 as a result of the growth in loans. The growth was adequately funded by investment portfolio maturities and deposit portfolio growth.
Capital Resources
Consolidated capital increased by $664 thousand or 5%, during 1999. The increase was due primarily to net income of $1.16 million. Capital was further increased by $359 thousand as a result of capital paid in upon exercise of stock options which was offset by $286 thousand in capital used to pay dividends and a $568 thousand increase in the net unrealized loss on available for sale securities. The consolidated capital to assets ratio declined by 20 basis points, to 8.23% from 8.43%, due to the growth in assets related to the growth in deposits.
The Bank's total risk-based and leverage capital ratios were 10.51% and 7.82%, respectively, at December 31, 1999 compared to 11.2% and 7.4%, respectively, at December 31, 1998. The decline in the total risk-based ratio reflects the additional leverage created by the growth in deposits as well as increased lending which moves assets from lower risk-weight categories to the higher risk- weight categories of loans. The total risk-based and leverage capital ratios at December 31, 1999, are in excess of the required regulatory minimums of 10% and 5%, respectively, for well-capitalized institutions.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See Item 14(a) herein.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable
PART III ITEMS 10, 11, 12 and 13.
The information required by these items is contained in the Company's definitive Proxy Statement for the Annual Meeting of Shareholders to be held on April 25, 2000, and is incorporated herein by reference. The definitive Proxy Statement will be filed with the Commission within 120 days after the close of the Company's fiscal year pursuant to Regulation 14A of the Securities Exchange Act of 1934.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) Financial Statements and Schedules Page Reference
Independent Auditors' Report 33 Consolidated Balance Sheets as of December 31, 1999 and 1998 34 Consolidated Statements of Income Years Ended 1999, 1998, and 1997 35 Consolidated Statements of Changes in Stockholders' Equity and Comprehensive Income Years Ended 1999, 1998, and 1997 36 Consolidated Statements of Cash Flows Years Ended 1999, 1998, and 1997 37 Notes to Consolidated Financial Statements 38
(b) Reports on Form 8-K
No reports were filed on Form 8-K during the last quarter of the period covered by this report.
(c) Exhibits
Exhibit No. Description ----------- -----------
3(a) Articles of Incorporation, as amended, filed as Exhibit 3.1 to the Company's General Form for Registration of Securities on Form 10, filed on September 21, 1983, is hereby incorporated by reference.
3(b) Bylaws, as amended, filed as Exhibit 3(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1998, is hereby incorporated by reference.
4 Specimen Common Stock Certificate, filed as Exhibit 4.1 to the Company's General Form for Registration of Securities on Form 10, filed on September 21, 1983, is hereby incorporated by reference.
10(a)* First Financial Bancorp 1991 Director Stock Option Plan and form of Nonstatutory Stock Option Agreement, filed as Exhibit 4.1 to the Company's Form S-8 Registration Statement (Registration No. 33-40954), filed on May 31, 1991, is hereby incorporated by reference.
10(b)* Amendment to First Financial Bancorp 1991 Director Stock Option Plan, filed as Exhibit 4.3 to the Company's Post-Effective Amendment No. 1 to Form S-8 Registration Statement (Registration No. 33-40954), filed as Exhibit 10 to the Company's Quarterly Report on Form 10-Q for the period ended March 31, 1995, is hereby incorporated by reference.
10(c)* First Financial Bancorp 1991 Employee Stock Option Plan and forms of Incentive Stock Option Agreement and Nonstatutory Stock Option Agreement, filed as Exhibit 4.2 to the Company's Form S-8 Registration Statement (Registration No. 33-40954), filed on May 31, 1991, is hereby incorporated by reference.
10(d)* Bank of Lodi Employee Stock Ownership Plan, filed as Exhibit 10 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, is hereby incorporated by reference.
10(e)* First Financial Bancorp 1997 Stock Option Plan, filed as Exhibit 10 to the Company's Quarterly Report on Form 10-Q for the period ended September 30, 1997, is hereby incorporated by reference.
10(f)* Bank of Lodi Incentive Compensation Plan, filed as Exhibit 10(f) to the Company's Annual Report on Form 10-K for the year ended December 31, 1997, is hereby incorporated by reference.
10(g) First Financial Bancorp 401(k) Profit Sharing Plan, filed as Exhibit 10(g) to the Company's Annual Report on Form 10-K for the year ended December 31, 1997, is hereby incorporated by reference.
10(h)* Employment Agreement dated as of September 30, 1998, between First Financial Bancorp and Leon J. Zimmerman., filed as Exhibit 10(h) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998, is hereby incorporated by reference.
10(i)* Employment Agreement dated as of September 30, 1998, between First Financial Bancorp and David M. Philipp, filed as Exhibit 10(i) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998, is hereby incorporated by reference.
10(j)* Executive Supplemental Compensation Agreement effective as of April 3, 1998, between Bank of Lodi, N.A. and Leon J. Zimmerman, filed as Exhibit 10(j) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998, is hereby incorporated by reference.
10(k)* Executive Supplemental Compensation Agreement effective as of April 3, 1998, between Bank of Lodi, N.A. and David M. Philipp, filed as Exhibit 10(k) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998, is hereby incorporated by reference.
10(l)* Life Insurance Endorsement Method Split Dollar Plan Agreement effective as of April 3, 1998, between Bank of Lodi, N.A. and Leon J. Zimmerman, filed as Exhibit 10(l) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998, is hereby incorporated by reference.
10(m)* Life Insurance Endorsement Method Split Dollar Plan Agreement effective as of April 3, 1998, between Bank of Lodi, N.A. and David M. Philipp, filed as Exhibit 10(m) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998, is hereby incorporated by reference.
10(n)* Form of Director Supplemental Compensation Agreement, effective as of April 3, 1998, as executed between Bank of Lodi, N.A. and each of Benjamin R. Goehring, Michael D. Ramsey, Weldon D. Schumacher and Dennis R. Swanson, filed as Exhibit 10(n) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998, is hereby incorporated by reference.
10(o)* Form of Life Insurance Endorsement Method Split Dollar Plan Agreement, effective as of April 3, 1998, as executed between Bank of Lodi, N.A. and each of Benjamin R. Goehring, Michael D. Ramsey, Weldon D. Schumacher and Dennis R. Swanson, filed as Exhibit 10(o) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998, is hereby incorporated by reference.
10(p)* Form of Director Supplemental Compensation Agreement, effective as of April 3, 1998, as executed between Bank of Lodi, N.A. and each of Angelo J. Anagnos, Raymond H. Coldani, Bozant Katzakian and Frank M. Sasaki, filed as Exhibit 10(p) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998, is hereby incorporated by reference.
10(q)* Form of Life Insurance Endorsement Method Split Dollar Plan Agreement, effective as of April 3, 1998, as executed between Bank of Lodi, N.A. and each of Angelo J. Anagnos, Raymond H. Coldani, Bozant Katzakian and Frank M. Sasaki, filed as Exhibit 10(q) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998, is hereby incorporated by reference.
11 Statement re computation of earnings per share is incorporated herein by reference to Footnotes 1(j) and 14 to the consolidated financial statements included in this report.
21 Subsidiaries of the Company: The Company owns 100 percent of the capital stock of Bank of Lodi, National Association, a national banking association, and 100 percent of the capital stock of Western Auxiliary Corporation.
23 Consent of KPMG LLP, independent auditors.
27 Financial Data Schedule.
(d) Financial Statement Schedules
No financial statement schedules are included in this report on the basis that they are either inapplicable or the information required to be set forth therein is contained in the financial statements included in this report.
______________________________
* Management contract or compensatory plan or arrangement
Independent Auditors' Report
The Board of Directors
First Financial Bancorp:
We have audited the accompanying consolidated balance sheets of First Financial Bancorp and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of income, stockholders' equity and comprehensive income and cash flows for each of the years in the three-year period ended December 31, 1999. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of First Financial Bancorp and subsidiaries as of December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1999, in conformity with generally accepted accounting principles.
/s/ KPMG LLP
Sacramento, California
February 23, 2000
FIRST FINANCIAL BANCORP AND SUBSIDIARIES Consolidated Balance Sheets (in thousands except share amounts) December 31, 1999 and 1998
See accompanying notes to consolidated financial statements.
FIRST FINANCIAL BANCORP AND SUBSIDIARIES
Consolidated Statements of Income (in thousands except per share amounts) Years Ended December 31, 1999, 1998 and 1997
See accompanying notes to consolidated financial statements.
FIRST FINANCIAL BANCORP AND SUBSIDIARIES
Statements of Stockholders' Equity and Comprehensive Income (in thousands except share amounts) Years Ended December 31, 1999, 1998 and 1997
See accompanying notes to consolidated financial statements.
FIRST FINANCIAL BANCORP AND SUBSIDIARIES Consolidated Statements of Cash Flows (in thousands) Years Ended December 31, 1999, 1998, and 1997
See accompanying notes to consolidated financial statements.
FIRST FINANCIAL BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1999, 1998 and 1997
(1) Summary of Significant Accounting Policies
The accounting and reporting policies of First Financial Bancorp (the Company) and its subsidiaries, Bank of Lodi, N.A., (the Bank) and Western Auxiliary Corporation (WAC) conform with generally accepted accounting principles and prevailing practices within the banking industry. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenue and expense for the period. Actual results could differ from those estimates applied in the preparation of the consolidated financial statements. The following are descriptions of the significant accounting and reporting policies:
(a) Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its subsidiaries for all periods presented. All material intercompany accounts and transactions have been eliminated in consolidation.
(b) Investment Securities
The Company designates a security as held-to-maturity or available-for-sale when a security is purchased. The selected designation is based upon investment objectives, operational needs, intent and ability to hold. The Company does not engage in trading activity.
Held-to-maturity securities are carried at cost, adjusted for accretion of discounts and amortization of premiums. Available-for-sale securities are recorded at fair value with unrealized holding gains and losses, net of the related tax effect reported as a separate component of stockholders' equity until realized. Effective October 1, 1998, all held-to-maturity securities with an amortized cost of $1,174,000, were transferred to the available-for-sale category when Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities was adopted. For the year ended December 31, 1997, there were no transfers between classifications.
To the extent that the fair value of a security is below cost and the decline is other than temporary, a new cost basis is established using the current market value, and the resulting loss is charged to earnings. Premiums and discounts are amortized or accreted over the life of the related held-to-maturity or available-for-sale security as an adjustment to yield using the effective interest method.
Gains and losses realized upon disposition of securities are recorded as a component of noninterest income on the trade date, based upon the net proceeds and the adjusted carrying value of the securities using the specific identification method.
(c) Loans
Loans are stated at principal balances outstanding, net of deferred origination fees, costs and loan sale premiums. A loan is considered impaired when based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the "contractual terms" of the loan agreement, including scheduled interest payments. For a loan that has been restructured, the contractual terms of the loan agreement refer to the contractual terms specified by the original loan agreement, not the contractual terms specified by the restructuring agreement. An impaired loan is measured based upon the present value of future cash flows discounted at the loan's effective rate, the loan's observable market price, or the fair value of collateral if the loan is collateral dependent. Interest on impaired loans is recognized on a cash basis. Large groups of small balance, homogenous loans are collectively evaluated for impairment. If the measurement of the impaired loan is less than the recorded investment in the loan, an impairment is recognized by increasing the allowance for loan losses. Loans held for sale are carried at the lower of aggregate cost or market.
Interest on loans is accrued daily. Nonaccrual loans are loans on which the accrual of interest ceases when the collection of principal or interest is determined to be doubtful by management. It is the general policy of the Bank to discontinue the accrual of interest when principal or interest payments are delinquent 90 days or more unless the loan is well secured and in the process of collection. When a loan is placed on non-accrual status, accrued and unpaid interest is reversed against current period interest income. Interest accruals are resumed when such loans are
brought fully current with respect to interest and principal and when, in the judgment of management, the loans are estimated to be fully collectible as to both principal and interest.
(d) Loan Origination Fees and Costs
Loan origination fees, net of certain direct origination costs, are deferred and amortized as a yield adjustment over the life of the related loans using the interest method, which results in a constant rate of return. Loan commitment fees are also deferred. Commitment fees are recognized over the life of the resulting loans if the commitments are funded or at the expiration of the commitments if the commitments expire unexercised. Origination fees and costs related to loans held for sale are deferred and recognized as a component of gain or loss when the related loans are sold.
(e) Gain or Loss on Sale of Loans and Servicing Rights
Transfers and servicing of financial assets and extinguishments of liabilities are accounted for and reported based on consistent application of a financial-components approach that focuses on control. Transfers of financial assets that are sales are distinguished from transfers that are secured borrowings. Servicing assets and other retained interests in transferred assets are measured by allocating the previous carrying amount of the transferred assets between the assets sold, if any and retained interests, if any, based on their relative fair value at the date of transfer. Liabilities and derivatives incurred or obtained by transferors as part of a transfer of financial assets are to be initially measured at fair value. Servicing assets and liabilities are to be subsequently amortized in proportion to and over the period of estimated net servicing income or loss and assessed for asset impairment or increased obligation based on fair value.
The Bank recognizes a gain and a related asset for the fair value of the rights to service loans for others when loans are sold. The fair value of the servicing assets is estimated based upon the present value of the estimated expected future cash flows. The Bank measures the impairment of the servicing asset based on the difference between the carrying amount of the servicing asset and its current fair value. As of December 31, 1999 and 1998, there was no impairment in mortgage servicing asset.
A sale is recognized when the transaction closes and the proceeds are other than beneficial interest in the assets sold. A gain or loss is recognized to the extent that the sales proceeds and the fair value of the servicing asset exceed or are less than the book value of the loan. Additionally, the fair value of servicing rights is considered in the determination of the gain or loss.
When servicing rights are sold, a gain or loss is recognized at the closing date to the extent that the sales proceeds, less costs to complete the sale, exceed or are less than the carrying value of the servicing rights held.
(f) Allowance for Loan Losses
The allowance for loan losses is established through a provision charged to expense. Loans are charged off against the allowance for loan losses when management believes that the collectibility of the principal is unlikely. Recoveries of amounts previously charged off are added back to the allowance. The allowance is an amount that management believes will be adequate to absorb losses inherent in existing loans, standby letters of credit, overdrafts and commitments to extend credit based on evaluations of collectibility and prior loss experience. The evaluations take into consideration such factors as changes in the nature and volume of the portfolio, overall portfolio quality, loan concentrations, specific problem loans, commitments, and current and anticipated economic conditions that may affect the borrowers' ability to pay. While management uses these evaluations to recognize the provision for loan losses, future provisions may be necessary based on changes in the factors used in the evaluations. The allowance for loan losses is also subject to review by the Comptroller of the Currency, the Bank's principal regulator.
(g) Premises and Equipment
Premises and equipment are carried at cost less accumulated depreciation and amortization. Depreciation and amortization is calculated using the straight-line method over the estimated useful lives of the related assets. Estimated useful lives are as follows:
Building 35 years Improvements, furniture, and equipment 3 to 10 years
Expenditures for repairs and maintenance are charged to operations as incurred; significant betterments are capitalized. Interest expense attributable to construction-in-progress is capitalized.
(h) Intangible Assets
Goodwill, representing the excess of purchase price over the fair value of net assets acquired, results from branch acquisitions made by the Bank. Goodwill is being amortized on an accelerated basis over eight years. Core deposit intangibles are amortized on an accelerated basis over eight years. Intangible assets are reviewed on a periodic basis for other than temporary impairment. If such impairment is indicated, recoverability of the asset is assessed based upon expected undiscounted net cash flows. Intangible assets totaled $900,000 and $1,182,000 at December 31, 1999 and 1998, respectively and are included in Other Assets.
(i) Other Real Estate Owned
Other real estate owned (OREO) consists of property acquired through foreclosure and is recorded at the time of foreclosure at its fair market value. Thereafter, it is carried at the lower of cost or fair market value less estimated completion and selling costs. If at foreclosure, the loan balance is greater than the fair market value of the property acquired, the excess is charged against the allowance for loan losses. Subsequent operating expenses or income, changes in carrying value, and gains or losses on disposition of OREO are reflected in other noninterest expense. Fair market value is generally determined based upon independent appraisals.
Revenue recognition on the disposition of OREO is dependent upon the transaction meeting certain criteria relating to the nature of the property sold and the terms of the sale. Under certain circumstances, revenue recognition may be deferred until these criteria are met.
(j) Earnings Per Share
Basic earnings per share (EPS) includes no dilution and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution of securities that could share in the earnings of an entity.
On June 18, 1999, the Company effected a three percent stock dividend payable to stockholders of record as of June 4, 1999. All share, per share, Common Stock and stock option amounts herein have been restated to reflect the effects of the stock dividend.
(k) Income Taxes
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
Income tax expense is allocated to each entity of the Company based upon analyses of the tax consequences of each company on a stand alone basis.
(l) Statements of Cash Flows
For purposes of the statements of cash flows, cash, non-interest bearing deposits in other banks and federal funds sold, which generally have maturities of one day, are considered to be cash equivalents.
(m) Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of
Long-lived assets and certain identifiable intangibles are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceed the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.
(n) Stock Based Compensation
The Company accounts for its stock option plan using the intrinsic value method. Compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeds the exercise price.
(o) Reclassifications
Certain amounts in prior years' presentations have been reclassified to conform with the current presentation. These reclassifications have no effect on previously reported income.
(2) Restricted Cash Balances
The Bank is required to maintain certain daily reserve balances in accordance with Federal Reserve Board requirements. Aggregate reserves of $2,340,000 and $1,855,000 were maintained to satisfy these requirements at December 31, 1999 and 1998, respectively.
(3) Investment Securities
Investment securities at December 31, 1999 and 1998 consisted of the following:
Investment securities totaling $8,555,000 and $4,559,000 were pledged as collateral to secure Local Agency Deposits as well as treasury, tax and loan accounts with the Federal Reserve at December 31, 1999 and 1998, respectively. In addition, investment securities totaling $5,942,000 were pledged to secure deposits with the California State Treasurer at December 31, 1999.
Proceeds from the sale of Available for Sale securities during 1999, 1998 and 1997 were $43,054,000, $8,500,000 and $28,077,000 respectively, and represented the sale of money market mutual fund shares at book value. Accordingly, no gain or loss was realized.
Federal Agency stock dividends paid to the Company were $7,000, in 1999, 1998 and 1997.
The amortized cost and estimated fair value of debt securities at December 31, 1999, by contractual maturity, or expected maturity where applicable, are shown below. Expected maturities will differ from contractual maturities because certain securities provide the issuer with the right to call or prepay obligations with or without call or prepayment penalties.
December 31, 1999 Amortized Market Cost Value ------------------------------------------------------------------------- Due in one year or less $ 2,164,000 2,184,000 Due after one year through five years 21,482,000 21,333,000 Due after five years through 10 years 4,905,000 4,797,000 Due after 10 years 7,877,000 7,656,000 ------------------------------------------------------------------------- $36,428,000 35,970,000 =========================================================================
(4) Loans
The Bank grants commercial, installment, real estate construction and other real estate loans to customers primarily in the trade areas served by its branches. Generally, the loans are secured by real estate or other assets. Although the Bank has a diversified loan portfolio, a significant portion of its debtors' ability to honor their contract is dependent upon the condition of the local real estate markets in which the loans are made.
Outstanding loans consisted of the following at December 31:
1999 1998 -------------------------------------------------------------------------- Commercial $ 89,089,000 73,195,000 Real estate construction 13,919,000 11,743,000 Other real estate 6,420,000 4,761,000 Installment and other 3,301,000 3,463,000 -------------------------------------------------------------------------- 112,729,000 93,162,000
Deferred loan fees and loan sale premiums (556,000) (520,000) Allowance for loan losses (2,580,000) (1,564,000) -------------------------------------------------------------------------- $109,594,000 91,078,000 ==========================================================================
Included in total loans are loans held for sale of $1,217,000 and $2,619,000 for 1999 and 1998, respectively. SBA and mortgage loans serviced by the Bank totaled $95,749,000, $66,903,000 and $45,939,000 in 1999, 1998, and 1997, respectively.
Changes in the allowance for loan losses were as follows:
1999 1998 1997 ------------------------------------------------------------------------- Balance, beginning of year $1,564,000 1,313,000 1,207,000 Loans charged off (110,000) (132,000) (290,000) Recoveries 75,000 133,000 456,000 Provision charged to operations 1,051,000 250,000 (60,000) ------------------------------------------------------------------------- Balance, end of year $2,580,000 1,564,000 1,313,000 =========================================================================
Nonaccrual loans totaled $2,303,000, $248,000, and $340,000 at December 31, 1999, 1998 and 1997, respectively. Interest income which would have been recorded on nonaccrual loans was $76,000, $43,000 and $45,000, in 1999, 1998, and 1997, respectively.
Impaired loans are loans for which it is probable that the Bank will not be able to collect all amounts due. At December 31, 1999 and 1998, the Bank had outstanding balances of $2,303,000 and $248,000 in impaired loans which had valuation allowances of $327,000 in 1999 and $32,000 in 1998. The average outstanding balances of impaired loans for the years ended December 31, 1999, 1998 and 1997 were $805,000, $535,000 and $1,150,000 respectively, on which $76,000, $40,000 and $47,000, respectively, was recognized as interest income.
At December 31, 1999 and 1998, the collateral value method was used to measure impairment for all loans classified as impaired. Impaired loans at December 31, 1999 and 1998 consisted solely of commercial loans.
(5) Premises and Equipment
Premises and equipment consisted of the following at December 31:
1999 1998 ------------------------------------------------------------------------- Land $ 874,000 874,000 Building 5,705,000 5,705,000 Leasehold improvements 1,613,000 1,477,000 Furniture and equipment 3,618,000 3,069,000 ------------------------------------------------------------------------- 11,809,000 11,125,000 ------------------------------------------------------------------------- Accumulated depreciation and amortization (4,713,000) (3,864,000) ------------------------------------------------------------------------- $ 7,096,000 7,261,000 =========================================================================
The Bank leases a portion of its building to unrelated parties under operating leases which expire in various years.
The minimum future rentals to be received on noncancelable leases as of December 31, 1999 are summarized as follows:
Year Ending December 31, ------------------------------------------------------------------------- 2000 $ 48,000 2001 1,000 ------------------------------------------------------------------------- Total minimum future rentals $ 49,000 =========================================================================
(6) Other Assets
Other assets includes the cash surrender value of life insurance totaling $8,674,000 and $4,274,000 at December 31, 1999 and 1998, respectively. The cash surrender value of life insurance consists primarily of the Bank's contractual rights under single-premium life insurance policies written on the lives of certain officers and the directors of the Company and the Bank. The policies, for which the Bank is the beneficiary, were purchased in order to indirectly offset anticipated costs of certain benefits payable upon the retirement, and the death or disability of the directors and officers pursuant to deferred compensation agreements. The cash surrender value accumulates tax-free based upon each policy's crediting rate which is adjusted by the insurance company on an annual basis.
Other real estate owned is also included in other assets and was $129,000 at December 31, 1999 and 1998. During 1997, other real estate owned of $170,000 was acquired through foreclosure as settlement for loans. There were no such acquisitions during 1999 or 1998. These amounts represent noncash transactions, and accordingly, have been excluded from the Consolidated Statements of Cash Flows.
(7) Deposits
The following is a summary of deposits at December 31:
1999 1998 -------------------------------------------------------------------------- Demand $ 21,105,000 18,535,000 NOW and Super NOW Accounts 39,458,000 36,181,000 Money Market 16,752,000 19,482,000 Savings 29,057,000 25,987,000 Time, $100,000 and over 19,008,000 14,965,000 Other Time 30,781,000 34,394,000 -------------------------------------------------------------------------- $156,161,000 149,544,000 ==========================================================================
Interest paid on time deposits in denominations of $100,000 or more was $765,000, $737,000 and $620,000 in 1999, 1998 and 1997, respectively.
At December 31, 1999, the aggregate maturities for time deposits is as follows:
-------------------------------------------------------------------------- 2000 $48,335,000 2001 782,000 2002 363,000 2003 240,000 2004 69,000 -------------------------------------------------------------------------- Total $49,789,000 ==========================================================================
(8) Operating Leases
The Bank has noncancelable operating leases with unrelated parties for office space and equipment. The lease payments for future years are as follows:
Year Ending December 31, Lease Payments -------------------------------------------------------------------------- 2000 $108,000 2001 67,000 2002 52,000 2003 52,000 2004 44,000 -------------------------------------------------------------------------- $323,000 ==========================================================================
Total rental expense for operating leases was $101,000, $114,000 and $32,000 in 1999, 1998 and 1997 respectively.
(9) Supplemental Compensation Agreements
Effective April 3, 1999 the Company and the Bank entered into nonqualified supplemental compensation agreements with all of the directors and certain executive officers for the provision of death, disability and post- employment/retirement benefits. The agreement with directors includes elective provisions for service as a director emeritus following termination of service as a member of the Bank's Board of Directors. Directors who elect to serve as a director emeritus receive certain benefits during such period of service in addition to benefits applicable to all directors which commence upon expiration of the three year emeritus period. The Company will accrue for the compensation based on anticipated years of service and the vesting schedule provided in the agreements. The executive officer agreements are defined contribution agreements whereby the benefit accruals under the plan are the amount by which, if any, the increase in cash surrender value of the related insurance policies exceeds a predetermined profitability index. At December 31, 1999 and 1998, accrued compensation under both plans was $160,000 and $72,000, respectively. The Company adopted SFAS No. 132, "Employers' Disclosures about Pensions and Other Post Retirement Benefits." SFAS No. 132 does not change the measurement or recognition of expenses under the supplemental compensation agreements.
(10) Financial Instruments with Off-Balance Sheet Risk
In the normal course of business, the Company is a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit.
The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.
At December 31, 1999 and 1998, financial instruments whose contract amounts represent credit risk are as follows:
1999 1998 ------------------------------------------------------------------------- Commitments to extend credit $24,418,000 21,290,000 ========================================================================= Standby letters of credit $ 892,000 156,000 ========================================================================= Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates, other termination clauses and may require payment of a fee. Many of the commitments are expected to expire without being drawn upon and accordingly, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer's creditworthiness on a case-by-case basis. Upon extension of credit, the amount of collateral obtained, if any, is based on management's credit evaluation of the counter-party. Collateral varies but may include accounts receivable, inventory, property, plant and equipment, and income-producing or other real estate.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. These guarantees are primarily issued to support private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral obtained, if any, is varied.
(11) Other Noninterest Income
During 1998, the Company purchased single-premium life insurance policies written on the lives of certain officers and the directors of the Company and the Bank. During 1999, one of the insurance companies converted from a mutual to a stock based company, which process is referred to as "demutualization." As a result of the demutualization, policyholders of the insurance company received shares of common stock of the insurance company. The number of shares of stock received by policyholders was based upon the cash surrender value of the individual policies. The Company received and subsequently sold the shares in December, 1999. The gain recognized upon the receipt of the stock totaled $287,000.
(12) Other Noninterest Expense
Other noninterest expense for the years 1999, 1998 and 1997 included the following significant items:
1999 1998 1997 ------------------------------------------------------------------------- Third party data processing expense $ 821,000 719,000 642,000 Professional fees 554,000 423,000 401,000 Marketing 323,000 213,000 120,000 Intangible amortization 282,000 372,000 479,000 Telephone and postage 271,000 217,000 182,000 Supplies 193,000 176,000 142,000 Directors' fees and retirement 158,000 223,000 150,000 Printing 109,000 145,000 117,000 Other 563,000 417,000 423,000 ------------------------------------------------------------------------- Total $3,274,000 2,905,000 2,656,000 =========================================================================
(13) Income Taxes
The provision for income taxes for the years 1999, 1998 and 1997 consisted of the following:
Income taxes payable of $51,000 are included in other liabilities at December 31, 1999. Income taxes receivable of $117,000 are included in other assets at December 31, 1998.
The provision for income taxes differs from amounts computed by applying the statutory Federal income tax rate to operating income before income taxes. The reasons for these differences are as follows:
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1998 and 1998 are presented below.
The valuation allowance for deferred tax assets decreased by $85,000 and $45,000 for the years ended December 31, 1999 and 1998, respectively. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods which the deferred tax assets are deductible, management believes it is more likely than not the Company will realize the benefits of these deductible differences, net of the existing valuation allowances at December 31, 1999 and 1998.
(14) Stockholders' Equity
(a) Stock Options
In December 1982, the Board of Directors adopted the First Financial Bancorp 1982 Stock Incentive Plan. A total of 257,500 shares of the Company's common stock were reserved for issuance under the Plan. Options were granted at an exercise price not less than the fair market value of the stock at the date of grant and became exercisable over varying periods of time and expired 10 years from such date.
In February 1991, the Board of Directors adopted the First Financial Bancorp 1991 Employee Stock Option Plan and Director Stock Option Plan. The maximum number of shares issuable under the Employee Stock Option Plan is 183,855. The maximum number of shares issuable under the Director Stock Option Plan was 56,650. Options are granted at an exercise price of at least 100% and 85% of the fair market value of the stock on the date of grant for the Employee Stock Option Plan and the Director Stock Option Plan, respectively. The 1991 Plans replaced the 1982 Plan; however, this does not adversely affect any stock options outstanding under the 1982 Plan.
In February 1997, the Board of Directors adopted the First Financial Bancorp 1997 Stock Option Plan. The maximum number of shares issuable under the Plan is 405,003 less any shares reserved for issuance pursuant to the 1991 Plans. Options are granted at an exercise price of at least 100% and 85% of the fair market value of the stock on the date of grant for employee stock options and director stock options, respectively. The options issued in 1999 and 1997 were not issued at less than 100% of market value. The 1997 Plan replaces the 1991 Plans; however, this does not adversely affect any stock options outstanding under the 1991 Plans.
Stock option plan activities are summarized as follows:
Options Outstanding Exercise Price Options Per Share -------------------------------------------------------------
Balance, December 31, 1996 201,545 $5.58 - 8.32
============================================================= Options granted 78,795 $9.71 - 12.14 ============================================================= Options exercised (24,609) $5.58 - 8.32 ============================================================= Options expired (32,659) $6.60 - 9.71 =============================================================
Balance, December 31, 1997 223,072 $5.58 - 12.14 ============================================================= Options exercised (16,944) $5.58 - 6.60 ============================================================= Options expired (18,051) $6.55 - 12.14 =============================================================
Balance, December 31, 1998 188,077 $5.58 - 12.14 ============================================================= Options granted 33,900 $9.94 - 12.00 ============================================================= Options exercised (44,562) $5.58 - 8.33 ============================================================= Options expired (24,013) $5.58 - 12.14 =============================================================
Balance, December 31, 1999 153,402 $5.58 - 12.00 =============================================================
At December 31, 1999 and 1998, the weighted-average remaining contractual life of all outstanding options was 5.50 years and 5.16 years, respectively. The number of options exercisable was 117,424, 142,700 and 123,775 and the weighted-average exercise price of those options was $7.11, $7.20 and $7.22 at December 31, 1999, 1998 and 1997, respectively.
There were no stock options granted during 1998. The per share weighted- average fair value of stock options granted during 1999 and 1997 was $3.12 and $3.03, respectively. The fair value of each option grant is estimated on the date of grant using the Black-Sholes option-pricing model with the following weighted-average assumptions used for grants as of December 31, 1999 and 1997, respectively: dividend yield of 0.00% and 2.18%; expected volatility of 18.4% and 18.4%; risk-free interest rate of 6.19% and 6.20%; and an expected life of five years in each of the years.
No compensation cost has been recognized for its stock options in the accompanying consolidated financial statements. Had the Company determined compensation cost based on the fair value at the grant date for its stock options, the Company's net income would have been reduced to the pro forma amounts indicated below for the period ended December 31:
1999 1998 1997 ---------------------------------------------------------------------- Net Income As reported $1,159,000 1,052,000 $1,015,000 Pro forma 1,138,000 1,022,000 985,000
Basic Net Income Per Share As reported .83 .76 .74 Pro forma .81 .74 .72
Diluted Net Income Per Share As reported .80 .72 .71 Pro forma .78 .70 .69
Pro forma net income reflects only options granted after 1994. Therefore, the full impact of calculating compensation cost for stock options using the fair value method is not reflected in the pro forma net income amounts presented above because compensation cost is reflected over the options' vesting period of five years and compensation cost for options granted prior to January 1, 1995 is not considered.
(b) Employee Stock Ownership Plan
Effective January 1, 1992, the Bank established the Bank of Lodi Employee Stock Ownership Plan. The plan covers all employees, age 21 or older, beginning with the first plan year in which the employee completes at least 1,000 hours of service. The Bank's annual contributions to the plan are made in cash and are at the discretion of the Board of Directors based upon a review of the Bank's profitability. Contributions for 1999, 1998 and 1997 totaled approximately $149,000, $116,000 and $98,000, respectively.
Contributions to the plan are invested primarily in the Common Stock of First Financial Bancorp and are allocated to participants on the basis of salary in the year of allocation. Benefits become 20% vested after the third year of credited service, with an additional 20% vesting each year thereafter until 100% vested after seven years. As of December 31, 1999, the plan owned 48,000 shares of Company Common Stock. Of that amount, 3,500 shares were unallocated to participants at December 31, 1999.
(c) Dividends and Dividend Restrictions
On January 20, 2000, the Company's Board of Directors declared a cash dividend of five cents per share payable on February 25, 2000, to shareholders of record on February 11, 2000.
The Company's principal source of funds for dividend payments is dividends received from the Bank. Under applicable Federal laws, permission to pay a dividend must be granted to a bank by the Comptroller of the Currency if the total dividend payment of any national banking association in any calendar year exceeds the net profits of that year, as defined, combined with net profits for the two preceding years. At December 31, 1999, there were Bank retained earnings of $2,739,000 free of this condition.
(d) Weighted Average Shares Outstanding
Basic and diluted earnings per share for the years ended December 31, 1999, 1998, and 1997 were computed as follows:
(15) Related Party Transactions
During the normal course of business, the Bank enters into transactions with related parties, including directors, officers, and affiliates. These transactions include borrowings from the Bank with substantially the same terms, including rates and collateral, as loans to unrelated parties. At December 31, 1999 and 1998, respectively, such borrowings totaled $1,177,000 and $1,018,000, respectively. Deposits of related parties held by the Bank totaled $363,000 and $671,000 at December 31, 1999 and 1998, respectively.
The following is an analysis of activity with respect to the aggregate dollar amount of loans made by the Bank to directors, officers and affiliates for the years ended December 31:
1999 1998 --------------------------------------------------------------------------- Balance, beginning of year $ 1,018,000 922,000 Loans funded 1,232,000 738,000 Principal repayments (1,073,000) (642,000) --------------------------------------------------------------------------- Balance, end of year $ 1,177,000 1,018,000 ===========================================================================
(16) Parent Company Financial Information
This information should be read in conjunction with the other notes to the consolidated financial statements. The following presents summary balance sheets as of December 31, 1999 and 1998, and statements of income, and cash flows information for the years ended December 31, 1999, 1998, and 1997.
(17) Lines of Credit
The Bank has two unsecured lines of credit with correspondent banks totaling $7,000,000 which renew annually. At December 31, 1999 the Bank had outstanding borrowings under these lines totaling $4,300,000. During 1999, the maximum amount outstanding was $4,300,000, the average balance outstanding was $176,000 and the weighted average interest rate was 6.25%. At December 31, 1998 no amounts were outstanding under these lines of credit.
(18) Regulatory Matters
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate mandatory and possibly additional discretionary actions by regulators, that, if undertaken, could have a direct material effect on the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measure of the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below).
First, a bank must meet a minimum Total Risk-Based Capital to risk-weighted assets ratio of 8%. Risk-based capital and asset guidelines vary from Tier I capital guidelines by redefining the components of capital, categorizing assets into different classes, and including certain off-balance sheet items in the calculation of the capital ratio. The effect of the risk-based capital guidelines is that banks with high exposure will be required to raise additional capital while institutions with low risk exposure could, with the concurrency of regulatory authorities, be permitted to operate with lower capital ratios. In addition, a bank must meet minimum Tier I Capital to average assets ratio.
Management believes, as of December 31, 1999, that the Bank meets all capital adequacy requirements to which it is subject. As of December 31, 1999, the most recent notification, the Federal Deposit Insurance Corporation (FDIC) categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as adequately capitalized, the Bank must meet the minimum ratios as set forth below. There are no conditions or events since that notification that management believes have changed the Bank's category.
The Bank's actual capital amounts and ratios as of December 31, 1999 are as follows:
The Bank's actual capital amounts and ratios as of December 31, 1998 are as follows:
(19) Fair Values of Financial Instruments
The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:
Cash and cash equivalents: The carrying amounts reported in the balance -------------------------- sheet for cash and due from banks and federal funds sold are a reasonable estimate of fair value.
Investment securities: Fair values for investment securities are based on ---------------------- quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. (See note 3).
Loans: For variable-rate loans that reprice frequently and with no ------ significant change in credit risk, fair values are based on carrying values. The fair values for fixed-rate loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.
Commitments to extend credit and standby letters of credit: The fair value ----------------------------------------------------------- of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreement and the present creditworthiness of the counter parties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of letters of credit is based upon fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligation with the counter parties at the reporting date.
Deposit liabilities: The fair values disclosed for demand deposits (e.g., -------------------- interest and non-interest checking, savings, and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). The fair values for fixed-rate time deposits are estimated using a discounted cash flow calculation that applies interest rates currently being offered on time deposits to a schedule of aggregated expected monthly maturities on time deposits.
* = Greater than
Short term borrowings: The discounted value of contractual cash flows ---------------------- at market interest rates for short term borrowings with similar terms and remaining maturities are used to estimate the fair value of existing short term borrowings.
Limitations: Fair value estimates are made at a specific point in time, ------------ based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company's financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
Fair value estimates are based on existing on and off balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Other significant assets and liabilities that are not considered financial assets or liabilities include deferred tax assets, premises, and equipment. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in many of the estimates.
The estimated fair values of the Company's financial instruments at December 31, are approximately as follows:
(20) Legal Proceedings
The bank is involved in various legal actions arising in the ordinary course of business. In the opinion of management, after consulting with legal counsel, the ultimate disposition of these matters will not have a material effect on the Bank's financial condition, results of operations, or liquidity.
(21) Derivative Financial Instruments
As of December 31, 1999 and 1998, the Company has no off-balance sheet derivatives. The Company held $6,627,000 and $457,000 in collateralized mortgage obligations and $0 and $500,000 in structured notes as of December 31, 1999 and 1998 respectively. These investments are held in the available for sale portfolio.
(22) Western Auxiliary Corporation
On June 9, 1998 the Company incorporated Western Auxiliary Corporation (WAC). The Company capitalized WAC as a wholly-owned subsidiary during the quarter ended September 30, 1998 with an initial capitalization of $10,000. WAC earns fee income by acting as trustee on the Bank's trust deed transactions and receives the necessary operational resources under an intercompany services agreement between WAC and the Bank.
(23) Quarterly Financial Information (Unaudited)
The loan loss provision for 1999 totaled $1,051,000 and represents an increase of $801,000 (320%) over 1998. The reason for the increase is attributable primarily to two factors; the primary factor being the continued year-over-year increase in the loan portfolio. Secondly, during the fourth quarter of 1999, the Company became aware of the deteriorating condition in the credit quality of a few specific loans. As a result, the provision for loan losses totaled $650,000 during the fourth quarter of 1999.
See Note 11 for information regarding the increase in noninterest income during the fourth quarter of 1999.
SIGNATURES
Pursuant to the requirements of Section 13 of 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 30th day of March, 2000.
FIRST FINANCIAL BANCORP
/s/ LEON J. ZIMMERMAN ----------------------- Leon J. Zimmerman President and Chief Executive Officer
Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
INDEX TO EXHIBITS
Exhibit Page ------- ----
23 Consent of Expert 59
27 Financial Data Schedule (electronic submission only) | 21,066 | 140,220 |
1076732_1999.html | 1076732_1999 | 1999 | 1076732 | Item 1. Business
About USi
USi’s service offerings integrate leading packaged software applications with computing hardware, network security and operational support to meet the needs of middle market companies for business functions such as e-commerce, sales force automation and customer support, messaging and collaboration and professional services automation. We implement these applications in our data centers and enable our clients to access and utilize the applications over the Internet. We take full responsibility for providing these services to our clients, freeing them from the need to own and manage related computer systems, networks and software.
Market Trends
We believe that there are four key market trends that drive our business opportunity:
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the increased acceptance of the applications hosting model;
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the rapid growth of e-commerce and Internet-based communications;
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the competitive need of middle market and global 1000 enterprises to automate key business processes; and
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the availability of Internet-enabled packaged software applications.
The increased acceptance of the Application Service Provider model.
The Application Service Provider model is being increasingly validated by the emergence of new entrants into this market. The “pure play” applications hosting companies today include companies such as Aristasoft, Breakaway Solutions, Corio, FutureLink, Interliant, Interpath and Telecomputing. KPMG, a leading systems integrator has announced a partnership with Qwest to provide application hosting solutions. USWeb/ CKS, another systems integrator, also provides application hosting solutions. The leading enterprise application companies such as Oracle, Siebel and SAP are either in the process of or are already providing application hosting solutions. The Web hosting companies such as Concentric, Digex and Verio, either by themselves or in partnership with other companies are expected to be participants in the Application Service Provider market. International Data Corporation estimates that the market opportunity in the high-end Application Service Provider market will reach $2 billion by 2003, representing a four-year compound annual growth rate of 91%.
The rapid growth of e-commerce and Internet-based communications.
An increasing number of companies use the Internet to enable fast and efficient communications between various constituents of their enterprises. The following examples illustrate this trend.
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E-commerce is becoming a critical element of many businesses’ strategies. Companies increasingly demand that their vendors communicate ordering, invoicing and payment transactions through Internet-enabled applications. International Data Corporation estimates that commerce on the Internet will be more than $1 trillion by 2003, reflecting a four-year compound annual growth rate of 85%.
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Enterprises are relying on the Internet to communicate with employees who are increasingly dispersed due to globalization and the development of alternative workplaces. According to Forrester Research, Inc. there are between 30 and 40 million telecommuters or home-based workers in the United States.
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To interact with customers, suppliers and remote employees efficiently, an increasing number of businesses are implementing mission-critical applications over intranets and extranets rather than through dedicated private networks. Forrester Research, Inc. forecasts that the increasing demand for corporate intranets and extranets will fuel growth rates in excess of 30% in distributed infrastructure services resulting in a $140 billion market in 2002.
As more companies implement mission-critical business applications on the Internet, the demand for the outsourced provision of key Internet infrastructure and services, or Web hosting, has significantly increased. The outsourcing of Web sites is occurring because businesses recognize that they do not have an infrastructure sufficient to ensure reliable and responsive deployment of mission-critical applications on the Internet. Web site hosting providers address these concerns by building substantial redundancy and capacious network bandwidth into their facilities. Moreover, they provide a physically secure data center environment, which helps to address businesses’ security concerns as they begin to move proprietary business information over the Internet.
The competitive need of middle market enterprises to automate key business processes.
Middle market enterprises increasingly face competitive demands to automate business processes, but they have frequently not been able to afford the functionality available to their larger competitors. This has been exacerbated by the shortage of IT professionals. We believe that these enterprises have a significant need for packaged application software to improve core business processes, reduce costs and enhance their global competitive position.
We believe that many of the leading enterprise resource planning software packages remain too complex and too costly to be effective solutions for middle market companies. While many enterprise resource planning providers have begun offering products that are targeted for the middle market, implementation of these packages generally still requires specialized skill sets and frequently takes three to twelve months. In addition, the infrastructure required to support these packages, once implemented, is also beyond the capabilities of many middle market businesses. Faced with these costs and time frames, many middle market companies choose to forgo the capabilities of leading enterprise resource planning packages in favor of less functional products. We believe that a lower cost, more easily implemented approach would allow these middle market businesses to capitalize on the functionality of leading enterprise resource planning packages and better position these businesses against larger competitors.
The availability of Internet-enabled packaged software applications.
Until recently, companies wanting to implement Internet applications had to develop their own software applications or customize existing packages. This made each implementation unique and costly. It also made implementation time frames and costs unpredictable. Over the past two years, however, major packaged application providers, such as Siebel, PeopleSoft, Lawson, Oracle, J.D. Edwards and others, have released versions of their software which can be accessed and used over the Internet. Internet-enabled software is becoming an increasingly common offering of providers of applications for distributed users such as e-commerce, enterprise resource planning applications, and sales force automation, where the increasing ubiquity of the Internet makes it a cost-efficient mechanism for implementing distributed functions.
We believe that the availability of Internet-enabled packaged software makes it possible, for the first time, to implement these applications on the Internet in predictable time frames, with predictable costs, and without writing custom code.
The USi Solution
We believe that we are well positioned to take advantage of these trends. We have established our iMAP services as a leading single-source solution for the Internet-enabled application software needs of middle market enterprises. We take responsibility for the deployment and maintenance of the iMAP best-of-breed packaged software applications. This allows our clients to focus on their core competencies without mediating among disparate vendors. Our iMAP solutions enable clients to buy these mission-critical functions as a service from a single vendor, rather than as a collection of technologies from multiple vendors.
We have teamed with major packaged application software providers to implement our iMAP solutions. We have built a network of EDCs through which our clients’ business software applications are deployed. The network offers fast, reliable and secure access to the client application web sites that we manage, which serve as the “Internet gateways” for enterprises and their employees, customers and partners to access and use business application software and data. The servers are generally procured and maintained by us and dedicated to specific clients. Clients can define specific groups, such as their sales force, customers, or investors, to have full or limited access to their web sites. Because our network is deployed globally, access to client applications can be equally responsive in North America, Europe and Asia. Moreover, geographically dispersed backup is designed to ensure high reliability and data integrity. We provide packaged application software and support along with our services on the basis of multi-year contracts paid on a monthly basis. We believe that the combination of our Internet communications capability along with Internet-enabled software applications makes our iMAP offerings the first truly integrated Internet communications and computing solution.
Operate a specialized global network
We have constructed a highly reliable, fully redundant, global network specifically designed to support our iMAP solutions. Our network is designed to provide the fastest possible response time, the highest level of security and 99.9% availability to our clients. We have EDCs in Annapolis, Silicon Valley, Amsterdam and Tokyo. These EDCs are monitored and managed from our Global Enterprise Management Center in Annapolis and a remote back-up GEMC in Silicon Valley. The network is designed around dual primary backbones connecting our EDCs and GEMCs. Our dedicated network is linked to the Internet in North America via eight major backbone providers, allowing our clients to bypass congested public exchange points. In addition, our network is linked with two backbone providers in each of Europe and Asia, enabling us to provide global connectivity to our clients. Large storage arrays in Annapolis and Silicon Valley can provide real-time back-up of North American client sites, enabling us to provide an unusually high level of data integrity. We use our network operations platform, USiView, to proactively manage and monitor our network systems, telecommunications hardware, network connectivity, operating systems and applications software.
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This specialized network enables us to provide very high levels of reliability, security and responsiveness to client constituents, whether they access our applications through the Internet or from behind a client LAN (as illustrated above).
Deliver integrated service offerings around business processes
We have expert product teams that specialize in implementing iMAP solutions to support specific business processes. Our consulting and implementation teams have specific expertise in implementing our iMAP solutions for e-commerce, sales force automation and customer support, human resource and financial management, messaging and collaboration and professional services automation. Each team can integrate a specific application software package and the required Internet communications services, which together provide a total solution for a specific business process. These teams can implement applications and generate value for customers very quickly. For example, our typical implementation of Siebel technology is designed to be completed in 45 days. We believe that this provides a competitive advantage over a more conventional implementation which requires six months to more than a year for completion. The consulting and implementation teams hand off the implemented application to our operations group, which runs and maintains the application as well as provides ongoing support to the client through our client care organization.
Leverage strategic relationships with leading software application providers
We have established relationships in key application areas with vendors, including BroadVision and Microsoft in e-commerce; Ariba in business-to-business e-commerce; Siebel in sales force automation, customer service and enterprise marketing; PeopleSoft and Lawson in human resources and financials;
Microsoft Exchange in messaging and collaboration; Niku in professional services automation; and Sagent in decision-making support. We are the exclusive Application Service Provider of Siebel enterprise relationship management applications for customers of SiebelNet, Inc. which is headquartered in North America and are one of ten currently certified PeopleSoft Application Service Providers. The agreements with software providers generally enable us to deploy the applications as a service, without the need to establish a separate licensing arrangement for each client. The agreements also enable us to provide our clients with an economically attractive service offering, and afford us co-marketing and co-branding opportunities. These agreements provide us with an initial software portfolio that can meet a broad range of our clients’ enterprise resource planning, e-commerce and communication needs. In addition, the agreements provide us with an accelerated path to developing our expert product teams around the software applications and business processes these applications support.
Implement services-based business model
We sell our iMAP solutions as a service, not as a technology. Accordingly, our clients sign long-term contracts with fixed monthly payments made as the service is delivered. We believe that selling our iMAP solutions as a service reduces our clients’ initial capital expenditures and makes it easier for non-technical executives to purchase our products.
The USi Strategy
The focus of our strategy is to deliver timely, reliable and secure iMAP services to our clients. We believe that by doing so we will rapidly build our client base and secure long-term relationships, especially with those clients in the middle market. We intend to continue investing to maintain a value advantage over our competitors and to capitalize on our first mover advantages, as follows:
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Develop new business. We will continue to develop new business by soliciting potential clients through joint marketing campaigns with our hardware, software and integration partners, advertising in industry specific periodicals and newspapers, sponsoring seminars and trade shows in selected markets, and conducting targeted mass mailings of marketing material.
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Cross-sell products to increase penetration of accounts. We are able to provide a range of packaged software applications and complex web hosting services to our clients. We actively seek to increase our sales to clients by cross-selling our products and services. Our aim is to increase our implementation and provision of our clients’ mission-critical business processes.
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Expand our portfolio of iMAP solutions. We have entered into strategic partnerships with numerous application software vendors. These vendors are offering or developing additional applications in specific vertical market segments which we expect to deploy in order to expand our portfolio of iMAP solutions.
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Enhance the capacity and functionality of our global network. We will continue to deploy enhanced value features into our network. In addition, as we begin to address clients located in Europe and Asia, we will expand our capacity in those regions. Today, we provide European and Asian mirror sites to our clients from collocated EDCs in Amsterdam and Tokyo.
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Emphasize the iMAP brand. We have focused our sales and marketing efforts to distinguish iMAP as a branded product offering focused on the middle market and selected divisions of larger multi-national organizations. Our direct sales organization allows our sales representatives to understand each client’s specific business needs better and provide the ongoing support that facilitates effective cross-selling.
iMAP Offerings
Our current iMAP offerings provide integrated solutions to meet the needs of middle market and global 1000 clients implementing distributed business functions, whether based on applications we provide
or where we are hosting existing applications provided by the client. These solutions integrate four basic components.
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Leading packaged application and database software. Our application packages address major business process areas including e-commerce, sales force automation and customer support, human resource and financial management, messaging and collaboration and professional services automation. We have chosen to focus on mission-critical business processes that serve distributed users. These processes can gain maximum value from Internet implementations, our management of database platforms and from our infrastructure.
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USi-managed client application Web sites available via our global network. USi-managed client application Web sites are housed on dedicated USi-managed servers and available via a reliable, high-performance and secure global Internet network. Our network architecture is designed to ensure responsiveness and allows clients to define which groups will have full or limited access to the Web site or the server.
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Consulting and systems integration services. iMAP consulting and systems integration services define, develop and offer a service that provides access to a combination of our network services, application software and related hardware necessary to provide our service and meet a specific client’s needs. Within the iMAP solutions, we do not develop software nor do we implement substantial customization of existing packages. Rather, modular packages applications are configured to meet a client’s requirements.
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Integrated client service. Once implemented, iMAP solutions are efficiently managed in our network of EDCs. We provide client support twenty-four hours a day, seven days a week, from dedicated teams with specific knowledge of each client implementation.
In addition to the specific application areas that we support, we allow clients to host their own software applications in our highly reliable and secure data center environment. In this context, the iMAP offering consists of all of the above elements other than the provision of application layer software. Clients for this complex Web hosting realize all the reliability, security and responsiveness benefits of our network; however, we take no responsibility for the application itself. We believe that many of our complex Web site management clients intend to migrate to a USi-supported application over time.
Most of our iMAP contracts, including our contracts for complex Web hosting, provide for a modest initial payment and are generally not less than three years in length. However, client contracts signed under our agreement with Siebel may have a term as short as six months and we foresee that some Web hosting contracts may also have shorter terms. Several of our earliest iMAP contracts permit early termination without substantial penalty. Our contracts provide for prospective payment reductions in the event that agreed service levels, as measured and quantified by system performance benchmarks, are not met.
The USi Service Components
Ongoing Support
Implementation Services
24 x 7 Security
Applications & Databases
Computing Hardware
Data Centers
Networked Communications
USi’s Special Applications Network
We designed our global network specifically to provide superior performance for the iMAP offerings. By maintaining architectural and operational control over our network up to the point at which the client’s traffic leaves its ISP backbone or corporate LAN, our network is designed to:
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provide uptime of 99.9% or better to the entire network, which includes the dedicated customer server;
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provide fast and predictable response time and access to customer content globally; and
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provide reliable and customized network security.
Network uptime
Our global network is designed to ensure 99.9% uptime by following four specific principles:
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avoiding incompatibility through standardization;
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utilizing redundant components;
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offering the ability to mirror client servers in separate EDCs; and
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implementing USiView, our global end-to-end network management system.
Our network is designed around Cisco networking hardware, which minimizes multi-vendor integration and reduces the risks of hardware incompatibility and implementation delay. Cisco has designated our network as a Cisco Powered Network, indicating that Cisco has reviewed and approved the network design. Our network architecture relies on redundancy of network hardware, facilities infrastructure such as power supplies and telecommunications circuits, which maximizes the network availability. In addition, we have redundant EDCs, GEMCs and wide area networks connecting our EDCs. The wide-area network connection can be used to dynamically mirror or provide a duplicate site for each client at an alternative EDC location. This mirroring feature protects the site from downtime resulting from catastrophic failure at a specific geographic location. For clients requiring real time disaster recovery, we use storage arrays that enable real time data mirroring and are designed to maintain the integrity of data to within minutes.
The GEMC staff manages and monitors the network systems environment, telecommunications hardware and data content servers in all of our EDCs, both domestic and international, using USiView, our global network operations technology, an end-to-end network management platform. USiView consists of an integrated suite of scalable software tools that allow the GEMC staff to proactively monitor systems-level events, processes and thresholds. USiView is the foundation of our systems and operations management strategy, providing us with:
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a unified configuration and change management method;
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an event correlation facility that collects, processes and responds to management event information from a variety of sources; and
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a central repository for inventory and asset management information.
Fast response time
In order to facilitate the faster response time, we have designed our PriorityPeering network to avoid congestion areas on the Internet and have specifically designed our primary GEMC to support our integrated network. We seek to avoid the known Internet congestion points at the Metro Area Exchanges and at the network access points. In order to bypass the MAEs and network access points, our network in North America connects directly with eight major Internet Service Providers’ backbones, which carry about 85% of all the traffic on the Internet today. Client data is routed directly over an ISP’s network to our network, bypassing congested public exchange points.
Network security
Each EDC features multiple levels of security to isolate private information from public information. Private network infrastructure is physically isolated with cabling, switches and routers separately maintained from the hardware for the public network infrastructure. In addition, access to the EDCs and GEMCs is restricted to authorized personnel by hand scan readers, which also monitor and record entrances and departures. The public network and the private network have minimal electronic or logical interconnection and are connected only through a redundant firewall. The network also includes firewall products that enforce data security and policy-based routing for clients who prefer secure access to server resources. We believe that these measures ensure complete separation and security between its public and private networks.
Strategic Software Vendor Relationships
In developing our iMAP solutions, we have formed relationships with some of the market-leading software providers whose applications support critical business processes. These application providers include BroadVision, Ariba, Siebel, Lawson, PeopleSoft, Microsoft, Niku and Sagent. We believe that we have proven to be an attractive partner for these software companies because of our strategy to deliver integrated solutions to middle market enterprises in a cost-effective service model. Each of our software agreements is unique, but most allow us to deploy packaged application software as a service without the need to establish a separate licensing arrangement for each client. The agreements also generally include co-marketing, specialized product training and preferred pricing on the licenses to the software. We plan to enter into additional agreements with other software vendors over time.
Each of our key application software relationships is described below.
BroadVision. We have agreed with BroadVision to offer BroadVision’s e-commerce application as an iMAP solution. BroadVision’s e-commerce application has been adopted by enterprises across a broad range of industries. The agreement with BroadVision allows us to offer a robust set of e-commerce solutions for business-to-business and business-to-consumer commerce. BroadVision has named us as its first certified e-commerce application service provider worldwide.
Our agreement with BroadVision allows for attractive discounts on licenses. Our arrangement with BroadVision also provides for flexible use of licenses worldwide, sharing of development methodology, technical support, joint sales activity and co-marketing. We maintain iMAP solutions engineers, trained and certified on BroadVision applications, in nine major metropolitan areas.
Ariba. Ariba is a leading provider of intranet- and Internet-based business-to-business electronic commerce solutions. The company’s products efficiently connect requestors to approvers and buyers to suppliers to deliver an automated solution for improving the acquisition and management of the goods and services required to operate a company.
Our comprehensive partnership with Ariba includes product development, application implementation and management services, as well as cooperative sales and marketing. Under terms of the agreement, USi is a preferred ASP for the Ariba ORMX solution. Our arrangement with Ariba enables us to not only offer buyers the Ariba ORMX solution as part of our iMAP portfolio, but it also allows us the opportunity to provide other iMAP solutions to the suppliers that want to connect to the Ariba Network.
Siebel. Siebel is the recognized leader in providing enterprise relationship management applications, a range of product offerings that includes sales force automation, customer service/help desk and enterprise marketing. We have entered into an agreement with SiebelNet, Inc., a wholly owned subsidiary of Siebel Systems, Inc., pursuant to which we serve as the exclusive application service provider of Siebel enterprise relationship management applications for customers of SiebelNet that are headquartered in North America. Under this agreement, SiebelNet pays us a monthly fee for services including ready-to-service hardware, network connectivity and client support.
Our agreement with Siebel establishes a joint program in which the Siebel sales force will offer outsourcing as a product option. While Siebel, in most instances, retains control of the application licensing, we implement the application in our EDCs, provide on-going management and support, and provide our consulting and implementation services. Enterprise relationship management opportunities identified by our sales force are handled in the same manner. In return for the exclusivity of this relationship, we have agreed not to offer any competing enterprise relationship management applications as part of our iMAP solutions. The agreement mandates joint marketing programs, joint oversight of, and agreement on, the program to sell enterprise relationship management application outsourcing services, and commissioning of both Siebel’s and our sales representatives participating in each sale.
We have extended our strategic partnership with Siebel Systems, Inc., to include Siebel for Workgroups applications, a powerful suite of e-business applications that automate the sales marketing and service functions of small to mid-sized businesses as a term license iMAP product. USi’s Workgroups offering is focused on providing mid-tier companies with Siebel business applications functionality over secure Internet and dedicated network connections, hosted and managed out of USi’s EDCs. Additionally, USi provides as a free download from its web site Siebel Sales, a single user sales marketing solution.
Lawson. Lawson is an established leader in the enterprise resource planning software industry and one of the pioneers of fully Internet-enabling its software products. Lawson is also a recognized leader in selling its enterprise applications on a worldwide basis. Lawson’s product functionality includes human resources, financial management, supply chain, collaborative commerce, enterprise budgeting and procurement. Lawson has selected USi as a global Application Service Provider.
Our agreement with Lawson provides that qualified new outsourcing leads identified by Lawson will be referred to USi for hosting and application management. Outsourcing leads identified by USi or Lawson will be jointly marketed and quoted. USi has committed to provide marketing support and resources for our Lawson offering. The term of the Lawson agreement is one year, and will renew annually for up to five years unless either party provides notice of termination prior to the end of any given year. In October 1999, we purchased Conklin & Conklin, Inc. a comprehensive provider of Lawson financial and human resources system implementation services and a certified reseller of Lawson software licenses.
PeopleSoft. We have agreed with PeopleSoft to offer PeopleSoft human resource and core financial applications as iMAP solutions. PeopleSoft is an established leader in the enterprise resource planning software industry and the recognized leader in human resource management solutions. We are one of 10 currently certified PeopleSoft Application Service Providers.
Our agreement with PeopleSoft provides that opportunities identified by our sales force be jointly marketed and quoted. Opportunities identified by the PeopleSoft sales force may be jointly marketed and quoted with us. Customers who elect outsourcing through us will purchase our iMAP solutions. The agreement also provides for the sharing of rapid deployment methodologies, complete software support, the ability to joint market products and services, shared visibility at industry events, sharing of sales leads and joint training efforts.
Microsoft. We have agreed with Microsoft to offer Microsoft’s Exchange and Site Server products as iMAP solutions. Microsoft Exchange is the recognized leader in messaging and collaboration management solutions. Microsoft Site Server is a leading e-commerce platform.
Our multi-year Exchange agreement with Microsoft grants us the right to distribute the Exchange software as part of our iMAP solution on a pay-per-user licensing fee basis. Under our other licensing agreement with Microsoft we implement, host and manage e-commerce solutions based on Microsoft Site Server.
Niku. Niku is a leading developer of Professional Services Automation solutions.
Our agreement with Niku allows us to offer, as an iMAP solution, up-front installation, training and conversion services for Niku’s PSA solutions. Under our agreement, we pay a discounted fee for each Niku license included in any iMAP solution.
Sagent. We have agreed with Sagent to offer Sagent Internet Enterprise Intelligence applications as an iMAP solution. Sagent is currently fully prepared to service the emerging Internet Enterprise Intelligence market with its single, integrated, fully Internet-enabled, data warehousing solution. Oracle and Siebel have selected Sagent as the exclusive data modeling and data movement technology upon which their data warehouse products are based.
Our agreement with Sagent allows for attractive discounts on licenses and services and grants us the right to distribute the software as part of our iMAP solutions without the need to establish a separate licensing arrangement for each client. The agreement also provides for flexible use of the licenses worldwide, access to rapid deployment methodology, software support, joint marketing and visibility as a Sagent Premier Partner at industry events, shared training resources and sharing of sales leads.
Sales and Marketing
We offer our products and services through a direct sales organization based in the U.S. Each sales representative is responsible for a limited number of client relationships. We believe this approach enables our sales representatives to understand each client’s specific business needs thoroughly and to provide top quality ongoing support. We currently have 45 sales representatives located throughout the U.S. We intend to expand our sales organization into all major U.S. markets.
Our sales teams target medium-sized enterprises based in the U.S. with annual revenues ranging from $50 million to $1 billion and selected divisions of larger multinational organizations. Our sales strategy emphasizes that iMAP solutions enable clients to avoid extensive initial capital outlays, maintain focus on their core businesses, reduce technical and integration risks and shorten implementation time for software applications.
We have developed programs to attract and retain high quality, motivated sales representatives that have the technical skills and consultative selling experience necessary to sell our iMAP solutions. In addition, our acquisitions have augmented our sales and technical team and have created opportunities for more rapid market penetration in their geographic region and access to established business relationships for cross-selling.
We have established a marketing communications organization that is responsible for the branding and marketing of all our iMAP solutions and for distinguishing iMAP as a branded product offering. The marketing organization is responsible for all new service launches to ensure both internal execution and marketplace acceptance. The marketing organization has developed cooperative marketing and trade show participation programs in conjunction with our strategic software and hardware partners.
USi and AT&T Corp. have entered into a cooperative market agreement whereby USi and AT&T will jointly market and deliver ASP services to mid-market and high-growth companies. AT&T sales channels will refer customers seeking to leverage our applications and services expanding the sales channel for all of our iMAP offerings. We will utilize AT&T’s domestic and international frame, ATM, and IP Services to connect and deliver the functionality of our iMAP services.
Under the agreement, we have been named the first “Platinum Member” of AT&T’s Ecosystem for ASPs. Additionally, we have named AT&T our “Preferred Network Services Provider,” whereby AT&T becomes the recommended network provider to our customers for Frame and ATM connectivity requirements. AT&T and USi will initially focus on marketing in the DC/ Northern Virginia/ Maryland area, with additional areas to be added later. Sales may also occur outside of the target geographic markets. The initial term is one year with an optional two year extension.
The Agreement may be terminated by either party for cause or, after six months, if certain performance objectives are not met. In connection with entering into the agreement we will issue AT&T warrants to acquire up to 150,000 shares of common stock at an exercise price of $32.00 per share. As part of the agreement, we will also agree to nominate for election as a director a designee of AT&T.
We are a party to a marketing agreement with U S WEST Communications, Inc., the incumbent local exchange carrier in fourteen western states. By the terms of that agreement, U S WEST gained exclusive rights to market some of our iMAP products in its fourteen-state region. We make our products available to U S WEST at a discount and provide technical support during the sales process. Due to the pending acquisition of U S WEST by Qwest, a competitor of USi’s, U S WEST and USi have mutually agreed to transition out of the marketing agreement. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” - Risk Factors. The markets we serve are highly competitive and many of our competitors have much greater resources.”
Client Care
A central element of the iMAP solution is a high level of responsive personalized service, referred to as client care. Through our client care process, a specific technical account manager is assigned to each client and support teams are designated to back up the account managers. This structure is designed to ensure service is available twenty-four hours a day, seven days a week. Assigned support teams comprise senior client support specialists, network engineers, and packaged application engineers. The teams have further support from a group of product-specific application engineers who are trained in the specific software applications that we offer.
Clients
We target primarily North American-based middle market enterprises and divisions of larger multinational organizations. We believe that these organizations will gain the most competitive advantage from iMAP solutions and that they provide the greatest opportunity for the outsourcing of information technology operations. Currently, business software application vendors are providing software predominantly to larger organizations. Historically, attempts to market to middle market enterprises have generally been unsuccessful due to the high up-front costs to obtain the required software, the long lead time to integrate the software into the specific business process and the competition for and shortage of IT resources in middle market companies.
We currently have clients for both our iMAP offerings and traditional information technology services. Revenues from iMAP services comprise 61% of total revenue for the year ended December 31, 1999. As of December 31, 1999 we had 109 signed contracts with 88 clients for our iMAP services, representing over $140.0 million in expected contract revenue (assuming payments over the full contract terms) and approximately $43.1 million of 12 month backlog, which we define as revenue under contract expected to be recognized in the next 12 months. As of December 31, 1999, selected clients of ours include:
Actuate Software
Intraware
Sagent
AllBooks4Less.com
Knoll Pharmaceutical
Samsung
Baltimore Sun
Lattice Partners
Service Hub
Clarus
Legg Mason
Star Telecommunications
CornerStone Brands
Liberty Financial Companies
Sunburst Hospitality
DEBTCOLLECT.COM
liveprint.com
TeleChoice
Franklin Covey
LHS Communications
The Luggage Center
GE Capital Investments
Loan Market Resources
U S WEST
Health Care Online
LocalVoice.com
V Technologies
Herman Miller
Niku
Ventana
Hershey Foods
Perfumania.com
WeTheShoppers.com
HP Shopping Village
PSDI
XL Capital
(hpshopping.com)
rdental.com
INSLAW
Rhythms NetConnections
Competition
The market for Internet-related services is extremely competitive. We anticipate that competition will continue to intensify as the use of the Internet grows. The tremendous growth and potential market size of the Internet market have attracted many start-ups as well as extensions of existing businesses from different industries. In the market for Internet-enabled application software and network solutions, we compete on the basis of performance, price, software functionality and overall network design. While our competition comes from many industry segments, we believe that no single segment provides the integrated, single-source solution that we provide.
Our current and potential competitors include Applications Service Providers and companies focused on the application hosting business such as Aristasoft, Breakaway Solutions, Corio, FutureLink, Interliant, Interpath, NaviSite and Telecomputing; Web hosting companies, such as Concentric, Digex and Exodus; enterprise applications vendors, such as Oracle, Siebel and SAP; business Internet Service Providers, such as MCI WorldCom, PSINet and Verio; telecommunications companies, such as AT&T, GTE, and Qwest (which has agreed to acquire our customer and significant stockholder, U S WEST); and systems integrators, such as Andersen Consulting, EDS, IBM and KPMG. While we believe that our network of proprietary EDCs together with our level of service, support and targeted business focus distinguish us from these competitors, some of these competitors have significantly greater market presence, brand recognition, and financial, technical and personnel resources than we do, and have extensive coast-to-coast Internet networks.
We compete with national, regional and local commercial systems integrators who bundle their services with software and hardware providers and perform a facilities management outsourcing role for the customer. These competitors generally have greater name recognition or more extensive experience than we do. Andersen Consulting, EDS and PricewaterhouseCoopers, among others, provide professional consulting services in the use and integration of software applications in single-project client engagements. Large systems integrators may establish strategic relationships with software vendors to offer services similar to our iMAP offerings. We expect that regional systems integrators are likely to compete with us based on local customer awareness and relationships with hardware and software companies. Additionally, regional systems integrators may align themselves with ISPs to offer complex Web site management combined with professional implementation services.
We compete with hardware and software companies in providing packaged application solutions as well as network infrastructure. In order to build market share, both hardware and software providers may establish strategic relationships to enhance their service offerings. IBM currently provides applications outsourcing for its Lotus Notes products and other non-IBM software applications. J.D. Edwards & Company, a developer of enterprise resource planning software, is offering its software in an outsourced model. Oracle is offering Oracle Business Online, a hosted enterprise resource planning application software solution. SAP has formed an outsourcing organization which is developing key partnerships with leading consulting firms to offer SAP software. We believe that additional hardware and software providers, potentially including our strategic partners, may enter the outsourcing market in the future.
All of the major long distance companies, including AT&T, MCI WorldCom, Qwest Communications and Sprint, offer Internet access services. Qwest has partnered with KPMG to deliver hosted enterprise resource planning solutions over the Internet, and Qwest has agreed to acquire our customer and substantial stockholder, U S WEST. In order to address the Internet connectivity requirements of the current business customers of long distance and local carriers, we believe that there is a move toward horizontal integration through acquisitions of, joint ventures with, and purchasing connectivity from, ISPs. Accordingly, we expect that we will experience increased competition from the traditional telecommunications carriers. Many of these telecommunications carriers, in addition to their substantially greater network coverage, market presence, and financial, technical and personnel resources, also have large existing commercial customer bases. We believe that our local presence, our strong technical and data-oriented sales force and our offering of branded software applications are important features distinguishing us from the telecommunications companies.
It is possible that new competitors or alliances may emerge and gain market share. Such competitors could materially affect our ability to obtain new contracts. Further, competitive pressure could require us to reduce the price of our products and services thus affecting our business, financial condition and results from operations.
Management
The following sets forth certain information regarding our current directors and executive officers as of December 31, 1999.
(1)
Member of the compensation committee
(2)
Member of the audit committee
Christopher R. McCleary is a co-founder of USi and has served as the Chairman and Chief Executive Officer of USi since January 1998. Prior to founding USi, he was the Chairman and Chief Executive Officer of DIGEX, Inc. from January 1996 to December 1997. Prior to serving at DIGEX, Mr. McCleary served as Vice President and General Manager for Satellite Telephone Service at American Mobile Satellite Corporation, a satellite communications company, from October 1990 to January 1996.
Stephen E. McManus is a co-founder of USi and has served as a director since April 1998. He served as President of USi until June 1999, at which time he became President of our E-Commerce Business Unit. Prior to joining USi, Mr. McManus was Director of U.S. Sales for the telecommunications unit of Data General Corporation from January 1998 to March 1998. From June 1995 to December 1997 Mr. McManus served as a Branch Manager for Silicon Graphics. Prior to joining Silicon Graphics,
Mr. McManus held several positions at Data General Corporation from June 1988 to May 1995, including District Manager for Distributor Sales, VAR District Manager and Branch Manager.
Jeffery L. McKnight has been Executive Vice President since December 1998. He originally joined USi in June of 1998 as Senior Vice President of Client Care. Previously, he held senior marketing and operations positions with Aeronautical Radio, Inc., or ARINC, the communications arm of all of the domestic airlines from May 1989 to July 1997. Prior to ARINC, he held senior operations positions with System One, Inc. from February 1963 to April 1989.
Andrew A. Stern has been Executive Vice President since June of 1999. He originally joined USi on July 24, 1998 as Executive Vice President and Chief Financial Officer. Prior to joining USi, Mr. Stern held positions at USF&G Corporation, an insurance company, from May 1993 to July 1998, most recently as Executive Vice President, Strategic Planning and Reinsurance Operations. In addition, Mr. Stern was a partner of Booz Allen & Hamilton, an international management and technology consulting firm with whom he was employed from August 1981 to May 1993.
Harold C. Teubner, Jr. has been Executive Vice President and Chief Financial Officer of USi since October 1999. From July 1998 until joining USi,Mr. Teubner worked as an independent consultant in the technology industry. Mr. Teubner served as the Executive Vice President and Chief Operating Officer at Concept Five Technologies from July 1997 to July 1998. During September 1996, Mr. Teubner served as COO of Nat Systems International, a French software company. Prior to joining Concept Five Technologies, Mr. Teubner was President and CEO of Visix Software, a company that builds high-end, object oriented, application development tools. Mr. Teubner was with Visix from July 1995 to June 1996. Mr. Teubner held positions with Sybase Inc. from January 1988 to April 1995. While at Sybase, Mr. Teubner served as the Senior Vice President of North American Operations from July 1992 to April 1995.
Gary J. Rogers joined USi in October 1999 as Senior Vice President, Worldwide Sales. Prior to joining USi, Mr. Rogers was with CMS/ Data, a division of PC Docs Group International, Inc. from September 1997 to September 1999. While at CMS/ Data, Rogers served in various capacities including: Vice President, Sales and Marketing and President, Chief Operating Officer. From May 1994 to July 1997, Mr. Rogers was with SQL Financials International, Inc. where he worked as Vice President of Sales and Regional Sales Manager. Mr. Rogers was an Area Sales Manager with The ASK Group/ Ingres from August 1990 to April 1994.
Lance H. Conklin has been President and General Manager, Lawson Business Unit since October of 1999. Mr. Conklin was a Vice-President and Co-Founder of Conklin & Conklin, Inc., a leading reseller and systems integrator of Lawson Software applications, from June 1982 until October 1999 when USi acquired Conklin & Conklin, Inc.
Michael Harper joined USi in April of 1998 as Vice President of Product Marketing. In January of 1999, Mr. Harper was promoted to Vice President and General Manager of PeopleSoft Business Unit. In July of 1999, Harper was named President and General Manager, PeopleSoft Business Unit. Prior to joining USi,Mr. Harper served as the Mid-Atlantic Systems Manager for Silicon Graphics, Inc. from July 1997 to April 1998 with responsibility for pre-sales and professional service to federal and commercial customers. Prior to Silicon Graphics, Mr. Harper was with IBM in various marketing, sales and professional service capacities from July 1989 to July 1994.
Alistar Johnson-Clague joined USi in October of 1999 as the President & General Manager, Siebel Business Unit. Prior to joining USi, Mr. Johnson-Clague was with Avent Inc., from December 1998 to June of 1999. From August of 1985 to December of 1998 Mr. Johnson-Clague served in various capacities while at JBA Holdings Plc, including: President/ CEO - Computer Solutions Division, President - US Software Solutions Division, General Manager-JBA (Northern) Ltd., and General Sales Manager-JPA Southeast.
Matthew D. Kanter has been President and General Manager of USi New York since July 1999. He originally joined USi in October of 1998 as Vice President and General Manager of USi New York. Prior
to joining USi, Mr. Kanter served as President and Chief Executive Officer of Advanced Communications Resources, Inc. from July 1995 to October 1998. Prior to serving as President and Chief Executive Officer, Mr. Kanter served as Vice President and Technical Director of Advanced Communications Resources, Inc. from January 1993 to July 1995.
Nick Magliato has been President and General Manager of Enterprise Messaging and Collaboration Business Unit since July 1999. Previously he served as the General Manager of the Private Networking Unit for DIGEX from March 1996 to May 1998. Prior to that, he was Director-Land Mobile Product, Sales and Distribution, for American Mobile Satellite Corporation from March 1994 to March 1996.
Mark J. McEneaney joined USi in April 1998 as its Vice President and Corporate Controller. In October 1999 Mr. McEneaney was promoted to Senior Vice President and Controller. Prior to USi, he was Chief Financial Officer of Questar Builders, Inc., from November 1997 to March 1998 and of William Ryan Homes, Inc. from April 1995 to October 1997.
William T. Price has been Vice President, Secretary and General Counsel of USi since April 1998. Prior to joining USi, Mr. Price was the senior trial associate in the Baltimore-based law firm of Albright, Brown & Goertemiller from April 1997 to April 1998, where he represented major corporate clients in antitrust, copyright, intellectual property and other commercial matters in various state and federal courts. Prior to joining Albright, Brown & Goertemiller, Mr. Price was a litigator and Managing Attorney for the New York based law firm of Finklestein and Levine. Mr. Price was with Finklestein and Levine from April 1993 to October 1996.
R. Dean Meiszer has been a director of USi since it was founded. Currently, Mr. Meiszer serves as the President of Lattice Communications, Ltd. Lattice Communications was formed in October 1997 by the principals and associates of Crisler Company to own, operate, and manage wireless transmission towers and related businesses. Meiszer has been President and Managing Director of The Crisler Company, a Cincinnati-based investment firm, since May 1989. Prior to Crisler, Mr. Meiszer was Senior Vice President of Society Bank from March 1978 to May 1989.
Benjamin Diesbach was appointed to the board of directors in May 1998 as a designee of Mr. McCleary in his role as Chief Executive Officer of USi. He has been President of Midwest Research, Inc., a consulting firm, since he formed it in January 1995. Prior to forming Midwest Research, Mr. Diesbach was Chief Executive Officer of Continental Broadcasting, Ltd., a broadcasting company, from September 1993 to January 1995.
David J. Poulin was appointed to the board of directors in May 1998 as a designee of Mr. McCleary in his role as Chief Executive Officer. He has been the head hockey coach at the University of Notre Dame since May 1995. Prior to joining Notre Dame as hockey coach, Mr. Poulin played in the National Hockey League for 13 years.
Ray A. Rothrock was appointed to the board of directors in June 1998 as a designee of the Venrock Group. He has been a General Partner of Venrock Associates, the high technology venture capital investment firm of the Rockefeller Family, since June 1988. Mr. Rothrock serves on the boards of directors of CheckPoint Software Technology and Fogdog Sports, Inc. and several private companies including Qpass, PrintNation.com, Appliant.com, SteelEye Technologies, Reciprocal, Inc., Shym Technology and Simba Technology.
Frank A. Adams was appointed to the board of directors in June 1998 as a designee of the Grotech Group. He is the President and Chief Executive Officer of Grotech Capital Group, which he co-founded in August 1984. Mr. Adams has served as President of the Mid-Atlantic Venture Association since July 1985. He has served on the board of directors of a number of technology companies including Thunderbird Technologies, Inc. and EPIC Therapeutics, Inc.
William F. Earthman was appointed to the board of directors in June 1998 as a designee of the Massey Burch Group. He has been a Partner of Massey Burch Capital Corporation since January 1994. Prior to becoming a Partner at Massey Burch Capital Corporation, Mr. Earthman served from
January 1990 as a Vice President of Massey Burch Investment Group. Prior to Massey Burch, he worked for the investment banks J.C. Bradford & Co. from September 1975 to October 1981, Prudential-Bache Securities from October 1981 to November 1985 and First Nashville Corp. from December 1985 to December 1989. He currently serves on the board of directors of Intellivoice Communications, Inc. and Legal Technologies Network, Inc.
John H. Wyant was appointed to the board of directors in June 1998 as a designee of the Blue Chip Group. He is the Managing Partner and President of Blue Chip Venture Company, which he founded in 1990. Mr. Wyant is currently a director of Regent Communications, Inc., Zaring Homes, Inc., Delicious Brands, Inc. and Ciao Cucina Corporation. He previously served as a director of DIGEX.
Joseph R. Zell was appointed to the board of directors in July 1998 as a designee of U S WEST. Mr. Zell has informed us that he will resign as a director effective February 1, 2000, upon acceptance of his resignation by the board of directors. We expect the board of directors to accept his resignation prior to our 2000 annual meeting. Since December 1991, he has held several positions with the !NTERPRISE Networking division of U S WEST Communications, Inc., including Director of Product Development for !NTERPRISE, Executive Director of Applications Innovation, President of U S WEST’s Wholesale Division and Vice President of Markets and innovation at !NTERPRISE. He has been President of the division since March 1997.
Michael C. Brooks was appointed to the board of directors in December 1998 as a designee of the Whitney Group. He has been a general partner of J. H. Whitney & Co. since 1984. He is also a director of SunGard Data Systems, Inc., Pegasus Communications Corporation, Media Metrix, Inc., Homestore.com, Inc., VitaminShoppe.com, Inc. and various other private companies.
Cathy M. Brienza was appointed to the board of directors in May 1999 as a designee of Waller-Sutton Media Partners, L.P. Since July 1997, Ms. Brienza has been a member of Waller-Sutton Media, L.L.C., the general partner of Waller-Sutton Media Partners, L.P. Prior to joining Waller-Sutton Media, she was a principal of Sutton Capital Associates, Inc., and its affiliated companies, which engaged in the ownership and operation of cable television and cellular telephone systems.
Item 2.
Item 2. Properties
We are headquartered in Annapolis, Maryland. Our training and conference facilities are located in a building we own in Annapolis, Maryland. We believe that the building we own, due to its age, may contain limited amounts of asbestos containing materials. We do not believe that the limited asbestos presence would subject us to any material liability.
On April 30, 1999, we purchased land and a building in Annapolis, Maryland for $11.8 million. The seller financed $7.1 million of the purchase price through a first mortgage note and will lend us an additional $1.5 million for construction costs if we meet certain conditions. We are primarily finished renovating this building, which became our headquarters in November of 1999. Total cost of these renovations are anticipated to be $12 million.
In December of 1999, we obtained additional financing for the acquisition and renovations to our headquarters in the amount of $4.75 million from a major institutional lender. Partial payment of the loan is guaranteed by the Maryland Industrial Development Financing Authority.
We lease space in a number of other locations, primarily for EDC and GEMC installations and to house our consulting and implementation staff. We believe that our leased facilities are adequate to meet our current needs in the markets in which we have begun to deploy our services, and that additional facilities are available to meet our expansion needs in our target markets for the foreseeable future.
Our leases are for terms varying from 30 to 84 months and generally contain renewal options of two to three years as well as rent escalation clauses. During 1999 we incurred approximately $3.2 million in rent expense.
Item 3.
Item 3. Legal Proceedings
From time to time we may be involved in litigation that arises in the normal course of business operations. As of the date of this prospectus, we are not a party to any litigation that we believe could reasonably be expected to have a material adverse effect on our business or results of operations.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the fourth quarter of 1999.
Part II
Item 5.
Item 5. Market for Registrant’s Common Equity and Related Shareholder Matters
On April 9, 1999, we sold 15.525 million shares of our common stock pursuant to a Registration Statement on Form S-1 (Registration No. 333-70717), which was declared effective by the Commission on April 9, 1999. Credit Suisse First Boston Corporation was the managing underwriter. The net proceeds were approximately $132.8 million, all of which will be used:
•
to continue expanding and enhancing our network and facilities,
•
to add additional services to our iMAP offerings, and
•
for working capital and other general corporate purposes.
In addition, we used some of the proceeds to pay accrued dividends on our shares of convertible preferred stock. Some of the net proceeds may also be used:
•
to repay current or future debts,
•
to fund acquisitions or acquire complementary products, or
•
to obtain the right to use complementary technologies.
On February 17, 2000, we sold 3 million shares of our common stock and some of our shareholders sold an aggregate of 7.35 million shares of our common stock pursuant to a Registration Statement on Form S-1 (Registration No. 333-95543), which was declared effective by the Commission on February 17, 2000. Credit Suisse First Boston Corporation was the managing underwriter. The net proceeds were approximately $119.0 million, all of which will be used:
•
to continue expanding and enhancing our network and facilities;
•
to increase marketing efforts;
•
to invest in licenses, research and product development in order to add new applications to our iMAP offerings;
•
to finance debt service;
•
to acquire complementary products; and
•
for working capital and other general corporate purposes.
Some of the net proceeds we receive may also be used;
•
to repay current or future debts;
•
to obtain the right to use complementary technologies; and
•
to fund acquisitions that we may pursue on an opportunistic basis.
Common Stock Price Range
Our common stock has been traded on The Nasdaq National Market under the symbol “USIX” since the completion of our initial public offering in April 1999. All sales prices below have been adjusted to reflect our three-for-two stock split effected by means of a stock dividend distributed on December 17, 1999 and an additional three-for-two stock split to be effected by means of a stock dividend to all shareholders of record at the close of business on March 14, 2000 which will be distributed on or about March 28, 2000.
The following table sets forth, for the periods indicated, the high and low prices of our common stock on The Nasdaq National Market for the second, third and fourth quarters of 1999 and the first quarter of 2000 from the commencement of trading on April 9, 1999 through February 17, 2000.
The last sale price of the common stock on The Nasdaq National Market on March 14, 2000 was $53.67.
Dividend Policy
We have never paid cash dividends on our common stock and have no plans to do so in the forseeable future. The declaration and payment of any dividends in the future will be determined by the board of directors and will depend on a number of factors, including our earnings, capital requirements and overall financial condition. The payment of dividends is also restricted by the terms of our indebtedness.
Recent Sales of Unregistered Securities
Set forth in chronological order is information regarding all securities sold and employee stock options granted by the Company since January 14, 1998. Further included is the consideration, if any, received by the Company for such securities, and information relating to the section of the Securities Act of 1933, as amended (the “Securities Act”), and the rules of the Securities and Exchange Commission under which exemption from registration was claimed. All awards of options did not involve any sale under the Securities Act. None of these securities were registered under the Securities Act. Except as described below, no sale of securities involved the use of an underwriter and no commissions were paid in connection with the sales of any securities.
1.
At various times during the period from January 1998 through March 22, 1999, the Company granted to employees and directors options to purchase an aggregate of 7,710,455 shares of Common Stock with exercise prices ranging from $1.17 per share to $2.67 per share. The issuance of these securities were not registered under the Securities Act in reliance upon Rule 701 of the rules promulgated under the Securities Act.
2.
On January 14, 1998, the Company issued 1,406,250 shares of Common Stock to Christopher R. McCleary for $5,000 in cash.
3.
On April 1, 1998, the Company issued 1,617,187 shares of Common Stock to Stephen E. McManus and Christopher Poelma for an aggregate purchase price of $57,500. The purchase price for the Common Stock was paid with cash and notes payable to the Company.
4.
On May 31, 1998, the Company issued 38,333.33 shares of Series A Preferred Stock for an aggregate purchase price of $23 million to the Initial Series A Investors. The purchase price for such shares was
paid in cash at the time of the issuance. The Company simultaneously issued 1,666.67 shares of Series A Preferred Stock for an aggregate purchase price of $1 million to Christopher R. McCleary. The purchase price for such shares was paid by the forgiveness by Mr. McCleary of $1 million of debt that the Company owed him.
5.
On June 18, 1998, the Company issued 5,000 shares of Series A Preferred Stock for an aggregate purchase price of $3 million to certain of the Initial Series A Purchasers. The Company simultaneously issued 5,833.33 shares of Series A Preferred Stock for $3.5 million to U S WEST. The purchase price for such shares was paid in cash at the time of issuance.
6.
On June 19, 1998, the Company issued 3,000 shares of Series A Preferred Stock for an aggregate purchase price of $1.6 million to HAGC Partners, Chris Horgan (who later transferred his interest to his affiliate, Southeastern Technology Fund, L.P.) and the Account Management Purchasers. The purchase price for such shares was paid in cash at the time of issuance. The Company simultaneously issued 1,166.67 shares of Series A Preferred Stock for a purchase price of $700,002 to USi Partners. The purchase price for such shares was paid in cash at the time of issuance.
7.
On July 27, 1998, the Company issued to Andrew A. Stern 1,406,250 shares of Common Stock with a fair market value of $1,000,000. Mr. Stern paid $5,000 in cash for these shares, and the remainder was recorded as a compensation expense to the Company.
8.
On September 8, 1998, the Company issued convertible promissory notes in the aggregate amount of $9,095,000, together with warrants to purchase 2,192,512 shares of Common Stock for $1.53 per share, to certain of the existing holders of the Series A Preferred Stock. The purchase price for such notes and warrants was paid in cash at the time of issuance. The Company also issued warrants to purchase 112,500 shares of Common Stock for $7.11 per share, to IIT as part of the purchase price paid in the acquisition of IIT.
9.
On September 22, 1998, the Company issued warrants to purchase 167,409 shares of Common Stock for $1.49 per share to Trans America Business Credit in connection with loans the Company obtained from it.
10.
On September 30, 1998, the Company issued warrants to purchase 971 shares of Series B Preferred Stock for $1,050.00 per share, to Venture Lending and Leasing in connection with loans the Company obtained from it.
11.
On October 2, 1998, the Company issued warrants to purchase 140,625 shares of Common Stock for $7.11 per share, to ACR as part of the purchase price paid in the acquisition of ACR.
12.
On December 16, 1998, the Company issued convertible promissory notes in the aggregate amount of $8 million to certain of the existing holders of the Series A Preferred Stock. The purchase price for such notes was paid in cash at the time of issuance.
13.
On December 18, 1998, the Company issued warrants to purchase 40,178 shares of Common Stock for $1.49 per share, to Leasing Technology, Inc. in connection with loans the Company obtained from it.
14.
On December 24, 1998, the Company issued convertible promissory notes in the amount of $5 million to U S WEST. The purchase price for such notes was paid in cash at the time of issuance.
15.
On December 31, 1998, the Company issued 59,278.56 shares of Series B Preferred Stock for an aggregate purchase price of $62,242,500 to certain holders of the convertible promissory notes described above, certain holders of Series A Preferred Stock, and a number of new investors. Of the total purchase price for such shares, $40,147,500 was paid in cash and $22,095,000 was paid by conversion of outstanding convertible promissory notes with an equivalent principal amount, all at the time of issuance.
16.
On October 29, 1999 the Company issued $100,000,000 7% Convertible Subordinated Notes Due November 1, 2004. The purchase price of such notes was paid in cash at the time of issuance. The
issuance of these notes was not registered under the Securities Act in reliance on the exemption from registration provided by Section 4(2) of the Securities Act, and resales of these Notes have been exempt from registration under Rule 144A.
17.
On November 5, 1999 the Company issued $25,000,000 7% Convertible Subordinated Notes Due November 1, 2004. The purchase price of such notes was paid in cash at the time of issuance. The issuance of these notes was not registered under the Securities Act in reliance on the exemption from registration provided by Section 4(2) of the Securities Act, and resales of these Notes have been exempt from registration under Rule 144A.
The issuances and resales of the securities above were made in reliance on one or more exemptions from registration under the Securities Act, including those provided by Section 4(2) and Rules 144A and 701 thereunder. The purchasers of these securities represented that they had adequate access, through their employment with the Company or otherwise, to information about the Company.
On April 8, 1999, in connection with USinternetworking’s initial public offering, a Registration Statement on Form S-1 (No. 333-70717) was declared effective by the Securities and Exchange Commission, pursuant to which 15,525,000 shares of USinternetworking’s common stock were offered and sold for the account of USinternetworking at a price of $9.33 per share. Generating gross offering proceeds of $144.9 million. The managing underwriters were Credit Suisse First Boston, Bear, Stearns & Co. Inc., BT Alex. Brown and Legg Mason Wood Walker Incorporated. After deducting approximately $10.1 million in underwriting discounts and $2.0 million in other related expenses, the net proceeds to USinternetworking were approximately $132.8 million.
The net proceeds to USinternetworking were invested in short-term, investment-grade interest-bearing securities. USinternetworking used a portion of the net proceeds to pay accrued dividends on its preferred stock. USinternetworking has no specific plans at this time for the use of the remaining proceeds and expects to use such proceeds for working capital and general corporate purposes.
(d) the Company filed its first registration statement under the Securities Act effective April 8, 1999, File No. 333-70717. From the effective date of the registration statement to December 31, 1999, the Company’s use of the net offering proceeds was as follows:
Item 6.
Item 6. Selected Historical Consolidated Financial Data
The following table summarizes:
•
our historical consolidated financial data for the period from our date of inception, January 14, 1998, through December 31, 1998 and as of December 31, 1998;
•
our historical consolidated financial data for the year ended December 31, 1999 and as of December 31, 1999.
The selected financial data have been derived from, and is qualified by reference to, our audited consolidated financial statements for the periods presented. Our audited consolidated financial statements for the period from our inception through December 31, 1998 include the results of I.I.T. Holding, Inc., or IIT, from September 8, 1998 through December 31, 1998 and the results of Advanced Communication Resources, Inc., or ACR, from October 2, 1998 through December 31, 1998. Our audited consolidated financial statements for the year ended December 31, 1999 include the results of Conklin & Conklin, Inc. from October 8, 1999 through December 31, 1999.
You should also read “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the financial statements and related notes of USi and IIT included in Part II, item 7
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read together with the financial statements and related notes of USi and IIT included in this report. The discussion in this report contains forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. The cautionary statements made in this report apply to all related forward-looking statements wherever they appear in this report. Our actual results could differ materially from those anticipated in such forward-looking statements. Factors that could cause or contribute to differences include those discussed in “Risk Factors,” as well as those discussed elsewhere in this report. The forward-looking statements contained in this report are made as of the date of this report, and we assume no obligation to update these forward-looking statements or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements. See “Risk Factors.”
Overview
I.I.T. Holding, Inc., the predecessor of USi for accounting purposes, specialized in systems analysis and design and systems integration solutions. IIT provided PeopleSoft human resources management and
financial system implementation. IIT’s consulting professionals have expertise in human resource management as well as accounting and financial systems.
We acquired IIT in September 1998 as a part of our program to develop a new Internet-based service offering. IIT provides implementation capabilities that enable us to provide human resource and financial management functionality as part of our iMAP service offerings.
We have developed an advanced, integrated service offering that provides our clients the ability to use leading business software applications through our state-of-the-art Internet-based network. During 1998, we devoted substantially all of our efforts to developing our network infrastructure, recruiting and training personnel, establishing strategic business partnerships with application software providers, completing two strategic acquisitions and raising capital. During our first full year of operations in 1999, we continued the development activities started in 1998 and began to market and sell our new iMAP product offerings. We have incurred a cumulative net loss since inception and expect to incur additional losses for at least the next twelve months, due primarily to additional start-up costs related to implementation of our services and the continued expansion and enhancement of our network. As of December 31, 1999, we had an accumulated deficit of approximately $135.8 million. As of December 31, 1999, we had 109 signed contracts with 88 clients accounting for total revenue, assuming payment over the full contract terms, of over $140.0 million. While we have experienced significant growth in revenue under contract in recent periods and currently expect substantial, although potentially lower, growth in revenue under contract throughout 2000, prior growth rates should not be considered as necessarily indicative of future growth rates or operating results for 2000. See “Risk Factors - Our business is difficult to evaluate because we have a limited operating history”; “- We expect to incur losses and experiences negative cash flow”; “- The markets we serve are highly competitive and many of our competitors have much greater resources”; and “- Our growth could be limited if we are unable to attract and retain qualified personnel”.
In October 1999, we purchased the assets of Conklin & Conklin, Inc. a comprehensive provider of Lawson financial and human resources system implementation services and a certified reseller of Lawson software licenses. The purchase price consisted of cash of $7.7 million, assumed liabilities of $1.5 million, and a $2.0 million secured note. The secured note is due on October 8, 2001, and bears interest at 10%, with interest payable monthly until the maturity date. In addition, the purchase price consists of contingent payments of up to $4.6 million in cash. Portions of the contingent payments can be earned by Conklin shareholders through January 2002 upon the attainment of specified financial milestones.
In April 1999, we completed an initial public offering of our common stock. The net proceeds from the sale of the 15,525,000 shares of common stock were approximately $132.8 million. The initial public offering of common stock met the criteria for the automatic conversion of our outstanding Series A Convertible Preferred Stock and Series B Redeemable Convertible Preferred Stock into common stock. In addition, the repurchase rights lapsed with respect to all common stock subject to repurchase.
In November 1999, we completed the sale of our 7% convertible subordinated promissory notes for net proceeds of approximately $119.9 million.
In February 2000, we completed a secondary offering of our common stock. The net proceeds from the sale of 3,000,000 shares of common stock were approximately $119.0 million.
Revenue. We generate revenue from iMAP services and information technology services. Revenues from professional IT services are recognized as services are provided. iMAP revenues consist of implementation fees and monthly recurring fees for services. Implementation fees are generally paid in advance and are deferred and recognized ratably over the term of the iMAP service contract. Monthly iMAP service fees are consideration for access to our network of EDCs hosting application software, and the implementation and management of that software. iMAP contracts generally have a three-to-five year term and revenues are recognized ratably over the contract term. Payments received in advance of revenue recognition, even if non-refundable, are recorded as deferred revenue. Some contracts permit termination
without cause by the clients. Contracts permitting termination without cause generally provide for termination payments to us that will be recognized as revenue when collectibility is assured.
Costs and expenses. We incur operating costs and expenses related to the delivery of iMAP and professional IT services. They include direct costs of service, network and infrastructure, general and administrative, sales and marketing, product research and development, stock compensation, depreciation and amortization expenses. Since inception, we have incurred expenses consisting primarily of compensation and benefits, recruiting, occupancy and consulting. We have expensed all start-up costs as incurred.
We incur up-front costs related to the delivery of iMAP services. Product research and development costs and the cost to operate our network and data centers are recognized as period costs. Costs related to the acquisition of hardware are capitalized and depreciated over the estimated useful life of the hardware of five years. Costs related to the acquisition of software licenses are capitalized and amortized over the lesser of either three years or the term of the individual client contract, depending on the nature of the software license agreement. Amortization is based on a straight-line basis over the remaining useful life. Direct costs related to the integration of software applications for a client on our network are capitalized and amortized over the related contract period.
Historical Results of Operations - USinternetworking
Comparison of the year ended December 31, 1999 to the period ended December 31, 1998
Revenue. For the year ended December 31, 1999, we generated $21.7 million in iMAP revenue and $13.8 million in professional IT services revenue. For the period January 14, 1998, our date of inception, through December 31, 1998 we generated $0.1 million in iMAP revenue and $4.0 million in professional IT services revenue. The increase of $21.6 million in iMAP revenue is a result of signing a total of 102 iMAP client contracts during 1999. The 1998 professional IT services revenue can be attributable to our subsidiaries IIT ($2.0 million) and ACR ($2.0 million) which were acquired during the third and fourth quarters of 1998, respectively. The increase of $9.8 million in professional IT services revenue can be attributed to a full year of operations during 1999.
Gross margins, direct costs of services, network and infrastructure costs. For the year ended December 31, 1999, we incurred $14.8 million and $8.8 million of direct costs related to the delivery of our iMAP and professional IT services, respectively. For the period from January 14, 1998, our date of inception, through December 31, 1998, we incurred $0.9 million and $2.5 million of direct costs related to the delivery of our iMAP and professional IT services, respectively. Additionally, we incurred $16.2 million of costs related to the maintenance of our network and infrastructure for the year ended December 31, 1999 and $2.2 million of such costs during the period ended December 31, 1998. Gross margins, including iMAP network and infrastructure costs, for the year ended December 31, 1999 were (42.5)% and 35.9% for iMAP and professional IT services, respectively. Gross margins for professional IT services for the period ended December 31, 1998 were 37.6%.
General and administrative expenses. For the year ended December 31, 1999, we incurred $22.0 million of general and administrative expenses compared to $19.4 million for the period from January 14, 1998, our date of inception, through December 31, 1998. The increase of $2.6 million reflects the costs required to support an additional 59 general and administrative personnel during a full year of operations in 1999, offset by one time start-up costs incurred in 1998.
Sales and marketing expenses. For the year ended December 31, 1999, we incurred $36.6 million of sales and marketing expenses compared to $5.1 million for the period from January 14, 1998, our date of inception, through December 31, 1998. The increase of $31.5 million reflects the costs associated with our increased efforts to market and brand our service offerings, and the sales commissions related to the increase in iMAP revenue for the year ended December 31, 1999.
Product research and development expenses. For the year ended December 31, 1999, we incurred $5.4 million of product research and development expenses compared to $0.7 million for the period from
January 14, 1998, our date of inception, through December 31, 1998. The increase of $4.7 million reflects the costs associated with the continued development of our new products and infrastructure during a full year of operations for the year ended December 31, 1999, compared to start-up activities during 1998.
Non-cash stock compensation expense. For the year ended December 31, 1999, we incurred $10.4 million in non-cash compensation expense. Of this amount, $8.5 million resulted from employee stock options issued at an exercise price of $2.67 and an estimated fair market value of $8.87 to $14.89 per share at the date of grant. We will record an additional $26.5 million over the next two years in relation to those options. The remaining amount of $1.9 million resulted from our contribution of common stock to the employee benefit plan and the amortization of unearned compensation from restricted stock grants. There was minimal non-cash stock compensation expense for the comparable period in 1998.
Depreciation and amortization. Depreciation and amortization for the year ended December 31, 1999 totaled $22.5 million. Of this amount, $6.0 million represents the amortization of the goodwill recorded upon our acquisitions of ACR, IIT and Conklin; the remaining $16.5 million represents depreciation of our property and equipment and the amortization of our prepaid software licenses. As described in the “Change in Accounting Estimate” below, depreciation expense for 1999 was approximately $2.9 million lower as a result of changing our useful life of computer equipment from 3 to 5 years. There was minimal depreciation and no amortization expense for the comparable period in 1998.
Interest income and expense. For the year ended December 31, 1999, we incurred $6.3 million in interest expense principally from increased borrowings including $1.5 million of expense from our convertible subordinated notes. We generated $4.1 million of interest income principally from the investment of the proceeds from our initial public offering and convertible subordinated notes offering. We had minimal interest income and expense during the period ended December 31, 1998.
Historical Results of Operations - Predecessor
Comparison of the period ended September 7, 1998 to the period ended August 31, 1997
Revenue. Revenues for the period ended September 7, 1998, increased 194% over the period ended August 31, 1997. This increase is attributable to the growth in IIT’s PeopleSoft implementation services.
Gross margins, costs of sales and services. IIT incurred $3.0 million and $1.1 million of expenses in the delivery of its PeopleSoft implementation services for the periods ended September 7, 1998 and August 31, 1997, respectively. As a result, IIT’s PeopleSoft implementation services generated gross margins of 32.4% and 25.8% for the periods ended September 7, 1998 and August 31, 1997, respectively. The improved gross margins from period to period is attributable to a reduction in the use of subcontractors, an increase in IIT’s staff utilization and continued improvement in the demand for PeopleSoft implementation services.
Selling, general and administrative expenses. IIT incurred $1.8 million and $1.3 million of selling, general and administrative expenses for the periods ended September 7, 1998, and August 31, 1997, respectively. Selling, general and administrative expenses for the period ended August 31, 1997 include $1.0 million attributable to non-cash compensation expense related to the issuance of stock to three of IIT’s officers. Selling, general and administrative expenses increased $1.3 million for the period ended September 7, 1998, as a result of bonuses and related payroll taxes. The remaining increase of approximately $0.2 million is attributable to the additional selling, general and administrative support required to support IIT’s growing customer base.
Comparison of the years ended December 31, 1997 to the year ended December 31, 1996
Revenue. Revenues for 1997 over 1996 increased 276%. The significant increase in 1997 is attributable to growth in IIT’s PeopleSoft implementation services.
Gross margin, costs of sales and services. IIT incurred $0.5 million and $1.9 million of expenses in the delivery of services for the years ended December 31, 1996 and 1997, respectively. As a result, IIT
services generated gross margins of 30.5% and 33.1% for the years ended December 31, 1996 and 1997, respectively. The improved gross margin from year to year is attributable to a reduction in the use of subcontractors, an increase in IIT’s staff utilization, and improving market conditions for the PeopleSoft implementation services industry during this period.
Selling general and administrative expenses. IIT incurred $0.2 million and $1.8 million in selling, general and administrative expenses for the years ended December 31, 1996 and 1997, respectively. The primary factor in the $1.6 million increase from 1996 to 1997 is due to $1.0 million of non-cash compensation expense related to the issuance of stock to three of IIT’s officers. The remaining increase is attributable to the additional support required for IIT’s growing customer base.
Future Assessment of Recoverability and Impairment of Goodwill
In connection with our acquisitions of IIT, ACR and Conklin we recorded goodwill that is being amortized on a straight line basis over its estimated useful life. At December 31, 1999, the unamortized portion of these intangibles was $29.6 million, which represented 9.1% of total assets and 28.9% of stockholders’ equity. Goodwill represents the amount that we paid for these acquired businesses in excess of the fair value of the acquired tangible and separately measurable intangible net assets. We have estimated the useful life of our goodwill to be five years based upon several factors, the most significant of which is the susceptibility of acquired businesses to change as a result of technological advances and the rapidly changing needs of their customers.
We periodically review the carrying value and recoverability of our unamortized goodwill and other intangible assets for impairment. If the facts and circumstances suggest that the goodwill or other intangible assets may be impaired, the carrying value of this goodwill will be adjusted by an immediate charge against income during the period of the adjustment. The length of the remaining amortization period may also be shortened, which will result in an increase in the amount of goodwill amortization during the period of adjustment and each period thereafter until fully amortized. Once adjusted, there can be no assurance that there will not be further adjustments for impairment and recoverability in future periods. We have integrated the acquired businesses into our primary iMAP service offerings. Therefore, in evaluating impairment a principal factor we consider is the failure to achieve expected cash flows from operations.
Change in Accounting Estimate
On July 1, 1999, we changed our estimate of the useful life of our computer equipment from three to five years. The change in estimate will be accounted for prospectively, with depreciation expense for periods subsequent to June 30, 1999 calculated so as to depreciate the remaining book value of the equipment at June 30, 1999 equally over the revised estimated useful life which has an annual impact of reducing depreciation expense by approximately $6 million.
Liquidity and Capital Resources
At December 31, 1999, we had cash and cash equivalents of $112.3 million and available-for-sale securities of $31.7 million.
For the year ended December 31, 1999, we have used $78.2 million in operating activities, $121.7 million in investing activities and generated $268.4 million through financing activities. Included in financing activities was $132.8 million raised from an initial public common stock offering in April 1999. We invested these proceeds primarily in marketable securities. During 1999, we purchased $147.0 million of marketable securities and sold $115.6 million of marketable securities. We used the proceeds of the sale of the marketable securities to fund our current operations.
We have used debt and capital leases to partially finance our capital investments for the development of our infrastructure and the hardware required to support the increase in our iMAP clients. As of December 31, 1999, we had obtained commitments for secured financing from several sources, including
Cisco System Capital Corporation ($8.8 million), Venture Lending & Leasing II, Inc. ($10.0 million), Finova Capital Corporation ($11.7 million), Transamerica Business Credit Corporation ($9.0 million), Charter Financial Corporation ($5.0 million), LINC Capital ($6.0 million) and EMC Corporation ($6.4 million). At December 31, 1999, the total of our secured financing commitments was $79.9 million, of which $72.6 million had been funded.
In the fourth quarter of 1999, we issued $125 million in principal amount of subordinated convertible notes. The net proceeds from the issuance were approximately $119.9 million. The subordinated convertible notes pay interest at 7% and are convertible into common stock at the holder’s option at a price of $24.85 per common share.
In April 1999 we purchased an office building for $11.8 million. The seller financed $7.1 million of the purchase price through a first mortgage note due May 2006 bearing interest at 7.5% per annum. We spent approximately $9 million in 1999 on improvements to the building and have obtained financing for $4.75 million of these improvements.
We believe that these resources, together with the net proceeds received from the issuance of our common stock in the February offering, will be sufficient to fund our operations for at least the next twelve months. The majority of the base infrastructure required to provide our iMAP services has been purchased. As a result, our capital expenditures for the next several years will now largely be success-based, consisting of software licenses, hardware and the expansion of existing data center facilities required to implement iMAP solutions for our new customers. These new customer contracts are expected to have an average term of three to five years; however, we anticipate that many of our customers will renew their contracts due to the cost and complexity of switching service providers.
If we expand more rapidly than currently anticipated, if our working capital needs exceed our current expectations or if we make acquisitions, we will need to raise additional capital from equity or debt sources. We cannot be sure that we will be able to obtain the additional financing to satisfy our cash requirements or to implement our growth strategy on acceptable terms or at all. If we cannot obtain such financing on terms acceptable to us, we may be forced to curtail our planned business expansion and may be unable to fund our ongoing operations. We are presently pursuing a variety of sources of other debt financing, but no additional commitments have been obtained to date.
Year 2000 Compliance
Year 2000 Issue. The Year 2000 issue is a result of computer programs or systems, which store or process date-related information using only two digits to represent the year. These programs or systems may not be able to properly distinguish between a year in the 1900’s and a year in the 2000’s. Failure of these programs or systems to distinguish between the two centuries could cause the programs or systems to yield erroneous results or even to fail.
Effect on USi. To date, we have not experienced any material difficulties associated with the Year 2000 and we have not incurred any material liability or costs due to the Year 2000 issue. Our total expenses related to Year 2000 compliance through the end of 1999 were $1.0 million. We do not anticipate that we will incur any material additional costs due to Year 2000 compliance.
Risk Factors
Investing in our common stock involves risk. You should carefully consider the risks and uncertainties described below before making an investment decision. These risks and uncertainties are not the only ones that we face or that may adversely affect our business. If any of the following risks or uncertainties actually occur, our business, financial condition or results of operations could be materially adversely affected. This report also contains forward-looking statements that involve risks and uncertainties. Our actual results may differ from those described in the forward-looking statements. This could occur because of the risks described below and elsewhere in this report.
Our business is difficult to evaluate because we have a limited operating history.
We began operating in January 1998. Our limited operating history makes predicting future results difficult. Since our inception, we have focused on developing our business and only since September 1998 have we begun to contract with customers for our iMAP offerings. Because of our limited operating history and the emerging nature of our markets, our historical financial information is of limited value in projecting our future results. Therefore, it is difficult to evaluate our business and prospects.
We expect to continue to incur losses and experience negative cash flow.
We expect to have significant operating losses and to record significant net cash outflow before financing in the near term. Our business has not generated sufficient cash flow to fund our operations without resorting to external sources of capital. Starting up our company and building our network required substantial capital and other expenditures. As a result, we reported a net loss of $103.3 million for the year ended 1999 and EBITDA of negative $65.5 million for the same period. Further developing our business and expanding our network will require significant additional capital and other expenditures.
We may need additional capital to fund our operations and finance our growth, and we may not be able to obtain it on terms acceptable to us or at all.
We believe that the net proceeds from the sale of the common stock, together with cash on hand and our existing and anticipated debt and capital lease financing, will be sufficient to fund our operations for at least the next twelve months. However, if we expand more rapidly than currently anticipated, if our working capital needs exceed our current expectations or if we make acquisitions, we will need to raise additional capital from equity or debt sources. If we cannot obtain financing on terms acceptable to us or at all, we may be forced to curtail our planned business expansion and may be unable to fund our ongoing operations.
Our historical revenues were derived from services that we do not expect to be the focus of our business in the future.
We derive a portion of our revenue from professional services. We acquired two professional services businesses in the fall of 1998 and their services are substantively different than our iMAP offerings. As a result, historical financial information of the acquired businesses does not reflect the results we expect from our core business offering in the future.
Our success depends on the acceptance and increased use of Internet-based business software solutions, and we cannot be sure that this will happen.
Our business model depends on the adoption of Internet-based business software solutions by commercial users. Our business could suffer dramatically if Internet-based solutions are not accepted or not perceived to be effective. The market for Internet services, private network management solutions and widely distributed Internet-enabled packaged application software has only recently begun to develop and is now evolving rapidly.
The growth of Internet-based business software solutions could also be limited by:
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concerns over transaction security and user privacy;
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inadequate network infrastructure for the entire Internet; and
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inconsistent performance of the Internet.
We cannot be certain that this market will continue to grow or to grow at the rate we anticipate.
The growth in demand for outsourced business software applications by middle market companies is highly uncertain.
Growth in demand for and acceptance of outsourced business software applications, including our iMAP offerings, by middle market companies is highly uncertain. We believe that many of our potential customers are not fully aware of the benefits of outsourced solutions. It is possible that these solutions may never achieve market acceptance. If the market for our products does not grow or grows more slowly than we currently anticipate, our business, financial condition and operating results would be materially adversely affected.
Our business strategy may not effectively address our market and we may never realize a return on the resources we have invested to execute our strategy.
We have made substantial investments to pursue our strategy. These investments include:
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building a global network of data centers;
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allying with particular software providers;
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expanding our work force;
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investing to develop unique service offerings; and
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developing implementation resources around specific applications.
These investments may not be successful. More cost effective strategies may be available to compete in this market. We may have chosen to focus on the wrong application areas or to work with the wrong partners. Potential customers may not value the specific product features in which we have invested. There is no assurance that our strategy will prove successful.
The markets we serve are highly competitive and many of our competitors have much greater resources.
Our current and potential competitors include Application Service Providers and companies focused on the application hosting business, such as Aristasoft, Breakaway Solutions, Corio, FutureLink, Interliant, Interpath, NaviSite and Telecomputing; Web hosting companies, such as Concentric, Digex and Exodus; enterprise applications vendors, such as Oracle, Siebel and SAP; business Internet Service Providers, such as MCI WorldCom, PSINet and Verio; telecommunications companies, such as AT&T, GTE and Qwest (which has agreed to acquire our customer and significant stockholder, U S WEST); and systems integrators, such as Andersen Consulting, EDS, IBM and KPMG. Our strategic partners and suppliers could also become competitors either directly or through strategic relationships with some of our other competitors. These relationships may take the form of strategic investments or marketing or other contractual arrangements.
Many of our competitors have substantially greater financial, technical and marketing resources, larger customer bases, longer operating histories, greater name recognition and more established relationships in the industry than we do. We cannot be sure that we will have the resources or expertise to compete successfully in the future. Our competitors may be able to:
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more quickly develop and expand their network infrastructures and service offerings;
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better adapt to new or emerging technologies and changing customer needs;
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take advantage of acquisitions and other opportunities more readily;
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negotiate more favorable licensing agreements with software application vendors;
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devote greater resources to the marketing and sale of their products; and
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adopt more aggressive pricing policies.
Some of our competitors may also be able to provide customers with additional benefits at lower overall costs. We cannot be sure that we will be able to match cost reductions by our competitors. In addition, we believe that there is likely to be consolidation in our markets. Consolidation could increase price competition and other competitive forces in ways that materially adversely affect our business, results of operations and financial condition. Finally, there are few substantial barriers to entry, and we have no patented technology that would bar competitors from our market.
We will require a significant amount of cash to service our indebtedness.
Our ability to make payments on our indebtedness and to fund planned capital expenditures, development and operating costs will depend on our ability to generate cash in the future through sales of our services. We cannot assure you that our available liquidity will be sufficient to service our indebtedness or to fund our other cash needs. We may need to refinance all or a portion of our indebtedness on or before maturity, but we may not be able to do so on commercially reasonable terms, or at all. Without sufficient funds to service our indebtedness, we would have serious liquidity constraints and would need to seek additional financing from other sources, but we may not be able to do so on commercially reasonable terms, or at all.
The significant amount of our indebtedness could adversely affect our financial health.
The issuance of the subordinated convertible notes in October 1999 increased our indebtedness and, therefore, made us highly leveraged. The following chart shows certain important as adjusted credit statistics, assuming we had completed the February 2000 offering and had applied the proceeds as intended.
Our leverage could have important consequences to you. For example, it could:
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make it more difficult for us to satisfy our obligations with respect to our indebtedness;
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increase our vulnerability to general adverse economic and industry conditions;
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limit our ability to fund future working capital, capital expenditures, acquisitions and other general corporate requirements;
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require us to dedicate a substantial portion of our cash flow from operations to repaying indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures, acquisitions and other general corporate purposes;
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limit our flexibility in planning for, or reacting to, changes in our business and industry; and
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limit our ability to borrow additional funds.
Any additional borrowings would further increase the amount of our leverage and the associated risks.
Others may seize the market opportunity we have identified because we may not effectively execute our strategy.
If we fail to execute our strategy in a timely or effective manner, our competitors may be able to seize the marketing opportunities we have identified. Our business strategy is complex and requires that we successfully and simultaneously complete many tasks. In order to be successful, we will need to:
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build and operate a highly reliable, complex global network;
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negotiate effective partnerships and develop economically attractive service offerings;
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attract and retain iMAP customers;
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attract and retain highly skilled employees;
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integrate acquired companies into our operations;
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evolve our business to gain advantages in an increasingly competitive environment; and
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expand our international operations.
In addition, although most of our management team has worked together for approximately one year, there can be no assurance that we will be able to successfully execute all elements of our strategy.
We plan to expand very rapidly, and managing our growth may be difficult.
We have rapidly expanded our operations since USi was founded in January 1998. We expect our business to continue to grow both geographically and in terms of the number of products and services we offer. We cannot be sure that we will successfully manage our growth. In order to successfully manage our growth we must:
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enlarge our network and infrastructure;
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improve our management, financial and information systems and controls; and
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expand, train and manage our employee base effectively.
There will be additional demands on our customer service support and sales, marketing and administrative resources as we increase our service offerings and expand our target markets. The strains imposed by these demands are magnified by the relatively early stage of our operations. If we cannot manage our growth effectively, our business, financial condition or results of operations could be adversely affected.
Our growth could be limited if we are unable to attract and retain qualified personnel.
We believe that our short- and long-term success depends largely on our ability to attract and retain highly skilled technical, managerial and marketing personnel. We particularly require additional management personnel in the areas of application integration and technical support. Individuals with information technology skills are in short supply and competition for application integration personnel is particularly intense. We may not be able to hire the necessary personnel to implement our business strategy, or we may need to pay higher compensation for employees than we currently expect. We cannot be sure that we will succeed in attracting and retaining the personnel we need to continue to grow.
We depend on a limited number of key personnel who would be difficult to replace.
Our success also depends in significant part on the continued services of our key technical, sales and senior management personnel. Losing one or more of our key employees could have a material adverse effect on our business, results of operations and financial condition. We have employment agreements with most of our vice presidents and other key employees, including Christopher R. McCleary, Stephen E. McManus, Jeffery L. McKnight, Andrew A. Stern, Harold C. Teubner, Jr. and Gary J. Rogers.
We may not be able to deliver our iMAP services if third parties do not provide us with key components of our infrastructure.
We depend on other companies to supply key components of our telecommunications infrastructure and systems and network management solutions. Any failure to obtain needed products or services in a timely fashion and at an acceptable cost could have a material adverse effect on our business, results of operations and financial condition. Although we lease redundant capacity from multiple suppliers, a disruption in telecommunications capacity could prevent us from maintaining our standard of service. Some of the key components of our system and network are available only from sole or limited sources in the quantities and quality we demand. For example, the hardware we use to support our real-time mirroring and disaster recovery functions is supplied only by EMC Corporation. We buy these components from time to time, do not carry significant inventories of them and have no guaranteed supply arrangements with our vendors.
Our ability to provide our iMAP services depends on strategic relationships with software vendors that we may not be able to maintain.
Our iMAP offerings are central to our business strategy. We obtain software products under license agreements with BroadVision, Ariba, Siebel, PeopleSoft, Lawson, Microsoft, Niku and Sagent and package them as part of our iMAP solutions. The agreements are for terms ranging from one to three years. All the agreements may be terminated upon a breach of the agreement, subject to cure periods. The agreement with PeopleSoft may be terminated by either party for convenience upon 90 days notice after an annual review, scheduled to first occur on or about June 22, 2000. Under an earlier version of our contract, PeopleSoft on one occasion notified us of its intention to terminate the agreement. After significant discussion, the issues in dispute were resolved, our agreement with PeopleSoft was renegotiated and PeopleSoft retracted its notification of its intent to terminate the agreement. However, we cannot be sure that one or more of our agreements with software vendors will not be terminated in the future. If these agreements were to be terminated or not renewed or we otherwise could not continue to use this software, we might have to discontinue products or services or delay or reduce their introduction unless we could find, license and package equivalent technology.
All but one of our agreements with software vendors are non-exclusive. Our agreement with SiebelNet, Inc., a wholly owned subsidiary of Siebel Systems, Inc., gives us exclusivity as the Application Service Provider of Siebel enterprise relationship management applications for direct customers of SiebelNet headquartered in North America. Our vendors may choose to compete with us directly or to enter into strategic relationships with our competitors. These relationships may take the form of strategic investments or marketing or other contractual arrangements. Our competitors may also license and utilize the same technology in competition with us. We cannot be sure that the vendors of technology used in our products will continue to support this technology in its current form. Nor can we be sure that we will be able to adapt our own products to changes in this technology. In addition, we cannot be sure that the financial or other difficulties of our vendors will not have a material adverse effect upon the technologies incorporated in our products, or that, if these technologies become unavailable, we will be able to find suitable alternatives.
Technology may change faster than we can update our network and technology.
The markets we serve are characterized by rapidly changing technology, evolving industry standards, emerging competition and the frequent introduction of new services, software and other products. Our success depends partly on our ability to enhance existing or develop new products, software and services that meet changing customer needs in a timely and cost-effective way. We cannot be sure, however, that we will do some or all of these things. For example, if software application architecture changes in significant ways, the software for which we have licenses could become obsolete, we may be forced to update our hardware and network configurations or we may be forced to replace our mirroring technology. This may require substantial time and expense, and even then we cannot be sure that we will succeed in adapting our businesses to these and other technological developments.
We could be harmed if our systems are not compatible with other products and services.
We believe that our ability to compete successfully also depends on the continued compatibility of our services with products, services and architectures offered by various vendors. Our failure to conform to a prevailing standard, or the failure of a common standard to emerge, could have a material adverse effect on our business, results of operations and financial condition. Although we will work with vendors to test new products, we cannot be sure that their products will be compatible with ours or that they will adequately address changing customer needs. Although we currently plan to support emerging standards, we cannot be sure what new industry standards will develop. We also cannot be sure that we will be able to conform to these new standards quickly enough to stay competitive. In addition, we cannot be sure that products, services or technologies developed by others will not make ours noncompetitive or obsolete.
The loss of a key customer could decrease our revenues.
During the year ended December 31, 1999, sales to SiebelNet accounted for approximately 16% of our revenues. We expect sales to SiebelNet to continue to constitute a significant portion of our revenues in the near term. During that period, if our sales to SiebelNet decrease, our business will suffer.
If we cannot obtain additional application software we will be unable to expand or enhance our iMAP service offerings.
Our business strategy also depends on obtaining additional application software. We cannot be sure, however, that we will be able to obtain the new or enhanced applications we may need to keep our iMAP solutions competitive. If we cannot obtain these applications and as a result must discontinue, delay or reduce the availability of our iMAP solutions or other products or services, our business, results of operations and financial condition may be materially adversely affected.
Developing and expanding our operations will depend, among other things, on our management’s ability to successfully integrate newly acquired operations.
In October 1999, we acquired Conklin & Conklin, Inc. We cannot be sure that we will be able to continue to successfully integrate the business of Conklin into our own, or that the Conklin business will perform as expected. In addition, we cannot be sure that we will be able to successfully integrate any business acquired in the future into our own. Our failure to successfully integrate an acquired company or its subsequent underperformance could have a material adverse effect on our business, results of operations and financial condition.
We may undertake additional acquisitions which pose risks to our business.
From time to time, we may undertake additional acquisitions. If we do, our risks may increase because:
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we may pay more for the acquired company than the value we realize from the acquisition;
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we may not fully understand the business we acquire;
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we may be entering markets in which we have little or no direct prior experience;
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our ongoing business may be disrupted and resources and management time diverted; and
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our accounting for acquisitions could require us to amortize substantial goodwill, adversely affecting our reported results of operations.
In addition, once we have made an acquisition we will face additional risks:
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it may be difficult to assimilate acquired operations and personnel;
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we may not be able to retain the management and other key personnel of the acquired business;
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we may not be able to maintain uniform standards, controls, procedures and policies; and
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changing management may impair relationships with an acquired business’s employees or customers.
We may make investments in entities that we do not control.
In the future, we may make investments in joint ventures or other entities over which we do not exercise control. We may make these investments in connection with entering into strategic partnerships with software vendors, systems integrators or Internet Service Providers or as strategic investments. Our inability to control the entity in which we may invest may have consequences on our ability to receive distributions from such entity or to implement our business plan. Debt agreements, if entered into by a non-control entity, may restrict or prohibit such entity from paying distributions to us. Applicable state or local law may also limit the amount that a non-control entity is permitted to pay a distribution on its equity interest, and we may not be able to influence the payment of dividends. If any of the other investors in a non-control entity fail to observe their commitments, that entity may not be able to operate according to its business plans or we may be required to increase our level of commitment to give effect to the plan. In addition, our ability to implement a business plan for a non-control entity may be limited or non-existent.
Because we have international operations, we face additional risks related to foreign political and economic conditions.
We have established EDCs in Europe and Japan. We intend to expand further into international markets. We cannot be sure that we will be able to obtain the necessary telecommunications infrastructure in a cost-effective manner or compete effectively in international markets. In addition, there are risks inherent in conducting business internationally. These include:
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unexpected changes in regulatory requirements;
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export restrictions;
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tariffs and other trade barriers;
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challenges in staffing and managing foreign operations;
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differing technology standards;
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employment laws and practices in foreign countries;
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political instability;
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fluctuations in currency exchange rates;
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imposition of currency exchange controls; and
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potentially adverse tax consequences.
Any of these could adversely affect our international operations. We cannot be sure that one or more of these factors will not have a material adverse effect on our current or future international operations and, consequently, on our business, results of operations and financial condition.
Government regulation and legal uncertainties could add additional costs to doing business on the Internet and could limit our clients’ use of the Internet.
Laws and regulations directly applicable to communications or commerce over the Internet are becoming more prevalent. The adoption or modification of laws or regulations relating to the Internet could adversely affect our business. In recent sessions, the United States Congress has enacted Internet laws regarding children’s privacy, copyrights, taxation and the transmission of sexually explicit material and other similar proposals are continuously being considered. The European Union recently enacted its own privacy regulations. The law of the Internet, however, remains largely unsettled, even in areas where there has been some legislative action. It may take years to determine whether and how existing laws such as
those governing intellectual property, privacy, libel and taxation apply to the Internet. In addition, the growth and development of the market for online commerce may prompt calls for more stringent consumer protection laws, both in the United States and abroad, that may impose additional burdens on companies conducting business online. For example, Germany and the European Union have enforced laws and regulations on content distributed over the Internet that are more strict than those currently in place in the United States.
The outcome of proposals put to a vote of stockholders will be determined by our existing principal stockholders, executive officers and directors.
Our executive officers, directors, existing 5% or greater stockholders and their affiliates, in the aggregate, will own shares representing approximately 58.6% of our outstanding voting capital stock after the completion of the February 2000 secondary offering. As a result, these persons, acting together, are able to control all matters submitted to our stockholders for approval and to control our management and affairs. For example, these people, acting together, control the election and removal of directors and any merger, consolidation or sale of all or substantially all of our assets.
The trading price of our common stock could be subject to significant fluctuations.
The trading price of our common stock has been volatile. Factors such as announcements of fluctuations in our or our competitors’ operating results and market conditions for Internet related and other technology stocks in general could have a significant impact on the future trading price of our common stock. In particular, the trading price of the common stock of many Internet related and other technology companies has experienced extreme price and volume fluctuations, which have at times been unrelated to the operating performance of such companies whose stocks were affected. In addition, the trading price of our common stock could be subject to significant fluctuations in response to variations in our prospects and operating results, which may in turn be affected by changes in interest rates and other factors. There can be no assurance that these factors will not have an adverse effect on the trading price of our common stock.
The market price of our common stock could be affected by the substantial number of shares that are eligible for future sale.
As of March 14, 2000, we had 96,345,190 shares of common stock issued and outstanding, excluding 1,257,709 shares issuable upon the exercise of warrants, 25,403,652 shares issuable upon the exercise of options granted under our 1998 Stock Option Plan and 7,545,272 shares issuable upon conversion of our convertible notes. We cannot predict the effect, if any, that future sales of shares of common stock, including common stock issuable upon conversion of the notes, or the availability of shares of common stock for future sale, will have on the market price of common stock prevailing from time to time.
Intellectual property infringement claims against us, even without merit, could cost a significant amount of money to defend and divert management’s attention away from our business.
As the number of software products in our target markets increases and the functionality of these products further overlap, software industry participants may become increasingly subject to infringement claims. Someone may even claim that our technology infringes their proprietary rights. Any infringement claims, even if without merit, can be time consuming and expensive to defend. They may divert management’s attention and resources and could cause service implementation delays. They also could require us to enter into costly royalty or licensing agreements. If successful, a claim of product infringement against us and our inability to license the infringed or similar technology could adversely affect our business.
We could be required to use our financial resources to repurchase shares of common stock from U S WEST.
We could be required to repurchase for cash some of the shares of our capital stock owned by U S WEST. This would require us to divert our resources at a time of rapid growth. If we engage in activities in which U S WEST would be prohibited from engaging and we were considered an affiliate of U S WEST under regulations of the Federal Communications Commission, U S WEST could force us to repurchase the number of shares required to make us no longer an affiliate. We are not presently considered an affiliate of U S WEST under these regulations. See “Certain Relationships and Related Transactions - Purchases of Series A Preferred Stock.” Although we believe the possibility of this occurring is remote, repurchasing the shares held by U S WEST could be costly.
Forward-looking statements contained in this prospectus are subject to risks and uncertainties.
This report includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to, among other things, analyses and other information that are based on forecasts of future results and estimates of amounts not yet determinable. These statements also relate to our future prospects, developments and business strategies.
These forward-looking statements are identified by their use of terms and phrases such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “predict,” “project,” “will” or the negative of those or other variations, or comparable expressions, including references to assumptions. These statements are contained in sections entitled “Prospectus Summary,” “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Business” and other sections of this report.
The forward-looking statements in this report, including statements concerning projections of our future results, operating profits and earnings, are based on current expectations and are subject to risks and uncertainties that could cause actual results to differ materially from those expressed or implied by those statements. The risks and uncertainties include but are not limited to our continued ability to:
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build and operate a highly reliable, complex global network;
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establish and maintain relationships with key software vendors and develop economically attractive products;
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attract and retain iMAP customers;
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attract and retain highly skilled employees;
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effectively manage our rapid growth; and
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evolve our business to gain advantages in an increasingly competitive environment.
Our risks are more specifically described in “Risk Factors.” If one or more of these risks or uncertainties materializes, or if underlying assumptions prove incorrect, our actual results may vary materially from those expected, estimated or projected. Given these uncertainties, you should not place undue reliance on forward-looking statements.
We undertake no obligation to update forward-looking statements or risk factors other than as required by applicable law, whether as a result of new information, future events or otherwise.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to market risk from changes in interest rates. In addition, changes in the quoted market price of our common stock will effect the fair value of convertible subordinated notes.
Interest Rate Risk
The fair value of our cash and cash equivalents would not be significantly impacted by either a 10% increase or a 10% decrease in interest rates due to the short-term nature of our portfolio.
Our earnings and financial position are affected by changes in interest rates as a result of our purchase of various fixed rate municipal bonds included in available-for-sale investments. If market interest rates for municipal bonds increase by 10%, the fair value of our available-for-sale investments will decrease, and unrealized gains/losses recognized as other comprehensive income will decrease by an estimated $0.7 million. Conversely, if market interest rates for municipal bonds decrease by 10%, the fair value of our available-for-sale investments will increase, and unrealized gains/ losses recognized as other comprehensive income will increase by an estimated $0.8 million. These amounts are determined by discounting future cash flows using hypothetical interest rates.
We have financed capital expansion through various long-term debt instruments bearing interest at both fixed and variable interest rates. At December 31, 1999, the fair value of this debt is not significantly impacted by either a 10% increase or a 10% decrease in interest rates.
Other Market Risk
Our convertible subordinated notes bear interest at 7% through November 1, 2004. The market value of these notes is affected by fluctuations in the quoted market value of our common stock. If the quoted market value of our common stock increases by 10%, the estimated fair value of the notes will increase by an estimated $35 million. Conversely, if the quoted market value of our common stock decreases by 10%, the estimated fair value of the notes will decrease by an estimated $35 million.
These analyses do not consider the effects of the reduced level of overall economic activity that could exist in such an environment. Further, in the event of a change of such magnitude, we would likely take actions to further mitigate our exposure to the change. However, due to the uncertainty of the specific actions that would be taken and their possible effects, the sensitivity analysis assumes no changes in our financial structure.
Item 8.
Item 8. Financial Statements and Supplemental Data
Report of Independent Auditors
The Board of Directors and Stockholders
USinternetworking, Inc.
We have audited the accompanying consolidated balance sheets of USinternetworking, Inc. (“the Company”) as of December 31, 1998 and 1999, and the related consolidated statements of operations, stockholders’ equity (deficit) and cash flows for the period from January 14, 1998 (date of inception) through December 31, 1998 and for the year ended December 31, 1999. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of USinternetworking, Inc. as of December 31, 1998 and 1999, and the consolidated results of its operations and its cash flows for the period from January 14, 1998 (date of inception) through December 31, 1998 and for the year ended December 31, 1999, in conformity with accounting principles generally accepted in the United States.
/s/ Ernst & Young LLP
Baltimore, Maryland
January 24, 2000,
except for Note 21, as to which the date is
March 3, 2000
USinternetworking, Inc.
Consolidated Balance Sheets
See accompanying notes.
USinternetworking, Inc.
Consolidated Statements of Operations
See accompanying notes.
USinternetworking, Inc.
Consolidated Statement of Stockholders’ Equity (Deficit)
For the Period From January 14, 1998 (date of inception) through December 31, 1998
[Additional columns below]
[Continued from above table, first column(s) repeated]
See accompanying notes.
USinternetworking, Inc.
Consolidated Statement of Stockholders’ Equity (Deficit) (continued)
For the Year Ended December 31, 1999
[Additional columns below]
[Continued from above table, first column(s) repeated]
See accompanying notes.
USinternetworking, Inc.
Consolidated Statements of Cash Flows
See accompanying notes.
USinternetworking, Inc.
Notes to Consolidated Financial Statements
1. Summary of Significant Accounting Policies
Description of Business
USinternetworking, Inc., (the “Company”) was incorporated on January 14, 1998 principally to provide clients the ability to use leading business software applications through the Company’s Internet-based network. The Company is an “Internet Managed Application Provider.SM ” The Company’s iMAP services integrate Internet communications, data center management, packaged software applications, implementation and support to meet the technology needs of businesses in a number of areas. These areas include sales force automation, customer support, e-commerce, and human resource and financial systems. The Company also makes its infrastructure available to clients who want to run their own applications in a highly reliable and secure Internet environment and provides information technology consulting services.
Basis of Presentation
The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Intercompany transactions and balances have been eliminated.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
Cash and Cash Equivalents
The Company considers all money market accounts and all other investments with a maturity of three months or less when purchased to be cash equivalents.
Investments
Available-for-sale securities are carried at fair value with the unrealized gains and losses, net of tax, reported as other comprehensive income. Realized gains and losses and declines in value judged to be other than temporary on available-for-sale securities are included in investment income. The cost of securities sold is based on the specific identification method. Interest and dividends on securities classified as available-for-sale are included in investment income.
At December 31, 1999, available-for-sale securities consisted principally of corporate and government agency obligations.
Deferred Costs
Direct costs related to the implementation of software under iMAP contracts are deferred and expensed ratably over the term of the related contract. Costs related to the issuance of debt are deferred and expensed over the term of the debt using the interest method.
Software Licenses
The Company capitalizes the costs associated with the purchase of licenses for major business process application software used in providing iMAP services. The licenses specify the maximum number of users permitted to utilize the license in connection with the Company’s service, and whether the licenses may be later transferred to subsequent users by the Company. All amounts are non-refundable, regardless of the actual number of users assigned a license in connection with iMAP services.
USinternetworking, Inc.
Notes to Consolidated Financial Statements - (Continued)
1. Summary of Significant Accounting Policies - (Continued)
Transferable licenses are amortized over their estimated useful life of three years. Non-transferable licenses are amortized over the lesser of the minimum contract period for iMAP clients subject to these licenses, or three years. Amortization commenced in January 1999, the date that transferable and non-transferable licenses were first available to generate revenue, and the average amortization period is expected to be three years.
The Company also purchases maintenance services from its software vendors under agreements that require annual payments for software maintenance, including technical support and software upgrades. These payments are included in prepaid expenses and amortized ratably over the annual service period.
Property and Equipment and Accounting Changes
Property and equipment is stated at cost less accumulated depreciation. Depreciation is computed for owned assets using the straight-line method over estimated useful lives of the assets. Assets under capital leases are amortized using the straight-line method over the lesser of the lease term or the estimated useful life of the assets.
Estimated useful lives for furniture and equipment range from five to seven years. Computer hardware and software, is depreciated over three to five years. Buildings are depreciated over 25 years, and leasehold improvements are depreciated over the term of the related lease.
On July 1, 1999, the Company changed its estimate of the useful life of its computer equipment from three to five years. The change in estimate will be accounted for prospectively, with depreciation expense for periods subsequent to June 30, 1999 calculated so as to depreciate the remaining book value of the equipment at June 30, 1999 equally over the revised estimated useful life.
The effect of this change was to decrease depreciation expense and net loss by $2,901,656 for the year ended December 31, 1999. Basic and diluted loss per share for the year ended December 31, 1999 was lower by $0.05 per share as a result of the change.
On January 1, 1999, the Company adopted Statement of Position 98-1 (“SOP 98-1”), Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. SOP 98-1 requires the capitalization of direct costs incurred in connection with developing or obtaining software for internal-use, including external direct costs of materials and services and payroll and payroll related costs for employees who are directly associated with and devote time to an internal use software development project. In 1998, the Company expensed approximately $1 million of costs related to the implementation of internal-use software. During 1999, the Company capitalized $2.3 million of costs related to the implementation of internal-use software which is included in computers and software at December 31, 1999.
Advertising Costs
The Company expenses advertising as incurred. Advertising expense totaled approximately $700,000 and $2.5 million in 1998 and 1999, respectively.
Impairment of Long-Lived Assets
Long-lived assets, consisting principally of software licenses, property and equipment and goodwill, are evaluated for possible impairment through a review of undiscounted expected future cash flows. If the sum of the undiscounted expected future cash flows is less than the carrying amount of the asset, an impairment loss is recognized.
USinternetworking, Inc.
Notes to Consolidated Financial Statements - (Continued)
1. Summary of Significant Accounting Policies - (Continued)
Short-term Obligations Expected to be Refinanced
At December 31, 1998 and 1999, the Company had liabilities for the purchase of fixed assets for which the Company had outstanding commitments to finance on a long-term basis. The Company has executed or will execute these financings early in the subsequent year, and therefore classified the long-term portion of the liabilities due based on the subsequent financings in the accompanying balance sheets. These obligations will bear interest at rates from 9% to 17% per annum, and will mature in varying installments through October 2001.
Revenue Recognition
The Company generates revenue from iMAP services and information technology services. Revenues from professional IT services are recognized as services are provided. iMAP revenues consist of implementation fees and monthly recurring fees for services.
Implementation fees are generally paid in advance, and are deferred and recognized ratably over the term of the iMAP service contract. Monthly iMAP service fees are consideration for access to the Company’s network of Enterprise Data Centers hosting application software, and the implementation and management of that software. iMAP contracts generally have a two to five year term, and revenues are recognized ratably over the contract term. Payments received in advance of revenue recognition, even if non-refundable, are recorded as deferred revenue. Some contracts permit termination without cause by the clients. Contracts permitting termination without cause generally provide for termination payments to the Company that will be recognized as revenue when collectibility is assured.
Product Research and Development
The Company incurs product research and development costs related to expanding its portfolio of iMAP solutions. These costs primarily include labor costs associated with the testing of new product offerings including the evaluation of hardware and software applications functionality in an iMAP environment. Product research and development costs are expensed as incurred.
Goodwill Amortization
The Company amortizes goodwill arising from purchase business combinations on a straight-line basis over its estimated useful life of 5 years.
Stock-Based Compensation
The Company records compensation expense for all stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB No. 25”). Under APB No. 25, if the exercise price of the Company’s employee stock-based awards equals or exceeds the estimated fair value of the underlying stock on the date of grant, no compensation expense is generally recognized.
Financial Accounting Standards Board Statement No. 123, Accounting for Stock-Based Compensation (“Statement No. 123”) encourages companies to recognize expense for stock-based awards based on their estimated fair value on the date of grant. Statement No. 123 requires the disclosure of pro forma net income or loss in the notes to the financial statements if the fair value method is not elected. The Company supplementally discloses in Note 15 to these consolidated financial statements the pro forma information as if the fair value method had been adopted.
USinternetworking, Inc.
Notes to Consolidated Financial Statements - (Continued)
1. Summary of Significant Accounting Policies - (Continued)
Income Taxes
The Company uses the liability method in accounting for income taxes. Under this method, deferred income tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.
Stock Splits
In February 1999, the Company’s Board of Directors approved an 8 for 1 reverse stock split of common stock, options and warrants which became effective on April 8, 1999. Accordingly, all share and per share data including stock option, warrant and loss per share information have been restated in the consolidated financial statements to retroactively reflect the stock split.
In November 1999, the Board of Directors approved a 3 for 2 stock split of common stock, options and warrants for holders of record on December 3, 1999. Accordingly, all share and per share data including stock option, warrant and loss per share information have been restated in the consolidated financial statements to retroactively reflect the stock split.
Reclassifications
Certain amounts in the 1998 consolidated financial statements have been reclassified to conform to the 1999 presentation.
2. Acquisitions
On September 8, 1998, the Company acquired all of the outstanding common stock of I.I.T. Holding, Inc. (IIT), a provider of Internet and intranet consulting, integration and support services principally to commercial companies located throughout the United States and South America. The initial purchase price consisted of cash of $12,887,000 and warrants to purchase 112,500 shares of common stock for $7.11 per share valued at $40,000. Direct acquisition costs of $394,968 were also incurred. The acquisition was accounted for using the purchase method of accounting, and the results of operations of IIT are included in the accompanying consolidated statements of operations commencing September 8, 1998. At the acquisition date, $14,131,788 of goodwill was recorded.
Additional contingent consideration was payable to the former shareholders of IIT to the extent that defined amounts of revenue, earnings before interest, income taxes, depreciation and amortization (EBITDA), and employee retention percentages (as related to the operations of IIT) in 1998 were exceeded. At December 31, 1998, the Company determined that the amount of additional consideration due to the sellers was $2,326,735, and therefore recorded that amount as due to former shareholders of acquired businesses and as additional goodwill. The contingent consideration was paid in May 1999.
On October 2, 1998, the Company acquired all of the outstanding common stock of Advanced Communication Resources, Inc. (ACR), a New York based systems integrator focused on the financial services industry. The initial purchase price aggregated $6,050,000, consisting of cash of $2,500,000, a $3,500,000 secured promissory note due in January 1999 bearing interest at 8.25%, and warrants to purchase 140,625 shares of common stock for $7.11 per share valued at $50,000. Direct acquisition costs of $338,916 were also incurred. The acquisition was accounted for using the purchase method of accounting, and the results of operations of ACR are included in the accompanying consolidated statements of operations commencing October 2, 1998. At the acquisition date, $5,290,535 of goodwill was recorded.
USinternetworking, Inc.
Notes to Consolidated Financial Statements - (Continued)
2. Acquisitions - (Continued)
Additional contingent consideration was payable to the former shareholders of ACR to the extent that defined amounts of revenue, EBITDA, and employee retention percentages (as related to the operations of ACR) in 1998 were exceeded. At December 31, 1998, the Company determined that the amount of additional consideration due to the sellers was $5,000,000, and therefore recorded that amount as due to former shareholders of acquired businesses and as additional goodwill. The contingent consideration was paid in January 1999.
On October 8, 1999, the Company purchased the assets of Conklin & Conklin, Inc. (“Conklin”), a comprehensive provider of Lawson financial and human resources system implementation services and a certified reseller of Lawson software licenses. The initial purchase price aggregated $11.2 million, and consisted of cash of $7.7 million, assumed liabilities of $1.5 million, and a $2.0 million secured note due on October 8, 2001. Additional contingent cash consideration of up to $4.6 million will be payable to the extent that specified financial milestones are achieved over a 26 month period, and any such payment will result in the recording of additional goodwill. The acquisition was accounted for as a purchase, and goodwill of approximately $9.4 million was recorded at the acquisition date, and is being amortized over its estimated useful life of five years.
The results of operations of Conklin are included in the accompanying consolidated statement of operations commencing October 8, 1999. The following summarizes unaudited pro forma consolidated results of operations for 1998 and 1999 assuming the Conklin acquisition had occurred at the beginning of each period. The results are not necessarily indicative of what would have occurred had this transaction been consummated as of the beginning of each period, or of future operations of the Company (in thousands):
USinternetworking, Inc.
Notes to Consolidated Financial Statements - (Continued)
3. Loss Per Share
The following table sets forth the computation of basic and diluted loss per common share:
Basic loss per share is based upon the average number of shares of common stock outstanding during the periods. The 1998 computation excludes 3,023,438 shares of common stock subject to repurchase.
Diluted loss per common share is equal to basic loss per common share because if potentially dilutive securities were included in the computation, the result would be anti-dilutive. These potentially dilutive securities consist of common stock subject to repurchase, convertible preferred stocks, stock options and warrants in the 1998 period, and stock options and warrants in the 1999 period.
4. Supplemental Disclosure of Cash Flow Information
The Company acquired equipment totaling $5,188,489 and $15,812,110 under leases classified as capital leases for the period from January 14, 1998 (date of inception) through December 31, 1998 and for the year ended December 31, 1999, respectively. The Company also acquired $7,500,000 and $3,000,000 of equipment in 1998 and 1999 that was included in accounts payable and short-term obligations expected to be refinanced at December 31, 1998 and 1999, respectively.
Interest paid was approximately $368,000 and $5,902,000 for the period from January 14, 1998 (date of inception) through December 31, 1998 and for the year ended December 31, 1999, respectively.
In December 1998, $22,095,000 of notes payable and a $1,000,000 loan from an officer of the Company were converted into Series B Convertible Redeemable Preferred Stock.
In 1998, the Company purchased all of the capital stock of IIT and ACR for approximately $27.8 million. In conjunction with these acquisitions, assets with a fair market value of approximately $30.8 million were acquired and liabilities of approximately $3.0 million were assumed.
In 1999, the Company purchased the assets of Conklin for approximately $11.2 million. In conjunction with this acquisition, assets with a fair market value of approximately $9.7 million were acquired and liabilities of approximately $1.5 million were assumed.
USinternetworking, Inc.
Notes to Consolidated Financial Statements - (Continued)
4. Supplemental Disclosure of Cash Flow Information - (Continued)
In July 1998, the Company sold 1,406,250 shares of common stock to an executive officer for $5,000. The common stock at the date of issuance had an appraised estimated fair value of $0.71 per share, or $1,000,000. The difference between the estimated fair value of the common stock of $1,000,000 and the amount paid of $5,000 ($995,000) was recorded as unearned compensation and is being amortized over the 22 month period in which it is earned. Other non-cash compensation of $5,000 related to common stock issuances was also recorded in 1998.
During 1999, the Company issued 141,750 shares of restricted common stock to executive officers at a weighted average price of $14.17 per share. The restricted common stock at the date of issuance had an aggregate quoted market value of $2,009,000, which was recorded as stockholders’ equity.
5. Available-For-Sale Securities
The following is a summary of available-for-sale securities at December 31, 1999:
At December 31, 1999, aggregate unrealized gains of $311,349 are recorded in other comprehensive income. At December 31, 1999, the Company has approximately $19.5 million of investments that mature within one year and $12.2 million of investments that mature beyond ten years. These investments are classified as current as the Company views its available-for-sale investments as available for use in its current operations.
6. Property and Equipment
Property and equipment consists of the following:
During 1999, the Company capitalized $346,106 of interest associated with assets under construction. Substantially all property and equipment is collateralized under financing arrangements.
USinternetworking, Inc.
Notes to Consolidated Financial Statements - (Continued)
7. Capital Lease Obligations
The Company has entered into capital lease agreements to acquire certain equipment. Property and equipment includes the following amounts for leases that have been capitalized.
Amortization of leased property is included in depreciation and amortization expense.
Future minimum payments under capital lease obligations consist of the following at December 31, 1999:
8. Long-Term Debt and Convertible Subordinated Notes
Long-term debt consists of the following:
USinternetworking, Inc.
Notes to Consolidated Financial Statements - (Continued)
8. Long-Term Debt and Convertible Subordinated Notes - (Continued)
Aggregate maturities of long-term debt at December 31, 1999 are as follows:
USinternetworking, Inc.
Notes to Consolidated Financial Statements - (Continued)
8. Long-Term Debt and Convertible Subordinated Notes - (Continued)
In 1999, the Company issued $125 million (principal amount at maturity) of Convertible Subordinated Notes (the “Notes”), due November 1, 2004. Interest on the Notes accrues at 7% per annum, payable semi-annually on May 1 and November 1 of each year, commencing May 1, 2000. A holder may, at any time prior to maturity, convert the principal amount of the Notes into shares of common stock at a conversion price of $16.57 per share. The Company has the option to redeem the Notes after November 5, 2002 through October 31, 2003 for 101.75% of the principal amount.
9. Fair Value of Financial Instruments
The following methods and assumptions were used by the Company in estimating its fair value disclosures of its significant financial instruments:
Cash and cash equivalents
The carrying amounts reported for cash and cash equivalents approximate fair value.
Available-for-sale securities
Available-for-sale securities are stated at quoted market value.
Accounts receivable and accounts payable
The carrying amounts of accounts receivable and accounts payable and accrued expenses approximate fair value because of the short-term nature of those transactions.
Long-term debt
The fair values of the long-term debt are estimated using a discounted cash flow analysis, based on the Company’s incremental borrowing rates for similar types of borrowing arrangements at December 31, 1999.
Convertible subordinated notes
The fair values of the convertible subordinated notes are estimated using quoted market rates as of December 31, 1999.
The carrying amounts and fair values of the Company’s financial instruments follows:
10. Initial Public Offering
In April 1999, the Company completed an initial public offering of 15,525,000 shares of common stock which resulted in net proceeds of $132,827,573, after deducting underwriting discounts, commissions and offering expenses. Upon the closing of the offering, the Series A Preferred Stock and Series B Preferred Stock automatically converted into 69,523,933 shares of common stock, and the common stock
USinternetworking, Inc.
Notes to Consolidated Financial Statements - (Continued)
10. Initial Public Offering - (Continued)
subject to repurchase no longer became mandatorily redeemable by the Company upon the occurrence of certain events. (See Notes 11 and 12.)
11. Preferred Stock
The Company has authorized the issuance of up to 225,000 shares of preferred stock, par value $.01 per share, of which 110,000 has been designated Series A Convertible Preferred Stock (“Series A”) and 115,000 has been designated Series B Convertible Redeemable Preferred Stock (“Series B”). During 1998, the Company issued 55,000 shares of Series A for a total aggregate purchase price of $33.0 million, and 59,279 shares of Series B for a total aggregate purchase price of $62.2 million, including $22.1 million of Series B issued upon conversion of notes payable. Upon the conversion of notes payable with a face value of $9,095,000 into Series B, unamortized debt discount of approximately $1,350,000 was recorded as additional interest expense.
Series A:
Conversion
The Series A outstanding at December 31, 1998 automatically converted into shares of common stock upon the closing of the initial public offering in April 1999. Each share of Series A was converted into 506.25 shares of common stock.
Dividends
The holders of the Series A were entitled to receive cumulative quarterly dividends at the annual rate of $48 per share. All accrued dividends were paid at the closing of the initial public offering in April 1999.
Voting Rights
Each share of Series A had substantially the same voting rights as the number of shares of common stock into which it was converted. In addition, certain corporate actions required the consent of two-thirds of the outstanding shares of Series A.
Series B:
Conversion
The Series B outstanding at December 31, 1998 automatically converted into shares of common stock upon the closing of the initial public offering in April 1999. Each share of Series B was converted into 703.12 shares of common stock.
Dividends
The holders of the Series B were entitled to receive cumulative quarterly dividends at the annual rate of $84 per share. All accrued dividends were paid at the closing of the initial public offering in April 1999.
Voting Rights
Each share of Series B had substantially the same voting rights as the number of shares of common stock into which it was converted.
USinternetworking, Inc.
Notes to Consolidated Financial Statements - (Continued)
12. Common Stock Subject to Repurchase
The Company sold 3,023,438 shares of common stock to three officers that at December 31, 1998 required the Company to repurchase the common stock at fair value in the event of disability or death. These agreements were amended on February 25, 1999 to void the repurchase obligation upon death or disability upon the closing of an initial public offering of the common stock.
The Company initially recorded the common stock subject to repurchase at an amount equal to the consideration received of $1,010,000 (purchase price of $1,057,500, less $47,500 represented by notes receivable). The common stock subject to repurchase was accreted to its estimated fair value during all periods the common stock was subject to repurchase through charges to additional paid-in capital. The estimated value per share of $1.39 at December 31, 1998 was determined through an independent appraisal of the Company’s common stock. Additional accretion in 1999 prior to the April initial public offering was recorded based on valuations consistent with the expected initial public offering price. As a result of the initial public offering in April 1999, these shares are no longer subject to mandatory repurchase by the Company, and their accreted value at that date of $28,218,750 was reclassified to stockholders’ equity.
13. Stock Warrants
In 1998, in connection with the issuance of debt or capital leases, the Company issued warrants to purchase 2,400,001 shares of common stock and warrants to purchase 971 shares of Series B. The warrants to purchase Series B converted into warrants to purchase 682,734 shares of common stock in April 1999 upon the closing of the initial public offering. The warrants expire from 2003 through 2008, and are exerciseable for $1.49 or $1.53 per share.
Upon issuance, the Company estimated the fair value of the warrants using a Black-Scholes option pricing model with the following weighted-average assumptions: risk-free interest rate of 5.50%, dividend yield of 0%; volatility factor of the expected market price of the Company’s common stock of 40%; and a weighted-average expected life of the warrant of 10 years. The range of values assigned to the warrants was $0.35 to $0.93 per share, and the total value assigned was $2,740,329. This amount was recorded as additional paid-in capital, and a corresponding debt discount was recorded that is being recognized as additional interest expense over the term of the related debt or capital lease.
Also, as discussed in Note 2, the Company issued warrants to purchase 253,125 shares of common stock in connection with the acquisition of IIT and ACR. These warrants expire in 2008 and are exerciseable for $7.11 per share. The Company estimated the value of these warrants considering the various terms, including the exercise price of the warrants, the estimated fair value of the Company’s common stock, and the length of time the warrants are exercisable. The aggregate value assigned to these warrants was $90,000.
During 1999, warrants to purchase 1,113,977 shares of common stock were exercised for proceeds of $3,086,203. A summary of warrants outstanding at December 31, 1999 is as follows:
USinternetworking, Inc.
Notes to Consolidated Financial Statements - (Continued)
14. Shares Reserved for Future Issuance
The Company at December 31, 1999 has reserved 23,478,794 shares of common stock for future issuance upon the exercise of stock options eligible for granting or previously granted under the 1998 Stock Option Plan (see Note 15), 7,545,272 shares of common stock issuable upon the conversion of the subordinated notes and 2,221,986 shares of common stock attributable to outstanding warrants.
15. Stock Compensation Plan
Stock Options
Effective July 2, 1998, the Company adopted the 1998 Stock Option Plan of USinternetworking, Inc. (“the Plan”) which is administered by the Compensation Committee of the Board of Directors. The Plan, as amended, provides for the granting of either qualified or non-qualified options to purchase an aggregate of up to 25,160,063 shares of common stock to eligible employees, officers, directors and consultants of the Company.
A summary of the Company’s stock option activity follows:
Weighted average fair value of options granted during 1999 is as follows:
USinternetworking, Inc.
Notes to Consolidated Financial Statements - (Continued)
15. Stock Compensation Plan - (Continued)
Exercise prices for options outstanding as of December 31, 1999 ranged from $1.17 to $46.59 as follows:
All options granted vested immediately at the date of grant. Shares of common stock purchased pursuant to these options will be subject to the Company’s right to repurchase them at the option exercise price upon the termination of the holder’s employment or business relationship with the Company. The repurchase right will lapse with respect to one-third of the shares purchasable upon exercise of an option on the first anniversary of the date of grant of the option. The repurchase right with respect to the remainder of the shares purchasable upon exercise of an option will lapse in equal quarterly installments over the subsequent eight calendar quarters. The options expire 10 years from the date of issuance. At December 31, 1999, the weighted- average remaining contractual life of outstanding options is 9.3 years.
Certain options granted in 1999 are exercisable at prices less than the fair market value of the Company’s common stock at the date of grant. The Company will record stock compensation expense of approximately $35.0 million as a result of these 1999 option grants that will be recognized ratably over the four-year period that the employees earn the right to retain the shares obtained upon exercise of the stock options without regard to continued employment. For the year ended December 31, 1999, the Company recorded non-cash stock compensation expense of $8.5 million related to these grants.
Restricted Stock Grants
During 1999, the Company issued for no consideration 141,750 shares of common stock to four officers. The common stock vests over a maximum four year period from the date of issuance. The common stock at the issuance date had an aggregate fair value of $2,009,000, which is being recognized as compensation expense over the vesting period. During 1999, the Company recognized as compensation expense $452,708 under these arrangements. At December 31, 1999, 20,250 shares of these restricted stock awards are vested.
Pro Forma Information
For the year ended December 31, 1998, pro forma net loss and loss per share information required by Statement No. 123 was determined using the minimum value method. The minimum value method calculates the fair value of options as the excess of the estimated fair value of the underlying stock at the date of grant over the present value of both the exercise price and the expected dividend payments, each discounted at the risk-free rate, over the expected life of the option. In determining the estimated fair value of granted stock options under the minimum value method, the risk-free interest rate was assumed
USinternetworking, Inc.
Notes to Consolidated Financial Statements - (Continued)
15. Stock Compensation Plan - (Continued)
to be 5.50%, the dividend yield was estimated to be 0% and the expected life of granted options was assumed to be four years.
The grant-date fair value of all options granted during 1998 using the minimum value method was less than $.01, thus no pro forma information has been presented. The exercise price at the grant-date of all options granted through December 31, 1998 was greater than the market value of the underlying common stock on the grant date, as determined by independent appraisal. As a result, the Company has not recognized compensation expense related to these options.
For the year ended December 31, 1999, pro forma net loss and loss per share information required by Statement No. 123 has been determined as if the Company had accounted for its stock-based awards using the fair value method. The fair value of these awards was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions for 1999: risk-free interest rate of 5.67%, dividend yield of 0%, volatility factors of the expected market price of the Company’s common stock of 1.28, and an expected life of 4 years.
The Black-Scholes option pricing model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s stock-based awards have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its stock-based awards.
For purposes of pro forma disclosures, the estimated fair value of the awards is amortized to expense over the period the employees earn the right to retain the shares obtained upon exercise of the stock options or upon the issuance of restricted common stock. The Company’s pro forma net loss is $116.8 million for the year ended December 31, 1999. Pro forma basic and diluted loss per share is $1.75 for the year ended December 31, 1999.
Pro forma compensation expense from stock-based awards reflects only the vesting of 1998 and 1999 awards in 1999. Not until 2001 is the full effect of recognizing compensation expense for stock-based awards representative of the possible effects on pro-forma net income (loss) for future years.
16. Income Taxes
At December 31, 1999, the Company has a U.S. federal net operating loss carryforward of $107.7 million. Included in the net operating loss is approximately $4.6 million that will not result in future tax benefits and will be recorded to stockholder’s equity. This carryforward expires in 2019. The amount available to be used in any given year will be limited by operation of certain provisions of the Internal Revenue Code. The Company also has state net operating loss carryforwards available, the utilization of which will be similarly limited. The Company has established a valuation allowance with respect to these federal and state loss carryforwards.
USinternetworking, Inc.
Notes to Consolidated Financial Statements - (Continued)
16. Income Taxes - (Continued)
Significant components of the Company’s deferred tax assets and liabilities at December 31 are as follows:
The reconciliation of the reported income tax expense to the amount that would result by applying the U.S. federal statutory rate to the net loss is as follows:
17. Operating Leases
The Company conducts a significant amount of its operations from leased facilities under operating leases that have terms of up to seven years and that generally contain renewal options of two to three years
USinternetworking, Inc.
Notes to Consolidated Financial Statements - (Continued)
17. Operating Leases - (Continued)
and rent escalation clauses. Future minimum payments under noncancellable operating leases with initial terms of one year or more consist of the following at December 31, 1999:
The Company incurred rent expense of $718,416 and $3,181,911 during the period from January 14, 1998 (date of inception) through December 31, 1998 and for the year ended December 31, 1999, respectively.
18. Employee Benefit Plan
The Company established a defined contribution benefit plan effective July 1, 1998. The plan covers substantially all employees who have 30 days of service with the Company. Participants may contribute from 1% to 15% of their annual compensation to the plan. The Company makes matching contributions of common stock up to 6% of the participant’s contributions pursuant to the terms of the plan. No contributions were made by the Company in 1998. In 1999, the Company contributed to the plan 54,738 shares of common stock with a fair value of $600,420.
19. Related Party Transactions
During 1998, the Company received a non-interest bearing loan from an officer in the amount of $1,000,000. The loan was subsequently converted into 1,667 shares of Series A Convertible Preferred Stock.
In September 1999, the Company loaned $2,250,000 to an officer to purchase 843,750 shares of common stock pursuant to a stock option exercise. The loan is evidenced by a full recourse note that bears interest at 5% per annum, and is payable on or before July 31, 2000. The Company has classified the note as a reduction of stockholders’ equity at December 31, 1999. Additionally, the Company loaned the same officer $1.9 million evidenced by a note bearing interest at 7% per annum and payable within 90 days on demand. The purpose of the loan was to fund the officer’s tax liability resulting from the exercise of the options described above.
20. Business and Geographic Segment Information
During 1998 and through June 1999, the Company was organized into two business units-iMAP and Professional IT Services. In the third quarter of 1999, the Company changed the manner in which it manages its operations and reports the activities of those operations. The Company is now organized into seven business units that offer unique software solutions. These operating segments have been aggregated for reporting purposes into two segments, as follows:
•
Enterprise Wide Solutions - provides enterprise relationship management, financial management, human resource, and professional services automation software product offerings; and
USinternetworking, Inc.
Notes to Consolidated Financial Statements - (Continued)
20. Business and Geographic Segment Information - (Continued)
•
E-Commerce and Web-Based Solutions - provides electronic commerce, enhanced messaging and decision support product offerings.
Management believes that the aggregation of the operating segments helps users of the financial statements better understand performance. The combined operating segments have similar economic characteristics and products and meet other criteria for aggregation. Both business units utilize an Internet-based network, which enables clients to use leading business software applications without the burden of owning or managing the underlying technology. These services are delivered to customers through a network of Enterprise Data Centers located in Maryland, California, Amsterdam and Tokyo.
The Company evaluates the performance of its new operating segments based on contribution margin, or revenues less variable direct costs. This contribution margin excludes an allocation of network and infrastructure costs, selling, general and administrative costs, product research and development costs, non-cash stock compensation expense, and depreciation and amortization.
The Company does not prepare information regarding segment assets. The accounting policies used by the reportable segments are the same as those used by the Company as described in Note 1 to the consolidated financial statements.
The following table sets forth information on the Company’s reportable segments. The 1998 data has been restated to conform to the new segment classifications.
USinternetworking, Inc.
Notes to Consolidated Financial Statements - (Continued)
20. Business and Geographic Segment Information - (Continued)
A reconciliation of segment operating profit to net loss during the periods presented is as follows:
Revenues from one customer of the Company’s Enterprise Wide Solutions segment accounted for approximately 16% of the Company’s consolidated revenue for the year ended December 31, 1999.
21. Subsequent Events
In March 2000, the Board of Directors approved a 3 for 2 stock split of common stock, options, and warrants for holders of record on March 14, 2000. Accordingly, all share and per share data including stock option, warrant, and loss per share information have been restated in the consolidated financial statements to retroactively reflect the stock split.
On January 14, 2000, the Company increased its authorized shares of common stock from 75,000,000 shares to 450,000,000 shares. The increase is reflected in the accompanying balance sheet at December 31, 1999.
USinternetworking, Inc.
Notes to Consolidated Financial Statements - (Continued)
21. Subsequent Events - (Continued)
Report of Independent Auditors
The Board of Directors and Stockholders
I.I.T. Holding, Inc.
We have audited the accompanying consolidated balance sheets of I.I.T. Holding, Inc. and subsidiaries as of December 31, 1996 and 1997, and September 7, 1998, and the related consolidated statements of operations, stockholders’ equity (deficit), and cash flows for the years ended December 31, 1996 and 1997, and for the period from January 1, 1998 through September 7, 1998. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the 1996 and 1997 financial statements of International Information Technology IIT, C.A., a wholly-owned subsidiary, which statements reflect total assets of $68,247 and $76,361 as of December 31, 1996 and 1997, respectively, and total revenues of $3,336 and $147,797 for the period from March 6, 1996 (inception) through December 31, 1996 and for the year ended December 31, 1997, respectively. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to data included for International Information Technology IIT, C.A., is based solely on the report of the other auditors.
We conducted our audits in accordance with auditing standards generally accepted in the 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for our opinion.
In our opinion, based on our audits and the report of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of I.I.T. Holding, Inc. and subsidiaries as of December 31, 1996 and 1997, and September 7, 1998 and the consolidated results of their operations and their cash flows for the years ended December 31, 1996 and 1997, and for the period from January 1, 1998 through September 7, 1998, in conformity with accounting principles generally accepted in the United States.
/s/ Ernst & Young LLP
Baltimore, Maryland
March 23, 1999
Report Of Independent Auditors
The Board of Directors
USinternetworking, Inc.
We have audited the accompanying balance sheets of International Information Technology IIT, C.A., at December 31, 1997 and for the period from March 5, 1996 (date of inception) through December 31, 1996, and the related statements of operations, changes in stockholders’ equity and cash flows for the years then ended (not presented separately herein). These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with U.S. generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as 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 financial position of International Information Technology IIT, C.A. at December 31, 1997 and for the period from March 5, 1996 (date of inception) through December 31, 1996, and the results of its operations and its cash flows for the years then ended in conformity with U.S. generally accepted accounting principles.
At December 31, 1997 and 1996, the accompanying financial statements have been prepared assuming that the Company will continue its ongoing operations, despite of the negative stockholder’s equity, which shows uncertainty about the Company’s ability to continue in operation. These financial statements do not include any adjustments that could result as a consequence of this uncertainty.
BASSAN & ASSOCIADOS S.C.
Ana Escudero de D’Aguiar
Certified Public Accountant
CPA D.F. Venezuela No. 7558
August 20, 1998
I.I.T. Holding, Inc. and Subsidiaries
Consolidated Balance Sheets
See accompanying notes.
I.I.T. Holding, Inc. and Subsidiaries
Consolidated Statements of Operations
See accompanying notes.
I.I.T. Holding, Inc. and Subsidiaries
Consolidated Statements of Stockholders’ Equity (Deficit)
See accompanying notes.
I.I.T. Holding, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
See accompanying notes.
I.I.T. Holding, Inc. and Subsidiaries
Notes to the Consolidated Financial Statements
1. Summary of Significant Accounting Policies
Reorganization and Basis Of Presentation
I.I.T. Holding, Inc. and subsidiaries (“the Company”) provides internet consulting, integration, and support services to commercial companies in the United States and South America. I.I.T. Holding, Inc. was formed in February 1998 when the shareholders of International Information Technology Inc. and International Information Technology IIT, C.A., enterprises under common control, exchanged their stock for 100% of the stock of I.I.T. Holding, Inc. The accompanying consolidated financial statements for all periods presented include the combined financial position and results of operations of the companies previously under common control. All significant intercompany transactions have been eliminated in preparation of the consolidated financial statements.
Conversion to U.S. Dollars
The financial information for a Venezuelan subsidiary includes financial information converted from Venezuelan Bolivares to U.S. Dollars.
Assets and liabilities were converted at the rate in effect at the balance sheet date and the statement of operations was converted at the average rate during the periods.
Use of Estimates
The preparation of the consolidated financial statements in conformity with generally accepted accounting principles, 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 amount of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Cash and Cash Equivalents
For purposes of the statement of cash flows, the Company considers all highly-liquid instruments, including certificates of deposit, purchased with a maturity of three months or less to be cash equivalents.
Concentration of Credit Risk
Financial instruments that subject the Company to concentrations of credit risk consist primarily of accounts receivable. The Company grants credit in the normal course of business to its clients. As part of this ongoing procedure, the Company monitors the creditworthiness of its clients. The Company does not believe that it is subject to any unusual credit risk beyond the normal credit risk inherent in its business.
For the period ended September 7, 1998, two customers accounted for 24% ($1,042,674), and 10% ($457,784) of total revenue, and three customers accounted for 38% ($508,212), 13% ($177,874) and 10% ($139,758) of accounts receivable at September 7, 1998.
For the year ended December 31, 1997, three clients accounted for 33% ($927,964), 17% ($478,042), and 11% ($309,321) of total revenues, and three clients accounted for 44% ($279,055), 16% ($101,474), and 11% ($69,764) of accounts receivable at December 31, 1997. For the year ended December 31, 1996, three clients accounted for 57% ($425,803), 29% ($216,637), and 11% ($82,173) of total revenues, and three clients accounted for 42% ($94,710), 24% ($54,120), and 11% ($24,805) of accounts receivable at December 31, 1996.
I.I.T. Holding, Inc. and Subsidiaries
Notes to the Consolidated Financial Statements - (Continued)
1. Summary of Significant Accounting Policies - (continued)
Revenue Recognition
Revenue is recognized in the period the services are performed.
Advertising Costs
The Company expenses advertising costs as incurred. Advertising expense was approximately $73,000 and $30,000 in 1997 and 1996, respectively. Advertising expense was approximately $27,000 for the period ended September 7, 1998.
New Accounting Pronouncements
In 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income (SFAS No. 130). SFAS No. 130 establishes standards for reporting and displaying comprehensive income and its components. SFAS No. 130 only impacts display as opposed to actual amounts recorded. Comprehensive income includes net income and all other non-owner changes in equity that are excluded from net income, such as foreign currency translation adjustments. SFAS No. 130 was adopted in 1998.
In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information (SFAS No. 131). This Statement requires that public business enterprises report certain information about operating segments in complete sets of financial statements of the enterprise and in condensed financial statements of interim periods issued to shareholders. It also requires that public business enterprises report certain information about their product and services, the geographic areas in which they operate, and their major customers. The Company adopted the provisions of SFAS No. 131 in 1998 which did not have a significant impact on the Company’s definition of operating segments and related disclosures.
2. Leases
The Company has entered into various capital leases for computer equipment during 1997. Computer equipment acquired under capital lease obligations was approximately $44,000. Depreciation expense was $11,116 and $6,000 for the period ended September 7, 1998 and for the year ended December 31, 1997, respectively.
Future lease payments under capital and operating leases are summarized as follows:
I.I.T. Holding, Inc. and Subsidiaries
Notes to the Consolidated Financial Statements - (Continued)
2. Leases - (continued)
Rent expense was $47,476, $32,000 and $17,000 for the period ended September 7, 1998, and for the years ended December 31, 1997 and 1996, respectively.
Capital leases have effective interest rates which range from 6% to 25%.
3. Accrued Expenses
Accrued expenses are comprised of the following:
4. Employee Benefit Plan
The Company has established a defined contribution benefit plan effective January 1, 1998. The plan covers substantially all employees of the Company who are 21 years of age or older. Participants may contribute up to 15% of their annual compensation to the plan, and the Company matches up to 3% of annual compensation. In 1998, the Company recorded contributions to the plan of $37,502.
5. Note Payable
The note payable, which matured in 1997, was due to a financing organization, and required monthly installments of $552, including interest at 9.90%.
6. Common Stock
Upon reorganization in February 1998, the Company was authorized to issue 100 shares of common stock with a par value of $5.00 per share. At September 7, 1998, 95 shares were issued and outstanding.
7. Stock Compensation Expense
In August 1997, the sole stockholder of the Company transferred 473 shares of the outstanding common stock to management employees for no consideration. An independent appraisal was obtained which estimated the fair value of the shares on the date of transfer at $1,002,316. This transfer was treated as a contribution to additional paid-in capital by the sole stockholder, with an offsetting charge to compensation expense. In 1997, the Company recorded compensation expense of $1,002,316 relating to the transfer of these shares.
8. Income Taxes
Deferred income tax assets and liabilities are determined based upon differences between financial reporting and the tax basis of assets and liabilities and are measured using the enacted tax rate and laws that will be in effect when the differences are expected to reverse.
I.I.T. Holding, Inc. and Subsidiaries
Notes to the Consolidated Financial Statements - (Continued)
8. Income Taxes - (continued)
The components of the income tax provision are as follows:
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of net deferred income taxes are as follows:
At September 7, 1998 the Company’s U.S. subsidiary has net operating loss carryforwards of approximately $359,000 available to offset future taxable income of the U.S. operations. These carryforwards begin to expire in 2012.
The Company’s Venezuelan subsidiary had cumulative net operating losses in the amount of $110,000 through December 31, 1997. These net operating losses resulted in net deferred tax assets of approximately $23,000 and $5,000 at December 31, 1997 and 1996, respectively. Management has determined that it is more likely than not that these net operating losses will not be utilized; therefore, a full valuation allowance was recorded against these deferred tax assets at December 31, 1997 and 1996. During the period from January 1, 1998 through September 7, 1998, the subsidiary utilized approximately $92,000 of the net operating loss carryforward, and increased the valuation allowance by approximately $2,500 to $25,500, which fully offsets the net deferred tax asset of $25,500 at September 7, 1998. The remaining net operating loss carryforward of approximately $18,000 will expire in 2000.
I.I.T. Holding, Inc. and Subsidiaries
Notes to the Consolidated Financial Statements - (Continued)
9. Geographic Segment Information
The Company is engaged in one business segment. This segment includes providing internet consulting, integration, and support services principally to commercial companies located throughout the United States and South America. The following table presents information regarding geographic segments for the period from January 1, 1998 through September 7, 1998 and the years ended December 31, 1997 and 1996. There were no service transfers between the United States and South America. Operating profit (loss) is total service revenue less cost of service revenue, general and administrative expenses, sales and marketing and depreciation.
10. Impact of Year 2000 (unaudited)
Some older computer programs were written using two digits rather than four to define the applicable year. As a result, those computer programs have time-sensitive software that recognize a date using “00” as the year 1900 rather than the year 2000. This could cause a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices, or engage in similar normal business activities.
The Company is assessing the modifications or replacement of its software that may be necessary for its computer systems to function properly with respect to the dates in the year 2000 and thereafter. The Company does not believe that the cost of either modifying existing software or converting to new software will be significant or that the year 2000 issue will pose significant operational problems for its computer systems.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The information with respect to directors and executive officers required by this Item 10 is incorporated in this report by reference to the information set forth under the caption “Directors and Executive Officers” in our definitive Proxy Statement for our 2000 Annual Meeting of Stockholders, which will be filed with the Commission no later than April 29, 2000.
Item 11.
Item 11. Executive Compensation
The information required by this Item 11 is incorporated in this report by reference to the information set forth under the caption “Executive Compensation” in our definitive Proxy Statement which will be filed with the Commission no later than April 29, 2000. The sections entitled “Compensation Committee Report on Executive Compensation” and “Performance Graph” in the Proxy Statement are not incorporated herein by reference. Information relating to certain filings on Forms 3, 4 and 5 is contained in the Proxy Statement under the caption “Section 16(a) Beneficial Ownership Reporting Compliance.”
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information required by this Item 12 is incorporated in this report by reference to the information set forth under the caption “Security Ownership of Certain Beneficial Owners and Management” in our definitive Proxy Statement which will be filed with the Commission no later than April 29, 2000.
Item 13.
Item 13. Certain Relationships and Related Transactions
The information required by this Item 13 is incorporated in this report by reference to the information set forth under the caption “Certain Relationships and Related Transactions” in our definitive Proxy Statement which will be filed with the Commission no later than April 29, 2000.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
Financial Statements
See Part II, Item 8 hereof.
Financial Statement Schedules
All schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instruction or are inapplicable and have therefore been omitted.
Exhibits.
(a)
Filed herewith.
(b)
Incorporated by reference to the Company’s Registration Statement on Form S-1, as amended (Reg. No. 333-70717)
(c)
Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 1999 filed by the Company on November 15, 1999.
(d)
Incorporated by reference to the Company’s Registration Statement on Form S-1, as amended (Reg. No. 333-93299).
(e)
Not filed, in accordance with Instruction No. 2 to Item 601 of Regulation S-K, because the contract is substantially identical to Exhibit 10.22 except as to the parties thereto and the principal amount of the note.
(f)
Confidential treatment obtained as to certain portions.
(g)
Incorporated by reference to the Company’s Registration Statement on Form S-1, as amended (Reg. No. 333-95543).
Reports on Form 8-K.
We filed a Current Report on Form 8-K dated October 21, 1999, under which we filed a press release relating to the announcement of our intention, subject to market and other conditions, to raise approximately $100 million in gross proceeds through an offering of convertible subordinated notes to qualified institutional investors.
We filed a Current Report on Form 8-K dated October 22, 1999 under which we filed exhibits relating to our recent purchase of the assets of Conklin & Conklin, Inc. (“Conklin”) for $8.0 million in cash, $0.6 million in assumed debt and $2.0 million represented by a secured note. Because the Conklin acquisition did not involve the acquisition of a significant business under Rule 305(a) or Rule 11-01(b) of Regulation S-X, financial statements of Conklin or pro forma financial information for the Conklin acquisition were not filed.
We filed a Current Report on Form 8-K dated October 28, 1999 under which we filed a press release relating to our recent placement of $100,000,000 aggregate principal amount of 7% Convertible Subordinated Notes due November 1, 2004.
We filed a Current Report on Form 8-K dated December 9, 1999 under which we filed a press release relating to our Board of Directors approval of a three for two stock split of our common stock for all shareholders of record at the close of business on December 3, 1999.
We filed a Current Report on Form 8-K dated February 18, 2000 under which we filed a press release relating to the announcement of our cooperative marketing agreement with AT&T.
We filed a Current Report on Form 8-K dated March 6, 2000 under which we filed a press release relating to our Board of Directors approval of a three for two stock split of our common stock for all shareholders of record at the close of business on March 14, 2000.
SIGNATURES
Pursuant to the requirements of the Securities Act of 1934, as amended, USinternetworking, Inc. has duly caused this registration statement to be signed on its behalf by the undersigned, thereunto duly authorized, in Annapolis, Maryland on March 23, 2000.
USINTERNETWORKING, INC.
By:
/s/ CHRISTOPHER R. MCCLEARY
Christopher R. McCleary
Chairman of the Board and
Chief Executive Officer
Pursuant to the requirements of the Securities Act of 1934, as amended, this Registration Statement has been signed by the following persons in the capacities and on the dates indicated. | 29,490 | 194,984 |
790730_1999.txt | 790730_1999 | 1999 | 790730 | ITEM 1 - BUSINESS
(a) GENERAL DEVELOPMENT OF BUSINESS.
Although the Company's antecedents date back to 1907, it evolved directly from the merger of two separate firms in 1929, resulting in the incorporation of American Concrete Pipe Co. on April 22, 1929. Various name changes occurred between that time and 1942, at which time the Company's name became American Pipe and Construction Co. By the late 1960s the Company was almost exclusively engaged in manufacturing and had expanded its product lines to include not only concrete and steel pipe but also high-performance protective coatings, ready-mix concrete, aggregates and reinforced thermosetting resin pipe and fittings.
At the beginning of 1970, the Company's name was changed to Ameron, Inc. In the meantime, other manufactured products had been added to its product lines. These included concrete and steel poles for street and area lighting, and steel poles for traffic signals.
In 1996, the Company's name was changed to Ameron International Corporation in order to better reflect its expanded, global focus. Also in 1996, the Company acquired assets of Centron, a leading manufacturer of fiberglass pipe for the worldwide oil field market, as well as the worldwide Devoe marine coatings business of Imperial Chemical Industries Plc ("ICI"). In 1998, the Company acquired the protective coatings and light industrial product finishes businesses of Croda International Plc in the United Kingdom, Australia and New Zealand.
Further details or commentary on the year's operations can be found in the Annual Report, which is Exhibit 13 to this report on Form 10-K, and which should be read in conjunction with this report.
(b) FINANCIAL INFORMATION AS TO INDUSTRY SEGMENTS.
The information contained in Notes (1), (6) and (18) of Notes to Consolidated Financial Statements on pages 30, 31, 32, 33, 40 and 41 of the Annual Report is incorporated herein by reference.
(c) NARRATIVE DESCRIPTION OF BUSINESS.
(1) For geographical and operational convenience, the Company is organized into divisions. These divisions are combined into the following groups serving the following-described industry segments.
a) The Coatings Group develops, manufactures and markets high-performance coatings and surfacer systems on a world-wide basis. These products are utilized for the preservation of structures, such as metallic and concrete facilities and equipment, to prevent their degradation by corrosion, abrasion, marine fouling and other forms of chemical and physical attack. The primary markets served include marine, offshore, petrochemical, power generation, petroleum, chemical, steel, pulp and paper, railroad, bridges, mining, metal processing and original equipment manufacturing. These products are marketed by direct sales, as well as through manufacturers' representatives, distributors and licensees. Competition is based upon quality, price and service. Manufacture of these products is carried out in the Company's plant in Arkansas, by wholly-owned subsidiaries in The Netherlands, the United Kingdom, Australia and New Zealand, by jointly-owned operations in Mexico and Saudi Arabia and by various third-party licensees.
b) The Fiberglass - Composite Pipe Group develops, manufactures and markets filament-wound and molded fiberglass pipe and fittings. These products are used by a wide range of process industries, including industrial, petroleum, chemical processing and petrochemical industries, for service station replacement piping systems, aboard marine vessels and on offshore oil platforms, and are marketed as an alternative to metallic piping systems which ultimately fail under corrosive operating conditions. These products are marketed by direct sales, as well as through manufacturers' representatives, distributors and licensees. Competition is based upon quality, price and service. Manufacture of these products is carried out in the Company's plants in Texas and Georgia, by its wholly-owned domestic subsidiary, Centron International Inc. ("Centron"), at its plant in Texas, by wholly-owned subsidiaries in The Netherlands, Singapore, and Malaysia, by a jointly-owned affiliate in Saudi Arabia and by third-party licensees.
c) The Concrete & Steel Pipe Group supplies products and services used in the construction of water pipelines. Five plants are located in Arizona and California. Also included within this group is American Pipe & Construction International, a wholly-owned subsidiary, with two plants in Colombia. These plants manufacture concrete cylinder pipe, prestressed concrete cylinder pipe, steel pipe and reinforced concrete pipe for water transmission, storm and industrial waste water and sewage collection. These products are marketed by direct selling using the Company's own personnel and by competitive bidding. Customers include local, state and federal agencies, developers and general contractors. Normally no one customer or group of customers will account for sales equal to or greater than 10 percent of the Company's consolidated revenue. However, occasionally, when more than one unusually large project is in progress, combined sales to all U.S. government agencies and/or general contractors for those agencies can reach those proportions. Besides competing with several other welded steel pipe and concrete pipe manufacturers located in the market area, alternative products such as ductile iron, asbestos cement, and clay pipe compete with the Company's concrete and steel pipe products, but ordinarily these other materials do not offer the full diameter range produced by the Company. Principal methods of competition are price, delivery schedule and service. The Company's technology is used in the Middle East through affiliated companies. This segment also includes the manufacturing and marketing on a world-wide basis through direct sales and manufacturing representatives of polyvinyl chloride and polyethylene sheet lining for the protection of concrete pipe and cast-in-place concrete structures from the corrosive effects of sewer gases, acids and industrial chemicals. Competition is based upon quality, price and service. Manufacture of this product is carried out in the Company's plant in California. This segment also includes engineered design, fabrication and direct sale of specialized proprietary equipment which is outside the regular business of the other segments of the Company's businesses. Competition for such work is based upon quality, price and service. Manufacture of such equipment is carried out in the Company's plant in California.
d) The Construction & Allied Products Group includes the Ameron Hawaii Division, which supplies ready-mix concrete, crushed and sized basaltic aggregates, dune sand, concrete pipe and box culverts, primarily to the construction industry in Hawaii. These products are marketed through direct sales. Ample raw materials are available locally in Hawaii. As to rock products, the Company has exclusive rights to a quarry containing many years' reserves. There is only one major source of supply for cement in Hawaii. Within the market area there are competitors for each of the segment's products. No single competitor offers the full range of products sold by the Company in Hawaii. The principal methods of competition are based upon quality, price and service. An appreciable portion of the segment's business is obtained through competitive bidding. This segment also includes the operations of the Pole Products Division, which manufactures and markets concrete and steel poles for highway, street and outdoor area lighting and for traffic signals. Sales are nationwide, but with a stronger concentration in the western states. Marketing is handled by the Company's own sales force and by outside sales agents. Competition for such products is mainly based on price and quality, but with some consideration for service and delivery. Manufacture of these products is carried out in two plants in California, as well as plants in Washington and Oklahoma.
e) Except as individually shown in the above descriptions of industry segments, the following comments or situations apply to all segments:
(i) Because of the number of manufacturing locations and the variety of raw materials essential to the business, no critical situations exist with respect to supply of materials. The Company has multiple sources for raw materials. The effects of increases in costs of energy are being mitigated to the extent practical through conservation and through addition or substitution of equipment to manage the use and reduce consumption of energy.
(ii) The Company owns certain patents and trademarks, both U.S. and foreign, related to its products. The Company licenses its patents, trademarks, know-how and technical assistance to various of its subsidiary and affiliated companies and to various third-party licensees. It licenses these proprietary items to some extent in the U.S., and to a greater degree abroad. These patents, trademarks, and licenses do not constitute a material portion of the Company's total business. No franchises or concessions exist.
(iii) Many of the Company's products are used in connection with capital goods, water and sewage transmission and construction of capital facilities. Favorable or adverse effects on general sales volume and earnings can result from weather conditions. Normally, sales volume and earnings will be lowest in the first fiscal quarter. Seasonal effects simply accelerate or slow the business volume and normally do not bring about severe changes in full-year activity.
(iv) With respect to working capital items, the Company does not encounter any requirements which are not common to other companies engaged in the same industries. No unusual amounts of inventory are required to meet seasonal delivery requirements. All of the Company's industry segments turn their inventory between three and eight times annually. Average days' sales in accounts receivable range between 41 and 108 for all segments.
(v) The value of backlog orders at November 30, 1999 and 1998 by industry segment is shown below. A substantial portion of the November 30, 1999 backlog is expected to be billed and recorded as sales during the fiscal year 2000.
(vi) There was no significant change in competitive conditions or the competitive position of the Company in the industries and localities in which it operates. There is no knowledge of any competitive situation which would be material to an understanding of the business.
(vii) Sales contracts in all of the Company's business segments normally consist of purchase orders, which in some cases are issued pursuant to master purchase agreements. Longer term contracts seldom involve commitments of more than one year by the Company, and exceptions are not deemed material by management. Payment is normally due from 30 to 60 days after shipment, with progress payments prior to shipment in some circumstances. It is the Company's practice to require letters of credit prior to shipment of foreign orders, subject to limited exceptions. The Company does not typically extend long-term credit to purchasers of its products.
(2) a) Approximate expense during each of the last three fiscal years for Research and Development costs is shown under the caption in Note (1) of Notes to Consolidated Financial Statements on page 30 of the Annual Report, which information is incorporated herein by reference.
b) The Company's business is not dependent on any single customer or few customers, the loss of any one or more of whom would have a material adverse effect on its business.
c) For many years the Company has been consistently installing or improving devices to control or eliminate the discharge of pollutants into the environment. Accordingly, compliance with federal, state, and locally enacted provisions relating to protection of the environment is not having, and is not expected to have, a material effect upon the Company's capital expenditures, earnings, or competitive position.
d) At year-end the Company and its consolidated subsidiaries employed approximately 3,100 persons. Of those, approximately 1,000 covered by labor union contracts. There are five separate bargaining agreements subject to renegotiation in 2000.
(d) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES.
The information contained in Notes (1), (6) and (18) of Notes to Consolidated Financial Statements on pages 30, 31, 32, 33, 40 and 41 of the Annual Report is incorporated herein by reference.
Export sales in the aggregate from U.S. operations during the last three fiscal years were:
ITEM 2
ITEM 2 - DESCRIPTION OF PROPERTY
(a) The location and general character of principal plants and other materially important physical properties used in the Company's operations are tabulated below. Property is owned in fee simple except where otherwise indicated by footnote. In addition to the property shown, the Company owns vacant land adjacent to or in the proximity of some of its operating locations and holds this property available for use when it may be needed to accommodate expanded or new operations. Property listed does not include any temporary project sites which are generally leased for the duration of the respective projects. With the exception of the Kailua, Oahu property, shown under the Construction & Allied Products industry segment, there are no material leases with respect to which expiration or inability to renew would have any material adverse effect on the Company's operations. The lease term on the Kailua property extends to the year 2052. Kailua is the principal source of quarried rock and aggregates for the Company's operations on Oahu, Hawaii and, in management's opinion, reserves are adequate for its requirements during the term of the lease.
(b) The Company believes that its existing facilities are adequate for current and presently foreseeable operations. Because of the cyclical nature of certain of the Company's operations, and the substantial amounts involved in some individual orders, the level of utilization of particular facilities may vary significantly from time to time in the normal course of operations.
INDUSTRY SEGMENT - GROUP
DIVISION - LOCATION DESCRIPTION ------------------- ----------- COATINGS GROUP
Coatings division - USA Brea, CA Office, Laboratory Little Rock, AR Office, Plant
Ameron B.V. Geldermalsen, The Netherlands Office, Plant Huthwaite, UK Office, Plant
Ameron (UK) Limited Hull, UK Office, Plant
Ameron (Australia) Pty. Limited Sydney, Australia Office, Plant Adelaide, Australia Plant
Ameron (New Zealand) Limited Auckland, New Zealand Office, Plant
FIBERGLASS - COMPOSITE PIPE GROUP
Fiberglass Pipe division - USA Houston, TX *Office Burkburnett, TX Office, Plant
Ameron Composites Inc. Newnan, GA Office, Plant
Centron International, Inc. Mineral Wells, TX Office, Plant
Ameron B.V. Geldermalsen, The Netherlands Office, Plant
Ameron (Pte) Ltd. Singapore *Office, Plant
Ameron Malaysia Sdn. Bhd. Malaysia *Office, Plant
CONCRETE AND STEEL PIPE GROUP
Rancho Cucamonga, CA *Office Etiwanda, CA Office, Plant Fontana, CA Office, Plant Lakeside, CA Office, Plant Phoenix, AZ Office, Plant Tracy, CA Office, Plant
Protective Linings division Brea, CA Office, Plant
Fabrication Plant South Gate, CA Office, Plant
American Pipe & Construction International Bogota, Colombia Office, Plant Cali, Colombia Plant
CONSTRUCTION & ALLIED PRODUCTS GROUP
Hawaii division Honolulu, Oahu, HI *Office, Plant Kailua, Oahu, HI *Plant, Quarry Barbers Point, Oahu, HI Office, Plant Puunene, Maui, HI *Office, Plant, Quarry
Pole Products division
Ventura, CA *Office Fillmore, CA Office, Plant Oakland, CA *Plant Everett, WA *Office, Plant Tulsa, OK *Office, Plant
CORPORATE
Corporate Headquarters Pasadena, CA *Office
Corporate Research & Engineering South Gate, CA Office, Laboratory
*Leased
ITEM 3
ITEM 3 - LEGAL PROCEEDINGS
An action was filed in 1992 in the U.S. District for the District of Arizona by the Central Arizona Water Conservation District ("CAWCD") seeking damages against several parties, including the Company and the Company's customer, Peter Kiewit Sons' Company ("Kiewit"), in connection with six prestressed concrete pipe siphons furnished and installed in the 1970's as part of the Central Arizona Project ("CAP"), a federal project to bring water from the Colorado River to Arizona. The CAWCD also filed separate actions against the U.S. Bureau of Reclamation ("USBR") in the U.S. Court of Claims and with the Arizona Projects Office of the USBR in connection with the CAP siphons. The CAWCD alleged that the six CAP siphons were defective and that the USBR and the defendants in the U.S. District Court action were liable for the repair or replacement of those siphons at a claimed estimated cost of $146.7 million. On September 14, 1994 the U.S. District granted the Company's motion to dismiss the CAWCD action and entered judgment against the CAWCD and in favor of the Company and its co-defendants. CAWCD has filed a notice of appeal with the Ninth Circuit Court of Appeals.
Separately, on September 28, 1995 the Contracting Officer for the USBR issued a final decision claiming for the USBR approximately $40 million in damages against Kiewit, based in part on the Contracting Officer's finding that the siphons supplied by the Company were defective. That claim amount is considered by the Company to be duplicative of the damages sought by the CAWCD for the repair or replacement of the siphons in its aforementioned action in the U.S. District for the District of Arizona. The Contracting Officer's final decision has been appealed by Kiewit to the U.S. Department of the Interior Board of Contract Appeals ("IBCA"). The Company is actively cooperating with, and assisting, Kiewit in the administrative appeal of that final decision before the IBCA.
The Company internally, as well as through independent third party consultants, has conducted engineering analyses regarding the allegations that the CAP siphons were defective and believes that the siphons were manufactured in accordance with the project specifications and other contract requirements, and therefore it is not liable for any claims relating to the siphons, whether by the CAWCD or by the USBR. The Company believes that it has meritorious defenses to these actions and that resultant liability, if any, should not have a material effect on the financial position of the Company or its results of operations.
In addition, certain other claims, suits and complaints, which arise in the ordinary course of business, have been filed or are pending against the Company. Management believes that these matters, and the matters discussed above, are either adequately reserved, covered by insurance, or would not have a material effect on the financial position of the Company and its results of operations if disposed of unfavorably. It is difficult to estimate with any certainty the total cost of remediation, the timing and extent of remedial actions required by governmental authorities, and the amount of the Company's liability, if any, in proportion to that of other potentially responsible parties. The Company is also subject to federal, state and local laws and regulations concerning the environment and is currently participating in administrative proceedings at several sites under these laws. While the Company finds it difficult to estimate with any certainty the total cost of remediation at the several sites, on the basis of currently available information and reserves provided, the Company believes that the outcome of such environmental regulatory proceedings will not have a material effect on the Company's financial position or its results of operations.
ITEM 4
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
(Not Applicable)
ITEM 4A - EXECUTIVE OFFICERS OF THE REGISTRANT
The following sets forth information with respect to individuals who served as executive officers as of November 30, 1999 and who are not directors of the Company. All executive officers are appointed by the Board of Directors to serve at the discretion of the Board of Directors.
All of the executive officers named above have held high level managerial or executive positions with the Company for more than the past five years except Messrs. Shogren and Wilkinson.
Mr. Shogren joined the Company in 1997 as Director of Finance and Administration for the Concrete & Steel Pipe Group. In 1999 he was named Vice President, Controller. Prior to joining the Company, he served in senior accounting and finance positions with Corning, Inc. and Manufacturing Technology, Inc.
Mr. Wilkinson joined the Company in 1996 and was named President of Ameron Hawaii in December of that year. In 1998, he was also named President of the Pole Products Division. Prior to that time he served as President and Chief Executive Officer of Sinclair Paint Company and as President and Chief Operating Officer of Frazee Paint Company.
PART II
ITEM 5
ITEM 5 - MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Common Stock, $2.50 Par Value, of the Company, its only outstanding class of common equity, is traded on the New York Stock Exchange, the only exchange on which it is presently listed. On February 8, 2000, there were 1,420 stockholders of record of such stock.
Dividends have been paid each quarter during the prior two years and for many years in the past. Information as to the amount of dividends paid during the reporting period and the high and low prices of the Company's Common Stock during that period are set out under the caption Quarterly Financial Data shown on page 40 of the Annual Report, which information is incorporated herein by reference.
Terms of lending agreements which place restrictions on cash dividends are discussed in Note (11) of Notes to Consolidated Financial Statements on pages 34 and 35 of the Annual Report, which are incorporated herein by reference.
ITEM 6
ITEM 6 - SELECTED FINANCIAL DATA
The information required by this item is contained in the Selected Consolidated Financial Information shown on page 20 of the Annual Report, which information is incorporated herein by reference.
ITEM 7
ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The information required by this item is contained in the Ameron International 1999 Financial Overview on pages 21-24 of the Annual Report, which information is incorporated herein by reference.
ITEM 7A
ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
The information required by this Item is contained on page 24 of the Annual Report under the caption Market Risks and is incorporated herein by reference.
ITEM 8
ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Consolidated Financial Statements for the year ended November 30, 1999, the report thereon of Deloitte & Touche LLP dated January 24, 2000 and Notes to Consolidated Financial Statements comprising pages 25 through 42 of the Annual Report, are incorporated herein by reference. The Consolidated Financial Statements for the years ended November 30, 1998 and 1997 and the Notes to such financial statements are also included on pages 25 through 42 of the Annual Report and are incorporated herein by reference. The report of Arthur Andersen LLP dated January 21, 1999, on such 1998 and 1997 financial statements, is included herein as Exhibit 99.
ITEM 9
ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Effective June 23, 1999, the Company replaced Arthur Andersen LLP ("AA") as its independent accountants.
The reports of AA on the Company's financial statements for fiscal years 1998 and 1997 did not contain an adverse opinion or a disclaimer of opinion, nor were they qualified or modified as to uncertainty, audit scope, or accounting principles.
The decision to replace AA was recommended by the Company's Audit Committee and approved by its Board of Directors.
During fiscal years 1998 and 1997 and the subsequent interim periods, there were no disagreements with AA on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreements, if not resolved to the satisfaction of AA would have caused it to make reference to the subject matter of the disagreement(s) in connection with its report.
During fiscal years 1998 and 1997 there were no reportable events (as defined in Item 304(a)(1)(v) of Securities and Exchange Commission Regulation S-K).
Effective, June 23, 1999, the Board of Directors of the Company engaged Deloitte & Touche LLP as the principal accountants to audit the Company's financial statements for the fiscal year ended November 30, 1999. No other event requiring disclosure has occurred.
PART III
ITEM 10
ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information with respect to the directors is contained under the section entitled, "Election of Directors" in the Company's Proxy Statement which was filed on February 22, 2000 in connection with the Annual Meeting of Stockholders to be held on March 22, 2000. Such information is incorporated herein by reference.
Information with respect to the executive officers who are not directors of the Company is located in Part I, Item 4A of this report.
ITEM 11
ITEM 11 - EXECUTIVE COMPENSATION*
ITEM 12
ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT*
ITEM 13
ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS*
*The information required by Items 11, 12 and 13 is contained in the Company's Proxy Statement which was filed on February 22, 2000 in connection with the 2000 Annual Meeting of Stockholders to be held on March 22, 2000. Such information is incorporated herein by reference.
PART IV
ITEM 14
ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(A) (1) FINANCIAL STATEMENTS:
The financial statements to be filed hereunder are cross-referenced, in the index immediately following, to the Annual Report, as to sections incorporated herein by reference.
(i) Summarized information as to the financial condition and results of operations for Ameron Saudi Arabia, Ltd., Bondstrand, Ltd, Oasis-Ameron, Ltd. and TAMCO are presented in Note (6) of Notes to Consolidated Financial Statements on pages 32-33 of the Annual Report, which information is incorporated herein by reference.
(a)(2) FINANCIAL STATEMENT SCHEDULES:
The following additional financial data should be read in conjunction with the consolidated financial statements in the 1999 Annual Report. Schedules not included with this additional financial data have been omitted because they are either not applicable, not required, not significant, or the required information is provided in the consolidated financial statements or notes thereto.
(b) REPORTS ON FORM 8-K
One report on Form 8-K was filed by the Company during the last quarter of the fiscal year ending November 30, 1999 as follows:
September 29, 1999 reporting under Item 5, the financial results for the Company's third quarter ended August 31, 1999
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of Ameron International Corporation:
We have audited the consolidated financial statements of Ameron International Corporation and subsidiaries (the "Company") as of November 30, 1999, and for the year then ended, and have issued our report thereon dated January 24, 2000. Such financial statements and report are included in your 1999 Annual Report to Shareholders and are incorporated herein by reference. Our audit also included the financial statement schedule for the year ended November 30, 1999 listed in Item 14(a)2. This financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based on our audit. In our opinion, such financial statement schedule, when considered in relation to the basic 1999 financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
Deloitte & Touche LLP Los Angeles, California January 24, 2000
AMERON INTERNATIONAL CORPORATION AND SUBSIDIARIES SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED NOVEMBER 30, 1999 (In thousands)
AMERON INTERNATIONAL CORPORATION AND SUBSIDIARIES SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED NOVEMBER 30, 1998 (In thousands)
AMERON INTERNATIONAL CORPORATION AND SUBSIDIARIES SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED NOVEMBER 30, 1997 (In thousands)
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
AMERON INTERNATIONAL CORPORATION
By: /s/ JAVIER SOLIS ---------------------------------------- Javier Solis, Senior Vice President & Secretary
Date: February 25, 2000
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. | 4,498 | 29,299 |
730045_1999.txt | 730045_1999 | 1999 | 730045 | Item 1. BUSINESS
(a) General Development of Business
IMTEC, Inc. (the "Company") designs, manufactures and sells labeling systems. These systems include label printer laminators, label printer applicators, preprinted labels and labeling supplies. IMTEC products are designed for automated identification (bar coding) applications in the electronics, pharmaceutical, transportation, textile, automotive and warehousing industries.
The Company acquired the Customark division of Markem Corporation in August 1997. A Form 8-K, dated August 26, 1997, was filed related to this acquisition.
The Company was incorporated in Vermont on March 17, 1982 under the name Imaging Technologies, Inc., and was reincorporated in Delaware under its present name on September 22, 1983. The Company's executive offices are located at One Imtec Lane, Bellows Falls, Vermont 05101, and its telephone number is (802) 463-9502.
(b) Financial Information About Industry Segments
See note 12 in the financial statements.
(c) Narrative Description of Business
Products and Services
The Company markets high-performance labels, label material, ribbons and laminates, and produces preprinted bar code labels for customers who prefer outsourcing of label printing. Although the Company sells a broad variety of label materials, the Company focuses on high performance label materials, designed to perform in demanding environments. Sales of such labeling supplies accounted for 70.5%, 71.5 % and 72.1% of the Company's revenues during fiscal years 1999, 1998 and 1997, respectively.
The Company also markets bar code label printer/applicators, label applicators, label dispensers and bar code label printer/laminators. Printer/applicators print bar codes and variable alphanumeric information onto pressure sensitive labels and automatically applies the label in a single integrated process to a product or package. These devices are typically used to automate information transfer and labeling processes in a real time production or distribution environment. Label applicators apply pre-printed labels to product or packages. Label dispensers present pre-printed labels for hand application. Printer/laminators enable rapid automated printing of bar code and variable information on labels with a laminated surface. These labels are often used in environments where resistance to temperatures, chemicals and weather are valued.
These labeling systems are microprocessor driven and involve proprietary software, label applicator elements and transport, cutting and laminating devices. The systems often include scanners, detectors and printers supplied by unaffiliated manufactures. Equipment sales accounted for 29.5%, 28.5% and 27.9% of the Company's revenue during fiscal years 1999, 1998 and 1997, respectively.
Marketing and Sales
The Company's marketing efforts are directed to those industries and businesses that have a need for bar coded labels and labeling systems. The Company conducts its marketing and sales efforts primarily through an in-house sales staff of 26 full-time employees and its executive officers; 2 sales management offices in the Metropolitan areas of Chicago, IL and Asheville, NC, respectively, each of which employs one full-time sales employee; and an independent reseller network consisting of 41 certified distributors and an additional 60 resellers throughout the United States who market other bar code products in addition to the Company's.
The Company also conducts marketing efforts and sales throughout Canada, Latin America, Europe, and the Pacific Rim through resellers and distributors.
The Company supplements these efforts by advertising, publishing articles in trade and business journals, and participating in trade shows.
Manufacturing and Sources of Supply
The Company purchases, from non-affiliated manufacturers, substantially all of the printers that it incorporates into its bar code printers. As there are numerous manufacturers and distributors of printers, the Company does not anticipate experiencing any curtailment in the availability of printers.
The Company is not materially dependent on any one supplier for its computer software, bar code printing supplies or components used in assembling its present or proposed products. It currently uses a number of outside contractors to fabricate machine parts and sub-assemblies for its products but is not currently materially dependent on any one such contractor.
Patents and Trademarks
During the current fiscal year the Company received one new patent. As of June 30, 1999, the Company owned ten patents, expiring at various dates ranging from 2001 to 2009, and eleven trademarks, respectively. Registrations of trademarks in nine foreign countries have been issued. The Company does not believe the proprietary protection afforded by such patents and trademarks is of material importance to its current or future operations or prospects.
Warranty
The Company's personnel install its products and train customers' personnel in their operation and service. The Company's personnel also service such products when a customer's own staff is unable to diagnose or correct a problem. The Company provides warranty for its enhanced printers for a one-year period for parts and in-house labor. The Company also offers service and warranty contracts directly to its customers.
Customers
The Company's primary customers are those businesses in industries that utilize bar code labels and labeling systems. The Company's customers include, but are not limited to, the fields of electronics, distribution, automotive and consumer's goods manufacturers. No one customer accounted for more than 10% of the Company's revenues during fiscal years 1999, 1998 and 1997.
Backlog
The aggregate backlog of firm orders for the Company's products as of June 30, 1999 was approximately $2,846,000 as compared with $1,590,000 at June 30, 1998. Approximately $2,554,000 of the current backlog is for media supplies with scheduled shipping dates over the next 12 months. The balance of the current backlog of $292,000 is for equipment, including several orders for multiple units, with scheduled delivery over several months. The Company anticipates that substantially all of its backlog will be filled during the current fiscal year. Competition
The Company competes with several other companies in the sale of its bar code accessories, supplies and services, and many of these companies are larger and have greater financial resources. The Company recognizes approximately 10 direct competitors in its field; however, the Company believes that no one competitor is a dominant factor therein.
The Company may face potential competition with respect to its specialized bar code labeling systems from other companies engaged in various areas of the bar code industry which have both the technical knowledge to develop competing systems and financial resources substantially greater than those of the Company.
The Company believes that it presently competes based on performance, simplicity of operation, reliability of products, and price. It also expects to compete with respect to specialized bar code labeling systems presently under development, based upon its chemical and systems engineering capabilities.
Research and Development
The Company conducts on-going research and development to refine, improve and enhance its product lines. Research and development expenses were $473,789, $577,864 and $591,767 in the fiscal years ended June 30, 1999, 1998 and 1997, respectively. The research and development expenses were primarily attributable to the Company's efforts with respect to its specialized bar code labeling systems and proprietary materials.
Employees
As of June 30, 1999, the Company employed 93 persons on a full time basis, including 8 employees in administration, 31 in marketing and sales, 8 in research and development and 46 in service and manufacturing.
None of the Company's employees are represented by a labor union and the Company has experienced no work stoppages. The Company believes that its employee relations are good.
(d) Financial Information about Foreign and Domestic Operations and Export Sales
Export sales aggregated approximately $2,365,000 in fiscal 1999, $2,125,000 in fiscal 1998 and $1,979,000 in fiscal 1997, representing 17.0%, 17.0% and 22.5%, respectively, of the Company's sales in such fiscal years. While our export sales are generally denominated in U.S. dollars, our international business may be affected by changes in demand resulting from fluctuations in currency exchange rates, trade restrictions and duties and other political and economic factors. The Company has no significant assets outside of the United States and all export sales in such years were made to persons or entities that had no affiliation to the Company.
Fiscal Years Ended June 30, 1999 1998 1997 ---- ---- ---- Latin America 53% 32% - Pacific Rim 21% 35% 46% Canada 15% 14% 15% Europe 10% 12% 26% Others 1% 7% 13% ---- ---- ---- 100% 100% 100% ==== ==== ====
Item 2.
Item 2. PROPERTIES
The Company currently occupies approximately 15,000 square feet in leased facilities and a plot of land measuring 11.59 acres situated in the Rockingham Industrial Park, Bellows Falls, Vermont, which house the Company's executive and administrative offices, and its bar code manufacturing and shipping facilities. The lease expires on December 31, 1999. The Company has the right to extend the lease for an additional five-year term and to purchase the building at any time at a purchase price equal to the then outstanding principal balance and accrued interest of a $525,000 Vermont Industrial Development Authority Industrial Development Revenue Bond, issued in May, 1985. Annual rent through June 30, 1999 at this facility is $54,000. The lease provides that the Company shall pay property taxes and utility charges. Sufficient land is available to allow for future expansion.
The Company also leases approximately 19,100 square feet in facilities at 33 Bridge Street, Bellows Falls, Vermont, which house additional manufacturing and storage facilities. This lease expires December 31, 2000 and the Company has the right to extend the lease for two terms of five years each. Annual rent through June 30, 1999 at this facility is $68,000.
The Company also leases approximately 9,000 square feet in facilities at 17 Bradco Road, Keene, New Hampshire, which house additional manufacturing and sales facilities. This lease expires May 31, 2000 and the Company has the right to extend the lease for another term of three years. Annual rent through June 30, 1999 at this facility is $52,920.
The Company also leases approximately 5,500 square feet in facilities at 90 Pattison Street, Evans City, Pennsylvania, which house additional manufacturing facilities. This lease expires April 30, 2001 and the Company has the right to extend the lease for another term of three years. Annual rent through June 30, 1999 at this facility is $19,250.
The Company plans to consolidate the majority of its New England facilities into a newly constructed 56,000 square foot building located in Keene, NH, which the Company intends to lease from Monadnock Economic Development Corporation of Keene, NH. The Company expects to begin the move in May, 2000. The Company signed a letter of intent on April 9, 1999 to lease new office and production facilities in Keene, NH. Although the lease has not yet been finalized, the lease calls for estimated annual rental payments of $300,000 and is expected to commence on May 1, 2000.
Item 3.
Item 3. LEGAL PROCEEDINGS
There is no material litigation currently pending, or, to the Company's knowledge, threatened against the Company.
Item 4.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended June 30, 1999.
PART II
Item 5.
Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
(a) Market Information
The Company's Common Stock is quoted on Nasdaq-SmallCap Market tier of The Nasdaq Stock Market under the symbol IMTC. The following table sets forth, for the periods indicated, the bid price range of the Common Stock as reported by National Quotation Bureau Incorporated. These quotations represent prices between dealers, do not include retail markups, markdowns or commissions and do not necessarily represent actual transactions:
1999 HIGH TRADE LOW TRADE
First Quarter $ 12 7/8 $ 9 1/4 Second Quarter 10 7/8 6 1/2 Third Quarter 8 1/2 5 1/4 Fourth Quarter 9 1/4 5 1/8
First Quarter $ 10 $ 8 Second Quarter 12 1/2 8 1/2 Third Quarter 11 1/2 8 3/4 Fourth Quarter 13 10 1/16
(b) Holders
At June 30, 1999, there were approximately 310 registered shareholders of record of the Company's Common Stock.
(c) Dividends
The Company has not paid any cash dividends since its inception and the Board of Directors does not contemplate doing so in the near future. Any decision as to future payment of dividends will depend on the earnings and financial position of the Company and such other factors as the Board of Directors deem relevant.
(a) The net income per share amounts for Fiscal 1999 include a net loss of $0.04 per share for basic and $0.03 per share for diluted attributable to the cumulative effect of accounting change.
Item 7.
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Cautionary Statement for Purposes of the "Safe Harbor" Provisions of the Private Securities Litigation Reform Act of 1995
The statements contained in the following Management's Discussion and Analysis of Financial Condition and Results of Operations which are not historical are "forward looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 31E of the Securities Exchange Act of 1934, as amended. These forward looking statements represent the Company's present expectations or beliefs concerning future events, however the Company cautions that such statements are qualified by important factors such as the Company's continued ability to develop and introduce innovative label products and applications, actions by competitors, the effect of economic conditions and other considerations and risks identified from time to time in the Company's filings with the Securities and Exchange Commission. Such factors, considerations and risks could cause actual results to differ materially from those indicated in Management's Discussion and Analysis of Financial Condition and Results of Operations.
Fiscal year ended June 30, 1999 as compared to fiscal year ended June 30, 1998.
Revenues for the fiscal year ended June 30 1999, increased approximately 11.3% over the fiscal year ended June 30, 1998.
Revenues from Bar Code labels and printing supplies were $9,822,661 for the fiscal year ended June 30, 1999, as compared to $8,942,540 for the year ended June 30, 1998, an increase of 9.8%. The sale of Bar Code labels and printing supplies represented approximately 70.5% of total revenues for fiscal year 1999 as compared to 71.5% of total revenues for fiscal year 1998.
Revenues from the sales and service of Industrial Bar Code Equipment were $4,102,570 for the year ended June 30, 1999, up 15.0% when compared to $3,568,015 for the year ended June 30, 1998. Industrial Bar Code Equipment revenues represented 29.5% of total revenues in fiscal year 1999 compared to 28.5% of total revenues in fiscal year 1998. The increase in bar code equipment sales in fiscal year 1999, when compared to fiscal year 1998, is primarily attributable to the increase in sales and marketing activity and a broader, more comprehensive product line.
Cost of sales were 55.7% of net sales for fiscal 1999 compared to 52.5% for fiscal 1998. Material costs, as a percentage of net sales, increased approximately 9.0% due to more competitive pricing of the product lines. Other cost increases are related to additional labor required to handle larger volumes of business.
Selling, general and administrative expenses represented 29.3% of net sales in fiscal year 1999 and 29.5% of net sales in fiscal year 1998. These expenses for fiscal 1999 increased by approximately $391,000 over fiscal 1998 levels. A significant portion of this increase reflects severance benefits and transition costs of approximately $253,000 incurred relating to the change of the Company's Chief Executive Officer.
Research and Development expenses represented 3.4% of net sales in fiscal year 1999 and 4.6% of net sales in fiscal year 1998. The actual costs decreased by approximately $104,000. This decrease is primarily due to the temporary redeployment of several of the Company's personnel to direct labor and field service.
In April 1998, the American Institute of Certified Public Accountants issued Statement of Position ("SOP") 98-5, "Reporting on the Costs of Start-Up Activities," which requires that all start-up activities and organizational costs be expensed as incurred. SOP 98-5 is effective for fiscal years beginning after December 15, 1998, however, early adoption is encouraged. The Company adopted this SOP in the fourth quarter of Fiscal 1999. The adoption of this statement resulted in a charge of $51,240 (net of an income tax benefit of $33,609), which is included in the Statement of Operations as a cumulative effect of accounting change. The cumulative effect of the adoption of SOP 98-5 is calculated as if the new statement was adopted as of the beginning of the year. Had the Company adopted this statement in the first quarter of the fiscal year, the cumulative effect, net of income taxes of $51,240, would have been reported in the Company's first quarter. The impact on operating income had this statement been adopted in the first quarter would have been to increase operating income by approximately $2,000 for the first, second and third quarters, respectively.
Operating Income, prior to the charges arising from the change at the C.E.O. position, was approximately $1,869,000 for fiscal 1999 compared to approximately $1,675,000 for fiscal 1998. This represents an increase of approximately 11.6%.
Interest Expense for fiscal year 1999 was $77,717, compared to $78,242 in fiscal 1998.
Interest Income generated during fiscal year 1999 was $1,052, compared to $28,502 during fiscal year 1998. This interest was earned on the balance of cash and cash equivalents. The decrease from 1998 was the result of decreased cash balances during the year.
Income before taxes and before the cumulative effect of accounting change was $1,541,605 in fiscal year 1999 compared to $1,632,801 in fiscal year 1998, reflecting a 5.6% decrease.
Income tax expense was $610,638 for the fiscal year ended June 30, 1999, compared to $648,179 in fiscal year 1998. The tax rate remains at approximately 40% of income before taxes.
At June 30, 1999 and 1998, the Company had accrued $136,633 and $124,570, respectively, against future product warranty claims based on experience with customer claims. Warranty expense charged to operations was $82,565 and $77,266 for the years ended June 30, 1999 and 1998, respectively.
Fiscal year ended June 30, 1998, as compared to fiscal year ended June 30, 1997.
Revenues for the fiscal year ended June 30 1998, increased approximately 42.1% over the fiscal year ended June 30, 1997.
Revenues from Bar Code labels and printing supplies were $8,942,540 for the fiscal year ended June 30, 1998, as compared to $6,345,047 for the year ended June 30, 1997, an increase of 40.9%. The sale of Bar Code labels and printing supplies represented approximately 71.5% of total revenues for fiscal year 1998 as compared to 72.1% of total revenues for fiscal year 1997. Approximately 70.0% of the increase is the result of the acquisition of the Customark division of Markem Corporation in August 1997.
Revenues from the sales and service of Industrial Bar Code Equipment were $3,568,015 for the year ended June 30, 1998, up 45.3% when compared to $2,456,342 for the year ended June 30, 1997. Industrial Bar Code Equipment revenues represented 28.5% of total revenues in fiscal year 1998 compared to 27.9% of total revenues in fiscal year 1997. The increase in bar code equipment sales in fiscal year 1998, when contrasted with fiscal year 1997, is primarily attributable to the increase in sales and marketing activity and a broader, more comprehensive product line.
Cost of sales improved to 52.5% of net sales for fiscal 1998 compared to 53.2% for fiscal 1997.
Selling, general and administrative expenses represented 29.5% of net sales in fiscal year 1998 and 30.1% of net sales in fiscal year 1997. These expenses for fiscal 1998 increased by $1,036,332 over fiscal 1997 levels. The majority of the dollar increase is related to compensation for the growing sales and marketing personnel.
Research and Development expenses represented 4.6% of net sales in fiscal year 1998 and 6.7% of net sales in fiscal year 1997. The actual costs decreased by about $13,900.
Interest Expense for fiscal year 1998 was $78,242, reflecting debt incurred to finance the acquisition of the Customark business. The Company had no interest expense for fiscal years 1997 and 1996.
Interest Income generated during fiscal year 1998 was $28,502, compared to $42,357 during fiscal year 1997. This interest was earned on the balance of cash and cash equivalents and marketable investment securities. The decrease was the result of using the cash to acquire the above-mentioned business.
Income before taxes was $1,632,801 in fiscal year 1998 compared to $921,458 in fiscal year 1997, reflecting a 77.2% increase.
Income tax expense was $648,179 for fiscal year ended June 30, 1998, compared to $365,384 in fiscal year 1997. The tax rate remains approximately 40% of income before taxes.
At June 30, 1998 and 1997, the Company had accrued $124,570 and $149,306, respectively, against future product warranty claims based on experience with customer claims. Warranty expense charged to operations amounted to an expense of $77,266 and $77,095 for the years ended June 30, 1998 and 1997, respectively.
CAPITAL RESOURCES AND LIQUIDITY:
As of June 30, 1999, the Company's principal available sources of liquidity were: operations, and a $2,000,000 bank line of credit, of which approximately $1,200,000 was available as of June 30, 1999.
Net accounts receivable at June 30, 1999 increased 40.2% when compared to June 30, 1998. This is the result of allowing several customer accounts to extend well beyond terms. The Company recognizes the problem and has taken very deliberate steps to improve its days outstanding. Those steps include the hiring of two administrative personnel to accelerate collections. The Company has increased its allowance for doubtful accounts from $198,000 at June 30, 1998 to $260,000 at June 30, 1999, which the Company believes is adequate to cover bad debts associated with the increased receivables balance.
Inventories increased by $179,249, from $2,286,123 at June 30, 1998 to $2,465,372 at June 30, 1999, as a result of increasing levels of business in sales across the entire product line.
The Company's capital commitments for fiscal 2000 are expected to be at approximately the same level as fiscal 1999. However, the Company is currently analyzing the effect that the proposed leased facility will have on capital commitments.
The Company believes that it will be able to offset the effects of inflation by selected price increases in its products, although it can give no assurances in this regard.
The Company anticipates that cash flows from operations, together with current cash and cash equivalents balances and funds available under the Company's line of credit, will be sufficient to meet the Company's working capital and capital equipment expenditure requirements for the foreseeable future.
Recent Accounting Pronouncements:
As discussed above, in Fiscal 1999, the Company adapted SOP 98-5, "Reporting on the Costs of Start-Up Activities."
Effective July 1, 1998, the Company adopted the provisions of Statement of Financial Accounting Standards ("SFAS") No. 131, "Disclosures about Segments of an Enterprise and Related Information." The standard requires the reporting of certain information about operating segments including the basis of presentation and segment profit or loss. The disclosures relating to this statement are included in Note 12.
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," subsequently amended in June 1999, and effective for fiscal years, including fiscal quarters, beginning after June 15, 2000. SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. It requires that an entity recognizes all derivatives as either assets or liabilities in the balance sheet and measures those instruments at fair value. The Company is currently analyzing the impact this statement will have on its financial statements.
Year 2000
The Company has reviewed the issue of Year 2000. All of the manufacturing and accounting software has been brought into compliance, effective June 16, 1998. There are neither internal clocks nor dating mechanisms within the Company's products that would be effected by changing dates. The Company is confident that its products and services will continue uninterrupted into the new millennium. No material additional costs are anticipated at this time.
The Company's contingency plan in the event other parties should be unable to provide Year 2000 compliant electronic data is to revert to paper documentation from these parties. However, to the extent that customers, vendors or other entities with which the Company has material relationships do not adequately address Year 2000 issues, the Company could experience payment delays.
Item 7A.
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's outstanding short-term debt at June 30, 1999 bears interest at a variable rate; therefore, the Company's results of operations would be affected by interest rate changes to the extent of the notes outstanding. Due to the short-term nature, an immediate 10 percent change in interest rates would not have a material effect on the Company's results of operations over the next fiscal year.
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders of IMTEC, Inc. Bellows Falls, Vermont
We have audited the accompanying balance sheets of IMTEC, Inc. as of June 30, 1999 and 1998, and the related statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended June 30, 1999. Our audits also included the financial statement schedule listed in the Index at Item 14.
Item 14. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material respects, the financial position of IMTEC, Inc. as of June 30, 1999 and 1998, and the results of its operations and its cash flows for each of the three years in the period ended June 30, 1999, in conformity with generally accepted accounting principles. Also, in our opinion, such 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.
/s/ Deloitte & Touche LLP
Boston, Massachusetts August 31, 1999
See notes to financial statements.
See notes to financial statements.
IMTEC, INC.
NOTES TO FINANCIAL STATEMENTS - --------------------------------------------------------------------------------
1. DESCRIPTION OF THE COMPANY'S BUSINESS
IMTEC, Inc. (the "Company") designs, manufactures and sells labeling systems. These systems include label printer laminators, label printer applicators, preprinted labels and labeling supplies. IMTEC products are designed for automated identification (bar coding) applications in the electronics, pharmaceutical, transportation, textile, automotive and warehousing industries. The Company conducts its marketing and sales efforts primarily through its in-house sales staff; two sales offices in different metropolitan areas in the United States; and throughout Canada, Latin America, Europe and the Far East through resellers and distributors. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Use of Management Estimates -The preparation of financial statements in conformity with generally accepted accounting principles 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 reporting period. Significant estimates include the allowance for doubtful accounts, useful lives of depreciable assets and intangibles, warranty accrual, and deferred income taxes, among others. Actual results could differ from those estimates.
Revenue Recognition - Product sales, including sales under contract, are recorded when the products are shipped.
Cash and Cash Equivalents - Cash and cash equivalents include all highly-liquid investments purchased with a remaining maturity of three months or less from date of purchase.
Inventories - Inventories are stated at the lower-of-cost-or-market. Cost is determined by the first-in, first-out method.
Property and Equipment - Property and equipment are carried at cost. Depreciation, including amortization of leasehold improvements, is computed using the straight-line method. When assets are retired or otherwise disposed of, the cost and related accumulated depreciation or amortization is removed from the accounts, and any resulting gain or loss is recognized in income for the period. The cost of maintenance and repairs is charged to expense as incurred and significant renewals and betterments are capitalized.
Computer Software - The cost of developing computer software to be included in the Company's products is expensed until the technological feasibility of the software is established. Subsequent costs are capitalized. Capitalized computer software costs are amortized using the straight-line method over the lesser of three years or the estimated life of the related product. Included in amortization expense is amortization of computer software of approximately $40,000, $40,000 and $61,000 during 1999, 1998 and 1997, respectively.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Other Intangibles - Other intangibles consist primarily of the cost of goodwill and patents and trademarks, which are amortized over their estimated useful lives. The composition at June 30 is as follows:
Amortization expense related to other intangibles amounted to approximately $89,000, $97,000 and $79,000 during 1999, 1998 and 1997, respectively.
Income Taxes - The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using currently enacted tax rates.
Income Per Share - In February 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No. 128, "Earnings Per Share," which establishes standards for computing and presenting earnings per share and applies to entities with publicly held common stock or potential common stock. Prior to 1998, the Company computed income per common share using the methods outlined in Accounting Principles Board ("APB") Opinion No. 15, "Earnings Per Share," and its interpretations. The Company adopted SFAS No. 128 in 1998 and restated its income per share for 1997.
Basic income per common share is computed using the weighted-average number of common shares outstanding during each year. Diluted income per common share reflects the effect of the Company's outstanding options, except where such items would be antidilutive.
A reconciliation of weighted-average shares used for the basic computation and that used for the diluted computation is as follows:
Options to purchase 64,800, 0 and 0 shares of common stock were outstanding at June 30, 1999, 1998 and 1997, respectively, but were not included in the computation of diluted earnings per share because the options' exercise prices were greater than the average market price of the common stock and, therefore, their effect would be antidilutive.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Product Warranties - Estimated costs related to product warranties are recorded at the time of the sale of the product.
Fair Value of Financial Instruments - The carrying amounts of cash, accounts receivable, accounts payable, accrued expenses and note payable approximate fair value because of the short maturity of these instruments. The fair value of long-term debt approximates the carrying value.
Stock-Based Compensation - The Company accounts for stock-based compensation in accordance with APB Opinion No. 25, "Accounting for Stock Issued to Employees," using the intrinsic value method. The difference between accounting for stock-based compensation under APB Opinion No. 25 and SFAS No. 123 is disclosed in Note 11.
Comprehensive Income - SFAS No. 130, "Reporting Comprehensive Income," requires the reporting of comprehensive income, which, in the case of the Company, is the same as net income for each of the three years ended June 30, 1999.
Segments - Effective July 1, 1998, the Company adopted the provisions of SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." The standard requires the reporting of certain information about operating segments including the basis of presentation and segment profit or loss. The disclosures relating to this statement are included in Note 12.
New Accounting Pronouncements - In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," subsequently amended in June 1999, and effective for fiscal years, including fiscal quarters, beginning after June 15, 2000. SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. It requires that an entity recognizes all derivatives as either assets or liabilities in the balance sheet and measures those instruments at fair value. The Company is currently analyzing the impact that this statement will have on its financial statements.
In April 1998, the American Institute of Certified Public Accountants issued Statement of Position ("SOP") 98-5, "Reporting on the Costs of Start-Up Activities," which requires that all start-up activities and organizational costs be expensed as incurred. SOP 98-5 is effective for fiscal years beginning after December 15, 1998, however, early adoption is encouraged. The Company adopted this SOP in the fourth quarter of Fiscal 1999. The adoption of this statement resulted in a charge of $51,240 (net of an income tax benefit of $33,609), which is included in the Statement of Operations as a cumulative effect of accounting change. The cumulative effect of the adoption of SOP 98-5 is calculated as if the new statement was adopted as of the beginning of the year.
Reclassifications - Certain amounts in the 1998 and 1997 financial statements have been reclassified to conform to the 1999 presentation.
3. ACQUISITION OF CUSTOMARK
In August 1997, the Company completed the acquisition of the Markem Corporation's Customark Division ("Customark") for a cash purchase price of $1.9 million.
The Customark acquisition has been accounted for by the purchase method of accounting, and, accordingly, the results of operations of Customark for the period from August 11, 1997 are included in the accompanying financial statements. The assets acquired consist primarily of $113,000 of inventory and $132,000 of property and equipment. The excess of cost over the estimated fair value of net assets acquired was allocated to goodwill. A total of $1,655,112 was allocated to goodwill and will be amortized on a straight-line basis over 20 years.
The Statement of Operations for the year ended June 30, 1999 includes a full year of operations of the acquired business. The following unaudited pro forma information presents the results of operations of the Company as if the acquisition had taken place as of the beginning of each period presented:
Year Ended Year Ended June 30, 1998 June 30, 1997
Revenues $12,705,159 $10,746,845 Net earnings $968,597 $688,798 Diluted income per share $0.59 $0.43
These pro forma results of operations have been prepared for comparative purposes only and do not purport to be indicative of the results of operations which actually would have resulted had the acquisition occurred on the date indicated, or which may result in the future.
4. INVENTORIES
5. PROPERTY AND EQUIPMENT
6. OTHER ACCRUED LIABILITIES
7. NOTE PAYABLE AND LONG-TERM DEBT
Note Payable: The Company has a secured line-of-credit agreement in the amount of $2,000,000, of which approximately $1,200,000 is available at June 30, 1999. The interest rate varies from time to time with changes in the prime interest rate. At June 30, 1999 the interest rate was 7.0%. The Note is due on demand and is renewed annually in March.
The following is a summary of the maturities of long-term debt as of June 30:
Year Ending 2000 $ 257,155 2001 279,886 2002 29,405 --------- $ 566,446 =========
8. INCOME TAXES
Total income tax expense differs from the amount computed by applying the statutory federal income tax rate of 34% to pretax income. The computed amount, and the items which make total income tax expense vary from it, are as follows for the years ended June 30:
8. INCOME TAXES (CONTINUED)
In assessing the recoverability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the projected future taxable income and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods during which the deferred tax assets are deductible, management believes it is more likely than not that the Company will realize the benefits of these deductible differences.
9. COMMITMENTS AND CONTINGENT LIABILITIES
The Company leases its facilities under lease agreements expiring through 2001 which are classified as operating leases. The lease for the Company's main building is noncancelable by the Company except through the exercise of an option to purchase the property for the remaining principal and interest balance on the Vermont Industrial Revenue Bond held by the lessor. The leases for the remaining three locations are noncancelable. Future minimum rental payments under the noncancelable operating leases for each of the years subsequent to June 30, 1999 are as follows:
2000 $165,620 2001 53,721 -------- $219,341 ========
Rental expense under cancelable and noncancelable operating leases amounted to approximately $161,000, $151,000 and $107,000 during 1999, 1998 and 1997, respectively. The Company is also subject to various legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business. While the outcome of these claims cannot be predicted with certainty, management does not believe that the outcome of any of these matters will have a material adverse effect on the Company's financial position or results of operations.
10. EMPLOYEE BENEFIT PLAN
The Company has a 401(k) savings plan under which eligible employees are allowed to contribute certain percentages of their pay, up to the maximum allowed under Section 401(k) of the Internal Revenue Code. The plan covers all employees meeting certain eligibility requirements. The Company contributed approximately $66,000, $60,000 and $45,000 to the plan during 1999, 1998 and 1997, respectively.
11. STOCKHOLDERS' EQUITY
Stock Option Plans - The Company has three plans: the 1985 Incentive Stock Option Plan, the 1993 Stock Option Plan, and the 1997 Stock Option Plan. These plans provide for granting of options for common stock to officers and key employees. The options granted are generally exercisable in four annual installments beginning one year after the date of the grant and expiring five to ten years after the date of the grant, depending on stock ownership on the grant date. The following is a summary of the option activity for the Company:
Weighted- Number Average of Exercise Price Shares per Share
Balance July 1, 1996 160,700 $4.27
Granted 3,000 6.75 Exercised (8,000) 2.61 Canceled (4,000) 7.60 ------- Balance June 30, 1997 151,700 4.32
Granted 53,000 8.51 Exercised (32,625) 3.14 Canceled (1,000) 8.50 ------- Balance June 30, 1998 171,075 5.80
Granted 35,250 10.87 Exercised (1,600) 4.72 Canceled (25,525) 8.78 ------- Balance June 30, 1999 179,200 $4.12 =======
11. STOCKHOLDERS' EQUITY (CONTINUED)
Stock Option Plans (Continued) - The following table sets forth information regarding options outstanding at June 30, 1999:
As described in Note 2, the Company uses the intrinsic value method (in accordance with APB No. 25) to measure compensation expense associated with grants of stock options to employees. Had the Company used the fair value method to measure compensation, the Company's net income and diluted net income per share for the years ended June 30, 1999, 1998 and 1997 would have been $836,679 or $.51 per share, $949,791 or $.57 per share and 539,782 or $.33 per share, respectively. The fair value of each option is estimated on the date of the grant using the Black-Scholes option-pricing model with the following assumptions used:
The weighted-average fair value of options granted in 1999, 1998 and 1997 was $5.29, $3.94 and $4.50, respectively. The option-pricing model used was designed to value readily tradable stock options with relatively short lives. The options granted to employees are not tradable and have contractual lives of ten years. However, management believes that the assumptions used and the model applied to value the awards yield a reasonable estimate of the fair value of the grants made under the circumstances.
12. SEGMENT INFORMATION
The Company has identified two distinct and reportable segments: the Hardware and the Media segments. The Company considers these two segments reportable under the requirements of SFAS No. 131 criteria as they are managed separately and the operating results of each segment are regularly reviewed and evaluated separately by the Company's chief decision-maker.
The Hardware segment provides printers, high performance applicators and laminators of labels for industrial environments. The Media segment provides the high performance label material for industrial environments. The accounting policies of each segment are in accordance with those described in Note 2.
A summary of information about the Company's operations by segment for the fiscal years ended June 30, 1999, 1998 and 1997 is as follows:
Depreciation and amortization for the Hardware and Media segments for 1999 were $260,787 and $324,385, for 1998 $235,056 and $309,843 and for 1997 $269,035 and $264,989.
Geographic Areas: Export sales aggregated approximately $2,365,000, $2,125,000 and $1,979,000 in 1999, 1998 and 1997, respectively.
13. CONCENTRATION OF SALES
During 1999, 1998 and 1997, no single customer accounted for 10% or more of total sales.
* * * * * *
PART IV
Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) 1. Financial Statements:
Included in Part II, Item 8, of this report:
(a) Reports of Independent Auditors
(b) Balance Sheets, June 30, 1999 and 1998.
(c) Statements of Operations for the years ended June 30, 1999, 1998 and 1997.
(d) Statements of Stockholders' Equity for the years ended June 30, 1999, 1998 and 1997.
(e) Statements of Cash Flows for the years ended June 30, 1999, 1998 and 1997.
(f) Notes to Financial Statements.
2. Financial Statement Schedule.
Schedule II - Valuation and Qualifying Accounts and Reserves, years ended June 30, 1999, 1998 and 1997.
All other schedules have been omitted because of the absence of conditions requiring them or because the required information is shown in financial statements or the notes thereto.
3. Exhibits
(a) Certificate of Incorporation as amended (1).
(b) By-Laws, as amended (1).
(c) The Exhibits required by 601 of Regulation S-K are set forth in (3) (a) above.
(d) The financial statement schedule required by Regulation S-K, which is excluded from the Annual Report to Shareholders is set forth in (2) above.
(b) Reports on Form 8-K
None - ------------------------------ (1) Denotes document filed as an Exhibit to the Company's Registration Statement on Form S-1 (File No. 2-86978) and incorporated herein by reference.
SIGNATURES
Pursuant to the requirements of Section 13 of 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
IMTEC, Inc.
By:_____/s/_Steven D. Anton_________ Steven D. Anton, President & CEO (Principal Executive Officer)
By:___/s/ George S. Norfleet III_________ George S. Norfleet III, Secretary - Treasurer (Principal Financial & Accounting Officer)
Dated: September 20, 1999
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities and on the dates indicated:
Signatures Titles Date
___/s/ Ralph E. Crump______ Chairman, Director September 20, 1999 Ralph E. Crump
___/s/ Douglas T. Granat___ Director September 20, 1999 Douglas T. Granat
___/s/ Robert W. Ham_______ Director September 20, 1999 Robert W. Ham
___/s/ David C. Sturdevant_ Director September 20, 1999 David C. Strudevant
EXHIBIT 11.1 STATEMENT RE: COMPUTATION OF PER SHARE EARNINGS
INDEPENDENT AUDITORS' CONSENT
We consent to the incorporation by reference in Registration Statement Nos. 333-65263, 33-62361 and 33-00666 of IMTEC, Inc. on Form S-8 of our report dated August 31, 1999, appearing in this Annual Report on Form 10-K of IMTEC, Inc. for the year ended June 30, 1999.
/s/ Deloitte & Touche LLP
Boston, Massachusetts September 22, 1999 | 7,321 | 47,765 |
1011991_1999.txt | 1011991_1999 | 1999 | 1011991 | ITEM 1. BUSINESS
GENERAL
SUSA Partnership, L.P. (the "Company" and the "Partnership") was formed by Storage USA, Inc. (the "GP"), general partner and holder of approximately 88% of the interest therein, to acquire, develop, construct, franchise, and own and operate self-storage facilities throughout the United States. We are the second largest owner and operator of self-storage space in the United States. At December 31, 1999, we owned 405 facilities containing 27.3 million net rentable square feet and managed 102 facilities for others (including 47 franchises) containing an additional 6.8 million net rentable square feet. Our owned and managed facilities are located in 31 states and the District of Columbia. The GP is structured as an umbrella partnership real estate investment trust ("UPREIT") in which substantially all of its business is conducted through the Partnership. Under this structure, we are able to acquire self-storage facilities in exchange for units of limited partnership interest, which permits the sellers to partially defer taxation of capital gains.
In 1996, we formed Storage USA Franchise Corp ("Franchise"), a Tennessee corporation. The Partnership owns 100% of the non-voting common stock of Franchise. The Partnership has a 97.5% economic interest in Franchise and accounts for Franchise under the equity method and includes our share of the profit or loss of Franchise in Other Income.
BUSINESS STRATEGY
INTERNAL GROWTH/OPERATIONS
Our internal growth strategy is to pursue an active leasing policy. This includes marketing available space and renewing existing leases at higher rents per square foot while controlling expense growth. Our implementation of our internal growth strategy can be evaluated by examining the "year-over-year" results of our same-store facilities during 1999 and 1998. Newly developed facilities and expansions are removed from this group to avoid skewing the results. During 1999, we achieved same-store revenue growth of 5.3% and net operating income ("NOI") growth of 8.0% over 1998. In 1998, as compared to 1997, we grew total revenue 5.9% and NOI 6.9%. We have reevaluated the amounts that we charge our customers and have implemented a new late fee policy reducing our late fees. We cannot currently determine the amount by which this new policy will reduce our revenue in future periods for a number of reasons, including the fact that our late fee charges vary across the country, they varied at facilities we acquired and facility managers have the discretion to waive late fees. However, the fee change could reduce revenues in 2000 by as much as $5 million. We expect that any revenue reduction may be offset, in part by increased rents, increased late fee collection efforts, and continued efficiencies in our operating margins, but we are not yet able to estimate the net effect of these items. You should refer to the discussions under "Forward-Looking Statements and Risk Factors" in this Item and "Legal Proceedings" in Item 3.
o LEASING - We seek to increase our revenues by increasing the occupancy in our facilities through the use of sales and marketing programs. Facility and district managers have authority and incentives to customize these programs for each location. We develop a written marketing plan for each facility and utilize yellow page advertising, site signage and location as the primary means to advertise our services. The facility managers are trained to market to both phone-in and walk-in prospective tenants. The primary emphasis of the training is to teach managers to act as salespeople and to convert prospective tenants into actual tenants. Emphasis is placed on conversion from the initial telephone call to an on-site visit, and from the on-site visit to a rental. During 1999, we created a national reservation center to ensure that a knowledgeable employee answer calls centrally from prospective customers when the property manager is unavailable. The reservation center can also be reached through our national toll-free number, 1-800-STOR-USA.
o RENT INCREASES - We have historically increased rents in all of our facilities at least once a year regardless of the occupancy level. As a facility nears 100% occupancy, we typically increase rents more frequently. We believe the average rental rate per net rentable square foot in our facilities is usually higher than our competitors' facilities.
o FACILITY MANAGERS - We carefully select and train managers of our self-storage facilities. Personality profiles and personal interviews are
used to screen applicants during the recruiting process. Training programs feature facility operations and marketing manuals, sales and marketing programs, telephone communication, computer systems, and daily facility operations (unit rental, retail sales, facility maintenance, security systems and financial duties). Our formal training programs are followed by on-the-job training (supervised by a regional manager) and a three-step, self-administered certification program. We conduct monthly telephone surveys in which "mystery shoppers" call each facility posing as prospective customers. These telephone calls are recorded and graded by management for policy compliance and sales skills.
o INTEGRATED MANAGEMENT INFORMATION SYSTEMS - We have installed management software at each facility to maintain appropriate controls and enhance operational efficiencies. In 1999, we completed installation of satellite dishes at all of our storage facilities, for timely transmission of monthly, weekly and daily data to our headquarters. These systems are used to monitor manager performance and market response to our rental structure.
EXTERNAL GROWTH
Our external growth strategy is designed to increase the number of facilities we own, manage or franchise through the following methods: o acquiring directly or through joint ventures, suitably located facilities that offer potential due to low occupancy rates or non-premium pricing or where our operating strategy would enhance performance, o developing and constructing new self-storage facilities directly or through joint ventures in favorable markets, or o license to owners and developers of self-storage facilities, the nonexclusive right to use and operate under the Storage USA name. In pursuing opportunities to expand the number of facilities in our system, we primarily seek to add facilities in those metropolitan areas in which we operate. We also selectively enter new markets that have desirable characteristics such as a growing population and a concentration of multifamily dwellings. Our intentions are to acquire or develop facilities that have strong retail characteristics and are attractively designed.
ACQUISITIONS
Since the GP's initial public offering ("IPO") in March, we have purchased 394 self-storage facilities containing 25.9 million net rentable square feet for approximately $1.501 billion.
o FRAGMENTED INDUSTRY OWNERSHIP - We believe that there are approximately 29,955 self-storage facilities in the United States with approximately 1.1 billion net rentable square feet. According to the SELF-STORAGE ALMANAC - 2000, 73.9% of the 1.1 billion square feet available is currently controlled by small entrepreneurs. The remaining 26.1% is controlled by the top 50 operators in the industry. Only 16.6%, or approximately 183 million square feet, is currently controlled by the top 5 operators. We believe that this fragmented ownership offers opportunities for acquisitions, including opportunities resulting from the following circumstances: o the necessity of sale by some smaller operators who cannot obtain refinancing of existing debt, o the desire of some smaller operators to sell their facilities to obtain retirement funds or to seek alternative investments, and o the inability of smaller operators to obtain funds to compete for acquisitions as timely and inexpensively as we can.
o OPERATING EFFICIENCIES - After a facility is acquired, we implement our operating methods, which are designed to increase rental rates and trim operating expenses.
o OPPORTUNITY FOR TAX DEFERRAL - In several of our acquisitions, we have financed a portion of the purchase price through the issuance of units of limited partnership interest in the Partnership ("Units"), permitting the sellers to partially defer taxation of capital gains. We believe that our ability to offer Units as a form of consideration is a key element in our ability to successfully negotiate with sellers of self-storage facilities. Since the IPO, we have issued 4.3 million Units valued at $146 million in consideration for the acquisition of self-storage facilities.
o ACCESS TO ACQUISITION CAPITAL - Historically, we had been able to access various forms of capital. Debt and equity markets, however, became difficult to access in 1998, and this trend continued through 1999. As
discussed in the "JOINT VENTURES" section, we formed two joint ventures with General Electric Capital Corporation ("GE Capital") in 1999, to acquire and develop self-storage facilities. Substantially all of our new acquisitions and developments over the next two years will be funded by these ventures.
DEVELOPMENT
Development of new facilitates provides long-term returns that could exceed returns achieved by acquired facilities. By developing properties, we are able to capitalize on unsaturated markets where suitable acquisition opportunities may be minimal or nonexistent. These locations may, in some instances, provide long-term returns greater than those available in typical suburban markets.
During the year, we placed in service eight newly developed facilities at a cost of $35.4 million, adding 619 thousand square feet. We also expanded the available square feet at fourteen existing facilities, adding 274 thousand square feet for a cost of $15.7 million.
As of December 31, 1999, we have 20 development projects in process. In connection with our joint ventures with GE Capital, we expect to transfer as many as 13 of these projects into the GE Capital development venture. We plan to continue the development of the remaining seven projects within the REIT.
o ACCESS TO DEVELOPMENT CAPITAL - As stated in the section entitled "ACQUISITIONS", debt and equity markets became difficult to access in 1998, and this trend continued through 1999. We believe, however, that borrowings under our current credit facilities combined with cash from operations will provide us with necessary liquidity and capital resources to complete the seven development projects within the REIT. Most new development activity over the next several years will be funded through and owned by our joint venture with GE Capital, as discussed in the "JOINT VENTURES" section.
o SELF-STORAGE ZONING - Local regulations may present barriers to new development. As with all real property, self-storage facilities must conform to local zoning ordinances. Typically, self-storage facilities are not a permitted use within the commercial and retail zones desired by us for development of a new facility. Therefore, we must generally obtain a special use permit or zoning variance to undertake the development of a new facility.
o DEVELOPMENT RETURNS - Newly developed properties provide the potential for long-term returns greater than what can typically be achieved by acquired facilities. However, losses during the lease-up period on these properties reduce earnings. In addition to the risks associated with owning and operating established facilities, development involves additional risks relating to delays in construction and less-favorable-than-anticipated rental rates, which could reduce our return.
JOINT VENTURES
In the second quarter of 1999, we formed a joint venture with Fidelity Management Trust Company (the "Fidelity Venture"), to raise capital. We contributed 32 self-storage facilities with a total value of $144 million to the Fidelity Venture in return for $131 million in cash and a 25% interest in the joint venture. We utilized approximately $90 million of these proceeds to acquire in tax-free exchanges new self-storage facilities that have greater growth potential than the facilities that were contributed.
During the fourth quarter, we formed two joint ventures with GE Capital ("GE Ventures"), providing a total investment capacity of $400 million for acquisitions and development of self-storage properties. We plan to fund substantially all of our new acquisition and development over the next two years through the GE Ventures.
For more details regarding these joint ventures, see Note 4 "Advancements and Investments in Real Estate" in the Notes to Consolidated Financial Statements contained in Exhibit 13-Annual Report.
FRANCHISING
Storage USA Franchise Corp. ("Franchise") was established in 1996. We own a 97.5% economic interest in Franchise and 100% of its Class B non-voting common stock. Franchise was created to enhance our short-term and long-term income streams and to provide a pipeline of acquisitions designed and constructed to our standards. Franchise offers a turnkey package including access to capital, analysis of potential markets and sites, facility design, general contractor work and facility management. As of December 31, 1999, Franchise had 47 facilities open and operating, 16 under development and 13 in due diligence. Of these 76 facilities, approximately 47 are joint venture properties that include earnings participation by Franchise (this figure is subject to change, as Franchisees in the due diligence stage have not definitively chosen which arrangement they will use).
On August 20, 1999, Budget Storage USA Joint Venture LLC was formed between affiliates of Budget Group, Inc., an international car and truck rental company, and Franchise. Both Budget's affiliate and Franchise own a 50% interest in the Venture. The Venture was formed for the primary purpose of selling to owners and developers of self-storage facilities, the nonexclusive right to use and operate under the Budget Storage USA trade name. As of December 31, 1999, the Venture was principally engaged in preparation of its Uniform Offering Circular in order to be registered to conduct business in its target markets.
CAPITAL STRATEGY
We maintain a conservative capital structure in order to improve our access to capital and earnings growth. We expect to finance our long-term capital needs through the issuance of equity (common and preferred) and debt securities. Since the IPO, the GP has issued $371 million of its common stock in three public offerings. The GP issued $284 million of its common stock in a series of direct placements with Security Capital U.S. Realty ("USRealty"), an affiliate of Security Capital Group, Inc. Since October 1996, we have issued $600 million of unsecured Senior Notes to the public. These notes were issued at interest rates ranging from 6.95% to 8.2% and with maturities ranging from 2003-2027. In addition, since the IPO, we have issued 4.3 million Units valued at $146 million in consideration for the acquisition of self-storage facilities.
Short-term capital needs are met through our revolving lines of credit. We have $240.0 million borrowing capacity in two unsecured revolving lines of credit with a group of commercial banks. As of December 31, 1999 we had borrowed $105.5 million under these revolving lines of credit. We also had mortgage loans outstanding of $63.6 million that were collateralized by 24 properties. Our policy, which is subject to change at the discretion of our Board of Directors, is to limit total indebtedness to the lesser of 50% of total assets at cost or an amount that will sustain a minimum debt service coverage ratio of 2.5:1. As of December 31, 1999, our total indebtedness is 43.9% of total assets at cost and our debt service coverage ratio for the year ended December 31, 1999, is 3.4:1. As discussed in "JOINT VENTURES", the majority of all acquisitions and developments over the next two years will be funded through and owned by the GE Capital joint ventures. We believe that borrowings under our current credit facilities combined with cash from operations will provide us with necessary liquidity and capital resources to complete any additional acquisitions and development projects outside of these joint ventures. We are limited in the amount of debt we can issue by the Amended and Restated Unsecured Revolving Credit Agreement, dated December 23, 1997 and Indenture dated November 1, 1996. (See "Liquidity and Capital Resources" in Management's Discussion and Analysis of Financial Condition and Results of Operations contained in Exhibit 13-Annual Report for more details.) We are also subject to certain limitations on the amount of debt we can incur under the existing line of credit facility and the Strategic Alliance Agreement, as described in the section entitled "Strategic Alliance with Security Capital U.S. Realty."
We may from time to time re-evaluate our borrowing policies according to the following factors: o current economic conditions, o relative costs of debt and equity capital, o market values of facilities, o growth and acquisition opportunities, and o other factors.
Borrowings may be incurred through the Partnership or the GP. Indebtedness incurred by us may be in the form of bank borrowings, secured and unsecured, and publicly and privately placed debt instruments. Indebtedness incurred by the Partnership may be in several forms: o purchase money obligations to the sellers of properties, o publicly or privately placed debt instruments, and o financing from banks, institutional investors or other lenders.
Any of the above indebtedness may be unsecured or may be secured by mortgages or other interests in the property owned by the Partnership. Such indebtedness may provide the lender recourse to all or any part of our assets or those of the Partnership, or may be limited to the particular property to which the indebtedness relates. The proceeds from any borrowings by the Partnership or the GP may be used for the following: o payment of distributions, o working capital, o refinancing existing indebtedness, or o financing acquisitions or expansions of facilities.
Our capital is used to further our investment objective of acquiring or developing self-storage facilities with cash flow growth potential. While we emphasize equity real estate investments, we may invest in mortgage and other real estate interests, including securities of other REITs. As of December 31, 1999, we had no investments in securities of other REITs. We may also invest in participating or convertible mortgages. Such mortgages are similar to equity participation. Specifically, we may make participating and non-participating loans collateralized by self-storage facilities owned by third parties (see "Strategic Alliance with Security Capital U.S. Reality").
Despite the decline in the real estate debt and equity markets in 1998 and 1999, we believe that our joint ventures with Fidelity Trust Management Corporation and GE Capital Corporation will allow us to continue to expand our system. We also believe that borrowings under our current credit facilities combined with cash from operations will provide us with necessary liquidity and capital resources to complete any additional acquisitions and development projects outside of those joint ventures.
In December 1999, the GP announced a plan authorized its Board of Directors to repurchase up to 5% of its outstanding shares of common stock through open market and private purchases. The timing of the purchases, the length of time that the repurchase program will continue and the exact number of shares to be repurchased will depend on market conditions and price levels. Purchases will be paid for through existing credit facilities. As of December 31, 1999, the GP had repurchased 250,000 shares at an average price of $28.91.
STRATEGIC ALLIANCE WITH SECURITY CAPITAL U.S. REALTY
On March 19, 1996, the GP and the Partnership entered into a Strategic Alliance Agreement with US Realty. The Strategic Alliance Agreement, among other things, permits US Realty to purchase up to 42.5% of the GP's common stock and to participate in certain offerings of the GP's equity securities. At December 31, 1998, US Realty owned 42.2% of the GP's common stock. We believe that the alliance with US Realty has provided us with access to significant additional financial and strategic resources not otherwise readily available to us, thereby enhancing our short-term and long-term growth prospects and better positioning us to capitalize on opportunities as the REIT industry matures. We also expect that we will continue to benefit significantly from our affiliation with US Realty and our access to US Realty's market knowledge, operating experience and research capabilities.
The Strategic Alliance Agreement places several restrictions on the GP. Pursuant to the Strategic Alliance Agreement, and until the first to occur of: (A) June 5, 2003, which can be extended; and (B) the first date following the date on which US Realty's ownership of the GP's common stock has been below 20% of the outstanding shares of common stock for a continuous period of 180 days, we may not: o incur total indebtedness in an amount exceeding 60% of the value of our total assets (which is deemed to be equal to the market value of our outstanding equity (on a fully-diluted basis at a price of $31.30 per share) and debt as of March 1, 1996, plus the acquisition cost of
properties acquired after March 1, 1996 (less any proceeds of property dispositions that are distributed to shareholders)), o cause or permit the sum of the following to, at any time, exceed 10%, at cost, of the consolidated assets owned by both GP and the Partnership: o securities of any other person, o assets not held other than directly by the GP, o loans made by the GP to the Partnership or any other subsidiary, or the reverse, o assets managed by persons other than the GP's employees, o own real property other than self-storage facilities or land suitable for the development of self-storage facilities whose value exceeds 10% of the aggregate value of our real estate assets at cost, o terminate the GP's eligibility for treatment as a REIT for federal income tax purposes, or o except as permitted or required by agreements existing as of March 1, 1996: o own any interest in any partnership unless the GP is the sole managing general partner of such partnership, or o issue Units, or securities convertible or exercisable for Units, if such issuance would cause the GP to own less than 90% of the Units on a fully diluted basis (collectively, the "Corporate Action Covenants"). We have amended this provision to allow us to own as little as 86.11%. We have certain specified rights to cure certain failures to comply with the Corporate Action Covenants.
In addition, the GP is subject to certain limitations pursuant to the Strategic Alliance that continue until US Realty's ownership of the GP's common stock shall have been below 20% by value of the actually outstanding shares of the GP's common stock for a continuous period of 180 days (subject to certain conditions). Generally, these limitations restrict the amount of assets that we may own indirectly through other entities and the manner in which the GP conducts its business.
US Realty requested these conditions because of its belief that REITs with direct and extensive control over the operation of all of their assets operate more effectively and in order to permit US Realty to comply with certain requirements of the Code and other countries' tax laws applicable to foreign investors. We, during the same period, have agreed not to take actions in the future that would result in more than 10% of our gross income, or more than 10% of our assets by value (subject to certain adjustments), being attributable to properties that are indirectly owned and are not managed by our employees or the Partnership. US Realty has agreed to waive these requirements in certain specific instances where indirect ownership facilitates our acquisition of certain facilities.
US Realty is restricted from acquiring more than 42.5% of the GP's common stock without its consent. US Realty is also restricted from certain other activities with respect to the GP including, among others, a restriction on selling the GP's common stock during a five year period ending on June 5, 2003 (so long as it owns at least 20% of the GP's common stock,) except pursuant to transfers in compliance with Rule 144 of the 1933 Securities Act, transfers pursuant to a negotiated transaction with a third party, to its affiliates, or to banks or similar institutions for purposes of securing a loan. These restrictions lapse if we, or the GP, among other things, default under the Strategic Alliance Agreement, another investor acquires more than 9.8% of the GP's outstanding common stock or other similar events occur.
We believe that these limitations are generally consistent with our, or the GP's, operating strategies and do not believe that they will materially restrict the GP's operations or have a material adverse effect on our financial condition or results of operations, though there can be no assurance that they will not do so in the future.
ANTI-TAKEOVER MEASURES
Our Charter and By-laws and Tennessee law include a number of provisions that could discourage a takeover or other transaction where our shareholders might receive a premium for their shares over the then prevailing market price. The provisions also cover situations that shareholders might believe to be otherwise in their best interest, including: o a prohibition on direct or constructive ownership of more than 9.8% of the outstanding shares of common stock in the GP by any person (except USRealty, which may acquire up to 42.5% of our common stock), o the capacity to issue "blank check" preferred stock with terms and preferences established by the Board of Directors, and
o the Tennessee Investor Protection Act, Business Combination Act and Greenmail Act, which impose certain restrictions and require certain procedures with respect to certain takeover offers and business combinations.
COMPETITION
Competition from other self-storage facilities exists in every market in which our facilities are located. We principally face competitors who seek to attract tenants primarily on the basis of lower prices. However, we usually do not seek to be the lowest price competitor. Rather, based on the quality of our facilities and our customer service-oriented managers and amenities, our strategy is to lead particular markets in terms of prices.
We monitor the development of self-storage facilities in our markets. We have facilities in several markets where we believe overbuilding has occurred, including the following: o Atlanta, GA (1.5% of portfolio square footage "sq. ft.") o Las Vegas, NV (2.2% sq. ft.), o Albuquerque, NM (1.8% sq. ft.), o Nashville, TN (2.4% sq. ft.), o Portland, OR (0.8% sq. ft.), and o Dallas, TX (5.0% sq. ft.).
In these markets we may experience a minimal reduction in Physical Occupancy and less growth in rental rates than other markets. As a result of the geographic diversity of our portfolio, we do not expect the potential for excess supply in these markets to have a significant impact on our financial condition or results of operations.
We are the second largest self-storage operator, with 34.7 million square feet in 405 owned and 112 managed (including 53 franchises) facilities as of March 20, 2000. There are four other publicly traded REITs and numerous private and regional operators. These other companies may be able to accept more risk than we can prudently manage. This competition may reduce the number of suitable acquisition opportunities offered to us and increase the price required to acquire particular facilities. Further, we believe that competition could increase from companies organized with similar objectives. Nevertheless, we believe that the operations, development, and financial experience of our executive officers and directors along with our customer-oriented approach to management of self-storage facilities should enable us to compete effectively.
SEASONALITY
Our revenues typically have been higher in the third and forth quarter primarily because we increase our rental rates on most of our storage units at the beginning of May. This also occurs to a lesser extent because self-storage facilities tend to experience greater occupancy during the late spring, summer, and early fall months due to greater incidence of persons moving during those periods. Accordingly, a greater percentage of our customers come to us as a result of the moving. We believe that our tenant mix, rental structure, and expense structure provide adequate protection against undue fluctuations in cash flows and net revenues during off-peak seasons. Thus, we do not expect seasonality to materially affect our results of operations.
EMPLOYEES
All persons referred to as our employees are employees of the Partnership or its subsidiaries (e.g. Franchise). As of December 31, 1999, we employed approximately 1,939 employees, of whom approximately 334 were employed part-time (fewer than 30 hours per week) on a regular basis. None of our employees are covered by a collective bargaining agreement.
GOVERNMENTAL REGULATION
The conduct of the self-storage business is regulated by various federal and state laws, both statutory and common law, including those relating to the form and content of rental agreements for individual storage spaces and requirements relating to collection practices and imposition of late fees. Franchise is subject to certain Federal and state laws, regulating the sale of franchises and other practices with respect to the franchisor/franchisee relationship. Taxation of Real Estate Investment Trusts ("REIT") is subject to governmental regulation and interpretation of the Internal Revenue Code.
On December 17, 1999, the Ticket to Work and Work Incentives Improvement Act of 1999 (the "Act") was signed into law. The Act includes several REIT provisions (the "REIT Provisions"). The REIT Provisions generally will be effective January 1, 2001 and will overhaul the existing tax rules applicable to taxable subsidiaries of REITs. Under the REIT Provisions, the GP will be allowed to own all of the stock in taxable REIT subsidiaries ("TRSs"). In addition, a TRS will be allowed to perform "non-customary" services to the GP's tenants (i.e. those types of services that would taint the rents from our tenants if provided by the GP). The use of TRSs, however, would be subject to restrictions, including the following: o no more than 20% of the REIT's assets may consist of securities of TRSs, o the tax deductibility of interest paid or accrued by a TRS to its affiliated REIT would be limited, and o a 100% excise tax would be imposed on non-arm's length transactions between a TRS and its affiliated REIT or the REIT's tenants.
The GP expects to restructure its ownership interests in its current taxable subsidiaries and establish additional taxable subsidiaries once the Act is effective.
QUALIFICATION AS A REAL ESTATE INVESTMENT TRUST
The GP operates in a manner to qualify as a Real Estate Investment Trust ("REIT") under the Internal Revenue Code of 1986, as amended (the "Code"). A REIT, which complies with the Code and distributes at least 95% of its taxable income to its shareholders, does not pay federal tax on its distributed income. ("95% REIT distribution test") Qualification as a REIT involves the application of highly technical and complex rules for which there are only limited judicial or administrative interpretations. The complexity of these rules is greater in the case of a REIT that holds its assets in partnership form. Furthermore, there are no controlling authorities that deal specifically with many tax issues affecting a REIT that operates self-storage facilities. Certain facts and circumstances not entirely within the GP's control may affect its ability to qualify as a REIT. In addition, new regulations, administrative interpretations or court decisions could have a substantial adverse effect on the GP's qualifications as a REIT or the federal income tax consequences. If the GP were to fail to qualify as a REIT, it would not be allowed a deduction for distributions to its shareholders in computing its taxable income. In this case, the GP would be subject to federal income tax (including any applicable alternative minimum tax) on its taxable income at regular corporate rates. Unless entitled to relief under certain Code provisions, the GP would also be disqualified from treatment as a REIT for the four taxable years following the year during which qualification was lost. As a result, the cash available for distribution to shareholders would be reduced for each of the years involved. Although the GP currently intends to operate in a manner designed to qualify as a REIT it is possible that future economic, market, legal, tax or other considerations may cause the Board of Directors, with the consent of a majority of the shareholders, to revoke the REIT election.
ENVIRONMENTAL MATTERS
We have obtained Phase 1 environmental audits on all of our facilities from various outside environmental engineering firms. The purpose of the Phase 1 audits is to identify potential sources of contamination at these facilities and to assess the status of environmental regulatory compliance. The Phase 1 audits include the following: o historical reviews of the facilities, o reviews of certain public records, o preliminary investigations of the sites and surrounding properties, o visual inspection for the presence of asbestos, o PCBs and underground storage tanks, and o the preparation and issuance of a written report.
A Phase 1 audit does not include invasive procedures, such as soil sampling or ground water analysis. In certain instances we have obtained Phase 2 environmental audits or procedures in order to determine (using invasive testing) whether potential sources of contamination indicated in Phase 1 audits actually exist. While some of the facilities have in the past been the subject of environmental remediation or underground storage tank removal, we are not aware of any contamination of facilities requiring remediation under current law. We will not take ownership of any acquisition facility prior to completing a satisfactory environmental review and inspection procedure. No assurance can be given that the Phase 1 and 2 audits have identified or will identify all significant environmental problems or that no additional environmental liabilities exist.
Under various federal, state and local laws and regulations, an owner or operator of real estate may be liable for the costs of removal or remediation of certain hazardous or toxic substances on properties. Such laws often impose such liability without regard to whether the owner caused or knew of the presence of hazardous or toxic substances and whether or not the storage of such substances was in violation of a tenant's lease. Furthermore, the cost of remediation or removal of such substances may be substantial, and the presence of such substances, or the failure to promptly remediate such substances, may adversely affect the owner's ability to sell such real estate or to borrow using such real estate as collateral. In connection with the ownership and operation of our facilities, we may become liable for such costs.
The environmental audit reports have not revealed any environmental liability that we believe would have a material adverse effect on our business, assets or results of operations. We are not aware of any existing conditions that currently would be considered an environmental liability. Nevertheless, it is possible that these reports do not or will not reveal all environmental liabilities or that there are material environmental liabilities of which we are unaware. Moreover, no assurances can be given concerning the following: o that future laws, ordinances or regulations will not impose any material environmental liability, o that the current environmental condition of the facilities will not be affected by the condition of the properties in the vicinity of the facilities (such as the presence of leaking underground storage tanks), or o that tenants will not violate their leases by introducing hazardous or toxic substances into our facilities. We may be potentially liable as owner of the facility for hazardous materials stored in units in violation of a tenant's lease, although to date we believe we have not incurred any such liability.
We believe that the facilities are in compliance in all material respects with all applicable federal, state and local ordinances and regulations regarding hazardous or toxic substances and other environmental matters. We have not been notified by any governmental authority of any material noncompliance, liability or claim relating to hazardous or toxic substances or other environmental substances in connection with any of our present or former properties.
FORWARD-LOOKING STATEMENTS AND RISK FACTORS
All statements contained in this Annual Report on Form 10-K that are not historical facts are based on our current expectations. This includes statements regarding anticipated future development and acquisition activity, the impact of anticipated rental rate increases on our revenue growth, our 2000 anticipated revenues, expenses and returns, and future capital requirements. Words such as "believes", "expects", "anticipate", "intends", "plans" and "estimates" and variations of such words and similar words also identify forward looking statements. Such statements are forward looking in nature and involve a number of risks and uncertainties. Actual results may differ materially. The following factors, among others, could cause actual results to differ materially from the forward-looking statements: o Changes in the economic conditions in the markets in which we operate could negatively impact the financial resources of our customers, impairing our ability to raise rents. o Certain of our competitors with substantially greater financial resources than us could reduce the number of suitable acquisition opportunities offered to us and increase the price necessary to consummate the acquisition of particular facilities. o Competition for development sites could drive up costs, making it unfeasible for us to develop properties in certain markets. o Increased development of new facilities in our markets could result in over-supply and lower rental rates. o Amounts we charge for late fees are periodically under review, have been and are the subject of litigation against us and are, in some states, the subject of government regulation. Consequently, such amounts could change, materially affecting the results of operations.
o The conditions affecting the bank, debt and equity markets could change. o The availability of sufficient capital to finance our business plan on satisfactory terms could decrease. o Competition could increase, adversely affecting occupancy and rental rates, thereby reducing our revenues. o Costs related to compliance with laws, including environmental laws could increase. o General business and economic conditions could change, adversely affecting occupancy and rental rates, thereby reducing our revenues.
We caution you not to place undue reliance on any such forward-looking statements. We assume no obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances.
In addition, our business is subject to the following particular risks and may be subject to other unidentified risks:
ACQUISITION AND DEVELOPMENT RISKS
Acquisitions risk is the possibility that investments will not perform in accordance with expectations. Acquisitions risks exist because of the following factors: o the price paid for acquired facilities is based upon a series of market judgements, o costs of any improvements required to bring an acquired facility up to standards to establish the market position intended for that facility may prove inaccurate, and o general investment risks associated with any new real estate investment.
We can give no assurance that acquisition targets meeting our guidelines for quality and yield will continue to be available in the quantity that were available in prior periods. We also may not be able to purchase such facilities in volumes adequate to meet our goals in the future.
The self-storage development business involves significant risks. Other risks in addition to those involved in the ownership and operation of established self-storage facilities include the following: o unfavorable financing terms, o amounts charged for late fees are periodically under review, have been and are subject of litigation and government regulation and could change, reducing revenues, o timing delays in construction and lease-up, o costs overruns in completing construction, o less-favorable than anticipated lease terms, o less demand than anticipated, and o an economic downturn reducing our rent collection rate.
Consequently, we give no assurance that we will realize our development goals or that newly developed facilities will perform as well as other facilities developed by us or realize their budgeted returns.
DEBT FINANCING
GENERAL RISKS. We finance certain of our acquisitions and development with unsecured debt and, in some cases mortgage debt. Because we use debt, we are subject to the risks normally associated with debt financing. The required payments on indebtedness are not reduced if the economic performance of any property or Storage USA as a whole declines. If such decline occurs, our ability to make debt service payments would be adversely affected. If we mortgage a property to secure debt and we are then unable to meet the mortgage payments, the mortgagee could then take possession of that property by foreclosure. This would cause a loss of revenue and asset value to us. Likewise our debt payment requirements could use funds that would have been distributed to meet the 95% REIT distribution test and the GP would lose its REIT status.
In connection with the 95% REIT distribution test, the GP may be required to make distributions in excess of cash available for distribution to shareholders in order to meet such distribution requirements. If this happened, we would try to borrow the funds or sell assets to obtain the cash necessary to make distributions to retain our qualification as a REIT for federal income tax purposes.
EFFECT OF MARKET INTEREST RATES ON PRICE OF COMMON STOCK. One of the factors that influences the price of the common stock in public trading markets is the annual yield from distributions on the price paid for common stock as compared to yields on other financial instruments. Thus, an increase in market interest rates will result in higher yields on other financial instruments, which could adversely affect the market price of the GP's common stock.
CHANGES IN POLICIES. Our major policies, including our policies dealing with acquisitions, development, financing, growth, operations, debt limitation and distributions, are determined by the Board of Directors of the GP. The Board of Directors may amend or revise these and other policies from time to time without a vote of its shareholders.
MARKET RISK. In the past, we have depended upon an inflow of external capital to carry out our acquisition and development strategies. Although there has been a decline in the real estate debt and equity markets in 1998 and 1999, we believe the flexibility we gained through our joint ventures with Fidelity Trust Management Corporation and GE Capital Corporation will allow us to continue to expand our system.
TAX RISKS
TAX LIABILITIES AS A CONSEQUENCE OF THE FAILURE TO QUALIFY AS A REIT. The GP intends to operate in a manner to qualify as a REIT for federal income tax purposes. However, no assurance can be given that the GP will qualify or remain qualified as a REIT. Qualification as a REIT involves the application of highly technical and complex provisions of the Code for which there are only limited judicial or administrative interpretations. The complexity of these provisions is greater in the case of a REIT that holds assets in partnership form. Furthermore, there are no controlling authorities that deal specifically with many tax issues affecting a REIT that operates self-storage facilities. Certain facts and circumstances not entirely within our control may affect the GP's ability to qualify as a REIT. In addition, no assurance can be given that legislation, new regulations, administrative interpretations or court decisions will not adversely effect the GP's qualification as a REIT or the federal income tax consequences.
If the GP were to fail to qualify as a REIT, it would not be allowed a deduction for distributions to shareholders in computing its taxable income. In this case, the GP would be subject to federal income tax (including any applicable alternative minimum tax) on our taxable income at regular corporate rates. Unless entitled to relief under certain Code provisions, the GP would also be disqualified from treatment as a REIT for the four taxable years following the year during which qualification was lost. As a result, the cash available for distribution to its shareholders would be reduced for each of the years involved. Although the GP currently intends to operate in a manner designed to qualify as a REIT it is possible that future economic, market, legal, tax or other considerations may cause the Board of Directors, with the consent of a majority of the shareholders, to revoke the REIT election.
ADVERSE EFFECTS OF REIT MINIMUM DISTRIBUTION REQUIREMENTS. In order to qualify as a REIT, the GP generally will be required each year to distribute to its shareholders at least 95% of its net taxable income (excluding any net capital gain). The GP would be subject to a 4% nondeductible excise tax on the amount, if distributions paid are less than the sum of one of the following scenarios during a calendar year: o 85% of the GP's ordinary income, o 95% of the GP's capital gain net income for that year, or o 100% of the GP's undistributed taxable income from prior years.
The GP intends to make distributions to its shareholders to comply with the 95% distribution requirement and to avoid the nondeductible excise tax. The GP's income and cash flow consists primarily of its share of those items from the Partnership. Differences in timing between taxable income and cash available for distribution could require the GP to borrow funds on a short-term basis to meet the 95% distribution requirement and to avoid the nondeductible excise tax. For federal income tax purposes, distributions paid to shareholders may consist of ordinary income, capital gains, nontaxable return of capital, or a combination of these. The GP will provide its shareholders with an annual statement as to the taxability of distributions.
Distributions by the Partnership are determined by the GP's Board of Directors and will be dependent on a number of factors. Some of those factors could include the following:
o the amount of the Partnership's cash available for distribution, o the Partnership's financial condition, o any decision by the Board of Directors to reinvest funds rather than to distribute such funds, o the Partnership's capital expenditures, o the annual distribution requirements under the REIT provisions of the Code, and o other factors as the Board of Directors deems relevant.
SELF-STORAGE INDUSTRY RISKS
OPERATING RISKS. Our facilities are subject to all operating risks common to the self-storage facility industry. These include the following risks: o a lack of demand for rental spaces in a given locale, o changes in supply of or demand for similar or competing facilities in an area, o changes in market rental rates, o an economic downturn reducing our customers ability to pay their rents or our ability to collect them, and o amounts charged for late fees are subject to review and could change, materially affecting results of operations.
COMPETITION. Our facilities compete with other self-storage properties in their geographic markets. Most of our competitors seek to compete by offering storage space at lower prices. We compete for customers and for investment opportunities with companies that have substantially greater financial resources. These companies may generally be able to accept more risk than we can prudently manage. Competition may generally reduce the number of suitable investment opportunities offered to us and increase the bargaining power of property owners seeking to sell. See "Item 1, Business-Competition" above.
REAL ESTATE INVESTMENT RISKS
GENERAL RISKS. Our investments are subject to varying degrees of risk associated with the ownership of real property. The underlying value of our real estate investments and our ability to make distributions depends on our ability to operate the facilities in a manner to maintain or increase cash provided by operations. Our income from our self-storage facilities may be adversely affected by the following: o adverse changes in national economic conditions, o adverse changes in local market conditions due to changes in general or local economic conditions and neighborhood characteristics, o competition from other self-storage properties, o changes in interest rates or loan fees, o changes in amounts we charge for late fees, o the availability, cost and terms of mortgage funds, o the impact of present or future legislation and regulatory compliance, including the costs of compliance with environmental, zoning and land use and fire and safety regulations as well as building codes and other laws, o the ongoing need for capital improvements, o changes in real estate tax rates and other operating expenses, o adverse changes in governmental rules and fiscal policies, o civil unrest, o acts of God, including earthquakes and other natural disasters (which may result in uninsured losses), o acts of war, and o other factors which are beyond our control.
ILLIQUIDITY OF REAL ESTATE MAY LIMIT ITS VALUE. Real estate investments are relatively illiquid. Our ability to vary our portfolio in response to changes in economic and other conditions is limited. There can be no assurance that we will be able to dispose of an investment when we find disposition advantageous or necessary or that the sale price will recoup or exceed the amount of our investment.
UNINSURED AND UNDERINSURED LOSSES COULD RESULT IN LOSS OF VALUE OF FACILITIES. We maintain comprehensive insurance on each of our facilities, including liability, fire and extended coverage. We believe this coverage is of the type
and amount customarily obtained for real property. However, there are certain types of losses, generally of a catastrophic nature, such as earthquakes, hurricanes and floods that may be uninsurable or not economically insurable. As such, our facilities are at risk in their particular locales. We use our discretion in determining amounts, coverage limits and deductibles for insurance. These terms are determined based on retaining an acceptable level of risk at a reasonable cost. This may result in insurance coverage that in the event of a substantial loss would not be sufficient to pay the full current market value or current replacement cost of our lost investment. Inflation, changes in building codes and ordinances, environmental considerations, and other factors also might make it unfeasible to use insurance proceeds to replace a facility after it has been damaged or destroyed. Under such circumstances, the insurance proceeds we receive might not be adequate to restore our economic position in a property.
POSSIBLE LIABILITY RELATING TO ENVIRONMENTAL MATTERS. We may be subject to liability under various environmental laws as an owner or operator of real estate. See "Item 1, Business Strategy Practices - Environmental Matters."
ITEM 2.
ITEM 2. PROPERTIES
The following are definitions of terms used throughout this discussion in analyzing our business: o "Physical occupancy" is the total net rentable square feet rented as of the date divided by the total net rentable square feet available. o "Economic occupancy" is determined by dividing the expected income by the gross potential income. o "Gross potential income" is the sum of all units available to rent at a facility multiplied by the market rental rate applicable to those units as of the date computed. o "Expected income" is the sum of the monthly rent being charged for the rented units at a facility as of the date computed. o "Rent Per Square Foot" is the annualized result of dividing gross potential income on the date by total net rentable square feet. o "Direct Property Operating Cost" means the costs incurred in the operation of a facility, such as utilities, real estate taxes, and on-site personnel. Costs incurred in the management of all facilities, such as accounting personnel and management level operations personnel are excluded.
SELF-STORAGE FACILITIES
Our self-storage facilities offer customers fully enclosed units. The customer furnishes their own lock, therefore each unit is controlled only by that customer. The average size of a Company-owned facility is 67,400 square feet and contains an average of 663 units. At December 31, 1999, the average rent per square foot for our-owned facilities was $12.01. The average direct expense per square foot for a Company owned facility is $2.00. According to Self-Storage Almanac - 2000, the typical customer base for a self-storage facility is 67% residential and 33% commercial. At December 31, 1999, the average occupancy of the 405 facilities owned by us was 81% physical and 72% economic.
Our self-storage facilities are located near major business and residential areas, and generally are clearly visible and easily accessible from major traffic arteries. Computer-controlled access gates, door alarm systems and video cameras, generally protect them. These facilities are typically constructed of one-story masonry or tilt-up concrete walls, with an individual roll-up door for each storage space and with removable steel interior walls to permit reconfiguration and to protect items from damage. Sites have wide drive aisles to accommodate most vehicles. At most of the facilities, a property manager lives in an apartment located on site. Climate-controlled space is offered in many facilities for storing items that are sensitive to extreme humidity or temperature. Some of the facilities provide paved secure storage areas for recreational vehicles, boat and commercial vehicles. The facilities generally contain 400 to 1,000 units varying in size from 25 to 400 square feet. The majority of our tenants are individuals, ranging from high-income homeowners to college students to lower income renters, who typically store furniture, appliances and other household and personal items. Commercial users range from sales representatives and distributors storing inventory to small businesses that typically store equipment, records and seasonal items. The facilities generally have a diverse tenant base of 500 to 600 tenants, with no single tenant occupying more than one to two percent of the net rentable square feet of a facility.
CAPITAL EXPENDITURES AND MAINTENANCE
Due to the type of simple structures and durable materials used for the facilities, property maintenance is minimal compared to other types of real estate investments. The majority of our facilities are one story, with either tilt-up concrete or masonry load-bearing walls, easily moved steel interior walls, and metal roofs. Typical capital expenditures include replacing asphalt roofs, gates, air conditioning equipment and elevators (as contrasted with expense items such as repairing asphalt, repairing a door, pointing up masonry walls, painting trim and facades, repairing a fence, maintaining landscaping, and repairing damage caused by tenant vehicles). Maintenance within a storage unit between leasing typically consists of sweeping out the unit and changing a light bulb. Maintenance is the responsibility of the facility manager who resides in the apartment located at most of the facilities.
The following table provides summarized information regarding our owned facilities, including stabilized and non-stabilized properties, as of December 31, 1999.
MARKETS
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
Actions for negligence or other tort claims occur routinely in the ordinary course of our business, but none of these proceedings involves a claim for damages (in excess of applicable excess umbrella insurance coverages) involving more than 10% of our current assets. We do not anticipate any amounts which we may be required to pay as a result of an adverse determination of such legal proceedings, individually or in the aggregate, or any other relief granted by reason thereof, will have a material adverse effect on our financial position or results of operation.
On July 22, 1999, a purported class action was filed against the GP and Partnership in the Circuit Court of Montgomery County, Maryland, under the style: Ralph Grunewald v. Storage USA, Inc. and SUSA Partnership, L.P., Case No. 201546V, seeking recovery of certain late fees paid by the our tenants and an injunction against further assessment of similar fees. We filed a responsive pleading on September 17, 1999, setting out our answer and affirmative defenses, and believe that we have defenses to the claims in the suit and intend to vigorously defend it. The case is currently in discovery and no trial date has been set.
On November 15, 1999 a purported class action was filed against the GP and Partnership in the Supreme Court of the State of New York, Ulster County, case no 99-3278 , also seeking the recovery of certain late and administrative fees paid by our tenants and an injunction against similar fees. We filed a responsive pleading on January 28, 2000. We believe that we have defenses to the suit and intend to vigorously defend it. The case is currently in discovery and no trial date has been set.
While the ultimate resolution of these cases will not have a material adverse effect on our financial position, if during any period the potential contingency should become probable, the results of operations in such period could be materially affected.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of the GP's shareholders during the last quarter of our fiscal year ended December 31, 1999.
EXECUTIVE OFFICERS OF THE REGISTRANT AT MARCH 20, 2000.
The following information relates to our executive officers:
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
No established public trading market exists for the Units. At January 31, 1999, there were 78 limited partners and 3,655,093 Units outstanding held by such limited partners. During 1999, the Partnership made the following quarterly cash distributions per Unit: $0.67 in the First Quarter; $ 0.67 in the Second Quarter; $ 0.67 in the Third Quarter; and $ 0.67 in the Fourth Quarter.
The table below sets forth all issuances of Units made by the Partnership to persons other than the GP during the year ended December 31, 1999. All Units were issued in exchange for interests in self-storage facilities acquired by the Partnership. The price per Unit is determined by the closing price of a share of the GP's common stock on the date of issuance as quoted on the New York Stock Exchange. The offerings were exempt from registration pursuant to Section 4(2) and Regulation D under the Securities Act of 1933, as amended (investors are required to establish their status as accredited investors pursuant to an investor questionnaire):
Price Date Units Issued Per Unit - ------------------------------------------------- 6/11/99 22,797 $ 33.46 6/15/99 43,908 $ 33.59 6/15/99 59,544 $ 33.59 9/25/99 37,071 $ 26.98 11/23/99 25,562 $ 27.79
The Units may be redeemed for cash, or at the GP's option, common stock of the GP commencing one year after the issuance of the Units, as described in the Company's partnership agreement.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
Incorporated herein by reference from the caption "Selected Financial Data" appearing in our 1999 Annual Report, the relevant portion of which is attached hereto as Exhibit 13.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION.
Incorporated herein by reference from the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" appearing in our 1999 Annual Report, the relevant portion of which is attached hereto as Exhibit 13.
ITEM 7.A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK.
Incorporated herein by reference from the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations - Qualitative and Quantitative Disclosure About Market Risk" appearing in our 1999 Annual Report, the relevant portion of which is attached hereto as Exhibit 13.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Our Financial Statements and Supplementary Data for the year ended December 31, 1999, are incorporated herein by reference from our 1999 Annual Report, the relevant portion of which is attached hereto as Exhibit 13.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT AT MARCH 20, 2000
For non-employee Directors, the information required hereunder is incorporated herein by reference from the captions "Election of Directors" in the GP's definitive proxy statement to be filed with respect to the GP's Annual Meeting of Shareholders.
For executive officers, the information required hereunder is included in Part 1, following Item 4 in this Annual Report on Form 10-K.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
Incorporated herein by reference from the caption " Executive Compensation" and "Indebtedness by Executives to Storage USA" in the GP's definitive proxy statement to be filed with respect to the GP's Annual Meeting of Shareholders.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
Incorporated herein by reference from the caption "Beneficial Ownership of Company Common Stock" in the GP's definitive proxy statement to be filed with respect to the GP's Annual Meeting of Shareholders.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Incorporated herein by reference from the caption "Transactions with Management and Others; Certain Business Relationships" and "Indebtedness of Executives" in the GP's definitive proxy statement to be filed with respect to the GP's Annual Meeting of Shareholders.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) The following documents are filed as a part of this report and are included or hereby incorporated by reference from our 1999 Annual Report, excerpts from which are attached hereto as exhibit 13:
1. FINANCIAL STATEMENTS: Report of Independent Accountants
Consolidated balance sheets as of December 31, 1999 and 1998
Consolidated statements of operations for the years ended December 31, 1999, 1998 and 1997
Consolidated statements of cash flows for the years ended December 31, 1999, 1998 and 1997
Consolidated statements of shareholders' equity for the years ended December 31, 1999, 1998 and 1997
Notes to consolidated financial statements
Supplementary information on quarterly financial data (unaudited)
Selected Financial Data
Schedule III, Real Estate and Accumulated Depreciation as of December 31, 1999
Report of Independent Accountants
All other schedules are omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the financial statements and notes thereto.
(B) REPORTS ON FORM 8-K
On December 1, 1999, the GP filed its current report on Form 8-K. The filing included information relating to the formation of our two joint ventures with General Electric Capital Corporation, as well as the GP's plan to repurchase up to 5% of its outstanding shares of common stock. More details regarding these events are contained in Notes to Consolidated Financial Statements contained in Exhibit 13-Annual Report.
On December 9, 1999, the GP filed an amendment to its Current Report on Form 8-K, filed on December 1, 1999. The amendment included additional information regarding the two joint ventures with General Electric Capital Corporation.
(C) EXHIBITS
The following exhibits are filed as part of this report:
EXHIBIT NO. DESCRIPTION
3.1 Amended and Restated Charter of Storage USA, Inc. (the "GP"), (filed as Exhibit 3.1 to our Registration Statement on Form S-3 (File No. 333-44641), and incorporated by reference herein).
3.2* Restated and Amended Bylaws of the GP.
4* Specimen Common Stock Certificate.
10.1* Agreement between the GP and certain executive officers prohibiting conflicting self-storage interests.
10.2* GP's 1993 Omnibus Stock Plan.
10.3* SUSA Partnership, L.P. (the "Partnership") 401(k) Savings Plan.
10.4** Form of Registration Rights Agreement relating to Partnership unit issuances in 1994.
10.5++ Form of Agreement of General Partners relating to certain Partnership unit issuances in 1995 and schedule of beneficiaries.
10.6++ Form of Registration Rights Agreement relating to certain issuances of Partnership units after 1994 and schedule of beneficiaries.
10.7++ Form of Stock Purchase Agreement in connection with the 1995 Employee Stock Purchase and Loan Plan, and schedule of participants.
10.8++ Form of Promissory Note in connection with the 1995 Employee Stock Purchase and Loan Plan, and schedule of issuers.
10.9++++ Second Amended and Restated Agreement of Limited Partnership of the Partnership, dated as September 21, 1994 (the "Partnership Agreement").
10.10 First Amendment to the Partnership Agreement, dated March 19, 1996 (filed as Exhibit 10.3 to our Current Report on Form 8-K/A, filed April 1, 1996, and incorporated by reference herein).
10.11 Second Amendment to the Partnership Agreement, dated as of June 14, 1996 (filed as Exhibit 10.0 to our Current Report on Form 8-K/A filed July 17, 1996, and incorporated by reference herein).
10.12 Third Amendment to Partnership Agreement, dated as of August 14, 1996 (filed as Exhibit 10.1 to our Amendment No. 1 to a Registration Statement on Form S-3 (File No. 333-04556), and incorporated by reference herein).
10.13 Strategic Alliance Agreement, dated as of March 1, 1996, between the GP and Security Capital Holdings S.A. and Security Capital U.S. Realty (filed as Exhibit 10.1 to our Current Report on Form 8-K, filed on April 1, 1996, and incorporated by reference herein).
10.14 Amendment No. 1 to Strategic Alliance Agreement, dated June 14, 1996, between the GP, the Partnership, Storage USA Trust, Security Capital U.S. Realty and Security Capital Holdings, S.A. (filed as Exhibit 10.2 to our Amendment No. 1 to Registration Statement on Form S-3 (File No. 333-04556), and incorporated by reference herein).
10.15 Registration Rights Agreement, dated as of March 19, 1996, between the GP, Security Capital Holdings, S.A. and Security Capital U.S. Realty (filed as Exhibit 10.2 to the Company's Current Report on Form 8-K, filed on April 1, 1996, and incorporated by reference herein).
10.16 Indenture, dated November 1, 1996, between the Partnership and First National Bank of Chicago, as Trustee (filed as Exhibit 10.1 to our Current Report on Form 8-K, filed on November 8, 1996, and incorporated by reference herein).
10.17+ First Amendment to the Adoption Agreement for our 401(k) Plan.
10.18 Amended and Restated Revolving Credit Agreement dated December 23, 1997 (filed as an exhibit to our current Report on Form 8-K, filed on January 20, 1998,) and incorporated by reference herein.
10.19## Second Amendment to Strategic Alliance Agreement dated as of November 20, 1997, between the GP and Security Capital U.S. Realty
10.20# Fourth Amendment to the Second Amended and Restated Agreement of Limited Partnership of SUSA Partnership, L.P. dated as of November 12, 1998
10.21## Amendment No. 3 to GP's 1993 Omnibus Stock Plan, dated as of December 16, 1996
10.22## Amendment No. 4 to GP's 1993 Omnibus Stock Plan, dated as of November 4, 1998
10.23## The GP's 1996 Officers' Stock Option Loan Program, effective as of December 16, 1996
10.24## Form of Restricted Stock Award pursuant to the GP's 1993 Omnibus Stock Plan
10.25## The GP's 1998 Non-Executive Employee Stock Option Plan, effective as of November 4, 1998
10.26## Shareholder Value Plan, effective as of January 1, 1999
10.27## Employment Agreements for: Larry Hohl, Executive VP and Senior Operating Officer, dated as of September 1, 1998, John McConomy, Executive VP and General Counsel, dated as of July 24, 1998, Richard Stern, Senior VP, Development, dated as of May 15, 1998, Morris J Kriger, Executive VP, Acquisitions, dated as of December 6, 1995.
10.28### Second Amended and Restated Unsecured Revolving Credit Agreement, dated as of May 26, 1999
10.29### Limited Liability Company Agreement of Storage Portfolio I LLC, by and between SUSA Partnership, L.P. and FREAM No. 18, LLC, dated May 13, 1999.
10.30### First Amendment to Limited Liability Company Agreement of Storage Portfolio I LLC, dated as of June 7, 1999
10.31### Amendment No. 2 to the GP's 1995 Employee Stock Purchase and Loan Plan, dated as of May 5, 1999
10.32####Form of Severance Agreement between the GP and Dean Jernigan, Chairman, President and Chief Executive Officer, effective August 16, 1999
10.33####Form of Severance Agreement between the GP and Christopher P. Marr, Chief Financial Officer, effective August 16, 1999.
10.34####Form of Change of Control Severance Agreement between the GP and each of: (I) John W. McConomy, Executive Vice President, General Counsel and Secretary; (II) Karl T. Haas, Executive Vice President Operations; (III) Morris J. Kriger, Executive Vice President Acquisitions; (IV) Francis C. ("Buck") Brown, III, Senior Vice President Human Resources; (V) Richard B. Stern, Senior Vice President Development; (VI) Russell W. Williams, Senior Vice President Sales and Marketing; and (VII) Mark E. Yale, Senior Vice President Financial Reporting, effective August 16, 1999.
10.35####Form of Change of Control Severance Agreement between the GP and each of: (I) Teresa K. Corona, Vice President, Investor Relations, (II) Michael P. Kenney, Vice President Operations - Western Division, (III) Stephen R. Nichols, Vice President Operations - Eastern Division, (IV) Richard J. Yonis, Vice President Operations - Central Division, effective August 16, 1999.
10.36####Amendment No. 3 to the GP's 1995 Employee Stock Purchase and Loan Plan dated as of August 5, 1999
10.37####Amended and Restated Amendment No. 4 to the GP's 1993 Omnibus Stock Plan dated as of November 4, 1998.
10.38####Employment Agreement between the GP and Christopher P. Marr, Chief Financial Officer, dated as of August 4, 1999
10.39####Employment Agreement between the GP and Bruce F. Taub, Senior Vice President, Capital Markets, dated as of June 12,1998
10.40x Storage USA Press Release dated December 1, 1999, announcing joint ventures With GE Capital Corporation
10.41x Storage USA Press Release dated December 1, 1999, announcing approval of repurchase program
10.42x Summary of Material Terms of the GE Capital Transactions
10.43xx Limited Liability Company Agreement of Storage Development Portfolio, L.L.C., dated November 30, 1999 between SUSA Partnership, L.P. and Storage Ventures, L.P.
10.44xx Limited Liability Company Agreement of Storage Acquisition Portfolio, L.L.C., dated November 30, 1999 between SUSA Partnership, L.P. and Storage Ventures, L.P.
10.45xx Warrant Purchase Agreement dated November 30, 1999 between the GP and Storage Ventures, L.P.
10.46xx Common Stock Warrant, dated November 30, 1999 issued by the GP to Storage Ventures, L.P.
10.47xx Participation Rights Letter dated November 12, 1999 from the GP to Security Capital U.S. Realty Management.
10.48 Amendment No. 5 to the GP's 1993 Omnibus Stock Plan, dated February 2, 2000
10.49 Form of Change of Control Severance Agreement between the GP and each of (I) Bruce F. Taub (II) Carol E. Shipley
13 Relevant portions of our 1999 Annual Report are filed herewith.
21 Subsidiaries of Registrant.
23 Consent of Independent Accountants
27.1 Financial Data Schedule
* Filed as an Exhibit to the GP's Registration Statement on Form S-11, File No. 33-74072, as amended, and incorporated by reference herein. ** Filed as an Exhibit to the GP's Registration Statement on Form S-11, File No. 33-82764, as amended, and incorporated by reference herein. *** Filed as an Exhibit to our Annual Report on Form 10-K for the fiscal year ended December 31, 1994, and incorporated by reference herein. + Filed as an Exhibit to our Annual Report on Form 10-K for the fiscal year ended December 31, 1995, and incorporated by reference. ++ Filed as an Exhibit to our Current Report on Form 8-K, as amended to Form 8-K/A Filed November 17, 1995, and incorporated by reference herein.
+++ Filed as an Exhibit to our Current Report on Form 8-K, filed May 30, 1995, and incorporated by reference herein. ++++ Filed as an Exhibit to our Registration Statement on Form S-3, File No. 33-91302, and incorporated by reference herein. # Filed as an Exhibit to our Current Report on Form 8-K, filed November 20, 1998, and incorporated by reference here in. ## Filed as an Exhibit to our Annual Report on Form 10-K for the fiscal year ended December 31, 1998, and incorporated by reference. ### Filed as an Exhibit to our Quarterly Report on Form 10-Q for the quarter ended June 30, 1999, and incorporated by reference here in. #### Filed as an Exhibit to our Quarterly Report on Form 10-Q for the quarter ended September 30, 1999, and incorporated by reference here in. x Filed as an Exhibit to the GP's Current Report on Form 8-K, filed December 1, 1999, and incorporated by reference here in. xx Filed as an Exhibit to the GP's Current Report on Form 8-K/A, filed December 9, 1999, and incorporated by reference here in.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on our behalf by the undersigned, thereunto duly authorized.
SUSA PARTNERSHIP, L.P. BY STORAGE USA, INC., GENERAL PARTNER
By: /s/ Christopher P. Marr --------------------------- Christopher P. Marr Chief Financial Officer (Principal Financial and Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
EXHIBIT INDEX
EXHIBIT NO. DESCRIPTION
3.1 Amended and Restated Charter of Storage USA, Inc. (the "GP"), (filed as Exhibit 3.1 to our Registration Statement on Form S-3 (File No. 333-44641), and incorporated by reference herein).
3.2* Restated and Amended Bylaws of the GP.
4* Specimen Common Stock Certificate.
10.1* Agreement between the GP and certain executive officers prohibiting conflicting self-storage interests.
10.2* GP's 1993 Omnibus Stock Plan.
10.3* SUSA Partnership, L.P. (the "Partnership") 401(k) Savings Plan.
10.4** Form of Registration Rights Agreement relating to Partnership unit issuances in 1994.
10.5++ Form of Agreement of General Partners relating to certain Partnership unit issuances in 1995 and schedule of beneficiaries.
10.6++ Form of Registration Rights Agreement relating to certain issuances of Partnership units after 1994 and schedule of beneficiaries.
10.7++ Form of Stock Purchase Agreement in connection with the 1995 Employee Stock Purchase and Loan Plan, and schedule of participants.
10.8++ Form of Promissory Note in connection with the 1995 Employee Stock Purchase and Loan Plan, and schedule of issuers.
10.9++++ Second Amended and Restated Agreement of Limited Partnership of the Partnership, dated as September 21, 1994 (the "Partnership Agreement").
10.10 First Amendment to the Partnership Agreement, dated March 19, 1996 (filed as Exhibit 10.3 to our Current Report on Form 8-K/A, filed April 1, 1996, and incorporated by reference herein).
10.11 Second Amendment to the Partnership Agreement, dated as of June 14, 1996 (filed as Exhibit 10.0 to our Current Report on Form 8-K/A filed July 17, 1996, and incorporated by reference herein).
10.12 Third Amendment to Partnership Agreement, dated as of August 14, 1996 (filed as Exhibit 10.1 to our Amendment No. 1 to a Registration Statement on Form S-3 (File No. 333-04556), and incorporated by reference herein).
10.13 Strategic Alliance Agreement, dated as of March 1, 1996, between the GP and Security Capital Holdings S.A. and Security Capital U.S. Realty (filed as Exhibit 10.1 to our Current Report on Form 8-K, filed on April 1, 1996, and incorporated by reference herein).
10.14 Amendment No. 1 to Strategic Alliance Agreement, dated June 14, 1996, between the GP, the Partnership, Storage USA Trust, Security Capital U.S. Realty and Security Capital Holdings, S.A. (filed as Exhibit 10.2 to our Amendment No. 1 to Registration Statement on Form S-3 (File No. 333-04556), and incorporated by reference herein).
10.15 Registration Rights Agreement, dated as of March 19, 1996, between the GP, Security Capital Holdings, S.A. and Security Capital U.S. Realty (filed as Exhibit 10.2 to the Company's Current Report on Form 8-K, filed on April 1, 1996, and incorporated by reference herein).
10.16 Indenture, dated November 1, 1996, between the Partnership and First National Bank of Chicago, as Trustee (filed as Exhibit 10.1 to our Current Report on Form 8-K, filed on November 8, 1996, and incorporated by reference herein).
10.17+ First Amendment to the Adoption Agreement for our 401(k) Plan.
10.18 Amended and Restated Revolving Credit Agreement dated December 23, 1997 (filed as an exhibit to our current Report on Form 8-K, filed on January 20, 1998,) and incorporated by reference herein.
10.19## Second Amendment to Strategic Alliance Agreement dated as of November 20, 1997, between the GP and Security Capital U.S. Realty
10.20# Fourth Amendment to the Second Amended and Restated Agreement of Limited Partnership of SUSA Partnership, L.P. dated as of November 12, 1998
10.21## Amendment No. 3 to GP's 1993 Omnibus Stock Plan, dated as of December 16, 1996
10.22## Amendment No. 4 to GP's 1993 Omnibus Stock Plan, dated as of November 4, 1998
10.23## The GP's 1996 Officers' Stock Option Loan Program, effective as of December 16, 1996
10.24## Form of Restricted Stock Award pursuant to the GP's 1993 Omnibus Stock Plan
10.25## The GP's 1998 Non-Executive Employee Stock Option Plan, effective as of November 4, 1998
10.26## Shareholder Value Plan, effective as of January 1, 1999
10.27## Employment Agreements for: Larry Hohl, Executive VP and Senior Operating Officer, dated as of September 1, 1998, John McConomy, Executive VP and General Counsel, dated as of July 24, 1998, Richard Stern, Senior VP, Development, dated as of May 15, 1998, Morris J Kriger, Executive VP, Acquisitions, dated as of December 6, 1995.
10.28### Second Amended and Restated Unsecured Revolving Credit Agreement, dated as of May 26, 1999
10.29### Limited Liability Company Agreement of Storage Portfolio I LLC, by and between SUSA Partnership, L.P. and FREAM No. 18, LLC, dated May 13, 1999.
10.30### First Amendment to Limited Liability Company Agreement of Storage Portfolio I LLC, dated as of June 7, 1999
10.31### Amendment No. 2 to the GP's 1995 Employee Stock Purchase and Loan Plan, dated as of May 5, 1999
10.32#### Form of Severance Agreement between the GP and Dean Jernigan, Chairman, President and Chief Executive Officer, effective August 16, 1999
10.33#### Form of Severance Agreement between the GP and Christopher P. Marr, Chief Financial Officer, effective August 16, 1999.
10.34#### Form of Change of Control Severance Agreement between the GP and each of: (I) John W. McConomy, Executive Vice President, General Counsel and Secretary; (II) Karl T. Haas, Executive Vice President Operations; (III) Morris J. Kriger, Executive Vice President Acquisitions; Francis C. ("Buck") Brown, III, Senior Vice President Human Resources; (IV) Richard B. Stern, Senior Vice President Development; (V) Russell W. Williams, Senior Vice President Sales and Marketing; and (VI) Mark E. Yale, Senior Vice President Financial Reporting, effective August 16, 1999.
10.35#### Form of Change of Control Severance Agreement between the GP and each of: (I) Teresa K. Corona, Vice President, Investor Relations, (II) Michael P. Kenney, Vice President Operations - Western Division, (III) Stephen R. Nichols, Vice President Operations - Eastern Division, (IV) Richard J. Yonis, Vice President Operations - Central Division, effective August 16, 1999.
10.36#### Amendment No. 3 to the GP's 1995 Employee Stock Purchase and Loan Plan dated as of August 5, 1999
10.37#### Amended and Restated Amendment No. 4 to the GP's 1993 Omnibus Stock Plan dated as of November 4, 1998.
10.38#### Employment Agreement between the GP and Christopher P. Marr, Chief Financial Officer, dated as of August 4, 1999
10.39#### Employment Agreement between the GP and Bruce F. Taub, Senior Vice President, Capital Markets, dated as of June 12,1998
10.40x Storage USA Press Release dated December 1, 1999, announcing joint ventures With GE Capital Corporation
10.41x Storage USA Press Release dated December 1, 1999, announcing approval of repurchase program
10.42x Summary of Material Terms of the GE Capital Transactions
10.43xx Limited Liability Company Agreement of Storage Development Portfolio, L.L.C., dated November 30, 1999 between SUSA Partnership, L.P. and Storage Ventures, L.P.
10.44xx Limited Liability Company Agreement of Storage Acquisition Portfolio, L.L.C., dated November 30, 1999 between SUSA Partnership, L.P. and Storage Ventures, L.P.
10.45xx Warrant Purchase Agreement dated November 30, 1999 between the GP and Storage Ventures, L.P.
10.46xx Common Stock Warrant, dated November 30, 1999 issued by the GP to Storage Ventures, L.P.
10.47xx Participation Rights Letter dated November 12, 1999 from the GP to Security Capital U.S. Realty Management.
10.48 Amendment No. 5 to the GP's 1993 Omnibus Stock Plan, dated February 2, 2000
10.49 Form of Change of Control Severance Agreement between the GP and each of (I) Bruce F. Taub (II) Carol E. Shipley
13 Relevant portions of our 1999 Annual Report are filed herewith.
21 Subsidiaries of Registrant.
23 Consent of Independent Accountants
27.1 Financial Data Schedule
* Filed as an Exhibit to the GP's Registration Statement on Form S-11, File No. 33-74072, as amended, and incorporated by reference herein. ** Filed as an Exhibit to the GP's Registration Statement on Form S-11, File No. 33-82764, as amended, and incorporated by reference herein. *** Filed as an Exhibit to our Annual Report on Form 10-K for the fiscal year ended December 31, 1994, and incorporated by reference herein. + Filed as an Exhibit to our Annual Report on Form 10-K for the fiscal year ended December 31, 1995, and incorporated by reference. ++ Filed as an Exhibit to our Current Report on Form 8-K, as amended to Form 8-K/A Filed November 17, 1995, and incorporated by reference herein.
+++ Filed as an Exhibit to our Current Report on Form 8-K, filed May 30, 1995, and incorporated by reference herein. ++++ Filed as an Exhibit to our Registration Statement on Form S-3, File No. 33-91302, and incorporated by reference herein. # Filed as an Exhibit to our Current Report on Form 8-K, filed November 20, 1998, and incorporated by reference here in. ## Filed as an Exhibit to our Annual Report on Form 10-K for the fiscal year ended December 31, 1998, and incorporated by reference. ### Filed as an Exhibit to our Quarterly Report on Form 10-Q for the quarter ended June 30, 1999, and incorporated by reference here in. #### Filed as an Exhibit to our Quarterly Report on Form 10-Q for the quarter ended September 30, 1999, and incorporated by reference here in. x Filed as an Exhibit to the GP's Current Report on Form 8-K, filed December 1, 1999, and incorporated by reference here in. xx Filed as an Exhibit to the GP's Current Report on Form 8-K/A, filed December 9, 1999, and incorporated by reference here in.
Storage USA, Inc.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders of Storage USA, Inc.
Our report on the consolidated financial statements of SUSA Partnership, L.P. has been incorporated by reference in this Form 10-K. In connection with our audits of such financial statements, we have also audited the related financial statement schedule incorporated by reference in this Form 10-K.
In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information required to be included therein.
PricewaterhouseCoopers LLP
Memphis, Tennessee January 26, 2000
SUSA Partnership, L.P.
Consolidated Balance Sheets
See accompanying notes.
SUSA Partnership, L.P.
Consolidated Statements of Operations
See accompanying notes.
SUSA Partnership, L.P.
Consolidated Statements of Cash Flows
See accompanying notes.
SUSA Partnership, L.P.
SUSA Partnership, L.P.
Notes to Consolidated Financial Statements
(dollar amounts in thousands, except share, unit and per unit data)
NOTE 1 ORGANIZATION
SUSA Partnership, L.P. (the "Company" and the "Partnership") was formed by Storage USA, Inc. (the "GP"), general partner and holder of approximately 88% of the interest therein, to acquire, develop, construct, franchise and own and operate self-storage facilities throughout the United States. On March 23, 1994, the GP completed an initial public offering (the "IPO") of 6,325,000 shares of common stock at $21.75 per share. The GP is structured as an umbrella partnership real estate investment trust ("UPREIT") in which substantially all of the GP's business is conducted through the Partnership. Under this structure, the Company is able to acquire self-storage facilities in exchange for units of limited partnership interest in the Partnership ("Units"), permitting the sellers to partially defer taxation of capital gains. Under the terms of the partnership agreement, all proceeds from the issuance of common stock are contributed to the Partnership in exchange for Units. At December 31, 1999 and 1998, respectively, the GP had an approximately 88.4% and 88.1% partnership interest in the Partnership.
In 1996, the Company formed Storage USA Franchise Corp ("Franchise"), a Tennessee corporation. The Partnership owns 100% of the non-voting common stock of Franchise. The Company accounts for Franchise under the equity method and includes its share of the profit or loss of Franchise in Other Income.
At December 31, 1999, the Company owned and managed 507 self-storage facilities containing approximately 34,069,000 square feet located in 31 states and the District of Columbia.
NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The consolidated financial statements include the accounts of the Company and SUSA Management. All intercompany balances and transactions have been eliminated. The Company accounts for Franchise under the equity method and includes its share of the profit or loss of Franchise in Other Income.
Use of Estimates in Preparation of Financial Statements
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and disclosure of contingent assets and liabilities. Actual results could differ from those estimates.
Segment Reporting
The "Property Operations" division is responsible for the operation of the Company's owned and managed facilities. Property Operations represents the only reportable segment of the Company. Performance for the division is measured through evaluating total property revenues and property expenses exclusive of general and administrative expenses and depreciation and amortization. All of the Company's facilities are located in the United States.
Federal Income Taxes
No provision for income taxes is provided since all taxable income or loss or tax credits are passed through to the partners.
The GP operates so as to qualify to be taxed as a Real Estate Investment Trust ("REIT") under the Internal Revenue Code of 1986, as amended (the "Code"). Generally, a REIT that complies with the Code and distributes at least 95% of its taxable income to its shareholders does not pay federal tax on its distributed income. Therefore, the statement of operations contains no provision for federal income taxes.
Cash and Cash Equivalents
The Company considers all highly liquid debt instruments purchased with maturity of three months or less to be cash equivalents.
Revenue Recognition
Rental income is recorded when due from tenants. Rental income received prior to the start of the rental period is deferred and included in rents received in advance.
Other Income
Other income consists primarily of revenue from property specific activities (rental of floor and storage space for locks and packaging material, truck rentals and ground rents for cellular telephone antenna towers and billboards), revenue for the management of facilities owned by third parties, and the proportionate share of net income of equity investments including joint ventures and Franchise. A summary of these amounts is as follows:
1999 1998 1997 - -------------------------------------------------------------------------- Property specific: $4,117 $3,371 $1,518 Management fees: 2,055 1,079 809 Income from equity: 2,779 242 445 - -------------------------------------------------------------------------- Total other income $8,951 $4,692 $2,772
Interest Expense, net
Interest income and expense are netted together and the breakout of income and expense is as follows:
1999 1998 1997 - ---------------------------------------------------------------------------- Interest income $ 13,101 $ 8,667 $ 2,083 Interest expense (55,323) (45,540) (18,111) - ---------------------------------------------------------------------------- Interest expense, net $(42,222) $(36,873) $(16,028)
Interest is capitalized on accumulated expenditures relating to the development of certain qualifying properties. During 1999, 1998, and 1997, total cash paid by the Company for interest was $55,511, $41,560, and $18,316, respectively, which includes $4,388, $3,461, and $1,866, which was capitalized in 1999, 1998, and 1997, respectively.
Interest Rate Management Agreements
The Company periodically enters into interest rate risk management agreements including interest rate swaps and caps to manage interest rate risk associated with anticipated debt transactions and with its variable rate line of credit. Gains and losses, if any, on these transactions are deferred and amortized over the terms of the related debt as an adjustment to interest expense. Any up- front premium is amortized over the effective period of the corresponding agreement as an adjustment to interest expense. Changes in the fair value of the interest rate risk management agreements are not recognized in the financial statements. In the event that any corresponding anticipatory transaction is no longer likely to occur, the Company would mark the derivative to market and would recognize any adjustment in the consolidated statement of operations. The Company does not enter into interest rate risk management agreements for trading or speculative purposes.
Investment in Storage Facilities
Storage facilities are recorded at cost. Depreciation is computed using the straight line method over estimated useful lives of 40 years for buildings and improvements, and three to ten years for furniture, fixtures and equipment. Expenditures for significant renovations or improvements that extend the useful life of assets are capitalized. Repairs and maintenance costs are expensed as incurred. Certain costs, principally payroll, directly related to real estate development, are capitalized. Upon disposition, both the asset and accumulated depreciation accounts are relieved, and the related gain or loss is credited or charged to the income statement.
If there is an event or a change in circumstances that indicates that the basis of the Company's property may not be recoverable, the Company's policy is to assess any impairment of value. Impairment is evaluated based upon comparing the sum of the expected future cash flows (undiscounted and without interest charges) to the carrying value of the asset. If the cash flow is less, an impairment loss is recognized for the amount by which the carrying amount of the asset exceeds the fair value of the asset.
Minority Interest
Minority interest reflects the ownership interest of the limited partners in several facilities in which the Partnership is the general partner. The limited partners' share of the net income of the Partnership is charged to minority interest expense and increases the Company's liability. Distributions to the limited partners reduce the Company's liability.
Reclassifications
Certain previously reported amounts have been reclassified to conform to the current financial statement presentation with no impact on previously reported net income or partner's capital.
NOTE 3 INVESTMENTS IN STORAGE FACILITIES
The following summarizes activity during the periods:
- ---------------------------------------------------------------------------- Cost - ---- Balance at December 31, 1997 $1,242,864 Property acquisitions 293,578 Land acquisitions and joint venture development 57,046 Facility expansions 1,867 Improvements and other 29,581 Properties exchanged (8,721) - ---------------------------------------------------------------------------- Balance at December 31, 1998 $1,616,215 - ----------------------------------------------------------------------------
Property acquisitions 86,879 Land acquisitions and joint venture development 71,004 Facility expansions 529 Improvements and other 16,723 Properties exchanged (120,458) - ---------------------------------------------------------------------------- Balance at December 31, 1999 $1,670,892 ============================================================================
Accumulated Depreciation Balance at December 31, 1997 $ 44,955 Additions during the year 28,954 Properties exchanged (413) - ---------------------------------------------------------------------------- Balance at December 31, 1998 $ 73,496 Additions during the year 33,625 Properties exchanged (12,583) - ---------------------------------------------------------------------------- Balance at December 31, 1999 $ 94,538 ============================================================================
The above cost balances include facilities acquired through capital leases of $31,334 at December 31, 1999 and $31,160 at December 31, 1998 and construction in progress of $89,870 at December 31, 1999 and $65,716 at December 31, 1998. Also included above is $11,800 at December 31, 1999 and $10,300 at December 31, 1998 of corporate office furniture and fixtures. Accumulated depreciation associated with the facilities acquired through capital leases was $771 at December 31, 1999 and $145 at December 31, 1998.
NOTE 4 ADVANCES AND INVESTMENT IN REAL ESTATE
Advances
During 1997, the Company began offering construction advances to franchisees of Franchise to fund the development of franchised self-storage facilities. The loans are collateralized by the property. The Company will advance the funds for construction and start-up costs at a market interest rate based on a spread over the 30-day LIBOR rate or the prime rate and adjusted monthly. Typically advances represent 70%-96% of the anticipated cost of the project at the prime rate plus one half to one percentage point. In consideration for coordinating the financing as well as other value derived by the franchisee, Franchise typically receives an equity interest in the facility. The equity interest typically allows Franchise to share in 40% to 45% of the positive cash flows of the facility, and if sold, the sale of the facility. Franchise recognizes its proportionate share of the facilities' net income. Due to the Company's equity participation in the underlying projects (through its 97.5% economic interest in Franchise) all related activity is being accounted for as direct investments in and advances to real estate joint ventures. As of December 31, 1999, the Company is committed to advance an additional $36,186 for similar construction loans. The table below summarizes certain information related to these advances:
1999 1998 - ---------------------------------------------------------------------------- Advances (collateralized by first mortgages) $ 117,022 $ 112,163 Interest rates at end of period 8.25%-10.00% 7.75%-8.41% W/A interest rate during period (1) 8.50% 8.72% - ---------------------------------------------------------------------------- (1) W/A = Weighted average
Joint Ventures
Fidelity Venture:
On June 7, 1999, the Company formed a joint venture with Fidelity Management Trust Company (the "Fidelity Venture"). The Company contributed 32 self-storage facilities with a fair value of $144,000 to the Fidelity Venture in return for a 25% interest and cash proceeds of approximately $131,000, representing Fidelity Management Trust Company's 75% interest in the joint venture and the Company's proportionate share of proceeds from a $93,600 non-recourse note obtained by the joint venture. The note is secured and has a fixed interest rate of 7.76%. The Company accounts for its investment in the Fidelity Venture under the equity method. The Company's original basis in the Fidelity venture was equal to 25% of the Company's historical cost basis in the self-storage facilities of approximately $91,200, less the approximate $23,400 in debt proceeds distributed from the joint venture. A $37,100 gain on the transaction, net of disposition costs, was deferred until such time the Company disposes of its interest in the Fidelity Venture or the underlying properties are sold. As of December 31, 1999, the Company had a recorded negative investment in the Fidelity Venture of $175. Under the terms of the venture agreement, cash flow from operations and liquidation of the venture will be distributed to each member based on its proportionate equity interest. The Company will manage the Fidelity Venture and continue to operate all of the venture's assets for a fee. During 1999, the Company recognized $845 in equity earnings from the venture and $780 in management fees for managing the venture's properties. The table below summarizes certain financial information related to the Fidelity Venture:
For the Period June 7, 1999 Through December 31, 1999 - -------------------------------------------------------------- (in thousands) Property revenues $ 12,847 Property expenses $ 1,919 Net Operating Income $ 10,928 Net income $ 3,381 Total assets $136,259 Total debt $ 92,976 - --------------------------------------------------------------
GECC Ventures:
On December 1, 1999, the Company formed two joint ventures with GE Capital Corporate ("GE Capital"), providing for a total investment capacity of $400,000 for acquisitions and development of self-storage facilities. The Company will have a 25% interest in the $160,000 Development Venture and a 16.7% interest in the $240,000 Acquisition Venture. All of the properties acquired and developed by the ventures will be operated by Storage USA under a five-year management contract. In addition to the property management, Storage USA will provide certain fee-based services for the ventures, including identifying suitable development and acquisition opportunities and general contractor services. It is expected that both ventures will be leveraged with targeted debt ratios of approximately 50%. The Company accounts for these joint ventures under the equity method of accounting. In connection with the closing of these joint ventures, GE Capital received warrants for the purchase of 1.25 million shares of Storage USA common stock at $42 per share. These warrants may be exercised at any time within a five-year period. The Company's recorded investment in the joint ventures of $2,749 as of December 31, 1999 is comprised of the estimated value of the warrants of $666 and investment advisory fees of $1,900 incurred directly by the Company. Through December 31, 1999, no development had commenced or acquisitions had occurred within the ventures.
During the first quarter of 2000, Storage USA does expect to transfer as many as 13 projects currently in early stages of development into the Development Venture. These projects have a projected total cost of $64,700, of which Storage USA has invested approximately $29,400 as of December 31, 1999.
Other Ventures:
The Company has equity interests in several single facility joint ventures. The Company accounts for these joint ventures under the equity method of accounting. As of December 31, 1999 and 1998, the recorded investments in these joint ventures was $650 and $103, respectively.
NOTE 5 OTHER ASSETS
Other assets consist of the following at December 31:
1998 1997 - -------------------------------------------------------------------------------- Deposits $ 4,147 $ 5,048 Deferred cost of issuances of unsecured notes 10,006 10,695 Accounts receivable 4,855 4,769 Mortgages receivable 4,449 3,624 Notes receivable 7,445 8,642 Other receivables 4,988 5,137 Advances and investments in Franchise 13,906 4,464 Other 6,824 5,932 - -------------------------------------------------------------------------------- $56,620 $48,311 - --------------------------------------------------------------------------------
Deferred financing costs are amortized using the interest method over the terms of the related debt.
NOTE 6 BORROWINGS
The following is a debt maturity schedule as of December 31,1999:
Notes Payable
The Partnership has issued various senior unsecured notes (the "Notes") due on various dates. The Notes are redeemable at any time at the option of the Partnership in whole or in part, at a redemption price equal to the sum of: (a) the principal amount of the Notes being redeemed plus accrued interest or (b) a "make-whole" amount as more fully defined in the Notes' prospectus. The Notes are not subject to any mandatory sinking fund and are an unsecured obligation of the Partnership. The Notes contain various covenants restricting the amount of secured and unsecured indebtedness the Partnership may incur. The amounts, maturities and interest rates of the notes are as follows:
- ------------------------ Amount - ------------------------ 1999 1998 Maturity Interest - ------------------------------------------------------------------------------- $ 100,000 $100,000 November, 2003 7.125% 100,000 100,000 July, 2006 6.950% 100,000 100,000 December, 2007 7.000% 100,000 100,000 June, 2017 8.200% 100,000 100,000 July, 2018 7.450% 100,000 100,000 December, 2027 7.500% - ------------------------------------------------------------------------------- $ 600,000 $600,000
The proceeds from the issuances of the Notes were used to fund the purchase of acquisitions and repay debt incurred under the revolving lines of credit, which are used to finance the acquisition of self-storage facilities and for working capital.
Mortgage Notes Payable
Mortgage notes payable consist of the following at December 31:
- ------------------------------------------------------------------------------- Face Assets Maturity Interest Rate Amount Encumbered Range Range - ------------------------------------------------------------------------------- Conventional fixed rate $58,318 $145,287 2000-2021 6.5%-11.5% Conventional variable rate 5,332 11,244 2006-2016 7.9%-9.0% - ------------------------------------------------------------------------------- Total $63,650 $156,531 Premiums 6,513 --------- Mortgage notes payable $70,163
- ------------------------------------------------------------------------------- Face Encumbered Maturity Interest Rate Amount Amount Range Range - ------------------------------------------------------------------------------- Conventional fixed rate $59,638 $142,174 2000-2021 6.5%-11.5% Conventional variable rate 8,043 18,180 2006-2016 7.9%-9.0% - ------------------------------------------------------------------------------- Total $67,681 $160,354 Premiums 11,056 --------- Mortgage notes payable $78,737
Certain mortgages were assumed at above market interest rates. Premiums were recorded upon assumption and amortized using the interest method over the terms of the related debt.
Line of Credit Borrowings
1999 1998 - -------------------------------------------------------------------------------- Total lines of credit at December 31 $240,000 $190,000 Borrowings outstanding at December 31 $105,500 $ 70,762 Weighted average daily borrowing during the year $ 93,122 $ 78,900 Maximum daily borrowing during the year $123,093 $179,288 Weighted average daily interest rate during the year 6.39% 6.73%
During 1999, the Company renegotiated its existing line of credit with a group of commercial banks, expanding the borrowing capacity under the line to $200,000 and extending the maturity to May 25, 2002. This line bears interest at various spreads over LIBOR based on the Company's long-term debt ratings. At December 31, 1999, the Company also had a $40,000 line of credit with a commercial bank. The line bears interest at spreads over LIBOR, matures on July 1, 2000 and is renewable at that time. Neither of these agreements have compensating balance requirements. The agreement imposes several limitations on the Company. The most restrictive of these requires the Company to maintain minimum levels of debt service coverage and limits the level of the Company's total borrowings as a percentage of the its assets.
OTHER BORROWINGS
During 1998, the Company issued $15,154 of unsecured, non-interest bearing notes in exchange for interest in self-storage facilities. The notes were issued at various maturities through 2001. The Company also consummated deferred unit agreements totaling $13,000 in exchange for interest in self-storage facilities. The agreements have various maturities through 2002, at which time units of limited partnership interest in SUSA Partnership, L.P. will be issued to satisfy the agreements. During 1998, the Company signed a lease agreement on several self-storage facilities. The lease is being accounted for as a capital lease. An initial deposit of $7,600 was made at the time of closing and minimum lease payments totaling $9,249 will be paid to the lessor through 2003 at which time the Company has the option to purchase the facilities for $29,000. If the Company does not exercise this option the Lessor has the option to sell the facilities to the Company for $29,250. Minimum lease payments broken out between principle and interest by maturity are shown below.
2000 2001 2002 2003 - ------------------------------------------------------------------------------- Principal ($56) $ 123 $ 296 $23,480 Interest 1,790 1,788 1,772 1,168 - ------------------------------------------------------------------------------- Minimum lease payment $1,734 $1,911 $2,068 $24,648
NOTE 7 INCOME PER UNIT
As of December 31, 1997, the Company adopted Statement of Financial Accounting Standards No. 128 "Earnings per Share," to report basic and diluted earnings per unit. As required by this statement, all prior periods have been restated. Basic and diluted income per common unit is calculated by dividing net income attributed to common unitholders by the appropriate weighted average common units as presented in the following table:
NOTE 8 PRO FORMA FINANCIAL INFORMATION (UNAUDITED)
The following summary of unaudited pro forma combined financial information of the Company is presented as if all acquisitions, exchanges of self-storage facilities, GP common stock issuances and notes payable issuances that transpired during 1999 and 1998 had occurred at the beginning of each period presented. The unaudited combined financial information is not necessarily indicative of what actual results of operations of the Company would have been assuming such transactions had been completed at the beginning of each period, nor does it purport to represent the results of operations for future periods.
Year ended December 31, 1999 1998 - ----------------------------------------------------------------------------- Pro forma total revenues $249,218 $213,267 Pro forma net income $ 71,237 $ 65,387 Pro forma basic net income per common unit $ 2.25 $ 2.10 Pro forma diluted net income per common unit $ 2.25 $ 2.09
NOTE 9 FINANCIAL INSTRUMENTS
The off-balance sheet instruments that the Company primarily uses are interest rate swaps and caps. The only instrument in effect during 1999 was an interest rate cap with a notional value of $100,000 and a cap strike price of 6.0%. The contract was effective November 5, 1999 and terminated on February 7, 2000. The Company paid an up-front premium of $45 and received a $40 upon termination of the contract.
The Company's carrying amounts and fair value of its financial instruments were as follows:
The Company, in determining the fair values set forth above, used the following methods and assumptions:
Advances
A market rate of interest is used based on a spread over the 30-day LIBOR rate or the prime rate and adjusted monthly; and therefore fair value approximates carrying value.
Mortgage and Notes Payable, and Line of Credit Borrowings
The Company's line of credit borrowings bear interest at variable rates and therefore cost approximates fair value. The fair value of the mortgage and notes payable were estimated using discounted cash flow analysis, based on the Company's current incremental borrowing rate at December 31, 1999 and 1998, for similar types of borrowing arrangements.
NOTE 10 COMMITMENTS AND CONTINGENCIES
Lease Agreements
The Company has various lease agreements for office space. Total future minimum rental payments on the office leases are $2,361 in year one, $2,585 in year two, $2,003 in year three, $1,872 in years four and five and $20,262 thereafter. Rental expense under these operating leases approximated $1,218 in 1999, $1,009 in 1998 and $667 in 1997. These minimum payments are net of amounts due to the Company under corresponding subleases of $573 in year one, $688 in two through five and $8,055 thereafter.
Construction Financing
The Company is committed to advance an additional $36,186 in construction financing to franchisees of Franchise as described in Note 4. The Company is also a limited guarantor on the financing of three open and operating projects in which Franchise has either a partnership interest or an option to purchase the facility at various times after completion. Under the terms of the guarantee, the Company has the option, upon notice by the financial institution of an event which would require payment by the Company under the guarantee, of (a) purchasing the note and all related loan documents without recourse or (b) payment of the guarantee. At December 31, 1999, the Company was guarantor on $7,768 of these financing arrangements, of which $0 was outstanding.
Redemption of Units
At December 31, 1999, there were 3,655,093 Units outstanding. Certain Units are redeemable for an amount equal to their fair market value ($2,481 based upon a price per Unit of $30.250 at December 31, 1999) payable by the Company in cash or by a promissory note payable in quarterly installments over two years with interest at the prime rate. Units held by other Limited Partners are redeemable, at the option of such Limited Partners, beginning on the first anniversary of their issue, for amounts equal to the then fair market value of their Units ($108,086 redeemable at December 31, 1999, based upon a price per Unit of $30.250 at December 31, 1999) payable by the Company in cash or, at the option of the GP, in shares of the GP's common stock at the exchange ratio of one share for each Unit.
NOTE 11 DISTRIBUTIONS(unaudited)
The Company distributed the following amounts per unit to holders of common Units during 1999, 1998 and 1997.
- ----------------------------------------------------------------------------
1999 1998 1997 - ---------------------------------------------------------------------------- Distributions $2.68 $2.56 $2.40
NOTE 12 PARTNER'S CAPITAL
Stock-Based Compensation Plan
The GP has a Stock Option Plan, Employee Stock Purchase and Loan Plan, Dividend Reinvestment Plan and Stock Purchase Plan, in which employees of the Company participate. Under the terms of the partnership agreement, all proceeds from the issuance of GP common stock, or exercise of GP stock options, under the plans are contributed to the Partnership in exchange for Units.
The GP applies Accounting Principles Board (APB)25 and related interpretations in accounting for its stock-based compensation plan. In accordance with SFAS123 "Accounting for Stock-Based Compensation", the GP elected to continue to apply the provisions of APB25. However, pro forma disclosures as if the GP adopted the cost recognition provisions of SFAS123 are required and are presented below along with a summary of the plan and awards.
The shareholders of the GP have approved and the GP has adopted the Storage USA, Inc. 1993 Omnibus Stock Plan (the "Plan"). The GP has granted options to certain GP directors, and officers and key employees of the Company to purchase shares of the GP's common stock at a price not less than the fair market value at the date of grant. Options granted to employees generally vest over a three to five year period. There are 4,000,000 shares available to be issued under the Plan.
Generally, the optionee has up to ten years from the date of the grant to exercise the options. Plan activity is as follows:
The following table provides additional information about the options outstanding and exercisable at December 31, 1999:
The GP has utilized a Black-Scholes option-pricing model with the following assumptions in order to estimate the fair value of the GP's stock options:
- -------------------------------------------------------------------------------- 1999 1998 1997 - -------------------------------------------------------------------------------- Risk-free interest rates 6.35% 4.57% 5.74% Estimated dividend yields 8.86% 7.50% 6.20% Volatility factors of the expected market price of the Company's common shares 22.80% 20.30% 16.80% Expected life of the options (years) 7 7 10 Weighted average fair value $ 3.35 $ 2.56 $ 3.98 - --------------------------------------------------------------------------------
The following pro forma disclosures were computed assuming the fair value of the options is amortized to compensation expense over the vesting period of the options:
- -------------------------------------------------------------------------------- 1999 1998 1997 - -------------------------------------------------------------------------------- Pro forma compensation Expense $ 1,063 $ 1,202 $ 939 Pro forma net income $71,228 $66,730 $66,995 Pro forma basic net income per unit $ 2.25 $ 2.14 $ 2.30 Pro forma diluted net income per unit $ 2.25 $ 2.13 $ 2.28 - --------------------------------------------------------------------------------
Employee Stock Purchase and Loan Plan
As of December 31, 1999, the GP has issued 523,000 shares of its common stock under the 1995 Employee Stock Purchase and Loan Plan. Pursuant to the terms of the plan, the GP and certain officers entered into stock purchase agreements whereby the officers purchased common stock at the then current market price. The GP provides 100% financing for the purchase of the shares with interest rates ranging from 6.1% to 9.2% per annum payable quarterly. The underlying notes have personal guarantees and are collateralized by the shares and mature between 2002 and 2006.
Dividend Reinvestment and Stock Purchase Plan
In 1995, the GP adopted the Dividend Reinvestment and Stock Purchase Plan. Under the plan, the GP offers holders of its common stock the opportunity to purchase, through reinvestment of dividends or by additional cash payments, additional shares of its common stock. The shares of common stock for participants may be purchased from the GP at the greater of the average high and low sales price or the average closing sales price on the investment date or in the open market at 100% of the average price of all shares purchased for the plan. During 1999 and 1998, 3,813 and 1,545 shares, respectively, were issued under the plan.
Stock Purchase Agreement
On March 1, 1996, the GP entered into a Stock Purchase Agreement with Security Capital U.S. Reality (USRealty), an affiliate of Security Capital Group to purchase shares of the GP's common stock. As of December 31, 1999, USRealty owns 11,765,654 shares of the GP's common stock, which represents 42.2% of the outstanding shares of the GP. On March 19, 1996, USRealty also executed a Strategic Alliance Agreement and a Registration Rights Agreement with the Company. The Strategic Alliance Agreement generally provides that USRealty may nominate a number of directors to the Company's Board of Directors proportionate to its ownership of the GP's common stock. As of December 31, 1999, three nominees of the USRealty serve on the Company's Board of Directors. During 1999, the Company paid Security Capital Group or its affiliates $3,857 for various services received by the Company during the year. The payments included $3,717 for investment advisory services and $140 for real estate research, insurance related services.
General Partner Contributions
In 1997, the GP issued 2,461,000 shares of common stock for an aggregate purchase price of $90,368. The proceeds from the issuances are contributed to the Partnership in exchange for additional Units. The Partnership used the net proceeds to repay debt incurred under its revolving lines of credit to finance the acquisitions of self-storage facilities and for working capital.
In December of 1999, the GP announced a Board authorized plan to repurchase up to 5% of its common shares outstanding through open market and private purchases. As of December 31, 1999, the GP had repurchased 250,000 shares at an average price of $28.91.
NOTE 13 PREFERRED UNITS
On November 12, 1998, the Partnership issued 650,000 units of $100 par value 8.875% Cumulative Redeemable Preferred Partnership Units (the "Preferred Units") valued at $65,000 in a private placement. The Partnership has the right to redeem the Preferred Units after November 1, 2003 at the original capital contribution plus the cumulative priority return to the redemption date to the extent not previously distributed. The Preferred Units are exchangeable for 8.875% Series A Preferred Stock of Storage USA, Inc., on or after November 1, 2008 (or earlier upon the occurrence of certain events) at the option of 51% of the holders of the Preferred Units.
NOTE 14 POST EMPLOYMENT BENEFIT PLAN
The Company contributes to a 401(k) savings plan (a voluntary defined contribution plan) for the benefit of employees meeting certain eligibility requirements and electing participation in the plan. Each year the Company is obligated to make a matching contribution on the employee's behalf equal to 50% of the participant's contribution to the plan, up to 2% of the participant's compensation. Company profit sharing contributions to the plan are determined annually by the Company. Company contributions totaled $865, $661, and $479 during 1999, 1998 and 1997, respectively.
NOTE 15 RECENT ACCOUNTING DEVELOPMENTS
On February 27, 1998, the AICPA Accounting Standards Executive Committee (AcSEC) issued Statement of Position 98-1 (SOP 98-1), "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use", which is effective for fiscal years beginning after December 15, 1998. SOP 98-1 sets forth guidelines for the capitalization of costs relating to internal-use software. In connection with the new SOP, the Company capitalized approximately $600 of qualifying costs in 1999.
On June 16, 1998, FASB issued Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS 133), which is effective for fiscal years beginning after June 15, 2000. SFAS 133 establishes accounting and reporting standards for derivative instruments and hedging activities. Under this statement derivatives are recognized at fair market value and changes in fair market value are recognized as gains or losses. The adoption of SAS 133 is not expected to have a material impact on the financial position or results of operation of the Company.
NOTE 16 QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a summary of quarterly results of operations for 1999 and 1998:
SUSA Partnership, L.P.
Report of Independent Accountants
To the Partners of SUSA Partnership, L.P.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, partner's capital and cash flows present fairly, in all material respects, the financial position of SUSA Partnership, L.P. (the "Company") at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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 the opinion expressed above.
PricewaterhouseCoopers LLP
Memphis, Tennessee January 26, 2000
Storage USA, Inc., Facilities Schedule III Real Estate and Accumulated Depreciation as of December 31, 1999 | 18,853 | 123,396 |
53260_1999.txt | 53260_1999 | 1999 | 53260 | Item 1. Business
General
Jayark Corporation ("Jayark" or "the Company") conducts its operations through two wholly owned subsidiaries, AVES Audiovisual Systems, Inc. ("AVES") and MED Services Corp. ("Med"), each of which constitute a business segment for financial reporting purposes.
AVES distributes and rents a broad range of audio, video and presentation equipment, and supplies. Its customer base includes businesses, churches, hospitals, hotels and educational institutions. The warehousing, sales and administrative operations of AVES are located in Houston, Texas.
Med finances the manufacture, sale and rental of medical equipment. It had one customer in fiscal 1999, Vivax Medical Corporation, a company that manufactures, sells and rents durable medical equipment to hospitals, nursing homes and individuals. The administrative operations of Med are located in Vestal, New York.
The Company was originally incorporated in New York in 1958. In 1991, the Company changed its state of incorporation to Delaware. In July 1998 the Company amended its Certificate of Incorporation increasing its authorized Common Stock to 30,000,000 shares and decreasing the par value of its Common Stock from $.30 to $.01 per share.
Discontinued Operations
As a result of continued losses due to a soft retail market, low margins, competitive pressures, and price reductions, in 1997 the Company discontinued the operations of Rosalco Inc., ("Rosalco") a wholly owned subsidiary of Jayark. Rosalco had been headquartered in Jeffersonville, Indiana and had been in the business of the distribution of more than 300 different products, including occasional furniture, brass beds, custom jewelry cases and accessories, most of which were imported from outside the continental United States. Shortly after the closing, a receiver was assigned to liquidate the secured assets of Rosalco to satisfy the loan principal. In fiscal 1997, Jayark incurred a $5,795,000 loss on discontinued operations, which included $3,294,000 loss from operations for the year ended April 30, 1997, the establishment of accruals in the amount of $300,000 for expenses and guarantees related to the closing, the write off of an intercompany receivable and other assets of $476,000, and the write off of the remaining net assets of Rosalco of $1,725,000.
Recent Events
In September 1998, the Company offered to each stockholder, the right to purchase, pro rata, two shares of Common Stock at a price of $.10 per share. The Company filed a Registration Statement on Form S-1 with the Securities and Exchange Commission in order to register such rights to purchase Common Stock, under the Securities Act of 1933, as amended.
The Rights Offering expired on October 30, 1998. The total offering of 18,442,398 shares was fully subscribed with 111,600 shares purchased with cash and the balance subscribed by conversion of debt. The Company issued the new shares in November 1998. The conversion of debt to stock in conjunction with the Rights Offering resulted in a $1,000,000 reduction in notes payable to related parties, a $761,000 reduction in subordinated debt, and a $72,000 reduction in accrued interest. The end result was $1,794,000 of equity enhancement.
The Koffman Group, which consists of David Koffman, Chairman of the Board of Directors and President of the Company, Burton Koffman, Richard Koffman, Milton Koffman, Jeffrey Koffman, Sara Koffman, Ruthanne Koffman, Elizabeth Koffman, Steven Koffman, and three entities controlled by members of the Koffman family, agreed to acquire all shares not purchased by other stockholders on Primary Subscription. As a result, the Koffman Group beneficially owns 20,417,188 shares of Common Stock, which represents approximately 74% of the Common Stock outstanding.
On November 13, 1998 Jayark Corporation, through its newly formed, wholly owned subsidiary Med, terminated its Purchase and Sale, Distribution, and Custody Agreements with Vivax Medical Corporation ("Vivax"), a company that manufactures, sells and rents durable medical equipment to hospitals, nursing homes and individuals. Under the terms of the Purchase and Sale Agreement, dated June 17, 1998, Med purchased certain medical equipment from Vivax for cash of $579,700 and a $144,925 unsecured promissory note due in five years. Med then entered into a Consignment Agreement with Vivax whereby this medical equipment was consigned to Vivax to rent through its distribution network. In consideration of Vivax renting and maintaining the Med equipment, Vivax was entitled to a range of forty-eight to sixty-seven percent of the rental proceeds, based upon the equipment rented. Vivax had an option to repurchase the medical equipment from Med after the twenty-fourth, thirty-six and forty-eighth month of the consignment period. Med, under the Purchase and Sale Agreement had an option, through October 31, 1999 to purchase an additional $2,475,000 of medical equipment from Vivax. The results of Med's operations were immaterial in fiscal 1999.
In consideration for terminating the Agreements, Med received $840,000 after eliminating net accounts receivable and notes payable of $44,925 from Vivax. Med, in turn, paid off the outstanding balance on its revolving line of credit to the bank and outstanding interest due on the line. As a result of the termination, Med realized a $203,000 gain on the sale of assets.
Description of AVES' Business
Products
AVES distributes and rents a broad range of audio, video and presentation equipment, and supplies. Among the items distributed are video, filmstrip and slide projectors; projection screens and lamps; video cameras and camcorders; laser videodisk, video projection, TV monitors and receivers; video recorders; still imaging systems; public address systems, microphones and headsets; tape recorders, record
players, cassette recorders, and related accessories and supplies. Some of the items sold (such as blank audio cassettes, headsets and cassette recorders, duplicating equipment and supplies, laminating film and equipment for document protection) are either assembled by AVES or purchased from private label and other sole source suppliers and distributed under the "AVES" and/or "LAMCO" names. AVES also distributes the products of brand name manufacturers such as RCAT, GET, Mitsubishi, Elmo, Panasonic, Sanyo, Ikegami, Videotek, Hitachi, Pioneer, Leitch, Quasar, Telex Corporation, Kodak, Dukane, Sharp, Sony, 3M Brand, Luxor and various other brand names. Brand name and "house" brand products account for approximately 97% and 3% of AVES product sales, respectively. The Company also offers repair services, audio visual consulting & design, engineering, installation and servicing of audiovisual systems to businesses, churches, hospitals, hotels and educational institutions.
Raw Materials
The sources and availability of raw materials are not significant for an understanding of AVES' business since competitive products are obtainable from alternative suppliers. AVES carries an inventory of merchandise for resale and for rental operations that is adequate to meet the rapid delivery requirements (frequently same day shipments) of its distribution business.
Patents
There are no patents, trademarks, licenses, franchises or concessions that are material to AVES business.
Sales
AVES currently distributes and rents its products in the United States, primarily by means of catalogs, direct mail, telephone orders and a field sales force. AVES exhibits at various regional shows to expose its products to an interested audience. AVES' sales are not seasonal, except that sales to schools typically are higher from April through July than at other times during the year.
Customers
In fiscal 1999, 74% of AVES' revenue was derived from sales to schools and other educational institutions. The remaining 26% of revenues came from sales to businesses (24%) and rental of AVES equipment (2%). In 1998, 72% of revenue came from sales to schools and educational institutions, while 25% came from sales to businesses and 3% came from rentals. In 1997, 70% of revenue came from sales to schools and educational institutions, while 27% came from sales to businesses and 3% came from rentals.
Backlog
The amount of unfilled sales orders of AVES at April 30, 1999, was $1,040,000 as compared with $904,000 at April 30, 1998, and $758,000 at April 30, 1997. The amount of unfilled sales orders is not a material measure of AVES' operations.
Competition
The Company believes that AVES is one of the most diversified national audio visual purveyors in the United States, given the different types of services and products offered. AVES' principal means of competition are its aggressive pricing, technical expertise, quick delivery and the broad range of product lines and brands available through its distribution channels.
Employees
At April 30, 1999, AVES had 20 employees.
Description of Med's Business
Products / Services
For the fiscal year ending April 30, 1999 Med financed the manufacture, sale and rental of durable medical equipment by Vivax, a company that manufactures, sells and rents this equipment to hospitals, nursing homes and individuals. The Company intends to pursue additional opportunities in the medical field.
Raw Materials
The sources and availability of raw materials are currently not applicable to Med's business.
Patents
There are no patents, trademarks, licenses, franchises or concessions that are material to Med's business.
1999 Transactions
In November 1998 Med terminated its Purchase and Sale, Distribution, and Custody Agreements with Vivax. Under the terms of the Purchase and Sale Agreement, dated June 17, 1998, Med purchased certain medical equipment from Vivax for cash of $579,700 and a $144,925 unsecured promissory note due in five years. Med then entered into a Consignment Agreement with Vivax whereby this medical equipment was consigned to Vivax to rent through its distribution network. In consideration of Vivax renting and maintaining the Med equipment, Vivax was entitled to a range of forty-eight to sixty-seven percent of the rental proceeds, based upon the equipment rented. Vivax had an option to purchase the medical equipment from Med after the twenty- fourth, thirty-six and forty-eighth month of the consignment period. Med, under the Purchase and Sale Agreement had an option, through October 31, 1999 to purchase an additional $2,475,000 of medical equipment from Vivax.
Customers
During the fiscal year ending April 30, 1999, Vivax was Med's only customer.
Backlog
Med does not currently have any backlog orders.
Item 2.
Item 2. Properties
The Company's Corporate office is located in Houston, Texas in a modern, two story, stone and glass building which includes adjoining parking for up to 50 cars. The Corporate office and AVES' business are conducted from approximately 13,000 square feet; 5,500 of which are used for office, sales and demonstration purposes and 7,500 for warehouse purposes. The current lease term expires on April 30, 2001. The current rental is $5,200 per month.
Item 3.
Item 3. Legal Proceedings
None
Item 4.
Item 4. Submission Of Matters To A Vote Of Security Holders
On May 22, 1998, the Board of Directors of the Company approved and authorized an amendment to the Company's Certificate of Incorporation to increase the number of authorized shares of the Company's common stock, par value of $.30 per share, from 10,000,000 shares to 30,000,000 shares and to change the par value to $.01 per share. As of May 22, 1998, the Company had 9,221,199 issued and outstanding shares of Common Stock. Each share of Common Stock is entitled to one vote on any matter brought to a vote of the Company's stockholders. By written consent dated May 22, 1998, a majority of the Company's stockholders representing 4,898,245 shares, or 53% of the outstanding shares entitled to vote, approved the amendment.
PART II
Item 5.
Item 5. Market For Registrant's Common Stock And Related Stockholder Matters
Effective July 10, 1997, the Company's Common Stock was delisted due to the Company's non-compliance with the NASDAQ's minimum capital and surplus requirement. Bid quotations for the Company's Common Stock may be obtained from the "pink sheets" published by the National Quotation Bureau, and the Common Stock is traded in the over-the- counter market.
The following table presents the quarterly high and low trade prices of the Company's common stock for the periods indicated, in each fiscal year as reported by NASDAQ. As of July 1, 1999, there were approximately 827 stockholders of record of common stock.
The Company has not paid any dividends on its common stock during the last five years and does not plan to do so in the foreseeable future.
Item 6.
Item 6. Selected Financial Data
Item 7.
Item 7. Management's Discussion and Analysis Of Financial Condition And Results Of Operations
Comparison of Fiscal Year Ended April 30, 1999 With Fiscal Year Ended April 30, 1998
Net Revenues
Consolidated Revenues of $15,288,000 increased $1,684,000, or 12.4%, from fiscal 1998. The increase was the result of a $1,584,000 increase in AVES' sales and the addition of $100,000 in rental income from the new subsidiary, Med.
Cost of Revenues
Consolidated Cost of Revenues of $12,999,000 increased $1,553,000, or 13.6%, from the prior fiscal year which is directly related to the increase in revenues.
Gross Margin
Consolidated Gross Margin of $2,290,000 was 15.0% of revenues, as compared with $2,159,000, or 15.9%, for the same period last year.
Selling, General and Administrative Expense
Consolidated Selling, General and Administrative Expenses of $1,754,000 increased $37,000, or 2.2%, as compared with the prior reporting year. This increase was due to $66,000 in expenses for the new subsidiary, Med and a $6,000 increase in Corporate spending. AVES
decreased spending by $35,000 which partially offset the increases experienced by Med and Corporate. Although expenses at Corporate are up from the prior year, this $6,000 increase is a result of a difference in miscellaneous tax expense of $60,000. Taxes in the current year were $6,000 versus a credit of $54,000 in the prior year. The prior year's credit was a result of miscellaneous tax refunds received. Corporate recognized an overall decrease in spending of $54,000 in all other expense categories due to their continued efforts to reduce costs. The savings at AVES were attributable to reductions in payroll expenses.
Operating Income
Consolidated Operating Income of $536,000 increased $94,000, or 21.3%, from last year's operating income of $442,000. This increase was directly related to the increase in sales.
Interest Expense
Consolidated Interest Expense of $283,000 decreased $83,000 or 22.6% as compared with the same period last year. This decrease was primarily a result of the decrease in subordinated debt and notes payable attributed to the conversion of debt in conjunction with the Rights Offering which expired on October 30, 1998. As compared with the prior period, subordinated debt was down $787,000, with an interest rate reduction on the $613,000 in remaining principal from 12% to 8%, and notes payable decreased $1,000,000 due to the exchange of equity for debt. The resulting decline in interest was partially offset by higher interest experienced from increased borrowing levels on the Company's line of credit.
Gain (Loss) on Sale of Assets
Consolidated Gain on Sale of Assets of $203,000 resulted from the termination of Med's Purchase and Sale, Distribution and Custody Agreements with Vivax.
Pre Tax Earnings
Pre Tax Earnings of $456,000 for the fiscal year ended April 30, 1999 increased $380,000, or 500.0%, as compared with the same period last year. This increase was due to higher revenues, decreased interest expense, and the $203,000 gain on sale from Med's termination of its agreements with Vivax. These increases were partially offset by a slight increase in selling, general and administrative expenses.
Provision for Income Taxes
Provision for Income Taxes of $10,000 for the fiscal year ended April 30, 1999 as compared with $0 for the same period last year.
Net Income (Loss)
Consolidated Net Income of $446,000 for the fiscal year ended April 30, 1999 as compared with $76,000 for the same period last year.
Comparison of Fiscal Year Ended April 30, 1998 With Fiscal Year Ended April 30, 1997
Net Revenues
Consolidated Revenues of $13,605,000 increased $967,000, or 7.6%, from fiscal 1997. The increase was the result of a $1,130,000 increase in direct sales due to volume increases. These increases were partially offset by decreases in rental sales ($206,000).
Cost of Revenues
Consolidated Cost of Revenues of $11,446,000 increased $854,000, or 8.1%, from the prior fiscal year primarily due to increased revenues.
Gross Margin
Consolidated Gross Margin of $2,159,000 was 15.9% of revenues, as compared with $2,046,000, or 16.2%, for the same period last year.
Selling, General and Administrative Expense
Consolidated Selling, General and Administrative Expenses of $1,717,000 decreased $253,000 or 12.9% as compared with the prior reporting year. Jayark Corporate recognized cost reductions in legal and professional fees of $119,000 due to reduced legal representation in the current year and higher than normal audit and accounting fees incurred in Fiscal 1997; an $88,000 decrease in taxes due to miscellaneous expense reduction and refunds received from prior year returns; and decreases in other miscellaneous expense accounts of $86,000 as a result of the Company's overall cost reduction plan. These decreases were partially offset by a $78,000 decrease in other income as a result of 1997 gains on the disposal of fixed assets and other miscellaneous income. AVES decreased spending $38,000, primarily a result of an increase in miscellaneous income.
Operating Income
Consolidated Operating Income of $442,000 increased $366,000, or 481.6%, from operating income of $76,000 during the same period last year. This increase was due to $113,000 in increased margin from higher revenues and a $253,000 reduction in selling, general and administrative expenses.
Interest Expense
Consolidated Interest Expense of $366,000 increased $26,000, or 7.6%, due to increased borrowing levels.
Income (Loss) from Continuing Operations
Consolidated Income from Continuing Operations was $76,000 as compared with a prior year's net loss of $264,000. This was a result of higher revenues combined with lower selling, general and administrative expenses.
LIQUIDITY AND CAPITAL RESOURCES
At April 30, 1999, consolidated open lines of credit available to the Company for borrowing, were $1,250,000 as compared with $950,000 at April 30, 1998. It is the opinion of the Company's management that operating expenses, as well as obligations coming due during the next fiscal year, will be met primarily by cash flow generated from operations and from available borrowing levels.
Working Capital
Working capital was $371,000 at April 30, 1999, compared with $157,000 at April 30, 1998. The increase in working capital is largely due to cash flows from operations.
Net cash provided by operating activities was $321,000 in 1999 as compared with $386,000 in 1998.
Cash flows provided by investing activities during the year ended April 30, 1999 were $68,000 as a result of sale of assets relating to the Med subsidiary, offset by capital expenditures by the AVES subsidiary.
Cash used by financing activities of $418,000 is due to payment on the Company's line of credit and principal payments on notes payable to related parties. The majority of the common stock issued in conjunction with the Rights Offering was subscribed using conversion of debt. Consequentially, there was little to no cash provided by the transaction.
The Company had no material commitments for capital expenditures as of April 30, 1999.
Impact of Inflation
Management of the Company believes that inflation has not significantly impacted either net sales or net earnings during the year ended April 30, 1999.
Effect of New Accounting Pronouncements
In June 1997, the Financial Accounting Standards Board issued SFAS No. 130, "Reporting Comprehensive Income," which establishes standards for reporting and display of comprehensive income, its components and accumulated balances. Comprehensive income is defined to include all changes in equity except those resulting from investments by owners and distributions to owners. This standard is effective for financial statements beginning fiscal 1999. There is no significant impact on current financial statement disclosures.
In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133 ("SFAS 133"), Accounting for Derivative Instruments and Hedging Activities. SFAS 133 is effective for transactions entered into after January 1, 2000. SFAS 133 requires that all derivative instruments be recorded on the balance sheet at fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of the hedge transaction and the type of hedge transaction. The ineffective portion of all hedges will be recognized in earnings. The Company does not expect this standard to have a significant impact on future financial statement disclosures.
Year 2000
The year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Certain information technology systems and their associated software ("IT Systems"), and certain equipment that uses programmable logic chips to control aspects of their operation ("embedded chip equipment"), may recognize "00" as a year other than the year 2000. The year 2000 issue could result, at the Company and elsewhere, in system failures or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions or to engage in other normal business activities.
The Company has addressed, and continues to address, its year 2000 issues, including efforts relating to IT Systems and embedded chip equipment used within the Company, efforts to address issues the Company faces if third parties who do business with the Company are not prepared for the year 2000, and contingency planning. The Company has used both internal and external resources to identify, correct, upgrade or replace and test its IT systems and embedded chip equipment for year 2000 compliance.
The Company's IT Systems have been tested and determined to be compliant in a simulated year 2000 environment. As a result, the Company believes that its IT systems are ready for the year 2000, although isolated incidences of non-compliance may be experienced. The Company plans to allocate internal resources and retain dedicated consultants and vendor representatives to be ready to take action should these events occur.
The Company has identified some non-IT systems, embedded chip equipment, such as telephones, fax machines, climate control devices and building security systems, which may be impacted by the year 2000 problem, and is in the process of determining what actions may be required to make the equipment year 2000 compliant. These non-IT systems are minor in nature and would not significantly impact the Company's operations.
With respect to the IT and non-IT Systems of critical third parties, such as product vendors, utilities, communications, transportation, government, banking and other important services, the Company has established communication to obtain assurances regarding their respective year 2000 efforts. While the Company expects such third parties to address the year 2000 issues based on the representations it has received to date, the Company cannot guarantee that these systems will be made year 2000 compliant in a timely manner. Computer errors or failures in any of these areas may have the potential to disrupt business operations. The Company will continue to monitor the progress of such third parties throughout the next fiscal year.
Although the Company values established relationships with key vendors, substitute products for most goods may be obtained from other vendors. If certain vendors are unable to deliver product on a timely basis, due to their own year 2000 issues, the Company anticipates that there will be others who will be able to deliver similar goods. However, the lead time involved in sourcing certain goods may result in temporary shortages of relatively few items.
The Company expects all expenditures relating to their year 2000 readiness to be funded by cash flows from operations and that this will not materially impact other operating or investment plans.
The Company believes that the IT and non-IT technologies which support its critical functions will be ready for the transition to the year 2000. There can be no assurance that similar unresolved issues for
key third parties will not cause an adverse effect on the Company. As a result, the Company is in the process of developing and finalizing the appropriate contingency plans, which plans will be established and then revised as necessary during the course of 1999. Although the Company believes that its efforts to address the year 2000 issue will be sufficient to avoid a material adverse impact on the Company, there can be no assurances that these efforts will be fully effective.
Item 8.
Item 8. Financial Statements And Supplementary Data
The Report of Independent Certified Public Accountants, Financial Statements and Notes to Consolidated Financial Statements filed as a part of this report are listed in the accompanying Index to Financial Statements and Schedules.
Item 9.
Item 9. Change In and Disagreement With Accountants on Accounting And Financial Disclosure
None
PART III
Item 10.
Item 10. Directors And Executive Officers Of The Registrant
Set forth below is a list of the directors, executive officers and key employees of the Company and their respective ages as of June 30, 1999, and, as to directors, the expiration date of their current term of office:
David L. Koffman was elected President and Chief Executive Officer of the Company in December 1988. Prior to that time, he served as Director and Vice President of the Company for over seven years.
Frank Rabinovitz was elected Executive Vice President, Chief Operating Officer and Director of the Company in 1989. In addition, he is the President of the Company's audiovisual subsidiary and has served in this capacity for more than twelve years, as well as in various other executive and management capacities since 1980.
Robert C. Nolt is Chief Financial Officer and Director of the Company. In addition, Mr. Nolt is Chief Financial Officer of Binghamton Industries, Inc., a company controlled by the principal shareholders of the Company. Prior to joining the Company, Mr. Nolt was Vice President of Finance of RRT-Recycle America, Inc. Mr. Nolt is a Certified Public Accountant with over 26 years of experience in the Accounting field and has served in a number of executive positions. Before joining RRT in 1993, Mr. Nolt was Chief Financial Officer for the Vestal, NY based Ozalid Corporation.
Arthur G. Cohen has been a real estate developer and investor for more than eight years. Mr. Cohen is a Director of Baldwin and Arlen, Inc. Burton I. Koffman and Richard E. Koffman are parties to an agreement with Arthur G. Cohen pursuant to which they have agreed to vote their shares in favor of the election of Mr. Cohen to the Board of Directors of the Company.
Information Concerning Operations of the Board of Directors
The Executive Committee of the Board of Directors consists of Mr. David L. Koffman (Chair) and Mr. Frank Rabinovitz. The function of the Executive Committee is to exercise the powers of the Board of Directors to the extent permitted by Delaware law. As a rule, the Executive Committee meets to take action with respect to matters requiring Board of Directors approval and which cannot await a regular meeting of the Board or the calling of a special meeting. Under Delaware law and the Company's By-laws, both the Board and Executive Committee can act by unanimous written consent to all members.
The Stock Option Committee of the Board of Directors was created to administer the Company's 1981 Incentive Stock Option Plan, as amended, pursuant to resolution adopted November 24, 1981, giving it authority to exercise powers of the Board with respect to the Plan. The Stock Option Committee consists of Mr. Frank Rabinovitz and Mr. Robert Nolt.
The Audit Committee of the Board of Directors was created in 1991 to administer and coordinate the activities and results of the annual audit of the Company by independent accountants and to comply with NASDAQ listing requirements. The Audit Committee is comprised of Mr. Frank Rabinovitz and Mr. Robert Nolt.
The Compensation Committee of the Board of Directors was created in 1993 to administer and review compensation structure, policy and levels of the Company. The Compensation Committee is composed of Mr. Frank Rabinovitz and Mr. David Koffman.
Item 11.
Item 11. Executive Compensation
Set forth in the following table is certain information relating to the approximate remuneration paid by the Company during the last three fiscal years to each of the most highly compensated executive officers whose total compensation exceeded $100,000.
(1) Does not include the value of non-cash compensation to the named individuals, which did not exceed the lesser of $50,000 or, 10% of such individuals' total annual salary and bonus. The Company provides a vehicle to each of the named executives for use in connection with Company business but does not believe the value of said vehicles and other non-cash compensation, if any, exceeds the lesser of $50,000 or 10% of the individual's total annual salary and bonus.
(2) The Company has entered into Split Dollar Insurance Agreements with David L. Koffman and Frank Rabinovitz, pursuant to which the Company has obtained insurance policies on their lives in the approximate amounts of $5,743,400 and $497,700, respectively. The premium is paid by the Company. Upon the death of the individual, the beneficiary named by the individual is entitled to receive the benefits under the policy. The approximate amounts paid by the Company during the fiscal year ended April 30, 1999 for this insurance coverage were $0 and $25,373, respectively. Such amounts are not included in the above table.
(3) The Company has accrued Mr. Koffman's 1999 salary, however, he has deferred payment until such time as the Company's working capital position improves.
The following table sets forth-certain information relating to the value of stock options at April 30, 1999:
Based on the $0.05 per share closing bid price of the common stock on the NASDAQ Stock Exchange on April 30, 1999
Effective November 24, 1981 and approved at the annual stockholders meeting in 1982, the 1981 Incentive Stock Option Plan (ISOP) was adopted. An amendment to the ISOP was adopted on December 11, 1989. This amendment increased the number of incentive stock options that can be granted from 150,000 shares to 600,000 shares. The ISOP provides for the granting to key employees and officers of incentive stock options, as defined under current tax laws. The stock options are exercisable at a price equal to or greater than the market value on the date of the grant. No stock options were granted during the fiscal year ended April 30, 1999.
Effective September 15, 1994 and approved at the annual stockholders meeting in 1994, the 1994 NonEmployee Director Stock Option Plan (the "Director Plan") was adopted and 200,000 shares of the Company's common stock reserved for issuance under the Director Plan. The Director Plan provides for the automatic grant of nontransferable options to purchase common stock to nonemployee directors of the Company; on the date immediately preceding the date of each annual meeting of stockholders in which an election of directors is concluded, each nonemployee then in office will receive options exercisable for 5,000 shares (or a pro rata share of the total number of shares still available under the Director Plan). No option may be granted under the Director Plan after the date of the 1998 Annual Meeting of Stockholders.
Options issued pursuant to the Director Plan are exercisable at an exercise price equal to not less than 100% of the fair market value (as defined in the Director Plan) of shares of common stock on the day immediately preceding the date of the grant. Options are vested and fully exercisable as of the date of the grant. Unexercised options expire on the earlier of (i) the date that is ten years from the date on which they were granted, (ii) the date which is three calendar months from the date of the termination of the optionee's directorship for any reason other than death or disability (as defined in the Director Plan), or (iii) one year from the date of the optionee's disability or death while serving as a director.
The Director Plan became effective immediately following the 1994 Annual Meeting of Shareholders. Each nonemployee director in office on the date immediately preceding the date of each year's annual meeting will receive options exercisable for 5,000 shares of common stock.
During fiscal year ended April 30, 1999, no director options were granted to nonemployee directors.
Report of the Compensation Committee of the Board of Directors on Executive Compensation
Except pursuant to its ISOP and the Director Plan, the Company does not have any formal annual incentive program, cash or otherwise, nor does it make annual grants of stock options. Cash bonuses and stock options, including bonuses and options paid to executive officers, have generally been awarded based upon individual performance, business unit performance and corporate performance, in terms of cash flow, growth and net income as well as meeting budgetary, strategic and business plan goals.
The Company is committed to providing a compensation program that helps attract and retain the best people for the business. The Company endeavors to achieve symmetry of compensation paid to a particular employee or executive and the compensation paid to other employees or executives both inside the Company and at comparable companies.
The remuneration package of the Chief Executive Officer includes a percentage bonus based on the Company's profitable performance.
Item 12.
Item 12. Security Ownership Of Certain Beneficial Owners And Management
The following table sets forth as of April 30, 1999, the holdings of the Company's Common Stock by those persons owning of record, or known by the Company to own beneficially, more than 5% of the Common Stock, the holdings by each director or nominee, the holdings by certain executive officers and by all of the executive officers and directors of the Company as a group.
1.All shares are owned directly by the individual named, except as set forth herein. Includes actual shares beneficially owned and Employee and Director Stock Options exercisable within 60 days. David L. Koffman and Jeffrey P. Koffman are sons of Burton I. Koffman. Ruthanne Koffman is the wife of Burton I. Koffman.
2.Excludes 37,000 shares owned by a charitable foundation of which Burton I. Koffman is President and Trustee.
3.Includes 537,000 shares owned as tenants in common by brothers Richard E. Koffman and Burton I. Koffman.
Item 13.
Item 13. Certain Relationships And Related Transactions
On March 12, 1997, in connection with the State Street Bank financing and the establishing of the BSB Bank & Trust line of credit, the Company issued stock warrants totaling 4,166,667 to A-V Texas Holding, LLC, an affiliate of the Company of which David Koffman is a principal shareholder. The warrants allowed the holder to purchase 4,166,667 shares of the Company's common stock at a warrant price of $.30. On March 31, 1999, A-V Texas Holding, LLC and the Company mutually agreed to cancel the warrants.
In September 1998, the Company offered to each stockholder, the right to purchase, pro rata, two shares of Common Stock at a price of $.10 per share. The Company filed a Registration Statement on Form S-1 with the Securities and Exchange Commission in order to register such rights to purchase Common Stock, under the Securities Act of 1933, as amended.
The Rights Offering expired on October 30, 1998. The total offering of 18,442,398 shares was fully subscribed with 111,600 shares purchased with cash and the balance subscribed by conversion of debt. The Company issued the new shares in November 1998. The conversion of debt to stock in conjunction with the Rights Offering resulted in a $1,000,000 reduction in notes payable to related parties, a $761,000 reduction in subordinated debt, and a $72,000 reduction in accrued interest. The end result was $1,794,000 of equity enhancement.
The Koffman Group, which consists of David Koffman, Chairman of the Board of Directors and President of the Company, Burton Koffman, Richard Koffman, Milton Koffman, Jeffrey Koffman, Sara Koffman, Ruthanne Koffman, Elizabeth Koffman, Steven Koffman, and three entities controlled by members of the Koffman family, agreed to acquire all shares not purchased by other stockholders on Primary Subscription. As a result, the Koffman Group beneficially owns 20,417,188 shares of Common Stock, which represents approximately 74% of the Common Stock outstanding.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules And Reports On Form 8-K
(a) Documents filed as part of this report: 1. And 2. Financial Statements. The Report of Independent Certified Public Accountants, Financial Statements and Notes to Consolidated Financial Statements which are filed as a part of this report are listed in the Index to Financial Statements. Note - no financial statement schedules were required to be filed. 3. Exhibits, which are filed as part of this report, are listed in the accompanying Exhibit Index. (b) Reports on Form 8-K - None
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
JAYARK CORPORATION
By:
/s/ David L. Koffman Chairman of the Board and Director July 19, 1999 DAVID L. KOFFMAN
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated.
/s/ David L. Koffman Chairman of the Board, President, DAVID L. KOFFMAN Chief Executive Officer and Director July 19, 1999
/s/ Frank Rabinovitz Executive Vice President, Chief FRANK RABINOVITZ Operating Officer and Director July 19, 1999
/s/ Robert C. Nolt Chief Financial Officer and Director July 19, 1999 ROBERT C. NOLT
/s/ Arthur G. Cohen Director July 19, 1999 ARTHUR G. COHEN
JAYARK CORPORATION AND SUBSIDIARIES
Index Page - ------------------------------------------------------------------------------- Consolidated Financial Statements: Report of Independent Certified Public Accountants 20 Balance Sheets - April 30, 1999 and 1998 21 Statements of Operations - For the years ended April 30, 1999, 1998 and 1997 22 Statements of Stockholders' Equity - For the years ended April 30,1999, 1998 and 1997 23 Statements of Cash flows - For the years ended April 30, 1999, 1998 and 1997 24 Notes to Consolidated Financial Statements 25-33
Report of Independent Certified Public Accountants
To the Shareholders and Directors Jayark Corporation
We have audited the accompanying consolidated balance sheets of Jayark Corporation and Subsidiaries as of April 30, 1999 and 1998 and the related consolidated statements of operations, changes in stockholders' equity, and cash flows for each of the three years in the period ended April 30, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Jayark Corporation and Subsidiaries as of April 30, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended April 30, 1999 in conformity with generally accepted accounting principles.
BDO Seidman, LLP
New York, New York
July 8, 1999
Jayark Corporation and Subsidiaries Consolidated Balance Sheets April 30, 1999 and 1998
Jayark Corporation and Subsidiaries Consolidated Statements of Operations For the Years Ended April 30, 1999, 1998 and 1997
Jayark Corporation and Subsidiaries Consolidated Statements of Stockholders' Equity (Deficit) For the Years Ended April 30, 1999, 1998 and 1997
Jayark Corporation and Subsidiaries Consolidated Statement of Cash Flows For the Years Ended April 30, 1999, 1998 and 1997
Notes to Consolidated Financial Statements
April 30, 1999, 1998 and 1997
(1) Summary of Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of Jayark Corporation and its wholly owned subsidiaries (the "Company"). All material intercompany profits, transactions and balances have been eliminated.
Prior to April 30, 1997, a decision was made to discontinue the operations of Rosalco, Inc. ("Rosalco"), a wholly owned subsidiary of the Company. Rosalco was officially closed on October 22, 1997 and shortly thereafter a receiver was assigned to liquidate its assets. The accompanying financial statements have been adjusted retroactively to segregate and report separately the net assets and results of operations of Rosalco as a discontinued operation.
Inventories
Inventories comprise finished goods and are stated at the lower of cost (first in, first out method) or market value.
Property and Equipment, Depreciation and Amortization
Property and equipment are recorded at cost. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets, ranging from approximately 3 to 20 years. On sale or retirement, the cost of assets sold or retired and related accumulated depreciation or amortization is eliminated from the accounts and any resulting gain or loss is included in operations. Maintenance and repairs are expensed as incurred; expenditures for major renewals and betterments are capitalized and amortized by charges to operations.
Intangibles
The accounts of purchased companies are included in the consolidated financial statements from the dates of acquisition. The excess of cost over the fair value of net assets of businesses acquired is being amortized using the straight-line method over a 40-year period commencing with the dates of acquisition.
Revenue Recognition
Revenues are recorded when products are shipped. Allowances are recorded for estimated returns and losses.
Income Taxes
The Company follows the asset and liability method required by Financial Accounting Standards Board Statement of Financial Accounting Standards No. 109 in accounting for income taxes. Deferred tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred tax assets are reduced by a valuation allowance when there is uncertainty as to the ultimate realization of the asset.
Earnings per Share
In the third quarter of fiscal 1998, the Company adopted Statement of Financial Accounting Standards No. 128, "Earnings per Share", which requires the presentation of both basic and diluted earning per share on the face of the Statements of Operations and the restatement of all prior periods earnings per share amounts. Assumed exercise of options are not included in the calculation of diluted earnings per share for the fiscal years ended April 30, 1999, 1998 and 1997 since the effect would be antidilutive. Accordingly, basic and diluted net earnings per share do not differ for any period presented.
The following table summarizes securities that were outstanding as of April 30, 1999, 1998 and 1997 but not included in the calculation of diluted net earnings per share because such shares are antidilutive.
Changes in Financial Presentation
Certain reclassifications have been made in the 1997 and 1998 financial statements to conform to the presentation used in 1999.
Statements of Cash Flows
For purposes of the statements of cash flows, the Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles 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 reporting period. Actual results could differ from these estimates.
Long-Lived Assets
Long-lived assets, such as property, equipment, and goodwill are evaluated for impairment when events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable through the estimated undiscounted future cash flows from the use of these assets. When any such impairment exists, the related assets will be written down to their fair value. This policy is in accordance with Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets to be Disposed
Of", which was adopted on May 1, 1996. No write-downs have been necessary through April 30, 1999, except for assets of the discontinued operation (Note 13).
Stock-Based Compensation
The Company uses the intrinsic value method for accounting for stock compensation plans, as permitted by Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation", which was adopted on May 1, 1996. Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the Company's stock at the date of the grant over the amount the employee must pay to acquire the stock.
Effect of new accounting pronouncements
In June 1997, the Financial Accounting Standards Board issued SFAS No. 130, "Reporting Comprehensive Income," which establishes standards for reporting and display of comprehensive income, its components and accumulated balances. Comprehensive income is defined to include all changes in equity except those resulting from investments by owners and distributions to owners. This standard is effective for financial statements beginning fiscal 1999. There is no significant impact on current financial statement disclosures.
In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133 ("SFAS 133"), Accounting for Derivative Instruments and Hedging Activities. SFAS 133 is effective for transactions entered into after January 1, 2000. SFAS 133 requires that all derivative instruments be recorded on the balance sheet at fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of the hedge transaction and the type of hedge transaction. The ineffective portion of all hedges will be recognized in earnings. The Company does not expect this standard to have a significant impact on future financial statement disclosures.
(2) Business
The Company operates in two reportable business segments as follows:
The Company's audio-visual subsidiary, AVES Audio Visual Systems, Inc. ("AVES"), distributes and rents a broad range of audio, video and presentation equipment, and supplies to businesses, churches, hospitals, hotels and educational institutions
The Company's other wholly owned subsidiary, MED Services Corp. ("Med"), finances the manufacture, sales and rental of medical equipment. It had one customer in fiscal 1999, Vivax Medical Corporation, a company that manufactures, sells and rents durable medical equipment to hospitals, nursing homes and individuals. Due to their immateriality, the operating results and assets of this segment have not been separately reported.
(3) Related Party Transactions
The Company has subordinated notes (Note 7) with related parties amounting to $232,228 and $795,712 at April 30, 1999 and 1998, respectively. The annual interest rate was reduced from 12% to 8% on November 1, 1998. Interest expense relating to subordinated notes payable to related parties was $49,224, $95,485 and $95,485 in 1999, 1998 and 1997, respectively.
The Company had long term notes payable to related parties amounting to $972,298 and $2,046,021 at April 30, 1999 and 1998, respectively. The interest rate on the $972,298 is 7.5%. The maturity date of the note has been extended to December 31, 2004. Interest expense relating to these notes for the years ended April 30, 1999 and 1998 was $134,986 and $172,139, respectively.
Accrued interest to related parties for the years ended April 30, 1999 and 1998 was $323,223 and $190,970, respectively.
(4) Property and Equipment
Property and equipment are summarized as follows:
(5) Lines of Credit
In March 1997, AVES negotiated a line of credit with BSB Bank & Trust, Binghamton, New York. The line of credit permits AVES to borrow up to an aggregate amount of $1,250,000. The interest rate is 8.75% annually and the line is due and payable on March 1, 2000. The line of credit is secured by the AVES' accounts receivable and inventories. There are no financial covenants associated with the line of credit. At April 30, 1999 and 1998, $0 and $300,000, respectively, was outstanding on the above line of credit.
In connection with the guarantee for the AVES line of credit described above and the interim financing of the Rosalco discontinued operations by State Street Bank, the Company issued stock warrants totaling 4,166,667 to A-V Texas Holding, LLC, an affiliate of the Company. The warrants allowed the holder to purchase 4,166,667 shares of the Company's common stock at $.30 per share. The warrants were deemed to have a minimal fair value and no amount was recorded for them. On March 31, 1999, A-V Texas Holding, LLC and the Company mutually agreed to cancel the warrants.
(6) Long Term Debt
Long term debt is summarized as follows:
(7) Subordinated Debentures
On December 19, 1989, the Company issued $2,000,000 of 12% convertible subordinated debentures to affiliates of the Company due December 1995, and later extended to December 1999. Through April 30, 1998, the Company had retired $600,000 of debentures. The conversion of debt to stock in conjunction with the common stock Rights Offering (Note 15), resulted in a $761,000 reduction in subordinated debentures. On November 1, 1998, new notes were issued for the remaining $613,263 in subordinated debt reducing the annual interest rate from 12% to 8%. The new notes provide for interest payments due quarterly beginning January 31, 1999 and annual principal payments in the amount of $61,332 starting December 31, 1999 with the balance due on December 31, 2004. The new subordinated debenture agreements have no conversion rights.
(8) Income Taxes
Income tax expense (benefit) attributable to income before income taxes consists of:
At April 30, 1999, the Company had, for federal tax reporting purposes, net operating loss carryforwards of approximately $12,000,000, expiring in years through 2013.
The actual tax expense (benefit) differs from the "expected" tax expense (computed by applying the U.S. Corporate rate of 34%) in each of the 3 years ended April 30, 1999 primarily as a result of valuation allowances against potential deferred tax assets. In fiscal 1999 alternative minimum tax of $10,000 was incurred due to utilization of net operating loss carryforwards.
Deferred tax assets were approximately $5,160,000 as of April 30, 1999 and 1998, arising primarily as a result of net operating losses. Valuation allowances of $5,160,000 as of April 30, 1999 and 1998 offset the deferred tax assets, resulting in net deferred tax assets of $0 as of April 30, 1999 and 1998.
(9) Leases
The Company has several operating leases that expire at various dates ranging through April 2001. Future minimum lease payments related to operating leases are detailed as follows:
Total rental expense for operating leases was $62,430, $72,559 and $73,559 for the years ended April 30, 1999, 1998, and 1997, respectively.
(10) Stock Options
At April 30, 1999, the Company had two stock options plans which are described below. The Company applies APB Opinion 25 - "Accounting for Stock Issued to Employees", and related Interpretations in accounting for the plans. In terms of APB Opinion 25, when the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of the grant, no compensation cost is recognized.
The Company's Incentive Stock Option Plan ("ISOP"), as amended, allows for the granting of 600,000 shares of the Company's common stock. The ISOP provides for the granting to key employees and officers of incentive stock options, as defined, under current tax laws. The stock options are exercisable at a price equal to or greater than the market value on the date of the grant.
Option activity under the ISOP is as follows:
The following summarizes information regarding stock options outstanding at April 30, 1999.
Effective September 17, 1994 and approved at the annual stockholders' meeting in 1994, the 1994 Non-Employee Director Stock Option Plan (the "Director's Plan") was adopted and 200,000 shares of the Company's Common Stock reserved for issuance under the Director's Plan. The Director's Plan provides for the automatic grant of nontransferable options to purchase common stock to nonemployee directors of the Company, on the date immediately preceding the date of each annual meeting of stockholders in which an election of directors is concluded. Each nonemployee director then in office will receive options exercisable for 5,000 shares (or a pro rata share of the total number of shares still available under the Director's Plan). No option may be granted under the Director's Plan after the date of the 1998 annual meeting of stockholders.
Options issued pursuant to the Director's Plan are exercisable at an exercise price equal to not less than 100% of the fair market value (as defined in the Director's Plan) of shares of Common Stock on the day immediately preceding the date of the grant. Options are vested and fully exercisable as of the date of the grant. Unexercised options expire on the earlier of (i) the date that is ten years from the date on which they were granted, (ii) the date which is three calendar months from the date of the termination of the optionee's directorship for any reason other than death or disability (as defined in the Director's Plan), or (iii) one year from the date of the optionee's disability or death while serving as a director.
Option activity under the Plan is as follows:
Statement of Financial Accounting Standards No. 123 ("SFAS 123"), "Accounting for Stock - Based Compensation", requires the Company to provide pro forma disclosure of net income (loss) and earnings (loss) per as if the optional fair value method had been applied to determine compensation costs for the Company's Stock option plans. Since no options were granted in the years ended April 30, 1999, 1998 and 1997, no pro forma disclosures are applicable.
(11) Financial Instruments
The carrying amounts of financial instruments, including cash and cash equivalents, accounts receivable, accounts payable and notes payable approximated fair value as of April 30, 1999 due to the short maturity of these items. The fair value of the convertible debentures is not reasonably determinable.
(12) Fourth Quarter Adjustments
No material adjustments were made in the fourth quarter of fiscal 1999. During the fourth quarter of fiscal 1997, the Company recorded the effects of the discontinuance of Rosalco. See Note 13.
(13) Discontinued Operations
As a result of continued losses due to a soft retail market, low margins, competitive pressures, and price reductions, in 1997 the Company discontinued the operations of Rosalco. Rosalco had been headquartered in Jeffersonville, Indiana and had been in the business of the distribution of more than 300 different products, including occasional furniture, brass beds, custom jewelry cases and accessories, most of which are imported from outside the continental United States. Shortly after the closing, a receiver was assigned to liquidate the secured assets of the company to satisfy the loan principal. As a result, Jayark incurred a $5,794,000 loss on Discontinued operations, which includes $3,294,000 loss from operations for the year ended April 30, 1997, the establishment of accruals in the amount of $300,000 for expenses and guarantees related to the closing, the write off of an intercompany receivable and other assets of $476,000, and the remaining net asset of Rosalco of $1,725,000.
The Rosalco business has been presented as a discontinued operation, and the consolidated statements of operations have been restated to conform with this presentation. Financial results of the Rosalco operation are as follows:
(14) Common Stock
In July 1998 the Company amended its Certificate of Incorporation increasing its authorized Common Stock to 30,000,000 shares and decreasing the par value of its Common Stock from $.30 to $.01 per share.
(15) Common Stock Rights Offering
During fiscal 1999 the Company issued to its shareholders rights to purchase shares of the Company's $.01 par value Common Stock. The subscription price of $.10 per share was good for an aggregate of up to 18,442,398 shares. The Common Stock could have been purchased either with cash or by tendering to the Company debt of the Company in a principal amount equal to the subscription price.
The primary shareholders of the Company chose to participate in the offering and as such all offered shares were issued. In lieu of cash, these shareholders tendered debt of the Company in exchange for the shares. As a result of these transactions, the Company effectively extinguished approximately $1,000,000 of notes payable to related parties (Note 3), $761,000 of subordinated debentures (Note 7) and $72,000 of accrued interest.
The shareholders who participated in the offering were primarily related parties and as such the resulting gains and losses from the extinguishment of debt were recorded as additional paid in capital in the Statement of Stockholders' Equity.
(16) Statement of Cash Flows
Exhibit Index
3(1) Certificate of Incorporation of the Company. Incorporated herein by reference to the Company's Proxy Statement for its 1991 Annual Meeting of Shareholders, Exhibit B thereto.
3(2) Bylaws of the Company. Incorporated herein by reference to the Company's Proxy Statement for its 1991 Annual Meeting of Shareholders, Exhibit C thereto.
4(1) Specimen Certificate of Common Stock, par value $0.30 per share, incorporated herein by reference from Registration Statement on Form S-1, File Number 2- 18743, Exhibit 4 thereto.
4(2) 12% Convertible Subordinated Debenture due 1994, incorporated herein by reference to the Report on Form 8-K filed January 4, 1990, Exhibit 28(a) thereto.
4(3) Registration rights agreement dated as of December 20, 1989, by and between the Company and Rosalco, Inc., incorporated herein by reference to the Report on Form 8-K filed January 4, 1990, Exhibit 28(c) thereto.
10(1)* 1981 Incentive Stock Option Plan, as amended as of December 15, 1989, incorporated herein by reference to the Annual Report on Form 10-K for the year ended April 30, 1990, Exhibit 10(1) thereto.
10(2) Notes and Loan and Security Agreements (Inventory & Accounts Receivable) each dated as of January 20, 1992, between Jayark Corporation, AVES Audio Visual Systems, Inc., Rosalco, Inc., Rosalco Woodworking, Inc., Diamond Press Company, and State Street Bank & Trust Company of Boston, Massachusetts, incorporated herein by reference from the Annual Report on Form 10-K for the year ended April 30, 1992, Exhibit 10(3) thereto.
10(3) Letter Agreement dated December 6, 1989, among Arthur Cohen, Burton I. Koffman, and Richard E. Koffman. Incorporated herein by reference to the Annual Report on Form 10-K for the year ended April 30, 1990, Exhibit 10(3) thereto.
10(4) Indemnity escrow Agreement dated as of December 20, 1989, by and between the Company, Rosalco, Inc. and certain individuals named therein, incorporated herein by reference to the Report on Form 8-K filed January 4, 1990, Exhibit 28(c) thereto.
10(5) Factoring Agreements dated as of February 7, 1992, by and between the Company, Pilgrim Too Sportswear, Inc., J.F.D. Distributors, Inc., and others named therein, and Barclays Commercial Corporation, incorporated herein by reference to the Annual Report on Form 10-K for the year ending April 30, 1992, Exhibit 10(10) thereto.
10(6) Diamond Press Asset Sale and Purchase Agreement dated as of November 23, 1992 by and between the Company and Harstan, Inc., incorporated herein by reference to the Company's Form 8-K, as amended, as of November 23, 1992, Exhibit 2 thereto.
10(7) Asset Sale and Lease Termination Agreement, by and between Pilgrim Too Manufacturing Company, Inc., New Images, Inc., Victor Freitag, Jr. and wife Gilbert R. Freitag, and Robert E. Skirboll and wife Robin T. Skirboll, dated as of April 2, 1993; Asset Purchase Agreement by and between the Company, Pilgrim Too Sportswear, Inc., Pilgrim Too Manufacturing Company, Inc. Stage II Apparel Corp., Shambuil Ltd., and Pilgrim II Apparel Corp., dated as of April 2, 1993; both incorporated herein by reference to the Company's Form 8-K as of April 2, 1993, Exhibits thereto.
10(8) Amendment to certain Notes and Loan and Security Agreements each dated as of January 20, 1992, incorporated herein by reference from the Annual Report on Form 10-K for the year ended April 30, 1993, Exhibit 10(8) thereto.
10(9) Amendment to certain Notes and Loan and Security Agreements each dated as of December 31, 1993, incorporated herein by reference from the Annual Report on Form 10-K for the year ended April 30, 1994, Exhibit 10(9) thereto.
10(10) Asset Purchase Agreement, dated June 5, 1995, among LIB-Com Ltd., Liberty Bell Christmas, Inc., Ivy Mar Co., Inc., Creative Home Products, Inc., and Liberty Bell Christmas Realty, Inc. as the sellers and LCL International Traders, Inc. as the buyer, incorporated herein by reference from the Company's report on Form 8-K dated June 27, 1995, Exhibit 2(a) thereto.
10(11) Asset Purchase Agreement, dated June 5, 1995, between Award Manufacturing Corporation as the seller, and LCL International Traders, Inc., as the buyer, incorporated herein by reference from the Company's report on Form 8-K dated June 27, 1995, Exhibit 2(b) thereto.
10(12) Guarantee Agreement, dated June 5, 1995, by Award Manufacturing Corporation in favor of LCL International Traders, Inc., incorporated herein by reference from the Company's report on Form 8-K dated June 27, 1995, Exhibit 2(c) thereto.
10(13) Guarantee Agreement, dated June 5, 1995, by LIB-Com Ltd., Liberty Bell Christmas, Inc., Ivy Mar Co., Inc., Creative Home Products, Inc., and Liberty Bell Christmas Realty, Inc. in favor of LCL International Traders, Inc., incorporated herein by reference from the Company's report on Form 8-K dated June 27, 1995, Exhibit 2(d) thereto.
10(14) Promissory Note of LCL International Traders, Inc., due July 29, 1998, payable to the order of Commerzbank AG, Hong Kong Branch, incorporated herein by reference from the Company's report on Form 8-K dated June 27, 1995, Exhibit 2(e) thereto.
10(15) Confirmation Letter Agreement dated June 22, 1995, among Citibank, N.A., Commerzbank AG, Bayerische Vereinsbank AG, LCL International Traders, Inc., and Jayark Corporation, incorporated herein by reference from the Company's report on Form 8-K dated June 27, 1995, Exhibit 2(f) thereto.
10(16) Factoring Agreement dated June 23, 1995, between LCL International Traders, Inc. and the CIT Group/Commercial Services, Inc., incorporated herein by reference from the Company's report on Form 8-K dated June 27, 1995, Exhibit 99(a) thereto.
10(17) Inventory Security Agreement dated June 23, 1995, between LCL International Traders, Inc. and the CIT Group/Commercial Services, Inc., incorporated herein by reference from the Company's report on Form 8-K dated June 27, 1995, Exhibit 99(b) thereto.
10(18) Letter Agreement dated June 23, 1995, between LCL International Traders, Inc. and the CIT Group/Commercial Services, Inc., incorporated herein by reference from the Company's report on Form 8-K dated June 27, 1995, Exhibit 99(c) thereto.
10(19) Letter Agreement dated June 23, 1995, between LCL International Traders, Inc. and the CIT Group/Commercial Services, Inc., Liberty Bell Christmas, Inc., Ivy Mar Co., Inc., and Creative Home Products, Inc., incorporated herein by reference from the Company's report on Form 8-K dated June 27, 1995, Exhibit 99(d) thereto.
10(20) Amendment to certain Notes and Loan and Security Agreements each dated as of December 31, 1994, incorporated herein by reference from the Annual Report on Form 10-K for the year ended April 30, 1995, Exhibit 10(20) thereto.
10(21) Loan and Security Agreements dated April 29, 1996 between Rosalco, Inc., and State Street Bank & Trust Company of Boston, Massachusetts.
10(22) Loan and Security Agreements dated April 29, 1996 between AVES Audio Visual Systems, Inc., and State Street Bank & Trust Company of Boston, Massachusetts.
10(23) First amendment to Loan and Security Agreements dated as of September 19, 1996 between Rosalco, Inc. and State Street Bank & Trust Company of Boston, Massachusetts.
10(24) Agreement of Extension of Maturity of 12% Convertible Subordinated Debentures dated April 30, 1990.
10(25) Forbearance and Modification Agreement dated March 12, 1997, between Jayark Corporation, Rosalco, Inc., AVES Audio Visual Systems, Inc., David L. Koffman, and State Street Bank and Trust Company of Boston, Massachusetts.
10(26) Stock Pledge Agreement dated March 12, 1997, between Jayark Corporation and State Street Bank and Trust Company of Boston, Massachusetts.
10(27) Subordination Agreement dated March 12, 1997, between Jayark Corporation, Rosalco, Inc., AVES Audio Visual Systems, Inc., David L. Koffman, and State Street Bank and Trust Company of Boston, Massachusetts.
10(28) Revolving Note dated March 12, 1997 between Jayark Corporation and A-V Texas Holding, LLC.
10(29) Stock Pledge Agreement dated March 12, 1997 between Jayark Corporation and A-V Texas Holding, LLC.
10(30) Stock Warrant to purchase 3,666,667 shares of common stock dated March 12, 1997 between Jayark Corporation and A-V Texas Holding, LLC.
10(31) Commercial Security Agreement dated February 18, 1997, between AVES Audio Visual Systems, Inc. and BSB Bank and Trust Company.
10(32) Promissory Note dated February 18,1997, between AVES Audio Visual Systems, Inc. and BSB Bank and Trust Company.
10(33) Commercial Guaranty dated February 18, 1997, between AVES Audio Visual Systems, Inc., David L. Koffman and BSB Bank and Trust Company.
10(34) Subordinated Promissory Note date March 12, 1997 between Rosalco, Inc. and Jayark Corporation.
10(35) Second Forbearance and Modification Agreement dated June 1, 1997, between State Street Bank and Trust Company of Boston, Massachusetts, Rosalco, Inc., and Jayark Coporation.
10(36) Stock Warrant to purchase 500,000 shares of common stock dated March 12, 1997 between Jayark Corporation and A-V Texas Holding, LLC.
10(37) Certificate of Amendment of The Certificate of Incorporation of Jayark Corporation dated July 10, 1998.
10(38) Purchase and Sale Agreement dated June 1, 1998, between Vivax Medical Corporation and MED Services Corp.
10(39) Distribution Agreement dated June 1, 1998, between MED Services Corp. and Vivax Medical Corporation.
10(40) Revolving Line of Credit Grid Promissory Note dated August 7, 1998, between MED Services Corp. and Atlantic Bank of New York.
10(41) Security Agreement dated August 7, 1998, between MED Services Corp. and Atlantic Bank of New York.
10(42) Amendment to certain 12% Convertible Subordinated Debentures dated April 30, 1990.
10(43) Amendment to certain Note dated March 12, 1997 between Jayark Corporation and A-V Texas Holding, LLC.
[ARTICLE] 5 [CIK] 0000053260 [NAME] JAYARK CORPORATION [MULTIPLIER] 1000 | 10,895 | 70,041 |
943489_1999.txt | 943489_1999 | 1999 | 943489 | null | 0 | 0 |
821407_1999.txt | 821407_1999 | 1999 | 821407 | ITEM 1 BUSINESS
INTRODUCTION
Wolverine Tube, Inc. ("Wolverine" or the "Company") is a leading North American manufacturer and distributor of copper and copper alloy tube. The Company believes that it offers the broadest product line of any North American tube manufacturer and focuses on custom-engineered, high value-added tubular and fabricated products, which enhance performance and energy efficiency in many applications. The Company also manufactures and distributes copper and copper alloy rod, bar and strip products.
Copper's unique attributes--thermal conductivity, ease of bending and joining, and resistance to erosion and corrosion--make it an attractive material for a broad range of applications in a large number of diverse industries. Customers include commercial and residential air conditioning and refrigeration equipment manufacturers, appliance manufacturers, automotive manufacturers, industrial equipment manufacturers, utilities and other power generating companies, refining and chemical processing companies and plumbing wholesalers.
HISTORY AND STRUCTURE
The Company is the successor to a business founded in Detroit in 1916. In 1987, the Company was purchased through a leveraged acquisition of substantially all the assets of the seamless copper tube business of The Henley Group, Inc. and its Canadian affiliates by an investor group that included the then-existing management of the Company. In 1988, the Company's wholly-owned subsidiary, Wolverine Tube (Canada) Inc., acquired substantially all of the assets of Noranda Metal Industries Limited, a Canadian company. In January 1991, Genstar Capital Corporation ("Genstar") acquired a controlling interest in the Company. At that time, Genstar owned 72.8% of the Common Stock with the balance of the Common Stock owned by the management of the Company and certain other investors.
In August 1993, the Company and certain stockholders engaged in an initial public offering of 6,555,000 shares of Common Stock. Of those shares, 3,280,000 were sold by Wolverine and 3,275,000 were sold by certain stockholders. Net proceeds to the Company were approximately $46.4 million.
In November 1994, the Company completed its acquisition of Small Tube Products Corporation ("STP"), a fabricated copper and copper alloy products manufacturer based in Altoona, Pennsylvania, by means of a merger of a wholly-owned subsidiary of the Company with and into STP. The Company acquired all of the outstanding stock of STP in exchange for $54.6 million in cash and 400,000 shares of Wolverine Common Stock. As a result of the merger, STP became a wholly-owned subsidiary of Wolverine and was renamed "STPC Holding, Inc."
In September 1995, the Company completed a secondary public offering of 4,882,700 shares of Common Stock (the "Secondary Stock Offering") in which Genstar and its affiliates sold
substantially all of their shares of Common Stock. No additional shares of Common Stock were issued by the Company in conjunction with the Secondary Stock Offering.
In September 1996, the Company completed the acquisition of Tube Forming, Inc., a manufacturer of value-added copper fabricated products based in Carrollton, Texas, for $34.6 million in cash.
In May 1998, the Company acquired a 240,000 square foot welded tube manufacturing facility located in Jackson, Tennessee, and the related equipment and technology, from Korea-based Poongsan Corporation, for approximately $35.4 million in cash.
In July 1999, the Company combined the assets of its Fergus, Ontario facility, a copper and copper alloy strip production facility, with certain of the assets of Ratcliffs Severn Ltd., a Toronto-based light gauge copper and brass strip manufacturing operation, to create the newly-formed joint entity of Wolverine Ratcliffs, Inc. ("WRI"). The Company owns 85.9% of WRI and the remaining 14.1% is owned by Ratcliffs Severn Ltd.
The Company, a Delaware corporation, was organized in 1987. The Company's principle executive offices are located at 1525 Perimeter Parkway, Suite 210, Huntsville, Alabama 35806, and its telephone number is (256) 353-1310.
PRODUCTS
COMMERCIAL PRODUCTS
The Company includes in the commercial products category several types of technically sophisticated tube and fabricated tubular products that it sells directly to equipment manufacturers and that are generally custom designed and manufactured. Because of the high level of added value, profitability tends to be higher for commercial products than for the Company's other products.
The Company's commercial products include:
Industrial Tube. Small (as small as .01") and medium diameter copper tube used primarily by residential air conditioning, appliance and refrigeration equipment manufacturers is known as "industrial" tube. Industrial tube is made to customer specifications for equipment manufacturing. The Company's industrial tube products include coils in lengths of up to one mile (to permit economical transport to customers for further processing), smooth straight tube, internally enhanced tube with internal surface ridges to increase heat transfer in air conditioning coils, and very small diameter capillary tube (for control valve applications).
Technical Tube. Technical tube is used to increase heat transfer in large commercial air conditioners, heat exchangers for power generating and chemical processing plants, water heaters, swimming pool and spa heaters and large industrial equipment oil coolers. Small, wedge-like grooves (fins) on the outer surface, together with internal enhancements of technical tube, increase surface area and refrigerant agitation, thereby increasing heat transfer efficiency. The Company was the first to develop integral finned tube, in which the fins are formed directly from the wall of the tube, and holds many patents in this area.
Copper Alloy Tube. Copper alloy tube (principally copper mixed with nickel) is manufactured for certain severe uses and corrosive environments such as condenser tubes and heat exchangers in power generating plants, chemical plants, refineries and ships. The Company's copper alloy tube products include smooth and surface enhanced tube produced from a variety of alloys, U-bends for heat exchangers and the Company's patented Korodense(R) corrugated heat transfer tube. Also included in the alloy tube category are surface enhanced titanium and steel tube produced by the Company from smooth tube supplied by outside sources.
Fabricated Products. Fabricated products encompass a wide variety of copper, copper alloy and aluminum tubing products and subassemblies for a myriad of different applications. Tubing can be supplied in various cut lengths, long straight lengths or coils. Specialty fabricated parts, sub-assemblies and components (such as return bends and manifolds) are also produced. Capabilities include cutting, bending, swaging, flaring, end-finishing and brazing, which can be applied to a wide range of products.
WHOLESALE PRODUCTS
Wholesale products include plumbing tube and refrigeration service tube. Plumbing tube and refrigeration service tube are produced in standard sizes and lengths primarily for plumbing, air conditioning and refrigeration service applications. Many major competitors manufacture the most common 3/4" and 1/2" diameter plumbing tube. These products are considered commodity products because price and delivery are the primary competitive factors. Plumbing tube and refrigeration service tube are sold primarily through wholesalers.
ROD, BAR AND STRIP PRODUCTS
Copper and Copper Alloy Rod and Bar. Copper and copper alloy rod and bar products include a broad range of copper and copper alloy solid products, including round, rectangular, hexagonal and specialized shapes. Brass rod and bar are used by industrial equipment and machinery manufacturers for valves, fittings and plumbing goods. Copper bars are used in electrical distribution systems and switchgear. Copper and copper alloy rod and bar products are sold directly to manufacturers and to service centers that keep an inventory of standard sizes.
Copper and Copper Alloy Strip. Copper and copper alloy strip products are used primarily by automotive, hardware and electrical equipment manufacturers, by roofing contractors and by mints for coins. Copper and copper alloy strip products are sold directly to manufacturers and to service centers that keep an inventory of standard sizes.
ENERGY EFFICIENCY AND GOVERNMENTAL REGULATIONS
In September 1987, the United States, Canada and many other countries signed The Montreal Protocol on Substances that Deplete the Ozone Layer (the "Montreal Protocol"). As originally drafted, the Montreal Protocol provided for the limitation on production and consumption of chlorofluorocarbons ("CFCs") over various periods of time. On November 15, 1990, the President of the United States signed The Clean Air Act Amendments of 1990 (the "1990 Amendments"). Title VI, Section 604 of the Clean Air Act requires the phaseout of CFCs (other than methyl chloroform) by the year 2000. On November 23, 1992, the fourth meeting of the parties to the Montreal Protocol was convened in Copenhagen. At that meeting the parties
agreed, among other things, to accelerate the phaseout of CFC production to January 1, 1996. On December 10, 1993, the United States Environmental Protection Agency (the "EPA") promulgated regulations requiring domestic producers to cease production of CFCs by January 1, 1996.
The Company has benefited and expects to continue to benefit, although at rates slower than originally anticipated, from the CFC phaseout as existing large commercial air conditioners ("chillers") are replaced with units utilizing alternative refrigerants. Based upon data from the EPA and the Air Conditioning and Refrigeration Institute ("ARI"), the Company estimates there are approximately 130,000 large industrial chillers worldwide, including 80,000 large industrial chillers in North America, that are affected by the 1990 Amendments and the Montreal Protocol. Industry sources estimate that as of December 31, 1999, there were approximately 48,000 large industrial chillers in North America that have not been replaced or retrofitted. These chillers are used to regulate the temperature and humidity in offices, hotels, shopping centers and other large buildings.
Non-CFC chillers can be 40 percent more efficient than the CFC units installed 20 years ago, resulting in operating savings that can pay back the replacement cost in a few years. However, U.S. federal tax laws pertaining to depreciation of capital improvements were not changed when the ban on CFCs went into effect. Congress has been asked to consider an accelerated depreciable life for CFC chillers so that unused depreciation could be apportioned over a four-year period, providing building owners with more incentives to replace their CFC units.
The Company expects demand for its high value-added, energy efficient tubes to improve as manufacturers produce more energy efficient and lower operating cost units and as existing chillers continue to be replaced in response to the ban on production of CFCs. There can be no assurance that this anticipated demand will materialize, or that the Company will not face increased competition, with an adverse effect on profitability, from other manufacturers in this high value-added segment. In addition, new refrigerants or technologies that are not compatible with copper tube may be developed in response to the requirements of the 1990 Amendments, the Montreal Protocol and the EPA regulations. The development of any such new refrigerant or technology could have a material adverse effect on the Company's business, operating results or financial condition. Furthermore, there can be no assurance that the use of reclaimed CFCs to a greater extent than anticipated will not continue, causing a slower pace of replacement and retrofitting of chillers currently using CFCs.
MARKETS
Major markets for each of the Company's product lines are set forth below:
PRODUCTS MAJOR MARKETS
Commercial Products
Industrial Tube Residential and small commercial air conditioning manufacturers, appliance manufacturers, automotive manufacturers, industrial equipment manufacturers, refrigeration equipment manufacturers and redraw mills (which further process the tube).
Technical Tube Commercial air conditioning manufacturers, power and process industry heat exchanger manufacturers, water, swimming pool and spa heater manufacturers and oil cooler manufacturers.
Copper Alloy Tube Utilities and other power generating companies, refining and chemical processing companies, heat exchanger manufacturers and shipbuilders.
Fabricated Products Consumer appliance manufacturers, air conditioning and refrigeration manufacturers, automotive manufacturers, heavy equipment manufacturers, industrial equipment manufacturers, marine industry, building and heating industries.
Wholesale Products Plumbing wholesalers and refrigeration service wholesalers.
Rod, Bar and Strip Products Electrical equipment and automotive parts manufacturers, coin mints, locomotive and other industrial equipment manufacturers, metal service centers and rerollers (which further process the product).
KEY CUSTOMERS
No customer accounted for as much as 10% of the Company's consolidated net sales in 1999 or 1997. York International accounted for 10% of the Company's consolidated net sales in 1998.
BACKLOG
A significant part of the Company's sales are based on short-term purchase orders. For this reason, the Company does not maintain a backlog and believes that backlog is not necessarily a meaningful indicator of future results. A significant amount of the Company's sales result from customer relationships wherein the Company provides a high degree of specialized service and generally becomes the largest supplier of a customer's copper tube requirements. Under these
arrangements, the Company's customers provide forecasts of their requirements, against which purchase orders are periodically released. In several cases the Company has entered into multi-year arrangements with major customers to continue to serve as the supplier of first choice on a global basis.
SALES AND MARKETING
The Company uses a direct field sales force augmented with sales agents in pursuing global sales opportunities. The Company believes its sales structure forms a critical link in the communication between the Company and its customers. This link is particularly important in the high value-added product segments, in which the Company often works with customers in their product enhancement and new product development efforts. The sales structure is coordinated through key senior executives responsible for the sales and marketing efforts of the Company.
North America. The sales structure in North America consists of sales officers, field marketing representatives and independent sales agents who are responsible for selling and servicing accounts for the entire product line.
International. The Company's overseas export sales are carried out both directly with major overseas customers and through foreign sales agents. The Company has sales, marketing and business development offices in Lyon, France, Leeds, United Kingdom and Hong Kong.
For information concerning the amount of sales, gross profit and certain other financial information about foreign and domestic operations see Note 15 of the Notes to Consolidated Financial Statements.
COMPETITION
While no single company competes with Wolverine in all of the Company's product lines, the Company faces significant competition in each of its product lines. The Company has numerous competitors, some of which are larger and have greater financial resources than the Company. Cerro Copper Products Co., Inc., Industrias Nacobre S.A. de C.V., Kobe Copper Products Inc., Wieland-Werke AG, Mueller Industries Inc., Olin Corporation, PMX Industries, Outokumpu American Brass Company and others compete with the Company in one or more product lines. There can be no assurance that the Company will be able to compete successfully or that competition will not have an adverse effect on the Company's business operating results or financial condition. Minimal product differentiation among competitors in the Company's wholesale and rod and bar product lines creates a pricing structure for these products resembling "commodity" pricing (i.e., a pricing structure where customers differentiate between products almost exclusively on price). In these product areas, certain of the Company's competitors have significantly larger market shares than the Company, and tend to be the industry pricing leaders. If the Company's competitors in these product lines were to significantly reduce prices, the Company's business, operating results or financial condition could be adversely affected.
The Company currently faces limited competition for certain high value-added commercial products. If other companies, or some of the Company's existing customers, begin or expand operations in these product categories, the Company's business, operating results or financial
condition could be adversely affected. Because the Company competes primarily on the basis of the technical advantages of its commercial products, technical improvements by competitors could reduce the Company's competitive advantage in these product lines and thereby adversely affect the Company's business, operating results or financial condition. The Company could also be adversely affected if new technologies emerge in the refrigeration industry, or other consumer industries, including technologies developed in response to the elimination of CFCs, which would reduce or eliminate the need for copper and copper alloy tube. Certain of the Company's products, such as plumbing tube, compete with products made of alternative substances, such as polybutylene plastic. A substantial increase in the price of copper could decrease the relative attractiveness of copper products in cases where an alternative exists and thereby adversely affect the Company's business, operating results or financial condition.
MANUFACTURING
The manufacture of seamless tube and tubular products consists of casting, extruding, drawing, forming and finishing processes. In most cases, the raw material is first cast into a solid cylindrical shape or "billet". The billet is then heated to a high temperature, a hole is pierced through the center of the cylinder, and the cylinder is then extruded under high pressure into a tube. The tube is either drawn to smaller sizes or reduced on a forging machine and then drawn to smaller sizes. The outside and/or inside surface can be enhanced to achieve the desired heat transfer qualities. Depending on customer needs, bending, annealing (heating to restore flexibility), coiling or other operations may be required to finish the product.
Virtually all of the tube produced by the Company is seamless as opposed to welded tube, with the exception of the tube manufactured at the Company's Jackson, Tennessee location. Welded tube is made from a flat strip that is rolled and welded together at the edges.
RAW MATERIALS, SUPPLIERS AND PRICING
The Company's principal raw materials are copper, nickel, zinc and tin. In 1999, the Company purchased approximately 379.3 million pounds of metal, approximately 88% of which was copper. The Company contracts for its copper requirements with a variety of sources, including producers, merchants, brokers, dealers and industrial suppliers. The Company's raw materials are available from a variety of sources, and the Company does not believe that the loss of any one source would materially affect its business, operating results or financial condition.
The key elements of the Company's copper procurement and product pricing strategies are the assurance of a stable supply and the avoidance of exposure to metal price fluctuations. The price of copper purchased by the Company is based on fluctuating market prices, usually with the COMEX price as a benchmark. The Company generally has an "open pricing" option under which the Company may set the price of all or a portion of the metal subject to a purchase contract at any time up to the last COMEX trading day (usually two days before the end of the month) of the last month in the contract period.
In the majority of cases, the price to the customer contains two components: (i) a metal charge based on the market value of the metal content on the date of shipment of the product to the customer; and (ii) a fixed fabrication charge. In other cases, the Company quotes a firm price to
the customer which covers both the metal price and the fabrication charge. In either case, the Company minimizes its exposure to metal price fluctuations through various strategies. Generally, at the time the metal price for the customer is established, the Company prices an equivalent amount of metal under its open pricing arrangements with its suppliers. It is the Company's policy not to attempt to profit from fluctuations in copper prices by taking commodity risks or speculative commodity positions.
RESEARCH AND DEVELOPMENT
The Company's research and development efforts are devoted to new product development and manufacturing process improvements. To further support the Company's advancements in product and process development, the Company completed construction of the 21,000 square foot Technology Center in Decatur, Alabama in 1998. The Technology Center supports the engineering and testing of specialized products and enhancement of the Company's custom-engineering processes through which the Company customizes products to the particular specifications of its customers. The Company's research and development is conducted primarily at the Technology Center.
Heat transfer products, including the Company's line of "Turbo" products, accounted for over 25% of commercial product gross profit in 1999. Turbo products include Turbo-A, the Company's internally enhanced tube, Turbo-B and Turbo-C, the proprietary line of enhanced surface boiling and condenser tube for chillers. Demand for enhanced tube products is driven by the need for improved energy efficiency. New product development will continue to be concentrated in the heat transfer area. The Company is involved in several industry, university and government sponsored research projects relating to alternative refrigerants as well as more energy efficient tube for the HVAC, refrigeration, power and petrochemical industries. The ARI has chosen the Company's tube as the "standard" to measure the efficiency of alternative refrigerants. See "Energy Efficiency and Governmental Regulations."
The Company's research and development expense was $3.0 million in 1999, $1.5 million in 1998, and $1.4 million in 1997. The Company uses its extensive manufacturing facilities and personnel to assist in manufacturing process research and development efforts. In addition, the Company engages in new product development efforts with certain of its major customers, as well as universities and government agencies.
ENVIRONMENTAL MATTERS
The Company's facilities and operations are subject to extensive environmental regulations imposed by federal, state, provincial and local authorities in the United States and Canada with respect to emissions to air, discharges to waterways, and the generation, handling, storage, transportation, treatment and disposal of waste materials. In addition, the Company has incurred, and in the future may incur, liability under environmental statutes and regulations with respect to the contamination of sites owned or operated by the Company (including contamination caused by prior owners and operators of such sites) and the off-site disposal of hazardous substances.
The Company believes its operations are in substantial compliance with the terms of all applicable environmental laws and regulations as currently interpreted. However, the Company
expects that future regulations and changes in the text or interpretation of existing regulations may subject the Company's operations to increasingly stringent standards. While the precise effect of these changes on the Company cannot be estimated, compliance with such requirements may make it necessary, at costs which may be substantial, to retrofit existing facilities with additional pollution-control equipment and to undertake new measures in connection with the storage, transportation, treatment and disposal of by-products and wastes.
The Company has a reserve of $2.6 million for environmental remediation costs. This reserve is reflected in the Company's December 31, 1999 Consolidated Balance Sheet and does not include any potential recovery for amounts indemnified by other parties. The total cost of environmental assessment and remediation depends on a variety of regulatory, technical and factual issues, some of which cannot be anticipated. While the Company believes that the reserve, under existing laws and regulations, is adequate to cover presently identified environmental remediation liabilities, there can be no assurance that such amount will be adequate to cover the ultimate costs of these liabilities, or the costs of environmental remediation liabilities that may be identified in the future. See "Item 3 - -Legal Proceedings" and "Item 7 - -Management's Discussion and Analysis of Financial Condition and Results of Operations--Environmental."
EMPLOYEES
As of December 31, 1999, the Company had a total of 3,465 employees. None of the United States or the London, Ontario employees are represented by a union. A majority of the hourly employees at the Montreal, Quebec and Fergus, Ontario plants are unionized and are covered by collective bargaining agreements that expire in 2002. As a whole, the Company believes its relations with its employees are good.
PATENTS AND TRADEMARKS
The Company owns a number of patents (in the United States and other jurisdictions) on its products and related manufacturing processes, as well as trademarks, and has granted licenses with respect to some of such patents and trademarks. While the Company believes that its patents and trademarks have competitive value, it does not consider the Company's success as a whole to be dependent on its patents, patent rights or trademarks.
SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
Certain of the statements and subject areas contained herein in "Business" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" that are not based on historical or current facts deal with or may be impacted by potential future circumstances and developments. Such statements and the discussion of such subject areas involve, and are therefore qualified by, the inherent risks and uncertainties surrounding future expectations generally, and also may materially differ from the Company's actual future experience involving any one or more of such subject areas. The Company has attempted to identify, in context, certain of the factors that it currently believes may cause actual future experience and results to differ from current expectations regarding the relevant statement or subject area. The Company's operations and results also may be subject to the effect of other risks and uncertainties in addition to the relevant qualifying factors identified herein, including, but not
limited to, cyclicality and seasonality in the industries to which the Company sells its products, the impact of competitive products and pricing, extraordinary fluctuations in the pricing and supply of the Company's raw materials, volatility of commodities markets, unanticipated developments in the areas of environmental compliance and other risks and uncertainties identified from time to time in the Company's reports filed with the Securities and Exchange Commission.
EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth certain information with respect to each executive officer of the Company:
Mr. Horowitz has been the President and Chief Executive Officer and a director of the Company since March 1998. Prior to joining the Company, Mr. Horowitz served as Corporate Vice President and President of the Americas of AMP Incorporated ("AMP"), a high technology electrical connector and interconnection systems company, since September 1994. Prior to joining AMP, Mr. Horowitz was employed for over fourteen years at Philips Electronics North America Corporation ("Philips") a diverse electronics manufacturer, where he served from October 1993 to August 1994 as President and Chief Executive Officer of Philips Technologies and previously served as President and Chief Executive Officer of Philips Magnavox CATV Systems and President and Chief Executive Officer of Philips Discrete Products Division. Mr. Horowitz also serves as a Director of Aerovox Incorporated and Superconductor Technologies, Inc.
Mr. Deason has been the Executive Vice President, Chief Financial Officer and Secretary of the Company since September 1994 and a director of the Company since October 1995. Prior to joining the Company, Mr. Deason, a Certified Public Accountant, was most recently a partner with Ernst & Young LLP in Birmingham, Alabama.
Mr. Weil has been the Senior Vice President, Tubing Products, of the Company since December 1998. Prior to joining the Company he had been a Global Business Executive and General Manager Consumer/Commercial for AMP since 1996. Prior to 1996, Mr. Weil was employed by Philips for fourteen years in positions that included President of Graner Company (a division of Philips), General Manager of Philips Circuit Assemblies and Vice President of Marketing for Philips Broadband.
Mr. Manning has been Vice President of Human Resources and General Counsel of the Company since May 1998. Prior to joining the Company, Mr. Manning served as Senior Counsel for Mercedes-Benz U.S. International, Inc. ("Mercedes-Benz"), a vehicle manufacturer, since March 1998. Prior to joining Mercedes-Benz, Mr. Manning was employed for over eight years with Genuine Parts Company, a diversified wholesale distribution company, where he held various positions including Vice President of Human Resources and Corporate Counsel for its Motion Industries, Inc. subsidiary.
ITEM 2
ITEM 2 PROPERTIES
UNITED STATES FACILITIES
The Company owns and operates manufacturing facilities in Decatur, Alabama; Shawnee, Oklahoma; Jackson, Tennessee; Roxboro, North Carolina; Carrollton, Texas; Booneville, Mississippi; and Ardmore, Tennessee. The Altoona, Pennsylvania facility is partially owned and partially leased from a local industrial development agency for $3,500 per year in perpetuity. The Company also has a 50,000 square foot facility in Greenville, Mississippi that is not being utilized for production and is currently being held for sale. The Company's corporate offices are comprised of approximately 9,200 square feet in a leased facility in Huntsville, Alabama.
The following table describes each of the Company's United States manufacturing facilities:
CANADIAN FACILITIES
The Company owns and operates manufacturing facilities in Montreal, Quebec, London, Ontario, and Fergus, Ontario. The following table describes each of the Company's Canadian manufacturing facilities:
OTHER FACILITIES
The Company leases minor square footage for sales offices in Lyon, France and Hong Kong, China. The Shanghai, China facility is leased from the Shanghai Waigaoqiao Free Trade Zone 3-U Development Co., Ltd. for a twelve year term. The following table describes the Company's Shanghai, China facility:
ITEM 3
ITEM 3 LEGAL PROCEEDINGS
The Company's facilities and operations are subject to extensive environmental laws and regulations, and the Company is currently involved in various proceedings relating to environmental matters as described under "Item 7 - -Management's Discussion and Analysis of Financial Condition and Results of Operations--Environmental." The Company is not involved in any legal proceeding that it believes could have a material adverse effect upon its business, operating results or financial condition.
ITEM 4
ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders by the Company during the final quarter of the fiscal year covered by this report.
PART II
ITEM 5
ITEM 5 MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock is traded on the New York Stock Exchange under the symbol "WLV." As of March 15, 2000, there were 12,296,738 shares of common stock outstanding, held by 319 shareholders of record.
The following table sets forth, for the periods indicated, the range of high and low reported sale prices for the Company's Common Stock on the New York Stock Exchange:
The Company did not declare or pay cash dividends on its Common Stock during the years ended December 31, 1999 or 1998. The Company does not currently plan to pay cash dividends on the Common Stock. Any future determination to pay cash dividends will depend on the Company's results of operations, financial condition, contractual restrictions and other factors deemed relevant by the Board of Directors. The Company intends to retain earnings to support the growth of the Company's business.
Under the terms of the Company's Cumulative Preferred Stock, the Company must pay all accrued dividends on outstanding Cumulative Preferred Stock prior to making any cash dividend payments on Common Stock. See Note 11 of the Notes to Consolidated Financial Statements. In addition, the Company's credit agreement with a group of banks permits the Company to pay dividends on the Common Stock only if certain financial and other tests are met. See "Item 7 - -Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Capital Resources."
ITEM 6
ITEM 6 SELECTED FINANCIAL DATA
The historical consolidated financial data presented below for the years ended December 31, 1999, 1998, 1997, 1996 and 1995 were derived from the audited consolidated financial statements of the Company, and should be read in conjunction therewith and with the information set forth under "Item 7
ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
The following general factors should be considered in analyzing the Company's results of operations:
COMPONENTS OF COST OF GOODS SOLD
A substantial portion of the Company's cost of goods sold reflects the cost of raw material, principally copper. These costs, which fluctuate with the markets for such raw material, are generally passed along to the Company's customers. Accordingly, the levels of the Company's net sales and costs of goods sold are affected by the rise and fall of copper prices, even in the absence of increases or decreases in business activity. Such increases or decreases cause variations in the Company's gross margin (gross profit as a percentage of net sales), but have little direct impact on the Company's levels of gross profit.
VARIABILITY OF WHOLESALE PRODUCT GROSS PROFIT
Gross profit attributable to sales of the Company's wholesale products has fluctuated and may continue to fluctuate substantially from period to period. In 1999, 1998, and 1997, gross profit from sales of these products was $12.2 million, $6.4 million and $2.8 million, respectively. Gross profit derived from the sale of wholesale products is mainly affected by changes in selling prices. Selling prices for these products are affected by general economic conditions (especially the rate of housing starts), industry competition and manufacturing capacity, industry production levels and other market factors, all of which are beyond the control of the Company.
IMPACT OF PRODUCT MIX
The Company's products range from higher value-added and higher margin commercial products to commodity-type products such as wholesale tube products and rod and bar products. The Company's overall profitability from period to period is affected by the mix in sales within these categories. The Company has substantial sales in Canada, and its product mix in that market, as compared to the United States market, reflects a much higher percentage of commodity type products, such as wholesale tube products and rod and bar products. The results of Canadian operations reflect both this different product mix and the impact of Canadian market and economic trends, which can be independent of United States trends.
CYCLICAL AND SEASONAL NATURE OF DEMAND
Because the Company primarily supplies component parts, the Company's operations are affected by changes in its customers' markets. Demand in certain industries to which the Company sells its products is cyclical. In particular, sales of plumbing tube and refrigeration service tube are affected by changes in residential construction rates. Demand in certain industries to which the Company sells, including the residential air conditioning industry, is also seasonal. Sales to the residential air conditioning market are generally greater in the first and second quarters of the year and lower in the third and fourth quarters because manufacturers
typically increase inventories in the early part of the year in anticipation of summer air conditioning sales and housing starts. In addition, sales of industrial tube are affected adversely in years with unusually cool summers.
RESULTS OF OPERATIONS
YEAR-ENDED DECEMBER 31, 1999, COMPARED WITH YEAR-ENDED DECEMBER 31, 1998
Consolidated net sales for the year ended December 31, 1999 were $645.8 million, an increase of 4.6% from net sales of $617.5 million in 1998. Pounds shipped increased by 8.3% in 1999 to 387.2 million from 357.5 million in 1998. Pounds shipped from the United States were 235.6 million in 1999, representing a 3.4% increase over 1998. Pounds shipped from Canada in 1999 were 151.6 million, a 16.9% increase over 1998. Net sales reflect a decrease in the price of copper, the Company's main raw material. The average COMEX copper price for 1999 was $0.72 per pound, compared with $0.75 per pound in 1998.
Shipments of commercial tube products increased 2.5% in 1999 over 1998, primarily as a result of increased shipments of industrial tube used in the residential air conditioning industry. The increase in shipments of industrial tube was offset somewhat by reduced shipments of technical tube products. Technical tube shipments have decreased over prior period levels as the Company experienced a significant, unexpected decline in demand for these products from major customers resulting from the decrease in the rate of replacement of large commercial air conditioning units using CFC refrigerants.
Shipments of the Company's wholesale products increased 8.1% as a result of increased participation by the Company in the United States market. Rod, bar and strip product shipments increased 30.5% as compared to a year ago due primarily to increased shipments of strip products to the Canadian mint during the first half of the year and to increased shipments of strip products from the newly formed Wolverine Ratcliffs, Inc. joint entity in the second half of 1999.
Consolidated gross profit decreased 19.3% in 1999 to $66.7 million from $82.7 million in 1998. In 1999, non-recurring charges of $14.4 million were recognized in cost of goods sold. These charges primarily consisted of $8.1 million relating to the liquidation of LIFO inventory values resulting from planned inventory reductions and $6.3 million of additional costs associated with the realignment of the Company's manufacturing operations and product rationalization. In 1998, non-recurring charges of $2.1 million were recognized in cost of goods sold. These charges primarily consisted of $1.4 million of costs associated with the closing of the Company's Greenville, Mississippi facility and $0.7 million of costs associated with efficiency initiatives implemented at the Company's Roxboro, North Carolina facility.
Excluding the effect of the non-recurring charges in both years, consolidated gross profit decreased 4.4% in 1999 to $81.1 million from $84.8 million in 1998. This decrease was primarily the result of decreased shipments of technical tube products, that are included in commercial products, which are generally the Company's highest margin products. To a lesser extent, higher costs associated with the slower than anticipated ramp-up of the Jackson, Tennessee facility affected gross profit. Increased shipments of wholesale products at higher average fabrication charges and rod, bar and strip products partially offset the reduction of gross profit resulting from the decreased shipments of technical tube. Gross profit from United States
operations decreased by 29.2% to $46.4 million from $65.5 million in 1998 due to the factors outlined above. Gross profit from Canadian operations increased by 18.0% to $20.3 million from $17.2 million in 1998, principally due to the factors outlined above.
Consolidated selling, general and administrative expenses for the year ended December 31, 1999 increased 17.1% to $30.8 million, compared with $26.3 million in 1998. This increase was primarily the result of depreciation and maintenance charges resulting from new information systems software, the increased costs due to the addition of Wolverine Ratcliffs, Inc., incremental depreciation on the Company's new research and development center and increased employee compensation expenses relating to performance incentives and relocation costs.
As a result of decreased gross profit, increased selling, general and administrative expenses, and restructuring and other charges recorded in 1999, as described in "Restructuring and Other Charges" section below, consolidated income from operations decreased by 64.0% to $16.0 million in 1999, from $44.5 million in 1998. United States income from operations decreased $31.4 million to a loss of $0.6 million in 1999 from income of $30.8 million in 1998, and Canadian income from operations increased by 21.2% to $16.6 million in 1999 from $13.7 million in 1998. Excluding the effect of the non-recurring and restructuring and other charges recorded in both years, income from operations was $50.3 million in 1999 and $58.5 million in 1998.
Consolidated net interest expense was $12.6 million in 1999 as compared to $6.6 million for the full year 1998. This increase was primarily the result of increased interest expense associated with the issuance of the Company's $150 million in principal amount of 7 3/8% Senior Notes due 2008 in August 1998 (the "Senior Notes") and a decrease in interest expense capitalized during the year.
For the year ended December 31, 1999, the Company recognized a tax benefit of $0.3 million resulting from the recognition of non-recurring charges in cost of goods sold and restructuring and other charges. Excluding the effect of the tax benefit and the associated non-recurring and restructuring and other charges recognized in both years, the effective tax rate would have been 35.3% in 1999 and 35.7% in 1998.
During the year ended December 31, 1999, the Company recognized a charge for the cumulative effect of a change in accounting principle of $8.0 million pre-tax ($5.8 million after tax). The Company adopted the American Institute of Certified Public Accountants Statement of Position 98-5, Reporting on the Costs of Start-Up Activities (the "Statement"). The implementation of the Statement required the Company to write-off the remaining start-up costs relating primarily to the Company's Roxboro, North Carolina, Jackson, Tennessee and Shanghai, China facilities.
Consolidated net loss in 1999 was $4.0 million, or $.32 loss per diluted share, compared to consolidated net income of $24.6 million or $1.72 per diluted share in 1998. Excluding the non-recurring charges included in cost of goods sold and restructuring and other charges recognized in both years, and the cumulative effect of an accounting change recognized in 1999, consolidated net income and diluted earnings per share for 1999 would have been $23.2 million and $1.73, respectively, compared to $33.5 million and $2.34, respectively, in the prior year period.
YEAR-ENDED DECEMBER 31, 1998, COMPARED WITH YEAR-ENDED DECEMBER 31, 1997
Consolidated net sales for the year ended December 31, 1998 were $617.5 million, a decrease of 7.5% from net sales of $667.7 million in 1997. Pounds shipped increased by 5.4% in 1998 to 357.5 million from 339.3 million in 1997. Pounds shipped from the United States were 227.8 million in 1998, representing a 1.5% increase over 1997. Pounds shipped from Canada in 1998 were 129.7 million, a 12.3% increase over 1997. Net sales reflect a decrease in the price of copper, the Company's main raw material. The average COMEX copper price for 1998 was $0.75 per pound, compared with $1.04 per pound in 1997.
Shipments of commercial tube products increased 4.1% in 1998 over 1997, primarily as a result of increased shipments of industrial tube used in the residential air conditioning industry. The increase in shipments of industrial tube was offset somewhat by reduced shipments of technical tube products. Technical tube shipments decreased over prior period levels as the Company experienced lower than anticipated demand for these products from major customers, especially those customers with significant international sales.
Shipments of the Company's wholesale products increased 4.5% as a result of increased participation by the Company in the United States market. Rod, bar and strip product shipments increased 11.8% as compared to a year ago, primarily as a result of increased shipments of strip products to the Canadian mint.
Consolidated gross profit increased 0.1% in 1998 to $82.7 million from $82.6 million in 1997. Gross profit from United States operations decreased by 5.9% to $65.5 million from $69.6 million in 1997 due to the factors outlined above. Gross profit from Canadian operations increased by 32.3% to $17.2 million from $13.0 million in 1997, principally due to the factors outlined above. Excluding the effect of the $2.1 million non-recurring charges included in cost of goods sold as previously described, consolidated gross profit was $84.8 million in 1998.
Consolidated selling, general and administrative expenses for the year ended December 31, 1998 increased 16.9% to $26.3 million, compared with $22.5 million in 1997. This increase was primarily the result of increased employee benefits, marketing expenses and professional fees.
As a result of increased selling, general and administrative expenses and restructuring and other charges recorded in 1998, as described in the "Restructuring and Other Charges" section below, consolidated income from operations decreased by 20.1% to $44.5 million in 1998, from $55.7 million in 1997. United States income from operations decreased by 31.7% to $30.8 million in 1998 from $45.1 million in 1997, and Canadian income from operations increased by 29.2% to $13.7 million in 1998 from $10.6 million in 1997. Excluding the effect of the non-recurring and restructuring and other charges recorded in both years, income from operations was $58.5 million in 1998 and $60.1 million in 1997.
Consolidated net interest expense decreased by 10.9% to $6.6 million in 1998 from $7.4 million in 1997. This decrease was primarily the result of reduced interest expense achieved through the Company's April 1997 refinancing and the related repayment of its 10 1/8% Senior Subordinated Notes due 2002 (the "10 1/8% Notes"), increased interest income from investing the remaining proceeds from the issuance of $150 million in principal amount of 7 3/8% Senior Notes due 2008
in August 1998 (the "Senior Notes") and increased capitalized interest associated with several capital projects in 1998. This decrease was partially offset by increased interest expense associated with the Company's Senior Notes. The Company incurred an extraordinary charge associated with the early extinguishment of the 10 1/8% Notes in 1997. The charge on the extinguishment, net of tax, was approximately $4.7 million ($7.5 million pre-tax).
The effective tax rate for the year ended December 31, 1998 was 35.2%, compared to 36.4% for the year ended December 31, 1997. The reduced effective tax rate in 1998 was the result of the Company recognizing a tax benefit associated with the restructuring and other charges in 1998. Excluding the effect of the tax benefit associated with the restructuring and other charges in 1998, the effective tax rate would have been 35.7% in 1998.
Consolidated net income in 1998 was $24.6 million, or $1.72 per diluted share, compared to $25.8 million or $1.80 per diluted share in 1997. Excluding the non-recurring charges included in cost of goods sold and restructuring and other charges recognized in 1998 and the restructuring and other charges and the extraordinary item recognized in 1997, consolidated net income and diluted earnings per share for 1998 would have been $33.5 million and $2.34, respectively, compared to $33.6 million and $2.34, respectively, in the prior year period.
RESTRUCTURING AND OTHER CHARGES
1999 RESTRUCTURING AND OTHER CHARGES
In 1999, the Company recognized restructuring and other charges of $19.9 million ($12.5 million net of tax). This charge included $10.0 million in expenses relating to the announced closing of the Company's Roxboro, North Carolina facility scheduled to take place in mid-2000, of which $8.6 million in expenses related to the write-down of impaired assets; $2.8 million in expenses related to the implementation of an indirect workforce reduction program of approximately 100 employees (further described below); $3.6 million in expenses related to impaired assets due to a product and plant rationalization plan; $1.9 million in expenses related to previously closed entities, of which $1.8 million related to the write-down of impaired assets; $0.8 million in expense related to the termination of an interest rate swap; and $0.8 million in professional fees and other costs, primarily associated with acquisitions that were not completed. To date, the Company has paid approximately $3.5 million in cash related to the restructuring. The Company believes the accrued restructuring costs of $1.6 million at December 31, 1999 represents its remaining cash obligations.
During the third quarter of 1999, the Company implemented an indirect workforce reduction program of approximately 100 employees. Each terminated employee's severance pay was, in general, calculated in accordance with a Severance Pay Plan (the "Severance Plan"), which provides benefits to all eligible employees who have at least one year of service and who are terminated for reasons other than cause. Severance benefits include payment of all accrued vacation and two weeks' pay at the employee's current base salary plus one week's pay for each full year of continuous service, less applicable taxes and withholding, not to exceed 26 weeks. At the end of the fourth quarter of 1999, the implementation of the indirect workforce reduction program was substantially complete. The Company expects to realize approximately $2.5 million in reduced salary and related expenses per year as a result of this workforce reduction.
Implementation of the workforce reduction program resulted in an approximate $2.8 million charge that was recognized in the third quarter of 1999. The primary components of this charge relating to the indirect workforce reduction program included approximately $2.1 million relating to severance and vacation pay and $0.7 million in increased post-retirement medical and life insurance benefits.
1998 RESTRUCTURING AND OTHER CHARGES
In 1998, the Company recognized restructuring and other charges of approximately $11.9 million ($7.5 million after tax). This charge included $7.4 million in expenses related to the closing of the Company's Greenville, Mississippi facility (further described below), of which $5.6 million in expenses related to the write-down of impaired assets resulting primarily from the closing of this facility; $2.7 million in expenses related to efficiency initiatives implemented at the Company's North Carolina facility; $0.9 million in expenses related to the implementation of a salaried workforce reduction program (further described below); and $0.9 million in professional fees and other costs primarily associated with an acquisition that was not completed.
During the third quarter of 1998, the Company implemented plans to close the Greenville, Mississippi fabricated products facility. The closing of this facility was completed in early November 1998, and the approximately 140 employees received severance pay in accordance with the Severance Plan and also received their regular pay for 60 days subsequent to the notice of closure. The Company expects to realize approximately $2.5 million in reduced salary and related expenses per year as a result of the closure of this facility. Implementation of the plan to close this facility resulted in an approximate $8.8 million charge, of which $7.4 million was included in restructuring and other charges and $1.4 million was included in cost of goods sold. Primary components of the charge relating to closing the Greenville facility included $5.6 million related to the write down of impaired fixed assets, $1.6 million primarily related to severance costs and $1.5 million primarily related to other asset write downs and operating inefficiencies resulting from the closure of this facility.
During the third quarter of 1998, the Company implemented a work force reduction program of approximately fifty salaried positions from various locations and departments, which was primarily aimed at reducing administrative costs. Each terminated employee's severance pay was, in general, calculated in accordance with the Severance Plan. The Company expects to realize approximately $2.0 million in reduced salary and related expenses per year as a result of this workforce reduction. Implementation of the workforce reduction program resulted in an approximate $0.9 million charge that was recognized in the third quarter of 1998. The primary components of the charge relating to the work force reduction program included approximately $0.8 million relating to severance and vacation pay and $0.1 million related to professional fees and miscellaneous expenses resulting from the workforce reductions.
1997 RESTRUCTURING AND OTHER CHARGES
In 1997, the Company recognized restructuring and other charges of $4.4 million ($3.0 million after tax). This charge included $1.8 million in expenses related to the implementation of the Company's 1997 Voluntary Early Retirement Program (further described below); $1.3 million in severance costs primarily associated with the departure of the Company's former Chief Executive Officer; $0.6 million in professional fees and other costs associated with an
acquisition that was not completed; and $0.7 million in costs for discontinuing the Poland operations of Small Tube Manufacturing Corporation (a wholly-owned subsidiary of the Company).
The Company adopted the 1997 Voluntary Early Retirement Program (the "Plan") in the first quarter of 1997. This Plan rewarded certain eligible employees who elected on a voluntary basis to take early retirement from the Company between March 26, 1997, and May 12, 1997. After the execution of a binding Voluntary Early Retirement Agreement and General Release by each eligible employee, the Company paid each such employee an early retirement payment and provided certain other consideration. The payment was an amount equal to four weeks' base pay plus one additional weeks' pay for each year of service, up to a maximum of twenty-six weeks total pay, less applicable taxes and withholdings required by law.
Twenty-six employees from various locations and departments throughout the Company elected to participate in the Plan. At the end of the second quarter of 1997, the implementation of the Plan was completed. The Company realized approximately $2.0 million in reduced salary and related expenses per year as a result of the Plan. Implementation of the Plan resulted in an approximate $1.8 million charge that was recognized in the second quarter of 1997. The primary components of the charge relating to the Plan included approximately $1.0 million relating to severance and vacation pay, $0.6 million in increased pension expense and $0.2 million for professional fees and miscellaneous expenses resulting from these early retirements.
LIQUIDITY AND CAPITAL RESOURCES
Net cash provided by operating activities is the Company's primary source of liquidity and totaled $18.6 million, $35.8 million and $46.7 million for the years ended December 31, 1999, 1998 and 1997, respectively. The decrease in net cash provided by operating activities in 1999 was primarily due to the decrease in net income exclusive of the cumulative effect of the accounting change.
The ratio of current assets to current liabilities was 3.2 in 1999 and 4.7 in 1998. The current ratio decreased in 1999 over 1998 due primarily to decreased cash and equivalents resulting from the net reduction of borrowings under the various credit facilities, a decrease in inventories and an increase in short-term borrowings.
The Company has a $200 million Revolving Credit Facility (the "Facility"), which matures on April 30, 2002. The Facility provides for a floating base interest rate that is, at the Company's election, either (a) the higher of the federal funds effective rate plus 0.50% and the prime rate or (b) LIBOR plus a specified margin (determined with reference to the Company's ratio of total debt to EBITDA and the Company's debt rating as determined by the Standard & Poor's and Moody's Rating Services) of 0.25% to 1.00%. Commitment fees on the unused available portion of the Facility range from 0.10% to 0.50%. As of December 31, 1999, the Company had approximately $30 million in outstanding borrowings and obligations under the Facility and approximately $170 million in additional borrowing availability thereunder.
Capital expenditures were $24.1 million in 1999, $34.7 million in 1998 and $21.6 million in 1997. The Company currently expects to spend approximately $35 to $40 million in 2000 under
its capital improvement program. The Company's 2000 capital improvement program includes asset replacement, environmental compliance and asset improvement items.
The Company believes that it will be able to satisfy its existing working capital needs, interest obligations, stock repurchases and capital expenditure requirements with cash flow from operations and funds available under the Facility.
SENIOR NOTES DUE 2008
In August 1998, the Company issued $150 million in principal amount of the Senior Notes. The Senior Notes were issued pursuant to an Indenture, dated as of August 4, 1998, between the Company and First Union National Bank, as Trustee. The net proceeds from the sale of the Senior Notes were applied to reduce borrowings by approximately $58 million under the Facility. Of the remaining net proceeds, the Company used the remainder for capital expenditures, working capital and other general corporate purposes. The Senior Notes (i) have interest payments dates on February 1 and August 1 of each year, which commenced February 1, 1999; (ii) are redeemable at the option of the Company at a redemption price equal to the greater of (a) 100% of the principal amount of the Senior Notes to be redeemed, or (b) the sum of the present value of the remaining scheduled payments of principal and interest thereon from the redemption date to the maturity date, discounted to the redemption date on a semiannual basis at the Treasury Rate plus 25 basis points, plus, in each case, accrued interest thereon to the date of redemption; (iii) are senior unsecured obligations of the Company and are pari passu in right of payment with any existing and future senior unsecured indebtedness of the Company, including borrowings under the Facility; (iv) are guaranteed by certain of the Company's subsidiaries; and (v) are subject to the terms of the Indenture, which contains certain covenants that limit the Company's ability to incur indebtedness secured by certain liens and to engage in sale/leaseback transactions.
MARKET RISKS
The Company is exposed to various market risks, including changes in interest rates, commodity prices and foreign currency rates. Market risk is the potential loss arising from adverse changes in market rates and prices. The Company does not enter into derivatives or other financial instruments for trading or speculative purposes. In the ordinary course of business, the Company enters into various types of transactions involving financial instruments to manage and reduce the impact to changes in interest rates, commodity prices and foreign exchange rates.
INTEREST RATE RISK
The fair market value of long-term fixed interest rate debt is subject to interest rate risk. Generally, the fair market value of fixed interest rate debt will increase as interest rates fall and decrease as interest rates rise. The estimated fair value of the Company's total long-term debt at December 31, 1999 was $131,636,000. A 1% increase from prevailing interest rates at December 31, 1999 would result in a decrease in fair value of total long-term debt by approximately $7,678,000. Conversely, interest rate changes generally do not affect the fair market value of variable rate debt but will impact future earnings and cash flows assuming all other factors are held constant. At December 31, 1999, the annual pretax earnings and cash flow
impact resulting from a one percentage point increase in interest rates would be approximately $400,000.
COMMODITY PRICE RISK
In connection with the purchase of certain raw materials, principally copper, on behalf of certain customers for future manufacturing requirements, the Company has entered into commodity forward contracts as deemed appropriate for these customers to reduce the Company's risk of future price increases. At December 31, 1999, the Company had entered into contracts hedging certain future commodity purchases through May 2001, of $32.6 million. The estimated fair value of these outstanding contracts was approximately $38.3 million at December 31, 1999. The effect of a 10% adverse change in commodity prices at December 31, 1999 would change the estimated fair value of these outstanding contracts to $34.5 million.
FOREIGN CURRENCY RISK
The Company sometimes uses foreign exchange contracts to reduce its exposure to foreign currency risk associated with purchasing contracts denominated in foreign currency. A forward foreign exchange contract obligates the Company to exchange predetermined amounts of specified foreign currencies at specified exchange rates on specified dates or to make an equivalent U.S. dollar payment equal to the value of such exchange. At December 31, 1999, the Company was not a party to any material contract relating to foreign currency forward agreements.
YEAR 2000 ISSUE UPDATE
In prior years the Company discussed the nature and progress of its plans to become Year 2000 ready. In late 1999, the Company completed its remediation and testing of systems. As a result of those planning and implementation efforts, the Company did not experience any significant issues or errors in its operating or business systems when the date changed from 1999 to 2000. Based on operations since January 1, 2000, the Company is not aware of any material problems resulting from Year 2000 issues, either with its products, its internal systems or the products and services of third parties.
The Company utilized both internal and external resources to reprogram, or replace, and test its software for Year 2000 modifications. The total cost of the Year 2000 project was estimated at $6.4 million and was funded through operating cash flows. Of the total project cost, approximately $6.2 million is attributable to the purchase of new software, which has been capitalized.
The Company will continue to monitor its mission-critical computer applications and those of its suppliers and vendors throughout the current year to ensure that any potential Year 2000 matters that may arise are addressed promptly.
ENVIRONMENTAL
The Company's facilities and operations are subject to extensive environmental laws and regulations. During the year ended December 31, 1999, the Company spent approximately $0.4
million on environmental matters, which include remediation costs, monitoring costs and legal and other costs. The Company has a reserve of $2.6 million for environmental remediation costs which is reflected in the Company's Consolidated Balance Sheet. The Company has approved and intends to spend $1.0 million for capital expenditures relating to environmental matters during 2000. Based upon information currently available, the Company believes that the costs of the environmental matters described below are not reasonably likely to have a material adverse effect on the Company's business, financial condition or results of operations.
OKLAHOMA CITY, OKLAHOMA
The Company is one of a number of Potentially Responsible Parties ("PRPs") named by the United States Environmental Protection Agency (the "EPA") with respect to the soil and groundwater contamination at the Double Eagle Refinery Superfund site in Oklahoma City, Oklahoma. The costs associated with the cleanup of this site will be entirely borne by the PRP group (the "Group"), as the site owner has filed for bankruptcy protection. In March 1993, twenty-three PRPs named with respect to the soil contamination of the site, including the Company, submitted a settlement offer to the EPA. Settlement negotiations between the Group and the EPA are continuing, and a settlement and consent order is currently being contemplated among the PRPs, the EPA and the State of Oklahoma which would provide for each PRPs liability to be limited to a prorata share of an aggregate amount based on the EPA's worst-case cost scenario to remediate the site. Under the current proposal the Company's settlement amount is estimated to be $390,000.
DECATUR, ALABAMA
In 1999, the Company negotiated a new Consent Order under Section 3008(h) of the Resource Conservation and Recovery Act. The new Order incorporated the Corrective Measures Study ("CMS") that Henley (a former owner of the facility) had submitted to the EPA regarding a waste burial site at the Decatur, Alabama facility. The order also included an upgrade to an existing chrome groundwater remediation system. The CMS proposes current monitoring and site maintenance. The remaining monitoring, legal, and other costs associated with the ground water remediation project are estimated to be $861,000. The cost to the Company to comply with the CMS, as currently approved, will not have an adverse effect on the Company's business, financial condition or results of operations.
ARDMORE, TENNESSEE
On December 28, 1995, the Company entered into a Consent Order and Agreement with the Tennessee Division of Superfund (the "Tennessee Division"), relating to the Ardmore, Tennessee facility (the "Ardmore facility"), under which the Company agreed to conduct a preliminary investigation regarding whether volatile organics detected in and near the municipal drinking water supply are related to the Ardmore facility and, if necessary, to undertake an appropriate response. That investigation has disclosed contamination, including elevated concentrations of certain volatile organic compounds, in soils of certain areas of the Ardmore facility and also has disclosed elevated levels of certain volatile organic compounds in the shallow residuum groundwater zone at the Ardmore facility. Under the terms of the Consent Order and Agreement, the Company submitted a Remedial Investigation and Feasibility Study ("RI/FS") work plan, which was accepted by the Tennessee Division, and the Company has
initiated the RI/FS. Based on the available information, the Company preliminarily estimates that it will cost between $319,000 and $1,174,000 to complete the investigation and remediation of this site.
A report of a 1995 EPA site inspection of the Ardmore facility recommended further action for the site. The Company believes, however, that because the Tennessee Division is actively supervising an ongoing investigation of the Ardmore facility, it is unlikely that the EPA will intervene and take additional action. If the EPA should intervene, however, the Company could incur additional costs for any further investigation or remedial action required.
GREENVILLE, MISSISSIPPI
Following the Company's acquisition of its Greenville, Mississippi facility (the "Greenville facility"), a preliminary investigation disclosed volatile organic contaminants in soil and groundwater at the site. Based on further investigation, it appears that the contamination has not spread off-site. The Company entered into a Consent Order with the Mississippi Department of Environmental Quality ("MDEQ") for a pilot study program which determined the effectiveness of technology identified for remediation and which will also help define the scope of remediation for the site. The pilot study program concluded on June 1, 1997. The Company entered into a final consent agreement with MDEQ on July 15, 1997. Remediation efforts began in the third quarter of 1997 and are expected to take approximately three years. The Company recently submitted a report of remediation activities requesting that the MDEQ allow it to cease and desist such remediation. However, there can be no assurance that remediation efforts will be allowed to be discontinued, and operations, maintenance and other expenses of the remediation system may continue for a longer period of time. Through October 3, 1998, applicable costs of testing and remediation required at the Greenville facility had been shared with the former owners of the Greenville facility pursuant to the terms of an Escrow Agreement established at the time the facility was acquired. Subsequent to October 3, 1998, the Company released the former owners of the facility from liability related to the remediation of the Greenville facility following the receipt of a $145,000 settlement payment. The Company estimates the remaining investigative and remedial costs could total $290,000 under the remediation plan the Company adopted, but these costs could increase if additional remediation is required.
In December 1999, the Company applied for admission into the Mississippi Land Recycling Program. It is anticipated that the Land Recycling Program will allow more latitude in remediation decision-making and property transfers.
JACKSON, TENNESSEE
In connection with the Company's acquisition of its Jackson, Tennessee facility (the "Jackson facility"), a preliminary investigation disclosed soil and/or groundwater contamination at this site. The Company had performed a Phase I Environmental Audit and identified the existence of volatile organic contaminants; however, the extent of any such contamination has not been fully determined. Investigation at the site is being conducted pursuant to a Consent Order with the State of Tennessee by a prior owner of the property. Based upon currently available information, the Company preliminarily estimates that remediation costs could total $730,000. However, certain of the remediation costs may be reimbursed pursuant to the terms of an indemnification agreement between the Company and the previous owners of the Jackson Facility.
ALTOONA, PENNSYLVANIA
The Company has entered into the State of Pennsylvania Department of Environmental Protection Act II Program (the "Program"). The Program was entered to address issues of contamination from closed hazardous waste lagoons and possible oil contamination of soil. The hazardous waste lagoons were closed in 1982. The Program is a voluntary site remediation program, which allows the Company to direct the site evaluation and any eventual remediation. Preliminary costs are estimated at $198,000 to complete the investigation phase of the Program. Once the investigation phase is completed, a decision on remediation (if any) will be made. Insufficient information exists at this point to estimate any remediation costs or if remediation will be required. The Company is fully indemnified by the previous owner for any costs associated with the Program, thus no liability has been recorded as of December 31, 1999.
OTHER
The Company has been named as a party in a Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) lawsuit by Southdown Environmental Services ("Southdown") and Allworth, Inc. ("Allworth"). The Company is named with approximately 200 other companies (the "Group") in the suit. The Company, along with the other members of the Group, contracted with Allworth, and subsequently Southdown, for treatment, storage and disposal of hazardous wastes between 1978 and 1995. The suit seeks compensation from the Group for costs related to environmental cleanup incurred by Southdown, and potentially Allworth, at the site in Birmingham, Alabama. The site is presently owned by Philips Services Corporation ("Philips"). To date, the Company has only incurred legal fees associated with this matter. Negotiations have been ongoing, unsuccessfully, between Philips, Southdown and Allworth to reach a settlement. The Company's potential share of liability, if any, is unknown at this point.
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement No. 133 Accounting for Derivative Instruments and Hedging Activities. In 1999, the FASB delayed the effective date of Statement No. 133 until years beginning after June 15, 2000. The Company expects to adopt Statement No. 133 effective January 1, 2001. Statement No. 133 will require the Company to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through income. If a derivative is a hedge, depending on the nature of the hedge, changes in the fair value of the derivative will either be offset against the change in fair value of the hedged asset, liability or firm commitment through earnings, or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative's change in fair value will be immediately recognized in earnings. The Company has not yet completed its analysis of the impact that Statement No. 133 will have on its financial statements.
ITEM 7A
ITEM 7A QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
The information required by this item is contained in "Item 7 - -Management's Discussion and Analysis of Financial Condition and Results of Operations."
ITEM 8
ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
ITEM 9
ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
No changes in or disagreements with accountants on accounting and financial disclosure matters existed during the most recent two years.
PART III
ITEM 10
ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item with respect to directors is incorporated by reference from the information under the caption "Election of Directors" contained in the Company's definitive proxy statement for the 2000 Annual Meeting of Stockholders. The required information concerning executive officers of the Company is contained in Part I of this report.
ITEM 11
ITEM 11 EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference from the information under the caption "Executive Compensation" in the Company's definitive proxy statement for the 2000 Annual Meeting of Stockholders.
ITEM 12
ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is incorporated by reference from the information under the caption "Stock Ownership of Management and Certain Beneficial Owners" in the Company's definitive proxy statement for the 2000 Annual Meeting of Stockholders.
ITEM 13
ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated by reference from the information contained under the caption "Certain Transactions" in the Company's definitive proxy statement for the 2000 Annual Meeting of Stockholders.
PART IV
ITEM 14
ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Index to exhibits, financial statements and schedules.
(1) The following consolidated financial statements for the Company and Report of Independent Auditors are included beginning on page hereof:
Consolidated Statements of Operations--For the years ended December 31, 1999, 1998, and 1997.
Consolidated Balance Sheets--December 31, 1999 and 1998.
Consolidated Statements of Stockholders' Equity--For the years ended December 31, 1999, 1998, and 1997.
Consolidated Statements of Cash Flows--For the years ended December 31, 1999, 1998, and 1997.
Notes to Consolidated Financial Statements.
Report of Ernst & Young LLP, Independent Auditors.
(2) The following consolidated financial statement schedule of the Company is included on page S-1 hereof:
SCHEDULE II Valuation and Qualifying Accounts
(3) Exhibits required by Item 601 of Regulation S-K:
The following exhibits are included in this Form 10-K:
The following exhibits are incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended July 3, 1999:
The following exhibits are incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended April 3, 1999:
The following exhibits are incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1998:
The following exhibits are incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended July 4, 1998:
The following exhibits are incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended April 4, 1998:
The following exhibit is incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 27, 1997:
The following exhibits are incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended March 29, 1997:
The following exhibits are incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1996:
The following exhibit is incorporated by reference to the Company's Registration Statement on Form 8-A, filed on February 22, 1996:
The following exhibit is incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1995:
The following exhibits are incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1994:
The following exhibit is incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended October 1, 1994:
The following exhibit is incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended July 2, 1994:
The following exhibits are incorporated by reference to the Company's Registration Statement on Form S-1 (File No. 33-65148):
* Identifies each exhibit that is a "management contract or compensatory plan or arrangement" required to be included as an exhibit to this Form 10-K pursuant to Item 14(c) of Form 10-K.
(b) Reports on Form 8-K.
The Company filed no reports on Form 8-K during the three month period ended December 31, 1999.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Huntsville, State of Alabama, on the 29th day of March, 2000.
WOLVERINE TUBE, INC.
By: /s/ James E. Deason ----------------------------------------- Name: James E. Deason Title: Executive Vice President, Chief Financial Officer, Secretary and Director
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities and on the dates indicated.
WOLVERINE TUBE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes.
WOLVERINE TUBE, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
See accompanying notes.
WOLVERINE TUBE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
See accompanying notes.
WOLVERINE TUBE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes.
WOLVERINE TUBE, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION AND BUSINESS
The accompanying consolidated financial statements include the accounts of Wolverine Tube, Inc. (the "Company") and its majority-owned subsidiaries after elimination of significant intercompany accounts and transactions.
The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make certain estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
The Company is engaged in the manufacturing and distribution of copper and copper alloy tubular products as well as rod, bar and strip products. The Company's focus is developing and manufacturing high value added products used in engineered applications which require tubular products that have superior heat transfer capability. The Company's major customers are primarily located in North America and include commercial and residential air conditioning and refrigeration equipment manufacturers, appliance manufacturers, automotive manufacturers, industrial equipment manufacturers, utilities and other power generating companies, refining and chemical processing companies and plumbing wholesalers.
REVENUE RECOGNITION POLICY
The Company records sales when products are shipped to customers or title passes. Sales are made under normal terms and generally do not require collateral.
CASH AND EQUIVALENTS
The Company considers all highly liquid financial instruments with a maturity of three months or less at the time of purchase to be cash equivalents.
INVENTORIES
Inventories are stated at the lower of cost or market. Approximately 60% and 64% of the total consolidated inventories at December 31, 1999 and 1998 are stated on the basis of last-in, first-out (LIFO) method. The remaining inventories, which primarily include supplies, are valued using the average cost method.
PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment is stated at cost. Depreciation is provided using the straight-line method over the following periods:
IMPAIRMENT OF LONG-LIVED ASSETS
Impairment losses are recorded on long-lived assets used in operations where indicators of impairment are present and the undiscounted cash flows estimated to be generated by these assets are less than their carrying amount.
INCOME TAXES
Deferred income taxes are provided for the temporary differences between the financial reporting basis and the tax basis of the Company's assets and liabilities. Property, plant and equipment, inventories, prepaid pension, postretirement benefit obligations and certain other accrued liabilities are the primary sources of these temporary differences.
DEFERRED CHARGES AND INTANGIBLE ASSETS
Debt issuance costs are deferred and amortized over the term of the debt to which they relate using the interest method. Intangible assets consist of patents and goodwill. Patents are amortized on the straight-line method over their estimated lives. Excess cost over the fair value of net assets acquired (or enterprise level goodwill) generally is amortized on a straight-line basis over 40 years. The carrying value of enterprise level goodwill is reviewed if the facts and circumstances suggest that it may be impaired. Negative operating results, negative cash flows from operations, among other factors, could be indicative of the impairment of enterprise level goodwill. The Company assesses the recoverability of enterprise level goodwill by determining whether the unamortized goodwill balance can be recovered through undiscounted future results of operations. The amount of enterprise level goodwill impairment, if any, is measured based on projected discounted future cash flows using a discount rate reflecting the Company's average cost of funds. To date, the Company has made no adjustments to the carrying value of its enterprise level goodwill.
EARNINGS PER COMMON SHARE
Basic net income per share is based on the weighted average number of common shares outstanding and net income reduced by preferred dividends. Diluted net income per share is based on the weighted average number of common shares outstanding plus the effect of dilutive employee stock options and net income reduced by preferred dividends.
FAIR VALUES OF FINANCIAL INSTRUMENTS
The following methods are used by the Company in estimating fair value disclosures for financial instruments:
Cash and equivalents: The carrying amount reported in the consolidated balance sheets for cash and equivalents approximates its fair value.
Financing arrangement, long-term debt and redeemable cumulative preferred stock: The carrying amount of the Company's borrowings under its financing arrangement approximates its fair value. The fair value of the Company's long-term debt and derivative financial instruments are based upon quoted market prices. The fair value of the Company's redeemable cumulative preferred stock is based upon its dividend rate and call provisions. The fair value of the Company's long-term debt and redeemable cumulative preferred stock was $131,636,000 and $2,156,000, respectively, at December 31, 1999 and $143,880,000 and $2,215,000, respectively, at December 31, 1998.
ENVIRONMENTAL EXPENDITURES
Environmental expenditures that pertain to current operations and relate to future revenues are expensed or capitalized consistent with the Company's capitalization policy. Expenditures that result from the remediation of an existing condition caused by past operations, that do not contribute to future revenues, are expensed. Liabilities are recognized for remedial activities when the cleanup is probable and the cost can be reasonably estimated.
INTEREST RATE SWAPS
From time to time the Company enters into interest rate swap agreements to modify the interest characteristics of its outstanding debt. Each interest rate swap agreement is designated as a hedge with the principal balance and term of a specific debt obligation. These agreements involve the exchange of amounts based on a fixed interest rate for amounts based on variable interest rates over the life of the agreement, without an exchange of the notional amount on which the payments are based. The differential to be paid as interest rates change is accrued and recognized as an adjustment of interest expense related to debt (the accrual accounting method). The fair value of the swap agreements and changes in the fair value as a result of changes in market interest rates are not recognized in the financial statements.
Gains and losses on terminations of interest rate swap agreements are deferred as an adjustment to the carrying amount of the outstanding debt and amortized as an adjustment to interest expense related to the debt over the remaining term of the original contract life of the terminated swap agreement. In the event of the early extinguishment of a designated debt obligation, any realized or unrealized gain or loss from the swap would be recognized in income coincident with the extinguishment gain or loss. The Company mitigates the risk that counter parties to these over-the-counter agreements will fail to perform by only entering into agreements with major international financial institutions.
At December 31, 1999, the Company was not a party to any interest rate swap agreements.
DERIVATIVE COMMODITY INSTRUMENTS
In connection with the purchase of certain raw materials, principally copper, on behalf of certain customers for future manufacturing requirements, the Company has entered into commodity forward contracts as deemed appropriate for these customers to reduce the Company's risk of future price increases. These forward contracts are accounted for as hedges and, accordingly, gains and losses are deferred and recognized in cost of goods sold as part of the product cost. The Company is exposed to loss on the forward contracts in the event of non-performance by the customers whose orders are covered by such contracts. However, the Company has not closed any contracts prior to the execution of the underlying sale transactions nor have any of the underlying sale transactions failed to occur.
At December 31, 1999, the Company had entered into contracts hedging certain future commodity purchases through May 2001, of approximately $32.6 million. The estimated fair value of these outstanding contracts was approximately $38.3 million at December 31, 1999.
FOREIGN CURRENCY FORWARDS
The Company sometimes uses foreign exchange contracts to reduce its exposure to foreign currency risk associated with purchasing contracts denominated in foreign currency. A forward foreign exchange contract obligates the Company to exchange predetermined amounts of specified foreign currencies at specified exchange rates on specified dates or to make an equivalent U.S. dollar payment equal to the value of such exchange.
These contracts are designated and effective as hedges and discounts or premiums (the difference between the spot exchange rate and the forward exchange rate at inception of the contract) are accreted or amortized to other operating expenses over the contract lives using the straight-line method while realized and unrealized gains and losses resulting from changes in the spot exchange rate (including those from open, matured, and terminated contracts), net of related taxes, are included in the cumulative translation adjustment account in stockholders' equity (the deferral accounting method). The Company mitigates the risk that counter parties to these over-the-counter agreements will fail to perform by only entering into agreements with major international financial institutions.
At December 31, 1999, the Company was not a party to any material contract relating to foreign currency forward agreements.
STOCK OPTIONS
Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, encourages but does not require companies to record compensation costs for stock-based employee compensation plans at fair value. The Company has chosen to continue to account for stock-based compensation using the method prescribed in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. The Company grants stock options for a fixed number of shares to employees with an exercise price equal to the fair value of the shares at the date of grant. Accordingly, the Company recognizes no compensation for stock option grants.
TRANSLATION TO U.S. DOLLARS
Assets and liabilities of the Company denominated in foreign currency are translated to U.S. dollars at rates of exchange at the balance sheet date. Income statement items are translated at average exchange rates during the period. Translation adjustments arising from changes in exchange rates are included in the accumulated other comprehensive income component of stockholders' equity. Realized exchange gains and losses are included in "Amortization and other, net" in the consolidated statements of operations. Net exchange (gains) losses totaled $666,000 in 1999, ($875,000) in 1998 and ($425,000) in 1997.
RESEARCH AND DEVELOPMENT COSTS
Expenditures relating to the development of new products and processes, including significant improvements and refinements to existing products, are expensed as incurred. The amounts charged to expense were $3.0 million in 1999, $1.5 million in 1998 and $1.4 million in 1997.
RECLASSIFICATIONS
Certain reclassifications have been made to the previously reported consolidated statements of operations for the years ended December 31, 1998 and 1997 and consolidated balance sheet as of December 31, 1998 to provide comparability with the current year presentation.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement No. 133 Accounting for Derivative Instruments and Hedging Activities. In 1999, the FASB delayed the effective date of Statement No. 133 until years beginning after June 15, 2000. The Company
expects to adopt Statement No. 133 effective January 1, 2001. Statement No. 133 will require the Company to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through income. If a derivative is a hedge, depending on the nature of the hedge, changes in the fair value of the derivative will either be offset against the change in fair value of the hedged asset, liability or firm commitment through earnings, or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative's change in fair value will be immediately recognized in earnings. The Company has not yet completed its analysis of the impact that Statement No. 133 will have on its financial statements.
2. INVENTORIES
Inventories are as follows at December 31:
The reserves for LIFO included in inventories at December 31, 1999 and 1998 are $8,445,000 and $18,996,000, respectively. During the third quarter of 1999, liquidation of certain LIFO layers increased cost of goods sold by $8.1 million, pre-tax.
3. ASSETS HELD FOR RESALE
Assets held for sale at December 31, 1998 included the net assets of the unoccupied Greenville, Mississippi and Carrollton, Texas facilites recorded at $0.7 million and $2.3 million, respectively. The remaining net book value of the Greenville, Mississippi facility was written off and included in the third quarter 1999 restructuring and other charges as discussed in Note 17. In July 1999, the Carrollton, Texas facility was sold for approximately $2.3 million.
4. PROPERTY PLANT AND EQUIPMENT
Property, plant and equipment are as follows at December 31:
During the implementation of the Company's new information systems, the Company reviewed the estimated useful lives of its property, plant and equipment. This evaluation revealed that certain equipment was being depreciated over periods of time which were shorter than their respective useful lives. Accordingly, effective January 1, 1999, a change in estimate was made
to the estimated useful lives of certain equipment, which resulted in an increase of approximately $1,444,000 in net income for the year ended December 31, 1999.
5. DEFERRED CHARGES AND INTANGIBLE ASSETS
Deferred charges and intangible assets are as follows at December 31:
In July 1999, the Company combined the assets of its Fergus, Ontario facility with certain of the assets of Ratcliffs Severn Ltd. to create the newly-formed joint entity of Wolverine Ratcliffs, Inc. ("WRI"). This transaction was accounted for using the purchase method. The purchase price was approximately $7.8 million, resulting in approximately $5.8 million of goodwill. The goodwill is being amortized over 40 years. The accounts and results of operations of WRI have been combined with those of the Company since the date of the acquisition.
6. FINANCING ARRANGEMENTS AND DEBT
In June 1998, the Company amended certain provisions of the Company's $200 million Revolving Credit Facility (the "Facility"), which included: (i) increasing the amount of unsecured indebtedness that the Company may incur while borrowings under the Facility are outstanding; (ii) waiving the requirement that the proceeds of an offering of senior notes must be used to repay all the outstanding borrowings under the Facility; and (iii) raising the ratio of total debt to EBITDA permitted while borrowings are outstanding under the Facility. The Facility, as amended, matures on April 30, 2002, and currently provides for a floating base interest rate that is, at the Company's election, either (a) the higher of the federal funds effective rate plus .50% and the prime rate; or (b) LIBOR plus a specified margin (determined with reference to the Company's ratio of total debt to EBITDA and the Company's debt rating as determined by the Standard & Poor's and Moody's Rating Services) of 0.25% to 1.00%. Commitment fees on the unused available portion of the Facility range from .10% to .50%. As of December 31, 1999, the Company had approximately $30 million in outstanding borrowings and obligations under the Facility and approximately $170 million in additional borrowing availability thereunder.
The Company originally entered into the Facility in April 1997 to replace the Company's then existing credit facility, as well as a tender offer for the $99 million in outstanding principal amount of the Company's 10 1/8% Senior Subordinated Notes due 2002 (the "10 1/8% Notes"). Upon consummation of the refinancing on April 30, 1997, the Company borrowed approximately $107 million under the Facility, substantially all of which was used to finance the purchase of the $98,225,000 in 10 1/8% Notes that were tendered as well as related financing expenses. Accordingly, the Company recorded an extraordinary after-tax charge of $4,738,000 ($7,520,000 pre-tax) resulting from the early retirement of the 10 1/8% Notes. On October 31, 1997, the balance of $775,000 in aggregate principal amount of the 10 1/8% Notes that had
remained outstanding was called for redemption by the Company at 103.8%, pursuant to the terms of the 10 1/8% Notes.
During 1998 and 1999, the Company was party to an interest rate swap agreement which effectively fixed the interest rate on $65,000,000 in principal amount of floating rate borrowings provided under the Facility at a rate of 6.82% plus the specified margin of .25% to 1.00%. This agreement was to expire on May 7, 2002, and was based on the three-month LIBOR. This interest rate swap was accounted for as a hedge; the differential to be paid as interest rates changes were accrued and recognized as an adjustment to interest expense. In September 1999, the Company entered into a cancellation agreement that terminated the interest rate swap. The resulting loss on termination, $810,000, was included in restructuring and other charges as stated in Note 16.
In August 1998, the Company issued $150 million in principal amount of 7 3/8% Senior Notes (the "Senior Notes") due August 1, 2008. The Senior Notes were issued pursuant to an Indenture, dated as of August 4, 1998, between the Company and First Union National Bank, as Trustee. The net proceeds from the sale of the Senior Notes were applied to reduce borrowings under the Facility by approximately $58 million. The remaining net proceeds were used for capital expenditures, working capital and other general corporate purposes. The Senior Notes (i) have interest payment dates of February 1 and August 1 of each year, commencing February 1, 1999; (ii) are redeemable at the option of the Company at a redemption price equal to the greater of (a) 100% of the principal amount of the Senior Notes to be redeemed, or (b) the sum of the present value of the remaining scheduled payments of principal and interest thereon from the redemption date to the maturity date, discounted to the redemption date on a semiannual basis at a rate based upon the yield of the specified treasury securities plus 25 basis points, plus, in each case, accrued interest thereon to the date of redemption; (iii) are senior unsecured obligations of the Company and are pari passu in right of payment with any existing and future senior unsecured indebtedness of the Company, including borrowings under the Facility; (iv) are guaranteed by certain of the Company's subsidiaries; and (v) are subject to the terms of the Indenture, which contain certain covenants that limit the Company's ability to incur indebtedness secured by certain liens and to engage in sale/leaseback transactions.
The Company has entered into two credit facilities with a Chinese bank providing for an aggregate available credit facility of up to $3.7 million. These facilities are payable upon demand and bear interest at the bank's prime rate. At December 31, 1999, the Company had outstanding borrowings of $3.0 million under these facilities.
In July 1999, WRI entered into a credit agreement with a Canadian bank providing for an aggregate available credit facility of up to Canadian $15 million (approximately U.S. $10 million) (the "Canadian Facility"). The Canadian Facility is payable upon demand and bears interest at the bank's prime rate. The Canadian Facility is secured by certain of WRI's assets. At December 31, 1999, WRI had outstanding borrowings of approximately Canadian $13.8 million (approximately U.S. $9.6 million).
The Company has a non-interest bearing loan agreement with the government of Canada. As of December 31, 1999 and 1998, the Company had outstanding advances of $693,000 and $980,000 respectively. The loan is being repaid in four annual installments which commenced in 1998.
The weighted average interest rate for short-term borrowings outstanding at December 31, 1999 was 7.1%.
The Company's credit agreements contain covenants that include requirements to maintain certain financial ratios and certain other restrictions and limitations, including the restrictions on payment of dividends by the Company, limitations on the issuance of additional debt, limitations on investments and contingent obligations, the redemption of capital stock and the sale or transfer of assets.
Interest expense is net of interest income and capitalized interest of $2,992,000 and $378,000 in 1999, $2,792,000 and $1,816,000 in 1998, and $383,000 and $381,000 in 1997, respectively.
7. RETIREMENT AND PENSION PLANS
U.S. PLANS
The Company has established trusteed, noncontributory defined benefit pension plans covering the majority of all U.S. employees fulfilling minimum age and service requirements. Benefits are based upon years of service with the Company and a prescribed formula based upon the employee's compensation. The Company contributes annual amounts that fall within the range determined to be deductible for federal income tax purposes.
Certain assumptions utilized in accounting for the U.S. defined benefit plans for the years ended December 31 are as follows:
The effect of the change in the assumed discount rate and the expected return on plan assets for the year ended December 31, 1999 resulted in an increase to the unrecognized net actuarial gain at December 31, 1999.
A summary of the components of net periodic pension cost for the U.S. defined benefit plans for the years ended December 31 is as follows:
The following table sets forth a reconciliation of the benefit obligation for the years ended December 31:
The following table sets forth a reconciliation of the plan assets for the years ended December 31:
The following table sets forth the funded status of the plan and the amounts recognized in the Company's consolidated balance sheets at December 31:
The Company has 401(k) plans covering substantially all U.S. employees. The Company provides a 40%-75% match for up to the first 5% to 7.5% of the employee's salary contributed to the plans. The amount of expense recorded by the Company with respect to these plans was $1,909,000 in 1999, $1,928,000 in 1998, and $1,317,000 in 1997.
The Wolverine Tube, Inc. Supplemental Benefit Restoration Plan (the "Restoration Plan") is a defined benefit pension plan, which is non-funded and provides benefits to certain eligible executives of the Company. The benefits provided under the Restoration Plan are identical to the benefits provided by the defined benefit pension plan. In addition, the Company provides a Supplemental Retirement Plan ("SERP") for the current CEO, which is non-funded. The benefits provided under this SERP are based upon years of service and compensation. Benefits become fully vested upon completion of six years of service from the date of employment or a change of control for the Company or dismissal without cause. The amount of expense incurred by the Company with respect to all supplemental plans was $215,000 in 1999, $123,000 in 1998 and $261,000 in 1997. At December 31, 1999, the balance of accrued pension costs related to these plans was $865,000.
CANADIAN PLANS
The Company sponsors a defined contribution profit-sharing retirement plan for the London, Ontario facility employees who are required to contribute 4% of regular wages, subject to a maximum contribution limit specified by Canadian income tax regulations. Employer contributions are determined based on the facility's operating results, which will not be less than the greater of 1% of regular earnings of participants up to 10% of an adjusted net income as defined in the agreement. Employer contributions to this plan were $669,000 in 1999, $585,000 in 1998, and $630,000 in 1997.
The Company has established noncontributory defined benefit pension plans covering substantially all employees at the Montreal, Quebec and Fergus, Ontario facilities. The Company contributes the actuarially determined amounts annually into the plans. Benefits for the hourly employees at the Montreal, Quebec and Fergus, Ontario facilities are based on years of service and a negotiated rate. Benefits for salaried employees are based on years of service and the employee's highest annual average compensation over five consecutive years.
Certain assumptions utilized in accounting for the Salaried Employees, Canadian Operational Employees and Quebec Operational Employees pension plans for the years ended December 31 are as follows:
The expected rate of increase in compensation used in accounting for the Salaried Employees' pension plan was 3.0% for the years ended December 31, 1999, 1998 and 1997, and is not applicable in accounting for the Canadian Operational Employees and Quebec Operational Employees pension plans for the same periods. The effect of the change in the assumed discount rate and the expected return on plan assets for the year ended December 31, 1999 resulted in an increase to the unrecognized net actuarial gain at December 31, 1999.
A summary of the components of net periodic pension cost for the Salaried Employees, Canadian Operational Employees and Quebec Operational Employees pension plans for the years ended December 31 are as follows:
The following table sets forth a reconciliation of the benefit obligation for the years ended December 31:
The following table sets forth a reconciliation of the plans assets for the years ended December 31:
The following table sets forth the funded status of the plans and the amounts recognized in the Company's consolidated balance sheets at December 31:
8. POSTRETIREMENT BENEFIT OBLIGATION
In addition to the Company's U.S. defined benefit pension plan, the Company sponsors a defined benefit health care plan and life insurance plan that provides postretirement medical benefits and life insurance to substantially all full-time U.S. employees who have worked ten years after age 50 to 52, and widows of employees who die while employed after age 55 and have at least five years of service with the Company. This plan is contributory, with retiree contributions being adjusted annually.
Net periodic postretirement benefit cost for the years ended December 31 includes the following components:
The change in benefit obligation for the years ended December 31 includes the following components:
The following table sets forth the funded status of the plan and the amounts recognized in the Company's consolidated balance sheets at December 31:
The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.75% and 7.00% at December 31, 1999 and 1998, respectively.
For purposes of determining the cost and obligation for postretirement medical benefits, a 5% annual rate of increase in the per capita cost of covered benefits (i.e. health care trend rate) was assumed for 1999 and is assumed to remain at that level thereafter. Assumed health care cost trend rates have a significant effect on the amounts reported for health care plans. A one percentage point change in the assumed health care cost trend rate would have had the following effects:
9. ENVIRONMENTAL REMEDIATION
The Company is subject to extensive U.S. and Canadian federal, state, provincial and local environmental laws and regulations. These laws, which are constantly changing, regulate the discharge of materials into the environment. The Company has received various communications from regulatory authorities concerning certain environmental matters and has currently been named as a potentially responsible party ("PRP") at one waste disposal site. The Company believes that its potential liability with respect to this waste disposal site is not material.
The Company had accrued estimated environmental remediation costs of $2,590,000 at December 31, 1999, consisting primarily of $861,000 for the Decatur facility, $290,000 for the Greenville facility, $730,000 for the Jackson facility, $319,000 for the Ardmore facility and $390,000 for the Shawnee facility (with respect to the Double Eagle Refinery site). Based on information currently available, the Company believes that the costs of these matters are not
reasonably likely to have a material effect on the Company's business, financial condition or results of operations.
10. INCOME TAXES
The components of income before income taxes, extraordinary item and cumulative effect of accounting change for the years ended December 31 are as follows:
The provision for income taxes on income before extraordinary item and the cumulative effect of accounting change for the years ended December 31 consists of the following:
Deferred income taxes included in the Company's balance sheet reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the carrying amount for income tax return purposes. Significant components of the Company's deferred tax assets and liabilities are as follows:
Reconciliation of differences between the statutory U.S. federal income tax rate and the Company's effective tax rate follows:
11. CUMULATIVE PREFERRED STOCK
The Company has 500,000 shares authorized for issuance of $1 par value cumulative preferred stock. Of these shares, there are currently 20,000 shares of cumulative preferred stock issued and outstanding which must be redeemed by the Company on March 1, 2002, if not earlier, for $100 per share plus accrued and unpaid dividends. The cumulative preferred stock provides for annual dividends at the rate of $14 per share. The dividends accrue quarterly whether declared or not, and compound quarterly at 14% per annum to the extent unpaid. At December 31, 1999 and 1998, all dividends had been paid.
The cumulative preferred stock is entitled to a preference, in liquidation, in the amount of $100 per share, plus any accrued and unpaid dividends and any related interest. The owners of the cumulative preferred stock are not entitled to any voting rights, except that in the event that six consecutive quarterly dividends are not paid, the holders of the cumulative preferred stock are entitled to vote separately as a class to elect 20% of the directors of the Company. There are also certain restrictions against the declaration or payment of dividends on common stock or the acquisition of common stock by the Company if it is in default on any dividends or redemption payments on the cumulative preferred stock. Additionally, amendment of the Company's Articles of Incorporation or changes in the number of authorized stock ranking on a parity with the preferred stock must be approved by the holders of the cumulative preferred stock.
12. COMMON STOCK
All holders of Common Stock are entitled to receive dividends when and if declared by the Company's Board of Directors (the "Board"), provided that all dividend requirements of the cumulative preferred stock have been paid. Additionally, the payment of dividends on the Company's Common Stock is restricted under the terms of the Company's various financing agreements. To date, no dividends have been paid to the holders of the Common Stock and there are no immediate plans to institute a dividend.
The Board has adopted a Stockholder Rights Plan designed to protect the Company and its stockholders from coercive, unfair or inadequate takeover bids. Pursuant to the Rights Plan, a dividend of one Preferred Share Purchase Right (a "Right") was declared for each share of Common Stock outstanding at the close of business on February 23, 1996. The Rights are generally not exercisable until ten days after a person or group acquires, or commences a tender offer that could result in the party acquiring, 15% of the outstanding shares of Common Stock. Each Right, should it become exercisable, will enable the owner to buy one one-thousandth of a
share of newly created Series A Junior Participating Preferred Stock at an exercise price of $175, and, in certain circumstances, to purchase shares of Common Stock at a substantially reduced price. The Board is generally entitled to redeem the Rights at $0.01 per Right at any time prior to the date they become exercisable. The Rights will expire on February 23, 2006.
The Board has authorized the Company to purchase up to 2,000,000 shares of the Company's outstanding stock in the open market from time to time as market conditions warrant. The aggregate purchase price for such purchases of Common Stock shall not exceed $50,000,000. During 1999 and 1998, the Company repurchased 858,100 shares of its Common Stock for $15,386,000, and 784,200 shares for $16,628,000, respectively.
13. STOCK-BASED COMPENSATION PLANS
The Company has elected to follow Accounting Principles Board Opinion No. 25, ("APB 25") Accounting for Stock Options Issued to Employees and related interpretations in accounting for its employee stock options because, as discussed below, the alternative fair value accounting provided for under Financial Accounting Standards Board Statement No. 123 ("Statement 123"), Accounting for Stock-Based Compensation, requires use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, no compensation expense is recognized because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of the grant.
Proforma information regarding net income and earnings per share is required by Statement 123, and has been determined as if the Company had accounted for its employee stock options under the fair value method of that statement. The weighted average fair value of options granted during 1999 estimated on the date of grant using the Black-Scholes pricing model was $10.58. The fair value for these options was estimated at the date of grant using the following weighted-average assumptions for 1999, 1998 and 1997, respectively: risk free interest rates of 5.78%, 5.29% and 6.32%; volatility factors of the expected market price of the Company's common stock of 0.337, 0.331 and 0.331; and a weighted-average expected life of the option of seven years.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
For purposes of proforma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The effects of applying Statement 123 for proforma disclosure may not be representative of the effects on reported proforma net income in future years. The Company's proforma information for the years ended December 31 follows:
The 1993 Equity Incentive Plan (the "1993 Equity Plan") provides for the issuance of stock options, restricted shares, stock appreciation rights, phantom shares and other additional awards to key executives and employees. The maximum number of additional shares issuable under the 1993 Equity Plan is 2,075,000 at a price as determined by the Company's Compensation Committee. All options granted to date have been issued at the market value at the date of the grant. Options granted prior to 1999 under the 1993 Equity Plan vest 20% on each anniversary thereafter and terminate on the tenth anniversary of the date of grant. Options granted in 1999 and subsequent years under the 1993 Equity Plan vest 33 1/3% on each anniversary thereafter and terminate on the tenth anniversary of the date of grant. Options granted under prior plans remain outstanding but are governed by the provisions of the 1993 Equity Plan.
The 1993 Stock Option Plan for Outside Directors (the "1993 Directors' Plan") provides for the issuance of stock options to outside directors at the fair market value on the date of grant. A maximum of 185,000 shares are issuable under the 1993 Directors' Plan. The initial options granted at the time the Director joins the Board vest at 33.3% per year but must be held one year before being exercised. All subsequent options granted vest immediately. All options terminate on the tenth anniversary of the date of grant.
The Company's stock option plans are summarized as follows:
The number of options outstanding, weighted-average exercise price, weighted-average remaining contractual life, vested options and the weighted-average exercise price of vested options outstanding at December 31, 1999, which were issued prior to August 1993, were 87,898, $6.27, 2.7 years, 87,898 and $6.27, respectively. The number of options outstanding, weighted-average exercise price, weighted-average remaining contractual life, vested options and the weighted-average exercise price of vested options outstanding at December 31, 1999, which were issued after August 1993, were 1,041,460, $29.87, 7.4 years, 343,375 and $31.58, respectively. The weighted average remaining life for all options outstanding at December 31, 1999 is 7.1 years.
In 1999, the Company awarded 26,847 shares of restricted stock under the 1993 Equity Plan, with a fair value at the date of grant of $20.44 per share. These restricted shares vest 50% annually at the anniversary date of the grant. Compensation expense recorded by the Company with respect to this restricted stock award was approximately $240,000 in 1999. In addition, selected senior executives as designated by the CEO and approved by the Compensation Committee, are eligible for restricted stock awards under the Long-Term Incentive Plan ("LTIP") based on the Company's return on total capital measured over a three year period. Performance objectives under the LTIP are based upon an incremental scale depending on achieving the specified target return rate. No compensation expense was recorded in 1999 with respect to these awards.
14. COMMITMENTS
Minimum future rental commitments under operating leases having non-cancelable lease terms in excess of one year totaled approximately $10,500,000 as of December 31, 1999 and are payable as follows: $2,927,000 in 2000, $1,728,000 in 2001, $1,133,000 in 2002, $1,063,000 in 2003, $1,004,000 in 2004 and $2,645,000 thereafter. Rental expense for operating leases was $2,872,000 in 1999, $1,976,000 in 1998 and $2,027,000 in 1997.
At December 31, 1999, the Company had commitments of $9,160,000 for capital expenditures.
15. INDUSTRY SEGMENTS AND FOREIGN OPERATIONS
The Company's reportable segments are based on the Company's three product lines: commercial products, wholesale products and other products. Commercial products consist primarily of high value-added products sold directly to equipment manufacturers. Wholesale products are commodity-type plumbing tube products, which are typically sold to a variety of customers. Other products consist primarily of rod, bar and strip products which are also sold to a variety of customers.
The accounting policies of the reportable segments are the same as those described in Note 1 of the Notes to the Consolidated Financial Statements. The Company evaluates the performance of its operating segments based on sales and gross profit. During 1999, 1998 and 1997, the Company did not allocate asset amounts and items of income and expense below gross profit or depreciation and amortization.
Summarized financial information concerning the Company's reportable segments is shown in the following table:
The Company's manufacturing operations are primarily conducted in the U.S. and Canada. In 1999 and 1997, no customer accounted for as much as 10% of the Company's net sales. In 1998, one customer accounted for 10% of the Company's net sales.
The following summarized geographic data is based on estimates that do not consider fully the extent to which the Company's product development, engineering, marketing and management activities are interrelated. Thus, the data is not totally indicative of the extent that each geographic area contributed to the Company's consolidated operating results.
16. RESTRUCTURING AND OTHER CHARGES
During the third quarter of 1999, the Company recognized restructuring and other charges of $19,938,000 ($12,461,000 net of tax). This charge included $10.0 million in expenses relating to the announced closing of the Company's Roxboro, North Carolina facility, which employed approximately 100 people, of which $8.6 million of these Roxboro expenses related to the write-down of impaired assets; $2.8 million in expenses related to the implementation of an indirect (non-manufacturing) workforce reduction program of approximately 100 employees; $3.6 million in expenses related to impaired assets due to a product and plant rationalization plan; $1.9 million in expenses related to previously closed entities, of which $1.8 million was related to write-down of impaired assets; $0.8 million in expenses related to termination of an interest rate swap; and $0.8 million in expenses related to professional fees and other costs primarily associated with acquisitions that were not completed. To date, the Company has paid approximately $3.5 million in cash relating to the restructuring. The Company believes the accrued restructuring costs of $1.6 million at December 31, 1999 represent its remaining cash obligations. Additionally, $14,414,000 of non-recurring charges were included in cost of goods sold in the consolidated statements of operations. These charges included $8.1 million relating to the liquidation of LIFO inventory values and $6.3 million of additional costs associated with the realignment of the Company's manufacturing operations and product rationalization.
During the third quarter of 1998, the Company recognized restructuring and other charges of $11,867,000 ($7,460,000 net of tax). This charge included $7.4 million in expenses related primarily to the closing of the Company's Greenville, Mississippi facility, of which $5.6 million in expenses related to the write-down of impaired assets and $1.6 million in severance costs resulting primarily from the closing of this facility, which employed approximately 140 people; $2.7 million in expenses related to efficiency initiatives implemented at the Company's Roxboro, North Carolina facility, which primarily related to the impairment in value of certain equipment; $0.9 million in expenses related to the implementation of a salaried workforce reduction program of approximately 50 employees; and $0.9 million in professional fees and other costs primarily associated with an acquisition that was not completed.
During the second quarter of 1997, the Company recognized restructuring and other charges of $4,384,000 ($2,997,000 net of tax). This charge included $1.8 million in expenses related to the
implementation of the Company's 1997 Voluntary Early Retirement Program; $1.3 million in severance costs primarily associated with the departure of the Company's former Chief Executive Officer; $0.6 million in professional fees and other costs associated with an acquisition that was not completed; and $0.7 million in costs for discontinuing the Poland operations of Small Tube Manufacturing Corporation (a wholly-owned subsidiary of the Company).
17. CUMULATIVE EFFECT OF ACCOUNTING CHANGE
During the first quarter of 1999, the Company adopted the American Institute of Certified Public Accountants' Statement of Position 98-5, Reporting on the Costs of Start-Up Activities (the "Statement"), which requires that certain costs related to start-up activities be expensed as incurred. In accordance with the Statement, the Company recognized a charge for the cumulative effect of a change in accounting principle of $8.0 million pre-tax ($5.8 million after-tax). The implementation of the Statement required the Company to write-off the remaining start-up costs relating primarily to the Company's Roxboro, North Carolina, Jackson, Tennessee, and Shanghai, China facilities.
18. EARNINGS PER SHARE
The following table sets forth the computation of earnings per share for the years ended December 31:
19. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
The following is a summary of the unaudited quarterly results of operations for the years ended December 31, 1999 and 1998:
The Board of Directors Wolverine Tube, Inc.
We have audited the accompanying consolidated balance sheets of Wolverine Tube, Inc. and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as 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 Wolverine Tube, Inc. and subsidiaries at December 31, 1999 and 1998, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States.
As discussed in Note 17 to the financial statements, in 1999 the Company changed its method of accounting for start-up activities.
/s/ Ernst & Young LLP
February 4, 2000
Birmingham, Alabama
WOLVERINE TUBE, INC. AND SUBSIDIARIES SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
(1) Reduction of reserve, net of translation adjustments.
(2) Uncollectable accounts written off, net of translation adjustments and recoveries and a $212,500 reduction of reserve, net of translation adjustments in 1998.
S-1
EXHIBIT INDEX
- ---------------
* Identifies each exhibit that is a "management contract or compensatory plan or arrangement" required to be included as an exhibit to this Form 10-K pursuant to Item 14(c) of Form 10-K. | 19,472 | 128,885 |
911534_1999.txt | 911534_1999 | 1999 | 911534 | ITEM 1. BUSINESS.
General
Trump's Castle Funding, Inc. ("Funding") was incorporated under the laws of the State of New Jersey in May 1985 and is wholly owned by Trump's Castle Associates, L.P. (the "Partnership"). Funding was formed to serve as a financing corporation to raise funds for the benefit of the Partnership. Trump's Castle Hotel & Casino, Inc. ("TCHI"), the general partner of the Partnership, was incorporated under the laws of the State of New Jersey in April 1985, and is wholly owned by Trump Hotels & Casino Resorts Holdings, L.P. ("THCR Holdings"). Since Funding and TCHI have no business operations, their ability to service their indebtedness is completely dependent upon funds they receive from the Partnership. Accordingly, the discussion in this Form 10-K relates primarily to the Partnership and its operations.
The Partnership was formed in 1985 for the sole purpose of acquiring and operating Trump's Castle Casino Resort, a luxury casino hotel located in the Marina District of Atlantic City, New Jersey (the "Marina District"). During the second quarter of 1997, the Partnership rethemed the property with a nautical emphasis and renamed it Trump Marina Hotel Casino ("Trump Marina"). Prior to the acquisition of Trump Marina (which at that time was Trump's Castle Casino Resort) (the "Castle Acquisition") on October 7, 1996 by THCR Holdings, the partners in the Partnership were TC/GP, Inc., currently known as Trump Casinos II, Inc. ("TCI-II"), which had a 37.5% interest in the Partnership, Donald J. Trump ("Trump"), who had a 61.5% interest in the Partnership, and TCHI, which had a 1% interest in the Partnership. Trump, by virtue of his ownership of TCI- II and TCHI, was the beneficial owner of 100% of the common equity interest in the Partnership, subject to the right of holders of warrants for 50% of the common stock of TCHI (the "Castle Warrants") to acquire an indirect beneficial interest in 0.5% of the common equity interest in the Partnership. Subsequent to the Castle Acquisition, the partners in the Partnership are THCR Holdings, which has a 99% limited partnership interest in the Partnership, and TCHI, which has a 1% general partnership interest in the Partnership. THCR Holdings, by virtue of its ownership of TCHI, is the beneficial owner of 100% of the common equity interest in the Partnership.
The Castle Acquisition has further strengthened the position of Trump Hotels & Casino Resorts, Inc. ("THCR") as an industry leader. The Castle Acquisition has provided THCR with a significant presence in the Marina District, the principal focus of expansion in the Atlantic City gaming market (the "Atlantic City Market"). In addition, the Castle Acquisition has provided further opportunities for operational efficiencies and economies of scale and eliminated the perceived conflict of interest caused by the differing ownership of Trump Marina and the other THCR properties in Atlantic City. Ownership of Trump Marina will enable THCR to retain patrons that may be drawn from The Boardwalk to the Marina District by new casino development in the Marina District. The Castle Acquisition has also enabled THCR to benefit from (i) the excellent condition of the current facilities at Trump Marina, which have been designed to accommodate additional development with minimal disruption to existing operations, and (ii) the proximity of Trump Marina to the "H-Tract," an approximately 150-acre parcel of land proposed to be Atlantic City's newest area of casino hotel development (the "H-Tract").
On October 23, 1996, Trump Casino Services, L.L.C., ("TCS"), Trump Plaza Associates ("Plaza Associates"), Trump Taj Mahal Associates ("Taj Associates") and the Partnership entered into an Amended and Restated Services Agreement pursuant to which TCS provides each of Plaza Associates, Taj Associates and the Partnership certain management, financial and other functions and services necessary and incidental to the respective operations of each of their casino hotels. Management believes that TCS' services to the Partnership result in cost savings and operational synergies.
The Partnership operates in only one industry segment, the gaming industry. See "Financial Statements and Supplementary Data".
Trump Marina
The Partnership owns and operates Trump Marina, a luxury casino hotel located on 14.7 acres in the Marina District approximately two miles from The Boardwalk. Trump Marina is approximately one-quarter mile from the H-Tract. Trump Marina consists of a 27-story hotel tower with 728 rooms, including 153 suites, 97 of which are "Crystal Tower" luxury suites, and contains approximately 75,900 square feet of gaming space. Trump Marina offers 2,159 slot machines, 86 table games, 8 restaurants, two clubs for the exclusive use of select customers, approximately 58,000 square feet of convention, ballroom and meeting space, a 9-story parking garage which can accommodate approximately 3,000 cars, a 540-seat cabaret theater, two cocktail lounges, a swimming pool, tennis courts, a health club and a roof-top helipad. In addition, Trump Marina operates a 645-slip marina (see "Properties"), which is adjacent to the casino hotel. An elevated enclosed walkway connects Trump Marina to a two-story building which contains offices, a nautically themed retail store, a cocktail lounge and a 240-seat gourmet restaurant that overlooks the marina and the Atlantic City skyline. As a result of its high quality amenities, its exceptional customer service and its geographical location, Trump Marina distinguishes itself as a desirable alternative to the Atlantic City casinos located on The Boardwalk.
Marketing Strategy
Management's recent retheming of Trump Marina has built upon the casino's established customer base by attracting a younger crowd to the facility. In keeping with this initiative, management has differentiated Trump Marina from other Atlantic City casinos by offering contemporary entertainment attractions and its "Wild Side" marketing campaign. The "Wild Side" marketing program consists of a coordinated advertising, entertainment and marketing campaign that is geared towards younger affluent patrons but does not exclude Trump Marina's established customer base. Management, which developed the "Wild Side" marketing program after careful study of the Atlantic City market, seeks to accomplish its goals via an advertising campaign with a fun and youthful appeal, as well as providing varied and extensive contemporary entertainment in the Grand Cayman Ballroom, "The Shell" (a cabaret style theater), "The Wave" (a night club), "The Deck" (for outdoor summertime entertainment) and large outdoor performances billed as "Rock the Dock" concerts.
Service. By providing and maintaining a first-class facility and exceptional service, Trump Marina has earned the Five Star Diamond Award from the American Academy of Hospitality Sciences and the American Automobile Association's "Four Diamond" rating. Trump Marina provides a broadly diversified gaming and entertainment experience consistent with the "Trump" name and reputation for quality amenities and first-class service.
Gaming Environment. To stay abreast of current gaming trends in Atlantic City, Trump Marina's management continuously monitors the configuration of the casino floor and the games it offers to patrons with a view towards making changes and improvements. A sophisticated computerized slot tracking and marketing system is employed to perform this analysis. This monitoring has confirmed the continuing recent trend in the Atlantic City market towards fewer table games and more slot machines. For example, slot machine revenue for the Atlantic City market increased from 54.6% of the industry table games and slot revenue in 1988 to 71.7% of industry table games and slot revenue in 1999. Trump Marina experienced a similar increase, with slot revenue increasing from 52.5% of table games and slot revenue in 1988 to 73.2% of table games and slot revenue in 1999. In response to this trend, starting in 1994 management devoted more of its casino floor space to slot machines, and by 1999 has replaced substantially all of its slot machines with newer machines.
"Comping" Strategy. In order to compete effectively with other Atlantic City casino hotels, Trump Marina offers complimentaries primarily to patrons with a demonstrated propensity to wager at Trump Marina. The policy at Trump Marina is to focus promotional activities, including complimentaries, on middle and upper middle market "drive-in" patrons who visit Atlantic City frequently and have proven to be the most profitable market segment. A patron's propensity to wager is determined by a review of the patron's prior gaming history at Trump Marina as well as other gaming establishments in Atlantic City. Each patron is analyzed to ensure that the
patron's gaming activity, net of any complimentaries, is profitable.
Entertainment and Special Events. Trump Marina pursues a coordinated program of headline entertainment and special events. Trump Marina offers headline entertainment approximately twenty times a year in its main ballroom, complemented by contemporary acts in the cabaret theater and nightclub. As a part of its marketing plan, Trump Marina offers special events aimed at its core, middle and upper-middle market segments. Trump Marina also hosts special events on an invitation-only basis in an effort to attract existing targeted gaming patrons and build loyalty among these patrons. These special events include theme parties and gaming tournaments. Headline entertainment is scheduled to complement these special events. In addition, as part of its "Wild Side" marketing campaign, Trump Marina features outdoor bands nightly (in season) as well as outdoor concerts promoted under the "Rock the Dock" theme. Recent performances have included Sting, Hootie and the Blowfish, Meatloaf, Bad Company and George Carlin.
Player Development and Casino Hosts. Trump Marina has contracts with sales representatives in New Jersey, New York and other states to promote the casino hotel. Trump Marina has sought to attract more middle market slot patrons, as well as premium players through its "junket" marketing operations, which involve attracting groups of patrons by providing airfare, gifts and room accommodations. Player development personnel host special events, offer incentives, and contact patrons directly in an effort to attract high-limit table game patrons.
The casino hosts at Trump Marina assist table game patrons, and the slot sales representatives at Trump Marina assist slot patrons on the casino floor, make room and dinner reservations, and provide general assistance. Slot sales representatives also solicit Marina Card (the frequent player identification slot card) sign-ups in order to increase Trump Marina's marketing base.
Promotional Activities. The Marina Card constitutes a key element in the direct marketing program of Trump Marina. Slot machine players are encouraged to register for and utilize their personalized Marina Card to earn various complimentaries based upon their level of play. The Marina Card is inserted during play into a card reader attached to the slot machine for use in computerized rating systems. These computer systems record data about the cardholder, including playing preferences, frequency and denomination of play and the amount of gaming revenues produced. Slot sales and management personnel are able to monitor the identity and location of the cardholder and the frequency and denomination of the cardholder's slot play. They also use this information to provide attentive service to the cardholder on the casino floor.
Trump Marina designs promotional offers, conveyed via direct mail and telemarketing, to patrons expected to provide revenues based upon their historical gaming patterns. Such information is gathered on slot wagering by the Marina Card and on table wagering by the casino games supervisor. Trump Marina conducts slot machine and table game tournaments in which cash prizes are offered to a select group of players invited to participate in the tournament based upon their tendency to play. Such players tend to play at their own expense during "off-hours" of the tournament. At times, tournament players are also offered special dining and entertainment privileges that encourage them to remain at Trump Marina.
Credit Policy. Historically, Trump Marina has extended credit on a discretionary basis to certain qualified patrons. Table games credit play, as a percentage of total dollars wagered, was approximately 32.4%, 30.1% and 32.6% for 1997, 1998 and 1999, respectively. Trump Marina bases credit limits on each individual patron's creditworthiness, as determined by an examination of the following criteria: (i) checking each patron's personal checking account for current and average balances; (ii) performing a credit check using a credit agency specializing in casino credit on each domestic patron; and (iii) checking each patron's credit limits and indebtedness at all casinos in the United States as well as many island casinos. The above determination of a patron's continued creditworthiness is performed for continuing patrons on a yearly basis or more frequently if Trump Marina deems a re-determination of creditworthiness is necessary. In addition, depositing of markers is regulated by the New Jersey Casino Control Act, (the "Casino Control Act"). Markers of $1,000 or less are deposited in a maximum of 7 days; markers of
$1,001 to $5,000 are deposited in a maximum of 14 days; and markers over $5,001 are deposited in a maximum of 45 days. Markers may be deposited sooner at the request of patrons or at Trump Marina's discretion.
Bus Program. Trump Marina has a bus program which transports approximately 600 gaming patrons per day during the week and 700 per day on the weekends. The Partnership's bus program offers incentives and discounts to certain scheduled and chartered bus customers. Based on historical surveys, management has determined that gaming patrons who arrive by special charters as opposed to scheduled bus lines or who travel distances greater than 60 miles are more likely to create higher gaming revenue. Accordingly, Trump Marina's marketing efforts are focused on such bus patrons.
Trump Marina Retheming
In 1997, Trump Marina completed a project to retheme the casino hotel with a nautical emphasis, targeting younger customers by offering contemporary entertainment attractions and emphasizing Trump Marina's energetic, lively atmosphere.
Employee Relations
As of December 31, 1999, the Partnership employed approximately 3,300 full and part-time employees, of whom approximately 1,200 were subject to collective bargaining agreements. The Partnership's collective bargaining agreement with Local No. 54 expires on September 15, 2004. Such agreement extends to approximately 900 employees. In addition, four other collective bargaining agreements cover approximately 300 maintenance employees. The Partnership believes that its relationships with its employees are satisfactory. Funding and TCHI have no employees.
Certain employees of the Partnership must be licensed by or registered with the New Jersey Casino Control Commission (the "CCC"), depending on the nature of the position held. Casino employees are subject to more stringent licensing requirements than non-casino employees, and must meet applicable standards pertaining to such matters as financial responsibility, good character, ability, casino training, experience and New Jersey residency. Such regulations have resulted in significant competition for employees who meet these requirements.
Historical Background
General. Funding was incorporated under the laws of the State of New Jersey in May 1985 and is wholly owned by the Partnership. Funding was formed to serve as a financing corporation to raise funds as an agent of the Partnership. TCHI, the general partner of the Partnership, was incorporated under the laws of the State of New Jersey in April 1985, and is wholly owned by THCR Holdings. Since Funding and TCHI have no business operations, their ability to service their indebtedness is completely dependent upon funds they receive from the Partnership. Accordingly, the following discussion is related primarily to the Partnership and its operations.
PIK Note Acquisition. On June 23, 1995, the Partnership entered into an agreement with Hamilton Partners, L.P. ("Hamilton") which granted the Partnership an option (the "Option") to acquire the Increasing Rate Subordinated Pay-in-Kind Notes due 2005 of Funding (the "PIK Notes") (which are currently subordinated to the Senior Notes (as defined), the Working Capital Loan (as defined) and the Mortgage Notes (as defined)) owned by Hamilton (the "Option Agreement"). The Option was granted to the Partnership in consideration of $1.9 million of aggregate payments to Hamilton. The Option was exercisable at a price equal to 60% of the aggregate principal amount of the PIK Notes delivered by Hamilton, with accrued but unpaid interest, plus 100% of the PIK Notes issued to Hamilton as interest subsequent to June 23, 1995. Pursuant to the terms of the Option Agreement, upon the occurrence of certain events within 18 months of the time the Option is exercised, the Partnership was required to make an additional payment to Hamilton of up to 40% of the principal amount of the PIK Notes. On May 21, 1996, the Partnership assigned the Option to THCR Holdings, which, on that same date, exercised the Option and acquired approximately 90% of the then outstanding PIK Notes for approximately $38.7 million, in exchange for
which THCR Holdings received an aggregate of approximately $59.3 million principal amount of PIK Notes.
April 1998 Refinancing. On April 17, 1998, Funding refinanced a portion of the Partnership's outstanding debt, on a consolidated basis, consisting of $38 million outstanding on a term loan with a bank (the "Term Loan") and its 11 1/2% Senior Secured Notes due 2000 (the "Old Senior Notes") by issuing 10 1/4% Senior Secured Notes due 2003 (the "Senior Notes"). The proceeds from the issuance of the Senior Notes were used to redeem all of the issued and outstanding Old Senior Notes at 100% of their principal amount and to repay the Term Loan in full. In conjunction with this refinancing, TCHI obtained a working capital credit facility (the "Working Capital Loan"). Both the Senior Notes and the Working Capital Loan are guaranteed by the Partnership. The Senior Notes have an outstanding principal amount of $62,000,000, bear interest at the rate of 10 1/4% per annum, payable semi-annually each April and October, and mature on April 30, 2003. The Working Capital Loan has an outstanding principal amount of $5,000,000, bears interest at the rate of 10 1/4% per annum, payable semi- annually each April and October and matures on April 30, 2003.
Trademark/Licensing
Subject to certain restrictions, THCR has the exclusive right to use the "Trump" name and likeness in connection with gaming and related activities (the "License") pursuant to a trademark license agreement and the amendments thereto between Trump and THCR (the "License Agreement"). Pursuant to the License Agreement, Trump granted to THCR the world-wide right and license to use the names "Trump," "Donald Trump" and "Donald J. Trump" (including variations thereon, the "Trump Names") and related intellectual property rights (collectively, the "Marks") in connection with casino and gaming activities and related services and products. The License Agreement does not restrict or restrain Trump from the right to use or further license the Trump Names in connection with services and products other than casino services and products.
The License is for a term of the later of: (i) June 2015; (ii) such time as Trump and his affiliates no longer hold a 15% or greater voting interest in THCR; or (iii) such time as Trump ceases to be employed or retained pursuant to an employment, management, consulting or similar services agreement with THCR. Upon expiration of the term of the License, Trump will grant THCR a non- exclusive license for a reasonable period of transition on terms to be mutually agreed upon between Trump and THCR. Trump's obligations under the License Agreement are secured by a security agreement (the "Trademark Security Agreement"), pursuant to which Trump granted THCR a first priority security interest in the Marks for use in connection with casino services, as well as related hotel, bar and restaurant services.
Certain Indebtedness of the Partnership
The Mortgage Notes bear interest, payable semi-annually in cash, at 11 3/4% and mature on November 15, 2003 (the "Mortgage Notes"). The Mortgage Notes may be redeemed at Funding's option at a specified percentage of the principal amount commencing in 1998.
The Mortgage Notes are secured by a promissory note of the Partnership to Funding (the "Partnership Note") in an amount and with payment terms necessary to service the Mortgage Notes. The Partnership Note is secured by a mortgage on Trump Marina and substantially all of the other assets of the Partnership. The Partnership Note has been assigned by Funding to the trustee of the indenture under which the Mortgage Notes were issued to secure the repayment of the Mortgage Notes. In addition, the Partnership has guaranteed the payment of the Mortgage Notes (the "Guaranty"), which is secured by a mortgage on Trump Marina and substantially all of the assets of the Partnership. The Partnership Note and the Guaranty are expressly subordinated to the indebtedness of the Senior Notes and the Working Capital Loan (collectively, the "Senior Indebtedness") and the liens of the mortgages securing the Partnership Note and the Guaranty are subordinate to the liens securing the Senior Indebtedness.
The PIK Notes bear interest payable, at Funding's option in whole or in part in cash and through the issuance of additional PIK Notes, semi-annually at the rate of 137/8% through November 15, 2003. After November 15, 2003, interest on the PIK Notes is payable in cash at the rate of 137/8%. The PIK Notes mature on November 15, 2005. The PIK Notes may be redeemed at Funding's option at 100% of the principal amount under certain conditions, as described in the indenture governing the PIK Notes, and are required to be redeemed from a specified percentage of any equity offering which includes the Partnership. Interest has been accrued using the effective interest method. On May 15, 1999 and November 15, 1999, the semi-annual interest payments of $6.4 million and $6.9 million, respectively, were paid by the issuance of additional PIK Notes. In addition, approximately 90% of the PIK Notes are owned by THCR Holdings.
The PIK Notes are secured by a subordinated promissory note of the Partnership to Funding (the "Subordinated Partnership Note"), which has been assigned to the trustee for the PIK Notes, and the Partnership has issued a subordinated guaranty (the "Subordinated Guaranty") of the PIK Notes. The Subordinated Partnership Note and the Subordinated Guaranty are expressly subordinated to the Senior Indebtedness, the Partnership Note and the Guaranty.
The Senior Notes bear interest, payable semi-annually in cash, at 10 1/4% and mature on April 30, 2003. Similar to the Mortgage Notes, the Senior Notes are secured by an assignment of a promissory note of the Partnership (the "Senior Partnership Note") which is in turn secured by a mortgage on Trump Marina and substantially all of the other assets of the Partnership. The Partnership has guaranteed the payment of the Senior Notes (the "Senior Guaranty"), which Senior Guaranty is secured by a mortgage on Trump Marina and substantially all of the assets of the Partnership. The Partnership has also guaranteed the payment of the Working Capital Loan (the "TCHI Guaranty"), which TCHI Guaranty is secured by a mortgage on Trump Marina and substantially all of the assets of the Partnership.
The terms of the Mortgage Notes, the PIK Notes and the Senior Notes include limitations on the amount of additional indebtedness the Partnership may incur, distributions of the Partnership's capital, investments and other business activities.
Atlantic City Market
The Atlantic City Market has demonstrated continued growth despite the recent proliferation of new gaming venues across the country. The 12 casino hotels in Atlantic City generated approximately $4.18 billion in gaming revenues in 1999, an increase of approximately 3.2% over 1998 gaming revenues of approximately $4.05 billion. From 1995 to 1999, total gaming revenues in Atlantic City have increased approximately 11.1%, while hotel rooms increased by 20.6% during that period. Although total visitor volume to Atlantic City remained relatively constant in 1999, the volume of less profitable bus customers decreased to 9.5 million in 1999 from 9.9 million in 1998, also representing a decline from 9.6 million in 1995. The volume of customers traveling by other means to Atlantic City has grown from 23.7 million in 1995 to 24.7 million in 1999.
Casino revenue growth in Atlantic City has lagged behind that of other traditional gaming markets, principally Las Vegas, for the last five years. Management believes that this relatively slower growth is primarily attributable to two key factors. First, there were no significant additions to hotel capacity in Atlantic City until 1996. Las Vegas visitor volumes have increased, in part, due to the continued addition of new hotel capacity. Both markets have exhibited a strong correlation between hotel room inventory and total casino revenues. Secondly, the regulatory environment and infrastructure problems in Atlantic City have made it more difficult and costly to operate than in Las Vegas. Total regulatory costs and tax levies in New Jersey have exceeded those in Nevada since inception, and there is generally a higher level of regulatory oversight in New Jersey than in Nevada. The infrastructure problems, manifested by impaired accessibility of the casinos, downtown Atlantic City congestion and the condition of the areas surrounding the casinos have made Atlantic City less attractive to the gaming customer.
Total Atlantic City slot revenues increased 4.6% in 1999 from 1998, continuing a trend of increases over the past seven years. From 1995 through 1999, slot revenue growth in Atlantic City has averaged 5.2% per year. Total table game revenue decreased 0.1% in 1999, while table game revenue from 1995 to 1999 has increased on average approximately 1.6% per year. Management believes the slow growth in table game revenue is primarily attributable to two factors. First, the slot product has been significantly improved over the last seven years. Bill acceptors, new slot machines, video poker, themed slot machines and other improvements have increased the popularity in slot play to include a larger number of guests interested in its entertainment value. Casino operators in Atlantic City have added slot machines in favor of table games due to increased public acceptance of slot play and due to slot machines' comparatively higher profitability as a result of lower labor and support costs. Since 1995, the number of slot machines in Atlantic City has increased by 19.4%, while the number of table games has increased by 2.5%. Slot revenues increased from 68.4% of total casino revenues in 1995 to 70.8% in 1999. The second reason for historic slow growth in table game revenue is that table game players are typically higher end players and are more likely to be interested in overnight stays and other amenities. During peak season and weekends, room availability in Atlantic City is currently inadequate to meet demand, making it difficult for casino operators to aggressively promote table play.
The regulatory environment in Atlantic City has improved over the years. Most significantly, 24-hour gaming has been approved, poker, simulcasting and keno have been added and certain regulatory burdens have been reduced. In particular, comprehensive amendments to New Jersey gaming laws were made in January 1995, which have eliminated duplicative regulatory oversight and channeled a certain portion of operator's funds through 2003 from regulatory support into uses of the New Jersey Casino Reinvestment Development Authority (the "CRDA"). Administrative costs of regulation will be reduced while increasing funds will be available for new development in Atlantic City. In addition, in 1994, legislation was enacted which eliminated the requirement that a casino consist of a "single room" in a casino hotel. A casino may now consist of "one or more locations or rooms" approved by the CCC for casino gaming.
Atlantic City's new convention center, with approximately 500,000 square feet of exhibit and pre-function space, 45 meeting rooms, food-service facilities and a 1,600-car underground parking garage, is the largest exhibition space between New York City and Washington, D.C. It is located at the base of the Atlantic City Expressway and opened in May 1997. Atlantic City's original convention center is located on The Boardwalk, physically connected to the Trump Plaza Hotel and Casino ("Trump Plaza"), another indirect wholly owned subsidiary of THCR. Its East Hall, which was completed in 1929 and is listed on the National Register of Historic Places, is currently undergoing, with funding approved by the CRDA in February 1999, a $72 million renovation to be completed by the summer of 2001. These improvements, while preserving the historic features of this landmark, will convert it into a modern special events venue and will include new seating for 10,000 to 14,000 in its main auditorium, and new lighting, sound and television-ready wiring systems.
In the fall of 1998, the South Jersey Transportation Authority ("SJTA") began constructing a 2.2 mile roadway and tunnel system in Atlantic City which will connect the Atlantic City Expressway to the Marina District and the City of Brigantine and is scheduled to be completed in the spring of 2001. This $330 million roadway project, upon completion, will provide vehicles arriving in Atlantic City on the Atlantic City Expressway with direct access to the Marina District, including the Trump Marina and the marina at Trump Marina. On January 25, 2000, the Appellate Division of the New Jersey Superior Court reversed, in part, the issuance of certain development permits which authorize the SJTA to construct this roadway and granted THCR the right to a trial-type administrative hearing in the New Jersey Department of Environmental Protection to determine whether the approved roadway design unfairly and unreasonably either impedes patron access to Trump Marina and the marina at Trump Marina from the proposed H-Tract casino resort development or obscures the visibility of the Trump Marina electronic reader board signage.
In addition to the planned casino expansions (see "Competition"), major infrastructure improvements have been completed. The CRDA oversaw the development of the $88 million "Grand Boulevard" corridor that links the new convention center with The Boardwalk. The project was completed in early 1998. Furthermore, as
set forth in a November 1998 agreement with the CRDA, a $20.8 million beautification project is now in progress for the five block Virginia and Maryland Avenue corridors which connect the thirty acre Boardwalk site of the Trump Taj Mahal Casino Resort (the "Taj Mahal") to Absecon Boulevard (Route 30), one of Atlantic City's principal access roadways. This comprehensive project includes the repair, resurfacing and resignalizing of these roads and the installation of new roadside lighting, the acquisition and demolition of deteriorated structures on Virginia Avenue and, to a lesser extent, Maryland Avenue, and the installation and maintenance of roadside landscaping on those sites, the construction of a twenty-six unit subdivision of two-story, single unit and duplex residences which will front on opposing sides of Virginia Avenue, and the improvement of the exterior facades of selected Virginia Avenue and other structures, with consents of the owners, to achieve a harmony and continuity of design among closely proximate properties. Construction of the roadway and housing elements of this project is expected to be substantially completed by the summer of 2000.
Management believes that these gaming regulatory reforms will serve to permit future reductions in operating expenses of casinos in Atlantic City and to increase the funds available for additional infrastructure development through the CRDA. Due principally to an improved regulatory environment, general improvement of economic conditions and high occupancy rates, significant investment in the Atlantic City Market has been initiated and/or announced. Management believes that these increases in hotel capacity, together with infrastructure improvements, will be instrumental in stimulating future revenue growth in the Atlantic City Market. See "Competition."
Competition
Atlantic City. Competition in the Atlantic City Market is intense. Trump Marina competes with other casino hotels located in Atlantic City, including the Trump Plaza and the Taj Mahal. At present, there are 12 casino hotels located in Atlantic City, including Trump Marina, Trump Plaza and the Taj Mahal, all of which compete for patrons. Trump Marina primarily competes with other Atlantic City casinos by, among other things, providing superior products and facilities, premier locations, name recognition and targeted marketing strategies. In addition, there are several sites on The Boardwalk and in the Marina District on which casino hotels could be built in the future and various applications for casino licenses have been filed and announcements with respect thereto made from time to time (including a casino resort joint venture (the "Mirage Joint Venture") between Mirage and the Boyd Gaming Corporation to be built in the Marina District which will contain approximately 1,200 rooms, and a casino resort by MGM Grand, Inc. ("MGM") which may be built on The Boardwalk after MGM purchases the land chosen as the site for the casino resort). Although management is not aware of any current construction on such sites by third parties, infrastructure improvements in the area have begun. Mirage intends to build a casino resort called Le Jardin which will contain approximately 2,000 rooms and will be linked to the resort created as a result of the Mirage Joint Venture. In March 2000, MGM announced an agreement to acquire Mirage, a transaction which includes Mirage's property holdings in Atlantic City. At this time, it is not possible to determine the impact this acquisition will have on Mirage's planned development in the H-Tract or MGM's planned development on The Boardwalk. Substantial new expansion and development activity has recently been completed or has been announced in Atlantic City, including the expansion at Harrah's, Hilton, Caesar's, Resorts, Tropicana and Bally's Wild West Casino, which intensifies competitive pressures in the Atlantic City Market. Also, in December 1999, Park Place Entertainment, Inc. ("Park Place") completed the acquisition of Caesar's Casino Hotels from Starwoods Hotel & Resorts Worldwide, Inc. This acquisition included the Caesar's Atlantic City property, which is adjacent to Bally's Park Place and Wild West casino hotel ("Bally's) owned by Park Place. Park Place has announced plans to connect the Caesar's and Bally's properties with a $24 million connector, which will include additional gaming space, restaurants and retail shops. Announced completion is September 2000. While management believes that the addition of hotel capacity would be beneficial to the Atlantic City Market generally, there can be no assurance that such expansion would not be materially disadvantageous to Trump Marina. There also can be no assurance that the Atlantic City development projects, which are planned or are underway will be completed.
Trump Marina also competes, or will compete, with facilities in the northeastern and mid-Atlantic regions of the United States at which casino gaming or other forms of wagering are currently, or in the future may be, authorized. To a minimal extent, Trump Marina faces competition from gaming facilities nationwide, including land-based, cruise line, riverboat and dockside casinos located in Colorado, Illinois, Indiana, Iowa, Louisiana, Mississippi, Missouri, Nevada, South Dakota, Ontario (Windsor and Niagara Falls), the Bahamas, Puerto Rico and other locations inside and outside the United States, and from other forms of legalized gaming in New Jersey and in its surrounding states such as lotteries, horse racing (including off-track betting), jai alai, bingo and dog racing, and from illegal wagering of various types. New or expanded operations by other persons can be expected to increase competition and could result in the saturation of certain gaming markets. In September 1995, New York introduced a keno lottery game, which is played on video terminals that have been set up in approximately 1,800 bars, restaurants and bowling alleys across the state. Bay Cruises is operating a gambling cruise ship where patrons are taken from a pier in Sheepshead Bay in Brooklyn, New York to international waters to gamble. In September 1997, another gambling cruise ship was launched off the coast of Montauk, New York. On April 24, 1998, Freeport Casino Cruises began operating a gambling ship in Long Island, New York. Manhattan Cruises, a company offering gambling cruises departing from Manhattan, New York City since January 28, 1998, suspended operations in early May 1998, but has announced plans to resume operations shortly. Other companies (including South Shore Cruise Lines, President Casino and Circle Line) are currently seeking permission to operate similar cruises in the New York City area. On December 5, 1997, the mayor of New York City proposed the construction of a casino on Governors Island, located in the middle of New York Harbor; however, the proposal would require an amendment to the New York State Constitution and the sale of the island to New York by the federal government. In Delaware, a total of approximately 2,600 slot machines were installed at three horse racetracks in 1996. Initial legislation allowed a maximum of 1,000 slot machines at each of the three racetracks. In 1998, the Delaware legislature approved a bill which would more than double the number of slot machines allowed at the three racetracks. At the end of 1999, there was a total of approximately 4,200 slot machines installed and operational. West Virginia also permits slot machines at racetracks, and track owners in several other states, including Maryland and Pennsylvania, are seeking to do the same. In December 1996, the temporary Casino Niagara opened in Niagara Falls, Ontario. Ontario officials expect that two- thirds of Casino Niagara's patrons will come from the United States, predominantly from western New York. In February 1998, the Ontario Casino Commission designated a consortium whose principal investor is Hyatt Hotels Corporation as the preferred developer of the permanent Casino Niagara. Moreover, Trump Marina may also face competition from various forms of internet gambling.
In addition to competing with other casino hotels in Atlantic City and elsewhere, by virtue of their proximity to each other and the common aspects of certain of their respective marketing efforts, including the common use of the "Trump" name, Trump Marina competes directly with Trump Plaza and the Taj Mahal for gaming patrons.
Other Competition. Trump Marina also faces competition from casino facilities in a number of states operated by federally recognized Native American tribes. Pursuant to the Indian Gaming Regulatory Act ("IGRA"), which was passed by Congress in 1988, any state which permits casino-style gaming (even if only for limited charity purposes) is required to negotiate gaming compacts with federally recognized Native American tribes. Under IGRA, Native American tribes enjoy comparative freedom from regulation and taxation of gaming operations, which provides them with an advantage over their competitors, including Trump Marina. In March 1996, the United States Supreme Court struck down a provision of IGRA which allowed Native American tribes to sue states in federal court for failing to negotiate gaming compacts in good faith. Management cannot predict the impact of this decision on the ability of Native American tribes to negotiate compacts with states.
In 1991, the Mashantucket Pequot Nation opened Foxwoods, a casino facility in Ledyard, Connecticut, located in the far eastern portion of such state, an approximately three-hour drive from New York City and an approximately two and one-half hour drive from Boston, which currently offers 24-hour gaming and contains approximately 5,900 slot machines. An expansion at Foxwoods, completed in April 1998, includes additional hotel rooms, restaurants and retail stores. A high-speed ferry operates seasonally between New York City and Foxwoods.
The Mashantucket Pequot Nation has also announced plans for a high-speed train linking Foxwoods to the interstate highway and an airport outside Providence, Rhode Island. In addition, in October 1996, the Mohegan Nation opened the Mohegan Sun Resort in Uncasville, Connecticut, located 10 miles from Foxwoods. Developed by Sun International Hotels, Ltd., the Mohegan Sun Resort has approximately 3,000 slot machines. The Mohegan Nation has announced plans for an expansion of the casino facilities and the construction of a hotel, convention center and entertainment center to be completed in the spring of 2002. In addition, the Eastern Pequots are seeking formal recognition as a Native American tribe for the purpose of opening a casino in the North Stonington area. There can be no assurance that any continued expansion of gaming operations of the Mashantucket Pequot Nation, the gaming operations of the Mohegan Nation or the commencement of gaming operations by the Eastern Pequots would not have a materially adverse impact on the operations of Trump Marina.
A group in Cumberland County, New Jersey calling itself the "Nanticoke Lenni Lenape" tribe has filed a notice of intent with the Bureau of Indian Affairs seeking formal federal recognition as a Native American tribe. In March 1998, the Oklahoma-based Lenape/Delaware Indian Nation, which originated in New Jersey and already has federal recognition, filed a lawsuit against the city of Wildwood claiming that the city is built on ancestral land. The city of Wildwood, which supported the plan to build a casino, had entered settlement negotiations, offering to deed municipal land to the tribe. The plan, which was opposed by the State of New Jersey, required state and federal approval. In early 1999, however, the Delaware Indian Nation's lawsuit was dismissed. In July 1993, the Oneida Nation opened a casino featuring 24-hour table gaming and electronic gaming systems, but without slot machines, near Syracuse, New York. The Oneida Nation opened a hotel in October 1997 that included expanded gaming facilities, and has constructed a golf course and convention center. In April 1999, the St. Regis Mohawk Nation opened a casino, with slot machines, in the northern portion of the state close to the Canadian border. In April 1999, the St. Regis Mohawks also announced their intent to open a casino at the Monticello Race Track in the Catskill Mountains region of New York; however, any Native American gaming operation in the Catskills is subject to the approval of the Governor of New York. The Seneca Nation plans to negotiate with New York State to open a casino in Western New York; however, the proposed casino would be subject to the purchase of additional property that is declared reservation territory by the federal government. The Narragansett Nation of Rhode Island, which has federal recognition, is seeking to open a casino in Rhode Island. The Aquinnah Wampanoag Tribe is seeking to open a casino in Massachusetts. Other Native American nations are seeking federal recognition, land and negotiation of gaming compacts in New York, Pennsylvania, Connecticut and other states near Atlantic City.
State Legislation. Legislation permitting other forms of casino gaming has been proposed, from time to time, in various states, including those bordering New Jersey. Six states have presently legalized riverboat gambling while others are considering its approval, including New York and Pennsylvania. Several states are considering or have approved large scale land-based casinos. Additionally, since 1993, the gaming space in Las Vegas has expanded significantly, with additional capacity planned and currently under construction. The operations of Trump Marina could be adversely affected by such competition, particularly if casino gaming were permitted in jurisdictions near or elsewhere in New Jersey or in other states in the Northeast. In December 1993, the Rhode Island Lottery Commission approved the addition of slot machine games on video terminals at Lincoln Greyhound Park and Newport Jai Alai, where poker and blackjack have been offered for over two years. Currently, casino gaming, other than Native American gaming, is not allowed in other areas of New Jersey or in Connecticut, New York or Pennsylvania. On November 17, 1995, a proposal to allow casino gaming in Bridgeport, Connecticut was voted down by that state's Senate. On June 18, 1998, the New York State Senate and General Assembly failed to enact a constitutional amendment to legalize casino gambling in certain areas of New York State, effectively postponing any referendum to authorize such a constitutional amendment until not earlier than November 2001. To the extent that legalized gaming becomes more prevalent in New Jersey or other jurisdictions near Atlantic City, competition would intensify. In particular, proposals have been introduced to legalize gaming in other locations, including Philadelphia, Pennsylvania. In February 1999, the Pennsylvania State General Assembly approved a bill allowing in May 1999 a non- binding public referendum on a variety of legalized gaming issues including riverboats, video poker in taverns and slot machines at racetracks, but the Pennsylvania State Senate failed to enact the General Assembly Bill. In addition, legislation has from time to time been introduced in the
New Jersey State Legislature relating to types of statewide legalized gaming, such as video games with small wagers. To date, no such legislation, which may require a state constitutional amendment, has been enacted. Management is unable to predict whether any such legislation, in New Jersey, Indiana, Illinois or elsewhere, will be enacted or whether, if passed, it would have a material adverse impact on Trump Marina.
Gaming and Other Laws and Regulations
The following is only a summary of the applicable provisions of the Casino Control Act and certain other laws and regulations. It does not purport to be a full description thereof and is qualified in its entirety by reference to the Casino Control Act and such other laws and regulations.
New Jersey Gaming Regulations
In general, the Casino Control Act and its implementing regulations contain detailed provisions concerning, among other things: the granting and renewal of casino licenses; the suitability of the approved hotel facility, and the amount of authorized casino space and gaming units permitted therein; the qualification of natural persons and entities related to the casino licensee; the licensing of certain employees and vendors of casino licensees; the rules of the games; the selling and redeeming of gaming chips; the granting and duration of credit and the enforceability of gaming debts; management control procedures, accounting and cash control methods and reports to gaming agencies; the security standards; the manufacture and distribution of gaming equipment; the simulcasting of horse races by casino licensees; equal employment opportunities for employees of casino operators, contractors of casino facilities and others; and advertising, entertainment and alcoholic beverages.
Casino Control Commission. The ownership and operation of casino/hotel facilities in Atlantic City are the subject of strict state regulation under the Casino Control Act. The CCC is empowered to regulate a wide spectrum of gaming and non-gaming related activities and to approve the form of ownership and financial structure of not only a casino licensee, but also its entity qualifiers and intermediary and holding companies and any other related entity required to be qualified ("CCC Regulations").
Operating Licenses. In June 1999, the CCC renewed the Partnership's casino license and approved Trump as a natural person qualifier through May 2003. This license is not transferable and its renewal will include a financial review of the Partnership. Upon revocation, suspension for more than 120 days or failure to renew a casino license, the Casino Control Act provides for the appointment of a conservator to take possession of the hotel and casino's business and property, subject to all valid liens, claims and encumbrances.
Casino License. No casino hotel facility may operate unless the appropriate license and approvals are obtained from the CCC, which has broad discretion with regard to the issuance, renewal, revocation and suspension of such licenses and approvals, which are non-transferable. The qualification criteria with respect to the holder of a casino license include its financial stability, integrity and responsibility; the integrity and adequacy of its financial resources which bear any relation to the casino project; its good character, honesty and integrity; and the sufficiency of its business ability and casino experience to establish the likelihood of a successful, efficient casino operation. The casino license currently held by the Partnership is renewable for periods of up to four years. The CCC may reopen licensing hearings at any time, and must reopen a licensing hearing at the request of the Division of Gaming Enforcement (the "Division").
To be considered financially stable, a licensee must demonstrate the following abilities: to pay winning wagers when due; to achieve an annual gross operating profit; to pay all local, state and federal taxes when due; to make necessary capital and maintenance expenditures to insure that it has a superior first-class facility; and to pay, exchange, refinance or extend debts which will mature or become due and payable during the license term.
In the event a licensee fails to demonstrate financial stability, the CCC may take such action as it deems necessary to fulfill the purposes of the Casino Control Act and protect the public interest, including: issuing
conditional licenses, approvals or determinations; establishing an appropriate cure period; imposing reporting requirements; placing restrictions on the transfer of cash or the assumption of liabilities; requiring reasonable reserves or trust accounts; denying licensure; or appointing a conservator. See "-Conservatorship."
Management believes that it has adequate financial resources to meet the financial stability requirements of the Casino Control Act for the foreseeable future.
Pursuant to the Casino Control Act, CCC Regulations and precedent, no entity may hold a casino license unless each officer, director, principal employee, person who directly or indirectly holds any beneficial interest or ownership in the licensee, each person who in the opinion of the CCC has the ability to control or elect a majority of the board of directors of the licensee (other than a banking or other licensed lending institution which makes a loan or holds a mortgage or other lien acquired in the ordinary course of business) and any lender, underwriter, agent or employee of the licensee or other person whom the CCC may consider appropriate, obtains and maintains qualification approval from the CCC. Qualification approval means that such person must, but for residence, individually meet the qualification requirements as a casino key employee.
Control Persons. An entity qualifier or intermediary or holding company, such as Funding, is required to register with the CCC and meet the same basic standards for approval as a casino licensee; provided, however, that the CCC, with the concurrence of the Director of the Division, may waive compliance by a publicly-traded corporate holding company with the requirement that an officer, director, lender, underwriter, agent or employee thereof, or person directly or indirectly holding a beneficial interest or ownership of the securities thereof, individually qualify for approval under casino key employee standards so long as the CCC and the Director of the Division are, and remain, satisfied that such officer, director, lender, underwriter, agent or employee is not significantly involved in the activities of the casino licensee, or that such security holder does not have the ability to control the publicly-traded corporate holding company or elect one or more of its directors. Persons holding five percent or more of the equity securities of such holding company are presumed to have the ability to control the company or elect one or more of its directors and will, unless this presumption is rebutted, be required to individually qualify. Equity securities are defined as any voting stock or any security similar to or convertible into or carrying a right to acquire any security having a direct or indirect participation in the profits of the issuer.
Financial Sources. The CCC may require all financial backers, investors, mortgagees, bond holders and holders of notes or other evidence of indebtedness, either in effect or proposed, which bear any relation to any casino project, including holders of publicly-traded securities of an entity which holds a casino license or is an entity qualifier, subsidiary or holding company of a casino licensee (a "Regulated Company"), to qualify as financial sources. In the past, the CCC has waived the qualification requirement for holders of less than 15% of the Mortgage Notes and the PIK Notes so long as the bonds remained widely distributed and freely traded in the public market and the holder had no ability to control the casino licensee. The CCC has, in the past, ruled that the publicity-traded Mortgage Notes and PIK Notes are widely-distributed and freely- traded in the public market. The CCC may require holders of less than 15% of a series of debt to qualify as financial sources even if not active in the management of the issuer or the casino licensee.
Institutional Investors. An institutional investor ("Institutional Investor") is defined by the Casino Control Act as any retirement fund administered by a public agency for the exclusive benefit of federal, state or local public employees; any investment company registered under the Investment Company Act of 1940, as amended; any collective investment trust organized by banks under Part Nine of the Rules of the Comptroller of the Currency; any closed end investment trust; any chartered or licensed life insurance company or property and casualty insurance company; any banking and other chartered or licensed lending institution; any investment advisor registered under the Investment Advisers Act of 1940, as amended; and such other persons as the CCC may determine for reasons consistent with the policies of the Casino Control Act.
An Institutional Investor may be granted a waiver by the CCC from financial source or other qualification requirements applicable to a holder of publicly- traded securities, in the absence of a prima facie showing by the
Division that there is any cause to believe that the holder may be found unqualified, on the basis of CCC findings that: (i) its holdings were purchased for investment purposes only and, upon request by the CCC, it files a certified statement to the effect that it has no intention of influencing or affecting the affairs of the issuer, the casino licensee or its holding or intermediary companies; provided, however, that the Institutional Investor will be permitted to vote on matters put to the vote of the outstanding security holders; and (ii) if (x) the securities are debt securities of a casino licensee's holding or intermediary companies or another subsidiary company of the casino licensee's holding or intermediary companies which is related in any way to the financing of the casino licensee and represent either (A) 20% or less of the total outstanding debt of the company or (B) 50% or less of any issue of outstanding debt of the company, (y) the securities are equity securities and represent less than 10% of the equity securities of a casino licensee's holding or intermediary companies or (z) the securities so held exceed such percentages, upon a showing of good cause. There can be no assurance, however, that the CCC will make such findings or grant such waiver and, in any event, an Institutional Investor may be required to produce for the CCC or the Antitrust Division of the Department of Justice upon request, any document or information which bears any relation to such debt or equity securities.
Generally, the CCC requires each institutional holder seeking waiver of qualification to execute a certification to the effect that (i) the holder has reviewed the definition of Institutional Investor under the Casino Control Act and believes that it meets the definition of Institutional Investor; (ii) the holder purchased the securities for investment purposes only and holds them in the ordinary course of business; (iii) the holder has no involvement in the business activities of and no intention of influencing or affecting, the affairs of the issuer, the casino licensee or any affiliate; and (iv) if the holder subsequently determines to influence or affect the affairs of the issuer, the casino licensee or any affiliate, it shall provide not less than 30 days' prior notice of such intent and shall file with the CCC an application for qualification before taking any such action. If an Institutional Investor changes its investment intent, or if the CCC finds reasonable cause to believe that it may be found unqualified, the Institutional Investor may take no action with respect to the security holdings, other than to divest itself of such holdings, until it has applied for interim casino authorization and has executed a trust agreement pursuant to such an application. See "Interim Casino Authorization."
Ownership and Transfer of Securities. The Casino Control Act imposes certain restrictions upon the issuance, ownership and transfer of securities of a Regulated Company, and defines the term "security" to include instruments which evidence a direct or indirect beneficial ownership or creditor interest in a Regulated Company including, but not limited to, mortgages, debentures, security agreements, notes and warrants. Currently, each of Funding and the Partnership is deemed to be a Regulated Company, and instruments evidencing a beneficial ownership or creditor interest therein, including partnership interest, are deemed to be the securities of a Regulated Company.
If the CCC finds that a holder of such securities is not qualified under the Casino Control Act, it has the right to take any remedial action it may deem appropriate, including the right to force divestiture by such disqualified holder of such securities. In the event that certain disqualified holders fail to divest themselves of such securities, the CCC has the power to revoke or suspend the casino license affiliated with the Regulated Company which issued the securities. If a holder is found unqualified, it is unlawful for the holder (i) to exercise, directly or through any trustee or nominee, any right conferred by such securities or (ii) to receive any dividends or interest upon any such securities or any remuneration, in any form, from its affiliated casino licensee for services rendered or otherwise.
With respect to non-publicly-traded securities, the Casino Control Act and CCC Regulations require that the corporate charter or partnership agreement of a Regulated Company establish a right in the CCC of prior approval with regard to transfers of securities, shares and other interests and an absolute right in the Regulated Company to repurchase at the market price or the purchase price, whichever is the lesser, any such security, share, or other interest in the event that the CCC disapproves a transfer. With respect to the publicly-traded securities, such corporate charter or partnership agreement is required to establish that any such securities of the entity are held subject to the condition that, if a holder thereof is found to be disqualified by the CCC, such holder shall
dispose of such securities.
Under the terms of the indentures pursuant to which the Senior Notes, the Mortgage Notes and the PIK Notes were issued, if a holder of such securities does not qualify under the Casino Control Act when required to do so, such holder must dispose of its interest in such securities and the Partnership and Funding may redeem the securities at the lesser of the outstanding amount or fair market value.
Interim Casino Authorization. Interim casino authorization is a process which permits a person who enters into a contract to obtain property relating to a casino operation or who obtains publicly-traded securities relating to a casino licensee to close on the contract or own the securities until plenary licensure or qualification. During the period of interim casino authorization, the property relating to the casino operation or the securities is held in trust.
Whenever any person enters into a contract to transfer any property which relates to an ongoing casino operation, including a security of the casino licensee or a holding or intermediary company or entity qualifier, under circumstances which would require that the transferee obtain licensure or be qualified under the Casino Control Act, and that person is not already licensed or qualified, the transferee is required to apply for interim casino authorization. Furthermore, except as set forth below with respect to publicly- traded securities, the closing or settlement date in the contract at issue may not be earlier than the 121st day after the submission of a complete application for licensure or qualification together with a fully executed trust agreement in a form approved by the CCC. If, after the report of the Division and a hearing by the CCC, the CCC grants interim authorization, the property will be subject to a trust. If the CCC denies interim authorization, the contract may not close or settle until the CCC makes a determination on the qualifications of the applicant. If the CCC denies qualification, the contract will be terminated for all purposes and there will be no liability on the part of the transferor.
If, as the result of a transfer of publicly-traded securities of a licensee, a holding or intermediary company or entity qualifier of a licensee, or a financing entity of a licensee, any person is required to qualify under the Casino Control Act, that person is required to file an application for licensure or qualification within 30 days after the CCC determines that qualification is required or declines to waive qualification. The application must include a fully executed trust agreement in a form approved by the CCC or, in the alternative, within 120 days after the CCC determines that qualification is required, the person whose qualification is required must divest such securities as the CCC may require in order to remove the need to qualify.
The CCC may grant interim casino authorization where it finds by clear and convincing evidence that: (i) statements of compliance have been issued pursuant to the Casino Control Act; (ii) the casino hotel is an approved hotel in accordance with the Casino Control Act; (iii) the trustee satisfies qualification criteria applicable to key casino employees, except for residency; and (iv) interim operation will best serve the interests of the public.
When the CCC finds the applicant qualified, the trust will terminate. If the CCC denies qualification to a person who has received interim casino authorization, the trustee is required to endeavor, and is authorized, to sell, assign, convey or otherwise dispose of the property subject to the trust to such persons who are licensed or qualified or shall themselves obtain interim casino authorization.
Where a holder of publicly-traded securities is required, in applying for qualification as a financial source or qualifier, to transfer such securities to a trust in application for interim casino authorization and the CCC thereafter orders that the trust become operative: (i) during the time the trust is operative, the holder may not participate in the earnings of the casino hotel or receive any return on its investment or debt security holdings; and (ii) after disposition, if any, of the securities by the trustee, proceeds distributed to the unqualified holder may not exceed the lower of their actual cost to the unqualified holder or their value calculated as if the investment had been made on the date the trust became operative.
Approved Hotel Facilities. The CCC may permit an existing licensee, such as the Partnership, to increase its casino space if the licensee agrees to add a prescribed number of qualifying sleeping units within two years after the commencement of gaming operations in the additional casino space. However, if the casino licensee does not fulfill such agreement due to conditions within its control, the licensee will be required to close the additional casino space, or any portion thereof that the CCC determines should be closed.
Persons who are parties to the lease for an approved hotel building or who have an agreement to lease a building which may in the judgment of the CCC become an approved hotel building are required to hold a casino license unless the CCC, with the concurrence of the Attorney General of the State of New Jersey, determines that such persons do not have the ability to exercise significant control over the building or the operation of the casino therein.
Unless otherwise determined by the CCC, agreements to lease an approved hotel building or the land under the building must be for a durational term exceeding 30 years, must concern 100% of the entire approved hotel building or the land upon which it is located and must include a buy-out provision conferring upon the lessee the absolute right to purchase the lessor's entire interest for a fixed sum in the event that the lessor is found by the CCC to be unsuitable.
Agreement for Management of Casino. Each party to an agreement for the management of a casino is required to hold a casino license, and the party who is to manage the casino must own at least 10% of all the outstanding equity securities of the casino licensee. Such an agreement shall: (i) provide for the complete management of the casino; (ii) provide for the unrestricted power to direct the casino operations; and (iii) provide for a term long enough to ensure the reasonable continuity, stability and independence and management of the casino.
License Fees. The CCC is authorized to establish annual fees for the renewal of casino licenses. The renewal fee is based upon the cost of maintaining control and regulatory activities prescribed by the Casino Control Act, and may not be less than $200,000 for a four-year casino license. Additionally, casino licensees are subject to potential assessments to fund any annual operating deficits incurred by the CCC or the Division. There is also an annual license fee of $500 for each slot machine maintained for use or in use in any casino.
Gross Revenue Tax. Each casino licensee is also required to pay an annual tax of 8% on its gross casino revenues. For the years ended December 31, 1997, 1998 and 1999, the Partnership's gross revenue tax was approximately $21.1 million, $21.1 million and $21.8 million, respectively, and its license, investigation and other fees and assessments totaled approximately $3.5 million, $3.7 million and $3.7 million, respectively.
Investment Alternative Tax Obligations. An investment alternative tax imposed on the gross casino revenues of each licensee in the amount of 2.5% is due and payable on the last day of April following the end of the calendar year. A licensee is obligated to pay the investment alternative tax for a period of 30 years. Estimated payments of the investment alternative tax obligation must be made quarterly in an amount equal to 1.25% of estimated gross revenues for the preceding three-month period. Investment tax credits may be obtained by making qualified investments or by the purchase of bonds issued by the CRDA ("CRDA Bonds"), which may have terms as long as 50 years and bear interest at below market rates, resulting in a value lower than the face value of such CRDA Bonds.
For the first ten years of its tax obligation, the licensee is entitled to an investment tax credit against the investment alternative tax in an amount equal to twice the purchase price of the CRDA Bonds issued to the licensee. Thereafter, the licensee (i) is entitled to an investment tax credit in an amount equal to twice the purchase price of such CRDA Bonds or twice the amount of its investments authorized in lieu of such bond investments or made in projects designated as eligible by the CRDA and (ii) has the option of entering into a contract with the CRDA to have its tax credit comprised of direct investments in approved eligible projects which may not comprise more than 50% of its eligible tax credit in any one year.
From the monies made available to the CRDA, the CRDA is required to set aside $175 million for investment in hotel development projects in Atlantic City undertaken by a licensee which result in the construction or rehabilitation of at least 200 hotel rooms. These monies will be held to fund up to 27% of the cost to casino licensees of expanding their hotel facilities to provide additional hotel rooms, a portion of which has been required to be available with respect to the new Atlantic City Convention Center.
Minimum Casino Parking Charges. As of July 1, 1993, each casino licensee was required to pay the New Jersey State Treasurer a $1.50 charge for every use of a parking space for the purpose of parking motor vehicles in a parking facility owned or leased by a casino licensee or by any person on behalf of a casino licensee. This amount is paid into a special fund established and held by the New Jersey State Treasurer for the exclusive use of the CRDA. The Partnership currently charges its parking patrons $2.00 in order to make its required payments to the New Jersey State Treasurer and cover related expenses. Amounts in the special fund will be expended by the CRDA for eligible projects in the corridor region of Atlantic City related to improving the highways, roads, infrastructure, traffic regulation and public safety of Atlantic City or otherwise necessary or useful to the economic development and redevelopment of Atlantic City in this regard.
Atlantic City Fund. On each October 31 during the years 1996 through 2003, each casino licensee shall pay into an account established in the CRDA and known as the Atlantic City Fund, its proportional share of an amount related to the amount by which annual operating expenses of the CCC and the Division are less than a certain fixed sum. Additionally, a portion of the investment alternative tax obligation of each casino licensee for the years 1994 through 1998 allocated for projects in northern New Jersey shall be paid into and credited to the Atlantic City Fund. Amounts in the Atlantic City Fund will be expended by the CRDA for economic development projects of a revenue producing nature that foster the redevelopment of Atlantic City other than the construction and renovation of casino hotels.
Conservatorship. If, at any time, it is determined any casino licensee or any other entity qualifier has violated the Casino Control Act or that any of such entities cannot meet the qualification requirements of the Casino Control Act, such entity could be subject to fines or the suspension or revocation of its license or qualification. If the Partnership's license is suspended for a period in excess of 120 days or is revoked, or if the CCC fails or refuses to renew such casino license, the CCC could appoint a conservator to operate or dispose of the Partnership's casino hotel facilities. A conservator would be vested with title to all property of the Partnership relating to the casino and the approved hotel subject to valid liens and/or encumbrances. The conservator would be required to act under the direct supervision of the CCC and would be charged with the duty of conserving, preserving, and, if permitted, continuing the operation of the casino hotel. During the period of the conservatorship, a former or suspended casino licensee is entitled to a fair rate of return out of net earnings, if any, on the property retained by the conservator. The CCC may also discontinue any conservatorship action and direct the conservator to take such steps as are necessary to effect an orderly transfer of the property of a former or suspended casino licensee. Such events could result in an event of default under the Partnership's indentures pursuant to which the Senior Notes, the Mortgage Notes and the PIK Notes were issued.
Qualification of Employees. Certain employees of the Partnership must be licensed by or registered with the CCC, depending on the nature of the position held. Casino employees are subject to more stringent requirements than non- casino employees and must meet applicable standards pertaining to financial stability, integrity and responsibility, good character, honesty and integrity, business ability and casino experience and New Jersey residency. These requirements have resulted in significant competition among Atlantic City casino operators for the services of qualified employees.
Gaming Credit. The Partnership's casino games are conducted on a credit as well as a cash basis. Gaming debts arising in Atlantic City in accordance with applicable regulations are enforceable in the courts of the State of New Jersey. The extension of gaming credit is subject to regulations that detail procedures which casinos must follow when granting gaming credit and recording counter checks which have been exchanged, redeemed or consolidated. Gaming credit may not be collectible in foreign countries.
Control Procedures. Gaming at Trump Marina is conducted by trained and supervised personnel. The Partnership employs extensive security and internal controls. Security checks are made to determine, among other matters, that job applicants for key positions have had no criminal history or associations. Security controls utilized by the surveillance department include closed circuit video cameras to monitor the casino floor and money counting areas. The count of moneys from gaming also is observed daily by representatives of the CCC.
Other Laws and Regulations
The United States Department of the Treasury (the "Treasury") has adopted regulations pursuant to which a casino is required to file a report of each deposit, withdrawal, exchange of currency, gambling tokens or chips, or other payments or transfers by, through or to such casino which involves a transaction in currency of more than $10,000 per patron, per gaming day. Such reports are required to be made on forms prescribed by the Secretary of the Treasury and are filed with the Internal Revenue Service (the "Service"). In addition, the Partnership is required to maintain detailed records (including the names, addresses, social security numbers and other information with respect to its gaming customers) dealing with, among other items, the deposit and withdrawal of funds and the maintenance of a line of credit.
In the past, the Service had taken the position that gaming winnings from the table games by nonresident aliens were subject to a 30% withholding tax. The Service, however, subsequently adopted a practice of not collecting such tax. Recently enacted legislation exempts from withholding tax table game winnings by nonresident aliens, unless the Secretary of the Treasury determines by regulation that such collections have become administratively feasible.
The Partnership is subject to other federal, state and local regulations and, on a periodic basis, must obtain various licenses and permits, including those required to sell alcoholic beverages in the State of New Jersey as well as in other jurisdictions. Management believes all required licenses and permits necessary to conduct its business have been obtained for operations in New Jersey.
ITEM 2.
ITEM 2. PROPERTIES.
The Casino Parcel. Trump Marina is located in the Marina District on an approximately 14.7 acre triangular-shaped parcel of land, which is owned by the Partnership in fee, located at the intersection of Huron Avenue and Brigantine Boulevard directly across from the marina, approximately two miles from The Boardwalk.
Trump Marina has approximately 75,900 square-feet of gaming space which accommodates 86 table games, 2,159 slot machines and race simulcasting facilities. In addition to the casino, Trump Marina consists of a 27-story hotel with 728 guest rooms, including 153 suites, of which 97 are "Crystal Tower" luxury suites. Renovation of 90, 64 and 60 of the guest rooms was completed in 1997, 1998 and 1999, respectively. The facility also offers eight restaurants, two clubs for the exclusive use of select customers, a 540-seat cabaret theater, two cocktail lounges, 58,000 square-feet of convention, ballroom and meeting space, a swimming pool, tennis courts and a sports and health club facility. Trump Marina has been designed so that it can be enlarged in phases into a facility containing 2,000 rooms and a 1,600-seat cabaret theater. Trump Marina also has a nine-story garage providing on-site parking for approximately 3,000 vehicles and a helipad which is located atop the parking garage, making Trump Marina the only Atlantic City casino with access by land, sea and air.
Trump Marina has commenced a slot room expansion project which is scheduled to be completed during the second quarter of 2000. This expansion project will increase Trump Marina's gaming space by approximately 5,600 square feet and is expected to include approximately 250 additional slot machines. Between 1994 and 1999, management replaced substantially all of its slot machines with newer, more popular models and upgraded its computerized slot tracking and slot marketing system. During 1997, the property was rethemed with a nautical emphasis and renamed Trump Marina. In 1994, management completed a 3,000 square- foot expansion to its casino which enabled Trump Marina to accommodate the addition of simulcast racetrack wagering and expended
in excess of $2 million on renovations to its hotel facility. The casino expansion also increased casino access and casino visibility for hotel patrons. In 1993, Trump Marina completed the construction of a Las Vegas-style marquee and reader board.
The Marina. Pursuant to an agreement with the New Jersey Division of Parks and Forestry (the "Marina Agreement"), the Partnership in 1987 began operating and renovating the marina at Trump Marina, including docks containing approximately 645 slips. An elevated pedestrian walkway connecting Trump Marina to a two-story building at the marina was completed in 1989. The Partnership constructed the two-story building, which contains a 240-seat restaurant and offices as well as a snack bar and a large nautical theme retail store. Pursuant to the Marina Agreement and a certain lease between the State of New Jersey, as landlord, and the Partnership, as tenant, dated as of September 1, 1990 (the "Marina Lease"), the Partnership commenced leasing the marina and the improvements thereon for an initial term of twenty-five years. The Marina Lease is a net lease pursuant to which the Partnership, in addition to the payment of annual rent equal to the greater of (i) a certain percentage of gross revenues of the Partnership from operation of the marina during the lease year and (ii) an initial minimum base rent of $300,000 annually (increasing every five years to $500,000 in 2010), is responsible for all costs and expenses related to the premises, including but not limited to, all maintenance and repair costs, insurance premiums, real estate taxes, assessments and utility charges. Any improvements made to the marina (which is owned by the State of New Jersey), excluding the elevated pedestrian walkway, automatically becomes the property of the State of New Jersey upon their completion.
The Parking Parcel. The Partnership also owns an employee parking lot approximately two miles from Trump Marina, which can accommodate approximately 1,000 cars.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
The Partnership, its partners, certain members of the former Executive Committee, Funding and certain of their employees are involved in various legal proceedings. Such persons and entities are vigorously defending the allegations against them and intend to contest vigorously any future proceedings. The Partnership and Funding have agreed to indemnify such persons against any and all losses, claims, damages, expenses (including reasonable costs, disbursements and counsel fees) and liabilities (including amounts paid or incurred in satisfaction of settlements, judgments, fines and penalties) incurred by them in said legal proceedings.
Steiner Action. On or about July 30, 1999, William K. Steiner, a stockholder of THCR, filed a derivative action in the Court of Chancery in Delaware (Civil Action No. 17336NC) against each member of the Board of Directors of THCR. The plaintiff claims that the directors of THCR breached their fiduciary duties by approving certain loans from THCR to Trump. The complaint seeks to rescind the loans, and also seeks an order requiring the defendants to account to THCR for losses and damages allegedly resulting from the loans. The defendants believe that the suit is without merit and on October 1, 1999, the defendants moved to dismiss the complaint. On January 31, 2000 the director defendants filed their opening brief in support of this motion to dismiss.
On August 14, 1996, certain stockholders of THCR filed two derivative actions in the Court of Chancery in Delaware (Civil Action Nos. 15148 and 15160) (the "Delaware cases") against each of the members of the Board of Directors of THCR, THCR, THCR Holdings, the Partnership and TCI-II. The plaintiffs claim that the directors of THCR breached their fiduciary duties in connection with the Castle Acquisition by purchasing these interests at an excessive price in a self-dealing transaction. The complaint sought to enjoin the transaction, and also sought damages and an accounting. The injunction was never pursued. These plaintiffs served a notice of dismissal in the Delaware cases on December 29, 1997. The Court of Chancery has not yet ordered the Delaware cases dismissed.
On October 16, 1996, a stockholder of THCR filed a derivative action in the United States District Court, Southern District of New York (96 Civ. 7820) against each member of the Board of Directors of THCR, THCR, THCR Holdings, the Partnership, Trump Casinos, Inc. ("TCI"), TCI-II, TCHI and Salomon Brothers, Inc
("Salomon"). The plaintiff claims that certain of the defendants breached their fiduciary duties and engaged in ultra vires acts in connection with the Castle Acquisition and that Salomon was negligent in the issuance of its fairness opinion with respect to the Castle Acquisition. The plaintiff also alleges violations of the federal securities laws for alleged omissions and misrepresentations in THCR's proxies, and that Trump, TCI-II and TCHI breached the acquisition agreement by supplying THCR with untrue information for inclusion in the proxy statement delivered to THCR's stockholders in connection with the Castle Acquisition. The plaintiff seeks removal of the directors of THCR, and an injunction, rescission and damages.
The Delaware cases were amended and refiled in the Southern District of New York and consolidated with the federal action for all purposes, including pretrial proceedings and trial. On or about January 17, 1997, the plaintiffs filed their Consolidated Amended Derivative Complaint (the "First Amended Complaint"), reflecting the consolidation. On or about March 24, 1997, the plaintiffs filed their Second Consolidated Amended Derivative Complaint (the "Second Amended Complaint"). In addition to the allegations made in the First Amended Complaint, the Second Amended Complaint claims that certain of the defendants breached their fiduciary duties and wasted corporate assets in connection with a previously contemplated transaction with Colony Capital, Inc. ("Colony Capital"). The Second Amended Complaint also includes claims against Colony Capital for aiding and abetting certain of those violations. In addition to the relief sought in the First Amended Complaint, the Second Amended Complaint sought to enjoin the previously contemplated transaction with Colony Capital or, if it was effectuated, to rescind it. On March 27, 1997, THCR and Colony Capital mutually agreed to end negotiations with respect to such transaction. On June 26, 1997, plaintiffs served their Third Consolidated Amended Derivative Complaint (the "Third Amended Complaint"), which omitted the claims against Colony Capital. THCR and the other defendants in the action moved to dismiss the Third Amended Complaint on August 5, 1997. The plaintiffs opposed the defendants' motions to dismiss the Third Amended Complaint by response dated October 24, 1997. The defendants' reply was served December 9, 1997. By letter dated April 2, 1998, the plaintiffs sought the Court's permission to amend further the Third Amended Complaint to add certain additional factual allegations. The defendants opposed the motion and the Court has not yet ruled on it.
Other Litigation. On March 13, 1997, THCR filed a lawsuit in the United States District Court, District of New Jersey, against Mirage, the State of New Jersey ("State"), the New Jersey Department of Transportation ("NJDOT"), the South Jersey Transportation Authority ("SJTA"), the CRDA, the New Jersey Transportation Trust Fund Authority and others. THCR was seeking declaratory and injunctive relief to recognize and prevent violations by the defendants of the casino clause of the New Jersey State Constitution and various federal securities and environmental laws relating to proposed infrastructure improvements in the Atlantic City marina area. While this action was pending, defendants State and CRDA then filed an action in the New Jersey State Court seeking a declaratory judgment as to the claim relating to the casino clause of the New Jersey State Constitution. On May 1, 1997, the United States District Court dismissed the federal claims and ruled that the State constitutional claims should be pursued in State Court. On April 2, 1998, the United States Court of Appeals for the Third Circuit affirmed the dismissal and THCR's petition to the Third Circuit for a rehearing was denied. On May 14, 1997 the State Court granted judgment in favor of the State and CRDA. On March 20, 1998, the Appellate Division affirmed. On August 2, 1999, the State Supreme Court affirmed with two justices dissenting.
On June 26, 1997, THCR filed an action against NJDOT, SJTA, Mirage and others, in the Superior Court of New Jersey, Chancery Division, Atlantic County (the "Chancery Division Action"). THCR sought to declare unlawful and enjoin certain actions and omissions of the defendants arising out of and relating to a certain Road Development Agreement dated as of January 10, 1997, by and among NJDOT, SJTA and Mirage (the "Road Development Agreement") and the public funding of a certain road and tunnel project to be constructed in Atlantic City, as further described in the Road Development Agreement. THCR moved to consolidate this action with other previously filed related actions. Defendants opposed THCR's motion to consolidate the Chancery Division Action, initially moved to dismiss this action on procedural grounds and subsequently moved to dismiss this action on substantive grounds. On October 20, 1997, the Chancery Court denied the defendants' motion to dismiss this action on procedural grounds, but entered summary judgment dismissing this action on substantive grounds. This
decision was affirmed at the appellate level on June 19, 1999. On November 23, 1999, the State Supreme Court denied THCR's petition for certification.
On June 26, 1997, THCR also filed an action, in lieu of prerogative writs, against the CRDA, in the Superior Court of New Jersey, Law Division, Atlantic County, seeking review of the CRDA's April 15, 1997 approval of funding ($120 million principal amount plus interest) for the road and tunnel project discussed above, a declaratory judgment that the said project is not eligible for such CRDA funding, and an injunction prohibiting the CRDA from contributing such funding to the said project. Defendants moved to dismiss this action on procedural grounds and also sought to transfer this action to New Jersey's Appellate Division. On October 3, 1997, the New Jersey Superior Court transferred this action to the Appellate Division. On June 19, 1999, the Appellate Division dismissed THCR's claims and on November 23, 1999, the State Supreme Court denied THCR's petition for certification.
On September 9, 1997, Mirage filed a complaint against Trump, THCR and Hilton Hotels Corporation, in the United States District Court for the Southern District of New York (the "New York Action"). The complaint sought damages for alleged violations of antitrust laws, tortious interference with prospective economic advantage and tortious inducement of a breach of fiduciary duties arising out of activities purportedly engaged in by defendants in furtherance of an alleged conspiracy to impede Mirage's efforts to build a casino resort in the Marina district of Atlantic City, New Jersey. Among other things, Mirage contended that the defendants filed several frivolous lawsuits and funded others that challenge the proposed state funding mechanisms for the construction of a proposed roadway and tunnel that would be paid for chiefly through government funds and which would link the Atlantic City Expressway with the site of Mirage's proposed new casino resort. On November 10, 1997, THCR and Trump moved to dismiss the complaint. On December 18, 1998 the Court denied the motion to dismiss brought by Trump and THCR. On April 20, 1999, Mirage and an affiliate, the Mirage Casino Hotel filed a complaint against THCR and other defendants in Nevada State Court (the "Nevada Action"). The Nevada Action, which was subsequently removed to the United States District Court for the District of Nevada, sought damages and an injunction for an alleged misappropriation of trade secrets, intentional interference with prospective economic advantage and contractual relations and conspiracy to injure Mirage. On February 23, 2000, THCR and Mirage entered into an agreement whereby the New York Action and the Nevada Action against THCR and all of its officers and directors will both be dismissed with prejudice. The parties exchanged mutual releases and no money was paid by either side.
Various other legal proceedings are now pending against the Partnership. The Partnership considers all such proceedings to be ordinary litigation incident to the character of its business. Management believes that the resolution of these claims will not, individually or in the aggregate, have a material adverse effect on the financial condition or results of operations of the Partnership.
From time to time, the Partnership may be involved in routine administrative proceedings involving alleged violations of certain provisions of the Casino Control Act. However, the Partnership believes that the final outcome of these proceedings will not, either individually or in the aggregate, have a material adverse effect on the Partnership or on its ability to otherwise retain or renew any casino or other licenses required under the Casino Control Act for the operation of Trump Marina.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted by the Registrants to their security holders during the fourth quarter of 1999.
PART II
ITEM 5.
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
There is no established public trading market for Funding's or TCHI's outstanding common stock or for the Partnership's partnership interests.
As of December 31, 1999, the Partnership is the sole holder of the outstanding common stock of Funding, THCR Holdings is the sole holder of the outstanding common shares of TCHI and THCR Holdings is a 99% limited partner of the Partnership and TCHI is a 1% general partner.
Funding and TCHI have paid no cash dividends on its common stock, and except as set forth under "Business-Trump Marina-Historical Background", the Partnership has made no general distributions with respect to its equity interests.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
The following table sets forth certain selected consolidated financial information from Funding's and the Partnership's Consolidated Statements of Operations for the year ended December 31, 1995, the period from January 1, 1996 through October 6, 1996, the period from October 7, 1996 (the date of the Castle Acquisition) through December 31, 1996 and the years ended December 31, 1997, 1998 and 1999, respectively, and the Consolidated Balance Sheets as of December 31, 1995, October 6, 1996, December 31, 1996, 1997, 1998 and 1999, respectively (see note (1) below). All financial information should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations," and the consolidated financial statements and the related notes thereto included elsewhere in this Form 10-K.
___________ (1) THCR Holdings acquired on October 7, 1996 all of the outstanding equity interest of the Partnership. This acquisition has been accounted for as a purchase. The excess of the purchase price over the fair value of the net assets acquired of $196,109,000 (including transaction costs, the purchase of the outstanding TCHI warrants and the historical negative book value of the Partnership of $20,714,000) has been recorded on the books of the Partnership and has been allocated to property, plant and equipment based upon an appraisal. As a result of the acquisition, a new basis of accounting was established and financial statements prior to October 7, 1996 are presented as Predecessor financial statements. The financial statements from October 7, 1996 are presented as Successor financial statements.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The financial information presented below reflects the financial condition and results of operations of the Partnership. Funding is a wholly owned subsidiary of the Partnership and conducts no business other than collecting amounts due under certain intercompany notes from the Partnership for the purpose of paying principal of, premium, if any, and interest on its indebtedness, which Funding issued as a nominee for the Partnership.
Gaming revenues are the primary source of the Partnership's revenues and primarily consist of slot machine and table game win. The following table details activity for the major components of gaming revenue:
Results of Operations for the Years Ended December 31, 1998 and 1999
Table game revenues remained relatively constant at approximately $72.9 million for the year ending December 31, 1999 as compared to the year ended December 31, 1998. This result reflects an increased table game drop offset by a decreased table game win percentage. Table game revenues represent the amount retained by the Partnership from amounts wagered at table games. The table game win percentage tends to be fairly constant over the long term, but may vary significantly in the short term due to the large wagers by "highrollers." The Atlantic City industry table game win percentages remained constant at 15.3% for the years ended December 31, 1998 and 1999.
Slot revenues increased by approximately $7.4 million (4.0%) to $194.6 million for the year ended December 31, 1999 from $187.2 million for the year ended December 31, 1998, due primarily to an increased slot handle. The increased slot handle is a result of sustained marketing programs and events designed specifically for the slot customer. In addition, the Partnership completed its slot machine renovation project during June 1999, and accordingly, benefited from an improved slot product during the second half of 1999.
Nongaming revenues, in the aggregate, remained relatively constant for the year ended December 31, 1999 as compared to the year ended December 31, 1998. This result reflects the continued focus designed to control marketing costs and to increase cash sales from nongaming operations. Accordingly, promotional allowances decreased by approximately $1.9 million (4.9%) to $36.8 million for the year ended December 31, 1999 from $38.7 million for the year ended December 31, 1998. In addition, cash sales from nongaming operations increased by approximately $2.1 million (9.4%) to $24.4 million for the year ended December 31, 1999 from $22.3 million for the year ended December 31, 1998.
Gaming costs and expenses decreased by approximately $3.5 million (2.1%) to $163.5 million for the year ended December 31, 1999 from $167.0 million for the year ended December 31, 1998. This decrease is primarily the result of a decrease in promotional and complimentary expenses achieved by eliminating less profitable programs.
Room costs increased by approximately $0.9 million (27.3%) to $4.2 million for the year ended December 31, 1999 from $3.3 million for the year ended December 31, 1998. This increase is due primarily to associated costs incurred related to the increased cash rooms revenues generated in 1999.
Food and beverage costs increased by approximately $1.2 million (12.5%) to $10.8 million for the year ended December 31, 1999 from $9.6 million for the year ended December 31, 1998. This increase is due primarily to associated costs incurred related to the increased food and beverage cash revenues generated in 1999.
General and administrative costs and expenses increased by approximately $6.3 million (10.5%) to $66.4 million for the year ended December 31, 1999 from $60.1 million for the year ended December 31, 1998. This increase is due primarily to incremental costs incurred related to the Services Agreement (as defined - see "Item 11"), employee incentive compensation and insurance costs.
Interest expense increased by approximately $1.9 million (3.6%) to $54.2 million for the year ended December 31, 1999 from $52.3 million for the year ended December 31, 1998 primarily due to an increase in the outstanding principal related to the PIK Notes.
Results of Operations for the Years Ended December 31, 1997 and 1998
Table game revenues decreased by approximately $3.2 million (4.2%) to $72.9 million for the year ended December 31, 1998 from $76.1 million for the year ended December 31, 1997, primarily due to a reduced table game drop. The reduced table game drop was partially offset by a higher table game win percentage. The reduction in table game drop is a result of the increased gaming capacity in the Atlantic City market as well as
management's decision to reduce promotional gaming costs in an effort to eliminate less profitable programs. Table game revenues represent the amount retained by the Partnership from amounts wagered at table games. The table game win percentage tends to be fairly constant over the long term, but may vary significantly in the short term, due to the large wagers by "highrollers." The Atlantic City industry table game win percentages were 15.0% and 15.3% for the years ended December 31, 1997 and 1998, respectively.
Slot revenues increased by approximately $2.8 million (1.5%) to $187.2 million for the year ended December 31, 1998 from $184.4 million for the year ended December 31, 1997, due primarily to an increased slot handle. The increased slot handle is due to a more aggressive marketing approach targeted towards the slot customer.
Nongaming revenues, in the aggregate, decreased by approximately $3.3 million (5.1%) to $61.0 million for the year ended December 31, 1998 from $64.3 million for the year ended December 31, 1997, primarily as a result of a decrease in rooms revenue due to a reduction in complimentary room rates. The complimentary room rates were reduced by management to more closely conform to current industry practice. Industry-wide room rates have recently decreased as a result of increased room inventory in the Atlantic City market.
The majority of the decrease in nongaming revenues was offset by a corresponding decrease in promotional allowances. Promotional allowances decreased by approximately $2.4 million (5.8%) to $38.7 million for the year ended December 31, 1998 from $41.1 million for the year ended December 31, 1997, primarily as a result of a decrease in complimentary room rates related to marketing activities.
Gaming costs and expenses decreased by approximately $4.8 million (2.8%) to $167.0 million for the year ended December 31, 1998 from $171.8 million for the year ended December 31, 1997. This decrease is primarily the result of a decrease in promotional and complimentary expenses achieved by eliminating less profitable programs.
General and administrative expenses decreased by approximately $2.6 million (4.1%) to $60.1 million for the year ended December 31, 1998 from $62.7 million for the year ended December 31, 1997 primarily due to reduced advertising expenses and insurance costs. During 1998, self-insurance reserves decreased due to an internally focused aggressive policy where potential lawsuits are challenged immediately. Additionally, a more aggressive litigation policy was pursued to deter present and future frivolous lawsuits. The Partnership also retained an outside consultant to comprehensively review certain claims and to assist the Partnership in establishing the estimated reserves at December 31, 1998.
Interest expense increased by approximately $2.4 million (4.8%) to $52.3 million for the year ended December 31, 1998 from $49.9 million for the year ended December 31, 1997 primarily due to an increase in the outstanding principal related to the PIK Notes.
Capital Resources and Liquidity
Cash flow from operating activities is the Partnership's principal source of liquidity. For the year ended December 31, 1999, the Partnership's net cash flow provided by operating activities was $11.5 million.
In addition to funding operations, the Partnership's principal uses of cash are capital expenditures and debt service.
Capital expenditures for 1999 were approximately $8.6 million, with $4.5 million acquired for cash and $4.1 million through capitalized lease financing. These capital expenditures consisted principally of a redesign of the casino floor, purchases of slot machines, hotel room renovations, and ongoing property enhancements.
The Partnership's debt consists primarily of (i) the Mortgage Notes, (ii) the PIK Notes, (iii) the Senior Notes, and (iv) the Working Capital Loan.
The Mortgage Notes have an outstanding principal amount of approximately $242.1 million, bear interest at the rate of 11 3/4 per annum and mature on November 15, 2003.
The PIK Notes have an outstanding principal amount of approximately $105.8 million and mature on November 15, 2005. Interest is currently payable semi- annually at the rate of 13 7/8%. On or prior to November 15, 2003, interest on the PIK Notes may be paid in cash or through the issuance of additional PIK Notes. During 1999, interest in the amount of $13.3 million was paid through the issuance of additional PIK Notes and the Partnership anticipates that additional interest due in 2000 of approximately $15.2 million will be paid through the issuance of additional PIK Notes. Also, approximately 90% of the PIK notes are currently owned by THCR Holdings.
On April 17, 1998, Funding refinanced its Old Senior Notes and its Term Loan by issuing the Senior Notes. The proceeds from this issuance were used to redeem all of the issued and outstanding Old Senior Notes at 100% of their principal amount and to repay the Term Loan in full. In conjunction with this refinancing, TCHI obtained the Working Capital Loan and loaned the proceeds to the Partnership.
The Senior Notes have an outstanding principal amount of $62.0 million and bear interest at the rate of 10 1/4% per annum, payable semi-annually each April and October. The entire principal balance of the Senior Notes matures on April 30, 2003.
The Working Capital Loan has an outstanding principal amount of $5.0 million and bears interest at the rate of 10 1/4% per annum, payable semi- annually each April and October. The entire principal balance of the Working Capital Loan matures on April 30, 2003.
The Partnership's total cash debt service requirement was approximately $38.2 million during 1999 and the Partnership anticipates that approximately $37.0 million in cash will be required during 2000 to meet its debt service obligations. The Partnership has the authority to obtain a working capital facility of up to $10.0 million (of which approximately $5.0 million is outstanding), although there can be no assurance that such financing will be available, or on terms acceptable to the Partnership.
The ability of Funding and the Partnership to pay their indebtedness when due will depend on the ability of the Partnership to either generate cash from operations sufficient for such purposes or to refinance such indebtedness on or before the date on which it becomes due. Cash flow from operations may not be sufficient to repay a substantial portion of the principal amount of the debt at maturity. The future operating performance of the Partnership and the ability to refinance this debt will be subject to the then prevailing economic conditions, industry conditions and numerous other financial, business and other factors, many of which are beyond the control of Funding, TCHI or the Partnership. There can be no assurance that the future operating performance of the Partnership will be sufficient to meet these repayment obligations or that the general state of the economy, the status of the capital markets or the receptiveness of the capital markets to the gaming industry will be conducive to refinancing this debt or other attempts to raise capital.
Year 2000
The Partnership assessed the Year 2000 issue and implemented a plan to insure its systems were year 2000 compliant. As a result of these efforts, the Partnership was fully year 2000 compliant. The cost of addressing the Year 2000 issue was not material.
This Year 2000 disclosure constitutes Year 2000 readiness disclosure within the meaning of the Year 2000 Information and Readiness Disclosure Act.
Impact of New Accounting Standards
The Partnership has assessed the impact of newly issued accounting standards expected to go into effect during 2000 in accordance with Staff Accounting Bulletin No. 74 and, where applicable, disclosures have been provided in the financial statements. Additionally, the Partnership has also reviewed the impact of new accounting standards which went into effect during 1999 and, where applicable, the Partnership has provided the required disclosures.
Seasonality
The gaming industry in Atlantic City is seasonal, with the heaviest activity occurring during the period from May through September. Consequently, the Partnership's operating results during the two quarters ending in March and December would not likely be as profitable as the two quarters ending in June and September.
Inflation
There was no significant impact on the Partnership's operations as a result of inflation in 1997, 1998 or 1999.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Management has reviewed the disclosure requirements for Item 7A and, based upon the Partnership, Funding and TCHI's current capital structure, scope of operations and financial statement structure, management believes that such disclosure is not warranted at this time. Since conditions may change, the Partnership, Funding and TCHI will periodically review its compliance with this disclosure requirement to the extent applicable.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
An index to financial statements and required financial statement schedules is set forth in Item 14.
ITEM 9.
ITEM 9. DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS.
All decisions affecting the business and affairs of the Partnership, including the operation of Trump Marina, are decided by the general partners acting by and through a Board of Partner Representatives, which includes a minority of Representatives elected indirectly by the holders of the Mortgage Notes and PIK Notes (the "Noteholder Representatives"). As currently constituted, the Board of Partner Representatives consists of Messrs. Donald J. Trump, Chairman, Nicholas L. Ribis, John P. Burke, Robert M. Pickus, Asher O. Pacholder, Thomas F. Leahy and Arthur S. Bahr. TCHI's Board of Directors consists of the members of the Board of Partner Representatives.
The sole director of Funding is Trump. Trump also serves as its Chairman of the Board, President and Treasurer.
Set forth below are the names, ages, positions and offices held with Funding and the Partnership, and a brief account of the business experience during the past five years of each member of the Board of Partner Representatives, the executive officers of Funding and the Partnership, and the director of Funding.
Donald J. Trump--Trump, 53 years old, has been Chairman of the Board of Directors of THCR and Trump Hotels & Casino Resorts Funding, Inc. ("THCR Funding") since their formation in 1995. Trump was a 50% shareholder, Chairman of the Board of Directors, President and Treasurer of TP/GP, Inc. ("Trump Plaza GP") and the managing general partner of Plaza Associates prior to June 1993. Trump was Chairman of the Executive Committee and President of Plaza Associates from May 1986 to May 1992 and was a general partner of Plaza Associates until June 1993. Trump has been a director of Trump Atlantic City Holding, Inc. ("Trump AC Holding") since February 1993 and was President of Trump AC Holding from February 1993 until December 1997. Trump was a partner in Trump Atlantic City Associates ("Trump AC") from February 1993 until June 1995. Trump has been Chairman of the Board of Directors of Trump Atlantic City Funding, Inc. ("Trump AC Funding") since its formation in January 1996 and the Chairman of the Board of Directors of Trump Atlantic City Funding II, Inc. ("Funding II") and Trump Atlantic City Funding III, Inc. ("Funding III") since their formation in November 1997. Trump has been Chairman of the Board of Directors of THCR Holding Corp. ("THCR Holding Corp.") and THCR/LP Corporation ("THCR/LP") since October 1991, President and Treasurer of THCR Holding Corp. since March 4, 1991; Chairman of the Board of Directors, President and Treasurer of TCI since June 1988; Chairman of the Executive Committee of Taj Associates from June 1988 to October 1991; and President and sole Director of Trump Taj Mahal Realty Corp. ("Realty Corp.") since May 1986. Trump has been the sole director of Trump Atlantic City Corporation ("TACC") since March 1991. Trump was President and Treasurer of TACC from March 1991 until December 1997. Trump has been the sole director of Trump Indiana, Inc. ("Trump Indiana") since its formation. Trump has been Chairman of the Board of Partner Representatives of the Partnership since May 1992; and was Chairman of the Executive Committee of the Partnership from June 1985 to May 1992. Trump is the Chairman of the Board of Directors of Funding and served as President and Treasurer of Funding until April 1998. Trump is the Chairman of the Board and Treasurer of TCHI. Trump is the President, Treasurer, sole director and sole shareholder of TCI-II. Trump has been a Director of THCR Enterprises, Inc., a Delaware corporation ("THCR Enterprises"), since its formation in January 1997. Trump is also the President of The Trump Organization, which has been in the business, through its affiliates and subsidiaries, of acquiring, developing and managing real estate properties for more than the past five years. Trump was a member of the Board of Directors of Alexander's Inc. from 1987 to March 1992.
Nicholas L. Ribis--Mr. Ribis, 55 years old, has been President, Chief Executive Officer and a director of THCR and THCR Funding and Chief Executive Officer of THCR Holdings since their formation in 1995. Mr. Ribis has been the Chief Executive Officer of Plaza Associates since February 1991, was President from April 1994 to February 1995, was a member of the Executive Committee of Plaza Associates from April 1991 to May 29, 1992 and was a director and Vice President of Trump Plaza GP from May 1992 until June 1993. Mr. Ribis served as
Vice President of Trump AC Holding from February 1995 until December 1997. Mr. Ribis has served as President of Trump AC Holding since December 1997. Mr. Ribis has served as a director of Trump AC Holding since June 1993. Mr. Ribis has been Chief Executive Officer, President and a director of Trump AC Funding since its formation in January 1996 and Chief Executive Officer, President and a director of Funding II and Funding III since their formation in November 1997. Mr. Ribis served as Vice President of TACC until December 1997. Mr. Ribis has served as the President of TACC since December 1997. Mr. Ribis has been the President and Chief Executive Officer of Trump Indiana since its formation. Mr. Ribis has been a Director of THCR/LP and THCR Holding Corp. since October 1991 and was Vice President of THCR/LP and THCR Holding Corp. until June 1995; Chief Executive Officer of Taj Associates since February 1991; Vice President of TCI since February 1991 and Secretary of TCI since September 1991; Director of Realty Corp. since October 1991; and a member of the Executive Committee of Taj Associates from April 1991 to October 1991. Mr. Ribis has served as Vice President of THCR/LP and THCR Holding Corp. since February 1998. He has also been Chief Executive Officer of the Partnership since March 1991 and President of the Partnership until April 1998; member of the Executive Committee of the Partnership from April 1991 to May 1992; member of the Board of Partner Representatives of the Partnership since May 1992; and has served as the Vice President and Assistant Secretary of TCHI since December 1993 and January 1991, respectively until April 1998. Mr. Ribis is now a director of TCHI. Since April 1998 Mr. Ribis has served as President and Chief Executive Officer of TCHI and Funding. Mr. Ribis has served as Vice President of TCI-II since December 1993 and had served as Secretary of TCI-II from November 1991 to May 1992. Mr. Ribis has been Vice President of Trump Corp. since September 1991. Mr. Ribis has been the President and a director of THCR Enterprises since January 1997. From January 1993 to January 1995 Mr. Ribis served as the Chairman of the Casino Association of New Jersey and has been a member of the Board of Trustees of the CRDA since October 1993. From January 1980 to January 1991, Mr. Ribis was Senior Partner in, and from February 1991 to December 1995, was Counsel to the law firm of Ribis, Graham & Curtin (now practicing as Graham, Curtin & Sheridan, A Professional Association), which serves as New Jersey legal counsel to all of the above-named companies and certain of their affiliated entities.
Robert M. Pickus--Mr. Pickus, 45 years old, has been Executive Vice President, General Counsel and Secretary of THCR since its formation in 1995. He has also been the Executive Vice President of Corporate and Legal Affairs of Plaza Associates since February 1995. From December 1993 to February 1995, Mr. Pickus was the Senior Vice President and General Counsel of Plaza Associates. Mr. Pickus served as the Assistant Secretary of Trump AC Holding from April 1994 until February 1998. Since February 1998, Mr. Pickus has served as the Secretary of Trump AC Holding. Mr. Pickus has been Secretary and a director of Trump AC Funding since its formation in January 1996 and Secretary and a director of Funding II and Funding III since their formation in November 1997. Mr. Pickus has been the Executive Vice President and Secretary of Trump Indiana since its inception. Mr. Pickus has been the Executive Vice President of Corporate and Legal Affairs of Taj Associates since February 1995, and a Director of THCR Holding Corp. and THCR/LP since November 1995. He was the Senior Vice President and Secretary of Funding from June 1988 to December 1993 and General Counsel of the Partnership from June 1985 to December 1993. Mr. Pickus has served as the Secretary of Funding since April 1998. Mr. Pickus served as the Assistant Secretary of TACC until February 1998. Since February 1998, Mr. Pickus has served as the Secretary of TACC. Mr. Pickus was also Secretary of TCHI from October 1991 until December 1993. Mr. Pickus is a director of TCHI, and has served as the Assistant Secretary of TCHI from February 1998 until April 1998. Since April 1998 Mr. Pickus has served as the Secretary of TCHI. Mr. Pickus has been the Executive Vice President of Corporate and Legal Affairs of the Partnership since February 1995, Secretary of the Partnership since February 1996 and a member of the Board of Partner Representatives of the Partnership since October 1995. Mr. Pickus is currently the Secretary of THCR Holding Corp., has been the Vice President, Secretary and Director of THCR Enterprises since January 1997 and has been Executive Vice President of TCS since its inception and its President since November 1998. He has been admitted to practice law in the states of New York and New Jersey since 1980, and in the Commonwealth of Pennsylvania since 1981.
John P. Burke--Mr. Burke, 52 years old, served as the Senior Vice President of Corporate Finance of THCR from January 1996 until June 1997. Mr. Burke served as the Senior Vice President of THCR, THCR Holdings and THCR Funding from June 1997 to January 1999. Mr. Burke has served as Executive Vice President
of THCR, THCR Holdings and THCR Funding since January 1999. Mr. Burke has been the Corporate Treasurer of THCR, THCR Holdings and THCR Funding since their formation in 1995. He has also been Corporate Treasurer of Plaza Associates and Taj Associates since October 1991. Mr. Burke has been the Treasurer of Trump Indiana since its formation. Mr. Burke has been Treasurer of Trump AC Funding since its formation in January 1996 and Treasurer of Funding II and Funding III since their formation in November 1997. Mr. Burke has been Treasurer of TACC since February 1998. Mr. Burke was a Director of THCR/LP and THCR Holding Corp. from October 1991 to April 1996 and was Vice President of THCR/LP until June 1995. Mr. Burke has served as the Assistant Treasurer of THCR Holding Corp. and THCR/LP since February 1998. Mr. Burke has been the Corporate Treasurer of the Partnership since October 1991, the Vice President of the Partnership, Funding, TCI-II and TCHI since December 1993 Assistant Treasurer of TCHI since April 1998, Treasurer of Funding since April 1998, a member of the Board of Partner Representatives of the Partnership since March 1997 and the Vice President- Finance of The Trump Organization since September 1990. Mr. Burke was an Executive Vice President and Chief Administrative Officer of Imperial Corporation of America from April 1989 through September 1990. Mr. Burke has been the Vice President and Treasurer of THCR Enterprises since January 1997.
Mark A. Brown--Mr. Brown, 39 years old, joined the Partnership as Executive Vice President of Operations in July 1995 and, from November 1997 through December 1999, served as President and Chief Operating Officer. Mr. Brown ended his employment with the Partnership and transferred to the Taj Mahal in January 2000. Mr. Brown also served as Vice President of TCHI. Previously, Mr. Brown served as Senior Vice President of Eastern Operations for Caesar's World Marketing Corporation, National and International Divisions from 1993 until 1995. Prior to that, Mr. Brown served as Vice President of Casino Operations at the Taj Mahal from 1989 until 1993. From 1979 until 1989, Mr. Brown worked for Resorts International Hotel Casino departing as Casino Shift Manager in December 1989.
Lawrence J. Mullin--Mr. Mullin, 37 years old, joined the Partnership as Vice President of Slot Operations and Marketing in August 1995, and effective January 2000, was promoted to and serves as President and Chief Operating Officer. Mr. Mullin also serves as Vice President of TCHI as well as Vice President and Assistant Secretary of Funding. Previously, Mr. Mullin served as Senior Vice President of Marketing of the Partnership since June 1998. Prior to that, Mr. Mullin served as Vice President of Slot and Casino Marketing from 1992 until 1995 at the Taj Mahal.
Joseph A. D'Amato--Mr. D'Amato, 52 years old, serves as Vice President of Finance of the Partnership, as well as, Chief Financial Officer, Chief Accounting Officer and Assistant Treasurer of Funding and Assistant Treasurer and Chief Financial Officer of TCHI since November 1999. Previously, Mr. D'Amato served as Chief Operating Officer of Trump Indiana since August 1997. Prior to that, Mr. D'Amato was Senior Vice President of Finance and Administration of Trump Indiana from April 1997 to August 1997. For the twelve years prior to working with THCR, Mr. D'Amato held various financial and administrative positions with Bally's (now Park Place) casino in Atlantic City.
Asher O. Pacholder--Dr. Pacholder, 62 years old, has been a partner representative of the Board of Partner Representatives since May 1992. Dr. Pacholder served as a director and the President of TCI-II from May 1992 to December 1993. He has served as the Chairman of the Board of Directors and Chief Financial Officer of ICO, Inc., an oil field services and petrochemicals processing company, since February 1995 and Chief Operating Officer and a director of Wedco Technology, Inc. since May 1996. Dr. Pacholder has served as Chairman of the Board and Managing Director of Pacholder Associates, Inc., an investment advisory firm, since 1983. In addition, Dr. Pacholder is Chairman of the Board of Directors of USF&G Pacholder Fund, Inc., a closed-end investment company, and he serves on the Board of Directors of Southland Corporation, which owns and operates convenience stores.
Thomas F. Leahy--Mr. Leahy, 62 years old, has been a partner representative on the Board of Partner Representatives since June 1993. Mr. Leahy served as a director and Treasurer of TCI-II from May 1992 to December 1993. From 1991 to July 1992, Mr. Leahy served as Executive Vice President of CBS Broadcast Group,
a unit of CBS, Inc. Mr. Leahy retired from CBS, Inc. in 1992, having served in various executive capacities over a 30-year period. Since November 1992, Mr. Leahy has served as President of The Theater Development Fund, a service organization for the performing arts. Since July 1992, Mr. Leahy has served as Chairman of VT Properties, Inc., a privately held corporation which invests in literary, stage and film properties.
Arthur S. Bahr--Mr. Bahr, 68 years old, has been a partner representative on the Board of Partner Representatives since June 1995 and previously served as a director of TCI-II from August 1993 to January 1994. Mr. Bahr retired in February 1994 after serving in various senior investment positions for General Electric Investment Corporation since 1970. Mr. Bahr also serves on the Board of Directors of Renaissance Reinsurance.
Each member of the Board of Partner Representatives and all of the other persons listed above have been licensed or found qualified by the CCC.
The employees of the Partnership serve at the pleasure of the Board of Partner Representatives subject to any contractual rights contained in any employment agreement.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
Executive officers of Funding and TCHI do not receive any additional compensation for serving in such capacity. In addition, Funding, TCHI and the Partnership do not offer their executive officers stock option or stock appreciation right plans, long-term incentive plans or defined benefit pension plans.
Summary Compensation Table. The following table sets forth compensation paid or accrued during the years ended December 31, 1999, 1998 and 1997 to the Chairman of the Board of Partner Representatives, the Chief Executive Officer, two executive officers of the Partnership whose cash compensation, including bonuses and deferred compensation, exceeded $100,000 for the year ended December 31, 1999 and one executive officer whose cash compensation would have exceeded $100,000 if he had been employed in his current position for the entire year of 1999. Compensation accrued during one year and paid in another is recorded under the year of accrual. Information relating to long-term compensation is inapplicable and has therefore been omitted from the table.
SUMMARY COMPENSATION TABLE
___________ (1) Represents the dollar value of annual compensation not properly categorized as salary or bonus, including amounts reimbursed for income taxes and director's fee. Following rules of the Securities and Exchange Commission (the "Commission"), perquisites and other personal benefits are not included in this table of the aggregate amount if that compensation is the lesser of either $50,000 or 10% of the total salary and bonus for that officer. (2) Represents amounts recorded pursuant to the Services Agreement (as defined). (3) In January 1999, Mr. Ribis received a net bonus of $50,000 which resulted in a before tax bonus of $96,000. It is anticipated that the tax portion of the bonus will be paid back to the Company. (4) Represents vested and unvested contributions made by the Partnership under the Trump Capital Accumulation Plan. Funds accumulated for an employee, which consist of a certain percentage of the employee's compensation plus Partnership contributions equaling 50% of the participant's contributions, are retained until termination of employment, attainment of age 59 1/2 or financial hardship, at which time the employee may withdraw his or her vested funds. (5) Mr. Brown ended his employment with the Partnership and transferred to the Taj Mahal in January 2000. (6) In January 1999, Mr. Brown received a net bonus of $75,000 which resulted in a before tax bonus of $109,410. (7) Mr. D'Amato joined the Partnership as Vice President of Finance in November 1999.
Employment Agreements
Mr. Ribis is compensated for his services to the Partnership under an employment agreement with THCR and THCR Holdings (the "Ribis THCR Agreement"). Under the Ribis THCR Agreement, Mr. Ribis's annual salary is $1,996,500. Mr. Ribis's annual salary is paid on an allocation basis by THCR, Taj Associates, Plaza Associates and the Partnership.
The Partnership had an employment agreement with Mark A. Brown, (the "Brown Agreement") pursuant to which Mr. Brown served as President and Chief Operating Officer. The Brown agreement was terminated in January 2000 upon Mr. Brown's transfer to the Taj Mahal.
The Partnership entered into an employment agreement with Lawrence J. Mullin on July 24, 1995, as amended most recently in January 2000 (the "Mullin Agreement"), pursuant to which Mr. Mullin serves as the Partnership's President and Chief Operating Officer. The Mullin Agreement expires on January 2, 2003 unless terminated by Mr. Mullin upon the occurrence of a Change of Control (as defined in the Mullin Agreement). The Mullin Agreement provides for an annual base salary of $350,000 in 2000, $400,000 in 2001 and $450,000 in 2002.
Compensation of the Board of Directors
Each Partner Representative of the Partnership (other than Messrs. Trump, Ribis, Burke and Pickus) receives an annual fee of $50,000. In addition, each Partner Representative of the Partnership (other than Messrs. Trump, Ribis, Pickus and Burke) receives $2,500 per meeting attended, plus reasonable out-of- pocket expenses incurred in attending any meeting of the Board of Partner Representatives.
Compensation Committee Interlocks and Insider Participation
In general, the compensation of executive officers of the Partnership is determined by the Board of Partners Representatives, which is composed of Trump, Nicholas L. Ribis, John P. Burke, Asher O. Pacholder, Thomas F. Leahy, Arthur S. Bahr and Robert M. Pickus. The compensation of Nicholas L. Ribis is set forth in his employment agreement. The Partnership has delegated the responsibility over certain matters, such as the bonus of Mr. Ribis, to Trump. Executive officers of Funding do not receive any additional compensation for serving in such capacity.
Castle Acquisition. On October 7, 1996, THCR Holdings acquired from Trump all of the outstanding equity of the Partnership. See "Business-Trump Marina- Historical Background-Castle Acquisition."
Certain Related Party Transactions. Beginning in late 1997, Castle Associates has utilized certain facilities owned by Trump to entertain high-end customers. Management believes that the ability to utilize these facilities has enhanced Castle Associates' revenues. In 1997, 1998 and 1999, Castle Associates incurred approximately $11,000, $239,000 and $636,000, respectively, for customer costs associated with such utilization. In exchange for having Trump's plane available to customers of Trump Marina, Castle Associates has incurred pilot costs of approximately $53,000, $49,000 and $60,000 for the years ended December 31, 1997, 1998 and 1999, respectively.
Services Agreement. On December 28, 1993, the Partnership entered into a Services Agreement with TCI-II (the "Services Agreement"). In general, the Services Agreement obligates TCI-II to provide to the Partnership, from time to time when reasonably requested, consulting services on a non-exclusive basis, relating to marketing, advertising, promotional and other services (the "Services") with respect to the business and operations of the Partnership, in exchange for certain fees to be paid only in those years in which EBITDA (EBITDA represents income from operations before depreciation, amortization, restructuring costs and the non-cash write-down of CRDA investments) exceeds prescribed amounts.
In consideration for the Services to be rendered by TCI-II, the Partnership will pay an annual fee (which is identical to the fee which was payable under the previously existing management agreement) to TCI-II in the amount of $1.5 million for each year in which EBITDA exceeds the following amounts for the years indicated: 1993-$40.5 million; 1994-$45.0 million; 1995 and thereafter- $50.0 million. If EBITDA in any fiscal year does not exceed the applicable amount, no annual fee is due. In addition, if the annual fee is attained, TCI-II will be entitled to an incentive fee beginning with the fiscal year ending December 31, 1994 in an amount equal to 10% of EBITDA in excess of $45.0 million for such fiscal year. The Partnership will also be required to advance to TCI-II
$125,000 a month which will be applied toward the annual fee, provided, however, that no advances will be made during any year if and for so long as the Managing Partner (defined in the Services Agreement as Trump) determines, in his good faith reasonable judgment, that the Partnership's budget and year-to-date performance indicate that the minimum EBITDA levels (as specified above) for such year will not be met. If for any year during which annual fee advances have been made it is determined that the annual fee was not earned, TCI-II will be obligated to promptly repay any amounts previously advanced. For purposes of calculating EBITDA under the Services Agreement, any incentive fees paid in respect of 1994 or thereafter shall not be deducted in determining net income. Pursuant to this agreement, Trump earned approximately $2.3 million based on the Partnership's EBITDA for the year ended December 31, 1999. During the years ended 1997 and 1998, there were no fees payable by the Partnership under the Services Agreement. As the Partnership did not meet the required level of EBITDA during 1996, the monthly advances to TCI-II related to the Services Agreement were suspended and on October 6, 1996, the Partnership recorded a receivable in the amount of $1.25 million which represented the amounts advanced to TCI-II during the year. This amount was offset against the fees earned for the year ended December 31, 1999. The Services Agreement expires on December 31, 2005.
Trump has granted the Partnership a license to use the Marks in connection with the operations of Trump Marina since June 17, 1985. See "Business- Trademark/Licensing."
Other Relationships. The Commission requires registrants to disclose the existence of any other corporation in which both (i) an executive officer of the registrant serves on the board of directors and/or compensation committee, and (ii) a director of the registrant serves as an executive officer. Messrs. Ribis, Pickus and Burke, executive officers of the Partnership, serve on the Board of Directors of other entities in which members of the Board of Partner Representatives (namely, Messrs. Trump, Ribis, Burke and Pickus) serve and continue to serve as executive officers. The Partnership believes that such relationships have not affected the compensation decisions made by the Board of Partner Representatives in the last fiscal year.
Mr. Ribis also serves on the Board of Directors of Realty Corp. which, prior to April 17, 1996, leased certain real property to Taj Associates, of which Trump is an executive officer. Trump, however, does not receive any compensation for serving as an executive officer of Realty Corp.
Messrs. Trump and Ribis serve on the Board of Directors of THCR of which Trump is Chairman of the Board. Messrs. Ribis, Pickus and Burke are executive officers of THCR and are compensated for their services by THCR.
John Barry, Trump's brother-in-law, is a partner of Tompkins, McGuire, Wachenfeld & Barry, a New Jersey law firm which provides, from time to time, legal services to the Partnership.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The following table sets forth information with respect to the amount of Funding's Common Stock and TCHI's Common Stock owned by beneficial owners of more than 5% of Funding's Common Stock or 5% of TCHI's Common Stock. Neither Funding nor TCHI have another class of equity securities outstanding.
All of the equity interests of the Partnership are beneficially owned by THCR Holdings. THCR Holdings is a 99% limited partner of the Partnership and TCHI, a wholly owned subsidiary of THCR Holdings, is a 1% general partner.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Affiliate party transactions are governed by the provisions of the indentures pursuant to which the Mortgage Notes, the Senior Notes and the PIK Notes were issued, which provisions generally require that such transactions be on terms as favorable as would be obtainable from an unaffiliated party, and require the approval of a majority of the Noteholder Representatives of the Board of Partner Representatives for certain affiliated transactions.
Trump, Ribis and certain affiliates have engaged in certain related party transactions with respect to the Partnership. See "Executive Compensation- Compensation Committee Interlocks and Insider Participation-Services Agreement" and "Other Relationships."
The Partnership has entered into a services agreement with TCS pursuant to which TCS provides the Partnership with certain management, financial and other functions and services necessary and incidental to the operations of Trump Marina.
In March 2000, the Board of Directors of THCR authorized and directed THCR to cause Taj Associates, Plaza Associates, the Partnership and Trump Indiana to enter into indemnification agreements with each of the Directors of THCR in connection with the performance of their duties as Directors.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) Financial Statements. See the Index immediately following the signature page.
(b) Reports on Form 8-K. The Registrants did not file any reports on Form 8-K during the quarter ended December 31, 1999.
(c) Exhibits. All exhibits listed below are filed with this Annual Report on Form 10-K unless specifically stated to be incorporated by reference to other documents previously filed with the Securities and Exchange Commission.
___________ (1) Incorporated herein by reference to the Exhibit to Trump's Castle Funding, Inc. and Trump's Castle Associates' Registration Statement on Form S-4, Registration No. 33-68038. (2) Incorporated herein by reference to the Exhibit to Amendment No. 5 to the Schedule 13E-3 of TC/GP, Inc. and the Partnership, File No. 5-36825, filed with the SEC on January on January 11, 1994. (3) Incorporated herein by reference to the Exhibit to Trump's Castle Funding, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1990. (4) Incorporated herein by reference to the Exhibit to Trump's Castle Funding, Inc.'s Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. (5) Incorporated herein by reference to the Exhibit to Trump's Castle Funding, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1991. (6) Incorporated herein by reference to the Exhibit to Trump's Castle Funding, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1986. (7) Incorporated herein by reference to the identically numbered Exhibit to Trump's Castle Funding, Inc.'s Registration Statement on Form S-4, Registration Number 33-52309 filed with the SEC on February 17, 1994. (8) Incorporated herein by reference to the identically numbered Exhibit to Trump's Castle Funding, Inc.'s and Trump Castle Associates' Current Report on Form 8-K dated as of June 23, 1995. (9) Incorporated herein by reference to the identically numbered Exhibit to Trump's Castle Funding, Inc.'s and Trump's Castle Associates' Quarterly Report on Form 10-Q for the quarter ended June 30, 1995. (10) Incorporated herein by reference to the identically numbered Exhibit in the Quarterly Report on Form 10-Q of Trump Hotels & Casino Resorts Holdings, L.P. and Trump Hotels & Casino Resorts Funding, Inc. for the quarter ended June 30, 1995. (11) Incorporated herein by reference to the identically numbered Exhibit in the Annual Report on Form 10-K of Trump's Castle Funding, Inc. and Trump's Castle Associates for the year ended December 31, 1995. (12) Incorporated herein by reference to the identically numbered Exhibit to Trump's Castle Funding, Inc.'s and Trump Castle Associates' Quarterly Report on Form 10-Q for the quarter ended September 30, 1996. (13) Incorporated herein by reference to the Exhibit in the Quarterly Report on Form 10-Q of Trump Taj Mahal Funding, Inc. for the quarter ended September 30, 1994.
(14) Incorporated herein by reference to the identically numbered Exhibit to Trump's Castle Funding, Inc. and Trump's Castle Associates, L.P.'s Quarterly Report on Form 10-Q for the quarter ended March 31, 1998.
(15) Incorporated herein by reference to the Exhibit to Trump's Castle Hotel & Casino, Inc., Trump's Castle Funding, Inc. and Trump's Castle Associates L.P.'s Registration Statement on Form S-4, Registration No. 333-56865. (16) Incorporated herein by reference to the identically numbered Exhibit in the Annual Report on Form 10-K of Trump's Castle Hotel & Casino, Inc., Trump's Castle Funding, Inc. and Trump's Castle Associates, L.P. for the year ended December 31, 1998.
(d) Financial Statement Schedules. See "Financial Statements and Supplementary Data-Index to Financial Statements and Financial Statement Schedules" for a list of the financial statement schedules included in this Annual Report.
IMPORTANT FACTORS RELATING TO FORWARD LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements so long as those statements are identified as forward-looking and are accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those projected in such statements. In connection with certain forward-looking statements contained in this Annual Report on Form 10-K and those that may be made in the future by or on behalf of the Registrant, the Registrant notes that there are various factors that could cause actual results to differ materially from those set forth in any such forward-looking statements. The forward-looking statements contained in this Annual Report were prepared by management and are qualified by, and subject to, significant business, economic, competitive, regulatory and other uncertainties and contingencies, all of which are difficult or impossible to predict and many of which are beyond the control of the Registrant. Accordingly, there can be no assurance that the forward-looking statements contained in this Annual Report will be realized or that actual results will not be significantly higher or lower. The statements have not been audited by, examined by, compiled by or subjected to agreed-upon procedures by independent accountants, and no third- party has independently verified or reviewed such statements. Readers of this Annual Report should consider these facts in evaluating the information contained herein. In addition, the business and operations of the Registrant are subject to substantial risks which increase the uncertainty inherent in the forward-looking statements contained in this Annual Report. The inclusion of the forward-looking statements contained in this Annual Report should not be regarded as a representation by the Registrant or any other person that the forward-looking statements contained in this Annual Report will be achieved. In light of the foregoing, readers of this Annual Report are cautioned not to place undue reliance on the forward-looking statements contained herein.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrants have duly caused this Annual Report to be signed on their behalf by the undersigned, thereunto duly authorized, on the 30th day of March, 2000.
Trump's Castle Hotel & Casino, Inc.
By: /s/ Nicholas L. Ribis ---------------------------------------------- By: Nicholas L. RibisTitle: President
Trump's Castle Funding, Inc.
By: /s/ Nicholas L. Ribis ---------------------------------------------- By: Nicholas L. Ribis Title: President
Trump's Castle Associates, L.P.
By: /s/ Donald J. Trump ---------------------------------------------- By: Donald J. Trump Title: Chairman of the Board of Partner Representatives
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Annual Report has been signed below by the following persons on behalf of the Registrants and in the capacities and on the date indicated.
Supplemental Information to be Furnished with Reports Filed Pursuant to Section 15(d) of the Securities Exchange Act of 1934 by Registrants Which Have Not Registered Securities Pursuant to Section 12 of the Act
The Registrants have not sent (and do not intend to send) an annual report to security holders covering the Registrants' last fiscal year and have not sent (and do not intend to send) a proxy statement, form of proxy or other proxy soliciting materials to security holders.
-----------------------------
Other Schedules are omitted for the reason that they are not required or are not applicable, or the required information is included in the consolidated financial statements or notes thereto.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Trump's Castle Associates, L.P. and Subsidiary:
We have audited the accompanying consolidated balance sheets of Trump's Castle Associates, L.P. (a New Jersey limited partnership) and Subsidiary as of December 31, 1998 and 1999, and the related consolidated statements of operations, partners' capital and cash flows for each of the three years in the period ended December 31, 1999. These consolidated financial statements and the schedule referred to below are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as 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 financial position of Trump's Castle Associates, L.P. and Subsidiary as of December 31, 1998 and 1999, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States.
Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in the index to the financial statements is presented for the purpose of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in our audits of the basic financial statements, and in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
ARTHUR ANDERSEN LLP
Roseland, New Jersey February 4, 2000
TRUMP'S CASTLE ASSOCIATES, L.P. AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS (in thousands)
The accompanying notes to consolidated financial statements are an integral part of these consolidated statements.
TRUMP'S CASTLE ASSOCIATES, L.P. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands)
The accompanying notes to consolidated financial statements are an integral part of these consolidated statements.
TRUMP'S CASTLE ASSOCIATES, L.P. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF PARTNERS' CAPITAL (in thousands)
The accompanying notes to consolidated financial statements are an integral part of these consolidated statements.
TRUMP'S CASTLE ASSOCIATES, L.P. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (Note 2)
The accompanying notes to consolidated financial statements are an integral part of these consolidated statements.
TRUMP'S CASTLE ASSOCIATES, L.P. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) Organization and Operations
The accompanying consolidated financial statements include those of Trump's Castle Associates, L.P., a New Jersey limited partnership (the "Partnership"), and its wholly owned subsidiary, Trump's Castle Funding, Inc., a New Jersey corporation ("Funding"). The Partnership is 99% owned by Trump Hotels & Casino Resorts Holdings, L.P., a Delaware limited partnership ("THCR Holdings") and 1% by Trump's Castle Hotel & Casino, Inc., a New Jersey corporation ("TCHI") . TCHI is wholly owned by THCR Holdings, and THCR Holdings is currently a 63.4% owned subsidiary of Trump Hotels & Casino Resorts, Inc., a Delaware corporation ("THCR").
All significant intercompany balances and transactions have been eliminated in the consolidated financial statements.
The Partnership operates the Trump Marina Hotel Casino ("Trump Marina"), a luxury casino hotel located in the Marina District of Atlantic City, New Jersey. The majority of Trump Marina's revenues are derived from its gaming operations. Competition in the Atlantic City gaming market is intense and while no significant expansion is expected in 2000, the Partnership believes that competition will continue to intensify due to planned future expansion by existing operators and as new entrants to the gaming industry become operational.
Since Funding has no business operations, its ability to repay the principal and interest on the $62,000,000 10 1/4% Senior Secured Notes due 2003 (the "Senior Notes"), the 11 3/4% Mortgage Notes due 2003 (the "Mortgage Notes") and its Increasing Rate Subordinated Pay-in-Kind Notes due 2005 (the "PIK Notes") is completely dependent upon the operations of the Partnership. (See Note 3).
Since TCHI has no business operations, its ability to repay the principal and interest on the $5,000,000 10 1/4% Senior Secured Notes due 2003 (the "Working Capital Loan") is completely dependent on the operations of the Partnership. (See Note 3).
(2) Accounting Policies
Use of Estimates
The preparation of these financial statements in conformity with generally accepted accounting principles requires the Partnership 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 reporting period. Actual results may differ from these estimates.
Revenue Recognition
Casino revenues consist of the net win from gaming activities, which is the difference between gaming wins and losses. Revenues from hotel and other services are recognized at the time the related services are performed.
The Partnership provides an allowance for doubtful accounts arising from casino, hotel and other services, which is based upon a specific review of certain outstanding receivables and historical collection performance. In determining the amount of the allowance, the Partnership is required to make certain estimates and assumptions and actual results may differ from these estimates and assumptions.
TRUMP'S CASTLE ASSOCIATES, L.P. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Promotional Allowances
Gross revenues include the retail value of the complimentary food, beverage and hotel services provided to patrons. The retail value of these promotional allowances is deducted from gross revenues to arrive at net revenues. The costs of such complimentaries have been included in gaming costs and expenses in the accompanying consolidated statements of operations and consist of:
Income Taxes
The accompanying consolidated financial statements do not include a provision for federal income taxes of the Partnership, since any income or losses allocated to the partners are reportable for federal income tax purposes by the partners.
Under the New Jersey Casino Control Act (the "Casino Control Act") and the regulations promulgated thereunder, the Partnership and Funding are required to file a consolidated New Jersey corporation business tax return.
As of December 31, 1999, the Partnership had New Jersey state net operating loss carryforwards of approximately $144,500,000, which are available to offset taxable income through the year 2006. The net operating loss carryforwards result in a deferred tax asset of $13,005,000, which has been offset by a valuation allowance of $13,005,000, as utilization of such carryforwards is not considered to be likely.
Inventories
Inventories of provisions and supplies are carried at the lower of cost (first-in, first-out basis) or market.
Property and Equipment
Property and equipment are recorded at cost and depreciated on the straight-line method over the estimated useful lives of the related assets.
Long-Lived Assets
The provisions of Statement of Financial Accounting Standards No. 121 "Accounting for the Impairment of Long-Lived Assets" requires, among other things, that an entity review its long-lived assets and certain related intangibles for impairment whenever changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. The Partnership does not believe that any such changes have occurred.
TRUMP'S CASTLE ASSOCIATES, L.P. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Statements of Cash Flows
For purposes of the statements of cash flows, the Partnership considers all highly liquid debt instruments purchased with a maturity of three months or less, at the time of purchase, to be cash equivalents.
Reclassifications
Certain reclassifications have been made to the prior period financial statements in order to conform to the 1999 presentation.
(3) Long-Term Debt
Long-term debt consists of:
The Mortgage Notes bear interest at 11 3/4%, payable in cash semi-annually, and mature on November 15, 2003. The Mortgage Notes may be redeemed at Funding's option at a rate of 103.917% of the principal amount commencing on December 31, 1999. In addition, the redemption rate declines to 101.958% at December 31, 2000 and to 100% at December 31, 2001 and thereafter.
The PIK Notes bear interest at 137/8% payable at Funding's option in whole or in part in cash and through the issuance of additional PIK Notes through November 15, 2003. After November 15, 2003, interest on the PIK Notes is payable in cash at the rate of 137/8%. The PIK Notes mature on November 15, 2005. The PIK Notes may be redeemed at Funding's option at 100% of the principal amount under certain conditions, as defined in the PIK Note Indenture, and a specified percentage is required to be redeemed from the proceeds of any equity offering of the Partnership. Interest payments of $10,156,000, $11,614,000 and $13,281,000 in 1997, 1998 and 1999, respectively, were satisfied by the issuance of additional PIK Notes. The Partnership anticipates that interest due in 2000 will also be satisfied through the issuance of additional PIK Notes. THCR Holdings owns approximately 90% of the PIK Notes.
The terms of both the Mortgage Notes and PIK Notes include limitations on the amount of additional indebtedness the Partnership may incur, distributions, investments and other business activities of the Partnership.
TRUMP'S CASTLE ASSOCIATES, L.P. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
The Mortgage Notes are secured by a promissory note of the Partnership to Funding (the "Partnership Note") in an amount and with payment terms necessary to service the Mortgage Notes. The Partnership Note is secured by a mortgage on Trump Marina and substantially all of the other assets of the Partnership. The Partnership Note has been assigned by Funding to the Trustee to secure the repayment of the Mortgage Notes. In addition, the Partnership has guaranteed (the "Guaranty") the payment of the Mortgage Notes, which Guaranty is secured by a mortgage on Trump Marina. The Partnership Note and the Guaranty are expressly subordinated to the indebtedness of the Senior Notes and the Working Capital Loan (collectively, the "Senior Indebtedness") and the liens on the mortgages securing the Partnership Note and the Guaranty are subordinate to the liens securing the Senior Indebtedness.
The PIK Notes are secured by a subordinated promissory note of the Partnership to Funding (the "Subordinated Partnership Note"), which has been assigned to the Trustee for the PIK Notes, and the Partnership has issued a subordinated guaranty (the "Subordinated Guaranty") of the PIK Notes. The Subordinated Partnership Note and the Subordinated Guaranty are expressly subordinated to the Senior Indebtedness, the Partnership Note and the Guaranty.
On April 17, 1998, Funding refinanced its 11 1/2% Senior Secured Notes due 2000 (the "Old Senior Notes") and its term loan with a bank (the "Term Loan") by issuing the Senior Notes. The Senior Notes have a priority mortgage lien ahead of the Partnership's Mortgage Notes and are further secured by virtually all of the Partnership's assets. The Senior Notes have an outstanding principal amount of $62,000,000, bear interest at the rate of 10 1/4% per annum, payable semi-annually and mature on April 30, 2003.
In connection with the refinancing discussed above, TCHI obtained a $5,000,000 working capital loan, the proceeds of which were loaned to the Partnership. The Working Capital Loan has an outstanding principal amount of $5,000,000, bears interest at the rate of 10 1/4% per annum, and matures on April 30, 2003. Both the Senior Notes and the Working Capital Loan are guaranteed by the Partnership.
The Partnership has entered into various capital leases which are secured by equipment. These leases mature on various dates during the years 2000 through 2002.
Future minimum payments under capital leases (principal portion included in the table of debt maturities below) are as follows:
2000...................................................... $ 1,968,000 2001...................................................... 1,241,000 2002...................................................... 2,884,000 2003...................................................... -- 2004...................................................... -- ----------- Total minimum payments.................................... 6,093,000 Less: amount representing interest....................... (1,453,000) ----------- Present value of minimum lease payments................... $ 4,640,000 ===========
The aggregate maturities of long-term debt as of December 31, 1999 are as follows:
2000...................................................... $ 1,296,000 2001...................................................... 719,000 2002...................................................... 2,625,000 2003...................................................... 286,235,000 2004...................................................... -- Thereafter................................................ 99,466,000 ------------ $390,341,000 ============
TRUMP'S CASTLE ASSOCIATES, L.P. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
The ability of Funding and the Partnership to pay their indebtedness when due, will depend on the ability of the Partnership to either generate cash from operations sufficient for such purposes or to refinance such indebtedness on or before the date on which it becomes due. Cash flow from operations may not be sufficient to repay a substantial portion of the principal amount of the debt at maturity. The future operating performance of the Partnership and the ability to refinance this debt will be subject to the then prevailing economic conditions, industry conditions and numerous other financial, business and other factors, many of which are beyond the control of Funding, TCHI or the Partnership. There can be no assurance that the future operating performance of the Partnership will be sufficient to meet these repayment obligations or that the general state of the economy, the status of the capital markets or the receptiveness of the capital markets to the gaming industry will be conducive to refinancing this debt or other attempts to raise capital.
(4) Related Party Transactions
Trump Management Fee
The Partnership has a Services Agreement (the "Services Agreement") with Trump Casinos II, Inc. ("TCI-II"), a corporation wholly-owned by Donald J. Trump ("Trump"). Pursuant to the terms of the Services Agreement, TCI-II is obligated to provide the Partnership, from time to time, when reasonably requested, consulting services on a non-exclusive basis, relating to marketing, advertising, promotional and other similar and related services with respect to the business and operations of the Partnership, including such other services as the managing partner of the Partnership may reasonably request.
Pursuant to the Services Agreement, the Partnership is required to pay an annual fee in the amount of $1,500,000 to TCI-II for each year in which Earnings Before Interest, Taxes, Depreciation and Amortization ("EBITDA"), as defined, exceeds $50,000,000. In addition, if the annual fee is attained TCI-II is to receive an incentive fee equal to 10% of the excess EBITDA over $45,000,000 for such fiscal years. The Services Agreement expires on December 31, 2005.
For the years ended December 31, 1997 and 1998, the Partnership incurred no fees and expenses under the Services Agreement. For the year ended December 31, 1999, the Partnership incurred fees and expenses of $2,258,000 under the Services Agreement. As the Partnership did not meet the required level of EBITDA during 1996, the monthly advances to TCI-II related to the Services Agreement were suspended and, at October 6, 1996, the Partnership recorded an amount due from affiliate of $1,250,000, which represented the amounts advanced during the year. This was offset against management fees earned during the year ended December 31, 1999. The Partnership made no monthly advances to TCI-II related to the Services Agreement during 1997, 1998 or 1999.
Transactions with Affiliates
At December 31, 1998 and 1999, amounts due to affiliates were $21,602,000 and $20,116,000, respectively. The Partnership has engaged in limited intercompany transactions with Trump Plaza Associates ("Plaza Associates"), Trump Taj Mahal Associates ("Taj Associates"), Trump Casino Services, L.L.C. ("TCS"), and the Trump Organization, all of which are affiliates of Trump.
Beginning in late 1997, Castle Associates has utilized certain facilities owned by Trump to entertain high-end customers. Management believes that the ability to utilize these facilities has enhanced Castle Associates' revenues. In 1997, 1998 and 1999, Castle Associates incurred approximately $11,000, $239,000 and $636,000, respectively, for customer costs associated with such utilization. In exchange for having Trump's plane available to customers of Trump Marina, Castle Associates has incurred pilot costs of approximately $53,000, $49,000 and $60,000 for the years ended December 31, 1997, 1998 and 1999, respectively.
TRUMP'S CASTLE ASSOCIATES, L.P. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
TCS, which was formed for the purpose of realizing cost savings and operational synergies, provides certain administrative functions and certain services to Plaza Associates, Taj Associates and the Partnership.
In 1997, the Partnership reclassified $5,000,000 of capital contributed in 1996 by THCR Holdings into a note payable. During June 1997, the Partnership repaid $2,000,000 plus accrued interest on this note. In January 1998, the Partnership repaid an additional $2,550,000. During 1999, the Partnership repaid the balance of principal and interest outstanding on this note.
Partnership Agreement
Under the terms of the Partnership Agreement, the Partnership is required to pay all costs incurred by TCI-II. For the years ended December 31, 1997, 1998 and 1999, the Partnership paid no expenses on behalf of TCI-II.
(5) Commitments and Contingencies
Casino License Renewal
The Partnership is subject to regulation and licensing by the New Jersey Casino Control Commission (the "CCC"). The Partnership's casino license must be renewed periodically, is not transferable, is dependent upon the financial stability of the Partnership and can be revoked at any time. Due to the uncertainty of any license renewal application, there can be no assurance that the license will be renewed. Upon revocation, suspension for more than 120 days, or failure to renew the casino license due to the Partnership's financial condition or for any other reason, the Casino Control Act provides that the CCC may appoint a conservator to take possession of and title to the hotel and casino's business and property, subject to all valid liens, claims and encumbrances.
On June 23, 1999, the CCC renewed the casino license of the Partnership through May 31, 2003, subject to certain continuing reporting and compliance conditions.
Self Insurance Reserves
Self insurance reserves represent the estimated amounts of uninsured claims related to employee health medical costs, workers' compensation, general liability and other legal proceedings in the normal course of business. These reserves are established by the Partnership based upon a specific review of open claims as of the balance sheet date as well as historical claims settlement experience, with consideration of incurred but not reported claims as of the balance sheet date. During 1998, self insurance reserves decreased due to an internally focused aggressive policy where potential lawsuits are challenged immediately. Additionally, a more aggressive litigation policy was pursued to deter present and future frivolous lawsuits. The Partnership also retained an outside consultant to comprehensively review certain claims and to assist the Partnership in establishing certain estimated reserves at December 31, 1998. The costs of the ultimate disposition of these claims may differ from these reserve amounts.
TRUMP'S CASTLE ASSOCIATES, L.P. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Employment Agreements
The Partnership has entered into employment agreements with certain key employees which expire at various dates through December 31, 2000. Total minimum commitments on these agreements at December 31, 1999 were approximately $2,453,000.
Legal Proceedings
The Partnership is involved in legal proceedings incurred in the normal course of business. In the opinion of management and its counsel, if adversely decided, none of these proceedings would have a material effect on the consolidated financial position of the Partnership.
Casino Reinvestment Development Authority Obligations
Pursuant to the provisions of the Casino Control Act, the Partnership must either obtain investment tax credits, as defined in the Casino Control Act, in an amount equivalent to 1 1/4% of its gross casino revenues, as defined in the Casino Control Act, or pay an alternative tax of 2 1/2% of its gross casino revenues. Investment tax credits may be obtained by making qualified investments, as defined, or by depositing funds which may be converted to bonds by the Casino Reinvestment Development Authority (the "CRDA"), both of which bear interest at below market rates. The Partnership is required to make quarterly deposits with the CRDA to satisfy its investment obligations.
For the years ended December 31, 1997, 1998 and 1999 the Partnership charged to operations $1,401,000, $1,149,000 and $1,444,000, respectively, to give effect to the below market interest rates and valuation allowance adjustments associated with CRDA deposits and bonds.
(6) Employee Benefit Plans
The Partnership has a retirement savings plan for its nonunion employees under Section 401(k) of the Internal Revenue Code. Employees are eligible to contribute up to 20% of their earnings (as defined) to the plan up to the maximum amount permitted by law, and the Partnership will match 50% of an eligible employee's contributions up to a maximum of 6% of the employee's earnings. The Partnership recorded charges of approximately $937,000, $1,138,000 and $1,117,000 for matching contributions for the years ended December 31, 1997, 1998 and 1999, respectively.
The Partnership makes payments to various trusteed multi-employer pension plans under industry-wide union agreements. The payments are based on the hours worked by or gross wages paid to covered employees. It is not practical to determine the amount of payments ultimately used to fund pension benefit plans or the current financial condition of the plans. Under the Employee Retirement Income Security Act, the Partnership may be liable for its share of the plans' unfunded liabilities, if any, if the plans are terminated or if the Partnership withdraws from participation in such plans. Pension expense charged to operations for the years ended December 31, 1997, 1998 and 1999 was $547,000, $598,000 and $743,000, respectively.
The Partnership provides no other material post employment benefits.
TRUMP'S CASTLE ASSOCIATES, L.P. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(7) Fair Value of Financial Instruments
The carrying amount of the following financial instruments of the Partnership and Funding approximate fair value, as follows: (a) cash and cash equivalents, receivables and payables based on the short-term nature of these financial instruments, (b) CRDA bonds and deposits based on the allowances to give effect to the below market interest rates.
The fair values of the Mortgage Notes and PIK Notes are based on quoted market prices as follows:
December 31, 1998 Carrying Amount Fair Value --------------- ---------- Mortgage Notes.......................... $215,334,000 $198,556,000 PIK Notes............................... $ 85,704,000 $ 83,259,000
December 31, 1999 Carrying Amount Fair Value --------------- ---------- Mortgage Notes.......................... $219,235,000 $199,766,000 PIK Notes............................... $ 99,466,000 $ 87,806,000
There are no quoted market prices for the Partnership's Senior Notes and Working Capital Loan. A reasonable estimate of their value could not be made without incurring excessive costs.
TRUMP'S CASTLE ASSOCIATES, L.P. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(8) Financial Information of Funding
Financial information relating to Funding is as follows:
TRUMP'S CASTLE ASSOCIATES, L.P. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(9) Financial Information of TCHI
Financial information relating to TCHI is as follows:
SCHEDULE II
TRUMP'S CASTLE ASSOCIATES, L.P. AND SUBSIDIARY SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
- ----------------- (A) Write-off of uncollectible accounts.
(B) Reversal of allowance applicable to contribution of CRDA deposits.
S-1 | 26,534 | 171,411 |
832769_1999.txt | 832769_1999 | 1999 | 832769 | Item 1. DESCRIPTION OF BUSINESS
General -------
The Company. Home Port Bancorp, Inc. (the "Company") was incorporated under the laws of the State of Delaware on November 12, 1987 for the purpose of becoming a holding company. On August 30, 1988, the Company acquired all of the common stock of Nantucket Bank (the "Bank" or "Nantucket Bank") following the Bank's conversion from a Massachusetts chartered mutual savings bank to a Massachusetts chartered stock savings bank. The Company is currently a single bank holding company registered under the Federal Bank Holding Company Act. As of December 31, 1999, the assets of the Company on an unconsolidated basis consisted principally of the capital stock of the Bank. The Company is subject to the regulations of, and periodic examinations by, the Federal Reserve Bank, the Commissioner of Banks of the Commonwealth of Massachusetts (the "Commissioner") and the Federal Deposit Insurance Corporation ("FDIC"). The Company's activities are conducted solely in Nantucket through its subsidiary, Nantucket Bank.
The Bank. The Bank is a Massachusetts chartered savings bank, organized in 1834. The Bank conducts its business through two full-service offices and one automated teller facility, all of which are located on the island of Nantucket, Massachusetts. The Bank's deposits are insured by the Bank Insurance Fund of the FDIC up to $100,000 per account and the Depositors Insurance Fund, a private deposit insuring company, for deposits in excess of $100,000. The Bank is subject to competition from other financial institutions. The Bank is subject to the regulations of, and periodic examinations by, the FDIC and the Massachusetts Division of Banks.
The Bank provides a full range of banking services to individual and corporate customers on the island of Nantucket. The Bank's primary services consist of attracting deposits from consumers and businesses on Nantucket and originating loans on Nantucket real estate, including both residential and commercial properties. Due to the seasonal tourist-related economy on Nantucket, the Bank's deposits generally peak during the summer months. The Bank's real estate lending business is generally not impacted by the seasonal economy. The Bank also grants commercial business loans and consumer loans. Commercial business loans normally peak in the spring, as merchants borrow to finance inventory and other purchases in advance of the tourist season. The Bank routinely sells loans in the secondary market, normally retaining the servicing rights. The Bank invests a portion of its funds in money market instruments, federal government and agency securities and corporate bonds. The Bank utilizes the Federal Home Loan Bank of Boston ("FHLB") as an additional source of funds.
The Nantucket Real Estate Market. The Nantucket real estate market has been very strong in recent years. Total real estate sales on Nantucket totaled $470 million in 1999, $401 million in 1998 and $318 million in 1997. During 1999, the median price of a home on Nantucket was $600,000 compared to $450,000 in 1998 and $400,000 in 1997.
Deterioration in the local or national economies could have a negative impact on the Nantucket real estate market. A downturn in the Nantucket real estate market could result in an increase in loan delinquencies for the Bank, which could have a negative effect on the Company's results of operations due to the possibility of additional loan loss provisions and reduced interest income.
Lending Activities - ------------------
Residential Real Estate Lending. The Bank makes conventional mortgage loans to single family residential properties with original loan-to-value ratios up to 80% of the appraised value of the property securing the loan. These residential properties serve as the primary or secondary homes of the borrowers. The Bank also originates loans on one to four family dwellings and loans for the construction of residential housing for owner occupying borrowers, also with original loan-to-value ratios up to 80% of the property's appraised value.
Residential mortgage loans made by the Bank have traditionally been long-term loans made for periods of up to 30 years at either fixed or adjustable rates of interest. It has generally been the Bank's policy to sell most of its longer term (greater than 10 years) fixed rate loans and a portion of its adjustable rate loans, while retaining the servicing rights. The Bank's Asset/Liability Committee ("ALCO"), which is comprised of the Bank's senior management and certain other officers, reviews this policy from time to time as part of the Bank's overall asset/liability management program.
The majority of long-term fixed rate loans are originated using underwriting standards and standard documentation allowing their sale to FHLMC. The Bank also offers jumbo fixed and variable rate mortgages. The underwriting standards for jumbo loans are similar to those used for non-jumbo mortgages. The Bank sells a portion of its jumbo mortgages.
The majority of the Bank's loan originations are adjustable rate residential mortgage loans. The interest rate on these loans may either adjust on an annual basis, or feature an initial period from three to ten years during which the interest rate is fixed. Generally, interest rates adjust on an annual basis after any initial fixed rate term. During 1999, most adjustable rate loan originations featured an initial fixed rate term. Adjustable rate loans may have limitations on the amount of the adjustment of 2.0% per adjustment and 6.0% over the life of the loan, and on the periods within which the adjustments may be made. Rate adjustments on residential mortgage loans are generally tied to the weekly average yield on U.S. Treasury securities adjusted to constant maturities of one year. Despite the benefits of adjustable rate mortgage loans to the Bank's asset/liability management program, they do pose potential additional risks, primarily because as interest rates rise, the underlying payments by the borrowers rise, increasing the potential for default, while at the same time the marketability of the underlying property may be adversely affected by higher interest rates. The history of the one year Treasury bill index, as of the last business day of each year for the last three years, shows that this index has fluctuated from 5.53% in 1997 to 4.52% in 1998 and 5.85% in 1999.
The Bank may at times offer adjustable rate mortgage loans with an initial discount, as is customary in the marketplace. This pricing decision is based on management's decision to remain competitive while at the same time assuring prudent underwriting guidelines. In this respect, the Bank underwrites loans as if fully indexed, or within maximum limitations established in secondary market guidelines, with a view toward minimizing potential losses resulting from increased costs to the borrowers.
Construction loans on residential properties are made to individuals for the construction of their primary or secondary homes. Construction loans are made for up to 80% of the appraised value of the property upon completion. Construction loan funds are periodically disbursed as pre-specified stages of construction are attained. Residential construction loans, which are typically made for a period of 30 years, require monthly interest payments during construction and begin to amortize after the construction phase has been completed, at which time they automatically convert into permanent mortgage loans.
Under a program that has been in existence since 1993, the Bank offers loans on one to four family primary dwellings for first time home buyers with original loan to value ratios up to 90%. These loans are made for periods up to 30 years for existing dwellings and up to 31 years for the construction of a primary dwelling.
Commercial Real Estate Lending. The Bank originates permanent and construction loans on commercial real estate. These loans mainly consist of mortgages on investment properties and properties utilized by retail and small service businesses such as restaurants, guest houses and retailers. The Bank lends for speculative real estate construction activities on a limited basis and closely monitors these loans. At December 31, 1999, such loans accounted for $3.2 million, or 1.2%, of the total loan portfolio (excluding loans held for sale).
The Bank's current policy limits commercial real estate loans (including both permanent and construction) to 30% of the total loan portfolio. At December 31, 1999 commercial real estate loans totaled 20.4% of the Bank's loan portfolio (including loans held for sale) as compared to 20.6% at the end of 1998.
During 1998 and 1999 most commercial real estate loans were granted for up to 75% of the appraised value of the property. Most of these loans were for terms from 6 months to 20 years at interest rates adjustable from one to three year periods at the Bank's sole discretion, or to a specific spread over the prime rate published in the Wall Street Journal. This policy has enabled the Bank to adjust the interest rate yield on the commercial real estate portfolio to compensate for changes in costs of funds, credit risk and balance relationships maintained by the borrowers. The periodic adjustable rate feature of this portfolio can enhance the Bank's liquidity by sale of these loans to participants when deemed advisable. Protection of the Bank's interest in the real estate collateral is covered by use of title, fire, casualty and flood insurance in applicable amounts.
Commercial real estate lending may entail significant additional risks compared to residential mortgage lending. Loan size typically may be larger. Payment experience on such loans can be more easily influenced by adverse conditions in the economy or in the real estate market. Construction financing involves a higher degree of risk of loss than long term financing on improved occupied real estate. Property values at completion of construction or development can be influenced by underestimation of construction costs. The Bank may be required to advance funds beyond the original commitment in order to finish the development. If projected cash flows or value of the property proves to be inaccurate because of unanticipated construction costs or lower than expected sales volume, the project may have a value that is insufficient to assure full repayment.
Construction loans on commercial properties are extended to individuals, unincorporated small business borrowers or to their companies, partnerships, trusts or other business entities formed to hold title to the business property. Such loans are made for periods up to 21 years with interest only during the construction period (usually nine to twelve months) and regular amortization thereafter. Funds are disbursed as prespecified stages of construction are completed.
Commercial Business Loans. The Bank offers a wide variety of commercial loan services, including short and long-term business loans, lines of credit and letters of credit. The principal market for these loans is small to medium size businesses in Nantucket. Most commercial business loans are written generally for terms of 30 to 180 days or under one year as a line of credit. Longer-term commercial business loans are granted up to five years and are subject to daily or monthly rate adjustments based on the prime rate as published in the Wall Street Journal. These interest rate sensitive loans allow the Bank to maintain an interest rate spread over its cost of funds. The interest rate paid by individual customers over the base rate is determined by the lenders and Bank management after consideration of the degree of credit risk, term of the loan, the borrower's overall relationships, the size of the loan and other pertinent criteria. These loans may be advanced on an unsecured basis or may be secured by real estate, inventory or other business assets. Loans to commercial businesses may entail significant additional risks compared to residential mortgage lending. These loans are subject to changes in the local and regional economy as well as changes in particular industries and lines of business. Analyzing the unique factors and risks affecting each business requires expertise and experience which is different from that needed for loans secured by real estate. Frequently, the arrangement involves both business services and consumer products, particularly residential real estate loans.
Consumer Lending. The Bank offers a variety of consumer loans, including second mortgage loans, home equity loans, automobile loans, secured and unsecured personal loans and boat loans. These loans are made at both fixed and adjustable rates of interest. They vary in terms depending on the type of the loan. Second mortgage loans have terms of up to 15 years, and provide for annual interest rate adjustments, while other consumer loans have shorter terms and/or fixed rates of interest.
Loan Solicitation and Processing. Loan originations come from a number of sources. Most real estate loans are attributable to referrals from existing customers, real estate brokers and builders as well as walk-in customers and depositors. Commercial business loan originations are generally obtained through officer calls, existing customers and business relationships and referrals. Consumer loans generally result from existing depositors.
Each loan originated by the Bank is underwritten by personnel of the Bank, with individual lending officers, a committee of loan officers and the Bank's Executive Committee having the authority to approve loans up to various limits. Independent appraisers are used to appraise the property intended to secure real estate loans. The Bank's underwriting criteria are designed to minimize the risks of each loan. There are detailed guidelines concerning the types of loans that may be made, the nature of the collateral required, the information that must be obtained concerning the loan applicant and follow-up inspections of collateral after the loan is made.
Income from Lending Activities. Interest rates charged by the Bank on its loans are determined by market interest rates, the Bank's strategic plans and goals, the availability of funds to lend, the demand for loans and competitive loan rates offered in its lending area.
In addition to interest earned on loans, the Bank receives loan origination fees for originating real estate loans. Loan origination fees are a percentage of the principal amount of the loan and are charged to the borrower for the creation of the loan. Currently, the Bank generally charges fees of up to 1% on permanent residential mortgage loans (2% is charged on certain residential loans), 1/2% to 1% on residential construction loans and 1% to 1 1/2% on commercial real estate loans. For accounting purposes, the Bank defers loan origination fees net of direct underwriting costs and amortizes the balance over the life of the loans. On loans written at a discounted initial rate, net origination fees are amortized over the period of discount. The Bank also receives other fees and charges relating to loans, which include loan application fees, late payment charges and fees collected in connection with loan modifications. These fees and charges do not constitute a material source of income for the Bank.
Investment Activities - ---------------------
Interest income from short-term investments (consisting of federal funds sold and interest bearing deposits in banks) and securities held to maturity and available for sale provides an additional significant source of income for the Bank. The Bank's securities portfolio consists of United States Government and agency obligations, short-term corporate bonds, notes and debentures and state and municipal obligations and mortgage backed securities, collateralized mortgage obligations and real estate mortgage investment conduits ("REMICS"). From time to time the Bank may invest in mutual funds or equity securities of various corporations and other issuers. It is the Bank's current policy to limit to 5% of its investment portfolio the amount invested in equity securities and to avoid concentration of equity investments in any one industry.
The Company's primary objective with respect to its securities portfolio is to provide liquidity and income, consistent with prudent consideration for risk, maturity and overall diversification. The Bank's President and Chief Financial Officer are generally charged with executing the Bank's investment policy on a daily basis. They have discretion generally to buy and sell securities within the guidelines of the current plan. All transactions outside of the scope of the current plan must be discussed with and approved by the Bank's Executive Committee. All funds not needed to meet the daily investment requirements are invested in either federal funds or money market instruments. All transactions are ratified by the Bank's Board of Directors.
Sources of Funds - ----------------
General. Savings accounts, checking accounts and other types of deposits have historically constituted the primary source of funds for the Bank. In addition to deposits, the Bank obtains funds from FHLB borrowings, scheduled loan repayments, loan prepayments and loan sales. Scheduled loan repayments are a relatively stable source of funds while deposit inflows and outflows and loan prepayments vary widely and are influenced by prevailing interest rates and general and local economic conditions. Dividends from the Bank represent the only source of liquidity for the Company.
Deposits. The Bank offers a broad selection of deposit instruments to the general public, including NOW accounts, regular savings accounts, money market checking accounts, fixed and variable rate time accounts, IRA and Keogh retirement accounts and commercial checking accounts. In the past the bank has utilized brokered deposits, however, at December 31, 1998 and 1999 brokered deposits totaled less than 1/2 of 1% of total deposits. The Bank's management determines the interest rates offered on deposit accounts based on the Bank's strategic plans and goals, U.S. Government treasury rates, borrowing rates, competition, liquidity needs and the expected volatility of existing deposits.
Borrowings. The Bank is a member of the FHLB of Boston. This membership enables the Bank to borrow from the FHLB, which helps address the inherent problem on Nantucket Island of a deposit base which is unable to fund loan demand. The Bank also utilizes borrowings to reduce interest rate risk.
Dividend Policy ---------------
The Company's Board of Directors reviews the payment of dividends on a quarterly basis. Many factors such as earnings, the economy, quality of assets, allowance for loan loss and projected capital needs are reviewed. After due consideration, the Board may vote to pay either the same dividend as the previous quarter, or to increase, decrease or omit the dividend.
Subsidiaries of the Bank - ------------------------
The Bank has two subsidiaries, N.B. Securities, Inc., which has been classified as a securities corporation under the laws of the Commonwealth of Massachusetts to take advantage of the tax benefits available to such corporations and N. Realty Corp., which has elected to be taxed as a real estate investment trust.
Supervision, Regulation and Operating Powers - --------------------------------------------
General. The Company and the Bank are extensively regulated under federal and state law. The Company, as a Delaware corporation, is subject to regulation by the Secretary of the State of Delaware and the rights of its stockholders are governed by the General Corporation Law of the State of Delaware.
Federal Bank Holding Company Act Regulation. On August 30, 1988, the Company became a registered bank holding company after receiving approval from the Board of Governors of the Federal Reserve Board System ("FRB"). As a result, its activities are subject to certain limitations, which are described below, and transactions between the Bank and the Company or its other affiliates are also subject to certain restrictions.
Under the Bank Holding Company Act, a bank holding company must obtain FRB approval before it acquires direct or indirect ownership or control of any voting shares of any bank if, after such acquisition, it will own or control directly or indirectly more than 5% of the voting stock of such bank, unless it already owns a majority of the voting stock of such bank. FRB approval must also be obtained before a bank holding company acquires all or substantially all of the assets of a bank or merges or consolidates with another bank holding company. Any acquisition, directly or indirectly, by a bank holding company or its subsidiaries of any voting shares of, or interest in, or all or substantially all, of the assets of any bank located outside of the state in which the operations of the bank holding company's banking subsidiaries are principally conducted, may not be approved by the FRB unless the laws of the state in which the bank to be acquired is located specifically, authorizes such an acquisition.
The Bank Holding Company Act and regulations adopted thereunder limit the activities of a bank holding company and its subsidiaries to the business of banking or of managing or controlling banks, and to such other activities as the FRB may determine to be so closely related to banking as to be a proper incident thereto. The activities of the Company and its non-bank subsidiaries are subject to these legal and regulatory limitations under the Bank Holding Company Act and the FRB's regulations thereunder.
In addition to the statutory and regulatory restrictions on the non-bank activities of the Company, the FRB has taken the position that it has the authority, under its general supervisory authority over bank holding companies and their subsidiaries, to prevent activities of a bank holding company's subsidiaries that the FRB regards as unsafe or unsound, or to require a bank holding company to maintain a higher level of capital to support such activities. In this connection, the FRB has expressed serious reservations about applications by bank holding companies to acquire savings banks that are engaged directly or through subsidiaries in real estate development activities.
As a bank holding company, the Company is required to give the FRB prior written notice of any purchase or redemption of its outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of the Company's consolidated net worth. The FRB may disapprove such a purchase or redemption if it determines that the proposal would violate any law, regulation, FRB order, directive, or any condition imposed by, or written agreement with, the FRB.
Financial Modernization
Effective March 11, 2000, pursuant to authority granted under the Gramm-Leach-Bliley Act ("GLB Act"), a bank holding company may elect to become a financial holding company ("FHC") which may affiliate with securities firms and insurance companies and engage in other activities that are financial in nature. The GLB Act defines "financial in nature" to include securities underwriting, dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agency; merchant banking activities; and activities that the Federal Reserve has determined to be closely related to banking. Under the GLB act, a bank holding company may become a FHC by filing a declaration with the FRB if each of its subsidiary banks is well capitalized under the FDICIA prompt corrective action provisions, is well managed, and has at least a satisfactory rating under the Community Reinvestment Act of 1977 ("CRA"). No prior regulatory approval will be required for a FHC to acquire a company, other than a bank or savings association, engaged in activities permitted under the GLB Act. Most of the provisions of the GLB Act require the applicable regulators to adopt regulations in order to implement these provisions. The GLB Act does not significantly alter the regulatory environment under which the Company and the Bank currently operate, as described above.
Because the legislation is so very new and the changes are radical, the Company cannot yet determine how it will be affected by the GLB Act. The Company has not, at this time, made any decision with respect to whether it will elect to become a FHC under the GLB Act.
Massachusetts Banking Laws and Supervision. Massachusetts chartered savings banks such as the Bank are regulated and supervised by the Commissioner. The Commissioner is required to examine each state-chartered bank at least once every two years. The approval of the Commissioner is required to establish or close branches, merge with other banks, form a bank holding company and undertake many other activities. Massachusetts statutes and regulations govern among other things, investment powers, lending powers, deposit activities, maintenance of surplus and reserve accounts, the distribution of earnings, the payment of dividends, issuance of capital stock, branching, acquisitions, mergers, and consolidations.
Any Massachusetts bank that does not operate in accordance with the regulations, policies and directives of the Commissioner may be subject to sanctions for non-compliance. The Commissioner may under certain circumstances suspend or remove trustees, directors or officers who have violated the law, conducted the bank's business in a manner which is unsafe, unsound or contrary to the depositors' interests, or been negligent in the performance of their duties.
Deposit Insurance. The Bank's deposit accounts are insured by the Bank Insurance Fund of the FDIC to a maximum of $100,000 per separately insured account, and deposits in excess of that amount in each separately insured account are insured by the Depositors Insurance Fund.
Pursuant to section 7 of the Federal Deposit Insurance Act (12 USC 1817), as amended, the FDIC has incorporated a risk based deposit insurance assessment. Under this risk based system, the assessment rate for an insured depository depends on the assessment risk determined by the institutions capital level and supervisory evaluations. Institutions are assigned to one of three capital groups - well capitalized, adequately capitalized or undercapitalized.
Any FDIC-insured bank which does not operate in accordance with FDIC regulations, policies and directives may be sanctioned for non-compliance. Proceedings may be instituted against any FDIC-insured bank or any director or trustee, officer or employee of such bank who engaged in unsafe or unsound practices, including the violation of applicable laws and regulations. The FDIC has the authority to terminate insurance of accounts pursuant to the procedures established for that purpose or impose civil money penalties.
All Massachusetts chartered savings banks are required to be members of the Depositors Insurance Fund ("DIF"). The DIF maintains a private deposit insurance fund which insures all deposits in member banks which are not covered by federal insurance, which, in the case of the Bank, are its deposits in excess of $100,000 per insured account. In 1999 and 1998, the Bank's premium for this insurance was assessed at an annual rate of 1/50 of 1% of insured deposits.
Competition - -----------
The Bank faces strong competition from other banks, mortgage banking companies and other financial service providers, many of which have substantially greater resources than the Bank.
The Bank's most direct competition for deposits primarily comes from other banks located on Nantucket Island and in southeastern Massachusetts, credit unions, mutual funds and government securities. The Bank competes for deposits principally by offering depositors convenient branch hours and locations, efficient and attentive service, a wide variety of deposit programs, automated teller machines and competitive interest rates. It does not rely upon any single individual, group or entity for a material portion of its deposits.
Competition for real estate loans comes primarily from other banks, mortgage banking companies and other institutional lenders. The Bank competes for loan origination primarily based on the efficiency and quality of service that it provides as well as the interest rates and loan fees that it charges. The competition for loans varies depending on factors which include, among others, the general availability of lendable funds and credit, general and local economic conditions, current interest rate levels, conditions in the mortgage market and other factors which are not readily predictable.
In addition to competing with other savings banks and financial services organizations based in Massachusetts, the Bank has and is expected to face increased competition from major commercial banks headquartered outside of Massachusetts as a result of the interstate banking laws which currently permit banks nationwide to enter the Bank's market area and compete with it for deposits and loan originations.
Employees - ---------
As of December 31, 1999, the Company and Bank had 68 full-time-equivalent employees. None of these employees is represented by a collective bargaining agreement. The Company believes its employee relations are good.
Guide 3 Statistical Disclosures - -------------------------------
The following tables contain additional consolidated statistical data about the Company and the Bank.
I. Distribution of Assets, Liabilities and Shareholders' Equity; Interest Rates and Interest Differential.
A. The following table presents average consolidated balance sheets for each of the three years ending December 31, 1999. Loans held for sale are included in residential real estate loans.
B. An analysis of net interest earnings, including the average amount of interest-bearing assets and liabilities outstanding during the period, interest earned or paid, average yields and costs, and net yield on interest-earning assets is presented under the caption "Net Interest Income" of "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the 1999 Annual Report.
Interest income is reported on a fully taxable-equivalent basis. Tax-exempt income is converted to a fully taxable equivalent basis by assuming a 34% marginal federal income tax rate adjusted for applicable state income taxes net of the related federal tax benefit. Interest on nonaccrual loans is included in the analysis of net interest earnings to the extent that such interest income has been recognized in the Consolidated Statements of Earnings.
C. An analysis of rate/volume changes in interest income and interest expense is presented under the caption "Net Interest Income" of "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the 1999 Annual Report.
II. Securities Available for Sale and Securities Held to Maturity
A. The carrying amounts of securities is presented in the "Notes to Consolidated Financial Statements" in the 1999 Annual Report.
B. Maturities of debt securities are presented in the "Notes to Consolidated Financial Statements" in the 1999 Annual Report. Mortgage-backed securities are included based on their weighted average maturities, adjusted for anticipated prepayments. Yields on tax exempt obligations are not computed on a tax equivalent basis.
III. Loan portfolio
A. The following table sets forth the composition of the loan portfolio for each of the past five years. Loans held for sale are included in residential mortgage loans.
B. An analysis of the maturity and interest rate sensitivity of Real Estate Construction and Commercial business loans as of December 31, 1999 follows:
Real estate construction includes residential and commercial construction loans, which are presented net of unadvanced funds. All of the loans included in the "after one year but within five year" and "over five year" categories have adjustable rates of interest.
C. Risk Elements. Reference is made to the captions "Non-performing Assets and Provision for Loan Losses" included in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the 1999 Annual Report.
1. Non-performing loans are summarized as follows:
2. Potential Problem Loans. Potential problem loans consist of certain accruing loans that were less than 90 days past due at December 31, 1999, but were identified by management of the Bank as potential problem loans. Such loans are characterized either by weaknesses in the financial condition of borrowers or by collateral deficiencies. Based on historical experience, the credit quality of some of these loans may improve as a result of collection efforts, while the credit quality of other loans may deteriorate, resulting in some amount of losses. These loans are not included in the analysis of nonaccrual, past due and restructured loans in Section III.C.1 above. At December 31, 1999, potential problem loans amounted to $598,000. The Bank's loan policy provides guidelines for the review of such loans in order to facilitate collection.
Depending on future events, these potential problem loans, and others not currently identified, could be classified as nonperforming in the future.
3. Foreign Outstandings. None
4. Loan Concentrations. The Company has no concentration of loans that exceed 10% of its total loans except as disclosed by types of loan in Section III.A.
D. Other Interest-Bearing Assets: None
III. Summary of Loan Loss Experience
A. An analysis of loss experience follows:
The factors influencing management's judgment in determining the amount of the additions to the loan loss allowance charged to operating expense are detailed in caption "Provision for Loan Losses" included in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the 1999 Annual Report.
B. The allocation of the allowance for loan losses, and percent of each loan category to total loans (excluding loans held for sale) is as follows:
V. Deposits
A. Average deposit balances outstanding and the average rates paid thereon are presented in the following table:
B. Not Applicable
C. Not Applicable
D. The maturity schedule of time deposits in amounts of $100,000 or more at December 31, 1999 was as follows:
E. Not Applicable
VI. Return on Equity and Assets
Information on the Company's return on equity, return on assets, dividend payout ratio and equity to assets ratio is presented in "Financial Highlights" in the 1999 Annual Report.
VII. Short Term Borrowings. Not Applicable
Item 2.
Item 2. Description of Property
The Bank owns three properties and leases two properties. The three properties owned consist of the Bank's main office, one branch office and an undeveloped parcel of land. The Bank leases 3,300 square feet of office space and one automated teller facility.
The Bank's main office is located at 104 Pleasant Street on Nantucket, and was acquired on June 30, 1979. This 8,500 square foot facility had a net book value of $1.1 million at December 31, 1999, including the book value of the land on which the facility is located.
The Bank's branch office, located at 2 Orange Street, Nantucket is a 3,200 square foot facility which the Bank acquired in 1921, and had a net book value of $31,000 at December 31, 1999, including the book value of the land on which the facility is located.
On August 30, 1995 the Bank purchased a three-quarter acre parcel of land located on Amelia Drive, Nantucket for $240,000. The bank is in the process of constructing a branch office on this land. At December 31, 1999 the Bank had entered into a contract for construction of the branch in the amount of $800,000.
The Bank believes that its properties are in good condition for their intended use and the fair market value of its properties is significantly in excess of the book value of these properties.
The Bank leases 16 square feet of space at the main terminal building on Nantucket Island for an automated teller machine facility. The lease expires on March 31, 2000.
During 1998, the Bank entered into a non-cancelable operating lease for 1,500 square feet of office space at 9 Bayberry Court that expires in 2003. In July 1999, the Bank amended the current lease to add 1,816 square feet in which the term shall commence between January 1 and March 1, 2000 and will also expire in 2003. This lease contains five one-year renewal options that may be exercised by the Bank.
At December 31, 1999, the net book value of the Bank's furnishings, equipment and autos was $1.4 million.
For further information, see Note 4 of Notes to Consolidated Financial Statements in the 1999 Annual Report to Stockholders.
Item 3.
Item 3. Legal Proceedings
From time to time, the Bank is involved in legal proceedings incidental to its business. None of these actions individually or in the aggregate is believed to be material to the financial condition of the Bank.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 1999.
PART II
Item 5.
Item 5. Market for Common Equity and Related Stockholder Matters
The information contained in the section captioned "Stock Market Data" in the 1999 Annual Report to Stockholders is incorporated herein by reference. For information regarding the Company's dividend policy see also "Item 1 -- Business - -- Dividend Policy."
Item 6.
Item 6. SELECTED Financial DATA
The information contained in the section captioned "Financial Highlights" in the 1999 Annual Report to Stockholders is incorporated herein by reference.
Item 7.
Item 7. Management's Discussion and Analysis or plan of Operation
The information contained in the section captioned "Management's Discussion and Analysis" in the 1999 Annual Report to Stockholders is incorporated herein by reference.
Item 7A.
Item 7A. QUANTITATIVE AND QUALITATIVE DOSCLOSURES ABOUT MARKET RISK
The information contained in the sub-section of "Management's Discussion and Analysis" captioned "Asset/Liability Management and Market Risk" in the 1999 Annual Report to Stockholders is incorporated herein by reference.
Item 8.
Item 8. Financial Statements AND SUPPLEMENTARY DATA
The financial statements contained in the 1999 Annual Report to Stockholders are incorporated herein by reference. Summaries of consolidated operating results on a quarterly basis for the years ended December 31 follow:
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Part III
Item 10.
Item 10. Directors, Executive Officers, promoters and control persons; compliance with section 16(A) Exchange Act
Item 11.
Item 11. Executive Compensation
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Item 13.
Item 13. Certain Relationships and Related Transactions
The information required by Items 10, 11, 12 and 13 is incorporated herein by reference to the Company's definitive proxy statement for the annual meeting of stockholders to be held on May 12, 2000 which will be filed with the Securities and Exchange Commission pursuant to Regulation 14A on or before April 12, 2000.
Item 14.
Item 14. Exhibits and Reports on Form 8 - K
(a) Documents Filed as Part of Form 10-KSB
1. Exhibits
(3) Certificate of Incorporation and Bylaws of Home Port Bancorp, Inc. Incorporated herein by reference to exhibit B and C to the Company's Registration on Form S-1 (No.33-21794) (the "Registration Statement")
(10.1.2) Employment Agreement between Nantucket Bank and William P. Hourihan, Jr. Incorporated herein by reference to the Registration Statement.
(10.1.3) Employment Agreement between Nantucket Bank and Daniel P. Neath. Incorporated herein by reference to the Registration Statement. (10.1.4) Supplemental Retirement Agreement between Nantucket Bank and Daniel P. Neath. Incorporated herein by reference to the Company's Form 10-K for the Year Ended December 31, 1989, as filed with the SEC on April 13, 1990.
(10.1.5) Consulting Agreement between Home Port Bancorp, Inc. and Karl L. Meyer dated May 1, 1998. Incorporated herein by reference to the Company's Form 10-QSB for the quarterly period ended June 30, 1998 as filed with the SEC on August 13, 1998.
(10.1.6) Home Port Directors Restricted Stock Option Plan dated May 1, 1998. Incorporated herein by reference to the Company's Form 10-QSB for the quarterly period ended June 30, 1998 as filed with the SEC on August 13, 1998.
(13) 1999 Annual Report to Stockholders for the Fiscal Year Ended December 31, 1999.
(21) Subsidiaries of the Registrant.
(b) No reports on Form 8-K were filed by the Registrant during the quarter ended December 31, 1999.
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant had duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
HOME PORT BANCORP, INC.
Date: March 20, 2000 By: /s/ Karl L. Meyer ----------------- Karl L. Meyer President and Chief Executive Officer (Duly Authorized Representative)
In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signatures Date - ---------- ----
/s/ Karl L. Meyer March 20, 2000 - ----------------- Karl L. Meyer Chairman of the Board, President and Chief Executive Officer
/s/ John M. Sweeney March 20, 2000 - ------------------- John M. Sweeney Treasurer & Chief Financial Officer (Principal Financial and Accounting Officer)
/s/ William P. Hourihan, Jr. March 20, 2000 - ---------------------------- William P. Hourihan, Jr. Director
/s/ Charles F. DiGiovanna March 20, 2000 - ------------------------- Charles F. DiGiovanna Director
/s/ Charles H. Jones, Jr. March 20, 2000 - ------------------------- Charles H. Jones, Jr. Director
Signatures (Continued) Date - ---------------------- ----
/s/ Robert J. McKay March 20, 2000 - ------------------- Robert J. McKay Director
/s/ Philip W. Read March 20, 2000 - ------------------ Philip W. Read Director
/s/ Robert A. Trevisani, Esq. March 20, 2000 - ------------------------------ Robert A. Trevisani, Esq. Director | 6,617 | 42,544 |
1092657_1999.txt | 1092657_1999 | 1999 | 1092657 | ITEM 1. BUSINESS
Webvan is an Internet retailer offering same-day delivery of consumer products through an innovative proprietary business design that integrates our Webstore, distribution center and delivery system. Our current product offerings are principally focused on food, non-prescription drug products and general merchandise including housewares, pet supplies and books.
THE WEBVAN WEBSTORE
Our Webstore is a user-friendly, informative and personalized web site which enables users to quickly and easily navigate and purchase from a wide selection of items. The Webstore makes the shopping experience easy for the customer by offering them multiple methods for shopping the site. The store directory is divided into twelve intuitively organized categories and allows the customer to quickly and efficiently find items. Once customers find the item they want, they may add it to the shopping cart or may save it to a shopping list. The shopping cart is always visible on the screen and instantly updates and calculates the order total while the customer shops. Our Webstore promotes brand loyalty and repeat purchases by providing a convenient, easy-to-use experience that encourages customers to return frequently.
HOME PAGE. Our home page serves as the entry point and gives visitors a glimpse of the wide selection available on the site. On our home page, customers find weekly specials on brand name products, a clearly defined directory structure and links that showcase specific products and areas of the site.
BROWSING. Our Webstore displays a store directory which allows visitors to browse through all the categories of products Webvan offers. The categories are intuitively organized by type of product and enable the user to drill down from general to more specific categories, such as moving from produce to fruits to bananas. The browsing tool also enables customers to see all products in a particular category before making a selection, similar to scanning the shelves of a neighborhood store. In addition, each item on the site has an image and many grocery products have nutritional information attached, which further enhances the user experience.
SEARCHING. Our Webstore contained an interactive, searchable database of approximately 18,000 SKUs at year end. The customer can search based on product type, brand name or category. The search results page displays each relevant item, along with the product category and subcategories.
CONTENT AND FEATURES. Webvan offers an array of content on the site to enhance the user experience and encourage visitors to try new items. Our weekly electronic magazine, Sensations, features special recipes,
cooking tips, features authored by food and health experts, and the opportunity to interact with culinary professionals. As we accumulate data, our Webstore can be personalized to appeal to individual customer preferences and buying habits.
PERSONALIZATION AND LISTS. Our Webstore enables a customer to personalize their shopping experience. The site's shopping list feature allows customers to create and retain personal shopping lists in their profiles. Multiple lists can be saved for weekly shopping, specific events or special occasions. Once a list has been created and saved, it can be retrieved and modified at any time, enabling customers to shop and check out in a few minutes. We believe that the personalization of a customer's shopping experience is an important element of our value proposition and we intend to continue to enhance our personalization services. For instance, we recently introduced the "My Personal Market" category which generates a shopping category with everything a customer has ever purchased at webvan.com sorted by product category as well as a shopping category with a customer's 50 most frequently purchased items sorted by purchase frequency.
DELIVERY. Customers schedule their delivery by selecting a time from a grid of 30-minute alternatives. Our real-time inventory tracking and delivery route software systems are designed to help ensure that the groceries a customer orders will be available so that they can be delivered at the delivery time window selected by the customer. Using this system, the customer is able to select and schedule a delivery to occur within an available specific 30-minute window, on the same day or up to four days after the order is placed. Deliveries are currently made from 7:00 a.m. to 10:00 p.m. every day of the week from our Oakland facility. Our customers must be at home to accept delivery of perishable or frozen items or regulated products such as alcohol and tobacco. Non-perishable items may be delivered when the customer is not home.
For the year, 92% of our deliveries were on time. While we strive to maintain high on-time delivery rate and order fulfillment accuracy rates, we have, on occasion, experienced operational "bugs" that have resulted in a high proportion of late deliveries or order fulfillment inaccuracies on particular days. Any material decrease in our on-time delivery rate or in order fulfillment accuracy would likely have an adverse impact on our consumer acceptance of our service and on our ability to increase average daily order volume. A prolonged decline in our on-time delivery rate or in order fulfillment accuracy would have an adverse impact on our financial results.
TECHNOLOGY
We have developed a technologically advanced systems platform, which integrates our entire business process from end to end. We have built an array of proprietary advanced inventory management, warehouse management, route management and materials handling systems and software to manage the entire customer ordering and delivery flow process. Our proprietary automated materials handling controller communicates with the Webstore and warehouse management system and issues instructions to the various mechanized areas of the distribution center to ensure the proper fulfillment of orders. We designed the system to utilize automated conveyors and carousels to transport items to centrally located employees. As a result, the system is designed to allow us to increase volume without a proportionate increase in human resources.
Once a delivery is scheduled, a route planning feature of the system determines the most efficient route to deliver goods to the customer's home. The courier communicates with the route planner and delivery scheduler modules throughout the delivery process through the use of a wireless mobile field device. Each aspect of this process is tightly integrated and enables us to provide high quality service to our customers.
We have devoted over 50 person years of effort to our software development effort. Our software development expenses were approximately $15 million, $3 million and $0.2 million in 1999, 1998 and 1997, respectively.were We are continuously refining and modifying our systems based on our experience and an attempt to incorporate additional features that make order processing more efficient and customer experience more rewarding. We outsource most of our network operations functions and employ our own customer services personnel. The continued uninterrupted operation of our Webstore and transaction-processing systems is essential to our business, and it is the job of the site operations staff to ensure, to the greatest extent possible, the reliability of our Webstore and transaction-processing systems. Webvan's web and database servers are hosted at AboveNet Communications, Inc. in Santa Clara County, California.
DISTRIBUTION CENTER ROLL OUT
We currently operate a 336,000 square foot distribution center facility in Oakland, California. The distribution center was designed to process product volumes equivalent to approximately 18 supermarkets and is the hub for the receipt and distribution of products and allows for efficient sorting and distribution of products. The distribution center is a clean, climate-controlled facility segmented into separate ambient, refrigerated and frozen areas that store grocery items at optimal temperatures. Identical software systems will be implemented at each distribution center, enabling the easy replication of the distribution center model across multiple locations and allowing for central management of the entire system. We intend to pursue a roll out of distribution centers into various locations in the U.S. to capitalize on what we view as a substantial market opportunity. Our first facility in Oakland, California was commercially launched in June 1999. Our second distribution center in Atlanta, Georgia is scheduled to open in the second quarter of 2000. Other planned openings in 2000 include Chicago and Seattle and we plan to have distribution centers open in a total of 15 geographic markets by the end of 2001. We plan to locate our distribution centers in industrially zoned areas, which generally have lower real estate costs than traditional supermarkets located in commercial areas.
In July 1999, we entered into an agreement with Bechtel Corporation for the construction of up to 26 additional distribution centers after Atlanta over the next three years in various locations that we designate. We believe that our alliance with Bechtel will enable us to more aggressively and cost-effectively roll out distribution centers in other markets by utilizing their engineering, design, procurement and construction expertise. Bechtel will be responsible for substantially all aspects of the build-out program and will deliver completed distribution centers to Webvan. We expect Bechtel to leverage its strengths in engineering management to incorporate improvements to the design of our distribution centers. For instance, "build-to-suit" design specifications are currently being designed with Bechtel to be provided to potential landlords for the development of buildings with "standardized" or identical layouts. Although the Company has no specific capital commitment under our agreement, our expenditures under the contract are estimated to be approximately $1.0 billion. We estimate the average cost of the construction of and equipment of distribution centers under our contract with Bechtel at $30.0 million to $35.0 million based on our experience to date and on efficiencies we expect will be progressively realized over the course of our contract from our relationship with Bechtel, including cost of construction efficiencies we expect to follow from "build-to-suit" design specifications. Bechtel is to perform services under its agreement with us within schedule and budgetary parameters determined by Webvan, and will be eligible to receive cash incentive payments to the extent distribution centers are completed within the preestablished parameters. Under our agreement with Bechtel, Bechtel has agreed not to provide substantially similar services to any other entity operating in a number of Internet retail segments. We also issued Bechtel a warrant to purchase up to 1,800,000 shares of our stock. The warrant has been exercised as to 150,000 shares and becomes exercisable as to 150,000 additional shares when the first six distribution centers are completed and as to an additional 57,690 shares upon the completion of each distribution center within agreed upon schedule and budgetary parameters.
We currently obtain all of our carousels for our distribution centers from Diamond Phoenix Corporation. Under our agreement with Diamond Phoenix, Diamond Phoenix has agreed not to sell carousels to any other entity operating in a number of Internet retail segments. In the event that the supply of carousels from Diamond Phoenix were delayed or terminated for any reason, the Company believes that it could obtain similar carousels from other sources; however, the integration of such other carousels into our distribution centers could result in construction delays and could require modifications to our software systems. Accordingly, any such delay or termination of our relationship with Diamond Phoenix could cause a material delay in our planned expansion program. In addition, in connection with this arrangement, we made a minority equity investment in Diamond Phoenix.
DELIVERY OPERATIONS
The distribution center will serve as the center of our hub-and-spoke delivery system. Orders are collected from the Webstore, routed and managed by the distribution center, transferred to stations and delivered from the stations to customers' homes. This model enables us to efficiently and cost effectively deliver consumer goods to the home by combining centralized order fulfillment with decentralized delivery.
We use temperature-controlled trucks to deliver from the distribution center to the station and smaller vans to deliver from the station to the home. The stations are strategically positioned throughout a delivery region within approximately 50 miles of a distribution center and typically within approximately 10 miles of target customer residences. Our initial market in the San Francisco Bay Area, has 12 stations, and we expect other distribution centers to support from 12 to 15 stations. We deliver to the customer's door in a smaller van complete with refrigeration equipment to keep chilled and frozen items at temperatures that insure their quality and freshness. Each customer's order is delivered in environmentally-friendly reusable containers, called totes.
All of our couriers are Webvan employees. We utilize strict hiring standards in choosing couriers and require each new employee to complete an intensive training program. The courier training lasts three weeks and includes 32 hours of classroom training, 24 hours of driving training and 16 hours of on the job training. Couriers are trained in responsible driving practices, verification procedures related to the sale of alcohol and tobacco products, courtesy and the proper handling of totes and products. Our couriers receive a competitive compensation package, including cash and stock options, and are incentivized to reinforce our brand and help to create a lasting one-to-one relationship with our customers. In addition, couriers have been trained to answer questions about the service and handle service issues directly and promptly at the customer residence. If the customer is not satisfied with the products received, the courier is able to initiate a transaction to replace items or credit the customer's bill.
CUSTOMER SERVICE
We believe that our ability to establish and maintain long-term relationships with our customers and to encourage repeat visits and purchases depends on the strength of our customer support and service operations and staff. We seek to achieve frequent communication with and feedback from our customers to continually improve the Webvan service. Webvan offers a number of automated help options as well as an on-line "chat" system that connects customers and customer service representatives on the website and an easy-to-use direct e-mail service to enable customers to ask questions and to encourage feedback and suggestions. We plan to respond to customer email inquiries within 12 hours of the submission and allow for a maximum response time of 24 hours. Our team of customer support and service personnel are responsible for handling general customer inquiries, answering customer questions about the ordering process, and investigating the status of orders, deliveries and payments. Users can contact customer service representatives via our toll free telephone number to ask questions. Our automated customer service function distributes e-mails to customers after registration and after each order is placed. We plan to enhance the automation of the tools used by our customer support and service staff in the future.
MARKETING AND PROMOTION
Our marketing and promotion program is designed to strengthen the Webvan brand name, drive trials of our service in our target markets, build strong customer loyalty and maximize repeat usage and purchases. We intend to build our brand name and customer loyalty through our public relations programs, advertising campaigns and promotional activities. Our efforts focus on building credibility with customers and achieving market acceptance for our services. We expect to advertise locally in our initial launch markets and plan to tailor our advertising to each specific market.
In the future, Webvan expects to be able to provide increasingly targeted and customized services by using the customer purchasing, preference and behavioral data obtained through the traffic and purchases generated at the Webstore. We also build brand loyalty though personalized interaction with customers through prompt, professional delivery persons and through use of Webvan delivery vehicles. By offering customers a compelling and personalized value proposition, our goal is to increase the number of visitors that make a purchase, to encourage repeat visits and purchases and to extend customer retention. In addition, loyal, satisfied customers generate strong word-of-mouth support and awareness which drive new customer acquisitions and increased order volumes.
MERCHANTS AND VENDORS
Webvan sources grocery products from a network of food and drug manufacturers, wholesalers and distributors. We source products from a network of manufacturers, distributors and wholesalers. We currently rely on rapid fulfillment from national and regional distributors for a substantial portion of our grocery items. We purchase a number of top grocery brands and high volume grocery items directly from manufacturers and may increase our use of direct suppliers as our product volumes increase with additional distribution centers. We also utilize premium specialty suppliers or local sources for gourmet foods, farm fresh produce, fresh fish and meats. Because we cover a broad area and service high volumes from a single point of distribution, we offer our suppliers a very efficient product supply model which is reflected in the discounts and pricing we receive. When we select a new product for purchase, it is entered into the inventory management system and our Webstore. We employ advanced replenishment and expiration date controls to manage our inventory and maintain product freshness. As of December 31, 1999, we were purchasing products from approximately 30 distributors and directly from approximately 230 vendors.
LEVERAGE DISTRIBUTION SYSTEM TO ENTER ADDITIONAL CONSUMER PRODUCT CATEGORIES.
Our initial focus is on groceries and non-prescription drugstore offerings because we believe this is the best way to establish long-term relationships with customers given the frequency with which people shop for these products compared to other items and the size of the grocery and drugstore market. We believe that customer reliance on the convenience and reliability of Webvan deliveries to their homes will enable implementation of the larger strategy of using our distribution system to sell products in other consumer product categories and ultimately to position ourselves as the preferred choice of customers for purchasing products over the Internet that are delivered to the home.
COMPETITION
Local, regional, and national food chains, independent food stores and markets, as well as online grocery retailers comprise our principal competition as an on-line grocery retailer, although we also face substantial competition from convenience stores, liquor retailers, membership warehouse clubs, specialty retailers, supercenters, and drugstore chains. To the extent that we add non-grocery store product categories to our offering, local, regional and national retailers in those product categories, as well as online retailers in those product categories, will provide our principal competition in those areas. Many of our existing and potential competitors, particularly traditional grocers and retailers and certain online retailers, are larger and have substantially greater resources than we do. We expect this competition in the online grocery and non-grocery areas will intensify as more traditional and online grocery retailers offer competitive services. For instance, in Seattle, where we expect to begin operations this year, Albertson's, a traditional supermarket chain, has introduced an Internet based service, and we expect competition from such retailers to intensify in the near future.
Our initial distribution center in Oakland, California, operates in the San Francisco Bay Area market. In this market, we compete primarily with traditional grocery retailers and with online grocers NetGrocer and Peapod. Homegrocer has announced plans to introduce its online grocery service in Atlanta. Our potential competitors in markets other than the San Francisco Bay Area include between five and ten full-service grocery retailers operating exclusively online. The number and nature of competitors and the amount of competition we will experience will vary over time and by market area. In other markets, we expect to compete with current online offerings from these companies and others, including HomeGrocer, HomeRuns, ShopLink, GroceryWorks and Streamline. Many of these services charge membership, delivery or service fees, and often offer their goods at a premium to traditional supermarkets. In addition, most competing online retailers currently use manual shopping and retrieval systems which we believe lack the capability to process a large number of orders for a large number of customers in a cost efficient manner.
The principal competitive factors that affect our business are location, breadth of product selection, quality, service, convenience, price and consumer loyalty to traditional and online grocery and non-grocery retailers. In the grocery business, we believe that we compete favorably with respect to each of these factors as
compared to other online grocery retailers. However, many traditional grocery retailers may have substantially greater levels of consumer loyalty and serve many more locations than we currently do. As we expand into additional product categories, our ability to attract and retain customers for these products will be a function of the same competitive factors. If we fail to compete effectively in any one or more of these areas, we may lose existing and potential customers, which could materially harm our business.
GOVERNMENT REGULATION
In addition to regulations applicable to businesses generally or directly applicable to electronic commerce, we are subject to a variety of regulations concerning the handling, sale and delivery of food, alcohol and tobacco products. Currently, we are not subject to regulation by the United States Department of Agriculture, or USDA. Whether the handling of certain food items in our distribution facility, such as meat and fish, will subject us to USDA regulation in the future will depend on several factors, including whether we sell food products on a wholesale basis or whether we obtain food products from non-USDA inspected facilities. Although we have designed our food handling operations to comply with USDA regulations, we cannot assure you that the USDA will not require changes to our food handling operations. We will also be required to comply with local health regulations concerning the preparation and packaging of our prepared meals and other food items. Any applicable federal, state or local regulations may cause us to incur substantial compliance costs or delay the availability of a number of items at one or more of our distribution centers. In addition, any inquiry or investigation from a food regulatory authority could have a negative impact on our reputation. Any of these events could have a material adverse effect on our business and expansion plans and could cause us to lose customers.
We will be required to obtain state, and in some cases county or municipal licenses and permits for the sale of alcohol and tobacco products in each location in which we seek to open a distribution center. Given the complexity of these regulations governing the issuance of these permits and licenses and the fact that most were enacted prior to the existence of an Internet-based sales model, we cannot assure you that we will be able to obtain any required permits or licenses in a timely manner, or at all. We may be forced to incur substantial costs and experience significant delays in obtaining these permits or licenses. For instance, we will not have an alcohol license in Atlanta when we open our distribution center, and our pursuit of regulatory or legislative clarification to existing rules in order to obtain a license may be ultimately unsuccessful or expensive. In addition, the United States Congress is considering enacting legislation which would restrict the interstate sale of alcoholic beverages over the Internet. Changes to existing laws or our inability to obtain required permits or licenses could prevent us from selling alcohol or tobacco products in one or more of our geographic markets or a portion of those markets where a market extends over two or more licensing jurisdictions. Any of these events could substantially harm our net sales, gross profit and ability to attract and retain customers.
The adoption of laws or regulations relating to large-scale retail store operations could adversely affect the manner in which we currently conduct our business. For example, the Governor of California recently vetoed legislation which would have prohibited a public agency from authorizing retail store developments exceeding 100,000 square feet if more than a small portion of the store were devoted to the sale of non-taxable items, such as groceries. While it is not clear whether our operations would be considered a retail store for purposes of this kind of legislation, we cannot assure you that other state or local governments will not seek to enact similar laws or that we would be successful if forced to challenge the applicability of this kind of legislation to our distribution facilities. The expenses associated with any challenge to this kind of legislation could be material. If we are required to comply with new regulations or legislation or new interpretations of existing regulations or legislation, this compliance could cause us to incur additional expenses or alter our business model.
In addition, because of the increasing popularity of the Internet, it is possible that a number of laws and regulations may be adopted with respect to the Internet and e-commerce that could adversely affect the manner in which we conduct our business. These laws may cover issues such as user privacy, freedom of expression, pricing, content and quality of products and services, taxation, advertising, intellectual property rights and information security. Furthermore, the growth of electronic commerce may prompt calls for more stringent consumer protection laws. Several states have proposed legislation to limit the uses of personal user
information gathered online or require online services to establish privacy policies. The Federal Trade Commission has also initiated action against at least one online service regarding the manner in which personal information is collected from users and provided to third parties. We do not currently provide user-specific personal information regarding our users to third parties. However, the adoption of such consumer protection laws could create uncertainty in web usage and reduce the demand for our products and services.
We are not certain how our business may be affected by the application of existing laws governing issues such as property ownership, copyrights, encryption and other intellectual property issues, taxation, libel, obscenity and export or import matters. The vast majority of these laws were adopted prior to the wide use of the Internet. As a result, they do not contemplate or address the unique issues of the Internet and related technologies. Changes in laws intended to address these issues could create uncertainty in the Internet market place. This uncertainty could reduce demand for our services or increase the cost of doing business as a result of litigation costs or increased service delivery costs.
INTELLECTUAL PROPERTY
We regard patent rights, copyrights, service marks, trademarks, trade secrets and similar intellectual property as important to our success. We rely on patent, trademark and copyright law, trade secret protection and confidentiality or license agreements with our employees, customers, partners and others to protect our proprietary rights; however, the steps we take to protect our proprietary rights may be inadequate. We have filed trademark registration applications, including for the marks "WEBVAN", "WEBVAN.COM," the Webvan logo and "THE ONLY .COM YOU REALLY NEED". We currently have no patents protecting our technology. From time to time, we have filed and expect to file patent applications directed to aspects of our proprietary technology. We cannot assure you that any of these applications will be approved, that any issued patents will protect our intellectual property or that any issued patents or trademark registrations will not be challenged by third parties. In addition, other parties may independently develop similar or competing technology or design around any patents that may be issued to us.
EMPLOYEES
As of December 31, 1999, we had 959 full-time employees consisting of 101 in software development, 242 in operations, administration and customer service, 33 in merchandising, 15 in marketing and 568 at our distribution centers. We expect to hire additional personnel as we expand our operations and staff additional distribution centers. None of our employees are represented by a labor union. We have not experienced any work stoppages and consider our employee relations to be good.
EXECUTIVE OFFICERS
Our executive officers and certain information about them as of December 31, 1999 are as follows:
Louis H. Borders has served as our Chairman of the Board since founding Webvan in December 1996. Mr. Borders served as President and Chief Executive Officer of Webvan from December 1996 to September 1999. Mr. Borders co-founded Synergy Software, a software consulting company, in November 1989 and served on its board of directors from November 1989 to November 1997. Mr. Borders founded Borders Books, a retail bookstore chain, in 1971 and served as President and Chief Executive Officer until 1983 and as Chairman from 1983 to 1992. He also developed the advanced information systems used by Borders Books to manage inventory across diverse geographic and demographic regions. In addition, Mr. Borders is chairman of
Mercury Capital Management, an investment firm he founded in 1995. Mr. Borders holds a B.A. in Mathematics from the University of Michigan.
George T. Shaheen has served as President and Chief Executive Officer and as a member of the Board of Webvan since September 1999. Prior to joining Webvan, he had been the managing partner and chief executive officer of Andersen Consulting, a global consulting firm, since the firm became an independent unit in 1989. He joined Andersen Consulting in 1967 and became a partner in 1977. From 1980 to 1985, he oversaw the consulting practice for North and South Carolina before heading the Northern California Consulting practice based in San Francisco. Prior to becoming managing partner and chief executive officer of Andersen Consulting, Mr. Shaheen was managing partner of the Southeast U.S. Region and North American practices. In addition, he was the practice director for Japan and the Pacific Northwest. Mr. Shaheen is also a director of Siebel Systems, Inc., a software company. He is on the Board of Trustees at Bradley University and is a member of the Board of Advisors for the Northwestern University J.L. Kellogg Graduate School of Business. Mr. Shaheen received a bachelor's degree in marketing and a master's degree in finance from Bradley University.
Robert H. Swan has served as Chief Financial Officer since February 2000; from October 1999 until February 2000 he served as Vice President, Finance of Webvan. From September 1985 to October 1999, Mr. Swan held a variety of positions at General Electric Company, most recently as Vice President, Finance and Chief Financial Officer of GE Lighting. From January 1997 to June 1998, Mr. Swan served as Vice President, Finance of GE Medical Systems in Europe. From October 1994 to January 1997, Mr. Swan served as Chief Financial Officer of GE Transportation Systems. From May 1988 to October 1994, Mr. Swan held several assignments with GE's Corporate Audit Staff. Mr. Swan holds a B.S. in Management from the State University of New York at Buffalo and an M.B.A. from the State University of New York at Binghamton.
Arvind Peter Relan has served as Senior Vice President Platform Group of Webvan since March 2000; from February 1998 until March 2000 he served as Senior Vice President, Technology of Webvan. From May 1994 to February 1998, Mr. Relan served in various management positions at Oracle Corporation, a software company, most recently as Vice President of Internet Server Products in its Application Server Division. In 1995, Mr. Relan founded Oracle's Internet Server Division, including Oracle's patented Web Request Broker technology, Oracle Application Server and Oracle Internet Commerce Server. From 1988 to 1994, Mr. Relan held various positions at Hewlett-Packard, a computer systems, equipment and services company, including principal technologist for the HP Openview Platform. Mr. Relan holds a B.S. in Computer Engineering from the University of California, Los Angeles and a M.S. in Engineering Management from Stanford University.
Mark X. Zaleski has served as Senior Vice President, Area Operations of Webvan since July 1999. From December 1998 to July 1999, he served as Chief Operating Officer of Webvan. From 1994 to 1998, Mr. Zaleski served in various executive management positions for ACNielsen, a market research company, most recently as Senior Vice President and Group Managing Director of Central Europe. From 1985 to 1994, Mr. Zaleski held several positions at Federal Express, most recently as a Managing Director for Federal Express, Europe. From 1985 to 1988, Mr. Zaleski held various management positions in hub, ground operation and sales for Federal Express. Mr. Zaleski holds a B.S. in Business Administration and an M.B.A. from the European University in Antwerp, Belgium.
F. Terry Bean has served as Senior Vice President, Human Resources since March 2000. From August 1998 to May 1999 Mr. Bean served as vice president of human resources and corporate services for Equiva Services, a joint venture between Shell Oil Company, Texaco and Saudi Aramco. From 1994 to July 1998, he was with Office Depot, Inc., serving first as the executive vice president, human resources, and from 1997 to 1998, as senior vice president of the company's commercial business unit. From 1989 to 1994, he was the senior vice president, human resources for Roses Stores, Inc. in Henderson, North Carolina and from 1978 to 1989, he held a series of senior positions within the personnel services group at Federal Express Corporation. Mr. Bean received his bachelor's degree in business from Memphis State University.
Officers serve at the discretion of the Board and are appointed annually. The employment of each of our officers is at will and may be terminated at any time, with or without cause. There are no family relationships between any of the directors or executive officers of Webvan.
ITEM 2.
ITEM 2. PROPERTIES
Our corporate offices are located in Foster City, California, where we lease a total of approximately 200,000 square feet under leases that expire between August 2001 and November 2012 which we anticipate will satisfy our corporate office space needs for the foreseeable future.
We lease approximately 340,000 square feet in Oakland, California for our distribution center under a lease that expires in June 2008, with an option to extend the lease for an additional five years. We lease approximately 350,000 square feet in Suwanee, Georgia for our second distribution center, serving Atlanta, which is expected to open in the second quarter of 2000. This lease expires in July 2009, with two options to extend the lease for additional five year periods. We have also signed leases for sites in Springfield, Virginia; Grapevine, Texas; Carol Stream, Illinois, Kent, Washington; Denver, Colorado; North Bergen, New Jersey; Logan, New Jersey; Bronx, New York; Ayer, Massachusetts; Foothill Ranch, Orange County, California; and Glen Burnie, Maryland; on which we plan to construct distribution centers averaging approximately 350,000 square feet in existing or to-be-built buildings that will serve the metropolitan areas of the District of Columbia, Dallas, Chicago, Seattle, Denver, northern New Jersey, Philadelphia, New York City, Boston, Orange County and Baltimore respectively. We are evaluating sites and negotiating leases for additional distribution centers in other markets. Although we expect those sites to be available, we cannot assure you that suitable sites will be available on commercially reasonable terms. We do not own any real estate and expect to lease distribution center and station locations in the other markets we enter.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
From time to time, we may be involved in litigation relating to claims arising out of our ordinary course of business. We are not currently a party to any material litigation.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not Applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
We effected the initial public offering of our Common Stock on November 4, 1999. As of March 15, 2000, there were approximately 560 registered holders of our Common Stock. Our Common Stock is listed for quotation in the Nasdaq National Market under the Symbol "WBVN." The following table sets forth for the periods indicated, the high and low prices of our Common Stock as quoted in the Nasdaq National Market.
We have not paid any dividends since our inception and do not intend to pay any dividends on our capital stock in the foreseeable future.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA.
You should read the following selected consolidated financial data in conjunction with our consolidated financial statements and the notes to those statements and "Management's Discussion and Analysis of Financial Condition and Results of Operations" appearing elsewhere in this report. Historical results are not necessarily indicative of future results.
- --------------- (1) As restated, see Note 15 of Notes to Consolidated Financial Statements.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
We are an Internet retailer offering same-day delivery of consumer products through an innovative proprietary business design which integrates our Webstore, distribution center and delivery system. Our current product offerings are principally focused on food, non-prescription drug products and general merchandise, such as housewares, pet supplies and books .
We were incorporated in December 1996 as Intelligent Systems for Retail, Inc. In April 1999, we changed our name to Webvan Group, Inc. We commenced our grocery delivery service in May 1999 on a beta test basis to approximately 1,100 persons and commercially launched our Webstore on June 2, 1999. For the period from inception in December 1996 to June 1999, our primary activities consisted of raising capital, recruiting and training employees, developing our business strategy, designing a business system to implement our strategy, constructing and equipping our first distribution center and developing relationships with vendors. Since launching our service in June 1999, we have continued these operating activities and have also focused on building sales momentum, establishing additional vendor relationships, promoting our brand name, enhancing our distribution, delivery and customer service operations and construction of additional distribution centers. Our cost of sales and operating expenses have increased significantly since inception and are expected to continue to increase. This trend reflects the costs associated with our formation and larger sales volumes, as well as increased efforts to promote the Webvan brand, build market awareness, attract new customers, recruit personnel, build out our distribution centers, refine and modify our operating systems and develop our Webstore and associated systems that we use to process customers' orders and payments.
Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in their early stage of development, particularly companies in new and rapidly evolving markets. These risks for Webvan include an unproven business system and our ability to successfully manage our growth. To address these risks, we must:
- develop and increase our customer base;
- implement and successfully execute our business and marketing strategy;
- continue to develop, test, increase the capacity of and enhance our Webstore, order fulfillment, transaction processing and delivery systems;
- respond to competitive developments; and
- attract, retain and motivate quality personnel.
Since our inception, we have incurred significant losses, and as of December 31, 1999, we had an accumulated deficit of $159.4 million. As of December 31, 1999 our initial distribution center in Oakland, California was operating at less than 25% of the capacity for which it was designed.
We do not expect any of our distribution centers to operate at designed capacity for several years following their commercial launch, and we cannot assure you that any distribution center will ever operate at or near its designed capacity. From the commercial launch of our Webstore on June 2, 1999 through December 31, 1999 we delivered orders to over 47,000 separate customers which generated approximately $13.3 million in net sales. During that period, over 71% of our orders were from customers who had previously used our service and our average order size was approximately $77.65. We expect that the addition of new distribution centers will cause our average order size to fluctuate, based on the number and timing of new distribution center openings and the expectation that average order size will initially be lower at a new distribution center. There can be no assurance that our average order size will not decline significantly in future periods.
We believe that our success and our ability to achieve profitability will depend on our ability to:
- substantially increase the number of customers and our average order size;
- ensure that our technologies and systems function properly at increased order volumes;
- realize repeat orders from a significant number of customers;
- achieve favorable gross and operating margins; and
- rapidly expand and build out distribution centers in new markets.
To meet these challenges, we intend to continue to invest heavily in marketing and promotion, distribution facilities and equipment, technology and personnel. As a result, we expect to incur substantial operating losses for the foreseeable future and the rate at which such losses will be incurred may increase significantly from current levels. In addition, our limited operating history makes the prediction of future results of operations difficult, and accordingly, we cannot assure you that we will achieve or sustain revenue growth or profitability.
RESULTS OF OPERATIONS
FISCAL YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
NET SALES
Net sales are comprised of the price of groceries and other products we sell, net of returns and credits. We commenced commercial operations in June 1999. Net sales were $13.3 million for our fiscal year ended December 31, 1999. We did not have any net sales in the comparable prior year periods. In December 1999, we launched our "America's Second Harvest Food Donation Program" in which individual or corporate customers order food from Webvan (included in Net Sales) for donation to local foodbanks. Net sales under this program were approximately $.8 million of which approximately $.7 million were purchased by entities and individuals associated or affiliated with Webvan or investors in Webvan. Our average order size was $77.65 for the whole year and $81.31 for the fourth quarter, not including net sales under the Second Harvest program. We expect that the addition of new distribution centers will cause our average order size to fluctuate, based on the number and timing of new distribution center openings, as increases in average order size at distribution centers with longer operating histories will be offset by lower average orders sizes at new distribution centers.
COST OF GOODS SOLD
Cost of goods sold includes the cost of the groceries and other products we sell, adjustments to inventory and payroll and related expenses for the preparation of our home replacement meals. Cost of goods sold was $11.3 million for the fiscal year ended December 31, 1999. We did not have any cost of goods sold in the comparable prior year periods. The Company's gross profit as a percentage of net sales was 15.2% for the fiscal year ended December 31, 1999. Gross profit is expected to fluctuate as a result of a variety of factors, including the number of distribution centers launched in the reporting period, and the level of inventory spoilage related to perishables.
OPERATING EXPENSES
SOFTWARE DEVELOPMENT. Software development expenses include the payroll and consulting costs for software developers directly involved in programming our computer systems. Software development expenses were $15.2 million for 1999, $3.0 million for 1998, and $.2 million for 1997. These increases were primarily attributable to increases in the number of employees and consultants required for developing, enhancing and increasing the capacity of our Web site, order processing, accounting, distribution center and delivery systems. Payroll and related expenses for 1999 increased to $7.9 million from $2.4 million in 1998 and $0 in 1997. Consulting expenses for 1999 increased to $6.2 million from $.9 million in 1998 and $0 for 1997. We believe that continued investment in software development is critical to attaining our strategic objectives and, as a result, expect software development expenses to increase significantly in future quarters.
GENERAL AND ADMINISTRATIVE. General and administrative expenses include costs related to fulfillment and delivery of products, real estate, technology operations, equipment leases, merchandising, finance, customer service and professional services, as well as non-cash compensation and related expenses. General and administrative expenses increased to $92.4 million in 1999 from $8.8 million in 1998 and $2.6 million in
1997. Of this $83.6 million increase in 1999 over 1998, $31.6 million pertained to certain non-cash compensation and other expenses comprised primarily of payroll and related charges in connection with the terms of Mr. Shaheen's employment and $30.7 million pertained to aggregate distribution center operating expenses for our Bay Area distribution center and other distribution centers in their pre-launch phase. Such expenses were $31.9 million in 1999 versus only $1.2 million in 1998. There were no distribution center expenses in 1997. At our corporate headquarters, payroll and related costs increased to $14.5 million in 1999 from $4.1 million in 1998 and $.9 million in 1997. Additionally, consulting and professional fees and rent and facility charges also contributed to the company's general and administrative expense increases. As we roll out our business in new markets, we expect general and administrative expenses, including pre-launch distribution center expenses, to increase significantly.
MARKETING AND SALES. Marketing and sales expenses include the costs of the creative development and placement of our advertisements, promotions, public relations, and the payroll and related expenses of our headquarters marketing staff. Marketing expenses were $11.7 million during 1999 compared to none in 1998 and 1997. The external costs of our advertisements and promotions for 1999 were $7.2 million compared to none in 1998 and 1997. Payroll and related expenses were $3.2 million for 1999, compared to none in 1998 and 1997. As we launch our business in new markets, we expect marketing expenses will increase as the company continues to build brand awareness and increase its customer base.
AMORTIZATION OF STOCK-BASED COMPENSATION. Deferred stock-based compensation primarily represents the difference between the exercise price and the deemed fair value of our common stock for accounting purposes on the date certain stock options were granted. During 1999, amortization of stock-based compensation was $36.5 million compared to $1.1 million for 1998, and $0 for 1997.
INTEREST INCOME (EXPENSE) NET
Interest income (expense), net consists of earnings on our cash and cash equivalents and interest payments on our loan and lease agreements. Net interest income was $9.3 million in 1999, $.9 million in 1998 and $16,000 in 1997. These increases were primarily due to earnings on higher average cash and cash equivalent balances during the relevant years.
LIQUIDITY AND CAPITAL RESOURCES
Since inception, we have financed our operations primarily through private sales of preferred stock which through September 30, 1999 totaled $393.6 million (net of issuance costs) and the initial public stock offering of our common stock in November, 1999 which totaled $402.6 million (net of underwriter's discount and other issuance costs). Net cash used in operating activities was $58.8 million for 1999. Operating activities in 1998 used net cash of $2.2 million and for 1997 used $2.4 million. Net cash used in operating activities for each of these periods primarily consisted of net losses in addition to increases in prepaid expenses, partially offset by increases in accounts payable, accrued liabilities, amortization of deferred compensation, non-cash compensation expenses, depreciation and amortization, as applicable.
Net cash used in investing activities was $641.1 million in 1999, of which $571.6 million was used to invest in marketable securities. Net cash used in investing activities was $39.0 million in 1998, of which $2.7 million was used to invest in marketable securities, and for 1997, net cash used for investing activities was $5.3 million, of which $5.0 million was used to invest in marketable securities. Net cash used in investing activities for each of these periods consisted, otherwise, primarily of leasehold improvements and purchases of equipment and systems, including computer equipment and fixtures and furniture.
Net cash provided by financing activities was $746.3 million in 1999, $52.1 million in 1998 and $10.7 million in 1997. In November 1999, we sold an aggregate of 28,750,000 shares of common stock in the initial public offering at a price of $15.00 per share. Net cash provided by financing activities during 1999 primarily consisted of proceeds from the issuance of preferred stock of $348.0 million as well as the proceeds from the issuance of public stock of $431.3 million, (approximately $402.6 million net of underwriter's discount and other issuance costs). Net cash from financing activities during 1998 and 1997 included proceeds from the issuance of preferred shares of $34.8 million and $10.7 million respectively. As of December 31,
1999, our principal sources of liquidity consisted of $60.2 million of cash and cash equivalents and $578.6 million of marketable securities.
As of December 31, 1999, our principal commitments consisted of obligations of approximately $15.9 million outstanding under capital leases and loans. As of December 31, 1999, we had capital commitments of approximately $100 million principally related to the construction of and equipment for future distribution centers. We anticipate a substantial increase in our capital expenditures and lease commitments to support our anticipated growth in operations, systems and personnel. We anticipate capital expenditures of from $300 to $350 million for the 12 months ending December 31, 2000, based on the recently announced acceleration of our expansion plans, although this amount may fluctuate based on the number, actual cost and timing of the build out of additional distribution centers. In July 1999, we entered into an agreement with Bechtel Corporation for the construction of up to 26 additional distribution centers over the next three years. Although the Company has no specific capital commitment under this agreement, our expenditures under the contract are estimated to be approximately $1.0 billion. Specific capital commitments under this contract are incurred only as we determine to proceed with a scheduled build out of a distribution center. The decision to proceed with each distribution center will require us to commit to additional lease obligations and to purchase equipment and install leasehold improvements.
We currently anticipate that our available funds will be sufficient to meet our anticipated needs for working capital and capital expenditures for the 12 months ending December 31, 2000. We intend to raise additional funds to support our business plan for 2001 or curtail our expansion plans. We cannot be certain that additional financing will be available to us on favorable terms when required, or at all. If we issue additional securities to raise funds, those securities may have rights, preferences or privileges senior to those of the rights of our common stock and our stockholders may experience additional dilution. Our future capital needs will be highly dependent on the number and actual cost of additional distribution centers we open, the timing of these openings and the success of these facilities once they are launched. Thus, any projections of future cash needs and cash flows are subject to substantial uncertainty. If our available funds and cash generated from operations are insufficient to satisfy our liquidity requirements, we may seek to sell additional equity or debt securities, obtain a line of credit or curtail our expansion plans. In addition, from time to time we may evaluate other methods of financing to meet our longer term needs on terms that are attractive to us.
YEAR 2000 COMPLIANCE
As of March 15, 2000 we had not experienced any material problems associated with the occurrence of the year 2000.
FACTORS THAT MAY AFFECT FUTURE RESULTS
In addition to other information in this Annual Report on Form 10-K, the following important factors should be carefully considered in evaluating us and our business because such factors currently have a significant impact or may have a significant impact on our business, prospects, financial condition or results of operations.
WE ARE AN EARLY-STAGE COMPANY OPERATING IN A NEW AND RAPIDLY EVOLVING MARKET.
We were incorporated in December 1996. From 1997 through May 1999, we were focused on developing our Webstore and constructing and equipping our first distribution center serving the San Francisco Bay Area. We did not begin commercial operations until June 1999. Our limited operating history makes an evaluation of our business and prospects very difficult. You must consider our business and prospects in light of the risks and difficulties we encounter as an early stage company in the new and rapidly evolving market of e-commerce. These risks and difficulties include, but are not limited to: a complex and unproven business system; lack of sufficient customers, orders, net sales or cash flow; difficulties in managing rapid growth in personnel and operations; high capital expenditures associated with our distribution centers, systems and technologies; and lack of widespread acceptance of the Internet as a means of purchasing groceries and other consumer products.
We cannot be certain that our business strategy will be successful or that we will successfully address these risks. Our failure to address any of the risks described above could have a material adverse effect on our business.
OUR BUSINESS SYSTEM IS NEW AND UNPROVEN AT HIGH VOLUMES, AND THE ACTUAL CAPACITY OF OUR SYSTEM MAY BE LESS THAN ITS DESIGNED CAPACITY.
We have designed a new business system which integrates our Webstore, highly automated distribution center and complex order fulfillment and delivery operations. We have only been delivering products to customers commercially since we launched our Webstore on June 2, 1999 and the average daily volume of orders that we have had to fulfill to date has been significantly below our designed capacity of 8,000 orders per day and the levels that are necessary for us to achieve profitability. Although our initial distribution center was designed to process product volumes equivalent to approximately 18 supermarkets, as of December 31, 1999 we were operating at less than 25% of such designed capacity.
We do not expect our distribution centers to operate at designed capacity for several years following their commercial launch, and we cannot assure you that any distribution center will ever operate at or near its designed capacity. If a distribution center is able to operate at its designed capacity seven days per week, we estimate that it would generate annual revenue of approximately $300 million assuming an average order size of approximately $103.00. We recently increased our days of operations at our Oakland distribution center to seven days a week. We cannot assure you how long it will take from the time of launch before any new distribution center will effectively operate at seven days a week. Our average order size for the fourth quarter of 1999 was $81.31. Thus, in Oakland, in addition to significantly increasing the number of orders per day we process, our average order size will have to increase by over $20.00 for the distribution center to be able to generate annual revenue of $300 million at its designed capacity. We cannot assure you that our average order size at our Oakland distribution center will remain at current levels or increase in the future or that the average order size at other distribution centers will be similar to our Oakland distribution center. If the average order size of any distribution center does not increase substantially from the amounts expected in the earlier quarters of its operation based on our experience in Oakland or if a distribution center is not able to operate at designed capacity seven days per week, our annual revenue at that distribution center will be substantially less than $300 million.
It is not practicable to test our system at high volumes except by processing commercial orders. As part of our testing process, we have voluntarily limited the number of customer orders accepted in any given delivery window in an effort to ensure that our systems and technologies function properly while maintaining a high level of customer service. We plan to incrementally increase our voluntary limit on orders as our systems and technologies are proven at each incremental volume level. As a result, the success of our system in a high order volume environment has yet to be proven. Based on our operational experiences, refinements and modifications to our business systems and technologies in connection with the process of scaling our business to its design capacity may be necessary or advisable and the costs associated with them may be material. In addition, new system and technology features developed in response to our marketing and operational experience have to be integrated coherently into our systems and technologies. We cannot assure you that our business system will be able to accommodate a significant increase in the number of customers and orders, or that our initial distribution center or other distribution centers will in fact ever operate at or near designed capacity. If we are unable to effectively accommodate substantial increases in customer orders, we may lose existing customers or fail to add new customers, which would adversely affect our business, net sales and operating margins.
OUR BUSINESS SYSTEM IS COMPLEX, AND WE ARE PERIODICALLY AFFECTED BY OPERATIONAL DIFFICULTIES.
Our business system relies on the complex integration of numerous software and hardware subsystems that utilize advanced algorithms to manage the entire process from the receipt and processing of goods at our distribution center to the picking, packing and delivery of these goods to customers in a 30-minute delivery window. We have, from time to time, experienced operational "bugs" in our systems and technologies which have resulted in order errors such as missing items and delays in deliveries. Operational bugs may arise from
one or more factors including electro-mechanical equipment failures, computer server or system failures, network outages, software performance problems or power failures. We expect bugs to continue to occur from time to time, and we cannot assure you that our operations will not be adversely affected. In addition, difficulties in implementing refinements or modifications to our systems have, from time to time, caused us to suffer unanticipated system disruptions, which impair the quality of our service during the period of disruption. The efficient operation of our business system is critical to consumer acceptance of our service. If we are unable to meet customer demand or service expectations as a result of operational issues, we may be unable to develop customer relationships that result in repeat orders, which would adversely affect our business and net sales.
OUR BUSINESS SYSTEM MAY NOT BE READILY OR COST-EFFECTIVELY REPLICABLE IN ADDITIONAL GEOGRAPHIC MARKETS.
A critical part of our business strategy is to expand our business by opening additional distribution centers in new and existing markets to achieve economies of scale and leverage our significant and ongoing capital investment in our proprietary business system. While we currently plan to have distribution centers open in 15 markets by the end of 2001, our expansion strategy is dependent upon the ability of our proprietary business system and enabling software to be readily replicated to facilitate our expansion into additional geographic markets on a timely and cost-effective basis. Because our business system is extremely complex and we currently have only one operational distribution center, we have not demonstrated whether our proprietary business system is in fact readily and cost-effectively replicable.
Our ability to successfully and cost-effectively replicate our business system in additional geographic markets will also depend upon a number of factors, including: the availability of appropriate and affordable sites that can accommodate our distribution centers; our ability to successfully and cost-effectively hire and train qualified employees to operate new distribution centers; our ability to develop relationships with local and regional distributors, vendors and other product providers; acceptance of our product and service offerings; and competition.
The number, timing and cost of opening of new distribution centers are dependent on these factors and are therefore subject to considerable uncertainty. If the replication element of our expansion strategy fails, we could incur substantial additional operating costs and be forced to delay our entrance into other markets.
In addition, we currently obtain all of our carousels for our distribution centers from Diamond Phoenix Corporation. In the event that the supply of carousels from Diamond Phoenix was delayed or terminated for any reason, we believe that we could obtain similar carousels from other sources; however, the integration of other carousels into the complex systems of our distribution centers could result in construction delays and could require modifications to our software systems. Accordingly, any delay or termination of our relationship with Diamond Phoenix could cause a material delay and increased cost in our planned expansion program.
OUR EXPANSION PLANS ARE DEPENDENT ON THE PERFORMANCE OF, AND OUR RELATIONSHIP WITH, BECHTEL CORPORATION.
In July 1999, we entered into an agreement with Bechtel for the construction of up to 26 additional distribution centers over the next three years. We expect that our next 26 distribution centers following our Atlanta, Georgia distribution center will be constructed by Bechtel pursuant to this agreement. These distribution centers may not necessarily be in 26 different markets. The success of our expansion program is highly dependent on the success of our relationship with Bechtel and Bechtel's ability to perform its obligations under the contract. Our working relationship with Bechtel has just recently commenced and we cannot assure you that we will not encounter unexpected delays or design problems in connection with the build-out of our distribution centers. We also cannot assure you that expected cost efficiencies on which are based our estimates of the average cost of a distribution center will result from our relationship with Bechtel and Bechtel's acquisition of experience in the construction of our distribution centers. If our relationship with Bechtel fails for any reason, we would be forced to engage another contractor, which would likely result in a significant delay in our expansion plans and could result in increased costs of constructing and equipping our distribution centers.
WE HAVE NO EXPERIENCE IN MANAGING GEOGRAPHICALLY DIVERSE OPERATIONS.
Although we plan to expand geographically, we have no experience operating in any other regions or in managing multiple distribution centers. Accordingly, the success of our planned expansion will depend upon a number of factors, including: our ability to integrate the operations of new distribution centers into our existing operations; our ability to coordinate and manage distribution operations in multiple, geographically distant locations; our ability to respond to issues specific to other geographic areas, such as adverse seasonal weather conditions that are not present in the Bay Area; and our ability to establish and maintain adequate management and information systems and financial controls.
Our failure to successfully address these factors could have a material adverse effect on our ability to expand and on our results of operations.
WE ANTICIPATE FUTURE LOSSES AND NEGATIVE CASH FLOW.
We have experienced significant net losses and negative cash flow since our inception. As of December 31, 1999, we had an accumulated deficit of $159.4 million. We incurred net losses of $144.6 million and $12.0 million in 1999 and 1998, respectively. We will continue to incur significant capital and operating expenses over the next several years in connection with our planned expansion, including:
- the construction of and equipment for new distribution centers in additional geographic markets at an estimated cost of $30.0 million to $35.0 million per distribution center based on our experience to date and efficiencies we expect will be progressively realized over the course of our contract with Bechtel, such as savings associated with procurement for multiple sites and the design of standardized build-to-suit buildings which will is expected to reduce construction time and result in construction efficiencies;
- the continued expansion and development of operations at our Oakland distribution center;
- increases in personnel at our Oakland and future distribution centers;
- brand development, customer service, marketing and other promotional activities;
- the continued development of our computer network, Webstore, warehouse management and order fulfillment systems and delivery infrastructure; and
- the development of strategic business relationships.
If a distribution center, viewed as a stand-alone business unit without regard to headquarters' costs, is able to successfully operate at the volume and cost levels expected to be reached by a distribution center at the end of the first year of operation, we expect that the annualized earnings before interest, taxes, depreciation and amortization for that distribution center, would be positive and the distribution center would start to generate significant cash flow beginning in the fifth quarter of operations. If a distribution center is able to generate positive operating cash flow from operations, we plan to use the cash flow to fund capital expenditures for other distribution centers. If a distribution center, viewed as a stand-alone business unit without regard to headquarters' costs, is able to operate successfully at volumes and costs expected to be reached through the end of the third year of operation, we expect that the annualized earnings before interest, taxes, depreciation and amortization for that distribution center, from its launch through the end of that three-year period, would approximate the expected costs of constructing and equipping such distribution center. We cannot assure you that our distribution centers will be able to successfully operate at expected volume or cost levels, which are dependant upon a numbers of factors including the geographic density of customers and the productivity of our employees.
As a result of the factors described above, we expect to continue to have operating losses and negative cash flow on a quarterly and annual basis for the foreseeable future. To achieve profitability, we must accomplish the following objectives: substantially increase our number of customers and the number of orders placed by our customers; generate a sufficient average order size; realize a significant number of repeat orders from our customers; and achieve favorable gross and operating margins. We cannot assure you that we will be able to achieve these objectives.
With respect to operating margins, we estimate that, as a result of the potential advantages of our business model compared to traditional supermarkets, if our distribution center is able to operate at its designed capacity of 8,000 orders per day seven days per week and at an average order size of $103.00 per order, we can achieve an operating margin of 12%. However, we cannot assure you that we will be able to achieve 8,000 orders per day at an average order size of $103.00 and at expected cost levels and any failure to do so will result in lower operating margins.
In addition, because of the significant capital and operating expenses associated with our expansion plan, our overall losses will increase significantly from current levels. If we do achieve profitability, we cannot be certain that we would be able to sustain or increase such profitability on a quarterly or annual basis in the future. If we cannot achieve or sustain profitability, we may not be able to meet our working capital requirements, which would have a material adverse effect on our business.
THE SIGNIFICANT CAPITAL INVESTMENT REQUIRED BY OUR BUSINESS DESIGN MAY ADVERSELY AFFECT OUR ABILITY TO ENTER ADDITIONAL MARKETS IN A TIMELY AND EFFECTIVE MANNER AND COULD HARM OUR COMPETITIVE POSITION.
Our business design requires a significant capital investment to build, equip and launch distribution centers and local stations in the markets in which we seek to operate. Our competitors have developed or may develop systems that are not as highly automated or capital-intensive as ours. This could enable them to commence operations in a particular geographic market before we are able to do so, which could harm our competitive position. In addition, because of the substantial capital costs associated with the development of our distribution centers, we will be unable to achieve profitability or reduce our operating losses if we do not process sufficient order volumes.
WE FACE INTENSE COMPETITION FROM TRADITIONAL AND ONLINE RETAILERS OF GROCERY PRODUCTS AND OTHER PRODUCTS.
The grocery retailing market is extremely competitive. Local, regional, and national food chains, independent food stores and markets, as well as online grocery retailers comprise our principal competition as an on-line grocery retailer, although we also face substantial competition from convenience stores, liquor retailers, membership warehouse clubs, specialty retailers, supercenters, and drugstore chains. To the extent that we add non-grocery store product categories to our offering, local, regional and national retailers in those product categories, as well as online retailers in those product categories, will provide our principal competition in those areas. Many of our existing and potential competitors, particularly traditional grocers and retailers and certain online retailers, are larger and have substantially greater resources than we do. We expect this competition in the online grocery and other product categories will intensify as more traditional and online grocery retailers offer competitive services.
Our initial distribution center in Oakland, California operates in the San Francisco Bay Area market. In this market, we compete primarily with traditional grocery retailers and with online grocers NetGrocer and Peapod. The number and nature of competitors and the amount of competition we will experience will vary by market area. In other markets, we expect to compete with these and other online grocers, including HomeGrocer, HomeRuns, GroceryWorks, Shoplink and Streamline. The principal competitive factors that affect our business are location, breadth of product selection, quality, service, price and consumer loyalty to traditional and online grocery retailers. If we fail to effectively compete in any one of these areas, we may lose existing and potential customers which would have a material adverse effect on our business, net sales and operating margins.
IF WE FAIL TO GENERATE SUFFICIENT LEVELS OF REPEAT ORDERS AND MARKET PENETRATION, OUR BUSINESS AND NET SALES WILL BE ADVERSELY AFFECTED.
In the online retail industry, customer attrition rates, or the rates at which subscribers cancel a service, are generally high. Although we do not charge on a subscription basis for our service, we do depend upon customers to continue to order from us after their initial order is placed, and we compete to retain customers once they have used our service.
In addition, the success of our business depends on our ability to establish sufficient levels of market penetration in each market in which we operate. This in turn will depend upon our ability to achieve customer loyalty by means of a high quality of customer service and operational execution. In general, in most of our initial markets, we believe we will need to achieve penetration levels of approximately 1% to 3% of the households in order for our distribution center in a market to be successful. However, we cannot assure you as to the levels of penetration we will achieve in any market, and even if we do achieve these levels of penetration, we cannot assure you that we will achieve positive earnings. If we experience significant decreases in repeat customer orders as a percentage of orders delivered, or if we are unable to establish sufficient customer loyalty to achieve market penetration levels, our business and net sales could be materially adversely affected.
THE INTERNET MAY FAIL TO BECOME A WIDELY ACCEPTED MEDIUM FOR GROCERY SHOPPING.
We rely solely on product orders received through our Webstore for sales. The market for e-commerce is new and rapidly evolving, and it is uncertain whether e-commerce will achieve and sustain high levels of demand and market acceptance, particularly with respect to the grocery industry. Our success will depend to a substantial extent on the willingness of consumers to increase their use of online services as a method to buy groceries and other products and services. Our success will also depend upon our vendors' acceptance of our online service as a significant means to market and sell their products. Moreover, our growth will depend on the extent to which an increasing number of consumers own or have access to personal computers or other systems that can access the Internet. If e-commerce in the grocery industry does not achieve high levels of demand and market acceptance, our business will be materially adversely affected.
OUR EFFORTS TO BUILD STRONG BRAND IDENTITY AND CUSTOMER LOYALTY MAY NOT BE SUCCESSFUL.
Since we only recently launched the Webvan brand, we currently do not have strong brand identity or brand loyalty. We believe that establishing and maintaining brand identity and brand loyalty is critical to attracting consumers and vendors. Furthermore, we believe that the importance of brand loyalty will increase with the proliferation of Internet retailers. In order to attract and retain consumers and vendors, and respond to competitive pressures, we intend to increase spending substantially to create and maintain brand loyalty among these groups. We plan to accomplish this goal by expanding our current radio and newspaper advertising campaigns and by conducting online and television advertising campaigns. We believe that advertising rates, and the cost of our advertising campaigns in particular, could increase substantially in the future. In addition we must continue to invest in the creation of a world class customer service function as a failure of our customer service representatives to promptly respond to customer inquiries and concerns in a helpful manner may negatively impact customer loyalty. If our branding efforts are not successful or our ability to provide high quality customer care are not successful, our net sales and ability to attract customers will be materially and adversely affected.
Promotion and enhancement of the Webvan brand will also depend on our success in consistently providing a high-quality consumer experience for purchasing groceries and other products. If consumers, other Internet users and vendors do not perceive our service offerings to be of high quality, or if we introduce new services that are not favorably received by these groups, the value of the Webvan brand could be harmed. Any brand impairment or dilution could decrease the attractiveness of Webvan to one or more of these groups, which could harm our reputation, reduce our net sales and cause us to lose customers.
IF WE ARE UNABLE TO OBTAIN SUFFICIENT QUANTITIES OF PRODUCTS FROM OUR KEY VENDORS, OUR NET SALES WOULD BE ADVERSELY AFFECTED.
We expect to derive a significant percentage of our net sales from high-volume items, well-known brand name products and fresh foods. We source products from a network of manufacturers, wholesalers and distributors. We currently rely on national and regional distributors for a substantial portion of our items. We also utilize premium specialty suppliers or local sources for gourmet foods, farm fresh produce, fresh fish and meats. From time to time, we may experience difficulty in obtaining sufficient product allocations from a key vendor. In addition, our key vendors may establish their own online retailing efforts, which may impact our ability to get sufficient product allocations from these vendors. Many of our key vendors also supply products
to the retail grocery industry and our online competitors. If we are unable to obtain sufficient quantities of products from our key vendors to meet customer demand, our net sales and results of operations would be materially adversely affected.
WE CURRENTLY OPERATE ONLY ONE DISTRIBUTION CENTER WHICH IS LOCATED IN THE SAN FRANCISCO BAY AREA.
We currently operate only one distribution center which is located in Oakland, California and serves the San Francisco Bay Area. Even after our second distribution center in Atlanta opens, our business and operations would be materially adversely affected if any of the following events affected our current distribution center or the San Francisco Bay Area and our insurance was inadequate to cover us for losses associated with: prolonged power or equipment failures; disruptions in our web site, computer network, software and our order fulfillment and delivery systems; disruptions in the transportation infrastructure including bridges, tunnels and roads; refrigeration failures; or fires, floods, earthquakes or other disasters.
Since the San Francisco Bay Area is located in an earthquake-sensitive area, we are particularly susceptible to the risk of damage to, or total destruction of, our distribution center and the surrounding transportation infrastructure caused by earthquakes. We cannot assure you that we are adequately insured to cover the total amount of any losses caused by any of the above events. In addition, we are not insured against any losses due to interruptions in our business due to damage to or destruction of our distribution center caused by earthquakes or to major transportation infrastructure disruptions or other events that do not occur on our premises.
WE WILL NEED SUBSTANTIAL ADDITIONAL CAPITAL TO FUND OUR PLANNED EXPANSION, AND WE CANNOT BE SURE THAT ADDITIONAL FINANCING WILL BE AVAILABLE.
We require substantial amounts of working capital to fund our business. In addition, the opening of new distribution centers and the continued development of our order fulfillment and delivery systems requires significant amounts of capital. The rate at which our capital is utilized is affected by the pace of our expansion, which we have recently accelerated. Since our inception, we have experienced negative cash flow from operations and expect to experience significant negative cash flow from operations for the foreseeable future. In the past, we have funded our operating losses and capital expenditures through proceeds from equity offerings, debt financing and equipment leases. We continue to evaluate alternative means of financing to meet our needs on terms that are attractive to us. We currently anticipate that our available funds will be sufficient to meet our anticipated needs for working capital and capital expenditures through December 31, 2000. We intend to raise additional funds to support our business plan for 2001 or curtail our expansion plans. We cannot be certain that additional financing will be available to us on favorable terms when required, or at all.
In July 1999, we entered into an agreement with Bechtel for the construction of up to 26 additional distribution centers over the next three years. Although the Company has no specific capital commitment under this agreement, our expenditures under the contract are estimated to be approximately $1.0 billion. Specific capital commitments under this contract are incurred only as we determine to proceed with a scheduled build out of a distribution center. Our future capital needs will be highly dependent on the number and actual cost of additional distribution centers we open, the timing of openings and the success of our facilities once they are launched. We cannot assure you of the actual cost of our additional distribution centers. Therefore, we will need to raise additional capital to fund our planned expansion. If we are unable to obtain sufficient additional capital when needed, we could be forced to alter our business strategy, delay or abandon some of our expansion plans or sell assets. Any of these events would have a material adverse effect on our business, financial condition or ability to reduce losses or generate profits. In addition, if we raise additional funds through the issuance of equity, equity-linked or debt securities, those securities may have rights, preferences or privileges senior to those of the rights of our common stock and our stockholders may experience dilution.
OUR LIMITED OPERATING HISTORY MAKES FINANCIAL FORECASTING DIFFICULT FOR US AND FOR FINANCIAL ANALYSTS THAT MAY PUBLISH ESTIMATES OF OUR FINANCIAL RESULTS.
As a result of our limited operating history, it is difficult to accurately forecast our total revenue, revenue per distribution center, gross and operating margins, real estate and labor costs, average order size, number of orders per day and other financial and operating data. We have a limited amount of meaningful historical financial data upon which to base planned operating expenses. We base our current and future expense levels on our experience of the last six months, our operating plans and estimates of future revenue, and our expenses are dependent in large part upon our facilities and product costs. Sales and operating results are difficult to forecast because they generally depend on the growth of our customer base and the volume of the orders we receive, as well as the mix of products sold. As a result, we may be unable to make accurate financial forecasts and adjust our spending in a timely manner to compensate for any unexpected revenue shortfall. We believe that these difficulties also apply to financial analysts that may publish estimates of our financial results. This inability to accurately forecast our results could cause our net losses in a given quarter to be greater than expected and could cause a decline in the trading price of our common stock.
OUR QUARTERLY OPERATING RESULTS ARE EXPECTED TO BE VOLATILE AND DIFFICULT TO PREDICT BASED ON A NUMBER OF FACTORS THAT WILL ALSO AFFECT OUR LONG-TERM PERFORMANCE.
We expect our quarterly operating results to fluctuate significantly in the future based on a variety of factors. These factors are also expected to affect our long-term performance. Some of these factors include the following: the timing of our expansion plans as we construct and begin to operate new distribution centers in additional geographic markets; changes in pricing policies or our product and service offerings; increases in personnel, marketing and other operating expenses to support our anticipated growth; our inability to obtain new customers or retain existing customers at reasonable cost; our inability to manage our distribution and delivery operations to handle significant increases in the number of customers and orders or to overcome system or technology difficulties associated with these increases; our inability to adequately maintain, upgrade and develop our Webstore, our computer network or the systems that we use to process customer orders and payments; competitive factors; and technical difficulties, system or web site downtime or Internet brownouts.
In addition to these factors, our quarterly operating results are expected to fluctuate based upon seasonal purchasing patterns of our customers and the mix of groceries and other products sold by us. Because of our short operating history and limited geographical coverage, we may not accurately predict the seasonal purchasing patterns of our customers and may experience unexpected difficulties in matching inventory to demand by customers.
Due to all of these factors, we expect our operating results to be volatile and difficult to predict. As a result, quarter-to-quarter comparisons of our operating results may not be good indicators of our future performance. In addition, it is possible that in any future quarter our operating results could be below the expectations of investors generally and any published reports or analyses of Webvan. In that event, the price of our common stock could decline, perhaps substantially.
IF WE EXPERIENCE PROBLEMS IN OUR DELIVERY OPERATIONS, OUR BUSINESS COULD BE SERIOUSLY HARMED.
We use our own couriers to deliver products from our distribution center to our local stations, and from the local stations to our customers. We are therefore subject to the risks associated with our ability to provide delivery services to meet our shipping needs, including potential labor activism or employee strikes, inclement weather, disruptions in the transportation infrastructure, including bridges, roads and traffic congestion. While we strive to maintain high on-time delivery rates and order fulfillment accuracy rates, we have, on occasion, experienced operational "bugs" that have resulted in a high proportion of late deliveries or order fulfillment inaccuracies on particular days. Operational bugs may arise from one or more factors including electro- mechanical equipment failures, computer server or system failures, network outages, software performance problems or power failures. To date, these bugs have been corrected in a short period of time by Webvan employees and have not resulted in any long term impact on our operations. Any material decrease in our on-time delivery rate or in order fulfillment accuracy would likely have an adverse impact on our consumer
acceptance of our service and harm our reputation and brand, and a prolonged decline in our on-time delivery rate or in order fulfillment accuracy would have an adverse impact on our financial results.
OUR NET SALES WOULD BE HARMED IF OUR ONLINE SECURITY MEASURES FAIL.
Our relationships with our customers may be adversely affected if the security measures that we use to protect their personal information, such as credit card numbers, are ineffective. If, as a result, we lose many customers, our net sales and results of operations would be harmed. We rely on security and authentication technology to perform real-time credit card authorization and verification with our bank. We cannot predict whether events or developments will result in a compromise or breach of the technology we use to protect a customer's personal information.
Furthermore, our computer servers may be vulnerable to computer viruses, physical or electronic break-ins and similar disruptions. We may need to expend significant additional capital and other resources to protect against a security breach or to alleviate problems caused by any breaches. We cannot assure you that we can prevent all security breaches, and any failure to do so could have a material adverse effect on our reputation and results of operations.
THE LOSS OF THE SERVICES OF ONE OR MORE OF OUR KEY PERSONNEL, OR OUR FAILURE TO ATTRACT, INTEGRATE NEW HIRES AND RETAIN OTHER HIGHLY QUALIFIED PERSONNEL IN THE FUTURE WOULD SERIOUSLY HARM OUR BUSINESS.
The loss of the services of one or more of our key personnel could seriously harm our business. We depend on the continued services and performance of our senior management and other key personnel, particularly Louis H. Borders, our founder and Chairman of the Board, and George T. Shaheen, our President and Chief Executive Officer. Our future success also depends upon the continued service of our executive officers and other key software development, merchandising, marketing and support personnel. The competition for talented employees in the San Francisco Bay Area is intense and our ability to retain key employees at our headquarters is a function of a number of factors, some of which are beyond our control, such as the value of other opportunities perceived to be available in the Bay Area. None of our officers or key employees is bound by an employment agreement and our relationships with these officers and key employees are at will. Several key members of our management team have recently joined us. If we do not effectively integrate these employees into our business, if they do not work together as a management team to enable us to implement our business strategy, or if we are unable to retain them due to increased demand for their services, our business will suffer. Additionally, there are low levels of unemployment in the San Francisco Bay Area and in many of the regions in which we plan to operate. These low levels of unemployment have led to pressure on wage rates, which can make it more difficult and costly for us to attract and retain qualified employees. Our inability to hire and train qualified employees in accordance with our schedule for meeting demand at any distribution center as we scale order volumes at that distribution center could have a negative impact on our ability to attract and retain customers. The loss of key personnel, or the failure to attract additional personnel, could have a material adverse effect on our business, results of operations and performance in specific geographic markets.
WE MAY NEED TO CHANGE THE MANNER IN WHICH WE CONDUCT OUR BUSINESS IF GOVERNMENT REGULATION OF THE INTERNET INCREASES OR IF REGULATION DIRECTED AT LARGE-SCALE RETAIL OPERATIONS IS DEEMED APPLICABLE TO US.
The adoption or modification of laws or regulations relating to the Internet and large-scale retail store operations could adversely affect the manner in which we currently conduct our business. In addition, the growth and development of the market for online commerce may lead to more stringent consumer protection laws which may impose additional burdens on us. Laws and regulations directly applicable to communications or commerce over the Internet are becoming more prevalent. The United States government recently enacted Internet laws regarding privacy, copyrights, taxation and the transmission of sexually explicit material. The Federal Trade Commission has indicated that it will investigate the practices of Internet companies relating to the handling of user-specific data. The law of the Internet, however, remains largely unsettled, even in areas where there has been some legislative action. It may take years to determine whether and how existing laws such as those governing intellectual property, privacy, libel and taxation apply to the Internet. In addition, the
Governor of California recently vetoed legislation which would have prohibited a public agency from authorizing retail store developments exceeding 100,000 square feet if more than a small portion of the store were devoted to the sale of non-taxable items, such as groceries. While it is not clear whether our operations would be considered a retail store for purposes of this kind of legislation, we cannot assure you that other state or local governments will not seek to enact similar laws or that we would be successful if forced to challenge the applicability of this kind of legislation to our distribution facilities. The expenses associated with any challenge to this kind of legislation could be material. If we are required to comply with new regulations or legislation or new interpretations of existing regulations or legislation, this compliance could cause us to incur additional expenses or alter our business model.
WE MAY INCUR SIGNIFICANT COSTS OR EXPERIENCE PRODUCT AVAILABILITY DELAYS IN COMPLYING WITH REGULATIONS APPLICABLE TO THE SALE OF FOOD PRODUCTS.
We are not currently subject to regulation by the United States Department of Agriculture, or USDA. Whether the handling of food items in our distribution facility, such as meat and fish, will subject us to USDA regulation in the future will depend on several factors, including whether we sell food products on a wholesale basis or whether we obtain food products from non-USDA inspected facilities. Although we have designed our food handling operations to comply with USDA regulations, we cannot assure you that the USDA will not require changes to our food handling operations. We will also be required to comply with local health regulations concerning the preparation and packaging of our prepared meals and other food items. Any applicable federal, state or local regulations may cause us to incur substantial compliance costs or delay the availability of a number of items at one or more of our distribution centers. In addition, any inquiry or investigation from a food regulatory authority could have a negative impact on our reputation. Any of these events could have a material adverse effect on our business and expansion plans and could cause us to lose customers.
WE MAY NOT BE ABLE TO OBTAIN REQUIRED LICENSES OR PERMITS FOR THE SALE OF ALCOHOL AND TOBACCO PRODUCTS IN A COST-EFFECTIVE MANNER OR AT ALL.
We will be required to obtain state licenses and permits for the sale of alcohol and tobacco products in each location in which we seek to open a distribution center. We cannot assure you that we will be able to obtain any required permits or licenses in a timely manner, or at all. We may be forced to incur substantial costs and experience significant delays in obtaining these permits or licenses. In addition, the United States Congress is considering enacting legislation which would restrict the interstate sale of alcoholic beverages over the Internet. Changes to existing laws or our inability to obtain required permits or licenses could prevent us from selling alcohol or tobacco products in one or more of our geographic markets. Any of these events could substantially harm our net sales, gross profit and ability to attract and retain customers.
IN THE FUTURE WE MAY FACE POTENTIAL PRODUCT LIABILITY CLAIMS.
We cannot assure you that the products that we deliver will be free from contaminants. Grocery and other related products occasionally contain contaminants due to inherent defects in the products or improper storage or handling. If any of the products that we sell cause harm to any of our customers, we could be subject to product liability lawsuits. If we are found liable under a product liability claim, or even if we are required to defend ourselves against such a claim, our reputation could suffer and customers may substantially reduce their orders or stop ordering from us.
OUR NET SALES WOULD BE HARMED IF WE EXPERIENCE SIGNIFICANT CREDIT CARD FRAUD.
A failure to adequately control fraudulent credit card transactions would harm our net sales and results of operations because we do not carry insurance against this risk. We may suffer losses as a result of orders placed with fraudulent credit card data even though the associated financial institution approved payment of the orders. Under current credit card practices, we are liable for fraudulent credit card transactions because we do not obtain a cardholder's signature. Because we have had an extremely short operating history, we cannot predict our future levels of bad debt expense.
IF THE PROTECTION OF OUR TRADEMARKS AND PROPRIETARY RIGHTS IS INADEQUATE, OUR BUSINESS MAY BE SERIOUSLY HARMED.
We regard patent rights, copyrights, service marks, trademarks, trade secrets and similar intellectual property as important to our success. We rely on patent, trademark and copyright law, trade secret protection and confidentiality or license agreements with our employees, customers, partners and others to protect our proprietary rights; however, the steps we take to protect our proprietary rights may be inadequate. We currently have no patents. We have filed, and from time to time expect to file, patent applications directed to aspects of our proprietary technology. We cannot assure you that any of these applications will be approved, that any issued patents will protect our intellectual property or that any issued patents will not be challenged by third parties. In addition, other parties may independently develop similar or competing technology or design around any patents that may be issued to us. Our failure to protect our proprietary rights could materially adversely affect our business and competitive position.
INTELLECTUAL PROPERTY CLAIMS AGAINST US CAN BE COSTLY AND COULD RESULT IN THE LOSS OF SIGNIFICANT RIGHTS.
Patent, trademark and other intellectual property rights are becoming increasingly important to us and other e-commerce vendors. Many companies are devoting significant resources to developing patents that could affect many aspects of our business. Other parties may assert infringement or unfair competition claims against us that could relate to any aspect of our technologies, business processes or other intellectual property. We cannot predict whether third parties will assert claims of infringement against us, the subject matter of any of these claims, or whether these assertions or prosecutions will harm our business. If we are forced to defend ourselves against any of these claims, whether they are with or without merit or are determined in our favor, then we may face costly litigation, diversion of technical and management personnel, inability to use our current web site technology, or product shipment delays. As a result of a dispute, we may have to develop non-infringing technology or enter into royalty or licensing agreements. These royalty or licensing agreements, if required, may be unavailable on terms acceptable to us, or at all. If there is a successful claim of patent infringement against us and we are unable to develop non-infringing technology or license the infringed or similar technology on a timely basis, our business and competitive position may be materially adversely affected.
ANY DEFICIENCIES IN OUR SYSTEMS OR THE SYSTEMS OF THIRD PARTIES ON WHICH WE RELY COULD ADVERSELY AFFECT OUR BUSINESS AND RESULT IN A LOSS OF CUSTOMERS.
Our Webstore has experienced in the past and may experience in the future slower response times or disruptions in service for a variety of reasons including failures or interruptions in our systems. In addition, our users depend on Internet service providers, online service providers and other web site operators for access to our Webstore. Many of them have experienced significant outages in the past and could experience outages, delays and other difficulties due to system failures unrelated to our systems. Moreover, the Internet infrastructure may not be able to support continued growth in its use. Any of these problems could have a material adverse effect on our business and could result in a loss of customers.
Our communications hardware and certain of our other computer hardware operations are located at the facilities of AboveNet Communications, Inc. in Santa Clara County, California. The hardware for the warehouse management and materials handling systems of each distribution center is maintained at that distribution center. Fires, floods, earthquakes, power losses, telecommunications failures, break-ins and similar events could damage these systems or cause them to fail completely. For instance, a power failure in October 1999 at the facilities of our previous webstore server host caused our Webstore to be inaccessible for approximately two hours. To date, we have experienced several other instances when our Webstore was inaccessible for unexpected reasons. Computer viruses, electronic break-ins or other similar disruptive problems could also adversely affect our Webstore. Our business could be adversely affected if our systems were affected by any of these occurrences. Problems faced by AboveNet, with the telecommunications network providers with whom it contracts or with the systems by which it allocates capacity among its customers, including Webvan, could adversely impact the customer shopping experience and consequently,
our business. Our insurance policies may not adequately compensate us for any losses that may occur due to any failures or interruptions in our systems.
OUR STOCK PRICE IS LIKELY TO BE VOLATILE AND COULD DECLINE SUBSTANTIALLY.
The stock market has experienced significant price and volume fluctuations, and the market prices of technology companies, particularly consumer-oriented Internet-related companies, have been highly volatile. For instance, prices of many "Business-to-Consumer" Internet retailer companies have on average declined substantially since the time of our initial public offering. The price at which our common stock trades is likely to be volatile and may fluctuate substantially due to factors such as:
Our historical and anticipated quarterly and annual operating results;
Variations between our actual results and the expectations of investors or published reports or analyses of Webvan;
Changes in analysts' estimates of our performance or industry performance;
Announcements by us or others and developments affecting our business, systems or expansion plans;
Sales of large blocks of our common stock; and
Conditions and trends in e-commerce industries, particularly the online grocery industry.
In the past, securities class action litigation has often been instituted against companies following periods of volatility in the market price of their securities. This type of litigation could result in substantial costs and a diversion of management's attention and resources.
FUTURE SALES OF OUR COMMON STOCK MAY CAUSE OUR STOCK PRICE TO DECLINE.
If our stockholders sell substantial amounts of our common stock in the public market, the market price of our common stock could decline. All of the 28,750,000 shares of our common stock sold in our initial public offering in November 1999 are freely tradable, without restriction, in the public market. Our directors, officers and stockholders have entered into lock-up agreements in connection with that offering generally providing that they will not offer, sell, contract to sell or grant any option to purchase or otherwise dispose of our common stock or any securities exercisable for or convertible into our common stock without the prior written consent of Goldman, Sachs & Co. According to the lock-up agreements, beginning on February 2, 2000, each stockholder was entitled to offer, sell, transfer, assign, pledge or otherwise dispose of up to 15% of his or her shares beneficially owned as of December 31, 1999; and each such stockholder was entitled on March 15 to offer, sell, transfer, assign, pledge or otherwise dispose of an additional 25% of his or her shares beneficially owned as of December 31, 1999. As a result, a substantial number of shares of our common stock will be eligible for sale in the public market prior to the expiration of the customary 180-day lock-up period following an initial public offering. The lock-up restrictions will expire in their entirety on May 3, 2000, at which time an additional substantial number of shares of our common stock will be eligible for sale in the public market.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Webvan maintains a short-term investment portfolio primarily consisting of corporate debt securities with maturities of thirteen months or less. These available-for-sale securities are subject to interest rate risk and will rise and fall in value if market interest rates change. The extent of this risk is not quantifiable or predictable due to the variability of future interest rates. Webvan does not expect any material loss with respect to its investment portfolio.
Webvan's restricted cash balance is invested in certificates of deposit. Accordingly, changes in market interest rates have no material effect on Webvan's operating results, financial condition and cash flows. There is inherent roll over risk on these certificates of deposit as they mature and are renewed at current market rates. The extent of this risk is not quantifiable or predictable due to the variability of future interest rates.
The following table provides information about Webvan's investment portfolio, restricted cash, capital lease obligations and long-term debt as of December 31, 1999, and presents principal cash flows and related weighted averages interest rates by expected maturity dates.
Fair value approximates carrying value for the above financial instruments.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS
The following consolidated financial statements, and the related notes thereto, of Ariba and the Report of Independent Auditors are filed as a part of this Form 10-K.
INDEPENDENT AUDITORS REPORT
To the Board of Directors and Shareholders of Webvan Group, Inc.: Foster City, California
We have audited the accompanying consolidated balance sheets of Webvan Group, Inc. (formerly Intelligent Systems for Retail, Inc.) and Subsidiary (collectively "Webvan") as of December 31, 1999 and 1998, and the related consolidated statements of operations and comprehensive loss, shareholders' equity, and cash flows for each of the two years in the period ended December 31, 1999 and for the period from December 17, 1996 (date of incorporation) to December 31, 1997. These financial statements are the responsibility of Webvan's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Webvan at December 31, 1999 and 1998, and the results of its operations and its cash flows for the periods stated above, in conformity with generally accepted accounting principles.
As discussed in Note 15, the accompanying 1997 and 1998 consolidated financial statements have been restated as to the basic and diluted net loss per share and the weighted average shares outstanding -- basic and diluted.
/s/ Deloitte & Touche LLP
San Jose, California January 26, 2000
WEBVAN GROUP, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS (IN THOUSANDS)
ASSETS
See notes to consolidated financial statements.
WEBVAN GROUP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
See notes to consolidated financial statements.
WEBVAN GROUP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF SHAREHOLDER'S EQUITY (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
See notes to consolidated financial statements.
WEBVAN GROUP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
See notes to consolidated financial statements.
WEBVAN GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Organization -- Webvan Group, Inc., formerly Intelligent Systems for Retail, Inc., and subsidiary (collectively,"Webvan" or the "Company") was incorporated in California on December 17, 1996. On April 21, 1999, Intelligent Systems for Retail, Inc. changed its name to Webvan Group, Inc. and reincorporated in Delaware in October 1999. Webvan is an Internet retailer offering home delivery of a variety of product offerings, including groceries, non-prescription drug products and other general merchandise. Webvan began selling and delivering products on a beta test basis in May 1999, and opened to the public in June 1999. Prior to 1999, Webvan was a development stage company.
On March 26, 1998, Webvan formed a wholly-owned subsidiary Webvan -- Bay Area, Inc. ("WBA"). WBA operates Webvan's San Francisco Bay Area distribution center and cross docking stations that provide the internet-based retail service and home delivery to this region.
Consolidation -- The accompanying consolidated financial statements include the accounts of Webvan and its wholly-owned subsidiary, WBA. Intercompany balances and transactions have been eliminated in the consolidated financial statements.
Use of Estimates -- The preparation of financial statements in conformity with generally accepted accounting principles 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 reporting period. Actual results could differ from those estimates.
Cash Equivalents -- Webvan considers all highly liquid instruments acquired with an original maturity of three months or less when purchased to be cash equivalents. The recorded carrying amounts of the Company's cash equivalents approximate their fair market value due to their highly liquid nature.
Marketable Securities -- Webvan considers all investments with a maturity of more than three months but less than one year when purchased and investments to be sold within one year to be short-term and available for sale.
Concentration of Credit Risk -- Financial instruments that potentially subject Webvan to concentrations of credit risk consist principally of cash, cash equivalents and short-term investments to the extent these exceed federal insurance limits. Risks associated with cash, cash equivalents and marketable securities are mitigated by banking with and purchasing commercial paper, market auction preferred stock, corporate notes, and corporate bonds from credit-worthy institutions.
Supplier Concentration -- During 1999, Webvan purchased goods for resale from numerous suppliers for its Bay Area operation. During 1999, two significant suppliers of food products accounted for approximately 34% and 12% of Webvan's purchases of goods for resale, respectively. Although products are available from other sources, the vendors' inability to supply products in a timely manner could adversely affect the Company's ability to satisfy customer demands.
Property, Equipment and Leasehold Improvements -- Property, equipment and leasehold improvements are stated at cost less accumulated depreciation and amortization. Depreciation on property and equipment is taken on assets placed into service using the straight-line method over estimated useful lives of three to seven years, and leasehold improvements are amortized, using the straight-line method, over the shorter of the lease term or the estimated useful lives of the improvements.
The Company evaluates the recoverability of its long-lived assets in accordance with Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of". The Company assesses the impairment of long-lived assets
WEBVAN GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
whenever events and circumstances indicate that the carrying value of an asset may not be recoverable. No such impairments have been identified to date.
Loan Fees -- Webvan capitalizes loan and capital lease origination fees, including the fair value of warrants and amortizes them over the life of the related obligations.
Income Taxes -- Income taxes are provided at current rates. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and amounts used for income tax purposes. Under the provisions of SFAS No. 109, "Accounting for Income Taxes," a valuation allowance is provided when it is more likely than not that some portion or all of the deferred tax assets recorded will not be recognized.
Stock Options -- As permitted by SFAS No. 123, "Accounting for Stock-Based Compensation," Webvan accounts for stock options to employees using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees." As required by SFAS No. 123, the pro forma impact on earnings and earnings per share resulting from the fair value method is disclosed in Note 8.
Revenue Recognition -- The Company recognizes revenues from product sales and delivery, net of returns and discounts, when the products are delivered to customers.
Net Loss Per Share -- Basic net loss per share excludes dilution and is computed by dividing net loss by the weighted average number of common shares outstanding for the period (excluding shares subject to repurchase). Diluted net loss per common share was the same as basic net loss per common share for all periods presented since the effect of any potentially dilutive securities is excluded as they are anti-dilutive because of Webvan's net losses.
Capitalized Software -- The Company capitalizes internally developed software costs in accordance with the provisions of Statement of Position ("SOP") 98-1, "Accounting for Costs of Computer Software Developed or Obtained for Internal Use." Capitalized costs are amortized on a straight line basis over the useful life of the software once it is placed into service.
Start-Up Costs -- The company expenses the costs of start-up activities and organization costs as they are incurred, in accordance with SOP 98-5, "Reporting on the Cost of Start-up Activities."
Recently Issued Accounting Standards -- In June 1998, the FASB issued SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities" which defines derivatives, requires that all derivatives be carried at fair value, and provides for hedging accounting when certain conditions are met. Webvan will adopt this statement in its first fiscal quarter of its fiscal year ending December 31, 2001. Management has not fully assessed the implications of adopting this new standard.
2. INVESTMENTS
On November 24, 1998, an agreement was signed between an equipment manufacturer and Webvan. As per the agreement, Webvan acquired 1,000 shares of such equipment manufacturer for a total amount of $1,000,000 which represents a less than 10% interest in the manufacturer. Investments are recorded at cost as fair market value is not readily determinable, and are included in other long-term assets on the accompanying balance sheets.
3. MARKETABLE SECURITIES
The fair value of marketable securities at December 31, 1999 and 1998 are presented below. Fair values are based on quoted market prices. The Company's marketable securities are classified as available-for-sale, as
WEBVAN GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
the Company intends to sell them as needed for operations. Balances at year-end consist of the following (in thousands):
4. PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS
Property, equipment and leasehold improvements at December 31, 1999, and 1998 consists of the following (in thousands):
Equipment under capital leases amounted to $2,994,000 and $794,000 at year end 1999 and 1998. Accumulated amortization on capital leases as of year end 1999 and 1998 was $911,000 and $72,000.
WEBVAN GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Construction in progress includes costs incurred in the construction of Webvan's distribution centers. Such costs include the purchase and installation of materials handling equipment, refrigeration and freezer storage units, and related finance charges.
5. BORROWING ARRANGEMENTS
In December 1998, WBA entered into a $17,000,000 loan and security agreement. The loan is payable in monthly installments of $472,000 from January 1999 through June 2002 with an additional $2,550,000 payment of the remaining balance payable in June 2002. Based upon this repayment schedule, the imputed interest on this loan is 16.33%. The loan is secured by substantially all the assets of Webvan Bay Area, and is guaranteed by Webvan Group, Inc.
Related to the above financing, Webvan issued warrants to the lenders to purchase an aggregate of 2,233,578 shares of Series B preferred stock at an exercise price of $0.91 per share. The fair value of the warrants at the date granted was $1,564,000 and was capitalized with loan fees (see Note 8). Webvan also paid $323,000 in loan fees. The loan fees are being amortized over the 42 month term of the loan.
As part of an operating lease for the Oakland facility the landlord agreed to finance $168,000 of improvements. The loan is payable in monthly installments including interest at 11% from January 1, 1999 through July 2003.
Future principal maturities under loan agreements as of December 31, 1999 are as follows (in thousands):
CAPITAL LEASE OBLIGATIONS
In March 1998, Webvan entered into a $3,000,000 nonrevolving master lease agreement. As part of the leasing arrangement, warrants for 164,232 shares of Series B preferred stock were granted to the provider at an exercise price of $0.91 per share. Such preferred shares were converted into common shares on a one for one basis at the time of the Company's initial public offering in November, 1999. The $115,000 fair value of the warrants at the date granted has been capitalized with loan fees and is being amortized over a range of 36 to 48 months (see note 8).
WEBVAN GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Future lease payments under the lease agreement as of December 31, 1999 are as follows (in thousands):
6. SHAREHOLDERS' EQUITY
STOCK SPLITS
In March 1998, January 1999, July 1999 and September 1999, the Company effected two-for-one, two-for-one, two-for-one and three-for-two stock splits, respectively, on the then outstanding shares, warrants and options. The splits have been retroactively reflected in the financial statements and notes to the financial statements.
CONVERTIBLE PREFERRED STOCK
From October 1997 through January 1998, the Company sold 112,635,168 shares of Series A preferred stock at $.0958 per share. From May through September 1998, the Company sold 39,113,304 shares of Series B preferred stock at $.91 per share. From January through April 1999, the Company sold 32,341,200 shares of Series C preferred stock at $2.32 per share. In September 1999, the Company issued 150,000 shares of Series C preferred stock related to the exercise of warrants. In July, 1999, the Company sold 21,670,605 shares of Series D preferred stock at $12.69 per share. Each share of preferred stock was convertible into one share of common stock at the option of the holder, and automatically upon an underwritten initial public offering (IPO) of the Company's common shares, meeting certain criteria. In November, 1999, at the closing of the Company's initial public offering, all of the Company's preferred stock was converted into 205,910,277 shares of common stock.
The Board of Directors is authorized, without stockholder approval, to issue up to an aggregate of 10,000,000 shares of preferred stock, in one or more series, each of the series to have rights and preferences, including voting rights, dividend rights, conversion rights, redemption privileges and liquidation preferences, as shall be determined by the Board of Directors. No shares of this preferred stock have been issued.
COMMON STOCK
At December 31, 1999, Webvan had 800,000,000 authorized shares of common stock of which 326,368,000 were issued and outstanding (including 4,785,000 shares of redeemable common stock). Webvan has the right to repurchase certain shares until vesting is completed. See Note 9. At December 31, 1999, Webvan had reserved 77,153,000 shares for issuance under stock option plans (including with respect to options granted but not exercised).
Webvan has recorded redeemable common stock, representing common stock sold to employees who have put rights. The put rights allow the shareholders to sell to the Company, at a price of $0.3658 per share, 2,871,000 shares of common stock after February 1999, and an additional 1,914,000 shares of common stock
WEBVAN GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
after February 2000. Redeemable common stock was originally recorded at its $0.0125 fair value as determined by the board of directors, and is being accreted to the redemption amounts as compensation expense over the period the put rights become exercisable. These rights expire in March 2000.
7. STOCK OPTION PLAN
On September 17, 1997, Webvan adopted the 1997 Stock Plan (the "1977 Plan"). A total of 79,500,000 shares of Webvan's common stock have been reserved for issuance under the 1997 Plan, which expires on September 17, 2007. Options are granted at fair market value at the date of grant based on the prior day's closing stock price. As provided for in the 1997 Plan, incentive and non-statutory stock options may be granted to employees, officers, directors or consultants. Incentive options may only be granted to employees and at an exercise price of no less than fair value on the date of grant. Non-statutory options may be granted at less than fair value; such options may not be granted at less than fair value in order to qualify as "performance based compensation" within the meaning of Section 162(m) of the Internal Revenue Code of 1986, as amended. For owners of more than 10% of Webvan's stock, incentive options may only be granted for an exercise price of no less than 110% of fair value. Options generally become exercisable at a rate of 25% on the one year anniversary of the vesting commencing date, which may precede the grant date, with an additional 6.25% exercisable at the end of each quarter thereafter until fully vested at the end of the fourth year. The term of an incentive option may not exceed five years for grants to owners of more than 10% of Webvan's voting power, nor exceed ten years for all other option holders.
In August 1999, Webvan adopted the 1999 Nonstatutory Stock Option Plan (the "NSO Plan"). A total of 23,000,000 shares of Webvan's common stock have been reserved for issuance under the NSO Plan. The NSO Plan provides for the grant of nonstatutory stock options to employees and consultants of Webvan. Executive officers (subject to Section 16 of the Securities Exchange Act of 1934, as amended) are only eligible to receive options under the NSO Plan in connection with their initial employment by Webvan. The exercise price, vesting and term of all stock options granted under the NSO Plan are determined by the administrator.
The 1997 Plan initially provided for the grant of 30,000,000 shares. During 1998 and 1999, Webvan's Board of Directors increased the 30,000,000 shares of common stock reserved under the 1997 Plan as follows: 12,000,000 in May 1998; 6,000,000 in July 1998; 6,000,000 in October 1998; 12,000,000 in December 1998; 6,000,000 in January 1999 and 7,500,000 in August 1999. Including the 23,000,000 shares reserved under the NSO Plan, 77,153,000 shares are reserved in the option pool as of December 31, 1999. At December 31, 1999, shares of common stock available for future options grants under the 1997 Plan and the NSO Plan totaled approximately 5.6 million.
WEBVAN GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Stock option activity under the Company's plans is summarized as follows:
Additional information regarding options outstanding as of December 31, 1999 is as follows:
ADDITIONAL STOCK PLAN INFORMATION
As discussed in Note 1, Webvan accounts for its stock-based awards using the intrinsic value method in accordance with APB 25. Based on the stock value and exercise prices, during the year ended December 31, 1999, $67,729,000 of compensation expense has been recognized in the financial statements for employee stock arrangements, including $36,520,000 of amortization of deferred compensation. During the year ended December 31, 1998, $2,302,000 of compensation expense was recognized, including $1,060,000 of amortization of deferred compensation.
SFAS 123 requires the disclosure of pro forma net income and earnings per share as if Webvan had adopted the fair value method as of the beginning of the period ended December 31, 1997. Webvan's calculations were made with the following weighted average assumptions for 1999, 1998 and 1997: expected life of 60 months following the grant date; risk free interest rates of 6%; and no dividends during the expected term. As to volatility, the assumed value for 1999, 1998 and 1997 was 80%, 0% and 0% respectively. Forfeitures are recognized as they occur. If the computed fair value of 1999, 1998 and 1997 awards had been charged to compensation over the vesting period of the awards, the net loss would have been $194,742,000 ($(1.93) per share, (basic and diluted) in 1999, $12,028,000 ($(0.31) per share, (basic and diluted) in 1998 and $2,841,000 ($(0.33) per share, (basic and diluted) in 1997.
WEBVAN GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
8. NONCASH FINANCING ACTIVITIES
STOCK AND OPTIONS FOR SERVICES
Webvan issued the following shares and options for certain consulting or recruiting services that represent non-cash operating expenses (in thousands, except per share amounts):
All preferred shares were converted into common shares on a one for one basis at the time of the Company's initial public offering in November, 1999.
In July 1999, the Company issued Yahoo! an option to purchase up to 150,000 shares of Webvan common stock at a price of $3.33 per share. The option vests 6.25% each quarter contingent upon the continued service of Yahoo!'s CEO on Webvan's Board of Directors. The fair value of the options at the grant date was determined to be $180,000 using the Black-Scholes option pricing model. Based upon the terms of the option, it is subject to variable plan accounting using the Multiple Award Method. As of December 31, 1999, the fair value of the remaining options was $1,945,000. Compensation expense related to these options amounted to approximately $225,000 for the year ended December 31, 1999.
In October 1999, Webvan issued 40,500 shares of Webvan common stock to a consultant in exchange for service, subject to restrictions which lapse as services are provided. The agreement provides for an initial three month term, as well as four six month extensions. As of December 31, 1999, 5,250 shares had vested and restrictions thereupon had lapsed. The stock which vested was valued at $87,000 based on the $16.50 market value of the stock on December 31, 1999.
Webvan agreed to issue an option for up to 150,000 shares of common stock at an exercise price of $10.79 per share in exchange for recruiting services. The agreement provides that 6,000 options vest for each individual placed under the agreement, contingent upon such individual's continued employment with the Company for eight months following commencement of employment. Based upon the terms of the agreement, the option is subject to variable plan accounting using the Multiple Award Method. Through December 31, 1999, $31,000 of expense was recorded for the fair value of options issued to the recruiter in respect of individuals placed with the Company.
DEFERRED COMPENSATION
In connection with the grant of certain stock options to employees in 1999 and 1998, the Company recorded deferred compensation of $124,961,000 and $11,797,000 and amortization of deferred compensation expense of $36,520,000 and $1,060,000, respectively, representing the difference between the deemed fair value and the option exercise price. The deferred compensation is generally being amortized over the four-year vesting period of the underlying options.
WEBVAN GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
WARRANTS FOR DEBT
Webvan issued the following warrants in connection with its long-term debt and capital lease arrangements (in thousands, except per share amounts):
The number of shares covered by warrants reflect the two-for-one stock splits in March 1998, January 1999 and July 1999 and the three-for-two stock split in September 1999. The fair value of the warrants was determined using the Black-Scholes option pricing model with the following assumptions: expected life ranging from five to seven years; risk-free interest rate of 6% in 1999, 1998 and 1997; no dividends during the expected term and volatility ranging from 80% to 100%. The calculations are based on a single option valuation approach and forfeitures are recognized as they occur.
WARRANTS FOR SERVICES
On July 8, 1999, the Company signed an agreement (the "Agreement") with a contractor to design, develop and construct up to 26 distribution center warehouse facilities ("Distribution Centers") in the United States. The Agreement includes a five year exclusivity clause. The Agreement expires July 8, 2002, unless extended by written agreement. As part of the Agreement, the contractor was granted a warrant to purchase up to 1,800,000 shares of the Company's Series C preferred stock at $2.32 per share (the "Warrant"). The Warrant was exercisable as to 150,000 shares on July 8, 1999 and generally becomes exercisable as to the remaining shares as Distribution Centers are completed by the contractor within agreed upon schedule and budgetary parameters. A portion of the Warrant shares will be forfeited to the extent schedule and budgetary parameters are not met for any Distribution Center.
Under the applicable accounting guidelines in Emerging Issues Task Force Issue No. 96-18, "Accounting for Equity Instruments That are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services", the measurement date for the Warrant is July 8, 1999 as that is the performance commitment date. As of July 8, 1999, the Company capitalized approximately $1.3 million, the fair value of the warrant related to the 150,000 exercisable shares, as determined by the board of directors and is amortizing that amount over the five year exclusivity period. No amount was capitalized as of that date for the fair value of the Warrant related to the non-exercisable shares as eventual exercisability is dependent on counterparty performance. Any amounts capitalized will be based on the contractor's future performance and will be amortized over the useful life of the Distribution Centers. If and when the Warrant becomes exercisable as to additional shares, based on counterparty performance, the Company will capitalize additional cost based on the then fair value of the Warrant related to such additional exercisable shares.
9. NET LOSS PER SHARE
Net loss per share is calculated by dividing the net loss by the weighted average shares outstanding for the period. The weighted average shares outstanding excludes certain shares subject to repurchase by the Company. Shares subject to repurchase by the Company include options exercised prior to vesting. Shares subject to repurchase by the Company also include certain shares issued in 1997 which vest under the agreements pursuant to which they were issued: The Company's rights to repurchase all but 144,000 of the shares issued in 1997 expire on March 10, 2000.
WEBVAN GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The following is a reconciliation of the numerators and denominators used in computing basic and diluted net loss per share (in thousands except per share amounts):
*Restated as to 1998 and 1997 -- See Note 15.
For the above-mentioned periods, the Company had securities outstanding which could potentially dilute basic earnings per share in the future, but were excluded from the computation of diluted net loss per share in the periods presented, as their effect would have been anti-dilutive. Such outstanding securities consist of the following (in thousands, except per share amounts):
- ---------------
* Restated as to 1998 and 1997 -- See Note 15.
10. INCOME TAXES
In 1999, when Webvan first generated revenues from operations, expenditures accumulated during the development stage started being amortized for income tax purposes over a five-year period. The deduction of these expenses for financial statement purposes in years preceding the deduction for income tax purposes is a temporary difference that creates a deferred tax asset. At statutory rates, the deferred tax asset amounts to approximately $67.8 million which has been offset by a valuation allowance of the same amount due to lack of operating history combined with risks and uncertainties surrounding Webvan's ability to generate future taxable income.
WEBVAN GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Significant components of the Company's deferred tax assets and liabilities are as follows (in thousands):
At December 31, 1999 the Company has federal net operating loss carryforwards of approximately $87.8 million, expiring from 2012 to 2019. The Company has research tax credit carryforwards available to offset future federal taxes of $45,000, expiring from 2012 to 2014. The Company has state net operating loss carryforwards of approximately $87.9 million, expiring from 2002 to 2004. The Company also has state tax credit carryforwards of approximately $25,000, which do not expire.
Utilization of the net operating losses and credits may be subject to an annual limitation due to ownership change limitations provided by the Internal Revenue Code and similar state provisions. The annual limitation may result in the expiration of net operating losses and credits before utilization.
The Company's effective tax rate differs from the expected benefit at the federal statutory tax rate at December 31 as follows:
11. LEASES
Webvan leases facilities under noncancelable operating lease agreements which expire at various dates through 2009.
Future lease payments under the lease agreements as of December 31, 1999 (including leases for ten distribution centers leased as of December 31, 1999) are as follows (in thousands):
WEBVAN GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Facilities rent expense was $4,702,000, $1,026,000 and $123,000 for the periods ended December 31, 1999, 1998 and 1997, respectively. In January 2000, the Company signed an additional distribution center lease with annual payments, commencing at $1,309,000, through 2010.
12. EMPLOYEE BENEFIT PLANS
Webvan has a 401(k) profit-sharing plan (the 401(k) Plan) that covers substantially all employees. The 401(k) Plan provides for voluntary salary reduction contributions of up to 15% of eligible participants' annual compensation subject to Internal Revenue Code limitations. Under the terms of the 401(k) Plan, Webvan will match 100% of employees' contributions for the first $500 and 25% thereafter to a maximum of $2,000 per year. Matching contributions made during 1999, 1998 and 1997 were $503,000, $81,000 and $17,000, respectively.
In November 1999, the Company introduced its Employee Stock Purchase Plan ("ESPP") to its associates. A total of 5,000,000 shares of common stock have been reserved for issuance under the ESPP. The first offering period commenced in November 1999 and will end on or about August 14, 2000, and new offering periods will end every six months thereafter. The number of shares reserved for issuance under the ESPP will be subject to an annual increase on each anniversary beginning January 1, 2000 equal to the lesser of the number of shares issued under the ESPP in the prior year and an amount determined by Webvan's board of directors.
The ESPP permits eligible employees to purchase common stock through payroll deductions up to a maximum of $25,000 per calendar year and up to 1,000 shares for each purchase period. The price at which common stock will be purchased is equal to 85% of the fair market value of the common stock on the first or last day of the applicable offering period, whichever is lower.
13. RELATED PARTY TRANSACTIONS
A general contractor of Webvan has subcontracted with an equipment manufacturer (see Note 2) to install equipment in Webvan's distribution center. A total of $5.5 million of this work was completed by December 31, 1999 and is included in fixed assets.
In September 1999, the Company loaned an officer $4,783,000. The loan bears interest at 6.26%, is secured by 1.25 million shares of Webvan common stock, and matures in connection with the sale of the shares securing the note.
Net sales in the fourth quarter of 1999 included approximately $0.8 million of purchases under Webvan's Second Harvest Donation Program pursuant to which individuals and entities order food from Webvan for donation to local foodbanks, of which approximately $0.7 million was purchased by entities and individuals associated or affiliated with Webvan, including an aggregate of $0.4 million by E*Trade Group, Inc. and Yahoo! Inc., whose chief executive officers are directors of Webvan.
14. SELECTED QUARTERLY DATA (UNAUDITED) (IN THOUSANDS, EXCEPT PER SHARE DATA)
WEBVAN GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
* As restated -- See Note 15
Subsequent to issuance of the Company's Consolidated Financial Statements for the three and nine months ended September 30, 1999 and 1998, it was determined that certain shares subject to repurchase (See Note 9) should have been excluded from the weighted average shares outstanding for the three month and nine month periods ended September 30, 1999 and 1998, used in calculating net loss per share for such periods. Accordingly, the following amounts have been restated for such periods:
15. RESTATEMENT
Subsequent to the issuance of the 1998 financial statements, it was determined that 28,832,000 and 27,770,000 shares subject to repurchase should have been excluded from the weighted average number of shares outstanding, for 1997 and 1998, respectively. As a result, basic and diluted net loss per share has been restated from amount previously reported. This restatement had no effect on our net loss for the periods ended December 31, 1997 and 1998. Accordingly, the following amounts have been restated:
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENT WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
Certain information required by Part III is omitted from this Report on Form 10-K in that the Registrant will file its definitive Proxy Statement for its Annual Meeting of Stockholders to be held on June 1, 2000, pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended (the "Proxy Statement"), not later than 120 days after the end of the fiscal year covered by this Report, and certain information included in the Proxy Statement is incorporated herein by reference.
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
(a) Executive Officers -- See the section entitled "Executive Officers" in Part I, Item 1 hereof.
(b) Directors -- The information required by this Item is incorporated by reference to the section entitled "Election of Directors" in the Proxy Statement.
The disclosure required by Item 405 of Regulation S-K is incorporated by reference to the section entitled "Section 16(a) Beneficial Ownership Reporting Compliance" in the Proxy Statement.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item is incorporated by reference to the sections entitled "Compensation of Executive Officers" and "Compensation of Directors" in the Proxy Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item is incorporated by reference to the sections entitled "Principal Share Ownership" and "Security Ownership of Management" in the Proxy Statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item is incorporated by reference to the section entitled "Certain Transactions" in the Proxy Statement.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
14(a) EXHIBITS
- --------------- (1) Incorporated by reference from the Registrant's Registration Statement on Form S-1 (file no. 333-84703), as amended.
* Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form.
14(b) REPORTS ON FORM 8-K:
None
SIGNATURES
In accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, in Foster City, California, on March 30, 2000.
WEBVAN GROUP, INC.
By: /s/ GEORGE T. SHAHEEN ------------------------------------ George T. Shaheen Chief Executive Officer
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints George T. Shaheen and Robert H. Swan, and each of them acting individually, as his attorney-in-fact, each with full power of substitution for him in any and all capacities, to sign any and all amendments to this report on Form 10-K, and file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming our signatures as they may be signed by our attorney to any and all amendments to said Report.
In accordance with the Exchange Act, this report has been signed below on March 30, 2000 by the following persons on behalf of the Registrant and in the capacities indicated.
EXHIBIT INDEX
- --------------- (1) Incorporated by reference from the Registrant's Registration Statement on Form S-1 (file no. 333-84703), as amended.
* Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form. | 22,436 | 145,426 |
20286_1999.txt | 20286_1999 | 1999 | 20286 | ITEM 1. BUSINESS --------
Cincinnati Financial Corporation ("CFC") was incorporated on September 20, 1968 under the laws of the State of Delaware. On April 4, 1992, the shareholders voted to adopt an Agreement of Merger by means of which the reincorporation of the Corporation from the State of Delaware to the State of Ohio was accomplished. CFC owns 100% of The Cincinnati Insurance Company ("CIC"), 100% of CFC Investment Company ("CFC-I") and 100% of CinFin Capital Management Company ("CinFin"). The principal purpose of CFC is to be a holding company for CIC, CFC-I and CinFin in addition for the purpose of acquiring other companies.
CIC, incorporated in August, 1950, is an insurance carrier presently licensed to conduct multiple line underwriting in accordance with Section 3941.02 of the Revised Code of Ohio. This includes the sale of fire, automobile, casualty, bonds, and all related forms of property and casualty insurance in 50 states, the District of Columbia, and Puerto Rico. CIC is not authorized to write any other forms of insurance. CIC is in a highly competitive industry and competes in varying degrees with a large number of stock and mutual companies. CIC also owns 100% of the stock of the following insurance companies.
1. The Cincinnati Life Insurance Company ("CLIC") incorporated in 1987 under the laws of Ohio for the purpose of acquiring the business of Inter-Ocean and The Life Insurance Company of Cincinnati. CLIC acquired The Life Insurance Company of Cincinnati and Inter-Ocean Insurance Company on February 1, 1988. CLIC is licensed for the sale of life insurance and accident and health insurance in 47 states and the District of Columbia.
2. The Cincinnati Casualty Company ("CCC") (formerly the Queen City Indemnity Company), incorporated in 1972 under the laws of Ohio, is licensed in the fire and casualty insurance business on a direct billing basis in 40 states. The business of CIC and CCC is conducted separately, and there are no plans for combining the business of said companies.
3. The Cincinnati Indemnity Company ("CID"), incorporated in 1988 under the laws of Ohio, is engaged in the writing of nonstandard personal and casualty lines of insurance in 31 states. The business of CIC and CID is conducted separately, and there are no plans for combining the business of said companies.
CFC-I, incorporated in 1970, owns certain real estate in the Greater Cincinnati area and is in the business of leasing or financing various items, principally automobiles, trucks, computer equipment, machine tools, construction equipment, and office equipment.
CinFin, incorporated in 1998, offers investment management services to corporations, insurance agencies and companies, institutions, pension plans, and high net worth individuals.
Industry segment information for revenues, income before income taxes, and identifiable assets is included on pages 35 and 36 of the Company's Annual Report to Shareholders and is incorporated herein by reference (see Exhibit 13 to this filing).
As more fully discussed in pages 6 through 14 in the Company's Annual Report to Shareholders, incorporated herein by reference (see Exhibit 13 to this filing), the Company sells insurance primarily in the Midwest and Southeast through a network of a limited number (977 in 30 states at December 31, 1999) of selectively appointed independent agents, most of whom own stock in the Company. Gross written premiums by property/casualty lines increased 7% to $1.775 billion in 1999. The Company's mix of property/casualty business did not change significantly in 1999. Life and accident and health insurance (which constituted 19% of the Company's premium income for 1999) is sold primarily through property/casualty agencies and independent life agencies. The growth rate of 267% was largely the result of a $302.9 million single pay life policy on a bank's officers (BOLI).
The consolidated financial statements include the estimated liability for unpaid losses and loss adjustment expenses ("LAE") of the Company's property/casualty ("P/C") insurance subsidiaries. Property and casualty insurance is written in 50 states, the District of Columbia, and Puerto Rico. The liabilities for losses and LAE are determined using case-basis evaluations and statistical projections and represent estimates of the ultimate net cost of all unpaid losses and LAE incurred through December 31 of each year. These estimates are subject to the effect of trends in future claim severity and frequency. These estimates are continually reviewed; and as experience develops and new information becomes known, the liability is adjusted as necessary. Such adjustments, if any, are reflected in current operations.
The Company does not discount any of its property/casualty liabilities for unpaid losses and unpaid loss adjustment expenses.
There are two tables used to present an analysis of the liability for losses and LAE. The first table, providing a reconciliation of beginning and ending liability balances for 1999, 1998, and 1997, is on page 31 in the Company's Annual Report to Shareholders, incorporated herein by reference (see Exhibit 13 to this filing). The second table, showing the development of the estimated liability for the ten years prior to 1999 is presented on the next page.
The reconciliation referred to in the preceding paragraph shows a 1999 recognition of $116,061,000 redundancy in the December 31, 1998 liability. This redundancy is due in part to the effects of settling case reserves established in prior years for less than expected and also in part to the over estimation of the severity of IBNR losses. Average severity continues to increase primarily because of increases in medical costs related to workers' compensation and auto liability insurance. Litigation expenses for recent court cases on pending liability claims continue to be very costly; and judgments continue to be high and difficult to estimate. Reserves for environmental claims have been reviewed, and the Company believes that the reserves are adequate. Environmental exposures are minimal as a result of the types of risks we have insured in the past. Historically, most commercial accounts are written with post-date coverages that afford clean-up costs and Superfund responses.
The anticipated effect of inflation is implicitly considered when estimating liabilities for losses and LAE. While anticipated price increases due to inflation are considered in estimating the ultimate claim costs, the increase in average severities of claims is caused by a number of factors that vary with the individual type of policy written. Future average severities are projected based on historical trends adjusted for anticipated changes in underwriting standards, policy provisions, and general economic trends. These trends are monitored based on actual development and are modified if necessary.
The limits on risks retained by the Company vary by type of policy, and risks in excess of the retention limits are reinsured. Because of the growth in the Company's capacity to underwrite risks and reinsurance market conditions, the Company raised its casualty line retention limits in 1995 and 1999 from $1,000,000 to $2,000,000 to $2,400,000, respectively, and raised its property line retention limits in 1995 from $1,000,000 to $2,000,000.
The principal reason for differences between the property/casualty liabilities reported in the accompanying consolidated financial statements in accordance with generally accepted accounting principles ("GAAP") and that reported in the annual statements filed with state insurance departments in accordance with statutory accounting practices ("SAP") relates to the reporting of reinsurance recoverables which are recognized as receivables for GAAP purposes and as an offset to reserves for SAP purposes.
ANALYSIS OF LOSS AND LOSS ADJUSTMENT EXPENSE DEVELOPMENT (Millions of Dollars)
The table above presents the development of balance sheet liabilities for 1989 through 1999. The top line of the table shows the estimated liability for unpaid losses and LAE recorded at the balance sheet date for each of the indicated years. This liability represents the estimated amount of losses and LAE for claims arising in all prior years that are unpaid at the balance sheet date, including losses that had been incurred but not yet reported to the Company. The upper portion of the table shows the reestimated amount of the previously recorded liability based on experience as of the end of each succeeding year. The estimate is increased or decreased as more information becomes known about the frequency and severity of claims for individual years.
The "net cumulative redundancy" represents the aggregate change in the estimates over all prior years. For example, the 1989 liability has developed a $93,000,000 redundancy over ten years and has been reflected in income over the ten years. The effects on income of the past three years of changes in estimates of the liabilities for losses and LAE for all accident years is shown in the reconciliation table, referred to above.
The lower section of the table shows the cumulative amount paid with respect to the previously recorded liability as of the end of each succeeding year. For example, as of December 31, 1999, the Company had paid $585,000,000 of the currently estimated $649,000,000 of losses and LAE that have been incurred as of the end of 1989; thus an estimated $64,000,000 of losses incurred as of the end of 1989 remain unpaid as of the current financial statement date.
In evaluating this information, it should be noted that each amount includes the effects of all changes in amounts for prior periods. For example, the amount of deficiency or redundancy related to losses settled in 1994, but incurred in 1989, will be included in the cumulative deficiency or redundancy amount for 1989 and each subsequent year. This table does not present accident or policy year development data which readers may be more accustomed to analyzing. Conditions and trends that have affected development of the liability in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this table.
The Company limits the maximum net loss that can arise by large risks or risks concentrated in areas of exposure by reinsuring (ceding) with other insurers or reinsurers. Related thereto, the Company's retention levels were last increased for casualty lines of business from $2,000,000 to $2,400,000 in 1999, and for property lines of insurance from $1,000,000 to $2,000,000 in 1995. The Company reinsures with only financially sound companies. The composition of its reinsurers has not changed, and the Company has not experienced any uncollectible reinsurance amounts or coverage disputes with its reinsurers in more than ten years.
Information concerning the Company's investment strategy and philosophy is contained on pages 21 through 23 of the Annual Report to Shareholders, incorporated herein by reference (see Exhibit 13 to this filing). The Company's primary strategy is to maintain liquidity to meet both its immediate and long-range insurance obligations through the purchase and maintenance of medium-risk fixed maturity and equity securities, while earning optimal returns on medium-risk equity securities which offer growing dividends and capital appreciation. The Company usually holds these securities to maturity unless there is a change in credit risk or the securities are called by the issuer. Historically, municipal bonds (with concentrations in the essential services, i.e. schools, sewer, water, etc.) have been attractive to the Company due to their tax exempt features. Because of Alternative Minimum Tax matters, the Company uses a blend of tax-exempt and taxable fixed maturity securities. Investments in common stocks have been made with an emphasis on securities with an annual dividend yield of at least 2 to 3 percent and annual dividend increases. The Company's strategy in equity investments is to identify approximately 10 to 12 companies in which it can accumulate 10 to 20 percent of their common stock. As a long-term investor, a buy and hold strategy has been followed for many years, resulting in an accumulation of a significant amount of unrealized appreciation on equity securities.
As of December 31, 1999, CFC employed 2,920 associates.
ITEM 2.
ITEM 2. PROPERTIES ----------
CFC-I owns a fully leased 85,000 square feet office building in downtown Cincinnati that is currently leased to an unaffiliated company, on a net, net, net lease basis. This property is carried in the financial statements at $535,000 as of December 31, 1999.
CFC-I also owns the Home Office building located on 75 acres of land in Fairfield, Ohio. This building contains approximately 380,000 square feet. The John J. and Thomas R. Schiff & Company, an affiliated company, occupies approximately 5,350 square feet, and the balance of the building is occupied by CFC and its subsidiaries. The property is carried in the financial statements at $9,967,693 as of December 31, 1999.
CFC-I also owns the Fairfield Executive Center which is located on the northwest corner of the home office property in Fairfield, Ohio. This is a four-story office building containing approximately 103,000 rentable square feet. CFC and its subsidiaries occupy approximately 91% of the building, unaffiliated tenants occupy approximately 7% of the building, and approximately 2% of the building is unoccupied. The property is carried in the financial statements at $9,407,040 as of December 31, 1999.
The CLIC owns a four-story office building in the Tri-County area of Cincinnati containing approximately 127,000 square feet. At the present time, 100% of the building is currently being leased by an unaffiliated tenant. This property is carried in the financial statements at $3,619,373 as of December 31, 1999.
In addition, the Company is in the process of constructing a second office tower to be used by CFC and its subsidiaries. This building is identical and connected to the current Home Office building. The total cost of the building is expected to be approximately $60 million. The new construction and related renovations will be completed in the first half of 2000. As of December 31, 1999, the Company had paid $45.8 million of such costs.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS -----------------
The Company is involved in no material litigation other than routine litigation incident to the nature of the insurance industry.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ---------------------------------------------------
CFC filed with the Securities and Exchange Commission (SEC) on March 2, 2000, definitive proxy statements and annual reports pursuant to Regulation 14A. Material filed was the same as that described in Item 4 and is incorporated herein by reference. No matters were submitted during the fourth quarter.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER ----------------------------------------------------------------- MATTERS -------
Cincinnati Financial Corporation had approximately 11,485 direct shareholders of record as of December 31, 1999. The information related to the market for the registrant's common stock is included in the Annual Report of the Registrant to its shareholders on page 38 for the year ended December 31, 1999 and is incorporated herein by reference (see exhibit 13 to this filing).
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA -----------------------
This information is included in the Annual Report of the Registrant to its shareholders on pages 16 and 17 for the year ended December 31, 1999 and is incorporated herein by reference (see exhibit 13 to this filing).
ITEM 7
ITEM 7 AND 7(A). MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ----------------------------------------------------------- AND RESULTS OF OPERATIONS AND QUANTITATIVE AND QUALITATIVE ---------------------------------------------------------- DISCLOSURES ABOUT MARKET RISK -----------------------------
This information is included in the Annual Report of the Registrant to its shareholders on pages 18 to 23 for the year ended December 31, 1999 and is incorporated herein by reference (see Exhibit 13 to this filing).
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA -------------------------------------------
(a) Financial Statements
The following consolidated financial statements of the Registrant and its subsidiaries, included in the Annual Report of the Registrant to its shareholders on pages 24 to 36 for the year ended December 31, 1999, are incorporated herein by reference (see Exhibit 13 to this filing).
Consolidated Balance Sheets--December 31, 1999 and 1998 Consolidated Statements of Income--Years ended December 31, 1999, 1998, and 1997 Consolidated Statements of Shareholders' Equity--Years ended December 31, 1999, 1998, and 1997 Consolidated Statements of Cash Flows--Years ended December 31, 1999, 1998, and 1997. Notes to Consolidated Financial Statements Independent Auditors' Report
(b) Supplementary Data
Selected quarterly financial data, included in the Annual Report of the Registrant to its shareholders on page 15 for the year ended December 31, 1999, is incorporated herein by reference (see Exhibit 13 to this filing).
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND --------------------------------------------------------------- FINANCIAL DISCLOSURE --------------------
There were no disagreements on accounting and financial disclosure requirements with accountants within the last 24 months prior to December 31, 1999.
PART III
CFC filed with the SEC on March 2, 2000 definitive proxy statements pursuant to regulation 14-A. Material filed was the same as that described in Item 10, Directors and Executive Officers of the Registrant; Item 11, Executive Compensation; Item 12, Security Ownership of Certain Beneficial Owners and Management; Item 13, Certain Relationships and Related Transactions, and is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K ----------------------------------------------------------------
(a) Filed Documents. The following documents are filed as part of this report:
1. Financial Statements--incorporated herein by reference (see Exhibit 13 to this filing) as listed in Part II of this Report.
2. Financial Statement Schedules: Independent Auditors' Report Schedule I--Summary of Investments Other than Investments in Related Parties Schedule II--Condensed Financial Information of Registrant Schedule III--Supplementary Insurance Information Schedule IV--Reinsurance Schedule VI--Supplemental Information Concerning Property-Casualty Insurance Operations
All other schedules are omitted because they are not required, inapplicable or the information is included in the financial statements or notes thereto.
3. Exhibits:
Exhibit 3(i) --Amended Articles of Incorporation of Cincinnati Financial Corporation. Exhibit 3(ii)--Regulations of Cincinnati Financial Corporation--incorporated by reference to Exhibit 2 to registrant's Proxy Statement dated March 2, 1992. Exhibit 11 --Statement re computation of per share earnings for years ended December 31, 1999, 1998, and 1997 Exhibit 13 --Material incorporated by reference from the annual report of the registrant to its shareholders for the year ended December 31, 1999 Exhibit 21 --Subsidiaries of the registrant-- information contained in Part I of this report Exhibit 22 --Published Report regarding matters submitted to vote of securityholders-- notice of Annual Meeting of Shareholders and Proxy Statement dated March 1, 2000--incorporated by reference to such document previously filed with Securities and Exchange Commission, Washington, D.C., 20549 Exhibit 23 --Independent Auditors' Consent Exhibit 27 --Financial Data Schedule
(b) Reports on Form 8-K--NONE
INDEPENDENT AUDITORS' REPORT
To the Shareholders and Board of Directors of Cincinnati Financial Corporation:
We have audited the consolidated financial statements of Cincinnati Financial Corporation and its subsidiaries as of December 31, 1999 and 1998, and for each of the three years in the period ended December 31, 1999, and have issued our report thereon dated February 3, 2000; such consolidated financial statements and report are included in your 1999 Annual Report to Shareholders and are incorporated herein by reference. Our audits also included the consolidated financial statement schedules of Cincinnati Financial Corporation and its subsidiaries, listed in Item 14. These consolidated financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
DELOITTE & TOUCHE LLP
/S/ Deloitte & Touche LLP
Cincinnati, Ohio February 3, 2000
SCHEDULE I
CINCINNATI FINANCIAL CORPORATION AND SUBSIDIARIES SUMMARY OF INVESTMENTS--OTHER THAN INVESTMENTS IN RELATED PARTIES DECEMBER 31, 1999
SCHEDULE II
CINCINNATI FINANCIAL CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT
This condensed financial information should be read in conjunction with the consolidated financial statements and notes included in the Registrant's 1999 Annual Report to Shareholders.
SCHEDULE II
CINCINNATI FINANCIAL CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT
This condensed financial information should be read in conjunction with the consolidated financial statements and notes included in the Registrant's 1999 Annual Report to Shareholders.
SCHEDULE III
CINCINNATI FINANCIAL CORPORATION & SUBSIDIARIES SUPPLEMENTARY INSURANCE INFORMATION FOR YEARS ENDED DECEMBER 31, 1999, 1998, AND 1997 (000's omitted)
Notes to Schedule III: - --------------------- (1) The sum of columns C, D, & E is equal to the sum of Losses and loss expense reserves, Life policy reserves, and Unearned premium reserves reported in the Company's consolidated balance sheets.
(2) The sum of columns I & J is equal to the sum of Commissions, Other operating expenses, Taxes, licenses, and fees, Increase in deferred acquisition costs, and Other expenses shown in the consolidated statements of income, less other expenses not applicable to the above insurance segments.
(3) This segment information is not regularly allocated to segments and reviewed by Company management in making decisions about resources to be allocated to the segments and assess their performance.
(4) Amounts represent written premiums on accident and health insurance business only.
SCHEDULE IV
CINCINNATI FINANCIAL CORPORATION AND SUBSIDIARIES REINSURANCE FOR YEARS ENDED DECEMBER 31, 1999, 1998, AND 1997 (000's omitted)
SCHEDULE VI
CINCINNATI FINANCIAL CORPORATION & SUBSIDIARIES SUPPLEMENTAL INFORMATION CONCERNING PROPERTY/CASUALTY INSURANCE OPERATIONS FOR YEARS ENDED DECEMBER 31, 1999, 1998, AND 1997 (000's omitted)
Index of Exhibits
Exhibit 3(i) --Amended Articles of Incorporation of Cincinnati Financial Corporation.
Exhibit 3(ii)--Regulations of Cincinnati Financial Corporation--incorporated by reference to Exhibit 2 to registrant's Proxy Statement dated March 2, 1992.
Exhibit 11 --Statement re computation of per share earnings for the years ended December 31, 1999, 1998, and 1997
Exhibit 13 --Material incorporated by reference from the annual report of the registrant to its shareholders for the year ended December 31, 1999
Exhibit 21 --Subsidiaries of the registrant--information contained in Part I of this report
Exhibit 22 --Notice of Annual Meeting of Shareholders and Proxy Statement dated March 1, 2000--incorporated by reference to such document previously filed with Securities and Exchange Commission, Washington, D.C., 20549
Exhibit 23 --Independent Auditors' Consent
Exhibit 27 --Financial Data Schedule
S I G N A T U R E S
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
CINCINNATI FINANCIAL CORPORATION | 3,654 | 24,460 |
777491_1999.txt | 777491_1999 | 1999 | 777491 | Item 1. Business --------
Overview
CH2M HILL is a project delivery firm founded in 1946. We provide engineering, consulting, design, construction, procurement, operations and maintenance, and program and project management services to clients in the private and public sector in the United States and abroad. We are an employee-owned Oregon corporation with approximately 9,200 employees working in 66 offices throughout the United States and 33 offices abroad.
Business Strategy
Our business strategy is to grow domestically and internationally by increasing market share in each of our operating segments. The key elements of this strategy are:
. Increasing the number and the dollar value of our contracts . Expanding and diversifying our client base by attracting new private and public sector clients and developing a diversified mix of projects . Increasing the number of large, longer-term projects with the potential for higher profit margins . Encouraging ownership in our CH2M HILL common stock across a greater proportion of our workforce
Operating Segments
We provide services to our clients through three operating segments:
. Environmental, Energy and Infrastructure . Water . Industrial
Environmental, Energy and Infrastructure
Our Environmental, Energy and Infrastructure (``EE&I'') operating segment consists of two businesses: Environmental, Nuclear, Energy & Systems (``ENE&S'') and Transportation. These two businesses are described below.
EE&I's business strategy is to grow by increasing market share in each of its two businesses, expanding its client base and obtaining large, longer-term projects with the potential for higher profit margins. While maintaining its focus on its traditional services, EE&I is expanding its expertise into related industries such as telecommunications, and into related business concepts such as ``sustainable development.'' Sustainable development is a design approach that addresses environmental issues throughout the life of a project, from design and construction to decommissioning and seeks to minimize total environmental impact.
ENE&S. ENE&S provides integrated environmental and waste management consulting and engineering services, and performs design and build, remediation, construction and implementation of infrastructure and telecommunications systems for a variety of public and private clients.
1. Environmental. Our Environmental group provides environmental consulting for remedial construction projects, ecological and natural resource damage assessments, strategic environmental management and permitting services, environmental liability management services, site investigations, remedial design,
implementation and construction services, treatment systems for hazardous, toxic and radioactive waste contaminated properties, and sustainable development planning, design and construction services. Representative Environmental projects include:
. Environmental consulting, engineering and remedial activities for the U.S. Air Force Center for Environmental Excellence . Remediation of contaminated sites on Naval and Marine Corps installations in 26 states and several foreign countries . Program management and remedial design of a refinery for a large oil company . Environmental impact studies for a number of proposed industrial projects and municipal programs on behalf of the Beijing city government in China
2. Nuclear. Our Nuclear group provides program management, integration, engineering, construction and operations and maintenance services for the U.S. Department of Energy and commercial nuclear power plants. We manage decommissioning and closure of weapons production facilities and design nuclear waste treatment and handling facilities in the United States, Western, Central and Eastern Europe and the former Soviet Union. Representative Nuclear projects include:
. Management and integration of decontamination, decommissioning, and closure of the nuclear weapons production facility at Rocky Flats in Golden, Colorado, on behalf of the U.S. Department of Energy . Engineering, design and technical services to support decontamination, decommissioning and remedial activities at the U.S. Department of Energy Hanford Reservation in Richland, Washington formerly known as Lockheed Martin Hanford Corporation . Decontamination and decommission planning and engineering for a university research center in Atlanta, Georgia
3. Energy. Our Energy group provides full lifecycle energy services for power projects around the world. The Energy group's services range from design to decommissioning, including consulting, engineering, construction, operations and maintenance services. Representative Energy projects include:
. Expert consulting on utility deregulation . Consulting and design for photovoltaic manufacturing process . The design and construction of energy efficiency upgrades . Development of generation services in renewable energy . Carbon and other greenhouse gasses management projects
4. Systems. For the communications industry, our Systems group provides program management, planning, design, and construction management of local and regional fiber optic and hybrid fiber/coaxial systems for voice, video and data communications. In other markets, our Systems group develops and implements environmental management information systems, total energy management and information technology systems, and industrial process design/build. It provides military base operation services for government agencies, and other outsourcing services for industrial and government clients. Representative Systems projects include:
. Program management, design and construction management of voice, video and data networks for a large telecommunications company in Europe . Design, construction and installation of an industrial process system for metal plating facility . Program management for the upgrade of a hybrid fiber/coaxial network for voice, video and high- speed data services in several U.S. cities
Transportation. Transportation provides planning, siting, permitting, design, program and construction management, intermodal transportation planning and consulting services for aviation, ports, highways, bridges and transit systems. Representative Transportation projects include:
. Master planning and program management for a large international airport in the northwest region of the U.S., including terminal, financial and airport environmental planning . Developing lighting control systems for large international airport in the U.S., including touch-screen controls, runway incursion protection and automatic safety measures . Designing and providing project management and engineering services for the expansion of a container shipping terminal in the Eastern U.S., including berths, wharf and cranes . Seismic retrofit design of seven bridges along an interstate highway in California . Design of the Eastern Transportation Corridor for the Orange County, California transportation authority including 27 miles of highway and 58 bridges . Designing parking structure and bridge for major U.S. airport
Water
Our Water operating segment consists of two businesses: Water & Wastewater and Operations & Maintenance. The business strategy of the Water operating segment is to grow through increasing market share in each of its businesses, both domestically and internationally, to diversify its client base, and to pursue larger projects. We seek to attract new clients by leveraging our reputation for providing quality services, and by taking advantage of the current trends for outsourcing operations and maintenance activities to specialized service providers.
Water & Wastewater. Our Water & Wastewater business focuses on the planning, design, construction and implementation of water supply systems and wastewater treatment facilities. Representative Water & Wastewater projects include:
. Design and construction of a water treatment plant expansion in Tampa, Florida . Design, construction and commissioning of a wastewater treatment facility in Manakau, New Zealand . Program management for design and construction of a deep tunnel sewage project in the Republic of Singapore . Design, construction and commissioning of a water treatment plant in Halifax, Nova Scotia
Operations & Maintenance. Our Operations & Maintenance business provides water, wastewater and public works operations and maintenance services to water and wastewater facility operators, including startup and performance testing, consulting, facility operations, on-going maintenance and management. The facility management services include water and wastewater treatment, collection, and distribution, equipment and process maintenance, and site grounds maintenance. Representative Operations & Maintenance projects include:
. Operations and maintenance of a water reclamation center in Fairfield, California
. Operations of the wastewater facilities in Hoboken, New Jersey . Operations of the wastewater plant for a large brewery in Jacarei, Brazil
Industrial
Our Industrial operating segment provides design, construction, specialized precision manufacturing support and facility services support to high-technology manufacturing companies, food and beverage processing businesses, and fine chemical and pharmaceutical manufacturers.
The business strategy of the Industrial operating segment is to diversify its client base beyond the microelectronics industry, capitalizing on a strong professional reputation in project delivery of complex manufacturing facilities and leadership in the area of single-source design, engineering and construction of industrial manufacturing facilities.
The Industrial operating segment built its reputation primarily in the micro- electronics industry, where it offers a single source for a broad range of integrated design and construction services. The Industrial segment's clients typically require design and installation services for complex systems that comprise many of their facilities, including clean rooms, ultrapure water and wastewater treatment systems, chemical and gas systems, and production tools. Representative Industrial projects include:
. Design and construction services for the development of multiple U.S. and foreign production facilities for a major microelectronics manufacturer . Design and construction services for a soy sauce production facility in California for a Japanese food processing manufacturer . Complete engineering and construction services for an ultrapure water system for a multi-national pharmaceutical manufacturer . Continuous facility engineering, maintenance and operations support services for several microelectronics manufacturers under multi-year contracts
Clients
Our clients include:
. Companies in the energy, transportation, chemical, steel, aluminum, mining, forest products, electronics, food, pharmaceuticals and manufacturing industries in the United States and more than 20 foreign countries . The U.S. Agency for International Development, U.S. Department of Defense, U.S. Department of Energy and U.S. Environmental Protection Agency . A variety of state and local government agencies in the United States and abroad
Kaiser-Hill
In 1995, through Kaiser-Hill, we won the U.S. Department of Energy's Performance Based Integrating Management Contract for the Rocky Flats Closure Project in Golden, Colorado. Kaiser-Hill is a joint venture with ICF Kaiser International, Inc. CH2M HILL holds a 50 percent interest in the joint venture. Rocky Flats is a former U.S. Department of Energy nuclear weapons production facility. Under the contract, Kaiser-Hill oversees plutonium stabilization and storage, environmental restoration, waste management, decontamination and decommissioning, site safety and security, and construction activities of subcontractor companies.
Under the initial performance-based contract signed by Kaiser-Hill, a concept that was developed in the U.S. Department of Energy's 1994 Contract Reform Initiative, 85% of Kaiser-Hill's fees are based on performance, while only 15% are fixed. Kaiser-Hill's contract commits it to dealing with urgent risks first. Achievement of measurable results in the following ``urgent risk'' areas determines Kaiser-Hill's incentive fee: stabilize plutonium and plutonium residues for specific time frames; consolidate plutonium in a single building; and clean up and remove all high-risk "hot spot" contamination.
Effective February 1, 2000, the U.S. Department of Energy extended Kaiser-Hill's Rocky Flats contract. Although the new contract is a closure contract and does not have a defined term, we anticipate that closure of the site would be in 2006. Under the new contract, Kaiser-Hill is compensated through a base fee affected, up or down, by its performance against the agreed site target closure costs. Outside a negotiated range, for every dollar that the U.S. Department of Energy saves with earlier clean-up, Kaiser-Hill receives a 30 cent increase in fee. At the same time, for every dollar the clean-up is over budget, the fee is reduced by 30 cents up to an agreed minimum. The ultimate fee will also be impacted by the project schedule and safety of our performance to achieve the site closure.
Backlog
At December 31, 1999, our backlog was approximately $2,292 million, compared to a backlog of approximately $1,337 million at December 31, 1998. We define backlog as contracted task orders less previously recognized revenue on such task orders. U.S. government agencies operate under annual fiscal appropriations by Congress and fund various federal contracts only on an incremental basis. The same is true of many state, local and foreign contracts. Our ability to earn revenues from our backlog depends on the availability of funding for various U.S., state, local and foreign government agencies.
Government Contracting
Overall, we received 17% of our revenues in 1999 from U.S. federal government contracts. Typically, a federal contract has an initial term of one year combined with two to five one-year renewal periods, exercisable at the discretion of the federal government. The government is not obligated to exercise its option to renew a federal contract. At the expiration of the term of a federal contract, the contract in its entirety is resubmitted for competitive bids by all interested service providers. The government's failure to renew, or the early termination of, any significant portion of our federal contracts would adversely affect our business and prospects.
Contracts with the federal government and its prime contractors usually contain standard provisions for termination at the convenience of the government or such prime contractors. Upon such a termination, we are generally entitled to recover costs incurred, settlement expenses and profit on work completed prior to termination. Terminations of federal contracts may occur, and such terminations could adversely affect our business and prospects.
Federal contract payments we receive in excess of allowable direct and indirect costs are subject to adjustment and repayment after audit by government auditors. The U.S. government has completed audits on our incurred contract costs through December 31, 1995, and audits are continuing for subsequent periods.
As a U.S. government contractor, we are subject to federal regulations under which our right to receive future awards of new federal contracts, or extensions of existing federal contracts, may be unilaterally suspended or barred if CH2M HILL is convicted of a crime or indicted based on allegations of a violation of specific federal statutes. Suspensions or debarment actions, even if temporary, can result in the loss of valuable contract awards for which we would otherwise be eligible. While suspension and debarment actions may be limited to that division or subsidiary of a company engaged in the improper activity, government agencies have authority to impose debarment and suspension on affiliated entities that were not involved in the improper activity.
Many similar regulations are also applicable to our contracts with state, local and foreign governments.
Our Environmental Activities and Potential Liabilities
A substantial portion of our business has been generated either directly or indirectly as a
result of federal, state, local and foreign laws and programs related to protection of the environment. Our environmental activities are conducted in the context of a rapidly developing and changing statutory and regulatory framework. Such activities are subject to regulation by a number of federal agencies, including the U.S. Environmental Protection Agency ("EPA"), the U.S. Nuclear Regulatory Commission and the U.S. Occupational Safety and Health Administration, as well as similar state, local and foreign regulatory agencies.
Several federal statutes govern our environmental activities. The Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") established the "superfund" program to clean up hazardous waste sites, and provides for penalties and punitive damages for noncompliance with EPA orders. CERCLA may impose strict liability (joint and several as well as individual) on hazardous substance waste owners, operators, disposal arrangers, transporters and disposal facility owners and operators (collectively, "Potentially Responsible Parties" or "PRPs"). Liabilities under CERCLA may include payment of the costs of removal or remedial action, for other necessary response costs, for damages for injury, destruction or loss of natural resources, and for the cost of health effects studies.
Although the liabilities imposed by environmental legislation are generally intended to remedy and prohibit pollution by industrial companies, we could face liability under environmental laws in some circumstances. Increasingly, there are efforts to expand the reach of CERCLA to make environmental contractors responsible for cleanup costs by claiming that environmental contractors are owners or operators of hazardous waste facilities or that they arranged for treatment, transportation, or disposal of hazardous substances. Should we be held responsible under CERCLA for damages caused while performing services or otherwise, CH2M HILL could be forced to bear such liability by itself, if contribution or indemnification is not available from other parties. The Resources Conservation and Recovery Act ("RCRA") governs hazardous waste generation, treatment, transportation, storage, and disposal. RCRA, or similar EPA-approved state programs, govern waste-handling activities involving wastes classified as "hazardous." Substantial fees and penalties may be imposed under RCRA and similar state statutes for any violation.
In addition to civil and criminal liabilities under environmental laws, we could face liabilities to clients and other private parties for property damage, personal injury and other claims. Such claims could arise in a number of ways, including:
. An accidental release of pollutants during our performance of services . The inability of one of our remedial plans to contain or correct an ongoing seepage or release of pollutants . The inadvertent exacerbation by us of an existing contamination problem . Reliance by others on reports or recommendations we prepare that turn out to be incorrect
In the environmental field, personal injury claims may arise in connection with our work while it is being done or long after completion of the project. In addition, claimants may assert that we should be strictly liable for performing environmental remediation services -- that is, liable for damages even though our services may have been performed using reasonable care -- on the grounds that such services involve "abnormally dangerous activities."
Our Contractual Obligations and Potential Liabilities
We operate under a number of different types of contracts with our private and public sector clients, including cost reimbursement contracts, time-and- materials contracts, and fixed price contracts. Fixed price contracts accounted for approximately 30% of our revenues in 1999. Under fixed price contracts, we are paid a predetermined amount for all services provided as determined at the project's inception. Under time-and-materials contracts, we are paid at a specified fixed hourly rate for direct labor hours worked. Under cost reimbursement contracts, our costs are reimbursed, often with a negotiated cost ceiling and also with an incentive fee to provide inducement for effective project management. We
assume the greatest financial risk on fixed price contracts because we assume the risk of performing those contracts at the stipulated prices regardless of actual costs incurred. We also incur some financial risks under time-and- materials contracts because we contract to complete the work at negotiated hourly rates. The failure to accurately estimate ultimate costs or to control costs during performance of the work could result in losses or reduced anticipated profits.
When we perform services for our clients, we can become liable for breach of contract, personal injury, property damage, and negligence. Such claims could include improper or negligent performance or design, failure to meet specifications, and breaches of express or implied warranties. Because our projects are typically large enough to affect the lives of many people, the damages available to a client or third parties are potentially large and could include punitive and consequential damages. For example, our transportation projects and manufacturing facility projects involve services and products that affect not only our client, but also the many end users of those services and products. In addition, our clients often require us to be responsible for liabilities through contractual indemnities. Such provisions typically require us to assume liabilities for damage or personal injury to the client, third parties and their property, and also for fines and penalties.
We seek to protect CH2M HILL from potential liabilities by obtaining indemnification where possible from our private sector clients. Under most of our private sector contracts, we have been successful in obtaining such indemnification, but such indemnification generally is not available if we fail to satisfy specified standards of care in performing our services or if the indemnifying party has insufficient assets to cover the liability.
We also try to obtain available indemnities from our public sector clients. For example, some of our clients, including some U.S. government agencies, are Potentially Responsible Parties under CERCLA. Under our contracts with these clients, we usually try to seek contribution from the client for liability imposed on us in connection with our work at these clients' CERCLA sites. In addition, when we perform superfund related work for our U.S. government clients, CERCLA generally permits us to limit our potential liabilities. However, the EPA recently has significantly narrowed the circumstances under which it will indemnify contractors against liabilities incurred in connection with CERCLA projects. There are also proposals both in Congress and at various regulatory agencies to further restrict indemnification of contractors from third-party claims. In connection with services at the Rocky Flats closure project, Kaiser-Hill is indemnified by its U.S. government client against liability claims arising out of contractual activities involving a nuclear incident.
International Operations Pose Risks and Complexities
We routinely conduct operations outside of the United States. Overall, we derived approximately $114 million or 10% of our service revenues in 1999 from such operations. International operations entail additional business risks and complexities such as foreign currency exchange fluctuations, different taxation methods, restrictions on financial and business practices and political instability. Our international clients include both private sector firms and foreign government agencies in more than 20 countries, with significant projects in Egypt, Italy, New Zealand, Singapore, and Spain.
Our Industry Is Highly Competitive
The market for the design, consulting, engineering and construction services that we offer is highly competitive. We compete with many firms, including large multinational firms having substantially greater financial, management, and marketing resources. Some of the competitors are small firms with lower cost structures enabling them to offer lower prices for particular services. We also compete with government agencies, including our own clients, that can utilize their internal resources to perform services that we might otherwise perform.
Most contracts between public sector clients and our EE&I and Industrial operating segments are awarded through a competitive bidding process that places no limit on the number or type of potential service providers. The process usually begins with a government agency request for proposal that
delineates the size and scope of the proposed contract. The government agency evaluates the proposals on the basis of technical merit and cost. For the Water operating segment, most contracts are awarded through qualification selection processes that vary among projects.
In both the private and public sectors, acting either as a prime contractor or as a subcontractor, we may join with other firms that we otherwise compete with to form a team to compete for a single contract. Because a team can often offer stronger combined qualifications than any firm standing alone, these teaming arrangements can be very important to the success of a particular contract competition or proposal. Consequently, we maintain a network of relationships with other companies to form teams that compete for particular contracts and projects.
Conflicts of Interest May Limit Opportunities
Many of our clients and potential clients are concerned about actual or possible conflicts of interest in retaining professional services consultants. Governmental agencies and some private sector clients have contracting policies that may, from time to time, prevent us from seeking or performing contracts for other clients if there is a conflict of interest. We have, on occasion, declined to bid on particular projects because of actual or perceived conflicts of interest, and we are likely to continue encountering such conflicts of interest in the future.
Item 2.
Item 2. Properties ----------
Our corporate headquarters, a 131,000 square foot facility, is located at 6060 South Willow Drive, Greenwood Village, Colorado 80111. We lease all of our significant facilities, including our corporate headquarters and approximately 66 domestic and 33 foreign office locations, under many separate leases. We believe that comparable facilities are available for lease and therefore that the loss of any such leases would not have a material adverse impact on our operations. We believe that our facilities are adequate for the present needs of our business.
Item 3.
Item 3. Legal Proceedings -----------------
CH2M HILL is party to various legal actions arising in the normal course of its business, some of which involve claims of substantial sums. Damages assessed in connection with and the cost of defending any such actions could be substantial. CH2M HILL's management believes that the levels of insurance coverage are generally adequate to cover CH2M HILL's liabilities, if any, with regard to such claims. CH2M HILL generally accrues amounts for retentions and deductibles based on advice from legal counsel when it is probable that a loss will be incurred and such loss is estimable. Gain contingencies or recoveries are rare and are usually recorded when the cash is collected.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders --------------------------------------------------- No items were submitted to a vote of security holders during the fourth quarter of 1999.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Shareholder Matters ---------------------------------------------------------------------
CH2M HILL has a policy of being employee owned. As a result CH2M HILL stock is available to CH2M HILL employees, directors and consultants only. There is no market for CH2M HILL stock with the general public. In order to provide liquidity for its shareholders, however, an internal market (the "Internal Market") will be maintained through a broker, Buck Investment Services, Inc.
The Internal Market permits existing shareholders to offer for sale shares of CH2M HILL common stock on predetermined days, (each, a "Trade Date"). Generally, there will be four Trade Dates each year which typically occur approximately four weeks after the quarterly meeting of CH2M HILL's Board of Directors which are currently scheduled for February, May, August and November. All sales of CH2M HILL common stock are made at the price determined by the Board of Directors pursuant to the valuation process described below.
All sales of common stock on the internal market will be restricted to the following buyers:
. Employees, directors and consultants of CH2M HILL . Employee Benefit Plans: . Trustees of the 401(k) Plan . Trustees of the Employee Stock Plan (ESP) . Trustees of the Deferred Compensation Plans . Administrator of the Payroll Deduction Stock Purchase Plan
All sellers on the Internal Market, other than CH2M HILL and the employee benefit plans, pay Buck Investment Services, Inc. a commission equal to 2% of the proceeds from such sales. No commission is paid by purchasers on the Internal Market.
In the event that the aggregate number of shares offered for sale in the Internal Market on any Trade Date exceeds the number of shares sought to be purchased by buyers, offers by shareholders to sell 500 or less shares of CH2M HILL common stock (or up to the first 500 shares if more than 500 shares of CH2M HILL common stock are offered by any such shareholder) will be accepted first. Offers to sell shares in excess of 500 shares of CH2M HILL common stock will be accepted on a pro-rata basis. If, however, there are insufficient purchase orders to support the primary allocation of 500 shares of CH2M HILL common stock for each interested seller, then the purchase orders will be allocated equally among all of the proposed sellers up to the total number of shares offered for sale.
CH2M HILL may, but is not obligated to, purchase shares of CH2M HILL common stock on the Internal Market, but, only if, and to the extent that the number of shares offered for sale by shareholders exceeds the number of shares sought to be purchased, and CH2M HILL, in its discretion, determines to make such purchases. No assurance can be given that an individual desiring to sell shares of CH2M HILL's common stock will be able to do so.
To the extent that the aggregate number of shares sought to be purchased by buyers exceeds the aggregate number of shares offered for sale by shareholders, CH2M HILL may, but is not obligated to, sell authorized but unissued shares of CH2M HILL common stock in the Internal Market. If the aggregate purchase orders exceed the number available for sale, the following prospective purchasers will have priority, in the order listed:
. Administrator of the Payroll Deduction Stock Purchase Plan . Trustees of the 401(k) Plan . Trustees of the Employee Stock Plan . Individual employees, directors and consultants on a pro-rata basis which includes purchases through the pre-tax and after- tax deferred compensation plans
To the extent that CH2M HILL chooses not to sell authorized but unissued shares of CH2M HILL common stock on the Internal Market, the ability of individuals to purchase shares may be adversely affected. CH2M HILL has imposed significant restrictions on the transfer of our CH2M HILL common stock other than through sales on the Internal Market. No assurance can be given that an individual desiring to buy shares of CH2M HILL common stock in any future trade will be able to do so.
Price of CH2M HILL Common Stock
The Board of Directors will determine the price, which is intended to be the fair market value, of the shares of CH2M HILL common stock that will be in effect on each Trade Date pursuant to a valuation process described below. The price per share of CH2M HILL common stock is determined as follows:
Share Price = [(7.8 x M x P) + (SE)] / CS
In order to determine the fair market value of the stock in the absence of a public trading market, the Board of Directors felt it appropriate to develop a valuation tool to determine a price that would be within a fair market value range. In determining the fair market value stock price, the Board of Directors believes that the use of a formula incorporating a going concern component (i.e., net income, which we call profit after tax) and a book value component (i.e., total shareholders' equity) is important. The Board of Directors believes that the process CH2M HILL has developed reflects modern equity valuation techniques and is based on those factors that are generally used in the valuation of equity securities.
The constant 7.8 is a multiple necessary for the stock price derived by the new formula to approximate our historical estimate of the fair market value of the CH2M HILL common stock as derived by the old formula. The 7.8 constant is the factor required to derive a fair market value stock price using an "M" factor of 1.0 at the beginning of the internal market.
"M" is the market factor, which is subjectively determined in the sole discretion of the Board of Directors. In determining the market factor, the Board of Directors will take into account factors the directors consider to be relevant in determining the fair market value of the CH2M HILL common stock, including:
. the market for publicly traded equity securities of companies comparable to CH2M HILL . the merger and acquisition market for companies comparable to CH2M HILL . the prospects for CH2M HILL's future performance . general economic conditions . general capital market conditions . other factors the Board of Directors deems appropriate
In setting the market factor, the Board of Directors may take into account the company appraisal information obtained by the trustees of the benefit plans. The existence of an over-subscribed or under-subscribed market on any given Trade Date will not affect the stock price on that Trade Date. However, the Board of Directors, when determining the stock price for a future Trade Date, may take into account the fact that there have been under-subscribed or over- subscribed markets on prior Trade Dates.
The Board of Directors has not assigned predetermined weights to the various factors it may consider in determining the market factor. A market factor greater than one would increase the price per share and a market factor less than one would decrease the price per share.
In its discretion, the Board of Directors may change, from time to time, the market factor component of the formula price. The Board of Directors could change the market factor, for example, following a change in general market conditions that either increased or decreased stock market equity values
generally, if the Board of Directors felt that the market change were appropriately applicable to the CH2M HILL common stock as well. The Board of Directors will not make any other change in the method of determining the price per share of CH2M HILL common stock unless in the good faith exercise of its fiduciary duties and, if appropriate, after consultation with its professional advisors, the Board of Directors determines that the method for determining the price per share of CH2M HILL common stock no longer results in a stock price that reasonably reflects the fair market value of CH2M HILL on a per share basis.
"P" is profit after tax, otherwise referred to as net income, for the four fiscal quarters immediately preceeding the Trade Date. Nonrecurring or unusual transactions could be excluded from the calculation at the discretion of the Board of Directors. Nonrecurring or unusual transactions are unforeseen developments that the market would not generally take into account in valuing an equity security. A change in accounting rules, for example, could increase or decrease net income without changing the fair market value of the CH2M HILL common stock. Similarly, such a change could fail to have an immediate impact on the value of the CH2M HILL common stock, but still have an impact on the value of the CH2M HILL common stock over time. As a result, the Board of Directors feels that in order to determine the fair market value of the CH2M HILL common stock, it needs the ability to review unusual events that affect net income.
"SE" is total shareholders' equity, which includes intangible items, set forth on CH2M HILL's most recently available quarterly or annual financial statements. Nonrecurring or unusual transactions could be excluded from the calculation at the discretion of the Board of Directors.
"CS" is the weighted average number of shares of CH2M HILL common stock outstanding during the four fiscal quarters immediately preceeding the Trade Date, calculated on a fully diluted basis. By "fully diluted" we mean that the calculations are made as if all outstanding options to purchase CH2M HILL common stock had been exercised, and the proceeds were used to purchase CH2M HILL common stock during the period, and, as if other "dilutive" securities were converted into shares of CH2M HILL common stock.
Price Range of CH2M HILL Common Stock
Because the CH2M HILL common stock has not been publicly traded, there has not been any historical market-determined price. However, the Board of Directors has periodically determined the price of the CH2M HILL common stock for purposes of incentive awards of CH2M HILL common stock.
The following table sets forth the price per share figures for 1989 through 1999 as established by the Board of Directors pursuant to the old formula for purposes of transactions under the key employee policy and employee benefit plans. There can be no assurance that the CH2M HILL common stock will, in the future, provide returns comparable to historical returns.
Because of the change from the old formula to the new valuation process for determining the price, the historical prices for the CH2M HILL common stock are not directly comparable to the stock prices that will be determined under the new formula. Since the determination of the price includes market analyses that are applied by the Board of Directors at the time of making its determinations, we do not know what the historical prices for the CH2M HILL common stock would have been under the new formula.
Date Price Per Share % Increase (Old Formula) (Decrease) - ------------------------------------------------------- 1989 $2.05 __% - ------------------------------------------------------- 1990 2.25 9.8 - ------------------------------------------------------- 1991 2.52 12.0 - ------------------------------------------------------- 1992 2.77 9.9 - ------------------------------------------------------- 1993 2.99 7.9 - -------------------------------------------------------
- ------------------------------------------------------- 1994 2.95 (1.3) - ------------------------------------------------------- 1995 3.07 4.1 - ------------------------------------------------------- 1996 3.31 7.8 - ------------------------------------------------------- 1997 3.59 8.5 - ------------------------------------------------------- 1998 3.82 6.4 - ------------------------------------------------------- 1999 4.31 12.8 - -------------------------------------------------------
Holders of CH2M HILL Common Stock
As of March 24, 2000, there were 2,729 holders of record of CH2M HILL common stock. As of such date, all of the CH2M HILL common stock was owned of record by current employees and directors of CH2M HILL and by various employee benefit plans of CH2M HILL and its subsidiaries.
Dividend Policy
CH2M HILL has never declared or paid any cash dividends on its capital stock and no cash dividends are contemplated in the foreseeable future. We intend to retain any future earnings to finance the growth and development of our business.
Item 6.
Item 6. Selected Financial Data -----------------------
The following data has been derived from the Consolidated Financial Statements of CH2M HILL, which have been reported on by Arthur Andersen LLP, independent public accountants, for each of the last five years. During the periods presented, CH2M HILL paid no cash dividends on its CH2M HILL common stock. The following information should be read in conjunction with ``Management's Discussion and Analysis of Financial Condition and Results of Operations'' and the Consolidated Financial Statements and related notes thereto, included elsewhere in this Form 10-K.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results ----------------------------------------------------------------------- of Operations - -------------
The following discussion and analysis explains our general financial condition, changes in financial condition and results of operations for CH2M HILL as a whole and each of our operating segments including:
. Factors affecting our business . Our revenues and profits . Where our revenues and profits came from . Why those revenues and profits were different from year to year . Where our cash came from and how it was used . How all of this affects our overall financial condition
The following discussion contains, in addition to historical information, forward-looking statements that involve risks and uncertainties. Our actual results may differ significantly from the results discussed in the forward- looking statements. As you read this section, you should also refer to our consolidated financial statements and the accompanying notes. These consolidated financial statements provide additional information regarding our financial activities and condition. This analysis may be important to you in making decisions about your investments in CH2M HILL.
Introduction
The engineering and construction industry has been undergoing substantial change as public and private clients privatize and outsource many of the services that were formerly provided internally. Numerous mergers and acquisitions in the industry have resulted in a group of larger firms that offer a full complement of single-source services including studies, designs, construction, operations, and in some instances, facility ownership. Included in the current trend is the movement towards longer-term contracts for the expanded array of services, e.g., 5 to 20 year contracts for facility operations. These larger, longer contracts require us to have substantially greater financial capital to remain competitive. We believe we provide our clients with innovative project delivery using cost-effective approaches and advanced technologies. We continuously monitor acquisition and investment opportunities that will expand our portfolio of services, add value to the projects undertaken for clients, or enhance capital strength. We believe that we are well positioned geographically, technically and financially to compete worldwide in the markets we have elected to pursue and clients we serve.
Results of Operations for the Year Ended December 31, 1999 Compared to 1998
Revenues for the year ended December 31, 1999 were $1,184.5 million compared to $935.0 million for the same period in 1998. The increase of $249.5 million or 26.7% is comprised of growth in the Environmental, Energy & Infrastructure (``EE&I'') segment of $111.4 million, the Water segment of $75.2 million, and the Industrial segment of $62.9 million.
Pre-tax profit for the year ended December 31, 1999 was $26.8 million compared to $14.4 million in the same period of 1998. The increase of $12.4 million was comprised of increases in the EE&I segment of $8.1 million and the Water segment of $9.1 million, offset by a decline in the Industrial segment of $3.6 million. Corporate expenses increased by $1.2 million.
Environmental, Energy and Infrastructure
Revenues in the EE&I segment for the year ended December 31, 1999 were $497.5 million compared to $386.1 million for the same period in 1998. This increase of $111.4 million was primarily attributable to growth of $26.2 million in the telecommunications markets, $30.3 million in the construction services market, and $22.0 million in the transportation markets. The growth in the telecommunications markets has occurred domestically and internationally. Clients are building new infrastructure or upgrading existing infrastructure to keep pace with the advancements in information technology. The growth in revenues from construction services is indicative of our commitment to diversify our business. Construction services revenues generated in the year ended December 31, 1999 were primarily from remedial action contracts with the U.S. Navy. The increase in the transportation markets is primarily the result of the Transportation Equity Act for the 21st Century (TEA-21) which was adopted by Congress in 1998. TEA-21 provides federal funding to the various states for transportation infrastructure improvement projects for highways, highway safety, and transit for the six-year period from 1998 to 2003.
Pre-tax profit for the EE&I segment was $17.4 million for the year ended December 31, 1999 compared to $9.3 million in the same period of 1998. Profit as a percent of revenue in 1999 was 3.5% compared to 2.4% in 1998. The increase in pre-tax profit of $8.1 million was primarily generated by increased project margins of $6.4 million from the telecommunications markets offset by an increase in indirect costs of $2.8 million. The remaining increase of $4.5 million was achieved in the construction services and transportation markets due to the increase in volume of contracts.
Water The Water segment reported revenues of $438.0 million for the year ended December 31, 1999 compared to revenues of $362.8 million in the same period of 1998. The increase of $75.2 million was attributable to significant growth in several market areas. In general, $37.7 million of the increase in the Water segment revenue resulted from prior traditional engineering consulting development efforts, as well as new business obtained from our existing clients due to the strong domestic economy. Revenues from design/build projects increased by $24.8 million, as a result of our ongoing efforts to provide a full array of services to our customers. Revenues from operations and maintenance services increased by $12.7 million due to the addition of new infrastructure support contracts, primarily with municipalities.
The Water segment reported $16.3 million of pre-tax profit for the year ended December 31, 1999 compared to $7.2 million of pre-tax profit for the same period of 1998. Profit as a percent of revenue for 1999 was 3.7% compared to 2.0% for 1998. The increase of $9.1 million in profit is attributable to the strong revenue growth within all of our Water businesses discussed earlier. In addition, spending increased due to continued investment in design/build infrastructure and development, and focused investment in strategic business development opportunities throughout the world.
Industrial
The Industrial segment reported revenues of $249.0 million for the year ended December 31, 1999, of which $164.4 million was generated from the microelectronics industry. The revenues for 1998 were $186.1 million, of which $129.0 million was generated from the microelectronics industry. The increase of $62.9 million was comprised of $35.4 million increase in revenues from the microelectronics industry and an increase in revenues of $27.5 million from other industries, including food, biopharmaceutical, fine chemical and facility services.
The mix of the revenues between construction costs versus services for engineering and construction management also changed significantly from 1999 versus 1998. The construction cost component of revenues increased from $46.8 million, which was 25.1% of 1998 revenues, to $153.4 million, which was 61.6% of 1999 revenues. The construction revenue increase was due to two large construction projects that were started in first quarter 1999. This increase in construction revenues of $106.6 million offset the decrease in service revenues, which declined from $139.3 million in 1998, to $95.6
million in 1999. This service revenue decrease of $43.7 million was due to the significant decline in non-construction related services provided to microelectronics businesses.
The Industrial segment reported no pre-tax profit for the year ended December 31, 1999 versus $3.6 million for 1998. Profit as a percent of revenues for 1998 was 1.9%. The most significant factor causing this profit decline was the decrease in volume of services sold during 1999 and decline in project margins. These were results of the significant decline in services provided to the microelectronics industry and an increase in low-margin construction projects.
1998 Results of Operations Compared to 1997
Revenues for 1998 were $935.0 million compared to $917.6 million in 1997. The increase of $17.4 million or 1.9% is comprised of significant improvements in the EE&I segment of $25.9 million and the Water segment of $52.9 million. These gains were reduced by the decrease of $61.4 million in the Industrial segment revenues.
Pre-tax profit for 1998 was $14.4 million compared to $12.0 million in 1997. The increase of $2.4 million or 20.0% was primarily due to volume increases in the EE&I and Water segments as well as a reduction in corporate expenses. Contracts in the EE&I and Water segments generally have a lower margin than the contracts in the Industrial segment, but increases in the volume of contracts offset any decline generated by the Industrial segment.
Bad debt expense was $57,000 in 1996, $1.4 million in 1997, and $5.2 million in 1998, which also impacts pre-tax profit. The increases in 1997 and 1998 relate to specific projects in the EE&I and Water segments that needed to be reserved for due to the uncertainty of collection. At December 31, 1997, the outstanding receivables related to these projects were $2.2 million of unbilled and $1.2 million of billed. No amounts were outstanding at December 31, 1998. The entire outstanding receivable balances were reserved for as the projects were halted due to poor economic conditions in Latin America. Currently, future collection of these receivables is not probable.
The loss on the sale of assets in 1998 of $1.7 million also negatively impacted pre-tax profit. This loss related to assets that were sold in closing two of our offices.
Environmental, Energy and Infrastructure
Revenues in the EE&I segment increased $25.9 million or 7.2% to $386.1 million in 1998, compared to $360.2 million in 1997. EE&I revenues accounted for 39.0% of our total operating revenues in 1997 and 41.0% in 1998. During 1998 we benefited from the business development efforts undertaken in 1997. We reported a full year of revenues in 1998 for public sector hazardous waste remediation contracts awarded in 1997 by the U.S. Department of Defense and the U.S. Department of Energy. Revenue growth from the U.S. Department of Defense was strong in part due to legislation requiring military base closure and remediation. The initial assessment phases are complete and the environmental remediation and clean-up phases have begun.
The telecommunications markets, both domestically and internationally, also attributed to the increase in revenues in 1998. We obtained several major clients in this market providing program management oversight, site development and construction management services to install or upgrade cable and wireless networks and related infrastructure. With the technological advances in wireless telecommunications, the ability to communicate rapidly via voice, data, and video have become a necessity for business enterprises and individuals around the world. We believe this market will provide continued revenue growth in future years.
Although the private sector of the environmental and infrastructure market slowed in 1997, we realized some recovery from this sector in 1998. We attribute this growth to the strong domestic economy,
which is affording larger, multinational corporations the opportunity to improve their environmental performance and sustainability.
The transportation market also contributed to the increase in revenues in 1998. We have benefited from the growth generated by the Intermodal Surface Transportation Efficiency Act (ISTEA) adopted by Congress in 1991, which caused significant increases in federal funding to the states for transportation projects. We believe that we are also well positioned in the market to benefit from the TEA-21 legislation.
The EE&I segment reported higher pre-tax profit in 1998, increasing from $5.8 million in 1997 to $9.3 million in 1998, an increase of 60.3%. Profit as a percent of revenues was 2.4% in 1998 compared to 1.7% in 1997. The growth in the telecommunications markets contributed $2.8 million in profit while the remaining net increase of $0.7 million was attained by successful cost containment efforts. The demand for services is high in the telecommunications market, which can return higher gross margins than the public and private sector environmental and infrastructure contracts.
During 1998, cost containment measures enacted in prior years reduced overhead costs as administrative functions have been consolidated to enable us to manage our resources more effectively.
Water
Water segment revenues were $362.8 million in 1998 versus $309.9 million in 1997, an increase of $52.9 million or 17.1%. Approximately 30% of the increase came from new contracts, with terms up to 15 years, in the utility plant operations market for public and private clients. The balance of the increase came from contract activities in water and wastewater infrastructure improvement projects undertaken by municipalities and other utility authorities across the United States and abroad. The desire by municipalities to preserve the environment and provide clean water creates a demand for services we offer.
Profitability in the Water segment increased from $5.0 million in 1997 to $7.2 million in 1998, an increase of 44.0%. Profit as a percent of revenues was 2.0% in 1998 compared to 1.6% in 1997. Profitability continues to improve as we continue to win significant new contracts as reflected by the increase in revenues mentioned above. Additionally, the Water segment reported an increase of $1.0 million in profit due to lower business development expenditures. From year to year, we achieved increasing margins by focusing on improvements in project delivery and effective cost management, even though competition in this industry is increasing as a result of rapid consolidation. We believe that our future success in the Water segment is dependent on continuing improvements in our project delivery performance and our ability to win significant new contracts.
Industrial
The Industrial segment's revenues for 1998 were $186.1 million, of which $141.4 million or 76.0% was generated from the microelectronics industry. The Industrial segment's revenues for 1997 were $247.5 million, of which $222.8 million or 90.0% was generated from the microelectronics industry. Total revenues from the industrial segment declined $61.4 million from 1997 to 1998 due to declines in the microelectronics industry offset by an increase in revenues from other industries including food, biopharmaceutical, fine chemical, and facility services. The microelectronics industry began to reduce capital spending in 1997 which has continued into 1999, resulting in a sharp decline in purchases of engineering and construction services by our microelectronics clients. In order to reduce its dependence on the microelectronics industry, the industrial segment has reallocated some of its workforce to focus on diversifying into other industries mentioned above.
Pre-tax profit in the industrial segment was $3.6 million in 1998 versus $7.2 million in 1997. Profit, as a percent of revenues was 1.9% in 1998 compared to 2.9% in 1997. The decrease in the total volume of services sold during 1998 to the microelectronics industry caused this profit decline. In addition to the impact of reduced volume, direct project costs as well as overhead expenses affected profitability. Direct project costs, as a percentage of revenues, decreased 2.0% in 1998 versus 1997, slightly improving gross margins. Indirect labor costs, included in overhead expenses, as a percentage of gross revenues, increased 4.0% from 1997 to 1998 because of the significant decline in revenue during 1998.
Joint Ventures
We routinely enter into joint venture arrangements in order to service the needs of our clients. Such arrangements are customary in the engineering and construction industry and generally are established to manage a specific project. Our largest joint venture is Kaiser-Hill Company, LLC (``Kaiser- Hill''), a joint venture in which we own a 50% interest. This joint venture is attributable to our EE&I operating segment. The earnings from this joint venture are reported as equity in earnings of investees accounted for under the equity method, along with other joint ventures that are individually insignificant.
For the year ended December 31, 1999, we reported equity in earnings of investees accounted for under the equity method of $12.4 million compared to $8.4 million in 1998 and $8.7 million in 1997. The earnings from the Kaiser-Hill joint venture for the same period of 1999 were $6.4 million compared to $7.8 million for 1998. Under the Performance Based Management contract, as discussed below, fees are earned based upon specific negotiated performance incentives which are heavily weighted to the U.S. Government's fiscal year end of September 30. Due to the timing of specific work scopes and the completion of these activities, earnings may not be comparable from period to period.
Equity in earnings of investees accounted for by the equity method generated $12.4 million of revenues in 1999 which represents 47.6% of operating income and 91.0% of net income. For 1998, the $8.4 million of revenues represents 56.7% of operating income and 144.53% of net income. Although Kaiser-Hill achieved the negotiated performance measures for 1999 in the performance based contract, the revenues from the contract for 1999 were expected to be lower than in 1998 due to the fee structure in this contract. This was due to the types of tasks required to be performed in 1999 to decommission the site and the corresponding fee levels negotiated based on the difficulty and risks of those tasks. No one specific task was material to the fee structure in this contract year over year. The original contract was set to expire on June 30, 2000. This contract was a Performance Based Management Contract, which means that the fees on the contract were dependent on Kaiser-Hill's performance measured against safety, budget, and schedule.
Effective February 1, 2000, the U.S. Department of Energy extended Kaiser-Hill's Rocky Flats contract. Although the new contract is a closure contract and does not have a defined term, we anticipate that closure of the site would be in 2006. Under the new contract, Kaiser-Hill is compensated through a base fee affected, up or down, by its performance against the agreed site target closure costs. Outside of a negotiated range, for every dollar that the U.S. Department of Energy saves with earlier clean-up, Kaiser-Hill receives a 30 cent increase in fee. At the same time, for every dollar the clean-up is over budget, the fee is reduced by 30 cents up to an agreed minimum. The ultimate fee will also be impacted by the project schedule and safety of our performance to achieve the site closure.
Corporate Expenses
Corporate expenses for the year ended December 31, 1999 were $6.9 million compared to $5.7 million in 1998 and $6.0 million in 1997. The increase of $1.2 million in 1999 is primarily related to the registration of our stock with the Securities and Exchange Commission. Corporate expenses
represent centralized management costs that are not allocable to individual operating segments and primarily include expenses associated with administrative compliance functions such as legal, treasury, accounting, tax, and general business development efforts. The fluctuations from year to year are generally dependent on the business development efforts undertaken as other administrative costs historically remained constant.
Income Taxes
The income tax provision for the year ended December 31, 1999 was $13.1 million, or an effective tax rate of 49.1%, compared to $8.6 million, or an effective tax rate of 59.6%, for 1998. The decrease in the effective tax rate in 1999 is primarily due to the reduction of non-deductible foreign net operating losses as we have been able to improve the financial performance of our international operations. The effective tax rate in 1998 was substantially the same as 1997. Our effective tax rate continues to be higher than the U.S. statutory income tax rate of 35.0% due to disallowed portions of meals and entertainment expenses and non-deductible foreign net operating losses. Our income tax provisions for the last several years were as follows:
- ----------------------------------------------------------------------- Date Income Tax Provision Effective Tax Rate - ----------------------------------------------------------------------- 1999 $13,144 49.1% - ----------------------------------------------------------------------- 1998 $ 8,571 59.6% - ----------------------------------------------------------------------- 1997 $ 7,295 60.7% - -----------------------------------------------------------------------
Liquidity and Capital Resources Cash Flows from Operating Activities
For the year ended December 31, 1999, operations provided $29.6 million of cash and used $4.4 million of cash in 1998. During 1999, our receivables, payables and billings in excess of revenues increased due to growth and due to the pass- through of revenues and expenses related to new, large construction projects. Other current liabilities decreased primarily due to the payment of accrued incentive compensation and the settlement of accrued liabilities. Operations generated $38.9 million of cash flows in 1997. The decrease of $43.3 million from 1997 to 1998 was attributable to the following working capital changes:
. revenue growth provided a corresponding increase in accounts receivable . prepaids increased as we contributed cash to our largest pension plan to maintain its funded status . billings in excess of revenues decreased due to a reduction in advance payments on contracts formerly realized in the Industrial operating segment
Cash Flows from Investing Activities
Our business does not require significant capital expenditures. The capital expenditures are generally for purchases of office equipment and leasehold improvements. We spent $4.7 million in 1999, $4.7 million in 1998, and $2.6 million in 1997 on such expenditures. We have now established a formal operating lease program under which most of our computing and related equipment is procured on an ongoing basis. The increase in capital expenditures from 1997 to 1998 reflects leasehold improvements for large regional office moves for which the leases had expired.
In 1999, we made three acquisitions, one of which was significant. We purchased the CH2M HILL common stock of Lockheed Martin Hanford Corporation ("Hanford") for $17.1 million. Hanford is an environmental management contractor that provides tank waste remediation services to the U.S. Department of Energy. The acquisition resulted in $16.9 million in goodwill that will be amortized over the anticipated life of the contract of seven years.
Cash Flows from Financing Activities
During 1999, we borrowed an average of $0.6 million at a weighted average interest rate of 5.9% against our line of credit to fund operations. At December 31, 1999, no amounts were outstanding. In
June 1999, we entered into a new credit facility for a $100.0 million revolving line of credit maturing June 2002, which may be extended for an additional one- year period, and the maximum amount of credit available may be increased by $25.0 million, under certain conditions. The facility may be used for general corporate purposes and permitted acquisitions. At the option of CH2M HILL, the facility bears interest at a rate equal to either the London Inter-Bank Offering Rate for interest periods of 1, 2, 3 or 6 months, plus applicable margins ranging from 1.0% to 2.0%, the lender's prime rate, or the sum of 0.5% plus the federal fund rate, if greater than the lender's prime rate. Borrowings under the credit agreement are available on a revolving basis through the final maturity date. The credit facility is guaranteed by each direct and indirect wholly-owned subsidiary of CH2M HILL whose gross revenues account for greater than 5% of the consolidated annual revenues of CH2M HILL. The credit agreement contains usual and customary representations and warranties, and affirmative and negative covenants and financial covenants for credit facilities of like size, type and purpose. CH2M HILL is in compliance with such covenants.
At December 31, 1999, under our unsecured loan agreement, we had an outstanding term loan for $2.0 million, which will be paid in full during 2000. The interest rate on the loan is 7.1% and payments are made quarterly. We also had $18.8 million in 1999, $20.6 million in 1998, and $22.5 million in 1997, in notes payable to over 300 former shareholders in varying amounts over the next ten years.
CH2M HILL believes its current sources of funds will be sufficient to satisfy its current operations and anticipated growth through 2000.
Derivatives and Financial Instruments
We occasionally enter into forward contracts to hedge foreign currency risks and not for speculative purposes. At December 31, 1999 and 1998, there were no significant forward contracts outstanding. Generally, we do not have derivative type instruments.
Year 2000 Compliance
The turn of the century posed many challenges to companies worldwide that rely on computers and/or programmed control devices to operate their businesses or are suppliers or providers of time-sensitive software or automated technology devices. The problem stemmed from the practice of software writers, software vendors and equipment suppliers of using only two digits to designate calendar year (e.g. 98 versus 1998) in automated applications. That practice did not provide for proper recognition of the Year 2000 because computers and other automated equipment may interpret the two-digit date "00" as, for example, 1900, rather than 2000. Consequently, computers and other automated systems may have ceased operation or operated incorrectly. This effect is commonly referred to as the "Year 2000 problem."
The Company estimated the Year 2000 remediation efforts were approximately $4.0 million. The actual cost did not materially differ from those estimates. The Company does not plan on spending any additional amounts on the Year 2000 problem, as there are no remaining contingencies.
The turn of the century had no significant impact on the Company. In addition, the impact on the Company related to third parties was also insignificant.
New Accounting Standards Not Yet Adopted
SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," establishes fair value accounting and reporting standards for derivative instruments and hedging activities. CH2M HILL will adopt SFAS No. 133 in the first quarter of fiscal 2001. CH2M HILL is currently assessing the effect of adoption, if any, on its financial position, results of operations, and cash flows.
Special Note Regarding Forward-Looking Statements
This report contains forward-looking statements that involve risks and uncertainties. Our actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to:
. the continuance of and funding for certain governmental regulation and enforcement programs which create demand for our services . our ability to attract, finance and perform large, longer-term projects . our ability to insure against or otherwise cover the liability risks inherent in our business, including environmental liabilities and professional engineering liabilities
. our ability to manage the risks inherent in the government contracting business . our ability to manage the costs associated with our fixed-price contracts . our ability to attract and retain professional personnel . general economic conditions
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk ---------------------------------------------------------- Market risk is the risk of loss from adverse changes in market prices and interest rates. We manage our market risk by matching projected cash inflows from operations, financing activities and investing activities with projected cash outflows to fund debt payments, capital expenditures and other cash requirements. We may utilize debt or equity financing for general corporate purposes and acquisitions. Historically, we have used short-term variable rate borrowings under our unsecured revolving credit agreement although we do have $2.0 million currently outstanding on a term note to be repaid by June 30, 2000. Our earnings and cash flows are affected by changes in interest rates affecting our variable rate borrowings under our bank credit facility. However, at December 31, 1999, there were no amounts outstanding on the bank credit facility. The interest rates on CH2M HILL's short-term and long-term borrowings approximate fair value.
Item 8.
Item 8. Financial Statements and Supplementary Data ------------------------------------------- Reference is made to the information set forth on pages through.
Item 9.
Item 9. Changes in and Disagreements With Accountants on Accounting and --------------------------------------------------------------- Financial Disclosure -------------------- None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant --------------------------------------------------
Directors - --------- See the information set forth in the section of the Proxy Statement entitled "Election of Directors," which is incorporated herein by reference.
Executive Officers - ------------------ See the information set forth in the section of the Proxy Statement entitled "Executive Officers" which is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation ---------------------- See the information set forth in the sections of the Proxy Statement entitled "Executive Compensation," which is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management -------------------------------------------------------------- See the information set forth under "Security Ownership of Certain Shareholders and Management" in the Proxy Statement which is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions ---------------------------------------------- See the information set forth in the section of the Proxy Statement entitled "Certain Relationships and Related Transactions," which is incorporated herein by reference.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K ----------------------------------------------------------------
(a) Documents Filed as Part of this Report 1. Financial Statements
Report of Independent Public Accountants - Arthur Andersen LLP...... Consolidated Balance Sheets at December 31, 1998 and 1999........... Consolidated Statements of Income for the Years Ended December 31, 1997, 1998 and 1999.............................................. Consolidated Statements of Temporary Shareholders' Equity for the Years Ended December 31, 1997, 1998 and 1999............. Consolidated Statements of Cash Flows for the Years Ended December 31, 1997, 1998 and 1999................................. Notes to Consolidated Financial Statements..........................
2. Financial Statement Schedules
All financial statement schedules have been omitted because the required information is included in the consolidated financial statements or notes thereto, or because such schedules are not applicable.
3. Exhibits
The following exhibits are filed as part of this annual report:
Exhibit Number Description ------ ----------- 2.1 Stock Purchase Agreement, dated as of November 29, 1999, by and between CH2M Hill Companies, Ltd. and Lockheed Martin Corporation [certain portions of the Stock Purchase Agreement have been omitted pursuant to a request for condifidential treatment filed seperately with the Securities and Exchange Commission] filed as Exhibit 2.1 on Form 8-K, on January 5, 2000 (File No. 000-27261)
*3.1 Restated Articles of Incorporation of CH2M HILL Companies, Ltd.
*3.2 Restated Bylaws of CH2M HILL Companies, Ltd.
*10.1 CH2M HILL Retirement and Tax-Deferred Savings Plan, as amended and restated effective January 1, 2000
*10.2 CH2M HILL Employee Stock Plan, as amended and restated effective January 1, 2000
*10.3 CH2M HILL Companies, Ltd. 1999 Stock Option Plan, as amended and restated on November 12, 1999
*10.4 CH2M HILL Companies, Ltd. Payroll Deduction Stock Purchase Plan
*10.5 CH2M HILL Companies, Ltd. Pre-Tax Deferred Compensation Plan
10.6 Trust Under CH2M HILL Companies, Ltd. Pre-Tax Deferred Compensation Plan, filed as Exhibit 10.6 to Registration Statement on Form S-1 on March 15, 1999 (File No. 333-74427)
*10.7 CH2M HILL Companies, Ltd. After-Tax Deferred Compensation Plan
10.8 Trust Under CH2M HILL Companies, Ltd. After-Tax Deferred Compensation Plan, filed as Exhibit 10.8 to Registration Statement on Form S-1 on March 15, 1999 (File No. 333-74427)
10.9 Contract with Buck Investment Services, Inc., filed as Exhibit 10.9 to Registration Statement on Form S-1, Amendment No. 1, on May 14, 1999 (File No. 333-74427)
10.10 Contract (#DE-AC3495RF00825) between Kaiser-Hill Company, LLC, a subsidiary of the Corporation, and the U.S. Department of Energy dated as of April 4, 1995, along with Modifications 1 to 81 to Contract #DE-AC3495RF00825 (Modifications 41, 72 and 78 not received), incorporated by reference from ICF Kaiser International Inc.'s (i) Form 10-K for the fiscal year ended February 28, 1995 filed on March 29, 1996 (File No. 1-12248); (ii) Registration Statement on Form S-1 filed on November 27, 1996 (SEC file no. 333-16937); (iii) Form 10-K for the fiscal year ended December 31, 1996 filed on March 31, 1998 (File No. 1- 12248).
*10.11 Contract between Kaiser-Hill Company, LLC, a subsidiary of the Corporation, and the U.S. Department of Energy dated January 24, 2000
10.12 $100,000,000 Senior Unsecured Revolving Credit Agreement dated as of June 18, 1999, Wells Fargo Bank, National Association, as Agent, filed as Exhibit 10.11 to Registration Statement on Form S-1, Amendment No. 2, on July 8, 1999 (File No. 333-74427)
*10.13 Deferred Compensation Retirement Program Arrangement effective December 1, 1995
*10.14 Executive Deferred Compensation Program Arrangement effective January 1, 1997
*21 Subsidiaries of CH2M HILL Companies, Ltd.
*27 Financial Data Schedule
99.1 Internal Market Rules, filed as Exhibit 99 to Registration Statement on Form S-1 on March 15, 1999 (File No. 333-74427)
*99.2 Opinion of KPMG LLP
__________
* Filed herewith
(b) Reports on Form 8-K:
None.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To CH2M HILL Companies, Ltd.:
We have audited the accompanying consolidated balance sheets of CH2M HILL Companies, Ltd. (an Oregon corporation) and subsidiaries as of December 31, 1998 and 1999 and the related consolidated statements of income, temporary shareholders' equity and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of CH2M HILL's management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the financial statements of CH2M HILL Industrial Design Corporation, which statements reflect total assets and total revenues of 17 percent and 27 percent in 1997, 8 percent and 20 percent in 1998, and 21 percent and 21 percent in 1999, respectively, of the related consolidated totals. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for this entity, is based solely on the report of the other auditors.
We conducted our audits in accordance with auditing standards generally accepted in the 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for our opinion.
In our opinion, based on our audits and the report of other auditors, the financial statements referred to above present fairly, in all material respects, the financial position of CH2M HILL Companies, Ltd. and subsidiaries as of December 31, 1998 and 1999, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States.
ARTHUR ANDERSEN LLP
Denver, Colorado, February 18, 2000.
CH2M HILL COMPANIES, LTD.
Consolidated Balance Sheets (Dollars in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
CH2M HILL COMPANIES, LTD.
Consolidated Statements of Income (Dollars in thousands except per share)
CH2M HILL COMPANIES, LTD. Consolidated Statements of Temporary Shareholders' Equity (Dollars in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
CH2M HILL COMPANIES, LTD.
Consolidated Statements of Cash Flows (Dollars in thousands)
CH2M HILL COMPANIES, LTD.
Notes to Consolidated Financial Statements (Dollars in thousands)
(1) Summary of business and significant accounting policies
CH2M HILL Companies, Ltd. and its wholly owned subsidiaries are a multinational infrastructure and environmental services firm. CH2M HILL's predominant line of business is providing engineering and construction management services related to water, environmental, transportation, infrastructure and management services. CH2M HILL also provides facility design and construction management services to the electronics, food processing and biopharmaceutical related industries and provides utility system operations and maintenance services primarily for water and wastewater treatment facilities.
CH2M HILL provides the above services for clients in private industry, federal government agencies, as well as state, municipal and local government entities. A substantial portion of professional fees arises from projects that are funded directly or indirectly by governmental entities.
Unaudited Pro Forma Information
On November 6, 1998, the Board of Directors approved a new ownership program for CH2M HILL and certain resolutions that were subsequently ratified by a vote of the shareholders on December 18, 1998. Such resolutions included, but were not limited to, adopting amendments to the Restated Bylaws and Articles of Incorporation which provide for the:
. termination of the existing Key Employee Policy and Agreement, . authorization to convert all outstanding Class A preferred stock into shares of common stock on a one-for-one basis, . increase in the authorized shares of common stock to 100,000,000, par value $.01 per share, and Class A preferred stock to 50,000,000, par value $.02 per share, . authorization of a ten-for-one stock split on CH2M HILL's common stock and Class A preferred stock, . imposition of certain restrictions on the stock including, but not limited to, the right but not the obligation to repurchase shares upon termination of employment or affiliation, the right of first refusal, and ownership limits, and, . approval of the 1999 Stock Option Plan.
The effective date of the above resolutions is January 1, 2000 as determined by the Board of Directors at its November 1999 meeting.
Common and preferred stock amounts, equivalent share amounts and per share amounts have been adjusted retroactively to give effect to the stock split. The conversion of outstanding Class A preferred stock to common stock has been reflected in the unaudited pro forma balance sheet at December 31, 1999.
Principles of Consolidation
The consolidated financial statements include the accounts of CH2M HILL and all of its wholly owned subsidiaries after elimination of all intercompany accounts and transactions. Investments in affiliates which are 50 percent or less owned are reported using the equity method. Certain amounts in prior years have been reclassified to conform with the current year presentation.
Currency Translation
All assets and liabilities of CH2M HILL's foreign subsidiaries are translated into U.S. dollars at the period-end exchange rate. Revenues and expenses are translated at the average exchange rate for the year. Translation gains and losses are reflected in shareholders' equity as part of accumulated other comprehensive loss. Taxes are not provided on the translation gains and losses as deferred taxes are not provided on the unremitted earnings of the foreign subsidiaries to which they relate. Gains and losses on foreign currency transactions are not significant.
Accounting for Revenue
Contract revenue is recognized primarily on a percentage-of-completion basis by relating the actual cost of work performed to date to the current estimated total cost of the respective contracts. Unbilled revenue represents the excess of contract revenue recognized over billings to date. Billings in excess of revenues represent the excess of billings to date over revenue recognized. Losses on contracts in process are recognized in their entirety when the loss becomes evident and the amount of loss can be reasonably estimated.
The federal government accounted for 15.8% and 17.2% of our net receivables in 1998 and 1999, respectively. Receivables are stated at net realizable values, reflecting reserves of $2,977, $6,166 and $7,805 in 1997, 1998 and 1999, respectively. The changes in the allowance for uncollectible accounts consisted of the following:
1997 1998 1999 ---------- ---------- ----------- Balance at beginning of year $1,536 $2,977 $ 6,166 Provision charged to expense 1,441 3,189 2,907 Accounts written off - - (1,268) ---------- ---------- ----------- Balance at end of year $2,977 $6,166 $ 7,805 ========== ========== ===========
Cash and Cash Equivalents
CH2M HILL maintains a cash management system which provides for cash in the bank sufficient to pay checks as they are submitted for payment and invests cash in excess of this amount in interest bearing short-term investments such as certificates of deposit, commercial paper and repurchase agreements. These investments are principally invested with original short-term maturities of less than three months and are considered cash equivalents in the consolidated balance sheets and statements of cash flows.
1997 1998 1999 ---------- ---------- ----------- Cash paid for interest $ 2,431 $ 1,777 $1,217 Cash paid for income taxes $11,869 $16,352 $5,775
The following noncash transactions have been excluded from the accompanying statements of cash flows:
. Stock purchases for debt of $4,204, $3,103 and $3,211 in 1997, 1998 and 1999, respectively . Decrease of an additional minimum pension liability and related asset at December 31, 1997, 1998 and 1999, of $2,122, $198 and $125, respectively.
Property, Plant and Equipment
All additions, including betterments to existing facilities, are recorded at cost. Maintenance and repairs are charged to expense as incurred. When assets are retired or otherwise disposed of,
the cost of the assets and the related accumulated depreciation are removed from the accounts. Any gain or loss on retirements is reflected in income in the year of disposition.
Depreciation for owned property is based on the estimated useful lives of the assets using both straight-line and accelerated methods for financial statement purposes. Useful lives for buildings and land improvements range from 15 to 30 years with an average life of 25 years. Leasehold improvements are depreciated over the remaining term of the associated lease. Useful lives on other assets range from two to ten years with an average of approximately five years.
Goodwill
Goodwill is based on the excess of cost (purchase price) over the fair value of net assets of businesses acquired. At December 31, 1999, $16,862 of goodwill related to the acquisition of Lockheed Martin Hanford Corporation. This goodwill is being amortized on a straight-line basis over the total estimated life of the contract, including options, of seven years. At December 31, 1998 and 1999, accumulated amortization related to goodwill was $590 and $742, respectively.
Other Assets
Other Assets includes capitalized software costs, investments in unconsolidated joint ventures, and prepaid pension expenses. The related amortization reflected in the statements of income and the statements of cash flows totaled $2,145 in 1997, $2,188 in 1998 and $1,973 in 1999.
Fair Value of Financial Instruments
The carrying amounts of cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities approximate fair value due to the short-term maturities of these assets and liabilities. The interest rates on CH2M HILL's bank borrowings are adjusted regularly to reflect current market rates. Accordingly, the carrying amount of CH2M HILL's short-term and long-term borrowings also approximate fair value. At December 31, 1998 and 1999, the fair value of CH2M HILL's notes payable to former shareholders was $19,237 and $16,613, respectively, based on a discount rate that is estimated using the rates currently offered for debt with similar remaining maturities.
Pervasiveness of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles 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 reporting period. Actual results could differ from those estimates.
Asset Impairment
CH2M HILL reviews its assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Assets which are held and used in operations would be impaired if the undiscounted future cash flows related to the asset did not exceed the net book value.
Stock-Based Compensation Plans
The Financial Accounting Standards Board has issued SFAS No. 123, "Accounting for Stock-Based Compensation." SFAS No. 123 requires that stock- based compensation plans be accounted for based on the fair value based method of accounting. CH2M HILL continues to measure compensation cost using the intrinsic value based method of accounting prescribed by Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," as permitted by SFAS No. 123 and discloses the difference between the two methods in Note 11. CH2M HILL accounts for
its stock-based employee compensation agreements using the intrinsic value method under which no compensation is generally recognized for equity instruments granted to employees with an exercise price equal to or greater than the fair market value of the underlying stock.
New Accounting Standards
SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," establishes fair value accounting and reporting standards for derivative instruments and hedging activities. CH2M HILL will adopt SFAS No. 133 in the first quarter of fiscal 2001. CH2M HILL is currently assessing the effect of adoption, if any, on its financial position, results of operations, and cash flows.
(2) Segment information
CH2M HILL operates in three reportable segments that offer different services to different customer bases. They are managed separately because each business requires different business and marketing strategies. Environmental, Energy, and Infrastructure (EE&I) includes management, consulting, design, construction, procurement, and operations and maintenance services to the environmental, nuclear, energy, systems, and transportation industries. Water focuses on the planning, design and implementation of water supply systems and wastewater treatment facilities as well as providing operations and maintenance services to water and wastewater facility operators. Industrial provides design, construction, specialized manufacturing support and sustained facility services support to high-technology manufacturing companies, food and beverage processing businesses, and fine chemical and pharmaceutical manufacturers.
CH2M HILL evaluates performance based on several factors, of which the primary financial measure is profit before tax. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. Intersegment sales are accounted for at fair value as if the sales were to third parties. Other includes the elimination of intersegment sales and unallocable corporate expenses.
Certain financial information for each segment is provided below:
CH2M HILL derived approximately 15% in 1997, 16% in 1998 and 17% in 1999, of its total revenues from contracts with federal government agencies.
Revenues are attributed to the country in which the services are performed. Although CH2M HILL provides services in numerous countries, no single country outside of the United States accounted for a significant portion of the total consolidated revenues.
1997 1998 1999 -------------- -------------- ---------------- United States $803,844 $877,794 $1,072,015 International 113,734 57,236 112,513 -------------- -------------- ---------------- Total $917,578 $935,030 $1,184,528 ============== ============== ================
(3) Lines of credit
CH2M HILL has an unsecured revolving credit agreement, as amended, with a line-of-credit facility with a maximum borrowing capacity of $100,000, and a $25,000 commercial paper facility. The line-of-credit facility expires on June 18, 2002. The commercial paper facility has a term of one year and may be renewed annually. Interest accrues on outstanding borrowings at variable rates, which as of December 31, 1999, ranged from 7.1 % to 7.7 %, based on maturity and a liabilities to earnings ratio. Additionally, a commitment fee is payable based on the liabilities to earnings ratio. At December 31, 1998 and 1999, no amounts were outstanding under this line.
The agreement requires CH2M HILL to maintain, among other restrictions, prescribed liabilities to earnings, tangible net worth, working capital, and fixed cost coverage ratios.
The agreement allows CH2M HILL to issue letters of credit to back various trade activities. Issued letters of credit are reserved against the borrowing base of the line of credit. As of December 31, 1998 and 1999, there were $5,125 and $5,735 issued and outstanding letters of credit, respectively.
(4) Notes payable to former shareholders
CH2M HILL issues interest-bearing notes to former shareholders for the purchase price of stock redeemed by CH2M HILL. The total amount outstanding for notes payable to former shareholders at December 31, 1998 and 1999 was $20,590 and $18,762, respectively. The interest on the notes is adjusted annually (on the anniversary dates of the notes) to 3/4 of the U.S. Federal Reserve Discount Rate on the first business day of each calendar year. At January 1, 1999 the interest rate on the notes was 3.4%. The notes are unsecured, and payable in varying annual installments through 2009.
Future minimum principal payments on notes payable to former shareholders are as follows:
Year Ending - ------------------------------ 2000 $ 4,154 2001 3,832 2002 3,379 2003 2,328 2004 1,799 Thereafter 3,270 ------------- $18,762 =============
(5) Long-term debt
Long-term debt consisted of the following at December 31:
Future minimum principal payments on long-term debt are as follows:
(6) Operating lease obligations
CH2M HILL has entered into certain noncancelable leases, which are being accounted for as operating leases. At December 31, 1999, future minimum operating lease payments are as follows:
Total lease and rental expense charged to operations was $40,561, $41,475 and $43,028 during 1997, 1998 and 1999, respectively.
Certain of CH2M HILL's operating leases contain provisions for a specific rent-free period. In accordance with generally accepted accounting principles, CH2M HILL accrues rental expense during the rent-free period based on total expected rent payments to be made over the life of the related lease. The excess of expense over actual cash payments to date is shown in the accompanying balance sheets in other long-term liabilities. The cash payments expected to exceed rental expense in the next year are included in other accrued liabilities.
(7) Shareholders' equity
As discussed in Note 1, CH2M HILL and the shareholders have approved changes to the features of its stock that took effect on January 1, 2000. Prior to January 1, 2000, the bylaws and key employee agreements of CH2M HILL restricted ownership of CH2M HILL's Class A preferred and CH2M HILL common stock to active employees and provided the following:
. Upon death, withdrawal, legal incapacity, retirement or discharge, a shareholder's shares must be sold back to CH2M HILL.
. Upon death, legal incapacity or retirement, the purchase price was determined by a formula calculated as of December 31 of each year, based on the net book value of CH2M HILL and a multiple of the average of the past five years' earnings.
. The purchase price of stock from employees withdrawing to compete or who were discharged is the greater of the net book value of the shares or the price of the shares at acquisition by the employee.
. The purchase price of stock returned to CH2M HILL became interest-bearing debt to be paid over a ten-year period. Subject to Board of Directors approval, the payout period could have been shortened upon occurrence of certain criteria.
(8) Income taxes
CH2M HILL accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes." SFAS No. 109 uses an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax effects of events that have been recognized in the financial statements or tax returns. In estimating future tax consequences, CH2M HILL generally considers all expected future events other than enactment of changes in the tax laws or rates.
Income (loss) from continuing operations before income taxes includes the following:
The provision for income taxes for the years ended December 31 is comprised of the following:
The reconciliation of income tax computed at the U.S. federal statutory tax rate to CH2M HILL's effective income tax rate for the years ended December 31 were as follows:
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and liabilities at December 31 were as follows:
1998 1999 ------------ ------------ Deferred tax assets: Foreign net operating losses $ 2,800 $ 3,100 Depreciation and amortization 1,133 - Investments in affiliates 4,413 2,447 ------------ ------------ Total deferred tax assets 8,346 5,547 Valuation allowance (2,800) (3,100) Net deferred tax assets 5,546 2,447 ------------ ------------
Deferred tax liabilities: Deferred recognition of net 28,860 26,955 income until collection of payment occurs Depreciation and amortization - 439 ------------ ------------ Total deferred tax liabilities 28,860 27,394 ------------ ------------ Net deferred tax liability $23,314 $24,947 ============ ============
A valuation allowance is required to be established for those deferred tax assets that it is more likely than not that they will not be realized based upon certain estimated circumstances. The above valuation allowances relate to foreign net operating losses of $9,000 and $9,500 for the years ended December 31, 1998 and 1999, respectively, which will require taxable income within the applicable foreign subsidiary in order for the deferred tax asset to be realized. The foreign net operating losses generally may be carried forward indefinitely.
At December 31, 1999, CH2M HILL has no material tax carryforwards.
Undistributed earnings of CH2M HILL's foreign subsidiaries amounted to approximately $9,215 at December 31, 1999. Those earnings are considered to be indefinitely reinvested and accordingly, no provision for U.S. federal and state income taxes or foreign withholding taxes has been made. Upon distribution of those earnings, CH2M HILL would be subject to U.S. income taxes (subject to a reduction for foreign tax credits) and withholding taxes payable to the various foreign countries. Determination of the amount of unrecognized deferred U.S. income tax liability is not practicable; however, unrecognized foreign tax credit carryovers would be available to reduce some portion of the U.S. tax liabilities.
(9) Earnings per share
The computation of basic earnings per share is based on the weighted average number of common and preferred shares outstanding during the year. The outstanding preferred shares are included in the basic earnings per share calculation since the preferred shares do not have any preferences over common shares, other than in liquidation, and CH2M HILL converted all preferred stock to common shares on a one-for-one basis on January 1, 2000. Diluted income per share is based on the weighted average number of common and preferred shares outstanding during the year and, to the extent dilutive, common stock equivalents consisting of stock options, stock awards subject to restrictions and stock appreciation rights. The difference between the basic and diluted shares relates to the issuance of 2,740,215 stock options during 1999. At December 31, 1997 and 1998, CH2M HILL did not have dilutive securities outstanding.
(10) Employee incentive and benefit plans
Incentive Plan
CH2M HILL, at the discretion of the Board of Directors, provides stock bonuses to employees of CH2M HILL through short-term and long-term incentive plans. Expenses under these programs amounted to $4,784, $5,550 and $9,621 in 1997, 1998 and 1999, respectively.
Employee Stock Plan
CH2M HILL has a profit sharing plan ("ESP") for all eligible employees and has established an Employee Stock Plan and Trust to administer the ESP. Contributions to the ESP are made to the Trust as determined by the Board of Directors. Contributions to the ESP were $2,804, $3,513, and $3,436 in 1997, 1998 and 1999, respectively. The contributions are to be made primarily through the issuance of common stock.
Retirement and Tax-Deferred Savings Plan (the "401(k) Plan")
CH2M HILL has a 40l(k) Plan that provides for company matching contributions, which range from 0.5% to 2.0% of eligible employees' base pay. Contributions for 1997, 1998 and 1999 were $1,589, $1,996 and $1,107, respectively, and vest equally over a five-year period, beginning with the employees' second year of service. The contributions were made primarily through the issuance of common stock.
Defined Contribution Savings Plan
CH2M HILL has a defined contribution plan that provides for contributions generally equal to 1.5% of eligible employees' base pay. These contributions vest equally over a five-year period, beginning with the employees' second year of service. For the years ended December 31, 1997, 1998 and 1999, CH2M HILL recorded $6,045, $5,084 and $5,418 in expense, respectively. Contributions are generally made in cash.
(11) Stock option plan
CH2M HILL's 1999 Stock Option Plan was approved by the Board of Directors on November 6, 1998 to reserve 8,000,000 shares of CH2M HILL common stock for issuance upon exercise of options granted under this plan.
Options have been granted at an exercise price equal to the fair market value of CH2M HILL's common stock at the date of the grant and vest over 36 months. Options generally have a term of five years from date of grant.
The following table summarizes the activity relating to options:
Year Ended December 31, ------------------------------------------ Shares Weighted Average Exercise Price --------------- ----------------------- Stock Options: Options outstanding, - $ - beginning of year Granted 2,740,215 4.31 Exercised - - Terminated (171,107) 4.31 --------------- -----------------------
Options outstanding, end of year 2,569,108 4.31 --------------- -----------------------
Options exercisable, end of year - $ - =============== =======================
Weighted average fair value of options granted during the year $0.74 =======================
The total fair value of options granted was computed to be approximately $2,165 for the year ending December 31, 1999. For purposes of the fair value proforma disclosures, this amount will be amortized over the vesting period of the options. Cumulative compensation cost recognized in pro forma net income with respect to options that are forfeited prior to vesting is adjusted as a reduction of pro forma compensation expense in the period of forfeiture. Pro forma stock-based compensation, net of the effect of forfeitures and tax, was approximately $285 for the year ended December 31, 1999.
If the fair value method were used to account for employee stock option grants, CH2M HILL's net income and earnings per share for the year ended December 31, 1999 would have decreased by the following pro forma amounts:
Year Ended December 31, 1999 ----------------- Net income: As reported $13,626 Pro forma $13,341
Earnings per share: As reported $ 0.46 Pro forma $ 0.45
There was no compensation expense related to SFAS No. 123 as of December 31, 1997 and 1998.
The fair value of each option grant was determined using the minimum value method. The assumptions used to determine the fair market value of each option grant are as follows:
Year Ended December 31, 1999 ------------------ Risk-free interest rates 6.47% Expected dividend yield rates 0.00% Expected lives 3 years Expected volatility .001%
The following table summarizes information about the stock options outstanding at December 31, 1999:
(12) Other employee benefits
Pension and Other Postretirement Benefits
CH2M HILL has several noncontributory defined benefit pension plans, of which one remains active. Benefits are based on years of service and compensation during the span of employment. Funding for these plans is provided through contributions based on recommendations from the plans' independent actuary. Plan assets consist primarily of CH2M HILL common stock, corporate debt instruments and U.S. government securities.
CH2M HILL sponsors a medical benefit plan for retired employees of three subsidiaries. The plan is contributory, with retiree premiums based on service at retirement. The benefits contain limitations and a cap on future cost increases. CH2M HILL continues to fund postretirement medical benefits on a pay-as-you-go basis.
For measurement purposes, 10.73% annual rate of increase in the per capita cost of covered health care benefits was assumed for 1999. The rate was assumed to decrease gradually to 6.00% for 2010 and remain at that level thereafter.
(13) Investments in unconsolidated affiliates
CH2M HILL has the following investments in affiliated companies that are 50% or less owned, which are accounted for under the equity method:
% of Ownership Domestic: Kaiser-Hill Company, LLC ("Kaiser-Hill") 50% MK/IDC (PSI) 50% Foreign: CH2M Gore and Storrie Limited 49% CH2M HILL/CSA 50% Sembawang-IDC 25% CH2M HILL BECA, Ltd. 50% TDC International of Israel 50%
As of December 31, 1998 and 1999, the total investments in these material unconsolidated affiliates were approximately $2,629 and $5,763, respectively, and are included in other assets in the accompanying consolidated balance sheets. As of December 31, 1998 and 1999, CH2M HILL received distributions from Kaiser-Hill Company, LLC of $7,750 and $3,300, respectively.
Kaiser-Hill's revenues are derived from the U.S. Department of Energy's Performance Based Integrating Management Contract for the Rocky Flats Closure Project in Golden, Colorado. Under this contract, performance based incentive fees and cost reduction proposal fees are accrued when management believes the contract performance milestones have been achieved and are therefore earned.
Summarized financial information for these affiliates is as follows:
December 31, ------------------------------- 1998 1999 -------------- -------------- FINANCIAL POSITION: Current assets $148,784 $143,036 Noncurrent assets 9,339 11,712 -------------- -------------- $158,123 $154,748 ============== ==============
Current liabilities $139,561 $131,501 Noncurrent liabilities 7,041 2,385 Shareholders' equity 11,521 20,862 -------------- -------------- $158,123 $154,748 ============== ==============
Year Ended December 31, ------------------------------------------------ 1997 1998 1999 -------------- -------------- -------------- RESULTS OF OPERATIONS: Revenues $874,534 $873,524 $757,434 Direct costs 835,562 836,302 712,746 -------------- -------------- -------------- Gross margin 38,972 37,222 44,688 General and administrative expenses 21,860 19,579 22,370 -------------- -------------- -------------- Operating income 17,112 17,643 22,318 Other income (expense) 483 348 (391) Net income $ 17,595 $ 17,991 $ 21,927 ============== ============== ============== (14) Acquisition
Effective December 22, 1999, CH2M HILL acquired all of the outstanding common stock of Lockheed Martin Hanford Corporation ("Hanford"), a wholly-owned subsidiary of Lockheed Martin Corporation. Hanford is an environmental management contractor that provides
tank waste remediation services to the U.S. Department of Energy. The acquisition was accounted for under the purchase method of accounting. Total consideration was for $17.1 million and resulted in $16.9 million in goodwill. The goodwill will be amortized on a straight-line basis over the total estimated life of the contract, including options, of seven years. Contingent consideration is determined based upon the additional contract years awarded under the option period and net fee awarded under those option years. It is not included as part of the initial purchase price as it is not readily determinable.
The initial purchase price is allocated to the acquired assets and liabilities as follows:
Initial consideration of cash $17,145
Allocated to: Other assets (364) Current working capital (916) Pension liability 997 ------- Goodwill $16,862 =======
The following unaudited pro forma financial data represent the acquisition as if it had occurred on January 1, 1998 and 1999, respectively:
December 31, ---------------------------------- 1998 1999 --------------- --------------- (Unaudited) (Unaudited)
Professional fees $1,215,190 $1,477,589 Net Income 7,400 15,916 Earnings per share $ 0.26 $ 0.54
(15) Contingencies
General
CH2M HILL is party to various legal actions arising in the normal course of its business, some of which may involve claims for substantial sums. Damages assessed in connection with and the cost of defending any such actions could be substantial. CH2M HILL's management believes that the levels of insurance coverage (after retentions and deductibles) are generally adequate to cover CH2M HILL's liabilities, if any, with regard to such claims. Any amounts that are probable of payment by CH2M HILL related to retentions and deductibles are accrued when such amounts are estimable.
Guarantor
CH2M HILL has guaranteed a $10,000 credit facility between a subsidiary and a joint venture partner. The facility is secured by assets of the joint venture and is used for general project purposes. CH2M HILL has joint and several liabilities with the joint partner for the full amount. At December 31, 1998 and 1999, $2,400 and $7,491 was outstanding on the credit facility which bears interest at
varying rates, based upon the chosen LIBOR rate plus 1.25%. The rate at December 31, 1999 was 7.46%.
Performance Bonds
In the normal course of business, CH2M HILL purchases performance bonds to comply with client mandated contractual obligations. At December 31, 1998 and 1999, the performance bonds purchased were $229,000 and $342,684.
Kaiser-Hill Company, LLC and Subsidiary
Consolidated Financial Statements as of December 31, 1999 and 1998 and for each of the three years in the period ended December 31, 1999 together with Report of Independent Accountants
Report of Independent Accountants
To the Members of Kaiser-Hill Company, LLC:
We have audited the accompanying consolidated balance sheets of Kaiser-Hill Company, LLC (a Colorado limited liability company) (the "Company") and Subsidiary as of December 31, 1999 and 1998, and the related consolidated statements of income, members' equity and cash flows for each of the three years in the period ended December 31, 1999. These consolidated financial statements and the supplementary consolidating information referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and supplementary consolidating information based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Kaiser- Hill Company, LLC and Subsidiary as of December 31, 1999 and 1998, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States.
Our audits were made for the purpose of forming an opinion on the consolidated financial statements taken as a whole. The consolidating information contained in Schedules I and II is presented for purposes of additional analysis of the consolidated financial statements, rather than to present the financial position, results of operations and cash flows of the individual companies. This information has been subjected to the auditing procedures applied in our audits of the consolidated financial statements and, in our opinion, is fairly stated in all material respects in relation to the consolidated financial statements taken as a whole.
ARTHUR ANDERSEN LLP
Denver, Colorado January 25, 2000
Kaiser-Hill Company, LLC and Subsidiary Consolidated Balance Sheets as of December 31, 1999 and 1998 (amounts in thousands of dollars) - --------------------------------------------------------------------------------
1999 1998 Assets Current assets: Cash and cash equivalents $ 5,336 $ 3,644 Contract receivables 107,267 124,352 Receivable from Member -- 396 ---------- ---------- Total current assets 112,603 128,392
Deferred financing and organization costs, net of accumulated amortization of $7 and $2,578, respectively 518 1,004 ---------- ---------- $ 113,121 $ 129,396 ========== ==========
Liabilities and Members' Equity Current liabilities: Accounts payable and payables $ 90,472 $ 114,988 to subcontractors Accrued vacation 7,947 7,627 Accrued salaries and employee 6,770 5,039 benefits Payable to Members 732 742 ---------- ---------- Total current liabilities 105,921 128,396
Contingencies (Note 6)
Members' equity 7,200 1,000 ---------- ---------- $ 113,121 $ 129,396 ========== ==========
The accompanying notes are an integral part of these consolidated financial statements.
Kaiser-Hill Company, LLC and Subsidiary Consolidated Statements of Income for the years ended December 31, 1999, 1998 and 1997 (amounts in thousands of dollars) - --------------------------------------------------------------------------------
The accompanying notes are an integral part of these consolidated financial statements.
Kaiser-Hill Company, LLC and Subsidiary Consolidated Statements of Members' Equity for the years ended December 31, 1999, 1998 and 1997 (amounts in thousands of dollars) - --------------------------------------------------------------------------------
The accompanying notes are an integral part of these consolidated financial statements.
Kaiser-Hill Company, LLC and Subsidiary Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998 and 1997 (amounts in thousands of dollars) - --------------------------------------------------------------------------------
The accompanying notes are an integral part of these consolidated financial statements.
Kaiser-Hill Company, LLC and Subsidiary Notes to Consolidated Financial Statements - -------------------------------------------------------------------------------
1. Organization
Kaiser-Hill Company, LLC (the "Company") was formed on October 24, 1994. The principal business of the Company is to procure, execute, deliver, and perform under a contract with the Department of Energy ("DOE") to manage the programs and operate the DOE facilities at Rocky Flats Environmental Technology Site ("RFETS") in Golden, Colorado. The mission of the RFETS is directed toward cleanup, deactivation, and preparation for decontamination and disposition of these DOE facilities.
The Company is a limited liability company owned equally by Kaiser K-H Holdings, Inc. (formerly known as ICF Kaiser Government Programs, Inc.), a wholly owned subsidiary of Kaiser Group International, Inc. (formerly known as ICF Kaiser International, Inc.) ("Kaiser"), and CH2M Hill Constructors, Inc., an indirect wholly owned subsidiary of CH2M Hill Companies, Ltd. ("CH2M Hill") (collectively, the "Members"). Net profits and/or losses and distributions thereof are allocated equally to the Members.
At December 31, 1999, the Company employed 1,733 hourly workers and 315 salaried workers. Approximately 84% of the hourly employees are represented by United Steel Workers of America (the "Union") under a collective bargaining agreement which expires on October 3, 2001.
The Company maintains its cash accounts primarily with banks located in Colorado, New York and Washington D.C. Cash balances are insured by the FDIC up to $100,000 per bank and cash equivalents are not insured by the FDIC. As of December 31, 1999, the majority of the cash balance was made up of cash equivalents.
On January 24, 2000, the Company and the DOE entered into a new contract effective February 1, 2000. The new contract is in effect until the physical completion of the Rocky Flats Closure Project including closure, disposal of nuclear material, demolition of facilities, environmental remediation, waste disposal, infrastructure and general site operations. Under the new contract, the Company has the opportunity to earn incentive fee if the total costs incurred are below the contract target cost or the completion of the site closure is before March 31, 2007. In addition, the Company can lose incentive fees if the costs exceed an amount equal to $200 million above the contract target cost or the site closure is after March 31, 2007. The maximum and minimum incentive fee available to be earned by the Company through the date of closure is $460 million and $130 million, respectively.
2. Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the Company and its wholly owned subsidiary Kaiser-Hill Funding Company, LLC. All intercompany accounts and transactions have been eliminated in the consolidated financial statements.
Revenue Recognition
Revenue is recognized using the percentage of completion method whereby revenue is accrued in an amount equal to cost plus management's best estimate of base fee, performance based incentive fees and cost reduction proposal fees to be received.
Statements of Cash Flows
For purposes of the statements of cash flows, the Company considers cash in checking and short-term investments with original maturities of three months or less to be cash and cash equivalents.
New Accounting Policy
Effective January 1, 1999, the Company adopted Statement of Position 98-5 ("SOP 98-5"), Reporting on the Costs of Start-up Activities, which states that costs of start-up activities, including organizational costs, be expensed when incurred. Upon adoption, the Company recorded a cumulative effect of a change in accounting principle of $839,000 in the accompanying consolidated statements of income. Assuming SOP 98-5 was not adopted in 1999, amortization on start-up activities would have been approximately $609,000 and the remaining
Kaiser-Hill Company, LLC and Subsidiary Notes to Consolidated Financial Statements - --------------------------------------------------------------------------------
$203,000 would have been expensed in 2000. The pro forma amounts shown on the income statement have been adjusted for the effect of retroactive application had SOP 98-5 been in effect during the years presented.
Income Taxes
The financial statements do not include a provision for income taxes because the Company is treated as a partnership for income tax purposes and does not incur federal or state income taxes. Instead, its earnings and losses are included in the Members' separate income tax returns.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles 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 reporting period. Actual results could differ from those estimates.
3. Related Party Transactions
In 1999 and 1998, the Members were subcontracted by the Company to perform certain tasks under the DOE contract. The "Payable to Members" in the accompanying balance sheets as of December 31, 1999 and 1998 consists of $297,000 and $742,000, respectively, to Kaiser and $435,000 and $0, respectively, to CH2M Hill for these subcontracted tasks. These payables are non-interest bearing. The "Receivable from Member" in the accompanying consolidated balance sheet as of December 31, 1998 consists of $396,000 due from CH2M Hill relating to advance payment of general and administrative expenses, less operating payables.
In addition, costs incurred related to work performed by Kaiser and CH2M Hill, the majority of which are reimbursable and billed under the DOE contract, were approximately $609,000 and $938,000 in 1999, respectively, $3,600,000 and $960,000 in 1998, respectively, and $2,600,000 and $1,100,000 in 1997, respectively.
4. Contract Receivables
Contract receivables as of December 31, 1999 and 1998 represent unbilled receivables due under the DOE contract. Unbilled receivables result from revenue that has been earned by the Company but not billed to the DOE as of the end of the period. The unbilled receivables can be invoiced at contractually defined intervals and milestones. Management anticipates that the unbilled receivables will be billed and collected in less than one year.
The Company's contract receivables result primarily from its long-term contract with the DOE. As a consequence, management believes that credit risk is minimal.
5. Business Loan and Security Agreement
Effective November 2, 1999, the Company, including its wholly owned subsidiary Kaiser-Hill Funding Company, LLC, entered into a Business Loan and Security Agreement (the "Agreement") with Bank of America, N.A. ("BOA") replacing its previous agreement with NationsBank, N.A. The Company, Kaiser and CH2M Hill granted a first lien security interest to BOA in all of the ownership and equity interest of the Company.
Under the agreement, the Company has financing available which provides temporary financing for the payment of the Company's costs incurred under the DOE contract. This financing is utilized throughout the year for periods of less than one month as, under the terms of the DOE contract, the DOE must pay the Company's invoices within three business days of receipt. The funding level under the agreement can not exceed a Maximum Borrowing Base calculated on the lesser of eligible billed and unbilled government accounts receivable, as defined, or $35,000,000. Under the terms of the agreement, interest on the advances is calculated either under a rate based upon LIBOR or a rate based upon the higher of the Federal Funds Rate or the Prime Rate.
Kaiser-Hill Company, LLC and Subsidiary Notes to Consolidated Financial Statements - -------------------------------------------------------------------------------
The agreement also contains various covenants, including tangible net worth, fixed charge ratio and minimum cash balances requirements, among other restrictions. Management believes the Company was in compliance with all restrictive covenants.
6. Contingencies
The Company's reimbursable costs are subject to audit in the ordinary course of business by various U.S. Government agencies. Management is not presently aware of any significant costs, which have been, or may be, disallowed by any of these agencies.
7. Employee Benefit Plans
In accordance with the DOE contract, the Company sponsors several benefit plans covering substantially all employees who meet length of service requirements. These plans include the following defined benefit pension plans: The Rocky Flats Multiple Employer Salaried Retirement Plan and the Kaiser-Hill Retirement Plan for Hourly Production and Maintenance Employees. The Company also sponsors the following defined contribution plans: Kaiser- Hill Company, LLC Savings Plan for Hourly Employees, which includes no Company matching; and Rocky Flats Multiple Employer Salaried Thrift Plan, which includes Company matching. The Company contribution amounts for the Savings Plan/Thrift Plan were approximately $454,000, $413,000 and $482,000 for 1999, 1998 and 1997, respectively. No amounts were contributed to the Retirement Plans during 1999, 1998 and 1997 because the Plans were overfunded.
The Company administers these benefit plans with benefits equivalent to the RFETS contractor benefit plans maintained by the contractor that preceded the Company at RFETS. Under the DOE contract, the Company recognizes the cost of benefit plans when paid, and such costs are reimbursed by the DOE. Any excess pension plan assets or unfunded pension plan liability which may currently exist or is remaining at the end of the DOE contract is the responsibility of the DOE.
SCHEDULE I Kaiser-Hill Company, LLC and Subsidiary Supplementary Consolidating Information to Consolidated Financial Statements
Balance Sheet as of December 31, 1999 (amounts in thousands of dollars) - -------------------------------------------------------------------------------
SCHEDULE II
Kaiser-Hill Company, LLC and Subsidiary Supplementary Consolidating Information to Consolidated Financial Statements
Statement of Income for the year ended December 31, 1999 (amounts in thousands of dollars) - --------------------------------------------------------------------------------
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
CH2M HILL Companies, Ltd.
By: /s/ Ralph R. Peterson Date: March 27, 2000 ------------------------------------- Ralph R. Peterson President and Chief Executive Officer
Signature Title Date - ------------------------ ----------------------------- -------------- /s/ Ralph R. Peterson - ------------------------ President and Chief March 27, 2000 Ralph R. Peterson Executive Officer (Principal Executive Officer)
/s/ Philip G. Hall - ------------------------ Chairman of the Board of March 27, 2000 Philip G. Hall Directors and Senior Vice President
/s/ Samuel H. Iapalucci - ------------------------ Chief Financial Officer March 27, 2000 Samuel H. Iapalucci (Principal Financial and Principal Accounting Officer)
/s/ Joseph A. Ahearn - ------------------------ Director March 27, 2000 Joseph A. Ahearn
/s/ Kenneth F. Durant - ------------------------ Director March 27, 2000 Kenneth F. Durant
/s/ Donald S. Evans - ----------------------- Director March 27, 2000 Donald S. Evans
/s/ James J. Ferris - ----------------------- Director March 27, 2000 James J. Ferris
/s/ Jerry D. Geist - ----------------------- Director March 27, 2000 Jerry D. Geist
/s/ Michael D. Kennedy - ----------------------- Director March 27, 2000 Michael D. Kennedy
/s/ Susan D. King - ----------------------- Director March 27, 2000 Susan D. King
/s/ Michael Y. Marcussen - ----------------------- Director March 27, 2000 Michael Y. Marcussen
/s/ Jewel T. Sideman - ----------------------- Director March 27, 2000 Jewel T. Sideman
/s/ Barry L. Williams - ----------------------- Director March 27, 2000 Barry L. Williams
EXHIBIT INDEX
Exhibit Number Description ------ ----------- 2.1 Stock Purchase Agreement, dated as of November 29, 1999, by and between CH2M Hill Companies, Ltd. and Lockheed Martin Corporation [certain portions of the Stock Purchase Agreement have been omitted pursuant to a request for condifidential treatment filed seperately with the Securities and Exchange Commission] filed as Exhibit 2.1 on Form 8-K, on January 5, 2000 (File No. 000-27261)
*3.1 Restated Articles of Incorporation of CH2M HILL Companies, Ltd.
*3.2 Restated Bylaws of CH2M HILL Companies, Ltd.
*10.1 CH2M HILL Retirement and Tax-Deferred Savings Plan, as amended and restated effective January 1, 2000
*10.2 CH2M HILL Employee Stock Plan, as amended and restated effective January 1, 2000
*10.3 CH2M HILL Companies, Ltd. 1999 Stock Option Plan, as amended and restated on November 12, 1999
*10.4 CH2M HILL Companies, Ltd. Payroll Deduction Stock Purchase Plan
*10.5 CH2M HILL Companies, Ltd. Pre-Tax Deferred Compensation Plan
10.6 Trust Under CH2M HILL Companies, Ltd. Pre-Tax Deferred Compensation Plan, filed as Exhibit 10.6 to Registration Statement on Form S-1 on March 15, 1999 (File No. 333-74427)
*10.7 CH2M HILL Companies, Ltd. After-Tax Deferred Compensation Plan
10.8 Trust Under CH2M HILL Companies, Ltd. After-Tax Deferred Compensation Plan, filed as Exhibit 10.8 to Registration Statement on Form S-1 on March 15, 1999 (File No. 333-74427)
10.9 Contract with Buck Investment Services, Inc., filed as Exhibit 10.9 to Registration Statement on Form S-1, Amendment No. 1, on May 14, 1999 (File No. 333-74427)
10.10 Contract (#DE-AC3495RF00825) between Kaiser-Hill Company, LLC, a subsidiary of the Corporation, and the U.S. Department of Energy dated as of April 4, 1995, along with Modifications 1 to 81 to Contract #DE-AC3495RF00825 (Modifications 41, 72 and 78 not received), incorporated by reference from ICF Kaiser International Inc.'s (i) Form 10-K for the fiscal year ended February 28, 1995 filed on March 29, 1996 (File No. 1-12248); (ii) Registration Statement on Form S-1 filed on November 27, 1996 (File No. 333-16937); (iii) Form 10-K for the fiscal year ended December 31, 1996 filed on March 31, 1998 (File No. 1- 12248).
*10.11 Contract between Kaiser-Hill Company, LLC, a subsidiary of the Corporation, and the U.S. Department of Energy dated January 24, 2000
10.12 $100,000,000 Senior Unsecured Revolving Credit Agreement dated as of June 18, 1999, Wells Fargo Bank, National Association, as Agent, filed as Exhibit 10.11 to Registration Statement on Form S-1, Amendment No. 2, on July 8, 1999 (File No. 333-74427)
*10.13 Deferred Compensation Retirement Program Arrangement effective December 1, 1995
*10.14 Executive Deferred Compensation Program Arrangement effective January 1, 1997
*21 Subsidiaries of CH2M HILL Companies, Ltd.
*27 Financial Data Schedule
99.1 Internal Market Rules, filed as Exhibit 99 to Registration Statement on Form S-1 on March 15, 1999 (File No. 333-74427)
*99.2 Opinion of KPMG LLP
__________
* Filed herewith
(b) Reports on Form 8-K:
None. | 19,239 | 130,042 |
876318_1999.txt | 876318_1999 | 1999 | 876318 | ITEM 1. BUSINESS
Unless otherwise indicated, all population data set forth herein is based on the 1999 Paul Kagan Associates, Inc. Cellular/PCS POP Book, and all industry data set forth herein is based upon information compiled by the Cellular Telecommunications Industry Association and/or Paul Kagan Associates, Inc.
We provide digital wireless personal communications services ("PCS") in the southeastern United States under the name "Powertel." Our licenses encompass a territory of approximately 246,000 contiguous square miles with a population of approximately 24.4 million people. We hold licenses to serve the Major Trading Areas ("MTAs") of Atlanta, Georgia; Jacksonville, Florida; Memphis, Tennessee/Jackson, Mississippi; and Birmingham, Alabama, as well as 13 Basic Trading Areas ("BTAs") in Kentucky and Tennessee. We hold 30 MHz of spectrum in our MTA markets, and we hold 20 MHz of spectrum in all of our BTA markets except for the Knoxville, Tennessee BTA, where we hold a license for 10 MHz of spectrum. We have one of the largest contiguous licensed PCS footprints in the southeastern United States.
We introduced our services in October 1996 in Jacksonville, Florida and Montgomery, Alabama and, to date, have launched our services in a total of 34 markets in the Southeast. In most of these markets, we were the first to offer PCS services commercially. As of December 31, 1999, we had approximately 341,000 postpaid subscribers and 205,000 prepaid subscribers.
On April 30, 1999, we sold substantially all of our cellular assets in western Georgia and eastern Alabama to Public Service Cellular, Inc. for approximately $89 million in cash. This transaction constituted the sale of all of our cellular telephone operations. On June 2, 1999, we and certain of our subsidiaries sold 619 of our communications towers to a subsidiary of Crown Castle International Corp. for approximately $262 million in cash. In connection with this sale, certain of our subsidiaries agreed to lease space on these towers for a period of ten years, with three five-year renewal periods that may be exercised at the lessee's option. On December 2, 1999, we and certain of our subsidiaries sold an additional 31 tower sites to Crown Castle for approximately $13 million in cash. We have also entered into a contract with Crown Castle under which they will provide us with build-to-suit tower construction services through December 31, 2000.
THE WIRELESS TELECOMMUNICATIONS INDUSTRY
Since 1983, the demand for wireless telecommunications services has grown dramatically as cellular, paging and other emerging wireless communications services have become widely available and increasingly affordable. Service revenues for the wireless telephone industry reached approximately $43 billion in 1999, as compared to approximately $364 million in 1985. The number of wireless telephone subscribers nationwide has grown from approximately 680,000 in 1986 to more than 88.7 million in 1999.
Analog cellular services are the most widely deployed two-way wireless services available today. However, analog cellular systems transmit voice and data signals by means of one continuous electronic signal that varies in amplitude or frequency over a single radio channel. In contrast, digital systems, including the systems used to provide PCS, transmit signals as a stream of digits that is compressed before transmission, enabling a single radio channel to carry multiple simultaneous signal transmissions. This increased capacity, along with other enhancements in digital protocols, allows digital-based wireless technologies to offer new and enhanced services, including greater call privacy and single number (or "find me") service, and more robust data transmission features, including "mobile office" applications such as facsimile and e-mail.
Although PCS and cellular networks use similar technologies and hardware, they are incompatible because they operate on different frequencies and utilize different signaling protocols. We began marketing dual-mode handsets capable of receiving and transmitting over both analog cellular and GSM-based PCS networks in December 1998. Our dual-mode service provides automatic delivery of calls over analog cellular systems to our PCS subscribers roaming in areas where GSM-based PCS service is not available and where we have a roaming agreement with the analog cellular provider.
PCS systems in the U.S. operate under one of three digital transmission protocols -- GSM, CDMA or TDMA. These protocols are incompatible with each other. Our network uses GSM, which is the leading digital wireless technology in the world with over 254 million subscribers worldwide. We are also a member of the GSM Alliance L.L.C., a consortium of 16 PCS carriers which offer PCS service using the GSM protocol in nearly 4,000 cities and towns throughout the U.S. Through the GSM Alliance, we allow our subscribers to roam in most major metropolitan areas in the U.S. and Canada. GSM Alliance members include us, Aerial, Airadigm, BellSouth Mobility DCS, the GSM subsidiary of BellSouth Corporation, Conestoga Wireless, Cook Inlet PCS, DiGiPH PCS, Iowa Wireless Services, Microcell Connexions, NPI Wireless, Pacific Bell Mobile Services, SOL Communications, Telemetrix Technologies, TWS, VoiceStream and Wireless 2000 PCS. We offer a single roaming rate to our subscribers when roaming on any GSM network throughout the U.S. and Canada and have launched our new 50-State Rates allowing our subscribers to roam on any GSM network in the U.S. where we have a reciprocal roaming agreement at no extra charge.
While the three existing PCS protocols are incompatible, there is an ongoing debate focused on determining the next generation of worldwide wireless standards. Controversy exists over whether world standards organizations, such as the European Telecommunications Standards Institute ("ETSI") and the International Telecommunications Union, should dictate a single standard for third generation ("3G") wireless services. The leading protocols under consideration include W-CDMA, which is a GSM-based version of next generation wideband CDMA technology supported by the GSM Alliance, and CDMA2000, which is a narrowband, I-95 CDMA-based 3G technology supported by certain U.S. manufacturers. This debate has become highly visible in international politics. ETSI, which has advocated W-CDMA as the European 3G standard, is being challenged by other standards bodies and the United States as being isolationist and precluding non-European manufacturers from a significant marketplace in the future. The GSM Alliance is actively lobbying for the adoption of multiple standards for 3G wireless, much like the co-existing standards for second generation wireless today. However, these international standards debates could have a significant impact upon the future of GSM carriers in the event that a standard or family of standards are adopted that have limited backwards compatibility with existing GSM networks.
OUR OPERATIONS
Markets. Our licenses cover approximately 246,000 contiguous square miles in portions of the following 12 states: Alabama; Arkansas; Florida; Georgia; Illinois; Indiana; Kentucky; Louisiana; Mississippi; Missouri; South Carolina; and Tennessee. Our markets include approximately 24.4 million people. We currently provide PCS services in the 34 markets where we have completed our initial buildout. Generally, our "initial buildout" of a licensed territory includes the construction of cell sites: (a) in metropolitan areas with a population greater than 100,000 people; (b) in smaller cities that, due to location or demographics, we consider to be strategically important; and (c) along the major highway corridors connecting these areas. We have completed the initial buildout of our PCS system in the following cities:
We also offer service along the major highway corridors connecting all of our markets. Based on subscriber demand and competitive factors, we intend to continue the buildout of our PCS system to enhance and expand our coverage. As of December 31, 1999, we had a total of approximately 546,000 post paid and prepaid subscribers.
Strategy. Our strategy is to:
- expand our subscriber base by providing wireless services of the highest quality, functionality and value;
- offer a broad range of services, including enhanced services and mobile data services;
- expand our regional market presence by managing and affiliating with other PCS licensees, as well as potentially acquiring additional strategic PCS licenses and other PCS providers; and
- provide our subscribers with the ability to receive service in areas outside of our service area, including internationally, by entering into additional roaming agreements.
We intend to achieve significant market penetration by aggressively marketing competitively priced PCS services, including enhanced services not currently provided by analog or digital cellular operators, and by providing superior customer service. We intend to remain a low-cost provider of PCS services by generating economies of scale through our operation in contiguous market areas and our focus on subscriber acquisition and retention.
Services. Our service offerings currently consist of a full range of wireless telecommunications services, including enhanced features and services not generally provided by analog or digital cellular operators, which include:
- secure communications;
- sophisticated call management incorporating features such as caller I.D. and call forwarding;
- enhanced battery life; and
- a short message service which allows subscribers to send and receive alphanumeric and text messages on their handsets.
In addition, we have expanded our service offerings to include alternative line service, international roaming and some data and information services, including mobile e-mail. In the future, we intend to offer single number service, home zone billing, virtual private network services and fixed wireless services that could serve as the subscriber's primary mode of telecommunication, as well as real-time high speed access to the Internet to facilitate content delivery, wireless commerce and personalized information services.
We provide prepaid services through an advanced intelligent network platform that allows real-time addition to and declination of a subscriber's account. Prepaid subscribers are not required to apply for credit and may purchase prepaid vouchers to increase their account balance at any time.
Our postpaid subscribers who subscribe to a calling plan with a $50 or higher monthly access fee may call anywhere in the U.S. from our service area with no additional long distance charges. Regular airtime rates apply. In July 1999, we launched our new 50-State Rates which offer our subscribers flat-rate pricing for local, long-distance and roaming calls on any GSM network in the U.S. where we have a reciprocal roaming arrangement. We also offer dual-mode services for an additional charge of $5 per month. We change our service offerings and pricing from time to time.
Roaming. Our subscribers may roam outside their "local" markets anywhere within our PCS coverage area without being assessed daily access fees or increased airtime usage rates. Some of our roaming partners own licenses in MTAs and BTAs that are contiguous to our PCS markets, which increases the size of the contiguous geographic area where our subscribers can use their handsets. We provide GSM roaming services outside of our service area at a single roaming rate which is lower than rates traditionally offered by most cellular providers. In addition, our 50-State Rates offer flat-rate prices on any GSM network in the U.S. where we have a reciprocal roaming arrangement. GSM service is currently available in nearly 4,000 cities and towns in the U.S. We have also entered into roaming agreements with international GSM providers, primarily through our membership in the GSM Alliance, which allow subscribers to roam internationally either through the use of subscriber identity module cards or multi-frequency handsets on "world phones."
System Buildout. Although we have completed the initial buildout of our PCS system, we continue to build out our existing markets for increased coverage and capacity needs, and we are planning to build out some secondary cities within our licensed footprint. Generally, we select sites on the basis of their coverage of targeted subscribers, the cost to construct the site and on frequency propagation characteristics. In many cases, we must obtain zoning approval prior to constructing a site. For new sites, our experience indicates that the site acquisition process can take three to twelve months. Once we acquire a site and obtain the requisite governmental approval, preparation of the site, including grounding, ventilation and air conditioning, equipment installation, testing and optimization, generally requires an additional two to four months.
Customer Service. We recognize that superior customer service is vital to minimizing subscriber churn and to the long-term success of our business. We try to ensure that our PCS subscribers are fully introduced to our service offerings, that they understand how to use their handsets and features and that they receive prompt and reliable service from our customer service representatives. We provide subscribers with toll-free access to our customer service representatives 24 hours a day, seven days a week. In addition, subscribers can reach a customer service representative from their handsets (with no airtime charge) by dialing 611. Our inbound customer service organization is located in one call center in Jacksonville, Florida so that we can serve our subscribers more efficiently.
Sales, Marketing and Distribution. We market our services primarily through:
- our direct sales force;
- retail stores and kiosks which we operate;
- a network of independent agents, each of which has a retail store presence;
- mass merchandisers, such as Best Buy, Sam's Club and Circuit City; and
- a limited amount of direct mail advertising.
In addition to traditional distribution channels, we market our PCS services through the Internet, including through our Web site which includes an on-line retail store where potential subscribers may apply for services, purchase handsets and accessories and review their account and billing information. We support our marketing activities with local and regional radio, television and print advertising.
Our direct and retail store sales force currently consists of approximately 700 employees. We train our sales employees to understand our products and services, so that they can provide extensive information to prospective subscribers. We generally link sales commissions to subscriber revenue and subscriber retention.
We also negotiate volume discounts from manufacturers of handsets and pass a substantial portion of the discount on and further subsidize the cost of these handsets to our subscribers, sales agents and distributors. Although we subsidize a portion of most handset purchases, even after this subsidy, our handsets are generally more expensive to subscribers than cellular handsets. We offer over-the-air activation whereby a subscriber can initiate service by purchasing a handset from any of our distribution channels and pressing any key on the handset to reach Powertel customer service. During this call, the customer service representative can obtain all necessary subscriber information and conduct a credit scoring assessment or, if the subscriber has chosen the prepaid plan, the customer service representative can activate the subscriber's handset immediately. At this time, we do not require our PCS subscribers to sign long-term service contracts.
In marketing our services, we emphasize the enhanced features and favorable pricing of our services. We also promote the improved call security of our PCS system, which we believe encourages users to make confidential calls that they might not otherwise make on an analog cellular telephone. We also expect that the services offered by PCS operators will eventually be capable of replacing some traditional landline telephone services. The potential for increased PCS penetration of the landline market was enhanced by the 1996 Telecommunications Act, which requires local exchange carriers to interconnect with other telecommunications providers like us at just and reasonable rates that are based on costs of providing the interconnection.
DISPOSITION OF OUR CELLULAR ASSETS
On April 30, 1999, we and our wholly-owned subsidiaries, ICEL, Inc. and InterCel Licenses, Inc., sold and assigned to Public Service Cellular, Inc. substantially all of our assets and rights relating to our cellular business in eastern Alabama and western Georgia, including FCC licenses to provide cellular and microwave service in this area. Through this transaction, we sold all of our cellular telephone operations. At closing, PSC paid us approximately $83 million in cash (including reimbursement for certain capital expenditures of $.3 million) and paid $6.2 million into escrow. On November 1, 1999, substantially all funds were released to us from escrow. We recorded a gain of $79.3 million on the sale.
DISPOSITION OF SOME OF OUR TOWER ASSETS
On June 2, 1999, we, together with some of our wholly-owned subsidiaries, sold and transferred to Crown Castle 619 of our towers, related assets and liabilities. At the closing, Crown Castle paid us approximately $262 million in cash, which equals approximately $423,077 per site. We also gave Crown Castle a $383,000 credit against the aggregate purchase price as consideration for Crown Castle's acceptance of towers with site leases which may require revenue received from us or our affiliates to be shared with the site lessors.
Also on June 2, 1999, pursuant to master site agreements, we and certain of our subsidiaries agreed to pay Crown Castle monthly rent of $1,800 per tower for the continued use of the space that we or our affiliates occupied on the towers prior to the closing. Monthly payments under the individual site leases are subject to increase based on an agreed upon schedule and if and when we or our affiliates add equipment to a site. In any event, the monthly rent, including additional rents related to the addition of equipment, will be increased on each fifth anniversary of each site lease up to an amount that is 115% of the monthly rent paid during the preceding five-year period. The term of each site lease is ten years. We have the right to extend any site lease for up to three additional five-year periods. Each site lease will automatically renew for an option term unless we or our affiliates notify Crown Castle of our intent not to renew at least 180 days prior to the end of the then current term.
On December 2, 1999, we sold and transferred an additional 31 towers to Crown Castle for approximately $13 million. We recorded an aggregate realized gain of $49.9 million in 1999 on these two sales, and we will amortize an aggregate deferred gain of $88.3 million over the 10-year lease term.
In September 1999, we entered into a build-to-suit construction contract with Crown Castle that grants Crown Castle a right of first refusal to build, acquire and lease back to us up to 40 tower sites to be constructed prior to December 31, 2000.
COMPETITION; OTHER TELECOMMUNICATIONS TECHNOLOGIES
Competition in the wireless communications business is intense, and we expect it to continue to increase as a result of the entrance of new competitors and the development of new technologies, products and services. Each of the markets in which we compete is or will be served by multiple other wireless service providers, including cellular, PCS and other wireless operators and resellers.
We compete directly with several other PCS providers, including BellSouth Mobility, GTE Wireless, Sprint PCS and AT&T Wireless, in our PCS markets. The FCC continues to auction additional licenses for wireless services, which may allow more competitors to enter the marketplace. We expect that existing wireless service providers in our PCS markets will continue to upgrade their systems. Some of these providers have been operational for a number of years and have significantly greater financial and technical resources than those available to us. Our wireless competitors include AT&T Wireless, AirTouch, BellSouth Mobility, GTE Mobilnet, Alltel, Nextel, Price Communications Wireless and Sprint PCS. Two of our PCS competitors, AT&T Wireless and Sprint PCS, claim a national digital network which some subscribers may view as an advantage. We, however, continue to believe that our large contiguous regional footprint, combined with our GSM and analog roaming agreements, allow us to effectively compete against these competitors.
Continuing technological advances in telecommunications, and FCC policies encouraging the development of new spectrum-based technologies, make it impossible to predict the extent of future competition. The 1996 Telecommunications Act alters regulatory and industry barriers which for years deterred easy competition within and between telecommunications markets. The amended statute and related FCC rulemakings are expected to continue to open new avenues for competitive offerings of wireless, wireline and hybrid services.
Since the introduction of PCS and enhanced specialized mobile radio ("ESMR"), the two-way wireless services industry has experienced a downward trend in market prices. We anticipate that this trend will continue in the future due to increased competition. We compete to attract and retain subscribers principally on the basis of our service offerings and pricing, our customer service and our large contiguous footprint. Our ability to compete successfully will also depend, in part, on our ability to anticipate and respond to various competitive factors affecting the industry, including new services that may be introduced, changes in consumer preferences, demographic trends, economic conditions and discount pricing strategies by competitors, which could adversely affect our operating margins.
Beginning March 23, 1999, the FCC re-auctioned additional PCS licenses (including licenses reserved for small businesses) which, for various reasons, had been returned to the FCC. These licenses were for varying amounts of spectrum, ranging from 10 MHz to 30 MHz. While we did not participate directly in this auction, we provided certain financing, subject to restrictions, to a qualified small business, Eliska Wireless, Inc., that acquired licenses for 15 MHz of spectrum in each of the Knoxville, Tennessee BTA and the Kingsport/Johnson City/Bristol, Tennessee BTA.
REGULATION OF WIRELESS TELECOMMUNICATIONS SYSTEMS
The FCC regulates the licensing, construction, operation and acquisition of wireless telecommunications systems in the United States pursuant to the Communications Act of 1934, as amended, and the rules, regulations and policies promulgated by the FCC. Additional regulatory authority over PCS providers is granted to the FCC by the Budget Act and the 1996 Telecommunications Act.
Under the Communications Act, the FCC is authorized to establish regulations governing the interconnection of PCS systems with wireline and other wireless carriers, allocate channels and frequencies, grant or deny license renewals and applications for transfer of control or assignment of PCS licenses, monitor the foreign ownership of PCS licenses, and impose fines and forfeitures for any violations of FCC regulations. The
1996 Telecommunications Act and ongoing FCC rulemakings have led to new regulations concerning interconnection of networks. The 1996 Telecommunications Act also permits the FCC to lift regulations where they are no longer necessary in the public interest.
Licensing of PCS. The FCC has divided the United States and its possessions and territories into PCS markets made up of 493 BTAs and 51 MTAs. Each MTA consists of at least two BTAs. Numerous licensees may compete in each PCS service area. The FCC has allocated 120 MHz of radio spectrum in the 2 GHz band for licensed broadband PCS services. The FCC divided the 120 MHz of spectrum into six individual blocks, each of which is allocated to serve either MTAs or BTAs. Under the FCC's rules, a broadband PCS licensee may own combinations of licenses (e.g., one MTA (30 MHz) and one BTA (10 MHz)) with total aggregate spectrum of up to 45 MHz in a single geographic area. All PCS licenses are granted for a ten-year period, at the end of which they must be renewed. Licenses may be revoked at any time for cause, including failure to meet certain buildout requirements imposed by the FCC on all PCS licensees.
The FCC has recently announced that it intends to conduct an auction for certain PCS licenses related to the bankruptcy of Nextwave Wireless, Inc. beginning in July 2000. We may participate in this auction in order to obtain additional spectrum which would enhance our current licensed footprint.
Other FCC Requirements. The FCC also imposes requirements on our operations with respect to interconnection to other telecommunications providers, the provision of 911 and enhanced 911 services, mandatory contributions to the FCC's universal service fund, obligations to allow resale of our services, and other technical and reporting matters.
Other Federal Regulations. Wireless systems are subject to Federal Aviation Administration regulations relating to the location, lighting and construction of wireless transmitter towers and antennas and may be subject to regulation under the National Environmental Policy Act and the environmental regulations of the FCC. We use common carrier point-to-point microwave and traditional landline facilities to connect our cell sites and to link them to our main switching offices. These facilities are separately licensed by the FCC and are subject to regulation as to technical parameters and service.
State and Local Regulation. In 1993, Congress amended the Communications Act to preempt state or local regulation of the entry of, or the rates charged by, any commercial or private mobile radio service provider. Notwithstanding this preemption, a state may petition the FCC for authority to begin regulating or to continue regulating commercial mobile radio service ("CMRS") rates. Petitioners must demonstrate that existing market conditions cannot protect consumers from unreasonable and unjust rates or that the service is a replacement for traditional wireline telephone service for a substantial portion of the wireline service within the state. So far, the states in which we currently provide or plan to provide service (Alabama, Arkansas, Florida, Georgia, Illinois, Indiana, Kentucky, Louisiana, Mississippi, Missouri, South Carolina and Tennessee) either have not sought to regulate these matters or, in the case of Louisiana, the FCC has denied their petition to regulate.
States are not, however, prohibited from regulating other terms and conditions of CMRS, such as service quality, billing procedures and consumer protection standards. In addition, the siting and construction of transmitter towers, antennas and equipment shelters are often subject to state or local zoning, land use and other regulations.
EMPLOYEES AND AGENTS
As of December 31, 1999, we had approximately 2,100 employees. We anticipate that the continued development of our PCS system will require us to continue to hire a substantial number of new employees. None of our employees is represented by a labor organization, and we consider our employee relations to be good.
ITEM 2.
ITEM 2. PROPERTIES
We maintain our 28,000 square foot corporate headquarters and network operations center in West Point, Georgia and lease an additional 10,000 square feet of office space from KNOLOGY, Inc. and approximately 10,000 square feet of office space from ITC DeltaCom, Inc. Additionally, our information technology center is located in leased space in Atlanta, Georgia, and we have a call center in Jacksonville, Florida. In connection with our PCS system, we lease space for regional headquarters and switch facilities in the following cities: Birmingham, Alabama; Memphis, Tennessee; Jacksonville, Florida; Atlanta, Georgia; Nashville, Tennessee; and Louisville, Kentucky. The Atlanta MTA leases two separate switching facilities, both of which are located in the city of Atlanta but in separate locations. The Birmingham MTA leases additional space in Jackson, Mississippi to accommodate its sales and operations personnel. We also lease warehouse space in Oneonta, Alabama for network equipment and cell site equipment related to the buildout of our PCS system.
We also currently lease retail space for 35 Powertel retail stores in the Atlanta market, 15 in the Birmingham market, eight in the Memphis market, 14 in the Jacksonville market, seven in the Nashville BTA market and ten in the other BTA markets. We lease a 55,500 square foot building in LaGrange, Georgia with warehouse and office space for our inventory and distribution activities. We also lease land, rooftop space or tower space for a significant number of our approximately 1,630 PCS cell sites.
We believe that all of our properties are well maintained.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
We are subject from time to time to legal proceedings that arise out of our business operations, including service, billing and collection matters. Although the actual damages sought in such legal proceedings are generally small, certain of these legal proceedings may seek punitive damages and/or attempt to be certified as class actions. While we do not expect such legal proceedings to have a material adverse effect on our business operations, no assurance can be given that the resolution of any or all of such legal proceedings will not have a material adverse effect on our business, financial condition or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During 1999, we only submitted matters to a vote of our stockholders at our 1999 annual meeting of stockholders held on May 20, 1999. We previously reported on such matters.
PART II
ITEM 5.
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Price Range of Common Stock. Our common stock is currently traded on the Nasdaq Stock Market's National Market System under the symbol "PTEL." As of March 27, 2000, there were approximately 310 holders of record of our common stock.
The high and low sales prices for each full quarterly period of 1999 and 1998 are as follows:
Dividend Policy. We have never declared or paid any cash dividends on our capital stock, and we do not anticipate paying cash dividends in the foreseeable future. We intend to retain earnings to finance the expansion of our operations. Our Series E 6.5% Cumulative Convertible Preferred Stock (the "Series E Preferred") and Series F 6.5% Cumulative Convertible Preferred Stock (the "Series F Preferred") pay a 6.5% annual dividend quarterly in common stock or cash. However, we are prohibited from paying cash dividends for the foreseeable future because of restrictions contained in our indentures relating to our public bonds and our credit agreement covering certain equipment purchases from Ericsson Inc. To date, we have issued an aggregate of 814,758 shares of common stock as dividends on the Series E Preferred and Series F Preferred.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth certain selected financial information for Powertel as of and for each of the years in the five-year period ended December 31, 1999. Arthur Andersen LLP has audited our consolidated financial statements. Our stockholders should read the selected financial information in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and our consolidated financial statements and notes thereto and other financial and operating information included elsewhere in this Report.
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(a) For the years ended December 31, 1999, 1998, 1997 and 1996, interest income was $18.9 million, $19.5 million, $21.0 million and $17.3 million, respectively. This excludes capitalized interest of $1.9 million, $22.1 million and $29.0 million for the years ended December 31, 1998, 1997 and 1996, respectively. We did not have interest income or capitalized interest for the year ended December 31, 1995 and did not capitalize interest for the year ended December 31, 1999. During the construction of the PCS system, the cost of the PCS licenses and the costs related to the construction expenditures are considered to be assets qualifying for interest capitalization under FASB Statement No. 34 "Capitalization of Interest Cost." (b) During the year ended December 31, 1999, we sold substantially all of our remaining cellular telephone assets for $89.3 million and 650 of our wireless towers for $274.6 million, resulting in an aggregate realized gain of $129.2 million. During the year ended December 31, 1997, we sold substantially all of our cellular telephone assets in the State of Maine for $77.2 million, resulting in a gain of $41.9 million. (c) During 1996, we changed our method of accounting for costs incurred in connection with certain promotional programs under which subscribers receive discounted cellular equipment or airtime usage credits. Under our previous accounting method, all such costs were deferred and amortized over the life of the related non-cancelable cellular telephone service agreement. Under the new accounting method, the costs are expensed as incurred. (d) EBITDA represents operating (loss) income before depreciation and amortization. EBITDA is provided because it is a measure commonly used in the industry. EBITDA is not a measurement of financial performance under generally accepted accounting principles and should not be considered an alternative to net income as a measure of performance or to cash flow as a measure of liquidity. (e) Cellular subscribers at end of period include 20,288 and 25,456 subscribers of Unicel in the State of Maine for the periods ended December 31, 1995 and 1996, respectively. (f) Net population equivalents means the estimated population of the license market area multiplied by the percentage ownership of the license. For the periods ended December 31, 1995 and 1996, net cellular population equivalents include 442,000 and 442,200 population equivalents, respectively, from Unicel's license market areas (including Maine RSA 2).
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
We provide PCS services in the southeastern United States under the name "Powertel." Our PCS licenses encompass a territory of approximately 246,000 contiguous square miles with a population of approximately 24.4 million people. We hold licenses to serve the Atlanta, Georgia MTA, the Jacksonville, Florida MTA, the Memphis, Tennessee/Jackson, Mississippi MTA and the Birmingham, Alabama MTA and 13 BTAs in Kentucky and Tennessee. We hold 30 MHz of spectrum licensed for PCS in the MTA Markets, and we hold 20 MHz of spectrum licensed for PCS in all of the BTA Markets except for the Knoxville, Tennessee BTA, where we hold a license for 10 MHz of spectrum. We have one of the largest contiguous licensed PCS footprints in the southeastern United States.
We introduced our PCS services in October 1996 in Jacksonville, Florida and Montgomery, Alabama and, to date, have launched our PCS services in a total of 34 markets in the Southeast. As of December 31, 1999, we had approximately 341,000 postpaid PCS subscribers and 205,000 prepaid PCS subscribers.
On April 30, 1999, we sold substantially all of our cellular telephone assets to Public Service Cellular, Inc. for $89.3 million. Prior to that sale, we provided cellular telephone service in contiguous portions of eastern Alabama and western Georgia under the name "InterCel."
On June 2, 1999, we sold 619 of our towers, related assets and liabilities to a subsidiary of Crown Castle International Corp. for $261.5 million in cash. In connection with this sale, we agreed to lease space on these towers for a monthly rent of $1,800 per tower for an initial lease term of ten years, with three five-year renewal periods that we may exercise at our option. On September 27, 1999, we also entered into a build-to-suit construction contract with Crown Castle that grants Crown Castle a right of first refusal to build, acquire and lease back to us at a rent of $1,800 per month up to 40 tower sites to be constructed prior to December 31, 2000. On December 2, 1999, we sold an additional 31 towers to Crown Castle under substantially similar terms as the June sale for $13.1 million in cash.
We incurred a net loss of $124.7 million for the year ended December 31, 1999, primarily as a result of the significant costs required to maintain our expanding PCS network, the hiring and management of required personnel to operate our business and market our services, the subsidization of handsets to our subscribers and the depreciation of PCS equipment and amortization of the PCS licenses. We expect to continue incurring operating losses beyond 1999 as we continue to expand and enhance our PCS network, increase our subscriber base and subsidize the cost of handsets to our subscribers.
Until recently, average revenues per subscriber in the wireless industry have declined, which we believe is the result of the addition of new subscribers on lower-priced rate plans, as well as intensified competition within the wireless industry. We believe the effects of these trends on our earnings will be mitigated by a corresponding increase in the number of wireless subscribers who desire additional value-added services primarily in the data area and our continued focus on offering products and services designed to encourage our subscribers to purchase higher - priced rate plans.
Minimizing subscriber attrition, or "churn," remains a challenge as our subscriber base grows and competition intensifies. We generated an average monthly churn rate of 2.9% and 5.3% for our postpaid and prepaid PCS subscriber base, respectively, for the year ended December 31, 1999, as compared to 4.1% for our postpaid PCS subscriber base for 1998. Because we did not launch prepaid service until September 1998, we did not report prepaid PCS churn during 1998. We believe the continued improvement in our postpaid PCS churn rate is the result of stricter credit evaluation policies, improved customer service response and training, our centralized call center, focused collections efforts and the availability of our prepaid service alternative.
We are a member of the GSM Alliance, a consortium of PCS carriers who offer GSM-based PCS service throughout North America. All members of the GSM Alliance have executed roaming agreements with each other, which allow GSM subscribers to roam throughout many major metropolitan areas in the U.S. and Canada. Additionally, we have signed a substantial number of international roaming agreements and expect to sign numerous others with international GSM carriers to facilitate international roaming, which we officially launched in August 1999.
RESULTS OF OPERATIONS
The following table reflects the composition of our cellular and PCS service revenue and equipment sales and related gross margins, as well as overall operating and other costs and margins. Our historical results of operations, particularly in view of the sale of our cellular telephone assets and certain of our tower assets and the start-up costs associated with our PCS business, will not be comparable with future periods.
- ----------------- (a) We sold our remaining cellular operations in April 1999.
YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998
Unless specifically noted, the following discussion reflects the results of operations for our PCS line of business only. We sold substantially all of the assets used in our cellular line of business in the second quarter of 1999.
Postpaid PCS service revenues increased $51.2 million, or 42.2%, for 1999 as compared to 1998. This increase is the result of continued PCS subscriber growth in our existing markets and our launch of 6 new PCS markets, primarily in Kentucky, since the beginning of the fourth quarter of 1998. Our postpaid PCS subscribers grew to approximately 341,000 at December 31, 1999, from approximately 253,000 at December 31, 1998. A significant portion of our postpaid subscriber growth in 1999 is attributable to the introduction of our 50-State Rates in July 1999.
The average monthly service revenue ("RPU") per postpaid PCS subscriber decreased to $49.18 for 1999 as compared to $54.27 for 1998. This decline in RPU reflects the addition of new subscribers on lower-priced rate plans, which is the result of intensified competition within the wireless industry. During the last half of 1999, we introduced rate plans which emphasize bundled airtime and toll minutes for higher-priced plans, which we believe contributed to a moderate increase in RPU towards the end of the year.
PCS roaming revenues (including roaming long distance) increased $2.6 million, or 74.3%, for 1999 as compared to 1998. This increase is due primarily to an increase in the number of roamers and usage per roamer, which is the result of increased penetration levels by surrounding GSM carriers and our success in obtaining roaming agreements with these carriers. We also launched international roaming in August and currently have agreements with other GSM carriers in more than 50 countries outside North America.
Prepaid PCS service revenues increased $53.2 million, or 2,061.8%, for 1999 as compared to 1998, which is attributable to the introduction of our intelligent network-based prepaid service alternative in September 1998. Our prepaid PCS subscribers grew to approximately 205,000 at December 31, 1999, from approximately 42,000 at December 31, 1998. A significant portion of our prepaid subscriber growth occurred in the fourth quarter of 1999 due to the launch of our promotional "Ready to Call" kit.
RPU per prepaid PCS subscriber increased to $48.08 for 1999 as compared to $40.05 for the fourth quarter of 1998. The increase during 1999 is attributable primarily to the growth in prepaid subscribers combined with increased minutes of use. Towards the end of 1999, RPU declined marginally due to the introduction of lower-denominated prepaid cards for airtime renewals.
Other service revenues, which include activation fees, fees from enhanced services and interconnection fees billed to local exchange carriers ("LECs") for connections to our PCS network, increased $6.4 million, or 94.9%, for 1999 as compared to 1998. This increase is due primarily to the increase in interconnection fees as a result of increased utilization of our PCS network by LECs and the re-introduction of activation fees in 1999.
Cost of services includes the cost of interconnection with LEC facilities, direct cell site costs (property taxes and insurance, site lease costs and electric utilities), roaming validation (provided by a third-party clearinghouse), long distance toll costs and certain prepaid subscriber-related fees. PCS cost of services increased $17.7 million, or 43.1%, for 1999 as compared to 1998. This increase is the result of the 221 additional cell sites we placed in service in 1999, as well as increased interconnection and toll costs related to increased traffic on our expanding PCS network and increased commissions due to the significant volume of prepaid card renewals.
We generated a negative PCS equipment margin of 151.1% on $29 million of sales during 1999 as compared to a negative 246.6% on $22.3 million of sales for 1998. The improvement in margins reflects a continued decrease in the average cost of handsets because of changes in the handset mix and our efforts to limit the subsidization of handset upgrades for existing subscribers. We expect to continue subsidizing the cost of handsets to subscribers for the foreseeable future.
PCS operations costs, which include the costs of managing and maintaining our PCS system, customer service, credit and collections (including bad debt) and inventory management increased $9.1 million, or 16.7%, for 1999 as compared to 1998. Substantially all of this increase is attributable to the costs of providing customer service through our centralized call center to the growing PCS subscriber base and the costs of maintaining our expanding PCS network, which increased due to certain equipment warranty expirations. This increase was partially offset by a substantial reduction in bad debt provisions resulting from improvements in credit and collections, as well as the success of our prepaid PCS service alternative.
PCS selling and marketing costs increased $36.7 million, or 59.5%, for 1999 as compared to 1998. Substantially all of this increase is attributable to increases in advertising and marketing costs and the continued expansion of our sales distribution channels, including increases in personnel, sales commissions and retail location costs. During 1999, we added approximately 370 new distribution points, including 45 new retail store locations.
PCS general and administrative costs increased $7.8 million, or 21.8%, for 1999 as compared to 1998. Substantially all of this increase is attributable to increased personnel and facilities costs at our corporate and regional administrative offices and information technology center.
Depreciation and amortization increased $21.5 million, or 31.8%, for 1999 as compared to 1998 and consists principally of the depreciation of the PCS network and the amortization of PCS licenses. Substantially all of the increase is attributable to the approximately 720 cell sites that we placed in service in 1999 and 1998 (including 221 cell sites in 1999), as well as depreciation of computer systems and infrastructure costs required to manage the administrative functions of our business.
Net consolidated interest expense increased $14.5 million, or 15.5%, for 1999 as compared to 1998. This increase in interest expense resulted primarily from increased borrowings under our credit facility and an increase in our bond accretion.
We recorded a gain on sale of assets of $129.2 million for 1999. We sold our cellular telephone operations for $89.3 million, which resulted in a gain of $79.3 million. We also sold 650 of our wireless transmission towers for $274.6 million, which resulted in a realized gain of $49.9 million and a deferred gain of $88.3 million. The deferred gain will be amortized over the initial lease term of ten years as a reduction of cost of services.
The effective income tax rate for 1999 and 1998 was 0%. We generated a net loss of $124.7 million for the year ended December 31, 1999, and expect to incur net losses beyond 1999. We will not recognize the tax benefit of these losses until management determines that it is more likely than not that such benefit is realizable.
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
Postpaid service revenues increased $80.8 million, or 155.5%, for 1998 as compared to 1997. PCS postpaid service revenues increased $85.1 million in 1998, or 234.6%, primarily as a result of our continued subscriber growth and our launch of seven new PCS markets, including Atlanta, Georgia, since the fourth quarter of 1997. Our postpaid PCS subscribers grew to approximately 253,000 at December 31, 1998, from approximately 119,000 at December 31, 1997. Cellular postpaid service revenues decreased $4.3 million, or 27.5%, primarily as a result of the sale of our cellular operations in the State of Maine during the second quarter of 1997 and the corresponding disposition of approximately 27,000 subscribers.
RPU per PCS postpaid subscriber decreased to $54.27 in 1998, as compared to $57.81 in 1997. This decrease was attributable primarily to changes in our rate plan offerings from 1997 to 1998. In 1997, a substantial portion of our PCS subscribers were participants in a promotional plan under which they received unlimited monthly airtime for local calling for a fixed monthly fee of $50. In 1998, we offered multiple rate plans with fixed monthly access charges ranging from $20 to $90. These rate plans contributed to an overall reduction in RPU per PCS postpaid subscriber as subscribers gravitated toward lower fixed-rate plans, a trend consistent with a general trend in the wireless industry of declining RPU.
RPU per cellular postpaid subscriber decreased to $35.58 in 1998 from $38.33 for 1997. This decrease reflected increased price competition among wireless carriers, which prompted us to offer cellular rate plans with more bundled airtime minutes.
PCS roaming revenues (including roaming long distance) were $3.6 million in 1998, as compared to $.2 million in 1997, which reflected the success of our roaming agreements with GSM Alliance partners that became effective during the last few months of 1997. Cellular roaming revenues increased $1.0 million, or 17.9%, in 1998, as compared to 1997. This increase was due primarily to an increase in the number of roamers and the increased usage per roamer in 1998.
Because we introduced our intelligent network-based prepaid service alternative in September 1998, we generated $2.6 million in PCS prepaid service revenues in 1998. RPU per PCS prepaid subscriber was $40.05 since the launch of this service.
Other service revenues, which include activation fees, fees from enhanced services, co-location revenue and interconnection fees billed to LECs for connections to our PCS and cellular networks, increased $1.8 million, or 36.6%, for 1998 as compared to 1997. This increase was due primarily to our concentrated efforts to secure tenants for co-location on our towers and the increase in interconnection fees as a result of increased traffic originating on the LECs' networks and terminating on our PCS and cellular networks. We waived all activation fees for new PCS subscribers in the third and fourth quarters of 1998.
Cost of services includes the cost of interconnection with LEC facilities, direct cell site costs (property taxes and insurance, site lease costs and electric utilities), PCS and cellular roaming validation (provided by a third-party clearinghouse), long distance toll costs and supplementary services (such as voice mail). PCS cost of services increased $15.7 million, or 62.0%, in 1998 as compared to 1997. This increase primarily reflected costs related to the approximately 500 additional cell sites we placed in service in 1998, as well as increased interconnection and toll costs related to increased traffic on our expanding PCS network. Cellular cost of services decreased $1.2 million, or 39.0%, in 1998 as compared to 1997, primarily as a result of the sale of our cellular operations in the State of Maine.
We generated a negative PCS equipment margin of 246.6% on $22.3 million of sales in 1998, as compared to 179.8% on $15.4 million of sales in 1997. The increase in negative PCS equipment margin was primarily the result of special promotional prices that we offered on several handsets during the third and fourth quarters of 1998. We generated a negative cellular equipment margin of 109.5% on $.8 million of sales in 1998, as compared to 189.9% on $.8 million of sales in 1997. This improvement in negative margin was attributable to a decrease in the cost of cellular handsets in 1998. We expect to continue subsidizing the cost of PCS handsets to subscribers for the foreseeable future.
Operations costs, which include the costs of managing and maintaining our cellular and PCS systems, customer service, credit and collections (including bad debt) and inventory management increased $32.5 million, or 135.6%, for 1998 as compared to 1997. PCS operations costs increased $33.2 million, or 156.3%, which was attributable to costs incurred to provide customer service to the growing PCS subscriber base, to maintain the expanding PCS network and to a significant increase in the bad debt provision resulting from the disconnection of non-paying PCS subscribers. Cellular operations costs decreased $.7 million, or 27.5%, which was attributable primarily to the sale of our cellular operations in the State of Maine.
Selling and marketing costs increased $22.5 million, or 54.4%, for 1998 as compared to 1997. PCS selling and marketing costs increased $23.5 million, or 61.7%, which was attributable to continued increases in PCS advertising and marketing costs and the expansion of our sales distribution channels, including increases in personnel, commissions and retail location costs. Cellular selling and marketing costs decreased $1.0 million, or 30.9%, which was attributable primarily to the sale of our cellular operations in the State of Maine.
General and administrative costs increased $11.9 million, or 46.2%, for 1998 as compared to 1997. Substantially all of this increase was attributable to PCS general and administrative costs, which increased due to
increased personnel and the related facilities costs at our corporate and regional administrative offices and information technology center.
Depreciation and amortization increased $18.4 million, or 37.3%, for 1998 as compared to 1997 and consists principally of the depreciation of the PCS and cellular network and the amortization of PCS licenses. Substantially all of the increase was attributable to depreciation associated with the approximately 500 additional PCS cell sites that we placed in service in 1998 and amortization associated with our launch of seven new PCS markets since the fourth quarter of 1997.
Net consolidated interest expense increased $51.1 million, or 120.0%, for 1998 as compared to 1997. This increase resulted primarily from interest expense incurred on our $300 million 11.125% Senior Notes Due 2007, lower funds available for investment due to the buildout of the PCS network and a reduction in capitalized interest ($1.9 million in 1998 compared to $22.1 million in 1997), which was attributable to the completion and placing in service of substantial portions of the PCS system.
The effective income tax rate for 1998 and 1997 was 0%. We generated a $265.8 million net loss for 1998 and expect to continue to incur significant operating losses in 1999 and beyond. We will not recognize the tax benefit of these operating losses until management determines that it is more likely than not that such benefit is realizable.
LIQUIDITY AND CAPITAL RESOURCES
We had cash and cash equivalents of $371.4 million and restricted cash of $16.2 million at December 31, 1999, as compared to $204.8 million and $33.4 million, respectively, at December 31, 1998. During 1999, we used net cash of $99.0 million for operating activities, as compared to $165.8 million for 1998. The net loss from operations totaled $124.7 million for 1999, which was after recognition of a gain on sale of assets of $129.2 million. The cash impact of the net loss was partially offset by $89.2 million of depreciation and amortization and $68.9 million of bond accretion on the senior discount notes.
Cash provided from investing activities was $255.3 million for 1999, as compared to cash used in investing activities of $184.1 for 1998. The cash was primarily generated from the sale of assets of $364.0 million and the liquidation of short-term investments of $31.5 million. This was partially offset by capital expenditures totaling $130.8 million primarily related to the buildout of our PCS system and support systems.
Cash provided from financing activities was $10.2 million for 1999, as compared to $227.7 million for 1998. Financing activities for 1999 consisted primarily of borrowings of $6.5 million under the Credit Facility and proceeds from the exercise of stock options and warrants of $4.0 million.
On June 2, 1999, we sold 619 of our towers, related assets and liabilities to a subsidiary of Crown Castle International Corp. for $261.5 million in cash. In connection with this sale, we agreed to lease space on these towers for a monthly rent of $1,800 per tower for an initial lease term of ten years, with three five-year renewal periods that we may exercise at our option. On December 2, 1999, we sold an additional 31 towers to Crown Castle under substantially similar terms as the June sale for $13.1 million in cash.
On April 30, 1999, we sold to Public Service Cellular, Inc. substantially all of our cellular assets for $89.3 million. At closing, PSC paid us $83.1 million in cash (including reimbursement for certain capital expenditures of $.3 million) and paid $6.2 million into escrow. On November 1, 1999, substantially all remaining funds were released to us from escrow.
During 1998, we sold 50,000 shares of our nonvoting Series E 6.5% Cumulative Convertible Preferred Stock (the "Series E Preferred") to SCANA Communications, Inc., a wholly-owned subsidiary of SCANA Corporation, and 50,000 shares of our nonvoting Series F 6.5% Cumulative Convertible Preferred Stock (the "Series F Preferred") to ITC Wireless, Inc., a wholly-owned subsidiary of ITC Holding Company, Inc., for an aggregate purchase price of $150 million. The Series E Preferred and Series F Preferred become convertible on June 22, 2003, at the option of the holder, into common stock at a conversion price of $22.01, subject to
adjustment. Each is redeemable at our option any time after June 22, 2003, but no later than June 1, 2010. Each has a liquidation preference over the common stock of $1,500 per share, subject to adjustment, plus accrued and unpaid dividends in the event of our liquidation, dissolution or winding up. The 6.5% annual dividend on each of the Series E Preferred and Series F Preferred is payable quarterly in common stock or, under certain circumstances, cash. We intend to pay such quarterly dividends in common stock for the foreseeable future.
During 1997, we issued $300 million principal amount of our 11.125% Senior Notes due June 2007. We used $89.6 million of the proceeds from the Senior Notes to purchase and pledge, for the benefit of the holders, certain U.S. government securities to provide for the payment of the first six scheduled interest payments.
During 1997, we sold 50,000 shares of our nonvoting Series C Convertible Preferred Stock (the "Series C Preferred") to The Huff Alternative Income Fund, L.P. ("Huff") and 50,000 shares of our nonvoting Series D Convertible Preferred Stock (the "Series D Preferred") to SCANA for an aggregate purchase price of $45 million. In September 1999, Huff converted all of the Series C Preferred shares into 1,764,706 shares of common stock. The Series D Preferred becomes convertible on March 14, 2002, at the option of the holder, into common stock at a conversion price of $12.75, subject to adjustment. The Series D Preferred is redeemable at our option any time after June 5, 2002. The Series D Preferred has a liquidation preference over the common stock of $450 per share, subject to adjustment, plus declared and unpaid dividends in the event of our liquidation, dissolution or winding up.
In May 1997, we sold our cellular operations in the State of Maine to a subsidiary of Rural Cellular Corporation. On the closing date, Rural Cellular Corporation paid us $71.8 million in cash and paid $5.4 million into escrow. In November 1997, we received the remaining funds from escrow. In addition, Rural Cellular reimbursed us for approximately $250,000 in capital expenditures made on its behalf prior to the closing of the transaction.
We maintain a $265 million credit facility, which funds our purchase of PCS network equipment and services. As of December 31, 1999, we had borrowed the maximum amount available under the credit facility. We will repay the aggregate advances under the credit facility in twenty equal quarterly installments, commencing in March 2000 and continuing for a period of five years thereafter, with the last installment in an amount necessary to repay in full the remaining outstanding balance.
Total capital expenditures, including capital expenditures for information technology and the support of the PCS business, were $130.8 million, $207.3 million and $291.8 million for 1999, 1998 and 1997, respectively. Costs associated with the initial PCS system buildout, which we have completed, included tower sites, leasehold improvements, base station and switch equipment and labor expenses related to construction of sites. We currently estimate that capital expenditures will total approximately $151 million for 2000. These expenditures are primarily to enhance and expand our PCS network in existing markets in order to increase capacity and to satisfy subscriber needs and competitive requirements, as well as to build out certain secondary cities within our licensed footprint. We will continue to upgrade our network capacity and service quality, particularly as they relate to our prepaid service intelligent-network platform, to support our anticipated subscriber growth.
Although we have completed the initial buildout of our PCS system, we continue to require significant amounts of capital to fund the operation and expansion of our PCS business. We believe cash on hand and cash from continuing operations will be sufficient to fund our PCS operations in 2000.
We are unable to predict the amount of expenditures that we will make beyond 2000, and we may need to raise additional capital to fund and expand our business operations. We also will need to raise additional capital if we decide to acquire additional licenses or businesses. We may attempt to raise additional capital through public or private debt or equity financings, vendor financings or other means. However, we cannot guarantee that additional financing will be available to us or, if available, that we will be able to obtain it on terms acceptable to us, favorable to our stockholders and within the limitations contained in our indentures, credit facility and any future financing arrangements. If we fail to obtain additional financing, we could experience delays in some or all of our expansion plans and expenditures, which could limit our ability to meet our debt service obligations and could materially adversely affect our business, financial condition and operating results.
We expect to continue to incur operating losses in the future while we continue to expand our PCS system and build our subscriber base. Our ability to satisfy our debt repayment obligations and covenants depends upon our future performance, which is subject to a number of factors, many of which are beyond our control. Cash interest will not be payable on our senior discount notes prior to 2001. We cannot guarantee that we will generate sufficient cash flow from our operating activities to meet our debt service and working capital requirements, and we may need to refinance our indebtedness. However, our ability to refinance our indebtedness will depend on, among other things, our financial condition, the state of the public and private debt and equity markets, the restrictions in the instruments governing our indebtedness and other factors, some of which may be beyond our control. In addition, if we do not generate sufficient cash flow to meet our debt service requirements or if we fail to comply with the covenants governing our indebtedness, we may need additional financing in order to service or extinguish our indebtedness. We may not be able to obtain financing or refinancing on terms that are either acceptable or favorable to our stockholders or us.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), which is effective for fiscal years beginning after June 15, 1999. In June 1999, the FASB issued Statement of Financial Accounting Standards No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133", which amends SFAS 133 to be effective for all fiscal quarters of all fiscal years beginning after June 15, 2000 (that is, January 1, 2001 for companies with calendar-year fiscal years). SFAS 133 establishes accounting and reporting standards for derivative instruments and transactions involving hedge accounting. We do not anticipate this statement will have a material impact on our financial statements.
In March 1998, the American Institute of Certified Public Accountants issued Statement of Position 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" ("SOP 98-1"), which is effective for fiscal years beginning after December 15, 1998. SOP 98-1 requires capitalization of certain costs of internal-use software. We adopted SOP 98-1 in January 1999, and it did not have a material impact on our financial statements.
OTHER
The Year 2000 issue relates to the inability of computer systems or any equipment with computer chips that use or store dates to distinguish between years with the same last two digits in different centuries, such as 1900 and 2000. We did not experience any significant malfunctions or errors in our operating or business systems when the date changed from 1999 to 2000.
As of December 31, 1999, we had incurred $8.4 million to address Year 2000 issues. Although we successfully transitioned into the year 2000 without any significant problems, our management will continue to monitor the situation, identify any problems and ensure that all systems are compliant throughout the year 2000. Given that many of our financial and network systems have been implemented in the last few years, our management is confident that this newer equipment and software is generally Year 2000 compliant. However, if we encounter significant Year 2000 problems, we will report them in our future reports.
DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS
This Report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements appear in a number of places in this Report and include all statements which are not historical facts and which relate to our intent, belief or current expectations, or that of our directors or officers. In this Report, we may have made forward-looking statements with respect to, among other things: (i) our financing plans; (ii) trends affecting our financial condition or results of operations; (iii) our growth and operating strategies; and (iv) our anticipated capital needs and capital expenditures. These statements can sometimes be identified by our use of forward-looking words such
as "believe," "may," "will," "anticipate," "estimate," "continue," "expect," "could," "should," "would" or "intend." We caution investors that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties. Our actual results may differ materially from those projected in these forward-looking statements as a result of: (i) factors affecting the availability, terms and cost of capital, risks associated with the selection of our PCS digital protocol, competitive factors and pricing pressures, general economic conditions, the failure of the market demand for our products and services to be commensurate with our management's expectations or past experience, issues associated with management of our growth, including the expansion of our network capacity, the impact of present or future laws and regulations on our business, changes in operating expenses or the failure of operating and buildout expenses to be consistent with our management's expectations and the difficulty of accurately predicting the outcome and effect of certain matters, such as matters involving litigation and investigations; (ii) various factors discussed herein; and (iii) those factors discussed in detail in our previous filings with the Securities and Exchange Commission, including the "Risk Factors" section of our Registration Statement on Form S-3 (Registration No. 333-84951), as declared effective by the Securities and Exchange Commission on September 24, 1999.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
Our management believes our exposure to market rate fluctuations on our investments is nominal due to the short-term nature of those investments. We have market risk to the extent of our borrowings under our credit facility because of the variable interest rate on the credit facility. However, our management does not foresee any material prolonged changes in interest rates in the near future. At present, we have no plans to enter into any hedging arrangements with respect to our borrowings.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our financial statements, including our consolidated balance sheets as of December 31, 1999 and 1998 and consolidated statements of income, consolidated statements of cash flows and consolidated statements of changes in stockholders' (deficit) equity for the years ended December 31, 1999, 1998 and 1997, together with the report of Arthur Andersen L.L.P. dated February 4, 2000, and the schedule containing certain supporting information are attached to this Report as pages through.
ITEM 9.
ITEM 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS IN ACCOUNTING AND FINANCIAL DISCLOSURES
We had no disagreements on accounting or financial disclosure matters with our accountants, nor did we change accountants, during the two fiscal years ended December 31, 1999.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
We incorporate by reference the information contained under the caption "ELECTION OF DIRECTORS" in the Definitive Proxy Statement for the 2000 Annual Meeting of Stockholders of Powertel (the "2000 Proxy Statement").
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
We incorporate by reference the information contained under the caption "EXECUTIVE COMPENSATION" in the 2000 Proxy Statement except for those portions entitled "Compensation/Stock Option Committee Report on Executive Compensation" and "Comparative Company Performance."
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
We incorporate by reference the information contained under the caption "EXECUTIVE COMPENSATION -- Beneficial Ownership of Capital Stock" in the 2000 Proxy Statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
We incorporate by reference the information contained under the caption "ELECTION OF DIRECTORS -- Certain Relationships and Related Transactions" in the 2000 Proxy Statement.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(A)(1) FINANCIAL STATEMENTS
The following financial statements of Powertel, Inc. are filed as a part of this Report and are attached as pages through.
Report of Independent Public Accountants
Consolidated Balance Sheets as of December 31, 1999 and 1998
Consolidated Statements of Income for the years ended December 31, 1999, 1998 and 1997
Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998 and 1997
Consolidated Statements of Changes in Stockholders' (Deficit) Equity for the years ended December 31, 1999, 1998 and 1997
Notes to Financial Statements
(A)(2) FINANCIAL STATEMENT SCHEDULES
The following financial statement schedules of Powertel, Inc. are filed as a part of this report and are attached as pages S-1 through S-2:
Report of Independent Public Accountants as to Schedules
Schedule II - Valuation and Qualifying Accounts for the years ended December 31, 1999, 1998 and 1997
All other schedules for which provision is made in the applicable accounting regulations of the SEC are not required under the related instructions or are inapplicable and, therefore, have been omitted.
(A)(3) EXHIBITS
27 Financial Data Schedule (for SEC use only)
- --------------------------------- * Previously filed.
** The Registrant agrees to furnish supplementally a copy of any omitted schedule or exhibit to the Securities and Exchange Commission upon request, as provided in Item 601(b)(2) of Regulation S-K.
+ Confidential treatment has been granted for certain confidential portions of this exhibit pursuant to Rule 24(b)(2) under the Exchange Act. In accordance with Rule 24(b)(2), these confidential portions have been omitted from this exhibit and filed separately with the Commission.
(B) REPORTS ON FORM 8-K
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereto duly authorized.
POWERTEL, INC.
March 29, 2000 By: /s/ Allen E. Smith ------------------------------------------------ Allen E. Smith Chief Executive Officer, President and Director
POWER OF ATTORNEY
KNOW BY ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints jointly and severally, Allen E. Smith and Fred G. Astor, Jr., and each one of them, his attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any and all amendments to this Annual Report (Form 10-K) and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchanges Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
March 29, 2000 /s/ Campbell B. Lanier, III ------------------------------------------------ Campbell B. Lanier, III Chairman of the Board of Directors
March 29, 2000 /s/ Allen E. Smith ------------------------------------------------ Allen E. Smith Chief Executive Officer, President and Director (principal executive officer)
March 29, 2000 /s/ Fred G. Astor, Jr. ------------------------------------------------ Fred G. Astor, Jr. Chief Financial Officer and Executive Vice President (principal financial and accounting officer)
March 29, 2000 /s/ Donald W. Burton ------------------------------------------------ Donald W. Burton Director
March 29, 2000 /s/ O. Gene Gabbard ------------------------------------------------ O. Gene Gabbard Director
March 29, 2000 /s/ Ann Milligan ------------------------------------------------ Ann Milligan Director
March ____, 2000 ------------------------------------------------ William H. Scott, III Director
March ____, 2000 ------------------------------------------------ William B. Timmerman Director
March ____, 2000 ------------------------------------------------ Donald W. Weber Director
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Powertel, Inc.:
We have audited the accompanying consolidated balance sheets of POWERTEL, INC. (a Delaware corporation) and subsidiaries as of December 31, 1999 and 1998 and the related consolidated statements of operations, changes in stockholders' equity (deficit), and cash flows for each of the three years ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as 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 financial position of Powertel, Inc. and subsidiaries as of December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years ended December 31, 1999, in conformity with accounting principles generally accepted in the United States.
ARTHUR ANDERSEN LLP
Atlanta, Georgia February 4, 2000
POWERTEL, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
The accompanying notes to consolidated financial statements are an integral part of these statements.
POWERTEL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes to consolidated financial statements are an integral part of these statements.
POWERTEL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' (DEFICIT) EQUITY FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
The accompanying notes to consolidated financial statements are an integral part of these statements.
POWERTEL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes to consolidated financial statements are an integral part of these statements.
POWERTEL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999, 1998, AND 1997
1. ORGANIZATION AND NATURE OF BUSINESS
Powertel, Inc. (the "Company") was incorporated in Delaware in April 1991 under the name Intercel, Inc. In June 1997, the Company changed its name to Powertel, Inc. The Company provides digital wireless personal communication services ("PCS") in the southeastern United States. Prior to April 30, 1999, the Company also provided cellular telephone services in contiguous portions of eastern Alabama and western Georgia under the name "Intercel" (Note 4).
Prior to May 1, 1997, the Company provided cellular telephone services in the State of Maine under the name "Unicel" (Note 4).
The Company's PCS licenses encompass a territory of approximately 246,000 contiguous square miles with a population of approximately 24.4 million people (according to industry publications) in the Major Trading Areas ("MTAs") of Atlanta, Georgia; Jacksonville, Florida; Memphis, Tennessee/Jackson, Mississippi; and Birmingham, Alabama; and in 13 Basic Trading Areas ("BTAs") in Kentucky and Tennessee. The Company holds 30 MHz of spectrum licensed for PCS in the MTA Markets and 20 MHz of spectrum licensed for PCS in all of the BTA Markets except for the Knoxville, Tennessee BTA, where the Company holds a license for 10 MHz of spectrum. The Company first introduced its PCS services in October 1996 in Jacksonville, Florida and Montgomery, Alabama and, to date, has launched its PCS services in a total of 34 markets in the Southeast.
While there are numerous wireless telephone systems operating in the United States and other countries, the wireless telecommunications industry has only limited operating history. Achieving profitable PCS operations will require the Company to successfully compete with other PCS providers in all of its markets, as well as with both existing and future wireless providers. In addition, successful PCS operations will require the development of products that are at least as commercially effective as its wireless competitors. Any failure to anticipate and respond to changes to technology and subscriber desires could have an adverse effect on the PCS business.
Management expects to continue incurring operating losses in future periods while it continues to develop and expand its PCS system and PCS subscriber base. Management believes it has adequate resources to fund these losses during its initial years of operation or that additional sources of funds will be available via public and private debt and equity placements or additional lines of credit. If such sources are needed but not available, management will have to alter its current operating plans.
2. SUMMARY OF ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements are prepared on the accrual basis of accounting and include the accounts of the Company and all majority-owned subsidiaries. All significant intercompany balances have been eliminated.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles 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. Estimates also affect the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Source of Supplies
The Company relies on local telephone companies and other companies to provide certain communications services. Although management feels alternative telecommunications facilities could be found in a timely manner, any disruption of these services could have an adverse effect on operating results.
Although the Company attempts to maintain multiple vendors for each required product, its inventory and equipment, which are important components of its operations, are each currently acquired primarily from less than five sources. In addition, some of the Company's suppliers have limited resources and production capacity. If the suppliers are unable to meet the Company's needs as it builds out its network infrastructure and sells services and equipment, then delays and increased costs in the expansion of the Company's network infrastructure or losses of potential subscribers could result, which would affect operating results adversely.
Presentation
Certain prior year amounts have been reclassified to conform to the current year presentation.
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand, demand deposits, and short-term investments with original maturities of three months or less.
Restricted Cash for Payment of Interest
Restricted cash consists of certain U.S. government securities with varying maturities which have been purchased and pledged, for the benefit of the holders of the 11.125% Senior Notes due June 2007, to provide for the payment of the first six scheduled interest payments on such Notes (Note 5).
Credit Risk
The Company's accounts receivable subject the Company to credit risk. The Company extends credit to its subscribers based upon an evaluation of the subscriber's financial condition and credit history and generally does not require collateral. The Company maintains an allowance for doubtful accounts based upon the expected collectibility of subscribers' accounts receivable. The Company bills certain services to subscribers in advance and has the ability to terminate access on delinquent accounts. The Company also introduced an intelligent-network-based prepaid service alternative during September 1998. Management believes these factors, as well as the large and geographically diverse number of subscribers comprising the subscriber base, mitigate the risk of loss and the concentration of credit risk.
The carrying amount of the Company's receivables approximates their fair value.
Inventories
The Company maintains inventories for resale of wireless handsets and accessory parts (i.e., antennae, batteries, cable, etc.). Inventories are valued at the lower of average cost (which approximates first-in, first-out) or market and are recorded net of a reserve for obsolescence of $1.5 million and $1.8 million at December 31, 1999 and 1998, respectively.
Property and Depreciation
Property and equipment are recorded at cost, including certain engineering costs. The Company records depreciation using the straight-line method over the estimated useful lives of the assets, which are 10 to 15 years for towers, buildings and improvements and 3 to 10 years for equipment, furniture and fixtures. The Company's policy is to remove the cost and accumulated depreciation of retirements from the accounts and recognize the
related gain or loss upon the disposition of assets. Such gains and losses were not material for any period presented, except as described in Notes 3 and 4.
Assets Under Construction
Expenditures to construct the Company's PCS system are recorded as assets under construction until the assets are placed in service. When the assets are placed in service, they are transferred to the appropriate property and equipment category and depreciated.
The Company capitalized interest incurred on borrowings related to assets under construction during the initial buildout of the PCS system. Of the cumulative aggregate capitalized interest of $50.3 million, $9.9 was attributed to property, plant and equipment at December 31, 1999.
Licenses
Licenses consist of costs incurred to acquire PCS licenses, including cumulative capitalized interest of $40.4 million at December 31, 1999, and certain microwave relocation costs. Licenses are stated at cost less accumulated amortization and are being amortized using the straight-line method over 40 years.
Deferred Charges and Other
Deferred charges and other consist primarily of costs related to the offerings of the Company's senior notes and senior discount notes (Note 5) and are being amortized over the 10-year lives of the related notes.
Impairment of Long-Lived Assets
The Company periodically reviews the values assigned to long-lived assets, including property and equipment, licenses and deferred charges, to determine if any possible impairment has occurred and is other than temporary. Management believes the long-lived assets in the accompanying consolidated balance sheets are appropriately valued.
Stock-Based Compensation Plans
The Company accounts for its stock-based compensation plans under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). Effective in 1996, the Company adopted the disclosure option of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123") (Note 7) for all options granted subsequent to January 1, 1995.
Revenue Recognition
The Company earns revenues by providing PCS and cellular service to both local subscribers and subscribers of other PCS and cellular carriers traveling ("roaming") through the Company's service area, as well as from sales of PCS and cellular equipment. Postpaid service revenues consist of base monthly service fees ("access"), airtime revenue and long-distance revenues ("toll revenues"). Generally, access fees are billed one month in advance, but recognized when earned, while airtime and toll revenues are recognized when service is provided.
The Company introduced a prepaid PCS service alternative in September 1998. Prepaid PCS service revenues are collected in advance but recognized as service is provided.
Roaming revenues consist of the airtime and toll fees charged to the subscribers of other PCS and cellular carriers for use of the Company's PCS network while traveling in the Company's service area. Roaming revenues are recognized when service is rendered.
Other revenues consist of activation fees, optional enhanced service features and interconnection fees charged to local exchange carriers for connections to the PCS network and are recognized when earned.
Equipment sales are recognized upon delivery of the equipment to the customer.
Advertising
The Company expenses advertising as incurred
Interest Expense, Net
Interest expense, net is comprised of the following (in millions):
Loss Per Share
Basic loss per share (EPS) was computed by dividing net loss available to common stockholders by the weighted average number of shares of common stock outstanding during the year. Diluted EPS is the same as basic EPS for all periods presented as all common stock equivalents would have an antidilutive effect.
Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), which is effective for fiscal years beginning after June 15, 1999. In June 1999, the FASB issued Statement of Financial Accounting Standards No. 137, "Accounting for Derivative Instruments and Hedging Activities -- Deferral of the Effective Date of FASB Statement No. 133", which amends Statement 133 to be effective for all fiscal quarters of all fiscal years beginning after June 15, 2000 (that is, January 1, 2001 for companies with calendar-year fiscal years). SFAS 133 establishes accounting and reporting standards for derivative instruments and transactions involving hedge accounting. The Company does not anticipate that this statement will have a material impact on its financial statements.
In March 1998, the American Institute of Certified Public Accountants issued Statement of Position 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" ("SOP 98-1"), which is effective for fiscal years beginning after December 15, 1998. SOP 98-1 requires capitalization of certain costs of internal-use software. The Company adopted SOP 98-1 in January 1999. Adoption of SOP 98-1 did not have a material impact on the Company's financial statements.
3. TOWER ASSETS SALE-LEASEBACK
On June 2, 1999, pursuant to an Asset Purchase Agreement dated March 15, 1999, the Company sold to CCP Inc., a wholly-owned subsidiary of Crown Castle International Corp ("Crown Castle"), 619 of its wireless transmission towers, related assets and certain liabilities for $261.5 million. On December 2, 1999, pursuant to an Asset Purchase Agreement dated September 27, 1999, the Company sold to Crown Castle an additional 31 towers for $13.1 million. In connection with these sales, the Company entered into master lease agreements with Crown Castle to lease space on the towers for a monthly rent of $1,800 per tower for an initial lease term of ten years, with three five-year renewal periods at the option of the Company. The transactions were recorded as a sale-leaseback. Accordingly, $88.3 million of the total gain on the sale of $138.2 million was deferred and will be amortized over the initial lease term of ten years as a reduction of cost of services. The unamortized portion of the deferred gain is recorded as a long-term obligation in the accompanying consolidated balance sheets.
In connection with these transactions, the Company also entered into a build-to-suit construction contract with Crown Castle (Note 9).
4. ASSET DISPOSITIONS
On April 30, 1999, pursuant to an Asset Purchase Agreement dated January 5, 1999, the Company and certain of its wholly-owned subsidiaries sold to Public Service Cellular, Inc. ("PSC") substantially all of the assets and FCC Licenses of the Company relating to its cellular telephone operations in eastern Alabama and western Georgia for $89.3 million. The transaction constituted the sale of all of the Company's cellular telephone operations and resulted in a $79.3 million gain to the Company. At closing, PSC paid the Company $83.1 million
in cash (including reimbursement for certain capital expenditures of $.3 million) and paid $6.2 million into escrow. On November 1, 1999, substantially all of the $6.2 million was released from escrow to the Company.
On May 1, 1997, pursuant to an Asset Purchase Agreement dated as of December 23, 1996, certain subsidiaries of the Company sold and assigned (the "Unicel Disposition") to a subsidiary of Rural Cellular Corporation ("Rural Cellular"), substantially all the assets and rights of the Company (including its 51% general partnership interest in the Northern Maine Cellular Partnership) to provide cellular and microwave service in the Bangor, Maine MSA and Maine RSA3 and to provide microwave service in Maine RSA2. This transaction resulted in a $41.9 million gain to the Company. At closing, Rural Cellular paid the Company $71.8 million in cash and paid $5.4 million into escrow. On November 3, 1997, the $5.4 million was released from escrow to the Company.
The following unaudited pro forma condensed consolidated statements of operations (in millions, except per share data) assume the sales occurred at the beginning of each period presented. In the opinion of management, all adjustments necessary to present fairly such unaudited pro forma condensed statements of operations have been made.
5. LONG-TERM OBLIGATIONS
During 1997, the Company issued $300 million principal amount of 11.125% Senior Notes due June 2007 (the "June Notes"). The June Notes may be redeemed at any time on or after June 1, 2002, at the option of the Company, at 105.5626% of their principal amount, plus accrued interest, declining to 100% of their principal amount, plus accrued interest, on and after June 1, 2004. In addition, at any time prior to June 1, 2000, up to 35% of the aggregate principal amount of the June Notes may be redeemed from the proceeds of one or more public equity offerings at 111.125% of their principal amount, provided that after any such redemption at least $195.0 million aggregate principal amount of the June Notes remains outstanding. Interest on the June Notes is payable semiannually in cash on June 1 and December 1 of each year.
The Company used $89.6 million of the proceeds from the June Notes to purchase and pledge, for the benefit of the holders of the June Notes, certain U.S. government securities to provide for the payment of the first six scheduled interest payments on the June Notes. The remaining unpaid portion of such amounts is classified as "Restricted Cash for Payment of Interest" in the accompanying consolidated balance sheets (Note 2).
During 1996, the Company issued $360 million principal amount at maturity of the Company's 12% Senior Discount Notes due April 2006 (the "April Notes") and $357 million aggregate principal amount at maturity of the Company's 12% Senior Discount Notes due February 2006 (the "February Notes"). The April Notes may be redeemed at any time on or after May 1, 2001, at the option of the Company, at 106% of their principal amount at maturity, plus accrued interest, declining to 100% of their principal amount at maturity, plus accrued interest, on and after May 1, 2003. The April Notes will fully accrete to face value on May 1, 2001, at which time they will bear interest, payable in cash, at a rate of 12% per annum on each May 1 and November 1, commencing November 1, 2001.
The February Notes may be redeemed at any time on or after February 1, 2001, at the option of the Company, at 106% of their principal amount at maturity, plus accrued interest, declining to 100% of their principal amount at maturity, plus accrued interest on and after February 1, 2003. The February Notes will fully
accrete to face value on February 1, 2001, at which time they will bear interest, payable in cash, at a rate of 12% per annum on each February 1 and August 1, commencing August 1, 2001.
Unamortized original issue discount on the April Notes and February Notes is being amortized using effective interest rates of 12% and 12.35%, respectively. For the years ended December 31, 1999, 1998 and 1997, total accretion of the original issue discount was $68.9 million, $61.1 million and $54.5 million, respectively, of which $0.0 million, $1.9 million and $20.4 million was capitalized and $68.9 million, $59.2 million and $34.1 million, respectively, was included in interest expense in the accompanying consolidated statements of operations.
The Company maintains a $265 million Credit Facility regarding the purchase of and vendor financing for PCS network equipment and services. Under the original terms of the Credit Facility, advances were made as requested by the Company to finance purchases from Ericsson Inc. pursuant to the terms of the related Ericsson Equipment Purchase Agreement (Note 9). As of December 31, 1999, the Company had borrowed the maximum available under the Credit Facility. The aggregate amount of the advances made will be repaid in twenty equal quarterly installments, commencing in March 2000 and continuing for a period of five years thereafter, with the last installment in an amount necessary to repay in full the remaining outstanding balance.
The interest rate under the Credit Facility is based on the applicable Eurodollar Rate plus 3% (9.0625% at December 31, 1999) but can be converted to a fluctuating interest rate per annum based on the higher of Citibank N.A.'s base rate or .5% above the Federal Funds Rate, plus 1%, at the discretion of the lender. Interest on the unpaid principal amount of each advance is payable in arrears on the last day of each calendar quarter.
The Credit Facility is secured by all the equipment purchased with the proceeds therefrom, subject to the terms of the Ericsson Equipment Purchase Agreement, as well as a pledge of the stock of the Company's subsidiaries that hold the PCS licenses.
Scheduled maturities of long-term obligations are as follows (in millions):
The indentures relating to the June Notes, February Notes and April Notes (the "Indentures") and Credit Facility contain certain restrictive covenants which significantly limit or prohibit, among other things, the ability of the Company to incur additional indebtedness, make prepayments of certain indebtedness, pay dividends, make investments, engage in transactions with stockholders and affiliates, issue capital stock, create liens, sell assets and engage in mergers and consolidations. The Credit Facility also requires the Company to maintain certain financial ratios. If the Company fails to comply with these restrictive covenants or maintain such ratios, the Company's obligation to repay all, or significant portions of, the Notes and Credit Facility may be accelerated. The limitations in the Indentures are subject to certain qualifications and exceptions, which, in particular, allow the Company and its subsidiaries to incur additional indebtedness in certain circumstances.
At December 31, 1999, the Company was in compliance with all covenants and financial ratios under the Indentures and Credit Facility.
6. PREFERRED STOCK
The Preferred Stock reflected in the accompanying consolidated balance sheets is as follows:
On September 22, 1999, The Huff Alternative Income Fund, L.P., which originally purchased 50,000 shares of Series C Convertible Preferred Stock (the "Series C Preferred") from the Company on June 5, 1997, converted all of the Series C Preferred shares into 1,764,706 shares of common stock.
On September 15, 1999, Sonera Ltd. purchased 100,000 shares of non-voting Series A Convertible Preferred Stock (the "Series A Preferred") from Ericsson Inc., which originally purchased the Series A Preferred from the Company on June 29, 1996. The Series A Preferred is currently convertible, at the option of the holder, at a rate of 46.27 shares of common stock per share of preferred stock, subject to adjustment. The Series A Preferred is redeemable, at the option of the Company, in whole or in part, on a pro rata basis, at a redemption price of $750 per share plus declared and unpaid dividends, anytime subsequent to June 28, 2001. The Series A Preferred has a liquidation preference of $750 per share plus declared and unpaid dividends in the event of a liquidation, dissolution or winding up of the Company.
On June 22, 1998, in separate private placements, the Company issued: (a) 50,000 shares of non-voting Series E 6.5% Cumulative Convertible, Redeemable Preferred Stock (the "Series E Preferred") to SCANA Communications, Inc., a wholly-owned subsidiary of SCANA Corporation ("SCANA"), for $75 million; and (b) 50,000 shares of non-voting Series F 6.5% Cumulative Convertible, Redeemable Preferred Stock (the "Series F Preferred") to ITC Wireless, Inc., a wholly-owned subsidiary of ITC Holding Company, Inc., for $75 million. The Series E Preferred and Series F Preferred become convertible on June 22, 2003, at the option of the holder, at a rate of 68.15 shares of common stock per share of preferred stock, subject to adjustment. Each is redeemable at the option of the Company, in whole or in part, on a pro rata basis, at a redemption price of $1,500 per share plus accrued and unpaid dividends, anytime subsequent to June 22, 2003, but no later than June 1, 2010. Each has a liquidation preference over the common stock of $1,500 per share, subject to adjustment, plus accrued and unpaid dividends in the event of a liquidation, dissolution or winding up of the Company.
Due to the mandatory redemption feature included in the Series E Preferred and Series F Preferred, the Series E Preferred and Series F Preferred have been classified in the mezzanine of the accompanying consolidated balance sheets at redemption value, net of issuance costs.
The 6.5% annual dividend on each of the Series E Preferred and Series F Preferred is payable quarterly in common stock or, under certain circumstances, cash. The Company intends to pay such quarterly dividend in common stock for the foreseeable future.
During 1997, the Company issued 50,000 shares of non-voting Series D Convertible Preferred Stock (the "Series D Preferred") to SCANA for $22.5 million. The Series D Preferred becomes convertible on March 14, 2002, at the option of the holder, at a rate of 35.29 shares of common stock per share of preferred stock, subject to adjustment. The Series D Preferred is redeemable, at the option of the Company, in whole or in part, on a pro rata basis, at a redemption price of $450 per share plus declared and unpaid dividends, anytime subsequent to June 5, 2002. The Series D Preferred has a liquidation preference of $450 per share plus declared and unpaid dividends in the event of a liquidation, dissolution or winding up of the Company.
During 1996, the Company issued 100,000 shares of non-voting Series B Convertible Preferred Stock (the "Series B Preferred") to SCANA for $75 million. The Series B Preferred becomes convertible on March 14, 2002, at the option of the holder, at a rate of 45.45 shares of common stock per share of preferred stock, subject to adjustment. The Series B Preferred is redeemable, at the option of the Company, in whole or in part, on a pro rata basis, at a redemption price of $750 per share plus declared and unpaid dividends, anytime subsequent to June 28, 2001. The Series B Preferred has a liquidation preference of $750 per share plus declared and unpaid dividends in the event of a liquidation, dissolution or winding up of the Company.
The Company's certificate of incorporation authorizes the Board of Directors to issue, from time to time and without further stockholder action, one or more series of preferred stock and to fix the relative rights and preferences of the shares, including voting powers, dividend rights, liquidation preferences, redemption rights, and conversion privileges.
7. STOCK OPTION PLANS
Stock Options
Under the Powertel, Inc. 1991 Stock Option Plan, as amended (the "Stock Plan"), 5,000,000 shares of common stock are reserved for issuance upon exercise of options. Substantially all of the employees of the Company are eligible to receive options under the Stock Plan. Management recommends to the Compensation/Stock Option Committee the number of options to grant based on management's analysis of the employee's performance and level of responsibility. The Board of Directors also may include in each option granted under the Stock Plan certain additional limitations on the recipient's right to exercise the option. Options under the Stock Plan may be either "incentive stock options," as defined under Section 422 of the Internal Revenue Code, or nonqualified options.
Under the Company's Nonemployee Stock Option Plan (the "Nonemployee Plan"), 400,000 shares of common stock are reserved for issuance upon exercise of options. All nonemployee directors of the Company and all employees of affiliates of the Company are eligible to receive options under the Nonemployee Plan. Options to purchase 10,000 shares of common stock are granted to each nonemployee director upon his or her election or appointment to the Board of Directors. The Nonemployee Plan does not provide for discretionary option grants.
Options granted under the Stock Plan and Nonemployee Plan generally become exercisable as to 50% two years after the date of grant, 25% three years after the date of grant, and 25% four years after the date of grant, but no option may be exercised more than ten years after the date of grant. Options generally are exercisable at a price established by the Compensation/Stock Option Committee equal to at least 100% of the fair market value of the Common Stock on the options' grant date, except that the exercise price with respect to options granted to an individual who owns more than 10% of the combined voting power of all classes of stock of the Company must be at least 110% of the fair market value of the common stock on the date of grant. The full exercise price for shares being purchased must be paid at the time of exercise in cash or, if permitted by the particular option agreement, in whole or in part by delivery of shares of Common Stock having a fair market value (on the delivery date) of not less than the exercise price.
The Company accounts for its stock-based compensation related to the Stock Plan and Nonemployee Plan under APB 25. Accordingly, no compensation expense has been recognized, as all options have been granted with an exercise price equal to the fair value of the Company's stock on the date of grant. For SFAS 123 pro forma purposes, the fair value of each option grant has been estimated as of the date of grant using the Black-Scholes option pricing model with the following assumptions:
Using these assumptions, the fair value of the stock options granted in 1999, 1998 and 1997 is $9.7 million, $6.7 million and $4.3 million, respectively, which would be amortized as compensation expense over the vesting period of the options. Had compensation cost been determined consistent with the provisions of SFAS 123, the Company's net loss and pro forma net loss per common share for 1999, 1998 and 1997 would have been as follows (in millions, except per share amounts):
Because SFAS 123 has not been applied to options granted prior to January 1, 1995, the resulting pro forma compensation cost may not be representative of that expected in future years.
Under the Company's 1995 Employee Restricted Stock Plan (the "Restricted Stock Plan"), 200,000 shares of common stock are reserved for issuance, of which 163,800 shares had been awarded through December 31, 1999. These restricted stock awards vest in three equal installments on the first, second and third anniversaries of the date of grant. The compensation associated with the restricted grants (i.e., the difference between the market price of the Company's Common Stock on the date of grant and the exercise price) is being amortized ratably over the three-year vesting period. Such compensation expense totaled $0.7 million, $0.6 million and $0.4 million for the years ended December 31, 1999, 1998 and 1997, respectively. Any unamortized deferred compensation is reflected as a reduction to stockholders' equity (deficit) in the accompanying consolidated balance sheets. The Restricted Stock Plan is administered by the Compensation/Stock Option Committee of the Board of Directors.
A summary of the combined status of all stock plans at December 31, 1999, 1998 and 1997 is presented in the following table:
The following table summarizes the exercise price range, weighted average exercise price and weighted average remaining contractual life for the options outstanding as of December 31, 1999:
Total stock options exercisable at December 31, 1999 were 1,298,791 at a weighted average exercise price of $12.45.
Stock Warrants
As of December 31, 1999, the Company had outstanding approximately 1.2 million warrants to purchase its common stock. Each warrant entitles the holder to purchase 1.0705 shares of common stock at $16.95 per share (as adjusted for the June 1996 issuance of the Series A Preferred and Series B Preferred). The warrants may be exercised at any time prior to February 1, 2006. At December 31, 1999, 69,301 warrants had been exercised.
8. INCOME TAXES
The reconciliation of the statutory federal income tax rate to the Company's effective income tax rate is as follows:
The significant components of the Company's net deferred tax asset are as follows (in millions):
At December 31, 1999, the Company had available net operating loss carryforwards for regular tax purposes of approximately $328 million, which will expire at various dates between 2005 and 2018, and alternative minimum tax credit carryforwards of $0.2 million, which have no expiration. The utilization of a portion of these carryforwards is subject to limitations under the Internal Revenue Code of 1986. Since management is currently unable to determine whether it is more likely than not that some portion of the net deferred tax asset will be realized, a valuation allowance of $237.1 million has been provided in the accompanying consolidated financial statements. The valuation allowance increased $54.6 million and $109.0 million in 1999 and 1998, respectively.
9. COMMITMENTS AND CONTINGENCIES
Leases
Lease expenses relate to the lease of office and warehouse space, land for cell sites, cell sites, dedicated lines and trunk access facilities, computer equipment, and billboards and include leases with affiliates (Note 10). Rents charged to expense were approximately $29.1 million, $20.6 million and $10.5 million for the years ended December 31, 1999, 1998 and 1997, respectively.
At December 31, 1999, future minimum lease payments under noncancelable operating leases with initial remaining terms of more than one year are as follows (in millions):
Construction Contract
On September 27, 1999, the Company entered into a build-to-suit construction contract (Note 3) with Crown Castle that grants Crown Castle a right of first refusal to build, acquire and lease back to the Company at $1,800 per month up to 40 tower sites to be constructed prior to December 31, 2000.
Equipment Purchase Commitments
In 1996, the Company entered into a five-year equipment purchase agreement and related vendor financing agreement (Note 5) with Ericsson Inc. for the purchase of certain network equipment and services required for the initial buildout and operation of the Company's PCS system. Under the terms of the agreement and subsequent amendments, the Company committed to purchase certain PCS network equipment and services for specific markets and utilize Ericsson as the exclusive provider of certain PCS network equipment until December 31, 2001 for all of its markets. The Company's grant of exclusivity is conditioned upon Ericsson's ability to provide sufficient quantities of PCS network equipment to meet the Company's needs in the PCS markets, provide commercial service for each PCS market by pre-defined dates, and continue to provide "state of the art" equipment. The Company's cumulative total purchases under the agreement were approximately $297 million at December 31, 1999.
Litigation
The Company is subject to litigation related to matters arising in the normal course of business. As of December 31, 1999 management is not aware of any asserted or pending material litigation or claims against the Company that would have a material impact.
10. TRANSACTIONS WITH AFFILIATES
The Company leases certain dedicated and trunk telephone access lines and purchases local and long-distance services through its former parent, ITC Holding Company, Inc., and certain of its other subsidiaries and related parties. The total expense recorded by the Company for these services was approximately $10.7 million, $10.1 million and $5.8 million for the years ended December 31, 1999, 1998 and 1997, respectively.
The Company purchases certain equipment, inventory and services related to the buildout and operation of its PCS line of business from preferred stockholders and certain of their subsidiaries. The Company's total purchases for equipment, inventory and services from these related parties were $75.5 million, $138.3 million and $106.8 million for the years ended December 31, 1999, 1998 and 1997, respectively.
11. BUSINESS SEGMENT DATA
Effective with the year ended December 31, 1998, the Company adopted Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131"), which requires the Company to report financial and descriptive information about its reportable operating segments. SFAS 131 requires the reporting of a measure of segment profit or loss, certain specific revenue and expense items and segment assets, as well as a reconciliation of total segment revenues, total segment profit or loss, total segment assets and other amounts disclosed for segments to corresponding amounts in the company's general purpose financial statements.
The Company classifies its operations into two business segments: PCS and cellular. Certain corporate administrative expenses have been allocated to the segments based upon the nature of the expense. Intersegment revenues are not material. Summarized financial information by business segment is as follows (in millions):
- --------------- (a) Includes realized gain on sale of tower assets of $49.9 million. (b) Includes gain on sale of subsidiary of $79.3 million. (c) Includes gain on sale of subsidiary of $41.9 million.
12. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES
We have audited in accordance with auditing standards generally accepted in the United States, the financial statements of POWERTEL, INC. and subsidiaries included in this Form 10-K and have issued our report thereon dated February 4, 2000. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in the index is the responsibility of the Company's management and is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
ARTHUR ANDERSEN LLP
Atlanta, Georgia February 4, 2000
S-1
POWERTEL, INC. AND SUBSIDIARIES SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
S-2 | 17,778 | 115,236 |
701985_1999.txt | 701985_1999 | 1999 | 701985 | ITEM 1. BUSINESS.
General.
The Limited, Inc., a Delaware corporation (including its subsidiaries, the "Company"), is principally engaged in the purchase, distribution and sale of women's, men's and children's apparel, women's intimate apparel, personal care products, and a wide variety of sporting goods. The Company operates an integrated distribution system which supports its retail activities. These activities are conducted under various trade names primarily through the retail stores and catalogue businesses of the Company. Merchandise is targeted to appeal to customers in various market segments that have distinctive consumer characteristics.
Description of Operations.
General. - -------
As of January 30, 1999, the Company conducted its business in two primary segments: (1) the Apparel segment, which derives its revenues from sales of women's, men's and children's apparel; and (2) Intimate Brands, Inc. ("IBI") (a corporation in which the Company holds an 84.5% interest), which derives its revenues from sales of women's intimate and other apparel, and personal care products and accessories.
Effective May 19, 1998, the Company completed a tax-free exchange offer to establish Abercrombie & Fitch ("A&F") as an independent public company. Further information regarding this transaction is contained in Note 3 of the Notes to the Consolidated Financial Statements included in The Limited, Inc., 1998 Annual Report to Shareholders, portions of which are annexed hereto as Exhibit 13 (the "1998 Annual Report") and are incorporated herein by reference.
The following chart reflects the retail businesses and the number of stores in operation for each segment at January 30, 1999 and January 31, 1998.
NUMBER OF STORES ------------------------------------ RETAIL BUSINESSES - ----------------- January 30, January 31, 1999 1998 ---------------- ---------------- Apparel Businesses - ------------------ Express 702 753 Lerner New York 643 746 Lane Bryant 730 773 The Limited 551 629 Structure 532 544 Limited Too 319 312 ---------------- ---------------- Total Apparel 3,477 3,757
Intimate Brands - --------------- Victoria's Secret Stores 829 789 Bath & Body Works 1,061 921 ---------------- ---------------- Total Intimate Brands 1,890 1,710
Other - ----- Galyan's Trading Co. 14 11 Henri Bendel 1 6 Abercrombie & Fitch* - 156 ---------------- ---------------- Total 5,382 5,640 ================ ================
* - The A&F business was split off effective May 19, 1998 via a tax-free exchange offer.
The following table shows the changes in the number of retail stores operated by the Company for the past five fiscal years:
* Includes 159 stores from the May 19, 1998 split-off of A&F.
The Company also owns Mast Industries, Inc., a contract manufacturer and apparel importer, and Gryphon Development, Inc. ("Gryphon"), which is a subsidiary of IBI. Gryphon creates, develops and contract manufactures a substantial portion of the personal care products sold by the Company. During fiscal year 1998, the Company purchased merchandise from approximately 4,700 suppliers and factories located throughout the world. In addition to purchases through Mast and Gryphon, the Company purchased merchandise in foreign markets and in the domestic market, some of which is manufactured overseas. The Company's business is subject to a variety of risks generally associated with doing business in foreign markets and importing merchandise from abroad, such as political instability, currency and exchange risks, and local business practice and political issues. The Company has established formal policies and procedures designed to address such risks; however, they remain beyond the Company's control. No more than 5% of goods purchased originated from any single manufacturer.
Most of the merchandise and related materials for the Company's stores is shipped to the Company's distribution centers in the Columbus, Ohio area. The Company uses common and contract carriers to distribute merchandise and related materials to its stores. The Company's businesses generally have independent distribution capabilities and no business receives priority over any other business.
The Company's policy is to maintain sufficient quantities of inventory on hand in its retail stores and distribution centers so that it can offer customers a full selection of current merchandise. The Company emphasizes rapid turnover and takes markdowns as required to keep merchandise fresh and current with fashion trends.
The Company views the retail apparel market as having two principal selling seasons, Spring and Fall. As is generally the case in the retail apparel industry, the Company experiences its peak sales activity during the Fall season. This seasonal sales pattern results in increased inventory during the Fall and Christmas holiday selling periods. During fiscal year 1998, the highest inventory level was $1.6 billion at the November 1998 month-end and the lowest inventory level was $1.0 billion at the May 1998 month-end.
Merchandise sales are paid for in cash, by personal check, and with credit cards issued by third parties or credit cards issued by the Company's 31%-owned credit card processing venture, Alliance Data Systems, for customers of Express, Lerner New York, Lane Bryant, Limited, Henri Bendel, Victoria's Secret Stores, Victoria's Secret Catalogue, and Structure.
The Company offers its customers a liberal return policy stated as "No Sale is Ever Final." The Company believes that certain of its competitors offer similar credit card and service policies.
The following is a brief description of each of the Company's operating businesses, including their respective target markets.
APPAREL BUSINESSES - ------------------
Express - is a leading specialty retailer of women's sportswear and accessories. - ------- Express' strategy is to offer new, international fashion to its base of young, style-driven women. Launched in 1980, Express had net sales of $1.4 billion in 1998 and operated 702 stores in 48 states.
Lerner New York - is a leading mall-based specialty retailer of women's - --------------- apparel. The business's strategy is to offer women's fashion with a "New York" feel, under the umbrella of the New York & Company brand. Originally founded in 1918, Lerner New York was purchased by The Limited in 1985. Lerner New York had net sales of $940 million in 1998 and operated 643 stores in 44 states.
Lane Bryant - is the leading specialty store retailer of full-figured women's - ----------- apparel, offering knit tops, sweaters, pants, jeans and intimate apparel for women size 14-plus. Originally founded in 1900, Lane Bryant was acquired by The Limited in 1982. The business had net sales of $933 million in 1998 and operated 730 stores in 46 states.
Limited - is a mall-based specialty store retailer. The business's strategy is - -------- to focus on classic, sophisticated, modern sportswear for twenty-something American women. Founded in 1963, Limited Stores had net sales of $757 million in 1998 and operated 551 stores in 47 states.
Structure - is a leading mall-based specialty retailer of men's clothing, - --------- offering classic American sportswear. Structure operates 532 stores in 43 states and had net sales of $610 million in 1998.
Limited Too - established in 1987, sells apparel, lifestyle and personal care - ----------- products for fashion-aware, trend-setting young girls, through 319 stores in 43 states. Limited Too had net sales of $377 million in 1998.
INTIMATE BRANDS - ---------------
Victoria's Secret Stores - is one of the world's leading specialty retailers of - ------------------------ women's intimate apparel and related products. Victoria's Secret Stores (including Victoria's Secret Beauty) operates over 820 stores nationwide and had net sales of $1.8 billion in 1998.
Victoria's Secret Catalogue- is a leading specialty catalogue retailer of - --------------------------- intimate and other women's apparel. At the end of 1998, Victoria's Secret Catalogue launched its own web site, www.VictoriasSecret.com, through which its products may be purchased worldwide. Victoria's Secret Catalogue mailed approximately 406 million catalogues and had net sales of $759 million in 1998.
Bath & Body Works - is the leading mall-based specialty retailer of personal - ----------------- care products. Launched in 1990, Bath & Body Works (including White Barn Candle Company) operates over 1,050 stores nationwide and had net sales of $1.3 billion in 1998.
OTHER - -----
Galyan's - is an operator of full-line sporting goods and apparel superstores in - -------- the Midwestern United States. Galyan's operates 14 stores in six markets, targeting sports enthusiasts. Acquired by The Limited in July 1995, Galyan's had net sales of $220 million in 1998.
Henri Bendel - operates a single specialty store in New York City which features - ------------ fashions for sophisticated, higher-income women. The business was purchased by The Limited in 1988 and had net sales of $40 million in 1998. The Limited closed five Henri Bendel stores during 1998.
Additional information about the Company's business, including its revenues and profits for the last three years, plus selling square footage and other information about each of the Company's operating businesses, is set forth under the caption "Management's Discussion and Analysis" of the 1998 Annual Report and is incorporated herein by reference. For the financial results of the Company's reportable operating segments, see Note 13 of the Notes to the Consolidated Financial Statements included in the 1998 Annual Report, incorporated herein by reference.
Competition.
The sale of intimate and other apparel, personal care products and sporting goods through retail stores is a highly competitive business with numerous competitors, including individual and chain fashion specialty stores, department stores and discount retailers. Design, price, service, selection and quality are the principal competitive factors in retail store sales. The Company's catalogue business competes with numerous
national and regional catalogue merchandisers. Design, price, service, quality, image presentation and fulfillment are the principal competitive factors in catalogue and on-line sales.
The Company is unable to estimate the number of competitors or its relative competitive position due to the large number of companies selling apparel and personal care products at retail through stores, catalogues and the Internet.
Associate Relations.
On January 30, 1999, the Company employed approximately 126,800 associates, 92,300 of whom were part-time. In addition, temporary associates are hired during peak periods, such as the Christmas season.
ITEM 2.
ITEM 2. PROPERTIES.
The Company's business is principally conducted from office, distribution and shipping facilities located in the Columbus, Ohio area. Additional facilities are located in New York City, New York; Indianapolis, Indiana; Andover, Massachusetts; Kettering, Ohio; Rio Rancho, New Mexico and London, England.
The distribution and shipping facilities owned by the Company consist of nine buildings located in the Columbus, Ohio area and one building in Indianapolis, Indiana. Excluding office space, these buildings comprise approximately 6.3 million square feet.
Substantially all of the retail stores operated by the Company are located in leased facilities, primarily in shopping centers throughout the continental United States. The leases expire at various dates between 1999 and 2028 and frequently have renewal options.
Typically, when space is leased for a retail store in a shopping center, all improvements, including interior walls, floors, ceilings, fixtures and decorations, are supplied by the tenant. In certain cases, the landlord of the property may provide a construction allowance to fund all or a portion of the cost of improvements. The cost of improvements varies widely, depending on the size and location of the store. Rental terms for new locations usually include a fixed minimum rent plus a percentage of sales in excess of a specified amount. Certain operating costs such as common area maintenance, utilities, insurance, and taxes are typically paid by tenants.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
The Company is a defendant in a variety of lawsuits arising in the ordinary course of business.
On November 13, 1997, the United States District Court for the Southern District of Ohio, Eastern Division, dismissed with prejudice an amended complaint that had been filed against the Company and certain of its subsidiaries by the American Textile Manufacturers Institute ("ATMI"), a textile industry trade association. The amended complaint alleged that the defendants violated the federal False Claims Act by submitting false country of origin records to the U.S. Customs Service. On November 26, 1997, ATMI served a motion to alter or amend judgment and a motion to disqualify the presiding judge and to vacate the order of dismissal. The motion to disqualify was denied on December 22, 1997, but as a matter of his personal discretion, the presiding judge elected to recuse himself from further proceedings and this matter was transferred to a judge of the United States District Court for the Southern District of Ohio, Western Division. On May 21, 1998, this judge denied all pending motions seeking to alter, amend or vacate the judgment that had been entered in favor of the Company.
On June 5, 1998, ATMI appealed to the United States Court of Appeals for the Sixth Circuit, where the matter remains pending.
On January 13, 1999, two complaints were filed against the Company and its subsidiary, Lane Bryant, Inc., as well as other defendants, including many national retailers. Both complaints relate to labor practices allegedly employed on the island of Saipan, Commonwealth of the Northern Mariana Islands, by apparel manufacturers unrelated to the Company (some of which have sold goods to the Company) and seek injunctions, unspecified monetary damages, and other relief. One complaint, on behalf of a class of unnamed garment workers, filed in the United States District Court for the Central District of California, Western Division, alleges violations of federal statutes, the United States Constitution, and international law. On March 29, 1999, a motion was filed to transfer this action to the United States District Court located on Saipan, and the Company intends to file a motion to dismiss the complaint for failure to state a claim upon which relief can be granted. The second complaint, filed by a national labor union and other organizations in the Superior Court of the State of California, San Francisco County, alleges unfair business practices under California law. On March 29, 1999, the Company filed a motion seeking dismissal of this complaint.
Although it is not possible to predict with certainty the eventual outcome of any litigation, in the opinion of management, the foregoing proceedings are not expected to have a material adverse effect on the Company's financial position or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
Not applicable.
SUPPLEMENTAL ITEM. EXECUTIVE OFFICERS OF THE REGISTRANT.
Set forth below is certain information regarding the executive officers of the Company as of January 30, 1999.
Leslie H. Wexner, 61, has been Chairman of the Board of Directors of the Company for more than five years and its President and Chief Executive Officer since he founded the Company in 1963.
Kenneth B. Gilman, 52, has been Vice Chairman and Chief Administrative Officer of the Company since June 1997. Mr. Gilman was the Vice Chairman and Chief Financial Officer of the Company from June 1993 to June 1997. Mr. Gilman was the Executive Vice President and Chief Financial Officer of the Company for more than five years prior thereto.
V. Ann Hailey, 48, has been Executive Vice President and Chief Financial Officer of the Company since August 1997. Ms. Hailey was Senior Vice President and Chief Financial Officer for Pillsbury from August 1994 to August 1997.
Martin Trust, 64, has been President and Chief Executive Officer of Mast Industries, Inc., a wholly-owned subsidiary of the Company, for more than five years.
Arnold F. Kanarick, 58, has been Executive Vice President and Chief Human Resources Officer since October 1992.
All of the above officers serve at the pleasure of the Board of Directors of the Company.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
Information regarding markets in which the Company's common stock was traded during fiscal years 1998 and 1997, approximate number of holders of common stock, and quarterly cash dividend per share information of the Company's common stock for the fiscal years 1998 and 1997 is set forth under the caption "Market Price and Dividend Information" on page 22 of the 1998 Annual Report and is incorporated herein by reference.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
Selected financial data is set forth under the caption "Financial Summary" on page 3 of the 1998 Annual Report and is incorporated herein by reference.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Management's discussion and analysis of financial condition and results of operations is set forth under the caption "Management's Discussion and Analysis" on pages 4 through 11 of the 1998 Annual Report and is incorporated herein by reference.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The Consolidated Financial Statements of the Company and subsidiaries, the Notes to Consolidated Financial Statements and the Report of Independent Accountants are set forth in the 1998 Annual Report and are incorporated herein by reference.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
Information regarding directors of the Company is set forth under the captions "ELECTION OF DIRECTORS - Nominees and directors", "- Committees of the Board of Directors" and "- Security ownership of directors and management" on pages 4 through 9 of the Company's proxy statement for the Annual Meeting of Shareholders to be held May 17, 1999 (the "Proxy Statement") and is incorporated herein by reference. Information regarding compliance with Section 16(a) of the Securities Exchange Act of 1934, as amended is set forth under the caption "EXECUTIVE COMPENSATION - Section 16(a) beneficial ownership reporting compliance" on page 15 of the Proxy Statement and is incorporated herein by reference. Information regarding executive officers is set forth herein under the caption "SUPPLEMENTAL ITEM. EXECUTIVE OFFICERS OF THE REGISTRANT" in Part I.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
Information regarding executive compensation is set forth under the caption "EXECUTIVE COMPENSATION" on pages 11 through 15 of the Proxy Statement and is incorporated herein by reference. Such incorporation by reference shall not be deemed to specifically incorporate by reference the information referred to in Item 402(a)(8) of Regulation S-K.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
Information regarding the security ownership of certain beneficial owners and management is set forth under the captions "ELECTION OF DIRECTORS - Security ownership of directors and management" on pages 8 and 9 of the Proxy Statement and "SHARE OWNERSHIP OF PRINCIPAL STOCKHOLDERS" on page 21 of the Proxy Statement and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Information regarding certain relationships and related transactions is set forth under the captions "ELECTION OF DIRECTORS - Nominees and directors" on pages 4 through 6 of the Proxy Statement and "ELECTION OF DIRECTORS - Certain relationships and related transactions" on pages 9 and 10 of the Proxy Statement and is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a)(1) List of Financial Statements. ----------------------------
The following consolidated financial statements of The Limited, Inc. and Subsidiaries and the related notes are filed as a part of this report pursuant to ITEM 8:
Consolidated Statements of Income for the fiscal years ended January 30, 1999, January 31, 1998 and February 1, 1997.
Consolidated Statements of Shareholders' Equity for the fiscal years ended January 30, 1999, January 31, 1998 and February 1, 1997.
Consolidated Balance Sheets as of January 30, 1999 and January 31, 1998.
Consolidated Statements of Cash Flows for the fiscal years ended January 30, 1999, January 31, 1998 and February 1, 1997.
Notes to Consolidated Financial Statements.
Report of Independent Accountants.
(a)(2) List of Financial Statement Schedules. -------------------------------------
All schedules required to be filed as part of this report pursuant to ITEM 14(d) are omitted because the required information is either presented in the financial statements or notes thereto, or is not applicable, required or material.
(a)(3) List of Exhibits. ----------------
3. Articles of Incorporation and Bylaws.
3.1. Certificate of Incorporation of the Company incorporated by reference to Exhibit 3.4 to the Company's Annual Report on Form 10-K for the fiscal year ended January 30, 1988.
3.2. Restated Bylaws of the Company.
4. Instruments Defining the Rights of Security Holders.
4.1. Copy of the form of Global Security representing the Company's 7 1/2% Debentures due 2023, incorporated by reference to Exhibit 1 to the Company's Current Report on Form 8-K dated March 4, 1993.
4.2. Conformed copy of the Indenture dated as of March 15, 1988 between the Company and The Bank of New York, incorporated by reference to Exhibit 4.1(a) to the Company's
Current Report on Form 8-K dated March 21, 1989.
4.3. Copy of the form of Global Security representing the Company's 8 7/8% Notes due August 15, 1999, incorporated by reference to Exhibit 4.1 to the Company's Current Report on Form 8-K dated August 14, 1989.
4.4. Copy of the form of Global Security representing the Company's 9 1/8% Notes due February 1, 2001, incorporated by reference to Exhibit 4.1 to the Company's Current Report on Form 8-K dated February 6, 1991.
4.5. Copy of the form of Global Security representing the Company's 7.80% Notes due May 15, 2002, incorporated by reference to the Company's Current Report on Form 8-K dated February 27, 1992.
4.6. Proposed form of Debt Warrant Agreement for Warrants attached to Debt Securities, with proposed form of Debt Warrant Certificate incorporated by reference to Exhibit 4.2 to the Company's Registration Statement on Form S-3 (File no. 33-53366) originally filed with the Securities and Exchange Commission (the "Commission") on October 16, 1992, as amended by Amendment No. 1 thereto, filed with the Commission on February 23, 1993 (the "1993 Form S-3").
4.7. Proposed form of Debt Warrant Agreement for Warrants not attached to Debt Securities, with proposed form of Debt Warrant Certificate incorporated by reference to Exhibit 4.3 to the 1993 Form S-3.
4.8. Credit Agreement dated as of September 25, 1997 among the Company, Morgan Guaranty Trust Company of New York and the banks listed therein, incorporated by reference to Exhibit 4.8 to the Company's Quarterly Report on Form 10-Q for the quarter ended November 1, 1997.
10. Material Contracts.
10.1. The 1987 Stock Option Plan of The Limited, Inc., incorporated by reference to Exhibit 28(a) to the Company's Registration Statement on Form S-8 (File No. 33-18533).
10.2. Officers' Benefits Plan incorporated by reference to Exhibit 10.4 to the Company's Annual Report on Form 10-K for the fiscal year ended January 28, 1989 (the "1988 Form 10-K").
10.3. The Limited Deferred Compensation Plan incorporated by reference to Exhibit 10.4 to the 1990 Form 10-K.
10.4 Form of Indemnification Agreement between the Company and the directors and executive officers of the Company.
10.5. Supplemental schedule of directors and executive officers who are parties to an Indemnification Agreement.
10.6. The 1993 Stock Option and Performance Incentive Plan of the Company, incorporated by reference to Exhibit 4 to the Company's Registration Statement on Form S-8 (File No. 33-49871).
10.7. Contingent Stock Redemption Agreement dated as of January 26, 1996 among the Company, Leslie H. Wexner and The Wexner Children's Trust, incorporated by reference to Exhibit 10.13 to the 1996 Form 10-K.
10.8. Amendment dated July 19, 1996 to the Contingent Stock Redemption Agreement dated as of January 26, 1996 among the Company, Leslie H. Wexner and The Wexner Children's Trust, incorporated by reference to Exhibit 10.14 to the 1996 Form 10-K.
10.9. The 1997 Restatement of The Limited, Inc. 1993 Stock Option and Performance Incentive Plan incorporated by reference to Exhibit B to the Company's Proxy Statement dated April 14, 1997.
10.10. The Limited, Inc. 1996 Stock Plan for Non-Associate Directors incorporated by reference to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended November 2, 1996.
10.11. The Limited, Inc. Incentive Compensation Performance Plan incorporated by reference to Exhibit A to the Company's Proxy Statement dated April 14, 1997.
10.12. Employment Agreement by and between The Limited, Inc. and Kenneth B. Gilman dated as of May 20, 1997 with exhibits, incorporated by reference to Exhibit 10.20 to the Company's Annual Report on Form 10-K for the fiscal year ended January 31, 1998 (the "1997 Form 10-K").
10.13. Employment Agreement by and between The Limited, Inc. and Arnold F. Kanarick dated as of May 20, 1997 with exhibits, incorporated by reference to Exhibit 10.21 to the 1997 Form 10-K.
10.14. Employment Agreement by and between The Limited, Inc. and Martin Trust dated as of May 20, 1997 with exhibits, incorporated by reference to Exhibit 10.22 to the 1997 Form 10-K.
10.15. The 1998 Restatement of the Limited, Inc. 1993 Stock Option and Performance Incentive Plan incorporated by reference to Exhibit A to the Company's Proxy Statement dated April 20, 1998.
10.16. Employment Agreement by and between The Limited, Inc. and V. Ann Hailey dated as of July 27, 1998 incorporated by reference to Exhibit 10.19 to the Company's Quarterly Report on Form 10-Q for the quarter ended August 1, 1998.
11. Statement re: Computation of Per Share Earnings.
12. Statement re: Computation of Ratio of Earnings to Fixed Charges.
13. Excerpts from the 1998 Annual Report to Shareholders including "Financial Summary", "Management's Discussion and Analysis", "Consolidated Financial Statements and Notes to Consolidated Financial Statements" and "Report of Independent Accountants" on pages 3 through 22.
21. Subsidiaries of the Registrant.
23. Consent of Independent Accountants.
24. Powers of Attorney.
27. Financial Data Schedule.
99. Annual Report of The Limited, Inc. Savings and Retirement Plan.
(b) Reports on Form 8-K. -------------------
No reports on Form 8-K were filed during the fourth quarter of fiscal year 1998.
(c) Exhibits. --------
The exhibits to this report are listed in section (a)(3) of Item 14 above.
(d) Financial Statement Schedule. ----------------------------
Not applicable.
SIGNATURES
Pursuant to the requirements of Section 13 or l5(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: April 19, 1999
THE LIMITED, INC. (registrant)
By /s/ V. Ann Hailey ------------------ V. Ann Hailey Executive Vice President and Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on January 29, 1999:
Signature Title --------- -----
/s/ LESLIE H. WEXNER* Chairman of the Board of Directors, - ------------------------- President and Chief Executive Officer Leslie H. Wexner
/s/ KENNETH B. GILMAN* Director, Vice Chairman and - ------------------------ Chief Administrative Officer Kenneth B. Gilman
/s/ ABIGAIL S. WEXNER* Director - -------------------------- Abigail S. Wexner
/s/ MARTIN TRUST* Director - -------------------------- Martin Trust
/s/ EUGENE M. FREEDMAN* Director - -------------------------- Eugene M. Freedman
/s/ E. GORDON GEE* Director - -------------------------- E. Gordon Gee
/s/ DAVID T. KOLLAT* Director - -------------------------- David T. Kollat
/s/ CLAUDINE MALONE* Director - -------------------------- Claudine Malone
/s/ LEONARD A. SCHLESINGER* Director - --------------------------- Leonard A. Schlesinger
/s/ DONALD B. SHACKELFORD* Director - -------------------------- Donald B. Shackelford
/s/ ALLAN R. TESSLER* Director - -------------------------- Allan R. Tessler
/s/ RAYMOND ZIMMERMAN* Director - -------------------------- Raymond Zimmerman
*The undersigned, by signing his name hereto, does hereby sign this report on behalf of each of the above-indicated directors of the registrant pursuant to powers of attorney executed by such directors.
By /s/ Kenneth B. Gilman -------------------------- Kenneth B. Gilman Attorney-in-fact
EXHIBIT INDEX -------------
Exhibit No. Document - ----------- ----------------------------------------------------------------
3.2 Restated Bylaws of the Company.
10.4 Indemnification Agreement.
10.5 Supplemental Schedule of Directors and Executive Officers Who are Parties to an Indemnification Agreement.
11 Statement re: Computation of Per Share Earnings.
12 Statement re: Computation of Ratio of Earnings to Fixed Charges.
13 Excerpts from the 1998 Annual Report to Shareholders including "Financial Summary", "Management's Discussion and Analysis", "Consolidated Financial Statements and Notes to Consolidated Financial Statements" and "Report of Independent Accountants" on pages 3 through 22.
21 Subsidiaries of the Registrant.
23 Consent of Independent Accountants.
24 Powers of Attorney.
27 Financial Data Schedule.
99 Annual Report of The Limited, Inc. Savings and Retirement Plan. | 4,625 | 30,387 |
42682_1999.txt | 42682_1999 | 1999 | 42682 | ITEM 1. BUSINESS
Registrant ("Gorman-Rupp" or the "Company") designs, manufactures and sells pumps and related equipment (pump and motor controls) for use in water, wastewater, construction, industrial, petroleum, original equipment, agricultural, fire protection, military and other liquid-handling applications.
PRODUCTS
The principal products of the Company are pumps and fluid control products. (The Company operates principally in one business segment, the manufacture and sale of pumps and related fluid control equipment.) The following table sets forth, for the years 1997 through 1999, the total net sales, income before income taxes and identifiable assets ($000 omitted) of the Company.
1999 1998 1997 ---- ---- ----
Net Sales $179,284 $171,245 $164,862 Income Before Income Taxes 21,541 19,152 16,952 Identifiable Assets 136,875 127,477 127,865
The Company's product line is composed of pump models ranging in size from 1/2" to 84" and ranging in rated capacity from less than one gallon per minute up to 500,000 gallons per minute. The types of pumps which the Company produces include self priming centrifugal, standard centrifugal, magnetic drive centrifugal, axial and mixed flow, rotary gear, diaphragm, bellows and oscillating.
The pumps have drives that range from 1/35 horsepower electric motors up to much larger electric motors or internal combustion engines. Many of the larger units comprise encased, fully integrated sewage pumping stations. In certain cases, units are designed for the inclusion of customer-supplied drives.
The Company's larger pumps are sold principally for use in the construction, industrial, sewage and waste handling fields; for boosting low residential water pressure; for pumping refined petroleum products, including the ground refueling of aircraft; for agricultural applications; and for fire fighting.
Many of the Company's smallest pumps are sold to customers for incorporation into such products as X-ray processing equipment; gas air conditioning equipment; office copy machines; chemical feeding, instrumentation and ice cube making machinery; photographic processing and soft drink dispensing equipment; laser cooling applications; graphic arts equipment; and floor cleaning equipment.
The Company is scheduled to complete the purchase of selective assets of the Fluid Products Division of Xolox Corporation in February 2000. The pump and flowmeter line to be acquired will complement products manufactured by the Company's Industries Division.
PART I--CONTINUED
ITEM 1. BUSINESS--CONTINUED
In 1998 the Company launched a line of new pump stations, known as Booster Pumps. These packaged systems consist of pressure booster stations designed for water tower applications and for boosting low residential water pressure in the municipal and commercial fresh water markets. The manufacture of Booster Pumps are a result of the combined effort of the Company's Mansfield Division, historically a leader in the packaged sewage pump market, and Patterson Pump Company (the Company's wholly owned subsidiary), a current leading producer of fire pumps for building and industry.
In 1996 the Company expanded its pump line with the introduction of the Prime-Aire(TM) trash pump, equipped with a unique auxiliary priming system. This priming system virtually eliminates any spewing of liquids from the priming air exhaust line and thereby reduces operational concerns, especially for applications containing environmentally hazardous liquids.
During 1996 vertical turbine pumps were also designed to better serve the water, wastewater and fire pump markets, extending the capacity range of the product line.
Gorman-Rupp continues to emphasize product development. Several of the Company's existing products, which were designed with added features, have also been expanded to various new applications.
MARKETING
Except for government and export sales, the Company's pumps are marketed in the United States and Canada through a network of about 1,000 distributors, through manufacturers' representatives (for sales to many original equipment manufacturers) and by direct sales. Government sales are handled directly by the Company; and export sales are made through the Company's wholly owned subsidiary, The Gorman-Rupp International Company, as well as through foreign distributors and representatives. During 1999 there were no shipments to any single customer greater than 10% of total net sales.
In recent years, Gorman-Rupp has actively pursued international business opportunities. In 1996 the Company established offices in Thailand and Greece to improve access to Asian Pacific, Mid-East and European markets. In 1998 Patterson Pump Company's majority-owned subsidiary, Patterson Pump Ireland Limited, started assembly of pumps in Ireland to further serve the European market. In 1998 the Company also organized a Foreign Sales Corporation to further enhance its exporting activities. In 1999 the Mansfield Division opened a warehouse in Grindstead, Denmark to further enhance marketing opportunities in Europe and the Middle East. Approximately 17% of all 1999 sales were made to customers outside the United States (as compared to 16% in 1998 and 15% in 1997). The Company continues to penetrate international markets principally by its aggressive response to worldwide pump needs.
PART I--CONTINUED
ITEM 1. BUSINESS--CONTINUED
COMPETITION
Consolidations of pump companies have occurred within the highly competitive pump business. Two large independent pump manufacturing companies combined with other companies in 1997. Gorman-Rupp estimates that 80 other companies selling pumps and pump units compete in one or more of the industries and applications in which comparable products of the Company are utilized. Many pumps are specifically designed and engineered for a particular customer's application. The Company believes that proper application, product performance and service are the principal methods of competition, and attributes its success to its emphasis in these areas.
PURCHASING AND PRODUCTION
Virtually all materials, supplies, components and accessories used by the Company in the fabrication of its products, including all castings (for which the patterns are made and owned by the Company), structural steel, bar stock, motors, solenoids, engines, seals, and plastic and elastomeric components, are purchased by the Company from other suppliers and manufacturers. No purchases are made under long-term contracts and the Company is not dependent upon a single source for any materials, supplies, components or accessories which are of material importance to its business.
The Company purchases motors for its polypropylene bellows pumps and its magnetic drive pumps from several alternative vendors and motor components for its large submersible pumps from a limited number of suppliers. Small motor requirements are also currently sourced from alternative suppliers.
The other production operations of the Company consist of the machining of castings, the cutting and shaping of bar stock and structural members, the manufacture of a few minor components, and the assembling, painting and testing of its products. Virtually all of the Company's products are tested prior to shipment.
OTHER ASPECTS
As of December 31, 1999, the Company employed approximately 1,015 persons, of whom approximately 600 were hourly employees. The Company has no collective bargaining agreements, has never experienced a strike and considers its labor relations to be satisfactory.
Although the Company owns a number of patents, and several of them are important to its business, Gorman-Rupp believes that the business of the Company is not materially dependent upon any one or more patents.
As of December 31, 1999, the value of the Company's backlog of unfilled orders was approximately $59,626,000, of which $40,378,000 was for the unfilled orders of Patterson Pump Company. All of the backlog at December 31, 1999 is scheduled to be shipped during 2000. At December 31, 1998,
PART I--CONTINUED
ITEM I. BUSINESS--CONTINUED
the value of the backlog of unfilled orders was approximately $48,228,000.
ITEM 2.
ITEM 2. PROPERTIES
All of the production operations of the Company are conducted at its plants located in Mansfield and Bellville, Ohio; St. Thomas, Ontario; Sand Springs, Oklahoma; Toccoa, Georgia; and County Westmeath, Ireland. All of the foregoing properties, except the leased facility in Ireland, are owned in fee without any material encumbrance. The Company owns in fee an approximately 26,000 square foot facility in Sparks, Nevada comprising a training center and warehouse. In addition, the Company leases an approximately 2,500 square foot facility in Grindstead, Denmark to house pumps and pump parts.
The Company's Ohio operations are principally located in facilities in Mansfield. These facilities consist of five buildings containing approximately 682,200 square feet of floor space for production, office and warehousing functions. The original portion of the largest production plant, consisting of approximately 238,000 square feet located on a 26 acre site, was built in 1917 and has been expanded on several occasions, the latest in 1973. Another production plant, also situated on the 26 acre site, was built in 1968 and has been frequently expanded, most recently in 1994. The 1994 expansion added approximately 37,600 square feet, including a modern testing facility. This plant currently comprises approximately 134,200 square feet of floor space. A third plant, containing approximately 215,000 square feet of floor space, located on a 5-1/2 acre site, was purchased in 1975 and is used for most machining operations and storage of raw materials. Its latest addition, consisting of 30,000 square feet of floor space, was made in 1978. A small office building of approximately 11,500 square feet was purchased in 1979 and houses a training facility and the Company's personnel and advertising departments. In late 1982, the Company purchased a building built in 1920 and located on 3.4 acres adjacent to the Company's 26 acre site. This acquisition, which was renovated in 1983, contains 83,500 square feet and is being used for additional warehouse space.
In 1997 the Company purchased 90 acres of undeveloped land near the Mansfield Lahm Airport for future expansion and consolidation of facilities for the Mansfield Division and the Corporate Office. In 1998 design work and site preparation began on the new consolidated facilities project. In 1999 construction began on the first phase consisting of a 360,000 square foot manufacturing and warehousing plant. Completion of the first phase is expected in May 2000 at which time the IPT Division and machining, weld and fabrication operations of the Mansfield Division are scheduled to move into the new facility. The Company plans to sell the facilities currently occupied by the machining operations and storage of raw materials. No plans or schedule have been determined for the completion of the multi-phased, approximately one million square foot consolidated facilities project.
The remainder of the Company's Ohio operations is conducted at a plant in Bellville, which comprises approximately 93,200 square feet of floor space situated on an 8.5 acre site. The initial portion of this plant was built in 1953 and has been expanded on several occasions, most recently in
PART I--CONTINUED
ITEM 2. PROPERTIES--CONTINUED
1973-74. In 1999 the Company sold a smaller facility which contained approximately 14,300 square feet of floor space.
The plant in St. Thomas, Ontario has undergone a number of expansions since it was established in 1960. In 1998, a 3,000 square foot expansion of the office and training facilities was completed. This facility contains about 52,600 square feet of floor space and is situated on an 11 acre site.
The Oklahoma facility, located on 4.5 acres of land, was purchased in 1977. Manufacturing and warehousing facilities are located in a 26,700 square foot building, originally built in 1973 and expanded four times between 1978 and 1991. A detached 2,200 square foot building is used for offices. In 1980, a contiguous parcel of two acres of undeveloped land was purchased for future needs.
Patterson Pump Company, in Toccoa, Georgia, includes a 31 acre site with buildings totaling approximately 165,900 square feet, with about 28,000 square feet of office space and 137,900 square feet of manufacturing space. In 1989 Patterson Pump Company completed an addition of 38,500 square feet to the building for manufacturing purposes and razed an approximately 12,700 square foot portion of the manufacturing facility. In 1992 Patterson completed a 64,000 square foot addition to the manufacturing plant, including a modern 400,000 gallon testing facility. A 28,000 square foot office addition was completed in 1993. Upon occupancy of the new building in 1993, the pre-existing office space of 15,200 square feet was razed for additional parking space. In late 1999 construction began on a 5,850 square foot addition to the manufacturing plant. This current expansion is scheduled for completion in the first quarter of 2000.
The manufacturing facilities occupied by Patterson Pump Ireland Limited in County Westmeath, Ireland consist of 4,500 square feet of leased manufacturing space. Office space is shared with another occupant in the building.
The Company considers its plants, machinery and equipment to be well maintained, in good operating condition and adequate for the present uses and business requirements of the Company.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Gorman-Rupp is not currently engaged in any litigation which in the opinion of the Company is material to its operations or assets.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the fourth quarter of the fiscal year covered by this Form 10-K, no matter was submitted to a vote of the Company's shareholders, through the solicitation of proxies or otherwise.
********************
PART I --CONTINUED
EXECUTIVE OFFICERS OF THE REGISTRANT
Pursuant to General Instruction G(3), the information regarding executive officers called for by Item 401 of Regulation S-K and by Item 10 of this Form 10-K is set forth below.
Date Elected to Name Age Office Position - ---- --- ------ ---------- James C. Gorman 75 Chairman 1989
Jeffrey S. Gorman 47 President and Chief Executive Officer; General Manager, Mansfield Division 1998/1989
Kenneth E. Dudley 62 Chief Financial Officer and Treasurer 1999/1982
Robert E. Kirkendall 57 Vice President Corporate Development and Corporate Secretary 1999/1990
William D. Danuloff 52 Vice President Information Services 1991
Except as noted, each of the above-named officers has held his executive position with the Company for the past five years. Mr. J. C. Gorman served as the Company's President from 1964 until 1989, and as Chief Executive Officer from 1964 until 1996. (He has served as a Director of the Company continuously since 1946.) Mr. J. S. Gorman was elected President and Chief Executive Officer effective May 1, 1998, after having served as Senior Vice President since 1996. Mr. J. S. Gorman has held the position of General Manager of the Mansfield Division since 1989. He served as Assistant General Manager from 1986 to 1988; and he held the office of Corporate Secretary from 1982 to 1990. (He has served as a Director of the Company continuously since 1989.) Mr. Dudley has held the position of Treasurer since 1982. Mr. Kirkendall was elected as Corporate Secretary in 1990 and also served as Assistant Treasurer from 1982 to 1999. Mr. Danuloff was elected Vice President Information Services in 1991, after having served as Director of Information Services from 1981 to 1991.
Mr. J. S. Gorman is the son of Mr. J. C. Gorman. Otherwise, there is no family relationship among any of the Executive Officers and Directors of the Company. (However, Mr. Christopher H. Lake, a Director nominee, is the son of Dr. Peter B. Lake, a Director of the Company.)
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Attention is directed to the section "Ranges of Stock Prices" and the data immediately below pertaining to the shareholder information reported by the Transfer Agent and Registrar on page 34 in the Company's 1999 Annual Report to Shareholders, which are incorporated herein by this reference.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
Attention is directed to the section "Ten Year Summary of Selected Financial Data" on pages 30 and 31 in the Company's 1999 Annual Report to Shareholders, which is incorporated herein by this reference.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Attention is directed to the section "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 28 and 29, and to page 35, in the Company's 1999 Annual Report to Shareholders, which are incorporated herein by this reference.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Attention is directed to the section "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 28 and 29, and to page 35, in the Company's 1999 Annual Report to Shareholders, which are incorporated herein by this reference. The Company has no material market risk exposures required to be reported by Item 305 of Regulation S-K.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Attention is directed to the Company's consolidated financial statements, the notes thereto and the report of independent auditors thereon on pages 22-27, and 31, and to the section "Summary of Quarterly Results of Operations" on page 30, in the Company's 1999 Annual Report to Shareholders, which are incorporated herein by this reference.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
The Company has not changed its independent public accountants and there have been no reportable disagreements with such accountants regarding accounting principles or practices or financial disclosure matters.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
With respect to Directors, attention is directed to the section "Election of Directors" in the Company's definitive Notice of 2000 Annual Meeting of Shareholders and related Proxy Statement (filed pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this Form 10-K), which is incorporated herein by this reference.
With respect to executive officers, attention is directed to Part I of this Form 10-K.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Attention is directed to the sections "Board of Directors and Directors' Committees", "Executive Compensation", "Pension and Retirement Benefits", "Salary Committee Report on Executive Compensation" and "Shareholder Return Performance Presentation" in the Company's definitive Notice of 2000 Annual Meeting of Shareholders and related Proxy Statement (filed pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this Form 10-K), which are incorporated herein by this reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Attention is directed to the sections "Principal Shareholders", "Election of Directors" and "Shareholdings by Executive Officers" in the Company's definitive Notice of 2000 Annual Meeting of Shareholders and related Proxy Statement (filed pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this Form 10-K), which are incorporated herein by this reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Except as disclosed in footnote 2 in the section "Principal Shareholders" in the Company's definitive Notice of 2000 Annual Meeting of Shareholders and related Proxy Statement (filed pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this Form 10-K), which is incorporated herein by this reference, the Company has no relationships or transactions required to be reported by Item 404 of Regulation S-K.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this report:
1. FINANCIAL STATEMENTS
With respect to the consolidated financial statements of the Registrant and its subsidiaries, the following documents have been incorporated by reference into this report:
(i) Consolidated balance sheets--December 31, 1999 and 1998 (ii) Consolidated statements of income--Years ended December 31, 1999, 1998 and 1997 (iii) Consolidated statements of shareholders' equity--Years ended December 31, 1999, 1998 and 1997 (iv) Consolidated statements of cash flows--Years ended December 31, 1999, 1998 and 1997 (v) Notes to consolidated financial statements (vi) Report of independent auditors
2. FINANCIAL STATEMENT SCHEDULES
All financial statement schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and, therefore, have been omitted.
3. EXHIBITS
The exhibits listed below are submitted in a separate section of this report immediately following the Exhibit Index.
(3) (i) Articles of incorporation and (ii) By-laws (4) Instruments defining the rights of security holders, including indentures (10) Material contracts (13) Annual report to security holders (21) Subsidiaries of the registrant (23) Consent of independent auditors (24) Powers of attorney (27) Financial data schedule
(b) No reports on Form 8-K were filed during the last quarter of the period covered by this report.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
THE GORMAN-RUPP COMPANY
*By ROBERT E. KIRKENDALL ------------------------ Robert E. Kirkendall Attorney-In-Fact
Date: March 24, 2000
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated.
*JEFFREY S. GORMAN President, Principal Executive - ----------------------- Officer and Director Jeffrey S. Gorman
*KENNETH E. DUDLEY Treasurer and Principal Financial - ----------------------- and Accounting Officer Kenneth E. Dudley
*JAMES C. GORMAN Director - ----------------------- James C. Gorman
*WILLIAM A. CALHOUN Director - ----------------------- William A. Calhoun
*THOMAS E. HOAGLIN Director - ----------------------- Thomas E. Hoaglin
*PETER B. LAKE Director - ----------------------- Peter B. Lake
*W. WAYNE WALSTON Director - ----------------------- W. Wayne Walston
*JOHN A. WALTER Director - ----------------------- John A. Walter
*JAMES R. WATSON Director - ----------------------- James R. Watson
*The undersigned, by signing his name hereto, does sign and execute this Annual Report on Form 10-K on behalf of The Gorman-Rupp Company and on behalf of each of the above-named Officers and Directors of The Gorman-Rupp Company pursuant to Powers of Attorney executed by The Gorman-Rupp Company and by each such Officer and Director and filed with the Securities and Exchange Commission.
March 24, 2000
By: /s/ROBERT E. KIRKENDALL ----------------------- Robert E. Kirkendall Attorney-In-Fact
ANNUAL REPORT ON FORM 10-K
THE GORMAN-RUPP COMPANY
For the Year Ended December 31, 1999
EXHIBIT INDEX
EXHIBIT
(3) (4) Amended Articles of Incorporation, as amended *
(3) (4) Regulations *
(10) Form of Indemnification Agreement between the Company and its Directors and Officers **
(13) Incorporated Portions of 1999 Annual Report to Shareholders 14
(21) Subsidiaries of the Company 26
(23) Consent of Independent Auditors 27
(24) Powers of Attorney 28
(27) Financial Data Schedule 31
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* Incorporated herein by this reference from Exhibits (3) (4) of the Company's Annual Report on Form 10-K for the year ended December 31, 1998.
** Incorporated herein by this reference from Exhibit (10) of the Company's Annual Report on Form 10-K for the year ended December 31, 1998. | 3,704 | 24,517 |
875359_1999.txt | 875359_1999 | 1999 | 875359 | Item 1. Business
Micro Linear Corporation (the "Company") designs, develops and markets high performance analog and mixed signal integrated circuits for a broad range of applications within the communications, computer and industrial markets. The Company's products provide integrated systems-level solutions for a variety of applications, including local area networks, video, telecommunications, power management and motor control. The Company utilizes its proprietary design techniques and BiCMOS, Bipolar and CMOS manufacturing processes to produce proprietary and application specific products that enable systems designers to achieve increased levels of systems integration and reduce system costs.
Strategy
Micro Linear's goal is to be a leading supplier of proprietary integrated analog and mixed signal circuits for applications that require systems-level features. To achieve this objective, the Company has adopted the following strategies:
Target High Growth Applications. Micro Linear targets high growth applications that require substantial analog and mixed signal content and that derive significant benefits from the use of the Company's systems-level expertise. The Company focuses on innovative proprietary analog and mixed-signal products which provide high performance and cost-effective solutions for a variety of applications, including data communications, video and power management.
Develop Highly Integrated Circuits with Systems-Level Features. Micro Linear uses its analog and mixed signal design expertise to integrate several analog building block circuits into a single circuit or chipset. thereby reducing the size and cost of the customer's electronic system, while providing greater functionality, performance and reliability. The uniqueness and complexity of such products, has enabled the Company to maintain its position as the sole source supplier for a number of its products.
Offer a Broad Range of Products. Micro Linear offers a broad range of innovative proprietary and application specific analog and mixed signal products for a variety of applications within the communications, computer and industrial markets. The Company provides customers the opportunity to identify the product features that address the technical and time to market requirements of each customer's specific application. By working closely with its customers to identify desirable features and functionality, Micro Linear has expanded the number of applications for its products.
Markets, Applications and Products
The Company develops standard products for a variety of applications within the communications, computer and industrial markets. The Company has focused primarily on products for use with applications in local area networks, video and power management. Within these markets the Company has supplied products to several different applications with focus on local and wide area networks, video, power supply and battery management. The Company intends to increase its focus on the development of products for the wireless networking segment following the introduction of its initial products for this segment during 1999.
The Company's approach to new product development is driven by application specific requirements and accepted industry standards for communications within its targeted markets. The Company relies upon its engineering and marketing personnel to identify market opportunities for new high performance products, to maintain close working relationships with targeted customers, to determine product opportunities that apply to a broad range of customers within the Company's target markets and to define mixed signal products for specific applications.
The following table illustrates the three major applications and product categories served by the Company:
Communications Products
The local area network (LAN) market has experienced significant growth in recent years. The emergence of increasingly sophisticated software applications, such as imaging, multimedia and remote communications requires innovative, high performance networking technology which must provide for increased data throughput and enhanced reliability.
The Company's local area network circuits are designed to allow for the transmission of electronic signals over various media, such as twisted pair copper wire and fiber optic cable. The Company's fiber optic physical interface circuits respond to very small, fast signals from fiber optic receiver ports and restore the signal to larger amplitudes with a minimum of signal and timing distortion. The Company is a supplier of transceiver circuits into 10BASE-T, 10BASE-FL, and 100BASE TX. The Company is also developing new products for the emerging 10/100BASE-SX market segment.
The Company introduced the first of its products directed at the growing wireless communication application segment in 1999. The Company's 900MHz RF transceiver for digital cordless telephone applications represents a highly integrated and cost effective solution for this application. The Company also introduced a two-chip radio for application in 2.4GHz Wireless Local Area Networks.
Video Products
The Company has utilized its analog and mixed signal expertise to develop several products for video applications. These circuits consist of filters which contain video amplifiers, clock synchronization, comb filters, encoders and specialized video A/D converters. These circuits have been accepted for applications in the high growth rate segment including set top boxes. The Company believes that video applications offer opportunity for increased revenue in fiscal year 2000.
Power Management Products
Micro Linear has focused its recent power management product development efforts in: the areas of switched-mode power supply controllers including power factor control, battery management and motor controllers. The trend toward smaller, lighter weight and more power-efficient computer and other portable electronic systems has created significant opportunities for advanced power supply controllers and battery management devices.
Sales and Distribution
Micro Linear targets high growth markets by designing its products into the electronic systems of systems manufacturers within the communications, computer and industrial markets. The Company seeks to achieve design wins by focusing its sales efforts at prospective customers' technical design engineers and management personnel who are responsible for new product design and component selection. This effort is coordinated by the Company's direct sales managers who support a worldwide network of independent sales representatives and distributors. The sales representatives and distributors sell the Company's products directly to customers and are assisted by the Company's field applications engineers and applications engineering group. The Company has three field sales offices in North America, one in Asia and one in Europe.
The Company currently sells its products in North America through 21 independent sales representative organizations and three distributors. In 1999, 1998 and 1997, sales to Insight Electronics, a domestic distributor, represented 23%, 20% and 15% of the Company's net revenues, respectively. In 1999 sales through the Company's domestic distributors represented approximately 29% of net revenues, compared to 22% in 1998. The Company defers recognition of revenue and gross margin derived from sales to domestic distributors until such distributors resell the Company's products to their customers. In addition, the Company offers its domestic distributors product return privileges and, in the event the Company lowers the prices of its products, price protection on unsold inventory, which is typical in the semiconductor industry. To date, product returns under this policy have not had a material effect on the Company's operating results.
Outside of the United States, the Company's products are sold direct to international customers through 19 independent international sales representatives and distributors, which accounted for approximately 42%, 42% and 53% of the Company's net revenues in 1999, 1998 and 1997, respectively. The Company expects international sales to continue to represent a significant portion of product sales. The Company defers revenue from shipments to international distributors until such distributors notify the Company of product sales to their customers. Due to the significance of its international sales, the Company is subject to risks of conducting business internationally. These risks include changes in regulatory requirements, legislation relating to the import or export of products, delays resulting from difficulty in obtaining export licenses for certain technology, trade barriers, tariff increases, quotas and other barriers and restrictions, and the burdens of complying with a variety of foreign laws. The Company is also subject to general geo-political risks, such as political and economic instability and changes in diplomatic and trade relationships and there can be no assurance that such factors will not adversely affect the Company's operations in the future or require the Company to modify its current business practices. Because sales of the Company's products are denominated in United States dollars, fluctuations in the value of the dollar could increase the prices of the Company's products in local currencies and make the Company's products relatively more expensive than competitors' products that are denominated in local currencies. Additionally, currency exchange fluctuations could reduce the cost of products from the Company's foreign competitors. Substantially all of the Company's international sales must be licensed by the Office of Export Administration of the U.S. Department of Commerce. The Company has not experienced any material difficulties in obtaining export licenses; however, there can be no assurance that such export licenses will be available in the future.
A relatively small number of customers have accounted for a significant portion of the Company's net revenues in each of the past several years. During 1999, 1998 and 1997, the Company's top ten customers, excluding domestic distributors, accounted for approximately 5148% 40% and 52% of net revenues, respectively. During 1999 Insight Electronics, Lucent Technologies and Allied Telesyn International each accounted for 10% or more of the Company's revenue. During 1998 Insight Electronics and Maxisum, Ltd each accounted for 10% or more of the Company's revenue. During 1997 Maxisum Ltd, Insight Electronics and Xircom Operation's each accounted for 10% or more of the Company's revenue. The Company anticipates that it will continue to be dependent on a limited number of key customers for a significant portion of its net revenues. The reduction, delay or cancellation of orders from one or more significant customers for any reason could materially and adversely affect the Company's operating results. In addition, since the Company's products are often sole sourced to its customers,
the Company's operating results could be materially and adversely affected if one or more of its major customers were to develop other sources of supply. Furthermore, in view of the relatively short product life cycles in the computer network equipment, set-top box, or digital cordless telephone markets, the Company's operating results would be materially and adversely affected if one or more of its significant customers were to select circuits manufactured by one of the Company's competitors for inclusion in future product generations. The Company also is entirely dependent upon sales representatives and distributors for the sales of its products to systems manufacturers. There can be no assurance that the Company's current customers will continue to place orders with the Company, that orders by existing customers will continue at the levels of previous periods or that the Company will be able to obtain orders from new customers. Loss of one or more of the Company's current customers or a disruption in the Company's sales and distribution channels could materially and adversely affect the Company's business and operating results.
A substantial majority of the Company's net revenues are derived from sales of products for the computer networking market. Sales of the Company's products to network equipment manufacturers accounted for approximately 47%, 57% and 65% of the Company's net revenues in 1999, 1998 and 1997, respectively. Sales of one of the Company's computer products represented 13%, 10% and 4% of the Company's net revenues during 1999, 1998 and 1997, respectively. The computer network equipment market is characterized by intense competition, relatively short product life cycles and rapid technological change. In addition, the computer network equipment market has undergone a period of rapid growth and consolidation in the last few years. The Company has attempted to expand its product mix and customer base and, as a result, does not expect revenues from the computer networking market to increase as a percentage of net revenues in 2000.
Backlog
At December 31, 1999, the Company's backlog was approximately $11.9 million, compared to approximately $11.4 million at December 31, 1998. Backlog consists of released purchase orders scheduled for shipment within six months following the order date. Although the Company's contract terms vary from customer to customer, customers for standard products may generally cancel or reschedule orders to purchase standard products without significant penalty to the customer. As a result, the quantities of the Company's products to be delivered and their delivery schedules are frequently revised by customers to reflect changes in such customers' needs. Since backlog can be canceled or rescheduled, the Company's backlog at any time is not necessarily indicative of future revenue.
Technology
The Company's new products are incorporated into a customer's products or systems at the design stage. However, design wins, which can often require significant expenditures by the Company without any assurance of success, often precede the generation of volume sales by a year or more. Moreover, the value of any design win will largely depend upon the commercial success of the customer's product and on the extent to which the design of the customer's electronic system accommodates components manufactured by the Company's competitors. No assurance can be given that the Company will achieve design wins or that any design win, particularly with regard to application specific products, will result in significant future revenues.
Design
Micro Linear's proprietary technology depends on the advanced analog and mixed signal circuit design skills of its analog design engineers. The Company utilizes analog, digital, and mixed signal circuits and cell simulation for digital and analog circuit elements and extensive testing capabilities to assure functionality and performance of final products. The Company has assembled a team of highly skilled analog and mixed signal design engineers, with significant design experience who are supported by a team of systems engineers, applications engineers, product engineers and test engineers who perform various support functions and allow the designers to focus on the core elements of the design. In addition, Micro Linear has utilized simulation models that facilitate
timely and predictable implementation of analog and mixed signal integrated circuits. As a result of performance demands and the complexity of analog circuits, the mixed signal design and development process is a multi-disciplinary effort, requiring substantial systems-level expertise, including knowledge of particular formats, standards and architectural constraints associated with a variety of targeted end-user applications. The Company also utilizes standard electronic design automation software to perform the schematic capture, simulation, design rule checks and layout verification of its circuit.
Process
The Company seeks to employ the most appropriate process technology for a given application. The Company's process technologies include Bipolar, CMOS and BiCMOS processes.
Bipolar. The Company used its Bipolar technology for networking, and power management applications such as transceivers, switched-mode power management circuits and DC to DC converters to manage offline power. While a portion of the Company's production continues to utilize Bipolar processes, no new product developments were undertaken during 1999 using this process.
CMOS. The Company's CMOS devices are full custom circuits and are used in applications, such as telecommunications, data communications and data conversion circuits, which require minimal power consumption and increased density. CMOS technology permits the design of circuits with lower power dissipation and a higher level of digital integration than Bipolar circuits. During 1999, the Company started to design power management products in a new 40v CMOS technology, with 1 micron feature size. The Company is working closely with a major silicon foundry on the development of a mixed signal 0.18 micron CMOS technology to support new product applications in the networking and wireless communications area.
BiCMOS. The Company's BiCMOS processes combine the low power dissipation capabilities of CMOS, and the high performance capabilities of Bipolar. As a result, BiCMOS processes allow the design of circuits with lower power dissipation than Bipolar or CMOS devices for certain applications. The feature size of these processes allows for significantly increased density of the logic functions that are necessary for advanced levels of mixed signal integration. The Company believes that these technologies represent the core of the Company's product offerings and are critical to its ability to continue to develop innovative, highly complex, high performance mixed signal products.
In addition to the high volume 5 volt BiCMOS process, the Company is also utilizing an 18 volt BiCMOS process primarily for power management products and motor controllers. The Company is now in volume production on a 0.8 micron BiCMOS process primarily for video and wireless RF applications. The Company's first products have been completed on a new 0.6 micron BiCMOS process and production is expected to begin ramping in the first quarter of 2000. This process offers smaller feature size and higher performance than the 0.8 micron process. If the production of these products does not proceed in a timely manner due to technical issues, manufacturing yield limitations or other factors, the Company's business and results of operations would be materially and adversely affected.
The markets for the Company's products are characterized by rapid technological change and frequent new product introductions. To remain competitive, the Company must develop or obtain access to new semiconductor process technologies in order to reduce die size, increase die performance and functional complexity, and improve manufacturing yields. Semiconductor design and process methodologies are subject to rapid technological change, requiring large expenditures for research and development. If the Company is unable to obtain access to advanced wafer processing technologies as they become needed, or is unable to define, design, develop and introduce competitive new products on a timely basis, its future operating results will be materially and adversely affected. In addition, if the Company is unable to transfer and install such new process technologies to one or more of its wafer foundries in a timely manner, its business and results of operations could be materially and adversely affected.
The Company believes the successful introduction of new products using BiCMOS and advanced CMOS technologies will be critical to its future success. There can be no assurance that the Company will be able to obtain alternative or more advanced process technologies in a timely manner. If such efforts prove unsuccessful, the Company's business and operating results would be materially and adversely affected.
The Company expects future BiCMOS and advanced CMOS circuit designs to be developed on both application specific functional arrays and full custom layouts. The Company currently uses its BiCMOS technology for its local area network transceivers, wireless radio, video products, bus products, motor controllers, power supply controllers and for battery management circuits. The inability of the Company to select and design BiCMOS and advanced CMOS products that satisfy particular market requirements, to succeed in having its BiCMOS and CMOS products designed into its customers' electronic systems or to establish the Company as a preferred supplier of BiCMOS and CMOS solutions within its targeted market areas would have a material adverse impact on the Company's business and operating results.
The Company's success also depends upon its ability to develop new analog and mixed signal circuits for existing and new markets, to introduce such products in a timely manner and to have such products selected for design into new product generations of leading systems manufacturers. The development of these new circuits is highly complex and from time to time the Company has experienced delays in completing the development of new products. Successful product development and introduction depends on a number of factors, including proper new product definition, timely completion and introduction of new product designs, availability of foundry capacity, achieving acceptable manufacturing yields and market acceptance of the Company's and its customers' products. There can be no assurance that the Company will be able to adjust to changing market conditions as quickly and cost-effectively as necessary to compete successfully. Furthermore, there can be no assurance that the Company will be able to introduce new products in a timely manner or that such products will achieve market acceptance. In addition, there can be no assurance that the electronic systems manufactured by the Company's customers will be introduced in a timely manner or that such systems will achieve market acceptance. The Company's failure to develop and introduce new products successfully would materially and adversely affect its business and operating results. In particular, there can be no assurance that the Company will succeed in developing innovative BiCMOS or CMOS circuits in a timely manner, that its BiCMOS or CMOS circuits will be designed into the electronic systems of current or prospective customers or that the Company will be able to establish itself as a supplier of BiCMOS or CMOS solutions within its targeted market applications. The Company's inability to introduce BiCMOS or CMOS products in a timely manner or to obtain market acceptance of such BiCMOS or CMOS products would materially and adversely affect the Company's business and operating results.
Manufacturing
The Company utilizes outside foundries for all of its wafer requirements. The Company believes that utilizing outside foundries enables the Company to focus on its design strengths, minimize fixed costs and capital expenditures and access diverse manufacturing technologies. The Company's Bipolar and a portion of the BiCMOS wafers are manufactured by a foundry located in Japan. A substantial portion of the Company's BiCMOS wafers are manufactured by one foundry in Taiwan. There are certain significant risks associated with the Company's reliance on outside foundries, including the lack of both assured wafer supply and control over delivery schedules, the unavailability of or delays in obtaining access to key process technologies and limited control over manufacturing yields and production costs. In addition, the manufacture of integrated circuits is a highly complex and technically demanding process. Although the Company has undertaken to diversify its sources of wafer supply and works closely with its foundries to minimize the likelihood of reduced manufacturing yields, the Company's foundries have from time to time experienced lower than anticipated manufacturing yields, particularly in connection with the introduction of new products and the installation and start-up of new processes. Such reduced yields have at times materially adversely affected the Company's operating results. There can be no assurance that the Company's foundries will not experience lower than expected manufacturing yields in the future, which could materially and adversely affect the Company's business and operating
results. In addition, dependence on foundries located outside of the United States subjects the Company to numerous risks, including exchange rate fluctuations, export and import restrictions, trade sanctions, political instability and tariff increases. In particular, the Company's dependence on a Taiwanese foundry for supply of BiCMOS wafers subjects the Company to risks associated with political instability in that region.
All of the Company's foundries manufacture wafers utilizing the Company's proprietary processes, except for three foundries which manufacture wafers for the Company utilizing each foundry's proprietary BiCMOS process.
The Company purchases its wafers from outside foundries pursuant to purchase orders and generally does not have a guaranteed level of wafer capacity or wafer costs at such foundries. Therefore, the Company's wafer suppliers could choose to prioritize capacity for other uses or reduce or eliminate deliveries to Micro Linear on short notice. Accordingly, there is no assurance that the Company's foundries will allocate sufficient wafer capacity to Micro Linear to satisfy the Company's requirements. In addition, the Company has been, and expects to be in the future, particularly dependent upon a limited number of its foundries for its wafer requirements. Any sudden demand for an increased amount of wafers or sudden reduction or elimination of any existing source or sources of wafers could result in a material delay in the shipment of the Company's products. There can be no assurance that material disruptions in supply, which have occurred periodically in the past, will not occur in the future. Any such disruption could have a material adverse effect on the Company's operating results. In the event of any such disruption, if the Company were unable to qualify alternative manufacturing sources for existing or new products in a timely manner or if such sources were unable to produce wafers with acceptable manufacturing yields, the Company's business and operating results would be materially and adversely affected.
The Company has granted nontransferable, limited process licenses to some of its foundries to utilize the Company's processes to manufacture and sell wafers to other foundry customers. Although the Company seeks to protect its proprietary technology, particularly its design methodology, there can be no assurance that certain of the Company's foundries will not attempt to reverse engineer the Company's products and manufacture and sell products which compete with those manufactured and sold by the Company.
The Company has a production staff in place to support its outside foundries in order to ensure design and process compatibility, product quality and reliability. The high volume Bipolar wafers are inventoried and later completed at a specific foundry. The Company also applies a tile array approach to certain of its BiCMOS products. Such BiCMOS products are inventoried and later completed at the foundries utilized for these processes. The Company purchases completely finished CMOS, BiCMOS and Bipolar wafers to which it adds no additional process steps, other than incoming wafer quality tests and specific electrical product testing prior to assembly.
Each die on all of the Company's wafers is electrically tested for performance compliance and the wafers are subsequently sent to subcontractors for assembly. During the assembly process, the wafers are separated into individual devices which are then placed in packages. Following assembly, the packaged units are returned to the Company for final testing and final inspection prior to shipment to customers. Extensive electrical testing is individually performed on all circuits at the Company's facilities, using advanced automated test equipment capable of high volume production to ensure that the circuits satisfy specified performance levels. From time to time, the Company has experienced difficulty in expeditiously completing testing of its products. If such problems are encountered in the future, shipments to customers could be delayed.
The Company also utilizes subcontractors for final testing of certain types of products pursuant to purchase orders and generally does not have a guaranteed level of test capacity at such subcontractors. Therefore, the Company's test service suppliers could choose to prioritize capacity for other uses or reduce or eliminate deliveries to Micro Linear on short notice. Accordingly, there is no assurance that the Company's test subcontractors will allocate sufficient test capacity to Micro Linear to satisfy the Company's requirements. Any sudden demand for an increased amount of testing or sudden reduction or elimination of
any existing source of test capacity could result in a material delay in the shipment of the Company's products. There can be no assurance that material disruptions in supply, which have occurred periodically in the past, will not occur in the future. Any such disruption could have a material adverse effect on the Company's operating results. In the event of any such disruption, if the Company were unable to qualify alternative testing sources for existing or new products in a timely manner the Company's business and operating results would be materially and adversely affected.
The manufacture of integrated circuits is a highly complex and precise process. Minute levels of contaminants in the manufacturing environment, defects in the masks used to print circuits on a wafer, difficulties in the fabrication process or other factors can cause a substantial percentage of wafers to be rejected or a significant number of die on each wafer to be nonfunctional. In addition, yields can be affected by minute impurities in the environment or other problems that occur in the complex manufacturing process. Many of these problems are difficult to diagnose and time consuming or expensive to remedy. At various times in the past, the Company has experienced lower than anticipated yields that have adversely affected production and, consequently, operating results. The manufacturing processes utilized by the Company are continuously being improved in an effort to increase yield and product performance. Process changes can result in interruptions in production or significantly reduced yields. In particular, new process technologies or new products can be subject to especially wide variations in manufacturing yields and efficiency. There can be no assurance that the Company will not experience irregularities, adverse yield fluctuations or other manufacturing problems in its manufacturing processes, any of which could result in production interruption or delivery delays and materially and adversely affect the Company's business and results of operations The Company currently intends to continue to rely exclusively upon its outside foundries for its wafer fabrication requirements.
The Company has signed a letter of intent to sell certain test equipment, lease certain office, and transfer certain employees to a third party, which will perform certain manufacturing work for the Company. Should this letter of intent result in an agreement on terms acceptable to the Company, this transaction is expected to have a favorable effect on the Company's results of operations.
Research and Development
Micro Linear believes that it is essential to define, design, develop and introduce new products offering technological innovations in order to take advantage of market opportunities and to compete successfully. The Company is currently engaged in the development of new products for a broad range of customer applications in the communications and computer markets. The Company's product development strategy is focused on highly integrated products providing increased levels of performance and functionality offering higher frequency, high or low operating voltage, depending upon the application, lower power and smaller size. The Company's development efforts are focused on the design of products based on certain foundry proprietary processes. To develop value-added mixed signal products for specific market categories, the Company must continue to obtain and develop extensive knowledge regarding its customers' systems. This "systems knowledge" is acquired through technical interactions with the Company's customers and potential customers in its targeted market categories. To this end, the Company has assembled a team of experienced analog and mixed signal engineers in a variety of disciplines, including design, systems, product, test, applications and marketing. The Company's engineer work to upgrade the Company's design methodology and process technologies, and to investigate and develop with its foundry partners new technologies for new generations of products.
The Company's design engineers are organized into six design groups consisting of a total of approximately 30 research and development design engineers, supported by approximately 40 additional technical professionals in test development and manufacturing engineering. Inability to attract and retain a sufficient staff of qualified engineers could pose a significant threat to the Company's ability to design and deliver new products. In 1999, 1998 and 1997, the Company spent approximately $13.8 million, $11.9 million and $12.0 million, respectively, on research and development. The Company expects that it will continue to spend substantial funds on research and development activities.
Competition
The semiconductor industry is intensely competitive and is characterized by price erosion, rapid technological change, short product life cycles, cyclical market patterns and heightened international and domestic competition. The analog and mixed signal market of the semiconductor industry is also highly competitive, and many semiconductor companies presently compete or could compete in one or more of the Company's target markets. Most of the Company's current and prospective competitors offer broader product lines and have substantially greater financial, technical, manufacturing, marketing and other resources than the Company. In addition, many of the Company's competitors maintain their own wafer fabrication facilities, which provides them with a competitive advantage. The Company's competitors vary in each product area. Its principal competitors in data communications are National Semiconductor Corporation ("NSC"), Conexant, Broadcom Corporation, and Level One (a subsidiary of Intel Corporation). In the power management products area, its principal competitors are Linear Technology Corporation, Maxim Integrated Products and Unitrode Semiconductor (a subsidiary of Texas Instruments). The Company also competes with manufacturers of discrete analog components, particularly for power management applications within the industrial market. As the Company attempts to expand its product line, it expects that competition will increase with these and other domestic and foreign companies. Although foreign companies, particularly Japanese companies, have not traditionally focused on the high performance analog and mixed signal markets, they have the financial and technical resources to participate effectively in these markets, and there can be no assurance that they will not do so in the future. Because the Company does not currently manufacture its own semiconductor wafers, it is also vulnerable to process technology advances utilized by competitors to manufacture products offering higher performance and lower cost. Accordingly, the Company believes it is disadvantaged in comparison to larger companies with wafer manufacturing facilities, broader product lines, greater technical and financial resources and greater service and support capabilities. In addition, certain of the Company's products are generally sole sourced to its customers, and the Company's operating results could be adversely affected if its customers were to develop other sources for the Company's products. There can be no assurance that the Company will compete successfully with new or existing competitors in the future.
The Company believes that its ability to compete successfully depends on a number of factors, including breadth of product line, the ability to introduce innovative products rapidly, access to advanced process technologies at competitive prices, product functionality and performance, successful and timely product development, price, adequate foundry capacity, manufacturing yields, efficiency of production, delivery capability, customer support and protection of the Company's intellectual property. The Company believes that product innovation, quality, reliability, performance and the ability to introduce products rapidly are more important competitive factors. The Company believes that, by virtue of its analog and mixed signal expertise and rigorous design methodology, it competes favorably in the areas of rapid introduction, product innovation, quality, reliability and performance, but it may be at a disadvantage in comparison to larger companies with broader product lines, greater technical and financial resources and greater service and support capabilities. As a result of the foregoing or other factors, there can be no assurance that the Company will be able to compete successfully in the future.
Patents and Licenses
The Company's success depends on its ability to obtain patents and licenses and to preserve other intellectual property rights covering its products and development and testing tools. To that end, the Company has obtained certain patents and intends to continue to seek patents on its inventions when appropriate. Specifically, the U.S. Patent and Trademark Office has issued 18 patents and allowed 10 more patents to the Company. The Company's issued patents expire from January 2007 to November 2017. The Company intends to continue to seek patents on its products, as appropriate, and currently has submitted applications for more U.S. patents with an additional nine patents in process. The Company believes that although these patents may have value, given the rapidly changing nature of the semiconductor industry, the Company depends primarily on the technical competence and creativity of its technical work force.
The Company attempts to protect its trade secrets and other proprietary rights through formal agreements with employees, customers, suppliers and consultants. Although the Company intends to protect its intellectual property rights vigorously, there can be no assurance that these and other security arrangements will be successful. The process of seeking patent protection can be long and expensive and there can be no assurance that existing patents, or any new patents that may be issued, will be of sufficient scope or strength to provide meaningful protection or any commercial advantage to the Company. The Company may be subject to or may initiate interference proceedings in the patent office, which can demand significant financial and management resources. As is typical in the semiconductor industry, the Company has from time to time received, and may in the future receive, communications from third parties asserting patents, mask-work rights, or copyrights on certain of the Company's products and technologies. The Company is presently involved in litigation with a party that has claimed infringement of their patent. The financial impact of this litigation is not expected to have a material impact on the financial results of the Company, however, a third party could make a valid claim and if a license were not available on commercially reasonable terms, the Company's operating results could be materially and adversely affected. Litigation, which could result in substantial costs and diversion of Company resources, could be necessary to enforce patents or other intellectual property rights of the Company or to defend the Company against claimed infringement of the rights of others. The failure to obtain necessary licenses or the occurrence of litigation relating to patent infringement or other intellectual property matters could have a material adverse affect on the Company's business and operating results.
The Company currently does not have any third parties that have been granted license rights to manufacture and sell any of its products. The Company has no current plans to grant product licenses with respect to any products; however, the Company may find it necessary to enter into product licenses in the future in order, among other things, to secure foundry capacity. The Company has granted nontransferable, limited process licenses to each of its foundries to utilize the Company's proprietary processes to manufacture and sell wafers to other foundries.
Employees
As of December 31, 1999, the Company had 233 full-time employees, 125 of whom were engaged in manufacturing (including test development, quality and materials functions), 68 in research and development, 26 in marketing, applications and sales, and 14 in finance and administration. The Company's employees are not represented by any collective bargaining agreements and the Company has never experienced a work stoppage. The Company believes that its employee relations are good.
The Company's success depends to a significant extent upon the continued service of its executive officers and other key management and technical personnel, and on its ability to continue to attract, retain and motivate qualified personnel, particularly experienced mixed signal circuit designers and systems application engineers. The competition for such employees is very intense. The Company has from time to time lost key analog designers, executive officers and other personnel to start-up or to established companies. The loss of the services of one of the Company's design engineers, executive officers or other key personnel, or the Company's inability to recruit replacements for such personnel or to otherwise attract, retain and motivate qualified personnel, could have a material adverse affect on the Company. The Company is currently recruiting for Vice President of Marketing and a Chief Financial Officer. Any failure to hire suitable candidates for such positions in a timely manner could have a material adverse effect on the Company's business.
Executive Officers
The executive officers of the Company are and their ages as of December 31, 1999 as follows:
Mr. Gellatly joined the Company in January 1999 as Chief Executive Officer and President. From 1982 to January 1999 he had been the principal of New Technology Marketing, a high technology marketing consulting company. Clients included Lucent Technology, IBM, National Semiconductor ("NSC"), Cyrix, Intel, Apple Corporation, and Siemens. Prior to 1982, Mr. Gellatly worked at Intel Corporation for five years where he served in various marketing management positions in the microprocessor operation. Mr. Gellatly has been a director of Micro Linear since December 1998. Mr. Gellatly received his MSEE from the University of Minnesota.
Mr. Bell joined the Company in April 1999 as Vice President, Communication Products. He brought to the Company more than twenty-five years of R&D management experience in computer architecture, communications, and semiconductor development. Prior positions include CEO of Equator Technologies, Vice-President and General Manager of LSI Logic, and Vice-President and Chief Technology Officer for the Computer Systems Group of the Unisys Corporation. Mr. Bell received his BSEE and MSCS from University of Utah.
Mr. Ladas joined the Company in January 1996 as Vice President, Operations. From January 1987 to December 1995, Mr. Ladas held several executive positions with NSC including Managing Director of Operations in Greenock, Scotland. From March 1983 to December 1986, Mr. Ladas worked at Fairchild Semiconductor as Research and Development Manager. Mr. Ladas received his B.S. degree in Chemistry from Arizona State University.
Mr. Neubauer joined the Company in May 1999 as Vice President of Sales. Mr. Neubauer previously served as Director of Worlwide Sales Development at Sun Microsystems, Inc. where he had worked for the past six years. Prior to that he was Director of Asia-Pacific Sales at Integrated Device Technology. Mr. Neubauer also spent fifteen years at Intel Corporation serving as Strategic Accounts Manager and other sales management positions. Mr. Neubauer received his B.A. degree in Physics from the University of Texas, Austin.
Officers serve at the discretion of the Board and are appointed annually. There are no family relationships between the directors or officers of the Company.
Item 2.
Item 2. Properties
The Company's executive offices and manufacturing facilities, located in San Jose, California, consist of two buildings comprising approximately 93,000 square feet. This property was acquired by the Company in October 1990 at a cost of $7.5 million and is used for manufacturing, product design and development, marketing, sales and administration. The acquisition of the property was financed by a $5.3 million note, secured by the property. This obligation was refinanced in September1999 with a $3.0 million note payable over five years with principal amortized on a ten year basis. The Company leases development center buildings in Cambridge, England and Livingston, Scotland. Micro Linear believes that its existing facilities are adequate to meet its current requirements.
Certain of the Company's wafer suppliers and assembly contractors are subject to a variety of U.S. and foreign government regulations related to the discharge or disposal of toxic, volatile or otherwise hazardous chemicals used in their manufacturing process. The failure by the Company's suppliers or subcontractors to comply with present or future environmental regulations could result in fines, suspension of production or cessation of operations. Such
regulations could also require the Company's suppliers or subcontractors to acquire equipment or to incur other substantial expenses to comply with environmental regulations. If substantial additional expenses were incurred by the Company's suppliers or subcontractors, product costs could significantly increase, thus materially and adversely affecting the Company's results of operations. Additionally, the Company is subject to a variety of governmental regulations relating to its operations, such as environmental, labor and export control regulations. While the Company believes it has obtained all permits necessary to conduct its business, the failure to comply with present and future regulations could result in fines being imposed on the Company or suspension or cessation of operations. Any failure by the Company or its suppliers or subcontractors to control the use of, or adequately restrict the discharge of, hazardous substances could subject the Company to future liabilities, and could have a material adverse effect on the Company's business and operating results.
Item 3.
Item 3. Legal Proceedings
In December 1995, Pioneer Magnetics, Inc. ("Pioneer") filed a complaint in the Federal District Court for the Central District of California alleging that certain of the Company's integrated circuits violate a Pioneer patent. Pioneer is seeking monetary damages and an injunction against such alleged patent violation. The Company has denied any infringement and filed a counter-claim seeking invalidity of the patent. The court held a patent claim construction hearing on November 9, 1998. The court subsequently issued a claim construction opinion that is favorable to Micro Linear. The court ordered Pioneer to brief additional claim elements. The final claim construction hearing took place on July 19, 1999. The court issued a claim construction order favorable to Micro Linear. The parties filed a stipulated judgment of Non-Infringement, which resulted in a termination of the district court action against Micro Linear. Pioneer has appealed. No hearing date on the appeal has been set.
On February 24, 1997, a former employee of Micro Linear filed a complaint in the Superior Court of California, County of Santa Clara, alleging breach of contract and employment discrimination. On June 5, 1997, the case was dismissed and the parties agreed to submit the dispute to arbitration. As of March 13, 2000, no arbitration date had been scheduled. The Company denies all liability and intends to vigorously defend its actions in the arbitration.
On September 4, 1998, NetVantage, Inc. ("NetVantage") filed a complaint relating to the Company's sale of part ML6692 to NetVantage through the Company's distributor, Insight Electronics, in the Superior Court of California, County of Los Angeles. On October 1, 1999 the parties reached an out of court settlement of this action. The terms of settlement in this matter are confidential, however, the Company took a $1.24 million charge reflecting settlement in 1999, and the action has been dismissed.
On December 16, 1998, Accton Technology Corporation ("Accton") filed a complaint relating to the Company's sale of part ML6692 to Accton, against the Company in the Superior Court of California, County of Santa Clara, alleging causes of action for: (1) breach of contract, (2) breach of express warranty, (3) breach of implied warranty of merchantability, (4) breach of implied warranty of fitness for particular purpose, (5) fraud and deceit-concealment, (6) negligent misrepresentation, (7) negligent interference with economic advantage, and (8) declaratory relief to establish the right to implied contractual indemnity. Accton seeks compensatory damages in excess of $7.0 million, exemplary damages according to proof, attorneys' fees and costs, and prejudgment and postjudgment interest. On February 10, 1999, the Company filed a demurrer and motion to strike attacking the legal sufficiency of Accton's complaint. On April 20, 1999, the same day scheduled for the hearing on the demurrer, Accton filed its Amended Complaint, which rendered the demurrer moot. Accton's Amended Complaint alleges essentially the same claims as its original Complaint, but pleads the breach of contract and fraud and deceit claims with somewhat more specificity, as well as alleging additional factual information. The Company filed its answer to Accton's Amended Complaint on July 27, 1999. Discovery was commenced in May, 1999. Both Parties have propounded and responded to extensive written discovery requests. Hewlett-Packard Company, Accton's customer, has also produced documents in response to the Company's deposition subpoena. Accton has taken the depositions of a number of the Company's employees. In turn, the Company has noticed the depositions of Accton personnel, several of which have been commenced. The depositions of Hewlett-Packard
personnel are scheduled to commence in early April, 2000. The action is scheduled to commence trial on June 5, 2000. On January 7, 2000 in response to discovery motions brought by both parities and the Company's request, the Court ordered the parties to stipulate to appointment of a discovery referee. The parties have agreed to have David Meadows, Esq. Serve as the discovery referee. The first discovery took place on February 23, 2000 and additional hearings will take place in March and April, 2000. At the initial status conference held on July 13, 1999, the court ordered the parties to mediation. An initial mediation session was held on December 16, 1999 before Hon. William T. Betineli (Ret.). A second session will take place on March 14, 2000.
The Company intends to contest this complaint vigorously, however, there can be no assurance that such actions will be resolved in the Company's favor or that an unfavorable resolution would not materially adversely effect the Company's financial condition or results of operations.
From time to time, the Company has received, and in the future it may receive, correspondence from certain vendors, distributors, customers or end-users of its products regarding disputes with respect to contract rights, product performance or other matters that occur in the ordinary course of business. There can be no assurance that any of such disputes will not eventually result in litigation or other actions involving the Company or as to the outcome of such disputes.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable.
PART II
Item 5.
Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters
The following table sets forth the high and low prices of the Company's Common Stock as quoted in the Nasdaq National Market for the periods indicated. As of February 27, 2000, there were approximately 285 holders of record of the Company's Common Stock. The Company's Common Stock is listed for quotation in the Nasdaq National Market under the Symbol "MLIN."
Common Stock Prices
The Company has not paid any cash dividends on its Common Stock and currently intends to retain any future earnings for use in its business. Accordingly, the Company does not anticipate that any cash dividends will be declared or paid on the Common Stock in the foreseeable future.
Item 6.
Item 6. Selected Consolidated Financial Data
The following selected consolidated financial data for the five-year period ended December 31, 1999, should be read in conjunction with the Company's Consolidated Financial Statements and notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in Item 7
Item 7. Management's Discussion and Analysis of Financial Condition and Resultsof Operations
This Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual results could differ materially from those projected in the forward-looking statements as a result of the risk related factors set forth below and elsewhere in this Form 10-K. Results of Operations
Overview
Micro Linear Corporation was founded in 1983. Micro Linear currently serves the communications, industrial and computer markets with a broad range of standard products for a variety of applications, including local area networks, video, telecommunications, power management, battery management, motor control. The Company utilizes three principal manufacturing process technologies, Bipolar, CMOS and BiCMOS.
In recent years, sales of communications products, including networking and telecom, have constituted a majority of the Company's revenues. Specifically, such products represented approximately 53%, 64% and 69% of net revenues for 1999, 1998, and 1997, respectively. The communications market is characterized by intense competition, relatively short product life cycles and rapid technological change. In addition, the communications market has undergone rapid growth and consolidation in the last few years. The Company's net revenues and results of operations would be materially and adversely affected in the event of a slowdown in this market. The Company is attempting to reduce its dependency on the communications industry through various means, such as expanding its product mix and customer base.
The Company's communications market includes networking applications. A substantial portion of the Company's net revenues are derived from sales of products for computer networking applications. Sales of the Company's products to network equipment manufacturers accounted for approximately 47% of the Company's net revenues in 1999 and accounted for 6 of the Company's 10 top selling products for 1999. These 6 products constituted approximately 39% of the Company's revenues for the same period. The computer networking equipment market is characterized by intense competition, relatively short product life cycles and rapid technological change. In addition, the computer network equipment market has undergone a period of rapid growth and experienced consolidation among the competitors in the market in recent years. Although the Company has expanded its product mix and customer base, the Company expects its dependency on sales to network equipment manufacturers to continue into 2000. The Company's business and results of operations would be materially and adversely affected in the event of a significant slowdown in the computer networking equipment market. In addition, as a result of competitive pricing pressures, the Company has experienced lower margins in certain of its existing products for computer networking applications. There can be no assurance as to when or if such pricing pressure will lessen. Such pricing pressures will have an adverse affect on the Company's results of operations unless they can be offset by higher margins on other products or reduced operating expenses.
The Company's operating results are subject to quarterly and other fluctuations which may result from the timing and extent of process development costs, changes in the mix of products sold, the timing and extent of research and development expenses, the availability and cost of wafers from outside foundries, fluctuations in manufacturing yields, and competitive pricing pressures. Other factors which may result in operating fluctuations are the Company's ability to access advanced process technologies, the ability to introduce new products on a timely basis, market acceptance of the Company's and its customers' products, the timing of new product announcements and cyclical semiconductor industry conditions. Moreover, the Company's business is characterized by short-term orders and shipment schedules, and customer orders typically can be canceled or rescheduled without significant penalty to the customer. As a result of the foregoing or other factors, the Company expects to continue to experience material fluctuations in its future operating results on a quarterly or annual basis.
Annual Results of Operations
The following table sets forth certain operating data as a percentage of net revenues for the periods indicated:
Net Revenues
Net revenues were $46.6 million for 1999, $47.8 million for 1998 and $65.8 million for 1997. Net revenues in 1999 decreased 3% from net revenues in 1998, and 1998 net revenues decreased 27% from 1997. The Company serves three principal markets, computer, communications and industrial. Net revenues for 1999 compared to 1998 increased 21% in the computer market and 29% in the industrial market and decreased 19% in the communications market. Net revenues for 1998 compared to 1997 increased 3% in the industrial market and decreased 33% and 37% in the communications market and computer market respectively.
The communications market includes the computer networking equipment ("networking") sub-market. Revenues in the networking sub-market for 1999 were $22.1 million, or 47% of net revenues, compared to $27.5 million, or 57% of net revenues for 1998 and $42.9 million, or 65% of net revenues for 1997. The networking sub-market is characterized by intense competition, relatively short product life cycles and rapid technological change. In addition, the networking sub-market has undergone a period of rapid growth, price erosion and consolidation in recent years. Although the Company has expanded its product mix and customer base, the Company expects its dependency on sales to network equipment manufacturers to continue. The Company's business and results of operations have been and will be adversely affected by a significant slowdown in the computer networking equipment sub-market.
International revenues for 1999 totaled $19.5 million or 42% of net revenues compared to $20.2 million or 42% of net revenues for 1998 and $34.6 million or 53% of net revenues for 1997. The moderate decrease in international revenues in 1999 compared to 1998 and decrease in 1998 compared to 1997 was due to a combination of lower demand for the Company's products in Asia and decreased Asia Pacific subcontract work for domestic customers.
Domestic distributor revenues were approximately 29% of net revenues for 1999, compared to 22% for 1998 and 17% for 1997. The Company defers recognition of revenue derived from sales to distributors until such distributors resell the products to their customers.
Gross Margin
The Company's gross margin is affected by the volume of product sales, price, product mix, manufacturing utilization, product yields and the mix of sales to OEM's and to distributors. Gross margin is periodically affected by costs incurred in connection with start-up and installation of new process technologies at outside manufacturing foundries.
Gross margin increased slightly to 51% in 1999 from 50% in 1998 due primarily to lower costs and better production yields. Gross margin declined from 52% in 1997, primarily due to a shift of product mix to lower margin products, lower levels of production and lower average selling prices related to competitive pricing pressures.
The Company's gross margin is affected by costs associated with installing new processes at its foundries. The Company has been able to mitigate the effect on gross margin associated with new wafer manufacturing process costs by relying upon process technologies existing at its outside wafer foundries. The costs of new processes installed in 1998 and 1999 related to the closure of an internal Bipolar fabrication facility are discussed below. The cost of additional new processes installed in 1999, unrelated to the closure of the Bipolar fabrication facility, were approximately $0.5 million.
The Company currently purchases its wafers from six wafer suppliers. A substantial majority of the Company's wafer supply is obtained from three wafer suppliers. The Company's products are assembled and packaged by four vendors. Supply interruptions due to such factors as inadequate capacity or raw material shortages at the Company's wafer suppliers or assembly vendors could materially and adversely affect product shipments. The Company purchases most of its BiCMOS wafers from one wafer foundry in Taiwan. Accordingly, the Company's BiCMOS wafer supply could be materially and adversely affected if this foundry is unable to meet the Company's supply requirements.
The Company closed its owned Bipolar fabrication facility in the fourth quarter of 1998. Production related to this fabrication facility has been moved to an outside foundry resulting in lower wafer costs. The cost of closing the operation, including asset disposal, inventory write-off, facility clean-up and new foundry qualification totaled $1.5 million. Of this amount approximately $1.0 million was expensed in 1998. The amount expensed in 1998 included new foundry qualification costs and installation costs of new process technologies of $0.6 million and an inventory write-off of approximately $0.4 million. Additional foundry qualification costsand installation costs of new process technologies of approximately $0.4 million were incurred and expensed in 1999. The net book value of fixed assets disposed totaled $103,000. In 1999 these assets were sold for approximately $114,000.
Research and Development Expenses
Research and development expenses include costs associated with the definition, design and development of standard and semi-standard products, tile arrays and standard cells. In addition, research and development expenses include test development and prototype assembly costs associated with new product development. The Company also expenses prototype wafers and new production mask sets related to new products as research and development costs until products based on new designs are fully characterized by the Company and are demonstrated to support published data sheets and satisfy reliability tests. The Company believes that the development and introduction of new products is critical to its future success. Research and development expenses such as mask and silicon costs that are related to the development of new products can fluctuate from quarter to quarter due to the timing of the product design process.
Research and development expenses were $13.8 million for 1999 or 30% of net revenues compared to $11.9 million or 25% of net revenues in 1998 and $11.2 million or 21% of net revenues in 1997. Research and development expenses in 1999 increased 16% over 1998. The increase in is primarily attributable to the addition of personnel associated with the Company's development center in Cambridge, England and the addition of a new design center in Livingston, Scotland.
Selling, General and Administrative
Selling, general and administrative expenses were $10.4 million for 1999 or 22% of net revenues compared to $11.7 million or 25% of net revenues in 1998 and $12.3 million or 19% of net revenues in 1997. The decrease in 1999 compared to 1998 is primarily attributable to lower staffing, patent and advertising costs. The decrease in 1998 compared to 1997 is primarily attributable to a decrease in sales commissions resulting from lower net revenues and decreased business conference costs.
Legal Settlement and Related Costs
The financial results in fiscal 1999 include a pre-tax charge of $1.9 million associated with the settlement of a legal claim. Of the total $1.9 million, $1.2 million was for the legal settlement and the remaining $0.7 million was for legal services related to the case.
Interest and Other Income and Interest Expense
Interest and other income was $1.5 million for 1999, $1.6 million for 1998 and $1.3 million for 1997. Interest income is affected by changes in the Company's cash balances as well as prevailing interest rates. Interest expense was $0.2 million in 1999 and $0.3 million in 1998 and 1997.
Provision for Income Taxes
The Company's effective tax rate was negative 64% for 1999 and 36% for 1998 and 1997. The effective tax rates differ from the statutory income tax rate primarily due to state income taxes and federal research credits.
Liquidity and Capital Resources
The Company has in recent years financed its operations and capital requirements principally through cash flow from operations. Operations provided $6.0 million of net cash during 1999, a decrease of $5.4 million from 1998. The decrease in 1999 is primarily attributable to lower net income and decreased accrued liabilities partially offset by lower inventory and higher ccounts payable at the end of 1999.
Cash used in investing activities for 1999 is attributable to capital expenditures of $3.2 million and the net purchase of short-term investments of $1.2 million. Financing activities for 1999 consist primarily of the repurchase of 283,400 shares of the Company's common stock for $1.5 million. From January 1996 through the end of 1999, the Company repurchased 2,696,900 shares of its common stock at an aggregate cost of $20.2 million. The Company terminated the share repurchase program at the end of the first quarter of 1999. The Company received $0.7 million from the sale of common stock issued under the employee stock option and employee stock purchase plans.
Working capital was $39.0 million at December 31, 1999 which includes cash and cash equivalents of $7.4 million and short-term investments of $24.1 million.
The Company anticipates that its existing cash resources and cash generated from operations will fund necessary purchases of capital equipment and provide adequate working capital for at least the next twelve months. The Company's liquidity is affected by many factors, including, among others, the extent to which the Company pursues additional wafer fabrication capacity from existing foundry suppliers or new suppliers, capital expenditures, and the level of the Company's product development efforts, and other factors related to the uncertainties of the industry and global economies. Accordingly, there can be no assurance that events in the future will not require the Company to seek additional capital sooner or, if so required, that such capital will be available on terms acceptable to the Company.
Other Factors Affecting Future Operating Results
The Company's quarterly and annual operating results are affected by a wide variety of factors that could materially and adversely affect revenues and profitability, including the Company's access to advanced process technologies, the timing and extent of process development costs, the Company's ability to introduce new products on a timely basis, the volume and timing of orders received, market acceptance of the Company's and its customers' products, the timing of new product announcements and introductions by the Company or its competitors, changes in the mix of products sold, the timing and extent of research and development expenses, the availability and cost of wafers from outside foundries, fluctuations in manufacturing yields, competitive pricing pressures and cyclical semiconductor industry conditions. Historically, average selling prices in the semiconductor industry have decreased over the life of any particular product. Competitive pricing pressures are expected to continue in the future, especially in the communications market, and may have a material adverse effect on the Company's gross margin. The Company's business is characterized by short-term orders and shipment schedules, and customer orders typically can be canceled or rescheduled without significant penalty to the customer. Due to the absence of substantial noncancellable backlog, the Company typically plans its production and inventory levels based on internal forecasts of customer demand, which are highly unpredictable and can fluctuate substantially. In addition, the Company is limited in its ability to reduce costs quickly in response to any revenue shortfalls. As a result of the foregoing or other factors, there can be no assurance that the Company will not experience material fluctuations in future operating results on a quarterly or annual basis which would materially and adversely affect the Company's business, financial condition and results of operations.
The markets for the Company's products are characterized by rapid technological change and frequent new product introductions. To remain competitive, the Company must develop or obtain access to advanced semiconductor process technologies in order to reduce die size, increase die performance and functional complexity, and improve yields. Semiconductor design and process methodologies are subject to rapid technological change, requiring large expenditures for research and development. If the Company is unable to develop or obtain access to advanced wafer processing technologies as they become needed, or is unable to define, design, develop and introduce competitive new products on a timely basis, its future operating results will be materially and adversely affected. In addition, if the Company is unable to transfer and install such new process technologies to one or more of its foundries in a timely manner, its business and results of operations could be materially and adversely affected.
The semiconductor industry is characterized by rapid technological change, cyclical market patterns, significant price erosion, periods of over-capacity and production shortages, variations in manufacturing costs and yields and significant expenditures for capital equipment and product development. The industry has from time to time experienced depressed business conditions. The Company may experience substantial period-to-period fluctuations in future operating results due to general semiconductor industry conditions or other factors.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Interest Rate Risk
As of December 31, 1999, the Company's investment portfolio consisted of U.S. government obligations and commercial paper of $25.1 million, typically with maturities of less than 12 months (see Note 1 of Notes to the Consolidated Financial Statements). These securities, like all U.S. government obligations and commercial paper, are subject to interest rate risk and will decline in value if market interest rates increase. If market interest rates were to increase immediately and uniformly by 10% from levels as of December 31, 1999, the decline in the fair value of the portfolio would not be material. Additionally, the Company has the ability to hold its fixed income investments until maturity and, therefore, the Company would not expect to recognize such an adverse impact in income or cash flows.
Foreign Currency Exchange Risk
The Company's inventory purchase and product sales transactions are almost all denominated in US dollars. The Company has international sales and research and development facilities and is, therefore, subject to foreign currency rate exposure. The Company's foreign currency risks are mitigated principally by maintaining only minimal foreign currency balances. To date, the exposure to the Company related to exchange rate volatility has not been significant. If the foreign currency rates fluctuate by 10% from rates at December 31, 1999, the effect on the Company's financial position and results of operations would not be material. However, there can be no assurance that there will not be a material impact in the future.
Item 8.
Item 8. Financial Statements and Supplementary Data
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of Micro Linear Corporation
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, of stockholders' equity and of cash flows listed in the index appearing under Item 14(a)(1) and (2) on page 43 present fairly, in all material respects, the financial position of Micro Linear Corporation and its subsidiaries at January 2, 2000 and January 3, 1999, and the results of their operations and their cash flows for each of the three years in the period ended January 2, 2000, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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 the opinion expressed above.
PricewaterhouseCoopers LLP
San Jose, California January 20, 2000, except to Note 10, which was as of April 3, 2000
See accompanying notes to the consolidated financial statements.
MICRO LINEAR CORPORATION
CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share amounts)
See accompanying notes to consolidated financial statements.
See accompanying notes to consolidated financial statements.
See accompanying notes to consolidated financial statements.
MICRO LINEAR CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Organization and Summary of Significant Accounting Policies
Organization
MicroLinear Corporation (the "Company") designs, develops, and markets high performance analog and mixed signal integrated circuits for a broad range of applications within the communications, computer, and industrial markets for sale primarily in North America, Asia and Europe. The Company is headquartered in San Jose, California and has two research centers in the United Kingdom. The Company operates in a single industry segment.
Basis of Presentation
The Company operates on a 52- or 53 -week fiscal year, ending on the Sunday closest to December 31. Fiscal years 1999, 1998 and 1997 ended on January 2, 2000, January 3, 1999 and December 28, 1997, respectively. Fiscal 1999 and 1997 were comprised of 52 weeks, and fiscal 1998 was comprised of 53 weeks. The Company's fiscal quarters end on the Sunday closest to the end of each calendar quarter. For presentation purposes, the accompanying financial statements refer to the calendar year end of each respective year for convenience. There were certain changes made to the consolidated financial statements of prior years to conform with current year's presentation.
The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles 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 reporting period. Actual results could differ from those estimates.
Revenue Recognition and Deferred Income
Revenue from product sales to customers other than sales to domestic distributors are recorded when products are shipped. Sales made to distributors, under agreements allowing price protection and right of return on merchandise unsold by the distributors, are deferred until the merchandise is sold by the distributors. Gross margin from shipments to international distributors is deferred until those distributors notify the Company of product sales to end users. There is not a significant difference to the Company's financial statements from the deferral methods used for domestic and international distributors.
In fiscal 1999, three customers accounted for 23%, 12% and 10% of net revenues, respectively. In fiscal 1998, two customers accounted for 20% and 11% of net revenues, respectively. In fiscal 1997, three customers accounted for 15%, 15% and 10% of net revenues, respectively.
Cash Equivalents
Cash equivalents consist of investments with original maturities at the date of acquisition of ninety days or less that have insignificant interest rate risk.
Short-Term Investments
The Company accounts for investments in accordance with Statement of Financial Accounting Standards No. 115 (FAS 115), "Accounting for Certain Investments in Debt and Equity Securities."
The Company has classified investments in debt securities as available-for-sale. All available-for-sale securities mature in one year or less. Available-for-sale securities are carried at fair value, with unrealized gains and losses, net of tax, reported as other comprehensive income (loss). The amortized cost of debt securities in this category is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in interest and other income. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are included in interest and other income or interest expense, as appropriate. The cost of securities sold is based on the specific identification method. Interest and dividends on securities classified as available-for-sale are included in interest and other income.
The following is a summary of available-for-sale securities at December 31, 1999 and 1998 (in thousands):
Fair Value of Financial Instruments
The Company records its financial assets and liabilities in accordance with generally accepted accounting principles. For certain of the Company's financial instruments, including cash and cash equivalents, short-term investments, accounts receivable, accounts payable and accrued expenses, the carrying amounts approximate fair value due to their short maturates. The amounts shown for long-term debt also approximate fair value because current interest rates offered to the Company for debt of similar maturities are substantially the same.
Inventory
Inventory is stated at the lower of cost (on a first-in, first-out basis) or market (estimated net realizable value).
Property, Plant and Equipment
Property, plant and equipment are stated at cost. Depreciation and amortization for financial reporting purposes are provided on the straight-line basis over the estimated useful lives of the assets. The Company depreciates machinery and equipment over 5 years, buildings over 40 years, building improvements over 10 and 20 years, equipment purchased on lease termination and personal computers over 2 years. Assets under capitalized leases are recorded at the present value of the lease obligations and amortized on a straight-line basis over the shorter of the assets useful lives or the lease term.
Net Income (Loss) Per Share
In the fourth quarter of fiscal 1997, the Company adopted the net income per share calculation methodology prescribed by Statement of Financial Accounting Standards No. 128 ("SFAS 128"). SFAS 128 requires presentation of basic and diluted net income per share. Basic net income (loss) per share is computed by dividing net income available to common stockholders (numerator) by the weighted average number of common shares outstanding (denominator) during the period and excludes the dilutive effect of stock options. Diluted net income (loss) per share gives effect to all dilutive potential common stock outstanding during the period. In computing diluted net income (loss) per share, the average stock price for the period is used in determining the number of shares assumed to be purchased from exercise of stock options. All prior year net income per share amounts in this Form 10-K have been restated in accordance with SFAS 128.
Stock-Based Compensation
The Company accounts for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees." The Company's policy is to grant options with an exercise price equal to the quoted market price of the Company's stock on the grant date. The Company has provided additional pro forma disclosures as required under Statement of Financial Accounting Standards No. 123 ("SFAS 123"), Accounting for Stock Based Compensation - See Note 5.
Concentrations of Credit Risk
The Company's sales and purchase transactions are denominated US dollars. The Company primarily sells its products to original equipment manufacturers and distributors. The Company believes the concentrations of credit risk in its trade receivables with its customer base are mitigated by the Company's credit evaluation process, relatively short collection terms, and the geographical dispersion of sales. The Company generally does not require collateral. Bad debt write-offs have been insignificant. The Company also has short-term cash investment policies that limit the amount of credit exposure to any one financial institution and restrict placement of these investments to financial institutions evaluated as highly credit worthy.
The Company's accounts receivable balances with customers based in Asia at December 31, 1999 and 1998 comprise 26% and 36% of accounts receivable, respectively. At December 31, 1999, two customers comprise 20% and 10% of accounts receivable, respectively. At December 31, 1998, two customers comprise 22% and 17% of accounts receivable, respectively.
Income Taxes
The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109 ("FAS 109"), "Accounting for Income Taxes." Under FAS 109, the liability method is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.
Comprehensive Income
In June 1998, the FASB issued Statement No. 130 ("FAS 130") "Reporting Comprehensive Income". FAS 130 establishes standards for reporting and display of comprehensive income and its components in a financial statement that is displayed with the same prominence as other financial statements. Comprehensive income as defined includes all changes in equity (net assets) during a period from nonowner sources. An example of an item to be included in comprehensive income which is excluded in net income would be unrealized gains and losses on available for sale securities.
Segment Reporting
In June 1998, the FASB issued Statement of Financial Accounting Standards No. 131 ("SFAS 131"), "Disclosure about Segments of an Enterprise and Related Information". SFAS 131 establishes standards for the way companies report information about operating segments in annual financial statements. It also establishes standards for related disclosures about products and services, geographic areas and major customers. The Company adopted SFAS 131 in fiscal 1998, however no additional disclosure is considered necessary since the Company operates in one segment as defined by SFAS 131.
Recent Accounting Pronouncements
In December 1999, the Securities and Exchange Commission (SEC) released Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements," (SAB 101) which clarifies the SEC's views on revenue recognition. The Company is required to adopt SAB 101 in the second quarter of fiscal 2000. The Company is currently studying the impact of SAB 101, but does not currently expect it to have a financial statements.
2. Supplemental Financial Information
Inventories consist of the following (in thousands):
The Company plans to dispose of certain testing equipment through sales to a third party. Such testing equipment had an aggregate net book value of $6.7 million at December 31, 1999. The Company does not expect to incur a significant losse on the disposal.
3. Long-term Debt
Prior to September 1999, the Company had a note for $3.4 million that bore interest at 9.125% per annum and was secured by a deed of trust on the Company's principal facilities. The note required monthly principal and interest payments of approximately $36,000 through October 1999, with a balloon payment of approximately $2,639,000 due October 31, 1999. In September 1999, the Company refinanced this note with a new note of $3,000,000. The new note bears interest at 7.59% per annum and is secured by a deed of trust on the Company's principal facilities. The note requires monthly principal and interest payments of approximately $36,000 through October 2004, with a balloon payment of approximately $1,780,000 due November 1, 2004. As of December 31, 1999 and 1998, $2,966,000 and $2,791,000 were outstanding under the loans. The unpaid principal has been reclassified to current portion of long-term debt in accordance with the maturity date of the promissory note.
4. Net Income (Loss) Per Share
Following is a reconciliation of the numerators and denominators of the basic and diluted income (loss) per share computations for the periods presented below (in thousands except per share data):
Options to purchase 3,347,566, 3,823,992 and 413,780 shares of common stock at weighted average exercise prices of $5.10, $7.55 and $12.53 per share were outstanding during 1999, 1998 and 1997, respectively, but were not included in the respective computation of diluted income (loss) per share because such options were anti-dilutive. The options, which expire periodically from 2006 through 2009, were still outstanding at the end of each respective year.
5. Stockholders' Equity
Preferred Stock
The Board of Directors has the authority, without any further vote or action by the stockholders, to provide for the issuance of up to 5,000,000 shares of preferred stock from time to time in one or more series with such designations, rights, preferences and limitations as the Board of Directors may determine, including the consideration received therefore, the number of shares compromising each series, dividend rates, redemption provisions, liquidation preferences, sinking fund provisions, conversion rights and voting rights. In August 1998, the Company designated 30,000 shares of Preferred Stock as Series A Participating Preferred Stock in connection with the adoption of a shareholders rights program. The issuance of Preferred Stock may have the effect of delaying, deferring or preventing a change in control of the Company. No such preferred stock was issued or outstanding anytime during fiscal years 1999, 1998 and 1997.
Shareholder Rights Plan
In August 1998, the Company implemented a plan to protect shareholders' rights in the event of a proposed takeover of the Company. Under the plan, each share of the Company's outstanding common stock carries one right to purchase one-thousandth of a share of the Company's Series A Participating Preferred Stock (the "Right") at an exercise price of $30.00 per share. The Right enables the holder to purchase common stock of the Company or the acquiring company ten days after a person or group publicly announces it has acquired or has tendered an offer for 15% or more of the Company's outstanding common stock. The Rights are redeemable by the Company at $0.01 per Right at any time on or before the tenth day following acquisition by a person or group of 15% or more of the Company's common stock. If prior to redemption of the Rights, a person or group acquires 15% or more of the Company's common stock, each Right not owned by a holder of 15% or more of the common stock (or an affiliate of such holder) will entitle the holder to purchase, at the Right's then current exercise price, that number of shares of common stock of the Company having a market value at the time of twice the Right's exercise price. The Rights expire in August 2008.
Common Stock
Holders of common stock are entitled to receive dividends as declared by the Board of Directors out of legally available funds. No dividends have been declared or paid.
The following summarizes all shares of common stock reserved for issuance as of December 31, 1999:
From January 1996 through the end of 1999, the Company had repurchased 2,696,900 shares of its common stock for a total cost of $20.2 million. The Company's common stock buy-back program was terminated at the end of the first quarter of 1999.
Stock Option Plans
The Company adopted the 1983 Incentive Stock Option Plan ("1983 Plan"), under which employees and consultants had been granted incentive stock options to purchase shares of the Company's common stock at not less than the fair value at the date of grant or nonstatutory stock options to purchase the Company's common stock at not less than 85% of the fair value at the date of grant, as determined by the Board of Directors. No stock options were granted with an exercise price at less than fair value on the date of grant. The 1983 Plan expired in March 1994. The Company has not issued common stock options to consultants during 1999, 1998 and 1997.
In August 1992, the Company adopted the 1991 Stock Option Plan ("1991 Plan"), under which employees and consultants may be granted incentive stock options to purchase shares of the Company's common stock at not less than the fair value on the date of grant or nonstatutory stock options to purchase the Company's common stock at not less than 85% of the fair value on the date of grant, as determined by the Board of Directors. To date, no stock options have been granted with an exercise price at less than the fair value on the date of grant.
In September 1998, the Company adopted the 1998 Nonstatutory Option Plan ("1998 Plan"), under which employees and consultants may be granted nonstatutory stock options to purchase shares of the Company's common stock at not less than the fair market value on the date of grant. Executive officers may only receive options under the plan as an inducement essential to his or her initial employment with the Company. An aggregate of 1,000,000 shares are reserved for options granted under the Plan.
Under the 1983, 1991 and 1998 plans, options are exercisable as determined by the Board of Directors on the date of grant. The Company's standard stock option agreements under the 1983, 1991 and 1998 plans provide that 25% of the stock subject to the option will vest upon each of the first and second anniversaries from the vesting commencement date, and the remainder of the shares subject to the option will vest monthly over the next two years. Generally, the terms of this plan provide that options expire up to a maximum of ten years from the date of grant.
Information with respect to the employee 1983, 1991 and 1998 plans is summarized as follows:
In 1997, the Board of Directors and stockholders approved an amendment to the Company's 1991 Plan to provide for an annual increase in the number of shares of common stock reserved for issuance thereunder equal to 4% of the Company's fully diluted shares for a two year period commencing on January 1, 1998. The number of shares so reserved increased by 588,720 in 1999.
In January 1998, the Board of Directors approved the repricing of all incentive stock options granted above $7.50 per share. The repricing did not include incentive stock options granted to any member of the Company's Board of Directors or the Chief Executive Officer. Prior options granted totaled 1,433,730 shares at prices ranging between $7.50 and $19.00. Employees had the choice of exchanging any stock options granted for new options on a one-for-one basis such that the new options would have an exercise price of $7.375. All of the new options retained the original vesting structure but restarted the vesting period as of January 27, 1998.
In July 1998, the Board of Directors approved the repricing of stock options granted above $4.75 per share. The repricing did not include stock options granted to any member of the Company's Board of Directors. Prior options granted totaled 2,928,370 shares at prices ranging between $4.75 and $14.06. Employees had the choice of exchanging any stock options granted for new options on a one-for- one basis such that the new options would have an exercise price of $4.75. All of the new options retained the original vesting structure but restarted the vesting period as of July 28, 1998.
Director Stock Option Plan
Prior to the adoption of its Director Stock Option Plan (see below), the Company offered to its non-employee directors the right to purchase 4,800 shares of common stock per year at the fair value on the date of the offer, as determined by the Board of Directors. Such offers vested at a rate of one-twelfth of the shares subject to the offer for each full month following the vesting commencement date, as determined by the Board of Directors, provided that the purchaser remained a member of the Board of Directors. As of December 31, 1999, options to purchase 9,600 shares were outstanding and exercisable at a price of $2.50 per share.
The Director Stock Option Plan ("the Director Plan") was adopted in October 1994 and amended in March 1997. Under the Director Plan the Company is authorized to issue non-qualified stock options to purchase up to 80,000 shares of the Company's common stock at an exercise price equal to the fair market value of the common stock on the date of grant. The Director Plan provides that each person who was an outside director on October 13, 1994, and each outside director who subsequently becomes a member of the Board of Directors shall be automatically granted an option to purchase 10,000 shares on the date on which such person first becomes an outside director, whether through election by the stockholders of the Company or appointment by the Board of Directors to fill a vacancy. In addition, each outside director automatically receives a nonstatutory option to purchase 7,000 shares of common stock upon such director's annual re-election to the Board, provided the director has been a member of the Board of Directors for at least 6 months upon the date of re-election.
The 10,000 share grant vests at the rate of 25% of the option shares upon the first and second anniversaries of the date of grant and 1/48th of the option shares per month thereafter and the 7,000 share grant vests monthly over a twelve-month period, in each case unless terminated sooner upon termination of the optionee's status as a director or otherwise pursuant to the Director Plan.
Option activity of the Directors' stock options is as follows:
Employee Stock Purchase Plan
The Company adopted an Employee Stock Purchase Plan ("1994 Purchase Plan") in October 1994. An aggregate of 455,000 shares of the Company's common stock have been reserved for issuance under the 1994 Purchase Plan. The 1994 Purchase Plan provides that all employees may purchase stock at 85% of its fair market value on specified dates via payroll deductions. Sales under the 1994 Purchase Plan in 1998 and 1997 were 131,930 and 119,156 shares of common stock with a total purchase price of approximately $475,000 and $770,000, respectively. There were no sales under the 1994 Purchase Plan in 1999. As of December 31, 1999, there were no shares available to purchase under the 1994 Purchase Plan.
The Company adopted a new Employee Stock Purchase Plan ("1999 Purchase Plan") in September 1999. An aggregate of 200,000 shares of the Company's common stock have been reserved for issuance under the 1999 Purchase Plan. The 1999 Purchase Plan provides that all employees may purchase stock at 85% of its fair market value on specified dates via payroll deductions. Sales under the 1999 Purchase Plan in 1999 were 55,380 shares of common stock with a total purchase price of approximately $181,000. Shares available for purchase may be replenished each year. As of December 31, 1999, there were 144,620 shares available to purchase under the 1999 Purchase Plan.
Pro Forma Net Income (Loss) Per Share
Disclosure of pro forma net income (loss) is required by SFAS 123, and has been determined as if the Company had accounted for its employer stock purchase plan, employee stock options and director stock options subsequent to December 31, 1994 under the fair value method of SFAS 123. The fair value for these options was estimated at the date of grant using the Black-Scholes option pricing model and the multiple option approach with the following weighted-average assumptions:
The Black-Scholes option valuation model was developed for use in estimating the fair value of publicly traded options that have no vesting restrictions and are fully transferable, which significantly differ from the Company's stock option awards. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility and the time to exercise, which greatly affect the calculated grant date fair value. The weighted average estimated fair values of shares issued under the Employee Stock Purchase Plan granted during 1999, 1998 and 1997 were $1.50, $2.13 and $3.42, respectively. The weighted average estimated fair value of options granted under the employee and directors stock option plans during 1999, 1998 and 1997 were $2.59, $4.01 and $5.79, respectively.
The following table summarizes information about all stock options at December 31, 1999:
For purposes of pro forma disclosures, the estimated fair value of the options is amortized to pro forma net income (loss) over the options' vesting period. The Company's pro forma information follows (in thousands, except for net income (loss) per share information):
6. 401(k) Tax Deferred Savings Plan
The Company has a 401(k) Tax Deferred Savings Plan (the 401(k) Plan) that allows eligible employees to contribute from 1% to 15% of their pre-tax salary up to a maximum of $10,000 during 1999. Effective October 27, 1997, the 401(k) Plan was amended to provide that the Company would begin making a discretionary matching contribution up to $80 per pay period to all employees who are contributing to the 401(k) Plan. Prior to October 27, 1997, the Company was making a discretionary matching contribution up to $40 per pay period to all employees who were contributing to the 401(k) Plan. The Company's contribution to the 401(k) Plan was approximately $412,000, $419,000 and $260,000 for 1999, 1998 and 1997, respectively.
7. Income Taxes
The provisions for income taxes consist of the following (in thousands):
The tax benefits resulting from disqualifying dispositions by employees who acquired shares under the Company's incentive stock option plan and from the exercise of nonqualified stock options, reduced taxes currently payable or increased taxes receivable as shown above by $149,000 and $686,000 in 1999 and 1997. Such benefits were immaterial in 1998 and were credited to additional paid-in capital in 1999 and 1997.
The difference between the provision for taxes and the amount computed by applying the federal statutory income tax rate to income (loss) before provision for taxes is explained below (in thousands):
Significant components of the Company's deferred tax assets and liabilities are as follows (in thousands):
8. Operations by Geographic Regions
The following is a summary of operations by geographical regions (in thousands):
9. Commitments and Contingencies
Legal Proceedings
A discussion of certain pending legal proceedings is included in Item 3 of Part I of the Company's form 10-K for the fiscal year ended December 31, 1999. The Company intends to contest these actions vigorously, however, there can be no assurance that these matters will be resolved in the Company's favor or that there will not be an adverse effect on the Company's financial position or its results of operations.
Lease Commitment
The Company has various equipment operating leases. The Company's rental expenses under operating leases in the years ended December 31, 1999, 1998 and 1997 totaled approximately $146,000, $147,000 and $157,000, respectively. Future minimum lease payments for all leases are as follows (in thousands):
Fiscal Year
2000 $17
2001................................................. 16
2001................................................. 7
Total minimum lease payments......................... $40
Purchase Commitments
The Company's manufacturing relationships with foundries allow for the cancellation of all outstanding purchase orders, but require repayment of all expenses to date. As of December 31, 1999, foundries had incurred approximately $1,182,000 of manufacturing expenses on the Company's outstanding purchase orders.
10. Subsequent Events
In March 2000, the Company signed a letter on intent (LOI) with a third party, whereby the company will sell certain test equipment (See Note 2 for assets held for sales), with an aggregate net book value of approximately $6.7 million, lease to this thrid party certain office space for approximately $22,200 per month, and transfer certain employees to the third party. The term of the LOI is three years. The Company intends to subcontract to this party certain test functions, which are currently performed internally. The Company does not anticipate a significant gain or loss associated with the sale of equipment. However, the Company may incur certain costs to transfer its employees to the third party as the Company will pay retention bonuses to such employees based on the length of their employment at the third-party company. In addition, all payments due to such employees to be hired by the third-party company as a result of the termination of their employment from the Company are the sole responsibility of the Company. Under the terms of the LOI, the Company will be required to pay approximately $380,000 per year for three years to access the sold equipment for certain engineering purposes.
In February 2000, the Board of Directors approved an amendment to increase the number of shares of common stock reserved for issuance under the 1998 NSO Plan by 500,000 shares to an aggregate of 1,500,000 shares.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Not Applicable.
PART III
Certain information required by Part III is omitted from this Report on Form 10-K in that the Registrant will file its definitive Proxy Statement for its Annual Meeting of Stockholders to be held on May 26, 1999, pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended (the "Proxy Statement"), not later than 120 days after the end of the fiscal year covered by this Report, and certain information included in the Proxy Statement is incorporated herein by reference.
Item 10.
Item 10. Directors and Executive Officers of the Registrant
(a) Executive Officers -- See the section entitled "Executive Officers" in Part I, Item 1 hereof.
(b) Directors -- The information required by this Item is incorporated by reference to the section entitled "Election of Directors" in the Proxy Statement.
The disclosure required by Item 405 of Regulation S-K is incorporated by reference to the section entitled "Section 16(a) Beneficial Ownership Reporting Compliance" in the Proxy Statement.
Item 11.
Item 11. Executive Compensation
The information required by this Item is incorporated by reference to the sections entitled "Compensation of Executive Officers" and "Compensation of Directors" in the Proxy Statement.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information required by this Item is incorporated by reference to the sections entitled "Record Date and Principal Share Ownership" and "Security Ownership of Management" in the Proxy Statement.
Item 13.
Item 13. Certain Relationships and Related Transactions
The information required by this Item is incorporated by reference to the section entitled "Certain Transactions" in the Proxy Statement.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) 1. List of Financial Statements and Financial Statement Schedules
The following financial statements of Micro Linear Corporation are included in Item 8 hereof:
Report of PricewaterhouseCoopers LLP, Independent Accountants
Consolidated Balance Sheets as of December 31, 1999 and 1998
Consolidated Statements of Income for the years ended December 31, 1999, 1998 and 1997
Consolidated Statements of Stockholders' Equity for the years ended December 31, 1999, 1998 and 1997
Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998 and 1997
Notes to Consolidated Financial Statements
2. Supplement Schedules
The following financial statement schedule of Micro Linear Corporation is included in Item 14(2):
Schedule II Valuation and Qualifying Accounts
Other schedules have not been filed because they are not applicable or the required information has been included in the consolidated financial statements.
* Management contract or compensation plan or arrangement required to be filed as an exhibit to this report on Form 10-K pursuant to Item 14(c) of this report.
** Confidential treatment granted as to certain portions of this exhibit.
(1) Incorporated by reference from the Registrant's Registration Statement on Form S-1 (file no. 33-83546), as amended, filed on September 1, 1994.
(2) Incorporated by reference from the Registrant's Registration Annual Report Form 10-K for the fiscal year ended December 31, 1995.
(3) Incorporated by reference from the Registrant's Statement on Form S-8 (file no. 333-67769) filed on November 23, 1998.
(b) Reports on Form 8-K.
None.
(c) Exhibits.
See (a) above.
(d) Financial Statement Schedules.
See (a) above.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of San Jose, State of California, on the 3rd day of April, 2000.
MICRO LINEAR CORPORATION
By /s/ DAVID L. GELLATLY David L. Gellatly Chairman, Chief Executive Officer and President
POWER OF ATTORNEY
KNOW ALL PERSON BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints David L. Gellatly , as his attorney-in-fact, with full power of substitution, for him in any and all capacities, to sign any and all amendments to this Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming our signatures as they may be signed by our said attorney to any and all amendments to said Report.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed by the following persons in the capacities and on the dates indicated:
Signature Title Date
/s/ DAVID L. GELLATLY Chairman, Chief Executive Officer April 3, 2000 David L. Gellatly and President (Principal Executive Officer), Chief Financial Officer (Principal Financial and Accounting Officer)
/s/ JOSEPH D. RIZZI Director April 3, 2000
Joseph D. Rizzi
/s/ WILLIAM B. POHLMAN Director April 3, 2000
William B. Pohlman
/s/ TIMOTHY A. RICHARDSON Director April 3, 2000
Timothy A. Richardson
INDEX TO EXHIBITS
Exhibit 23.1 Consent of PricewaterhouseCoopers LLP, Independent Accountants
Exhibit 23.1
Consent of Independent Accountants
We hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 333-78753) pertaining to the 1991 Stock Option Plan and the 1998 Nonstatutory Stock Option Plan of Micro Linear Corporation of our report dated January 20, 2000 appearing on page 25 in this Form 10-K.
/s/PricewaterhouseCoopers LLP
San Jose, California April 3, 2000 | 16,689 | 110,710 |
313563_1999.txt | 313563_1999 | 1999 | 313563 | Item 1. Deposit and Withdrawal of Securities . -----------------------------------------
Item 2.
Item 2. Exercise of Voting Rights. -------------------------
The Voting Trustees did not exercise voting rights under the Voting Trust Agreement during the fiscal year with respect to any matter, except that the Voting Trustees voted the shares of Common Stock held by them in favor of the election of 15 directors.
Item 3.
Item 3. Exercise of Other Powers. ------------------------
The Voting Trustees exercised no powers under the Voting Trust Agreement, other than voting rights and the distribution of dividends upon the underlying securities, during the fiscal year.
Item 4.
Item 4. Ownership of Voting Trust Certificates and Other Securities. -----------------------------------------------------------
The following table presents information, as of March 28, 2000, as to Voting Trust Certificates owned of record or beneficially by each Voting Trustee. As of March 28, 2000, no Voting Trustee owned any securities of Graybar other than those deposited under the Voting Agreement nor any securities of Graybar's subsidiaries. No other person owns of record, or is known by the Voting Trustees to own beneficially, more than five percent of the Voting Trust Certificates.
Item 5.
Item 5. Business Experience of Voting Trustees. -------------------------------------- The information with respect to the business experience of the Voting Trustees required to be included pursuant to this Item 5 will be included under the caption "Directors and Executive Officers -- Nominees for Election as Directors" in Graybar's Information Statement relating to the 2000 Annual Meeting of Shareholders (the "Information Statement"), to be filed with the Commission pursuant to Rule 14(c)-5 under the Securities Exchange Act of 1934, and is incorporated herein by reference.
Item 6.
Item 6. Business and Professional Connection of Voting ---------------------------------------------- Trustees with Issuer, Affiliates and Underwriters. ------------------------------------------------- The information with respect to the business and professional connections of each Voting Trustee with Graybar and any of its affiliates will be included under the caption "Directors and Executive Officers-Nominees for Election as Directors" in the Information Statement and is incorporated herein by reference.
Item 7.
Item 7. Other Activities of Voting Trustees. -----------------------------------
Except as described in this Annual Report, the Voting Trustees did not perform any other activities during the fiscal year.
Item 8.
Item 8. Representation of Other Persons by Voting Trustees. --------------------------------------------------
The Voting Trustees represented no persons other than holders of Voting Trust Certificates during the fiscal year.
Item 9.
Item 9. Remuneration of Voting Trustees. -------------------------------
The following table presents information as to the aggregate remuneration received by each Voting Trustee for services in all capacities during the fiscal year from Graybar and its subsidiaries. No Voting Trustee received any remuneration from any person or persons for acting as Voting Trustee.
[FN]
Includes meeting fees of $300 for attendance at directors' meetings of Graybar and remuneration paid March 15, 2000 under Graybar's Management Incentive Plan with respect to services rendered during 1999.
Contributions by the Company under the Profit Sharing and Savings Plan are made at the discretion of the Board of Directors for eligible employees and, subject to certain exceptions, are made in proportion to their annual earnings. Except as otherwise provided in the Deed of Trust, the moneys held in trust thereunder are paid to employees upon termination of employment for any reason including their retirement or, in the event of their death prior to the complete distribution of their interests, are paid to their estates or designated beneficiaries. The contributions for the accounts of the individuals listed will be made on April 3, 2000. In addition, the portion of the profit sharing payment earned by an employee in excess of the annual limitations imposed by Sections 401 or 415 of the Internal Revenue Code will be credited to his deferred compensation account or paid in cash.
Item 12.
Item 12. Lists of Exhibits Filed. -----------------------
(4) Instruments defining the rights of security holders, including indentures.
The Voting Trust Agreement dated as of April 1, 1997, attached as Annex A to the Prospectus, dated January 21, 1997, constituting a part of the Registration Statement on Form S-1 (Registration No. 333-15761), is incorporated herein by reference.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Annual Report on Form 10-K, amended as prescribed by the Commission, has been signed below by the following persons, as Voting Trustees, as of March 28, 2000, said Trustees being invested with the power to bind all of the Voting Trustees.
As trustees under the Voting Trust Agreement dated as of April 1, 1997.
By /S/ C. L. HALL ---------------------------------- C. L. HALL
/S/ R. H. HANEY ---------------------------------- R. H. HANEY
/S/ G. W. HARPER ---------------------------------- G. W. HARPER
/S/ R. D. OFFENBACHER ---------------------------------- R. D. OFFENBACHER
/S/ R. A. REYNOLDS, JR. ---------------------------------- R. A. REYNOLDS, JR. | 797 | 5,464 |
1006837_1999.txt | 1006837_1999 | 1999 | 1006837 | ITEM 1. BUSINESS
General
We are a facilities-based global total service provider offering bundled international and domestic Internet, data and voice services to business and residential retail customers and other carriers located in the United States, Canada, Brazil, the United Kingdom, continental Europe, Australia and Japan. We seek to capitalize on the increasing demand for high-quality international communications services which is being driven by the globalization of the world's economies, the worldwide trend toward telecommunications deregulation and the growth of data and Internet traffic.
We primarily target customers with significant international long distance usage, including small- and medium-sized enterprises (SMEs), multinational corporations, ethnic residential customers and other telecommunications carriers and resellers. We also intend to target Internet-based businesses as we deploy our global ATM+IP network. As of December 31, 1999, we had approximately 1.9 million customers. We provide our customers with a portfolio of competitively priced services, including:
. International and domestic long distance services and private networks;
. Prepaid and calling cards, toll-free services and reorigination services; and
. Local services in Australia, Canada, Puerto Rico and the United States Virgin Islands.
Through our subsidiary iPRIMUS.com, we target SMEs and residential customers for data and Internet services, including dial-up, dedicated and high-speed Internet access, virtual private networks, Web hosting, data center co-location, voice-over IP services, e-commerce services and other data services.
By constructing and expanding our network, we have reduced costs, improved service reliability and increased flexibility to introduce new products and services. We believe that, as the volume of telecommunications traffic carried on our network increases, we should continue to improve profitability as we more fully utilize our network capacity and realize economies of scale. Currently, 29 countries are connected directly to our network. We expect to continue to expand our network through additional investment in undersea and domestic fiber optic cable systems, international gateway and domestic switching facilities and international satellite earth stations as customer demand justifies the capital investment.
We are a Delaware corporation that was formed in 1994.
Strategy
Our objective is to become a leading global provider of international and domestic Internet, data, e-commerce and voice services. Key elements of our strategy to achieve this objective include:
. Provide One-Stop Shopping for Internet, Data and Voice Services: We offer in selected markets, and intend to offer our customers in each of the markets we serve, a portfolio of bundled Internet, data and voice services. We typically enter international markets in the early stages of deregulation by initially offering international long distance voice services and subsequently expanding our portfolio of offerings to include Internet access and data services. For example, through our recent acquisitions in Canada, we now offer our business and residential customers a comprehensive array of voice services, including international and domestic long distance, as well as Internet access and enhanced services, including Internet roaming and Web hosting. By bundling our traditional voice services with data and Internet services, we believe that we will attract and retain a strong base of retail customers, which are traditionally the highest margin communications customers.
. Expand the Reach and Data Capabilities of Our Global Network: Through the geographic expansion of our global network, we expect to be able to increase the amount of our on-net traffic and thereby continue to reduce transmission costs and operating costs as a percentage of revenue, improve gross margins, reduce reliance on other carriers, and improve service reliability. In addition, we are leveraging our existing network to provide a full range of asynchronous transfer mode (ATM), frame relay and Internet protocol-based data and voice communications over a global broadband ATM+IP network. Our commitment
and ability to provide reliable, carrier-grade voice, data and Internet communications over our global network on a standard platform recently enabled us to qualify as a Cisco powered network. We also expect to offer Web hosting services at various locations in our core markets, beginning in the second quarter of 2000 when we intend to offer Web hosting services co-located at some of our major switch sites. In addition, through our satellite earth station in London, we currently offer Internet and data transmission services in the Indian Ocean/Southeast Asia region. Our target satellite customers are PTTs, other communications carriers, ISPs and multinational corporations in developing countries. We plan to replicate this strategy by offering Internet and data services in Latin America and the Pacific Rim through the addition of four satellite earth stations, two on each of the east and west coasts of the United States.
. Build Base of Retail Customers with Significant International Communications Usage: We are focused on building a retail customer base with significant demand for international Internet, data and voice services. These customers typically include small- and medium- sized enterprises, multinational corporations, Internet-based businesses and ethnic residential customers. We are particularly targeting SME customers worldwide by focusing on the need SMEs have for secure Internet and data services and e-commerce services and solutions. Our strategic focus on retail customers reflects that we generally realize a higher gross margin as a percentage of net revenue from these customers compared to carrier customers. By offering high quality services at competitive prices through experienced sales and service representatives and bundling a comprehensive portfolio of communications services, we intend to further broaden our retail base.
. Pursue Early Entry Into Selected Deregulating Markets: We seek to be an early entrant into selected deregulating communications markets worldwide where we believe there is significant demand for voice, data and Internet services as well as substantial growth and profit potential. We believe that early entry into deregulating markets provides us with competitive advantages as we develop sales channels, establish a customer base, hire personnel experienced in the local communications industry and achieve name recognition prior to a large number of competitors entering these markets. We intend to concentrate our immediate expansion plans in those markets that are more economically stable and are experiencing more rapid deregulation, such as continental Europe and Canada. Subsequently, we plan to expand in additional markets, including Japan, other parts of the Asia-Pacific region and Latin America.
. Grow Through Selected Acquisitions, Joint Ventures and Strategic Investments: As part of our business strategy, we frequently evaluate potential acquisitions, joint ventures and strategic investments, some of which may be material, with companies in the voice, data and Internet businesses. We view acquisitions, joint ventures and strategic investments as a means to enter additional markets, add new products and market segments (e.g., DSL and Web hosting), expand our operations within existing markets, and generally accelerate the growth of our customer and revenue base. We target voice and data service providers, ISPs and Web hosting companies with an established customer base, complementary operations, telecommunications licenses, experienced management or network facilities in our target markets. In particular, we anticipate that we will make additional investments in or acquisitions of ISPs and other Internet-related and data service businesses worldwide.
RECENT DEVELOPMENTS, INVESTMENTS AND ACQUISITIONS
Acquisition of Shore.Net
In March 2000, we acquired Eco Software, Inc. (Shore.Net), a U.S. based, business-focused ISP for $43.1 million, comprised of $21.6 million in cash and 489,163 shares of our common stock.
Hewlett-Packard Alliance and Investment
In March 2000, we entered into a strategic business alliance agreement with Hewlett-Packard Company pursuant to which Hewlett-Packard will provide us products and services to enable us to develop data centers in Europe, Australia, Japan and Brazil. These data centers will allow us to deliver our customers' e-commerce, Web hosting and other data/Internet services. Hewlett-Packard also agreed to purchase up to $50 million in convertible debt. Such debt will bear interest at a rate of 9.25% per annum and is convertible into our common stock at a price of $60 per share. We have the right under certain circumstances to require Hewlett-Packard to convert the debt to equity. To date, Hewlett-Packard has invested $25 million. Until converted, the debt will be secured by equipment purchased from Hewlett-Packard with the proceeds of the investment.
Acquisition of Citrus
In February 2000, we acquired 51% of CS Communications System GmbH and CS Network GmbH (Citrus), a reseller of voice traffic and seller of telecommunication equipment and accessories for $0.4 million, comprised of $0.3 million in cash and 2,092 shares of our common stock.
Acquisition of LCR Telecom
In February 2000, we acquired over 96% of the common stock of LCR Telecom Group, Plc in exchange for 2,100,920 shares of our common stock valued at $85.9 million. The purchase price is subject to adjustment and could be increased to a total of 2,463,000 shares.
LCR Telecom operates principally in European markets and is an international telecommunications company providing least cost routing, international callback and other value added services, primarily to small-and medium-sized enterprises (SMEs). Least cost routing involves the selection, on a call-by-call basis, of the most cost-effective carrier for each call and enables customers to benefit from volume purchasing, giving them substantial cost savings previously only available to larger organizations with extensive telecommunications volume. LCR Telecom has grown from about 1,000 customers at the beginning of 1997 to approximately 10,000 customers currently, primarily in the United Kingdom, France, Spain and Belgium.
Issuance of Convertible Subordinated Debentures
In February and March 2000, we completed the sale of $300 million in aggregate principal amount of 5 3/4% convertible subordinated debentures due 2007. The debentures are convertible into approximately 6,025,170 shares of our common stock at a conversion price of $49.7913.
Strategic Partnership with Sitara Networks
In February 2000, we entered into a multi-year product and service agreement with, and made a $3 million equity investment in, Sitara Networks. Sitara's quality-of-service (QoS) technology permits users to monitor and manage bandwidth consumption remotely to ensure mission critical applications are adequately supported. Pursuant to the arrangement, we will use Sitara Networks' QoS appliances as a complement to our global ATM+IP network and Sitara will provide installation and service support.
Acquisition of Infinity Online
In January 2000, we acquired Infinity Online Systems, an Internet service provider based in Ontario, Canada, for $2.2 million, comprised of $1.1 million in cash and 29,919 shares of our common stock. The acquisition increases our total Internet subscribers in Canada by over 10,000 to nearly 80,000, gives us an established Internet protocol infrastructure to deliver Web hosting and Web design to the SME market and also gives us two Internet content sites, "filedudes.com" and "gamedudes.com." These sites are part of a series of content sites known as "thedudes.net," an Internet-based distribution network for free software and down-loadable files on a variety of topics.
U.S. Broadband Backbone
In December 1999, we expanded our existing fiber capacity agreement with Qwest. Pursuant to this expansion, we have agreed to purchase approximately $23.2 million of fiber capacity which will provide us with an ATM+IP based nationwide broadband backbone of nearly 11,000 route miles of fiber optic cable in the U.S. and will provide us with private Internet peering at select sites in the U.S. and overseas. The agreement initially provides us with access to OC-3 and OC-12 expandable to OC-48 capacity between our six existing U.S. gateway switches and up to at least nine future points of presence (POPs) in 12 U.S. cities including New York, Los Angeles, San Francisco, Chicago, Boston and Washington, DC. Under the agreement, we also may choose to expand to OC-48 capacity as our bandwidth requirements increase.
Pilot Investment
In December 1999, we entered into a strategic agreement with Pilot Network Services, a provider of secure, subscription-based e-business services. Pilot has agreed to configure our network operations centers, hosting centers and data centers around the world with Pilot's proprietary Heuristic Defense Infrastructure(TM) (HDI) and to provide real time security on our global network. HDI technology provides us with advanced Internet security that will enable our customer base to transmit secure data to conduct business-to-business e-commerce on a global basis. In addition, Pilot will utilize our network to provide secure access Web hosting, Application Service Provider (ASP) hosting and e-business services to its corporate clients.
In connection with the strategic business arrangement, in January 2000, we made a $15 million strategic investment in Pilot pursuant to which we purchased 919,540 shares, or 6.3%, of Pilot's common stock at a price of $16.3125 per share. We also received a warrant to purchase an additional 200,000 shares at $25.00 per share. K. Paul Singh, our Chairman and Chief Executive Officer, has been elected to Pilot's Board of Directors.
Acquisition of DigitalSelect
In November 1999, we purchased substantially all of the assets of DigitalSelect, LLC, a provider of digital subscriber line (DSL) high-speed Internet access and Web content services to over 2,000 small and medium-sized enterprises located primarily in the Eastern seaboard region of the U.S. DSL technology allows for secure high-speed Internet access using the existing copper phone wires found in nearly every home and business today. Once installed, the high-speed DSL connection is secure and is "always on," removing the need to dial-in each time a user wants to connect to the Internet.
We paid the $7.5 million purchase price with $5.3 million in cash, the issuance of a $0.7 million short-term promissory note and 69,023 shares of our common stock valued based on a 20 day trailing average of the last sale price of our common stock.
Acquisition of 1492 Technologies
In November 1999, we purchased substantially all of the assets of 1492 Technologies, LLC, an Internet Web site development, consulting and service firm. With the acquisition of this company, we hope to help Primus clients develop Internet operations, network management and hosting services and also work with customers to evolve their web presence as new technologies become available.
The purchase price of $0.5 million was paid for with $0.2 million in cash and 15,500 shares of our common stock valued based on a 20 day trailing average of the last sale price of our common stock.
Acquisition of Matrix Internet
In November 1999, we invested $11.4 million in cash in exchange for 51% of Matrix Internet, S.A., Brazil's fifth largest ISP. Matrix currently has a subscriber base of about 54,000 active corporate, governmental and consumer users. Matrix's network consists of nearly 50 POPs in most major Brazilian cities which are connected by Matrix's own fiber backbone. We also have options to acquire the remaining 49% ownership interests in Matrix not currently owned by us.
Acquisition of Telegroup Retail Assets
On June 30, 1999 and effective as of June 1, 1999, we acquired the global retail business of Telegroup, including the acquisition of selected Telegroup foreign subsidiaries, which includes:
. Approximately 372,000 retail customers located primarily in the United States, Europe and Canada;
. Two carrier grade switches, one located in the New York City area and one located in London;
. Approximately 20 programmable switching platforms and POPs located in the United States, Europe and Japan;
. Telegroup's global network of sales agents;
. A Web-based order-entry and provisioning system for agents; and
. A global network operations center and call center.
We paid the $71.9 million purchase price, plus $23.3 million for certain current assets, by issuing $45.5 million in aggregate principal amount of our 11 1/4% senior notes due 2009 and by issuing a $4.6 million short-term promissory note and paying the remainder in cash. The acquisition had an effective date of June 1, 1999 such that the financial results of the acquired business have been included in the Company's results beginning June 1, 1999.
Acquisition of AT&T Canada Consumer Business
On May 31, 1999, we purchased the residential long distance customer base and customer support assets and residential Internet customers and network of AT&T Canada and ACC Telenterprises for a purchase price of $36.7 million ($27.1 million in cash and $9.6 million in debt). We also entered into a strategic alliance pursuant to which AT&T Canada agreed to:
. provide us with underlying network services in Canada for five years;
. provide Canadian domestic termination for our global customers;
. provide customer support services to the customer base transferred to us for up to twelve months after the purchase; and
. license to us its bill face for six months after the purchase.
With this transaction, we acquired approximately 428,000 retail voice customers, including 28,000 residential Internet customers, customer support assets, and related POPs.
Internet and Data Services
In May 1999, we organized our Internet and data services business to be operated by our subsidiary, iPRIMUS.com, which provides services in some of the markets where we operate. We are leveraging our existing global network infrastructure to deploy a global broadband ATM+IP network optimized for e-commerce and Internet Protocol-based data and voice services. In December 1999, we entered into an agreement with Qwest to purchase a nationwide broadband OC-48 fiber optic backbone ring, which will constitute the U.S. portion of our global ATM+IP network. We expect deployment of this ring to be completed in the second quarter of 2000. In February 1999, we acquired Globalserve Communications, a leading ISP in Canada, and we acquired the remaining 40% interest in Hotkey Internet Services that we did not previously own. We also recently acquired two German ISPs, TCP/IP, which operates an Internet backbone in Germany with over 20 POPs nationwide, and TouchNet. As a result of these acquisitions, we are now providing Internet services to business and residential customers in Australia, Canada and Germany. With our satellite earth station in London, we offer Internet transmission services in the Indian Ocean/Southeast Asia region. We intend to deploy additional satellite earth stations to service Latin America and the Pacific Rim. Our commitment and ability to provide voice, data and Internet communications over our global integrated communications network enabled us to qualify as a Cisco-powered network.
Global Crossing Capacity Purchase Agreements
On May 24, 1999, we entered into capacity purchase agreements with Global Crossing Holdings Ltd. We agreed to purchase up to $50 million of fiber capacity from Global Crossing and Global Crossing agreed to purchase up to $25 million of services on our global satellite network, subject to certain conditions.
Acquisition of London Telecom
On March 31, 1999, we acquired London Telecom, a provider of domestic and international long distance services to approximately 162,000 residential and business customers in Canada and substantially all of the operating assets of Wintel CNC Communications, Inc. and Wintel CNT Communications, Inc., which are Canadian-based long distance telecommunications providers affiliated with the London Telecom companies, for $50 million in cash. As part of this acquisition, we acquired network assets as well as call centers located in Toronto and Vancouver. We intend to continue marketing the London Telecom services under the London Telecom brand names.
Description of Operating Markets
The following is a description of our operations in each of our primary service regions:
United States. In the United States, we provide long distance services to small- and medium-sized businesses, residential customers, multinational corporations and other telecommunication carriers. We operate international gateway telephone switches in the New York City area, Washington, Fort Lauderdale and Los Angeles which are connected with countries in Europe, Latin America and the Asia-Pacific region through owned and leased international fiber cable systems. We maintain a direct sales organization in New York and Virginia to sell to business customers and have a telemarketing center for small business sales in Tampa. To reach residential customers, we advertise nationally in ethnic newspapers and other publications, offering discounted rates for international calls to targeted countries. We also utilize independent agents to reach and enhance sales to both business and residential customers and have established a direct sales force for marketing international services to other long distance carriers. Additionally, as a result of the TresCom merger, we have expanded our marketing activities to customers in the United States seeking to transmit international calls to Latin America, consisting principally of businesses with sales or operations in Latin America, as well as the growing Hispanic population in the United States. We maintain a national customer service center in Florida staffed with multi-lingual representatives and operate a 24-hour global network management control center in Virginia that monitors our network. We also operate network management control centers in London, Sydney and, following the Telegroup acquisition, in Cedar Rapids, Iowa. In addition to international long distance services, we provide local service in Puerto Rico and the United States Virgin Islands.
In the United States, we also offer DSL Internet access services to business and residential customers through our agreements with NorthPoint Communications and Covad Communications as well as through the assets acquired from DigitalSelect in November 1999. In addition, we provide Web site development and services through our acquisition of 1492 Technologies in November 1999.
Canada. In Canada, we provide long distance services to small- and medium-sized businesses, residential customers and other telecommunication carriers and have sales and customer service offices in Vancouver, Toronto and Montreal. We operate international gateway switches in Toronto and Vancouver, maintain points-of-presence in Ottawa, Montreal and Calgary and lease interexchange circuits in Canada. In Canada, we offer Internet access services through our February 1999 acquisition of GlobalServe Communications, Inc. In March 1999, we acquired London Telecom Network, Inc. and related entities which provide long distance telecommunications services in Canada. In May 1999, we purchased customer bases and assets of AT&T Canada. In June 1999, we acquired Telephone Savings Network, Ltd., a reseller of local services to small- and medium-sized business customers in Canada.
As of December 31, 1999, we had approximately 167,023 business customers and 964,572 residential customers in North America.
Europe. We are a fully-licensed carrier in the United Kingdom and provide domestic and international long distance services to residential customers, small businesses, and other telecommunications carriers. We operate an Ericsson AXE-10 international gateway telephone switch in London, which is directly connected to the United States and is directly connected to continental Europe via our international gateway switch in Frankfurt, Germany. In addition, we have completed the construction in London of an Intelsat earth station and lease capacity on the Intelsat-62 satellite. This new earth station is operational and is able to carry voice, data and Internet traffic to and from countries in the Indian Ocean/Southeast Asia region. Our European operations are headquartered in London, where we maintain both a 24-hour customer service call center and a 24-hour network management control center which monitors our network in the United Kingdom. We market our services in the United Kingdom using a combination of direct sales, agents, and direct media advertising primarily to ethnic customers who make a higher-than-average percentage of international calls.
We are in the process of expanding our services and network to continental Europe which has recently begun the process of deregulation of its telecommunications markets. We currently hold a Class-4 switched voice telephone license in Germany, an L34.1 switched voice license in France and a voice services license in Switzerland. Our international gateway switch in Paris recently became operational, and by the end of the second quarter of 2000, our network in Europe is expected to include the Frankfurt international gateway switch which is currently operational, and up
to 11 additional switches in various countries. Through the TelePassport/USFI acquisition, we acquired a base of small business customers in Germany to whom we provide reorigination services, establishing a platform for our expansion into that market. Additionally, we have opened our first continental European sales office in Frankfurt and are in the process of building a direct sales force and engaging independent sales agents to market our services. We have recently acquired two German ISPs, TCP/IP, which operates an Internet backbone in Germany with over 20 POPs nationwide, and TouchNet. With these acquisitions we can now begin to offer bundled voice, data and Internet services to existing and new customers in Germany.
As of December 31, 1999, we had approximately 2,698 business customers and 86,032 residential customers in the United Kingdom.
Asia-Pacific. We are a licensed carrier permitted to own and operate transmission facilities in Australia. We are the fourth largest long distance company in Australia based on revenues, providing domestic and international long distance services, data and Internet access services, as well as local and cellular service on a resale basis, to small- and medium-sized business customers and ethnic residential customers. We have invested substantial resources over the past three years to build a domestic and international long distance network to transform our Australian operations into a facilities-based telecommunications carrier. During 1997, we installed and began operating a five-city switched network using Northern Telecom switches in Sydney, Melbourne, Perth, Adelaide, and Brisbane. We purchased international fiber cable capacity during 1997 and linked the Australian network to the United States via the TPC-5, APCN, and Jasaurus cable systems, as well as to New Zealand. We became a fully licensed facilities-based telecommunications carrier on July 1, 1997. In August 1997, equal access was introduced in Australia, and we began the process of migrating and connecting customers directly onto our own network. We maintain both a 24-hour customer service center and a network management control center in Australia.
In March 1998, we purchased a controlling interest in Hotkey, an Australia-based ISP, and in April 1998, we acquired all of the outstanding stock of Eclipse, an Australia-based data communications service provider. In February 1999, we purchased the remaining stock in Hotkey. The Hotkey and Eclipse acquisitions positioned us to offer a complete range of telecommunications services for corporate customers in Australia, including fully integrated voice and data networks, as well as Internet access. We market our services through a combination of direct sales to small- and medium-sized business customers, independent agents which market to business and residential customers, and media advertising aimed at ethnic residential customers living in Australia who make a high volume of international calls.
We entered the Japanese market in late 1997 through the TelePassport/USFI acquisition. According to the International Telecommunications Union, in 1998, the total telecommunications market in Japan accounted for approximately $84.0 billion in revenues. We maintain an office in downtown Tokyo and operate an international gateway switch to provide international calling services to resellers and small businesses. We interconnected our Tokyo switch to Los Angeles via the TPC-5 fiber cable system. We have a Type I carrier license, which permits us to provide selected telecommunications services using our own facilities in Japan. We plan to market our services in Japan through direct sales and relationships that we are establishing with business partners.
As of December 31, 1999, we had approximately 30,047 business customers and 387,471 residential customers in the Asia-Pacific region.
Services
We offer a broad array of communications services through our network and through interconnection with the networks of other carriers. Our decision to offer certain services in a market is based on competitive factors and regulatory restraints within the market. Below is a summary of services we offer:
. International and Domestic Long Distance. We provide international long distance voice services terminating in approximately 230 countries, and provide domestic long distance voice services within selected countries within our principal service regions.
. Private Network Services. For business customers, we design and implement international private network services that may be used for voice, data and video applications.
. Data and Internet Services. In Australia, we offer data transfer services over ATM and frame relay networks in addition to Internet access services. In Canada, we offer Internet access services through our February 1999 acquisition of GlobalServe, our May 1999 acquisition of ACC Telenterprises and our January 2000 acquisition of Infinity Online. In Germany, we offer Internet access services through our acquisitions of TCP/IP and TouchNet. In Brazil, we offer Internet access services through our November 1999 acquisition of 51% of Matrix Internet, which also maintains an Internet portal. We also offer Web design, Web hosting, co-location and e-commerce services in selected regions and we recently acquired 1492 Technologies, an Internet Web site development and service firm. We also recently acquired substantially all of the assets of DigitalSelect, a provider of DSL Internet access. Our satellite earth station in London enables us to offer Internet and data transmission services in the Indian Ocean/Southeast Asian region. We plan to replicate this strategy to offer such services in Latin America and the Pacific Rim by adding four additional satellite earth stations, two each on the east and west coasts of the United States.
. Reorigination Services. In selected countries, we provide call reorigination services which allow non-United States country to country calling to originate from the United States, thereby taking advantage of lower United States accounting rates.
. Local Switched Services. We intend to provide local service on a resale basis as part of our "multi-service" marketing approach, subject to commercial feasibility and regulatory limitations. We currently provide local service in Australia, Canada, Puerto Rico and the United States Virgin Islands.
. Toll-free Services. We offer domestic and international toll-free services within selected countries within our principal service regions.
. Cellular Services. We resell Telstra analog and digital cellular services in Australia.
. Prepaid and Calling Cards. We offer prepaid and calling cards that may be used by customers for domestic and international telephone calls both within and outside of their home country.
Network
General. Since our inception in 1994, we have been deploying a global intelligent communications network consisting of international and domestic switches, related peripheral equipment, undersea fiber optic cable systems and leased satellite and cable capacity. We believe that our network allows us to control both the quality and cost of the on-net communications services we provide to our customers. To ensure high-quality communications services, our network employs digital switching and fiber optic technologies, uses SS7 signaling and is supported by comprehensive monitoring and technical services. Our network consists of:
. a global backbone network connecting intelligent gateway switches in our principal service regions:
. a domestic long distance network presence within certain countries within our principal service regions; and
. a combination of owned and leased transmission facilities, resale arrangements and foreign carrier agreements.
Each of our international gateway switches is connected to our domestic and international networks as well as those of other carriers in a particular market, allowing us to:
. provide seamless service;
. package and market the voice and data services purchased from other carriers under the "Primus" brand name; and
. maintain a substantial portion of each market's United States-bound return traffic through our integrated communications network to maintain quality of service and cost efficiencies and increase gross margins.
We have targeted North America, the United Kingdom, continental Europe and Australia for the immediate development of our network due to their economic stability and the more rapid pace of deregulation as
compared to other areas of the world. We expect to expand our network into additional markets within our principal service regions, including in Japan and other parts of the Asia-Pacific region and Latin America. We are using our United Kingdom operations to coordinate efforts to enter other major markets in Europe in conjunction with the deregulation of the telecommunications industry in certain EU countries which began in 1998. This expansion commenced with our installation of an international gateway switch in Frankfurt, and is continuing with our international gateway switch in Paris, which has recently become operational, and with our acquisition of an international gateway switch in London from a European subsidiary of Telegroup.
Switches and Points of Presence. Our network consists of 19 carrier-grade switches, including 15 international gateway switches and four domestic switches in Australia. We currently operate more than 150 POPs and Internet access nodes within our principal service regions.
Here is further information about the location and type of our switches:
Fiber Optic Cable Systems. Where our customer base has developed sufficient traffic, we have purchased and leased undersea and land-based fiber optic cable transmission capacity to connect to our various switches. Where traffic is light or moderate, we obtain capacity to transmit traffic on a per-minute variable cost basis. When traffic volume increases and such commitments are cost effective, we either purchase lines or lease lines on a monthly or longer term basis at a fixed cost and acquire economic interests in transmission capacity through minimum assignable ownership units and indefeasible rights of use to international traffic destinations. The following chart sets forth a listing of the undersea fiber optic cable systems in which we have capacity (which includes both minimum assignable ownership units and indefeasible rights of use):
In December 1999, we expanded our existing fiber capacity agreement with Qwest. Pursuant to this expansion, we have agreed to purchase approximately $23.2 million of fiber capacity which will provide us with a nationwide broadband backbone of nearly 11,000 route miles of fiber optic cable in the U.S. and will provide us with access to OC-3 and OC-12 capacity between our six existing U.S. gateway switches and up to at least nine future POPs in 12 U.S. cities including New York, Los Angeles, San Francisco, Chicago, Boston and Washington, DC. Under the agreement, we also may choose to expand to OC-48 capacity as our bandwidth requirements increase. On May 24, 1999 through a capacity purchase agreement with Global Crossing Holdings Ltd., we agreed to purchase up to $50 million of fiber capacity on Global Crossing's undersea fiber network.
Satellite Earth Stations and Capacity. We are constructing international satellite earth stations and purchasing capacity on international satellites in order to provide data and Internet transmission services, in addition to voice services, principally to and from post, telephone and telegraph operators, other telecommunications carriers and Internet service providers, in developing countries. We have completed the construction in London of an Intelsat earth station and lease capacity on the Intelsat-62 satellite. This earth station now is operational and is able to carry voice, data and Internet traffic to and from countries in the Indian Ocean/Southeast Asia region. Pursuant to our purchase agreement with Global Crossing, Global Crossing has agreed to purchase up to $25 million of capacity on our global satellite network.
Foreign Carrier Agreements. In selected countries where competition with the traditional incumbent post, telephone and telegraph operators is limited or is not currently permitted, we have entered into foreign carrier agreements with post, telephone and telegraph operators or other service providers which permit us to provide traffic into and receive return traffic from these countries. We have existing foreign carrier agreements with post, telephone and telegraph and other licensed operators in Cyprus, Greece, India, Iran, Italy, New Zealand, the Philippines, Belgium, Denmark, Israel, Ireland, Singapore, Malaysia, Japan, Australia, France, Switzerland, Argentina, the Bahamas and the Dominican Republic and maintain additional agreements with other foreign carriers in other countries.
Network Management and Control. We own and operate network management control centers in McLean, Virginia, London, Sydney and, with the Telegroup acquisition, in Cedar Rapids, Iowa, which are used to monitor and control a majority of the switches and other transmission equipment used in our network. These network management control centers operate seven days a week, 24 hours per day, 365 days a year. In Canada, Tokyo and Frankfurt, we currently monitor and control each switch locally. We are continually upgrading the existing network management control centers so that they can monitor all of our switching and other transmission equipment throughout the entire network.
Planned Expansion of Network. We recently installed and commenced operating an international gateway switch in Paris. By the end of 2000, we intend to add up to 11 additional switches in Europe, one switch in North America and one switch in Japan. Additionally, we intend to continue to invest in additional switches and points of presence in major metropolitan areas of our principal service regions as the traffic usage warrants the expenditure. We also intend to acquire capacity in terrestrial and undersea fiber optic cable systems in our principal service regions, particularly in North America and Europe.
Planned Enhancement of Network for Data and Internet Services. Pursuant to our agreement with Qwest, we have invested in a U.S. Internet backbone network and an overlay to our existing network architecture that will enable our existing global network to carry Internet and data traffic for our business, residential, carrier and ISP customers. This network will use packet switched technology, including Internet protocol and ATM, in addition to traditional circuit switched voice traffic. Packet switched technology will enable us to transport voice and data traffic compressed as "packets" over circuits shared simultaneously by several users. This network investment will allow us to offer to existing and new customers a full range of data and voice communications services, including, in selected geographic areas, dial-up and dedicated Internet access, Web hosting, e-commerce, managed virtual private network services, and ATM and frame relay data services. In addition, through our strategic business relationship with Pilot, we will be able to offer these services over a secure network. We are also able to provide customers with enhanced access to these services through our relationship with Akamai Technologies, Inc. which provides proprietary content delivery and intelligent network services.
Customers
As of December 31, 1999, Primus had approximately 1.9 million business and residential customers. Set forth below is a description of our customer base:
.Businesses. Historically, our business sales and marketing efforts targeted small- and medium-sized businesses with significant international long distance traffic. More recently, we also have targeted larger multi-national businesses. In an effort to attract these larger business customers in multiple markets, we intend to offer a broad array of bundled services (including long distance voice, Internet, data and cellular services) in approximately 10 major markets, including the United States, Canada, Australia, the United Kingdom, Germany, France, Japan and Italy. We believe that these businesses are and will continue to be attracted to us primarily due to price savings compared to traditional
carriers and, secondarily, due to our personalized approach to customer service and support, including customized billing and bundled service offerings.
.Residential Customers. Our residential sales and marketing strategy targets ethnic residential customers who generate high international long-distance traffic volumes and, increasingly, call-through and reorigination customers in Europe and other markets which have not fully deregulated. We believe that such customers are attracted to us because of price savings as compared to traditional carriers, simplified pricing structure, and multilingual customer service and support. We are now offering Internet access to our residential customers in select markets and intend to expand our Internet and data offerings to additional markets and bundle them with traditional voice services.
.Telecommunications Carriers, Resellers and ISPs. We compete for the business of other telecommunications carriers and resellers primarily on the basis of price and service quality. Sales to other carriers and resellers help us maximize the utilization of our network and thereby reduce our fixed costs per minute of use. We are also carrying international ISP traffic over our global satellite network and plan to increase the ISP traffic on our terrestrial and undersea fiber network once we have completed the enhancement of our network for data and Internet services.
We strive to provide personalized customer service and believe that the quality of our customer service is one of our competitive advantages. Our larger customers are covered actively by dedicated account and service representatives who seek to identify, prevent and solve problems. We provide toll-free, 24-hour a day customer service in the United States, Canada, the United Kingdom and Australia which can be accessed to complete collect, third party, person-to-person, station-to-station and credit card validation calls. We also provide a multi-lingual "Trouble Reporting Center" for our residential customers. As of December 31, 1999, we employed 572 full-time customer service employees, many of whom are multi-lingual.
Sales and Marketing
We market our services through a variety of sales channels, as summarized below:
.Direct Sales Force. As of December 31, 1999, our direct sales force was comprised of 398 full-time employees who focus on business customers with substantial international traffic, including multinational businesses and international governmental organizations. We intend to use our direct sales force in the future to offer bundled voice, Internet and data services to existing and new multinational business customers. As of December 31, 1999, we employed approximately 245 full-time direct sales representatives focused on ethnic residential consumers and direct sales representatives who exclusively sell wholesale services to other long-distance carriers and resellers. Direct sales personnel are compensated with a base salary plus commissions. We currently have offices in New York City, Virginia, Tampa, Puerto Rico, St. Thomas, Montreal, Toronto, Vancouver, Mexico City, London, Frankfurt, Adelaide, Brisbane, Melbourne, Perth, Sydney and Tokyo.
.Independent Sales Agents. We also sell our services through independent sales agents and representatives, who typically focus on residential consumers and small- and medium-sized businesses. In June 1999, we significantly expanded our independent sales agent program through the acquisition of Telegroup's global network of agents and its agent support systems. These support systems include RepLink, a World Wide Web interface that allows agents to send customer information directly to us via the Internet for fully automated provisioning. Through RepLink, agents also receive monthly usage reports, commission reports, reports on new products and updates about the agent program. An agent receives commissions based on revenue generated by customers obtained for us by the agent. We also provide additional incentives in the form of restricted stock to those agents that meet certain revenue growth targets. We usually grant only nonexclusive sales rights and require our agents and representatives to maintain minimum revenues. We also market our services through representatives of network marketing companies.
.Telemarketing. We employ full-time telemarketing sales personnel in our Tampa call center to supplement sales efforts to ethnic residential consumers and small- and medium-sized business customers.
.Media and Direct Mail. We use a variety of print, television and radio advertising to increase name recognition and generate new customers. We reach ethnic residential customers by print advertising campaigns in ethnic newspapers, and by advertising on select radio and television programs.
Management Information and Billing Systems
We have various management information, network and customer billing systems in our different operating subsidiaries to support the functions of network and traffic management, customer service and customer billing. For financial reporting, we consolidate information from each of our markets into a single database. For our billing requirements in the United States, we use a customer billing system developed by Electronic Data Systems Inc. (EDS) which supplies, operates and maintains this system and is responsible for providing backup facilities and disaster recovery. The EDS system is widely used in the telecommunications industry and has been customized to meet our specific needs. Elsewhere, we use other third party systems or systems developed in-house to handle our billing requirements. We bill all of our business, reseller and residential customers directly in all of our principal service regions. We have also recently chosen Portal Software, Inc.'s customer management and billing software to provide a business infrastructure for our worldwide Internet and data service offerings. This software allows real-time access to service and billing information.
We believe that our financial reporting and billing systems are generally adequate to meet our needs in the near term. However, as we continue to grow, we will need to invest additional capital to purchase hardware and software, license more specialized software, increase capacity and link our systems among different countries.
Competition
The international communications industry is highly competitive and significantly affected by regulatory changes, marketing and pricing decisions of the larger industry participants and the introduction of new services made possible by technological advances. We believe that long distance service providers compete on the basis of price, customer service, product quality and breadth of services offered. In each country of operation, we have numerous competitors. We believe that as the international communications markets continue to deregulate, competition in these markets will increase, similar to the competitive environment that has developed in the United States following the AT&T divestiture in 1984. Prices for long-distance voice calls in the markets in which we compete have declined historically and are likely to continue to decrease. In addition, many of our competitors are significantly larger, have substantially greater financial, technical and marketing resources and larger networks.
Privatization and deregulation have had, and are expected to continue to have, significant effects on competition in the industry. For example, as a result of legislation enacted in the United States, regional Bell operating companies will be allowed to enter the long distance market, AT&T, MCI/WorldCom and other long distance carriers will be allowed to enter the local telephone services market, and cable television companies and utilities will be allowed to enter both the local and long distance telecommunications markets. In addition, competition has begun to increase in the European Union communications markets in connection with the deregulation of the telecommunications industry in most EU countries, which began in January 1998. This increase in competition could adversely affect net revenue per minute and gross margin as a percentage of net revenue.
The following is a brief summary of the competitive environment in selected countries within each of its principal service regions:
North America.
.The United States. In the United States, which is the most competitive and among the most deregulated long distance markets in the world, competition primarily is based upon pricing, customer service, network quality, and the ability to provide value-added services. AT&T is the largest supplier of long distance services, with MCI/WorldCom and Sprint being the next largest providers. In the future, under provisions of recently enacted federal legislation, we anticipate that we will also compete with regional Bell operating companies, local exchange carriers and ISPs in providing domestic and international long-distance services.
.Canada. The Canadian communications market is highly competitive and is dominated by a few established carriers whose marketing and pricing decisions have a significant impact on the other
industry participants including us. We compete with facilities-based carriers, other resellers and rebillers, primarily on the basis of price. The principal facilities-based competitors include the former Stentor member companies, in particular, Bell Canada, the dominant supplier of local and long-distance services in Canada, and TELUS Communications, the next largest Stentor company, as well as non- Stentor companies, Teleglobe Canada and Call-Net Enterprises (Sprint Canada). The former Stentor member companies discontinued their alliance on January 1, 1999 and now Bell Canada and TELUS compete against one another for the first time. In a significant development, Bell Canada's parent, BCE Inc., announced a C$9.6 billion stock bid for Teleglobe in February 2000.
Europe.
.United Kingdom. Our principal competitors in the United Kingdom are British Telecom, the dominant supplier of telecommunications services in the United Kingdom, and Cable & Wireless Communications. Other competitors in the United Kingdom include Colt, Energis, GTS/Esprit and RSL Communications. We compete in the United Kingdom and continental Europe, and expect to compete in other European countries, by offering competitively-priced bundled and stand-alone services, personalized customer service and value-added services.
.Germany. Our principal competitor in Germany is Deutsche Telekom, the dominant carrier. We also compete with Mannesmann ARCOR/O.tel.o Communications, VIAG Interkom, MobilCom, Talkline, NTS/Colt, MCI/WorldCom and RSL Communications. Additionally, we also face competition from other licensed public telephone operators that are constructing their own facilities-based networks, cable companies and switch-based resellers, including the emerging German local exchange carriers known as "City Carriers."
Asia-Pacific.
.Australia. Australia is one of the most deregulated and competitive communications markets in the Asia-Pacific region. Our principal competitors in Australia are Telstra, the dominant carrier, Cable & Wireless Optus and AAPT and a number of other switchless resellers. We compete in Australia by offering a comprehensive menu of competitively-priced products and services, including value-added services, and by providing superior customer service and support. We believe that competition in Australia will increase as more companies are awarded carrier licenses in the future.
.Japan. Our principal competitor in Japan is KDD, the dominant carrier, as well as Japan Telecom, IDC and a number of second tier carriers, including Cable & Wireless, MCI/WorldCom and ATNet.
The market for data services and Internet services is extremely competitive. We anticipate that competition will continue to intensify. Our current and prospective competitors offering these services include national, regional and local Internet service providers, Web hosting companies, other long distance and international long distance telecommunications companies, including AT&T, MCI/WorldCom and Sprint, local exchange telecommunications companies, cable television, direct broadcast satellite, wireless communications providers and on-line service providers. Some of these competitors have a significantly greater market presence and brand recognition than we. Many of our competitors also have greater financial, technological and marketing resources than those available to us.
Government Regulation
As a global communications company, we are subject to varying degrees of regulation in each of the jurisdictions in which we provide services. Local laws and regulations, and the interpretation of such laws and regulations, differ significantly among the jurisdictions in which we operate. There can be no assurance that future regulatory, judicial and legislative changes will not have a material adverse effect on us, that domestic or international regulators or third parties will not raise material issues with regard to our compliance or noncompliance with applicable regulations or that regulatory activities will not have a material adverse effect on us.
Regulation of the telecommunications industry is changing rapidly both domestically and globally. The Federal Communications Commission is considering a number of international service issues in the context of several policy rulemaking proceedings in response to specific petitions and applications filed by other international carriers. We are unable to predict how the FCC will resolve the pending international policy issues or how such
resolution will effect its international business. In addition, the World Trade Organization Agreement, which reflects efforts to dismantle government-owned telecommunications monopolies throughout Europe and Asia may affect us. Although we believe that these deregulation efforts will create opportunities for new entrants in the telecommunications service industry, there can be no assurance that they will be implemented in a manner that would benefit us.
The regulatory framework in certain jurisdictions in which we provide services is described below:
United States
In the United States, our services are subject to the provisions of the Communications Act of 1934, FCC regulations thereunder, as well as the applicable laws and regulations of the various states and state regulatory commissions.
As a carrier offering services to the public, we must comply with the requirements of common carriage under the Communications Act, including the offering of service on a non-discriminatory basis at just and reasonable rates, and obtaining FCC approval prior to any assignment of authorizations or any transfer of de jure or de facto control of the company. We are classified as a non-dominant common carrier for domestic service and are not required to obtain specific prior FCC approval to initiate or expand domestic interstate services.
International Service Regulation. International common carriers like us are required to obtain authority under Section 214 of the Communications Act and file a tariff containing the rates, terms, and conditions applicable to their services prior to initiating their international telecommunications services. We have obtained all required authorizations from the FCC to use, on a facilities and resale basis, various transmission media for the provision of international switched services and international private line services and have filed a tariff.
In addition to the general common carrier principles, we must conduct our international business in compliance with the FCC's International Settlements Policy, the rules that establish the permissible boundaries for U.S.-based carriers and their foreign correspondents to settle the cost of terminating each others' traffic over their respective networks.
Domestic Service Regulation. We are considered a non-dominant domestic interstate carrier subject to minimal regulation by the FCC. We are not required to obtain FCC authority to expand our domestic interstate operations, but we are required to maintain a tariff on file at the FCC, file various reports and pay various fees and assessments. Among other things, interstate common carriers must offer service on a nondiscriminatory basis at just and reasonable rates. As a nondominant carrier, we are subject to the FCC's complaint jurisdiction. In particular, we may be subject to complaint proceedings in conjunction with alleged noncompliance such as unauthorized changes in a customer's preferred carrier. The Telecommunications Act of 1996 also addresses a wide range of other telecommunications issues that may potentially impact our operations.
Our costs of providing long distance services will be affected by changes in the access charge rates imposed by incumbent local exchange carriers for origination and termination of calls over local facilities. The FCC has significantly revised its access charge rules in recent years to permit incumbent local exchange carriers greater pricing flexibility and relaxed regulation of new switched access services in those markets where there are other providers of access services. The FCC recently granted local exchange carriers pricing flexibility. As such, the carriers may offer volume discounts that may benefit larger long distance carriers.
The FCC has also significantly revised the universal service subsidy regime to be funded by interstate carriers, such as us, and certain other entities. The FCC recently established new universal service funds to support qualifying schools, libraries, and rural health care providers and expanded subsidies for low income consumers. Recently the U.S. Court of Appeals for the Fifth Circuit reversed and remanded for reconsideration portions of the FCC's universal service subsidy plan. The FCC has requested certiorari from the U.S. Supreme Court. The outcome of these proceedings or their effect cannot be predicted.
State Regulation. Our intrastate long distance operations are subject to various state laws and regulations, including, in most jurisdictions, certification and tariff filing requirements. Some states also require the filing of periodic reports, the payment of various fees and surcharges and compliance with service standards and consumer protection rules. States often require pricing approval or notification for certain stock or asset transfers or, in several states, for the issuance of securities, debt or for name changes. We have received the necessary certificate and tariff approvals to provide intrastate long distance service in 48 states. Certificates of
authority can generally be conditioned, modified, canceled, terminated, or revoked by state regulatory authorities for failure to comply with state law and/or the rules, regulations, and policies of the state regulatory authorities. Fines and other penalties also may be imposed for such violations. Public service commissions also regulate access charges and other pricing for telecommunications services within each state. The regional Bell operating companies and other local exchange carriers have been seeking reduction of state regulatory requirements, including greater pricing flexibility which, if granted, could subject us to increased price competition. We may also be required to contribute to universal service funds in some states.
Wireless Service Regulations. Through TresCom, we hold a variety of wireless licenses issued by the FCC. As a licensee authorized to provide microwave and satellite earth station services, we are subject to Title III of the Communications Act of 1934, as amended by the 1996 Telecommunications Act, and FCC regulations promulgated thereunder. Pursuant to Title III, foreign entities may not directly hold more than 20% of the stock or other ownership interests in an entity, including Primus, that holds certain types of FCC licenses, such as the wireless licenses held by TresCom and referred to above. In addition, subject to FCC waiver, citizens and corporations of WTO non-member nations may not indirectly hold more than 25% of the stock or other ownership interest in such entities. Citizens and corporations of WTO member nations are not subject to indirect ownership limitations.
Canada
The operations of telecommunications carriers are regulated by the Canadian Radio-television and Telecommunications Commission (CRTC), which has recently established a new competitive regulatory framework governing the international segment of the long-distance market, eliminating certain barriers to competition, consistent with Canada's commitments in the World Trade Organization Agreement. As a result, full facilities-based and resale competition has been introduced in the provision of international services in Canada, effective October 1, 1998, coincident with the elimination of traffic routing limitations on switched hubbing through the United States. In addition, foreign ownership rules for facilities-based carriers have now been waived in relation to ownership of international submarine cables landed in Canada and satellite earth stations used for telecommunications purposes. Effective January 1, 1999, all international service providers must be licensed by the CRTC under the Telecommunications Act of 1993, and we received our international license as of December 23, 1998. Our international operations will remain subject to conditions of our CRTC license, which address matters such as competitive conduct and consumer safeguards, and to a regime of contribution charges (roughly the equivalent of access charges in the U.S.). The CRTC recently adjusted its international services contribution regime and is preparing to conduct a review of its domestic services contribution regime in light of its recent decision to move from a per circuit to a per minute contribution charge arrangement.
Primus, as a reseller of domestic Canadian telecommunications, virtually is unregulated by the CRTC. In particular, because we do not own or operate transmission facilities in Canada, we are not subject to the Canadian Telecommunications Act or the regulatory authority of the CRTC, except to the extent that our provision of international telecommunications services is subject to CRTC licensing and other regulations. Therefore we may provide resold Canadian domestic long distance service without rate, price or tariff regulation, ownership limitations, or other regulatory requirements.
Competition. Long distance competition has been in place in Canada since 1990 for long distance resellers and since 1992 for facilities-based carriers. Since 1994, the incumbent local exchange carriers have been required to provide "equal access" which eliminated the need for customers of competitive long distance providers to dial additional digits when placing long distance calls. In June 1992, the CRTC issued its ground-breaking Telecom Decision CRTC 92-12 requiring the incumbent local exchange carriers to interconnect their networks with their facilities-based as well as resale competitors. However, these companies have now disbanded the Stentor alliance effective January 1, 1999, and former Stentor companies, Bell Canada and TELUS Communications, the two largest carriers in Canada, have begun to compete against one another. Other nationwide providers are AT&T Canada Corp., and Sprint Canada. Additional long distance services competition is provided by a substantial resale long distance industry in Canada.
Foreign Ownership Restrictions. Under Canada's Telecommunications Act and certain regulations promulgated pursuant to such Act, foreign ownership restrictions are applicable to facilities-based carriers (known as "Canadian carriers"), but not resellers, which may be wholly foreign-owned and controlled. These restrictions limit the amount of direct foreign investment in Canadian carriers to no more than 20% of the voting equity of a Canadian carrier operating company and no more than 33 1/3% of the voting equity of a
Canadian carrier holding company. The restrictions also limit the number of seats which may be occupied by non-Canadians on the board of directors of a Canadian carrier operating company to 20%. In addition, under Canadian law, a majority of Canadians must occupy the seats on the board of directors of a Canadian carrier holding company. Although it is possible for foreign investors to also hold non-voting equity in a Canadian carrier, the law requires that the Canadian carrier not be "controlled in fact" by non-Canadians.
Australia
The provision of our services is subject to federal regulation. The two primary instruments of regulation are the Australian Telecommunications Act of 1997 and federal regulation of anti-competitive practices pursuant to the Australian Trade Practices Act of 1974. The current regulatory framework came into effect in July 1997.
We are licensed under the Telecommunications Act of 1997 to own and operate transmission facilities in Australia. Under the regulatory framework, we are not required to maintain a carriage license in order to supply carriage services to the public using network facilities owned by another carrier. Instead, with respect to carriage services, we must comply with legislated "service provider" rules contained in the Telecommunications Act of 1997 covering matters such as compliance with the Telecommunications Act of 1997, operator services, regulation of access, directory assistance, provision of information to allow maintenance of an integrated public number database, and itemized billing.
Two federal regulatory authorities exercise control over a broad range of issues affecting the operation of the Australian telecommunications industry. The Australian Communications Authority (ACA) is the authority regulating matters including the licensing of carriers and technical matters, and the Australian Competition and Consumer Commission (ACCC) has the role of promotion of competition and consumer protection. We are required to comply with the terms of our own license, are subject to the greater controls applicable to licensed facilities-based carriers and are under the regulatory control of the ACA and the ACCC. In addition, other federal legislation, various regulations pursuant to delegated authority and legislation, ministerial declarations, codes, directions, licenses, statements of Australian government policy and court decisions affecting telecommunications carriers also apply to us.
There is no limit to the number of carriers who may be licensed. Any company that meets the relevant financial and technical standards and complies with the license application process can become a licensed carrier permitted to own and operate transmission facilities in Australia. Carriers are licensed individually, are subject to charges that are intended to cover the costs of regulating the telecommunications industry, and are obliged to comply with license conditions (including obligations to comply with the Telecommunications Act of 1997, with certain commitments made in their industry development plan and with the telecommunications access regime and related facilities access obligations). Carriers also must meet the universal service obligation, to assist in providing all Australians, particularly in remote areas, with reasonable access to standard telephone services. The levy required to be paid by in connection with this obligation has been set previously at a level that is not material. The levy is currently under review. The outcome from the Australian Communications Authority's assessment and the Australian Government's policy considerations is expected to result in a levy that will not be material for us. However, there can be no guarantee that the Australian Communications Authority will not make an assessment of a universal service levy that would be material or that the Australian Government will not legislate for an outcome that would be material.
Fair Trading Practices. The ACCC enforces legislation for the promotion of competition and consumer protection, particularly rights of access (including pricing for access) and interconnection. The ACCC can issue a competition notice to a carrier which has engaged in anti-competitive conduct. Where a competition notice has been issued, the ACCC can seek pecuniary penalties, and other carriers can seek damages, if the carrier continues to engage in the specified conduct.
The Telecommunications Act of 1997 package of legislation includes a telecommunications access regime that provides a framework for regulating access rights for specific carriage services and related services through the declaration of services by the ACCC. The regime establishes mechanisms within which the terms and conditions of access can be determined. The Australian government intends the access regime to reduce the power of Telstra and Cable & Wireless Optus (as the former protected fixed line carriers) and other carriers who may come to own or control important infrastructure or services necessary for competition.
The access regime establishes a mechanism for the industry to develop an access code containing model terms and conditions for access to particular declared services. Once approved by the ACCC, those model terms and conditions may be adopted in an undertaking by individual carriers who are under an access obligation.
Since July 1997, the ACCC has mandated progressively that Telstra provide access to a range of its facilities at specified rates to other service providers including us. We have negotiated access arrangements with Telstra in substitution for certain mandated arrangements. In July 1999, the ACCC mandated access to Telstra's local call network. We expect that access to Telstra's local call network will provide us with new opportunities.
Foreign Ownership Limitations. Foreign investment in Australia is regulated by the Foreign Acquisitions and Takeovers Act 1975. We notified the Australian government of our proposed acquisition of Axicorp in 1996 and were informed at that time that there were no objections to the investment in terms of Australia's foreign investment policy. There can be no assurance, however, that additional foreign ownership restrictions will not be imposed on the telecommunications industry or other foreign investors, including us, in the future.
Japan
Our services in Japan are subject to regulation by the Japanese Ministry of Post and Telecommunications under the Japanese Telecommunications Business Law. We have obtained licenses as a Type I business, and as a Special Type II business, and also as a General Type II business through the Telegroup acquisition. Our licenses allow us to provide selected international telecommunications services using our own facilities, as well as leased facilities, and domestic telecommunications services using leased facilities. There can be no guarantee that the Japanese regulatory environment will allow us to provide service in Japan at competitive rates.
European Union
In Europe, the regulation of the telecommunications industry is governed at a supra national level by the European Commission, consisting of members from the following countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden and the United Kingdom, which is responsible for creating pan-European policies and, through legislation, developing a regulatory framework to ensure an open, competitive telecommunications market.
In March 1996, the EU adopted the Full Competition Directive containing two provisions which required EU member states to allow the creation of alternative telecommunications infrastructures by July 1, 1996, and which reaffirmed the obligations of EU member states to abolish the post, telephone and telegraph operators' monopolies in voice telephony by 1998. Certain EU countries were allowed to delay the abolition of the voice telephony monopoly based on derogations established in the Full Competition Directive. These countries include Luxembourg (July 1, 1998), Spain and Ireland (which were liberalized on December 1, 1998), Portugal (January 1, 2000) and Greece (December 31, 2000).
Each EU member state in which we currently conduct or plan to conduct our business has a different regulatory regime and such differences have continued beyond January 1998. The requirements for us to obtain necessary approvals vary considerably from country to country and are likely to change as competition is permitted in new service sectors. Most EU member states require companies to obtain a license in order to provide voice telephony services or construct and operate telecommunications networks. However, the EU generally does not permit its member states to require individual licenses for other types of services. In addition, we have obtained and will continue to seek to obtain interconnection agreements with other carriers within the EU. While EU directives require that dominant carriers offer cost-based and nondiscriminatory interconnection to competitors, individual EU member states have implemented and may implement this requirement differently. As a result, we may be delayed in obtaining or may not be able to obtain interconnection in certain countries that would allow us to compete effectively. Moreover, there can be no guarantee that long distance providers like us will be able to afford customers "equal access" to their networks, and the absence of such equal access could put such long distance companies at a disadvantage with respect to existing post, telephone and telegraph operators.
United Kingdom
Our services are subject to the provisions of the United Kingdom Telecommunications Act. The Secretary of State for Trade and Industry, acting on the advice of the United Kingdom Department of Trade and Industry, is responsible for granting UK telecommunications licenses, while the Director General of Telecommunications
and Oftel are responsible for enforcing the terms of such licenses. Oftel attempts to promote effective competition both in networks and in services to redress anti-competitive behavior.
In 1991, the British government established a "multi-operator" policy to replace the duopoly that had existed between British Telecom and Cable and Wireless Communications. Under the multi-operator policy, the Department of Trade and Industry recommends the grant of a license to operate a telecommunications network to any applicant that it believes has a reasonable business plan and where there are no other overriding considerations not to grant such license. All public telecommunications operators and international simple voice resellers operate under individual licenses granted by the Secretary of State for Trade and Industry pursuant to the United Kingdom Telecommunications Act. Any telecommunications system with compatible equipment that is authorized to be run under an individual license is permitted to interconnect to British Telecom's network. As of June 30, 1999, only those systems providing bearer services will be entitled to interconnection, providing the operator has been registered in Annex II. Under the terms of British Telecom's license, it is required to allow any such licensed operator to interconnect its system to British Telecom's system, unless it is not reasonably practicable to do so (e.g., due to incompatible equipment).
Our subsidiary, Primus Telecommunications Limited, holds a license that authorizes it to provide switched voice services over leased private lines to all international points. In addition, Primus Telecommunications Limited has received a license from the United Kingdom's Secretary for Trade and Industry to provide international and United Kingdom domestic facilities-based voice services. This license also allows the holder to acquire ownership interests in or construct the United Kingdom half circuit of any IRU as well as backhaul and other United Kingdom domestic facilities provision. The international facilities-based license, as amended, together with the international simple resale license authorize the provision of every voice and data service, except the provision of broadcasting and mobile services. While the international facilities-based license authorizes us to acquire ownership interests in the United Kingdom half-circuit of satellite space segment in order to provide satellite-based services, it is also necessary to apply for a Wireless Telegraphy Act 1949 License which authorizes the use of the spectrum.
Telegroup Network Services Ltd. holds an ISVR license granted on December 31, 1997 and Telegroup UK Ltd. holds an international facilities-based license granted on December 30, 1997, amended effective as of September 27, 1999 to cover United Kingdom domestic facilities provision.
Tariffs. Telecommunications tariffs on operators in the United Kingdom (excluding British Telecom) are generally not subject to prior review or approval by regulatory authorities, although Oftel has historically imposed price caps on British Telecom. British Telecom has advocated and will likely continue to advocate for greater pricing flexibility, including flexibility for pricing toll free and other services. Greater pricing flexibility could allow British Telecom to charge us higher prices for certain services or to charge end user customers prices that are lower than we are able to charge.
Interconnection and Indirect Access. We must interconnect our U.K. network to networks of other service providers in the United Kingdom and allow our end user customers to obtain access to our services in order to compete effectively in the United Kingdom. In the United Kingdom, licensed long distance carriers like us can obtain interconnection to British Telecom at cost-based rates. However, while customers of British Telecom's long distance service can access that service automatically (i.e., without dialing additional digits), customers of other long distance carriers generally must dial additional digits to access their chosen carrier's services.
Fair Trading Practices. Oftel is the principal regulator of the competitive aspects of the United Kingdom telecommunications industry. There are no foreign ownership restrictions that apply to telecommunications company licensing in the United Kingdom although the Department of Trade and Industry does have a discretion as to whether to award licenses on a case by case basis. We also are subject to general European law, which, among other things, prohibits certain anti-competitive agreements and abuses of dominant market positions through Articles 81 and 82 of the Treaty of Rome.
Germany
The German Telecommunications Act of 1996 liberalized all telecommunications activities as of January 1, 1998. The German Telecom Act has been complemented by several ordinances. Under the German regulatory scheme, licenses are required for the operation of infrastructure and the provision of voice telephony services. Licenses required for the operation of infrastructure are divided into 3 license classes: mobile telecommunications (license class 1); satellite (license class 2); and other telecommunications services for the
general public (license class 3). In addition to the infrastructure licenses, a separate license is required for provision of voice telephony services to the general public on the basis of self-operated telecommunications networks (license class 4). A class 4 license does not include the right to operate transmission infrastructure. All other telecommunications services (e.g. valued- added, data, etc.) are only subject to a notification requirement. We operate under a license class 4 which has been extended to a Germany-wide area license under a change of regulatory policy that requires Germany-wide area licenses for the Germany-wide offer of public switched voice telephony. License fees caused by this license extension are high, but have been challenged by a German court and have therefore not yet been imposed.
Under the German Telecom Act, companies that desire to connect with Deutsche Telekom's network must enter into an interconnection agreement with the regulated interconnection tariffs. We entered into an interconnection agreement with Deutsche Telekom on February 27, 1998 at the regulated standard interconnection rates presently under court review. The interconnection agreement may be terminated by commencing a six month notice period at the end of the calendar year. After the public announcement on December 15, 1998, Deutsche Telekom, by letter of December 23, 1998, informed us that, as a matter of precaution, it terminated the interconnection agreements with us and all other carriers as of December 31, 1999 and it asked that renegotiations be opened.
Several complaints, the outcome of which may affect our business, currently are pending before the Regulierungsbehorde fur Telekommunikation und Post (RegTP) or German courts concerning interconnection with Deutsche Telekom. The RegTP issued a decision in January 2000 on Primus' application. Aspects of the RegTP's decision are being disputed in German courts. It is possible that the final resolution of these disputes and the interconnection agreement with Deutsche Telekom will include terms that are adverse to Primus, including minimum traffic requirements and restrictions on sharing points of interconnection. We cannot predict the results of the new interconnection regulation, but the results may severely affect our business in Germany.
The RegTP established provisional interconnection tariffs in September 1997 which Deutsche Telekom has since challenged in court. These rates have been part of the standard offer of Deutsche Telekom and were valid for all interconnected and licensed carriers until the end of 1999. On December 23, 1999, RegTP adopted regulations requiring new, substantially lower interconnection rates, effective as of January 1, 2000, which may again be attacked by Deutsche Telekom in court. Other pending complaints concern the costs of billing services provided by Deutsche Telekom to other carriers and rates for direct access to the end-user lines of Deutsche Telekom. It is expected that a final resolution to these matters will take several years.
The first new interconnection agreement signed with Mannesmann Arcor, the major market player besides Deutsche Telekom, however, introduced a reduction of interconnection tariffs by extending off-peak times to comply with end-user off-peak times. These new lower rates were undercut by the RegTP decision as of December 23, 1999 described above. Non-discrimination with regard to all other terms of this agreement between large and smaller carriers such as Primus will become an important regulatory issue in the market once this new agreement comes into force. Discrimination would severely affect our business.
Further, the general price depression in the end-customer market along with the fact that the RegTP has authorized Deutsche Telekom's price cuts in the end-customer market (announced to be effective as of January 1, April 1 and July 1, 1999) may adversely affect us. Other large operators also have reduced their prices which may adversely affect our business. These price cuts have come under attack before the European Commission and the courts. The outcome of these proceedings is, however, difficult to predict; decision-making may take years.
Finally, RegTP has auctioned off the first round of wireless local loop licenses. This has attracted additional competitors to enter the German market, which may also affect our business even though we are not active in the local exchange market.
We are or may become subject to certain other requirements as a licensed telecommunications provider in Germany. For example, licensed providers are under an obligation to present their standard terms and conditions to the RegTP. The RegTP may, based upon certain criteria, decide not to accept these terms and conditions. We also may become subject to universal service financing obligations. Currently, it is unlikely that the universal service financing system will be implemented in Germany in the foreseeable future. However, in the event that the system is implemented, we could be subject to such universal service requirements and financing schemes if we at that time should have a market share in Germany of at least 4%.
France
The French Telecommunications Act of 26 July 1996 further developed the new legal framework for the development of a competitive telecommunications market in France.
As a result, the French Regulator (Autorite de Regulation des Telecommunications) was created on January 1, 1997 with the task of overseeing the development of a competitive telecommunications sector which would provide benefits to the user. In addition, the monopoly on the provision of voice telephony services to the public was abolished as of January 1, 1998.
Under the French regulatory regime, an L33.1 licence is required for the establishment and running by the operator of a telecommunications network open to the public (an infrastructure licence) and the provision of public voice telephony services requires an L34.1 licence. An infrastructure licence is required by those operators who wish to install or purchase dark fiber for the running of a network. As with the L34.1 voice licence, L33.1 infrastructure licences are granted on a regional or nation-wide basis and it is possible to be granted a licence just for the region of Paris and its suburbs. We (via our French subsidiary) were awarded the first L34.1 only license on May 29, 1998. Call back operators and least cost routing operators not using their own leased lines as defined by the French Regulator, do not need to apply and obtain an L34.1 licence. Certain competitors obtained a joint L34.1 & L33.1 licence and we are considering applying for an L33.1 licence in addition to our L34.1 license so that we can benefit from the lower interconnection tariffs afforded to L33.1 infrastructure license holders.
Because we hold a nation-wide class L34.1 licence, we have the authority to originate and terminate calls throughout France.
Companies that desire to interconnect with France Telecom's network must enter into an interconnection agreement which applies certain fixed interconnection tariffs set out in an interconnection catalog. In order to obtain the lowest available interconnection tariffs throughout France, we would need to obtain a nation-wide infrastructure licence and install dark fiber and points of interconnection in all the different French regions (a minimum of 18 regions) where we are to be originating and terminating traffic.
We have entered into an interconnection agreement with France Telecom at the regulated standard interconnection rates applicable to L34.1 voice licence holders set out in the interconnection catalog. In order to interconnect with France Telecom, we are required to install, in addition to our principal switch in the city of Paris, a second point of presence to be interconnected with France Telecom in the outer zone of the Parisian region as defined for telecommunications purposes. We have located a site for our principal Ericsson AXE-10 switch and have ordered the leased lines from France Telecom to interconnect our switch with the most convenient France Telecom points of interconnection. France Telecom estimates and sets out in the interconnection agreement that leased lines so requested will be provided within a period of 6 to 18 months.
It is possible that the licence fees currently paid could be further increased. In addition, the interconnection fees payable to France Telecom include an element relating to the funding of France Telecom's universal service financing obligations, and it is possible that the levels of such contributions will be raised in the foreseeable future.
We have been granted the 1656 four digit indirect access code; however, there have been seven one digit indirect access numbers granted to other telecommunications providers in France. Those operators with a one digit access number will have a competitive advantage. It is highly unlikely that we will be able to obtain a one digit access number.
The Telegroup French subsidiary holds a mixed voice and infrastructure license and has been allocated the 1633 carrier selection code. We understand that this Telegroup subsidiary employs over 10 employees and has entered into a number of contracts with other telecom operators in France. It has also contracted with France Telecom for the use of two "3PBQ" numbers which are the equivalent of four digit freephone access numbers for use in regions where the carrier selection code is not operational due to the lack of a point of interconnection. Primus is in the process of determining whether to maintain its separate license and carrier selection code, in light of those held by Telegroup.
Latin America
Various countries in Latin America have taken initial steps towards deregulating their telecommunications markets. Each Latin American country has a different national regulatory regime and each country is in a different stage of liberalization. Historically, Latin American countries have reserved the provision of voice services to the state-owned post, telegraph and telephone operators. In the last few years, several Latin American countries have privatized completely or partially their national carriers, including Argentina, Chile, Mexico, Peru and Venezuela. In addition, certain countries have opened partially or completely their local and/or long distance markets, most notably Chile, which has competitive operators in all sectors. Argentina has liberalized certain telecommunications services, such as value-added, paging, data transmission, and personal communications services. Brazil currently is in the process of opening its telecommunications market to competition. Brazil intends to privatize Telecomunicas Brasileras S.A. (Telebras), which, through its 28 regional subsidiaries, holds a monopoly over the provision of local telephone services, as well as Empresa Brasiliera de Telecomunicacoes S.A., the monopoly provider of long distance and international telephone services. Moreover, Colombia recently has opened national and international long distance services to competition, and has awarded two new concessions for the provision of these services to two major local exchange carriers in Colombia--Empresa Brasiliera de Telecomunicaciones S.A. de Bogota and Orbitel, S.A. In Colombia the provision of value-added services and voice services to closed-user groups is open to competition. Mexico initiated competition in the domestic and international long distance services market on January 1, 1996, which are subject to a concession requirement. In addition, the Mexican government has opened recently basic telephony, and currently is auctioning radio-electric spectrum frequencies for the provision of personal communications services and Local Multipoint Distribution System Services. Value-added services are also fully open to competition in Mexico. Finally, in the Central American region, Guatemala and El Salvador recently have opened their telecommunications market to competition, abolishing all restrictions on foreign investment in this sector. Other countries in Central America, such as Nicaragua and Honduras, are in the process of privatizing their state-owned carriers, and have not opened fully their markets to competition.
Employees
The following table summarizes the number of our full-time employees as of December 31, 1999, by region and classification:
We have never experienced a work stoppage, and none of our employees is represented by a labor union or covered by a collective bargaining agreement. We consider our employee relations to be excellent.
ITEM 2.
ITEM 2. PROPERTIES
We currently lease our corporate headquarters which is located in McLean, Virginia. Additionally, we also lease administrative, technical and sales office space, as well as space for our switches, in various locations in the countries in which we operate, including the United States, Canada, Australia, the United Kingdom, Japan, Germany, France, Switzerland and Italy. Total leased space approximates 579,000 square feet and the total annual lease costs are approximately $11.4 million. The operating leases expire at various times through 2009. Certain communications equipment which includes network switches and transmission lines is leased through operating and capital leases. We believe that our present administrative and sales office facilities are adequate for our anticipated operations and that similar space can be obtained readily as needed. We further believe that the current leased facilities are adequate to house existing communications equipment. However, as our network grows, we expect to lease additional locations to house the new equipment.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
On December 9, 1999, Empresa Hondurena de Telecommunicaciones, S.A., based in Honduras, filed suit in Florida State Court in Broward County against TresCom and one of TresCom's wholly-owned subsidiaries, St. Thomas and San Juan Telephone Company, alleging that such entities failed to pay amounts due to plaintiff pursuant to contracts for the exchange of telecommunications traffic during the period from December 1996 through September 1998. We acquired TresCom in June 1998 and TresCom is currently our subsidiary. Plaintiff is seeking approximately $14 million in damages, plus legal fees and costs. We filed our answer on January 25, 2000 and discovery has recently commenced. Because it is only in the early stages of discovery, our ultimate legal and financial liability with respect to such legal proceeding cannot be estimated with any certainty at this time. We intend to defend the case vigorously.
We are also involved from time to time in litigation incidental to the conduct of our business. We believe the outcome of such pending legal proceedings to which we are a party will not have a material adverse effect on our business, financial condition, results of operations or cash flows.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Common Stock
Primus Telecommunications Group, Incorporated ("Primus" or the "Company") Common Stock trades on the Nasdaq Stock Market under the symbol "PRTL". The following table sets forth, for the period indicated, the high and low sales prices of the Company's Common Stock.
Dividend Policy
The Company has not paid any cash dividends on its Common Stock to date. The payment of dividends, if any, in the future is within the discretion of the Board of Directors and will depend on the Company's earnings, its capital requirements and financial condition. Dividends are currently restricted by the senior note indentures, and may be restricted by other credit arrangements entered into in the future by the Company. It is the present intention of the Board of Directors to retain all earnings, if any, for use in the Company's business operations, and accordingly, the Board of Directors does not expect to declare or pay any dividends in the foreseeable future.
Holders
As of February 29, 2000, the Company had approximately 221 holders of record of its Common Stock. The Company believes that it has in excess of 400 beneficial owners.
Recent Sales of Unregistered Securities
In November 1999, the Company purchased substantially all of the assets of DigitalSelect, LLC, a provider of digital subscriber line high-speed Internet access and Web content services. The purchase price of $7.5 million was paid with $5.3 million in cash, the issuance of a $0.7 million short-term promissory note and 69,023 shares of the Company's common stock valued based on a 20 day trailing average of the last sale price of the Company's common stock.
In November 1999, the Company purchased substantially all of the assets of 1492 Technologies, LLC, an Internet Web site development and service firm. The purchase price of $0.5 million was paid for with $0.2 million in cash and 15,500 shares of the Company's common stock valued based on a 20 day trailing average of the last sale price of the Company's common stock.
In June 1999, the Company acquired Telephone Savings Network Limited, a Canadian reseller of local services to small- and medium-sized business customers, for a purchase price of $5.1 million comprised of $2.4 million in cash and 152,235 shares of the Company's common stock. In October 1999 and February 2000, pursuant to an earn-out provision of the purchase agreement, the Company issued an additional 57,391 shares of the Company's common stock.
In February 1999 the Company acquired GlobalServe Communications, Inc., a privately held ISP based in Toronto, Canada. The purchase price of approximately $4.4 million was comprised of $2.2 million in cash and 142,806 shares of the Company's common stock.
In February 1999, the Company purchased the remaining 40% of Hotkey Internet Services Pty., Ltd. ("Hotkey"), a Melborne, Australia-based ISP for approximately $1.1 million, comprised of $0.3 million in cash and 57,025 shares of the Company's common stock.
The issuances listed above were made in reliance upon the exemption from registration provided by Section 4(2) of the Securities Act of 1933, as amended. Each corporation that was acquired or from which the Company acquired assets was a privately-held company with a very limited number of holders, each of whom represented that they were acquiring the Company's shares for investment without an intent or view to resell.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following sets forth selected consolidated financial data of the Company for the years ended December 31, 1999, 1998, 1997, 1996, and 1995 as derived from the historical financial statements of the Company:
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW
Overview
Primus is a facilities-based total service provider offering bundled international and domestic Internet, data and voice services to business, residential and carrier customers. Primus's customers are primarily in North America, Europe and selected markets within the Asia-Pacific region. It seeks to capitalize on the increasing demand for high-quality international communications services. The Company provides services over its network, which consists of:
. 19 carrier-grade switches, including 15 international gateway switches in the United States, Australia, Canada, France, Germany, Japan, Puerto Rico and the United Kingdom, and four domestic switches in Australia;
. more than 150 POPs and Internet access nodes in additional markets within its principal service regions;
. both owned and leased transmission capacity on undersea and land- based fiber optic cable systems; and
. an international satellite earth station located in London, together with the capacity the Company leased on an Intelsat satellite.
Utilizing this network, along with resale arrangements and foreign carrier agreements, Primus offers quality service to approximately 1.9 million customers as of December 31, 1999.
Primus was founded in February 1994, and through the first half of 1995 the Company was a development stage enterprise involved in various start-up activities. It began generating revenue during March 1995. On March 1, 1996 it acquired Axicorp Pty. Ltd., the fourth largest telecommunications provider in Australia. Primus then entered the Japanese and German markets with its October 1997 acquisition of TelePassport/USFI and expanded its service offerings in Australia with the March 1998 acquisition of a controlling interest in Hotkey Internet Services Pty. Ltd., an Australia-based ISP, and the April 1998 acquisition of Eclipse Telecommunications Pty. Ltd., an Australia-based data communications service provider.
On June 9, 1998, Primus acquired the operations of TresCom. The TresCom merger expanded the scope and coverage of the Company's communications network, thereby providing additional opportunities to migrate traffic onto the network, resulting in better utilization of the network and reduced variable costs.
In 1999, among other things, Primus:
. acquired London Telecom, a Canadian long distance provider, and certain related companies;
. purchased a residential long distance customer base, customer support assets and residential Internet customers and network from AT&T Canada and ACC Telenterprises;
. purchased Telegroup's global retail customer businesses, which include retail customers primarily in North America and Europe;
. organized its Internet and data services business into a new subsidiary, iPRIMUS.com, acquired GlobalServe, a Canadian ISP, Matrix Internet, a Brazilian ISP, TCP/IP and TouchNet, two independent German ISPs, and the remaining interest in Hotkey Internet Services, entered into agreements with Covad Communications and NorthPoint Communications to offer DSL services, acquired DigitalSelect, a provider of DSL Internet access and Web content, and 1492 Technologies, a Web site development, consulting and service firm, and began to build an Internet Protocol-based network platform in Australia.
Net revenue is earned based on the number of minutes billable and is recorded upon completion of a call, adjusted for sales allowance. The Company generally prices its services at a savings compared to the major carriers operating in Primus's principal service regions. Net revenue is derived from carrying a mix of business, residential and carrier long distance traffic, data and Internet traffic in the United States, Australia, Canada, Brazil and Germany, and, in Australia, also from the provision of local and cellular services. Primus expects to continue to generate net revenue from internal growth through sales and marketing efforts focused on customers with significant international long-distance usage, including small- and medium-sized businesses, multinational corporations, ethnic residential customers and other telecommunications carriers and resellers.
Prices in the long distance industry in the United States and the United Kingdom have declined in recent years and, as competition continues to increase, the Company believes that prices are likely to continue to decrease. Additionally, Primus believes that because deregulatory influences only recently have begun to affect non-United States and non-United Kingdom telecommunications markets, including Australia, the deregulatory trend in such markets will result in greater competition which could adversely affect Primus's net revenue per minute and gross margin as a percentage of net revenue. However, the Company believes that such decreases in prices will be offset by increased communications usage and decreased costs.
Cost of revenue is comprised primarily of costs incurred from other domestic and foreign telecommunications carriers to originate, transport and terminate calls. The majority of Primus's cost of revenue is variable, based upon the number of minutes of use, with transmission and termination costs being the most significant expense. As the portion of traffic transmitted over leased or owned facilities increases, cost of revenue increasingly will be comprised of fixed costs. In order to manage such costs, Primus pursues a flexible approach with respect to the expansion of its network. In most instances, Primus initially obtains transmission capacity on a variable-cost, per-minute leased basis, next acquires additional capacity on a fixed-cost basis when traffic volume makes such a commitment cost-effective, and ultimately purchases and operates its own facilities when traffic levels justify such investment. The Company also seeks to lower the cost of revenue through:
. optimizing the routing of calls over the least cost route;
. increasing volumes on the fixed cost leased and owned lines, thereby spreading the allocation of fixed costs over a larger number of minutes;
. negotiating lower variable usage based costs with domestic and foreign service providers and negotiating additional and lower cost foreign carrier agreements with the foreign incumbent carriers and others; and
. continuing to expand the network when traffic volumes justify such investment.
The Company generally realizes a higher gross margin as a percentage of net revenue on its international as compared to its domestic long distance services and a higher gross margin as a percentage of net revenue on its services to both business and residential customers compared to those realized on its services to other telecommunications carriers. In addition, Primus generally realizes a higher gross margin as a percentage of net revenue on long distance services as compared to those realized on local switched and cellular services. Carrier services, which generate a lower gross margin as a percentage of net revenue than retail services, are an important part of net revenue because the additional traffic volume of such carrier customers improves the utilization of the network and allows the Company to obtain greater volume discounts from its suppliers than it otherwise would realize. Primus's overall gross margin as a percentage of net revenue may fluctuate based on the relative volumes of international versus domestic long distance services, carrier services versus business and residential long distance services, and the proportion of traffic carried on Primus's network versus resale of other carriers' services.
Selling, general and administrative expenses are comprised primarily of salaries and benefits, commissions, occupancy costs, sales and marketing expenses, advertising and administrative costs. These expenses have been increasing consistently with the expansion of operations. Primus expects this trend to continue and believes that it will incur additional selling, general and administrative expenses to support the expansion of sales and marketing efforts and operations in current markets as well as new markets in the principal service regions.
Although the Company's functional currency is the United States dollar, a significant portion of net revenue is derived from sales and operations outside the United States. In the future, Primus expects to continue to derive the majority of net revenue and incur a significant portion of its operating costs from outside the United States, and therefore changes in exchange rates may have a significant effect on Primus's results of operations. Primus historically has not engaged in hedging transactions and does not currently contemplate engaging in hedging transactions to mitigate foreign exchange risks.
Other Operating Data
The following information for the year ended December 31, 1999 is provided for informational purposes and should be read in conjunction with the Consolidated Financial Statements and Notes.
Results of operations for the year ended December 31, 1999 as compared to the year ended December 31, 1998
Net revenue increased $411.1 million or 97.5% to $832.7 million for the year ended December 31, 1999, from $421.6 million for the year ended December 31, 1998. Of the net revenue increase, $218.1 million was associated with the Company's North American operations, which represents a growth rate of approximately 116.0%. The growth reflects increased traffic volumes in business and ethnic residential retail operations and in carrier operations, and a full year's results of the acquired TresCom operations, as compared to approximately 7 months' Trescom operations in 1998. The 1999 results also include operations of Telegroup (since the June 1, 1999 effective date of the acquisition), AT&T Canada (since the May 31, 1999 customer base acquisition), and the LTN and Wintel Companies (since the March 31, 1999 acquisition). The total of these acquisitions contributed $124.7 million or 57% of the total North American increase. The European net revenue increased from $60.9 million for the year ended December 31, 1998 to $195.5 million for the year ended December 31, 1999, resulting from the acquisition of Telegroup, increased retail business and residential traffic and a full year of carrier services, in the United Kingdom and Germany. The Company's Asia-Pacific net
revenue increased by $58.4 million or 33.8% to $231.2 million for the year ended December 31, 1999 from $172.8 million for the year ended December 31, 1998.
Cost of revenue increased $271.6 million, from $353.0 million, or 83.7% of net revenue, for the year ended December 31, 1998 to $624.6 million, or 75.0% of net revenue, for the year ended December 31, 1999. The increase in the cost of revenue is primarily attributable to the increased traffic volumes and associated net revenue growth. The cost of revenue as a percentage of net revenue decreased by 870 basis points as a result of expansion of the Company's global Network, the continuing migration of existing and newly generated customer traffic onto the Company's Network, and the increase and introduction of new higher margin product offerings such as data and Internet services.
Selling, general and administrative expenses increased $120.1 million to $199.6 million for the year ended December 31, 1999 from $79.5 million for the year ended December 31, 1998. The increase is attributable to the impact of increased advertising, marketing and sales expenses focused on retail revenue growth. Also, the increase is primarily attributable to the addition of expenses from acquired operations including GlobalServe, London Telecom, the retail customer base of AT&T Canada, Telegroup, TelSN, DigitalSelect, and Matrix Internet.
Depreciation and amortization increased from $24.2 million for the year ended December 31, 1998 to $55.0 million for the year ended December 31, 1999. The increase is associated with increased amortization expense related to intangible assets arising from the Company's acquisitions and with increased depreciation expense related to capital expenditures for fiber optic cable, switching and other network equipment being placed into service.
Interest expense increased to $79.6 million for the year ended December 31, 1999 from $40.0 million for the year ended December 31, 1998. The increase is primarily attributable to the interest expense associated with five additional months of interest expense associated with the Company's May 1998 $150 million 9 7/8% Senior Notes Offering, due 2008 ("1998 Senior Notes"), the January 1999 $245.5 million 11 1/4% Senior Notes Offering, due 2009, ("January 1999 Senior Notes") and the Company's October 1999 $250 million 12 3/4% Senior Notes Offering, due 2009, ("October 1999 Senior Notes") and, to a lesser extent, the Company's capital lease financing.
Interest and other income increased from $11.5 million for the year ended December 31, 1998 to $13.3 million for the year ended December 31, 1999. The increase is a result of the investment of the net proceeds of the Company's 1999 and 1998 Senior Notes offerings, and the secondary equity offering.
Results of operations for the year ended December 31, 1998 as compared to the year ended December 31, 1997
Net revenue increased $141.4 million or 51% to $421.6 million for the year ended December 31, 1998, from $280.2 million for the year ended December 31, 1997. Of the net revenue increase, $113.7 million was associated with the Company's North American operations, which represents a growth rate of approximately 153%. The growth reflects increased traffic volumes in business and ethnic residential retail operations and in carrier operations, and includes operations of TresCom (since the June 9, 1998 acquisition), and a full year's results of the acquired Canadian operations and the acquired operations of TelePassport L.L.C./USFI, Inc. The European net revenue increased from $22.7 million for the year ended December 31, 1997 to $60.9 million for the year ended December 31, 1998, resulting from increased retail business and residential traffic and the addition of carrier services, both in the United Kingdom and Germany. The Company's Asia-Pacific net revenue decreased by $10.3 million or 5.7% to $172.8 million for the year ended December 31, 1998 from $183.1 million for the year ended December 31, 1997 primarily resulting from a 13% decrease in the Australian dollar average exchange rate. Net revenue of the Australian operations, in Australian dollar terms, grew 7% to Australian $259.5 million as a result of increased retail business and residential traffic growth and the addition of data and Internet services.
Cost of revenue increased $100.3 million, from $252.7 million, or 90.2% of net revenue, for the year ended December 31, 1997 to $353.0 million, or 83.7% of net revenue, for the year ended December 31, 1998. The increase in the cost of revenue is primarily attributable to the increased traffic volumes and associated net revenue growth. The cost of revenue as a percentage of net revenue decreased by 650 percentage points as a result of expansion of the Company's global Network, the continuing migration of existing and newly
generated customer traffic onto the Company's Network, and new higher margin product offerings such as data and Internet services.
Selling, general and administrative expenses increased $28.9 million to $79.5 million for the year ended December 31, 1998 from $50.6 million for the year ended December 31, 1997. The increase is attributable to the addition of expenses from acquired operations including TresCom, Hotkey, Eclipse and the Canadian operations, the hiring of additional sales and marketing staff and network operations personnel and increased advertising and promotional expenses associated with the Company's residential marketing campaigns.
Depreciation and amortization increased from $6.7 million for the year ended December 31, 1997 to $24.2 million for the year ended December 31, 1998. The increase is associated with increased amortization expense related to intangible assets arising from the Company's acquisitions and with increased depreciation expense related to capital expenditures for fiber optic cable, switching and other network equipment being placed into service.
Interest expense increased to $40.0 million for the year ended December 31, 1998 from $12.9 million for the year ended December 31, 1997. The increase is primarily attributable to the interest expense associated with the Company's July 1997 $225 million 11 3/4 % Senior Notes Offering, due 2004, ("1997 Senior Notes") and the Company's May 1998 $150 million 9 7/8 % Senior Notes Offering, due 2008, ("1998 Senior Notes") and, to a lesser extent, the Company's Bank Revolving Credit Facility and additional capital lease financing.
Interest income increased from $6.2 million for the year ended December 31, 1997 to $11.5 million for the year ended December 31, 1998. The increase is a result of the investment of the net proceeds of the Company's 1998 and 1997 Senior Notes offerings.
Liquidity and Capital Resources
The Company's liquidity requirements arise from cash used in operating activities, purchases of network equipment including switches, related transmission equipment and international and domestic fiber optic cable transmission capacity, satellite earth stations and satellite transmission capacity, interest and principal payments on outstanding indebtedness, and acquisitions of and strategic investments in businesses. The Company has financed its growth to date through public offerings and private placements of debt and equity securities, bank debt, equipment financing and capital lease financing.
Net cash used in operating activities was $55.6 million for the year ended December 31, 1999 as compared to net cash used in operating activities of $71.3 million for the year ended December 31, 1998. The increase in the net loss from 1998 to 1999's net loss of $112.7 million was offset by greater non-cash operating expenses of $83.6 million. The decrease in operating cash used is primarily comprised of an increase in accounts payable of $56.2 million caused by higher expenses in 1999, and an increase in accrued interest payable due to the interest due on the January 1999 Senior Notes and the October 1999 Senior Notes. These increases to operating cash flow are offset by an increase in accounts receivable of $64.8 million due to higher revenue in 1999, and an increase in prepaid expenses and other current assets partly due to the increase in the deferral of direct marketing expenses that are amortized over a 12 month period.
Net cash used in investing activities was $200.2 million for the year ended December 31, 1999 compared to net cash used in investing activities of $54.2 million for the year ended December 31, 1998. Net cash used in investing activities for the year ended December 31, 1999 includes $114.3 million used to acquire Telegroup, the LTN and Wintel Companies, AT&T Canada, GlobalServe, TelSN, Hotkey, TCP/IP, TouchNet, Cards & Parts, DigitalSelect, 1492 Technologies and 51% of Matrix Internet. Additionally, $110.6 million of cash was used for capital expenditures primarily for the expansion of the Company's global Network, partially offset by $24.7 million of cash provided by the sale of restricted investments used to fund interest payments on the 1997 Senior Notes. During the year ended December 31, 1999 the Company funded additional equipment and fiber purchases of $24.4 million through equipment financing agreements.
Net cash provided by financing activities was $591.0 million for the year ended December 31, 1999 as compared to net cash provided by financing activities of $146.8 million during the year ended December 31, 1998. Cash provided by financing activities for the year ended December 31, 1999 resulted primarily from $192.5 million of net proceeds from the January 1999 Senior Notes offering, $242.4 million of net proceeds from the October 1999 Senior Notes offering, and the sale of 8,000,000 shares of the Company's common stock at a price of $22.50 per share, netting $169.3 million. $4.5 million was also received from the 49% minority shareholder of Matrix Internet to fund the operations of Matrix Internet. Offsetting the cash provided
by the offerings of debt and equity securities was the $17.8 million repayment of the Revolving Credit Agreement and $5.4 million of payments on capital leases.
In March 2000, the Hewlett-Packard Company agreed to purchase up to $50 million in convertible debt. Such debt will bear interest at a rate of 9.25% per annum and is convertible into the Company's common stock at a price of $60 per share. The Company has the right under certain circumstances to require Hewlett-Packard to convert the debt to equity. To date, Hewlett-Packard has invested $25 million. Until converted, the debt will be secured by equipment purchased from Hewlett-Packard with the proceeds of the investment.
The Company anticipates aggregate capital expenditures of approximately $210 million during 2000. Such capital expenditures will be primarily to expand and enhance Primus' existing communications network, to deploy the Company's global broadband ATM+IP network, and to purchase international and domestic switches, POPs and data centers for voice, data and Internet services, other transmission equipment and support systems.
In February and March 2000, Primus completed an offering of $300,000,000 in aggregate principal amount of 5.75% convertible subordinated debentures due February 15, 2007 ("2000 Convertible Debt") in a private placement. The debentures are convertible into PRIMUS common stock at a price of $49.7913 per share. The purpose of the offering was to fund capital expenditures to expand and enhance the Company's communications network and for other permitted corporate purposes, including possible acquisitions.
The Company believes that the net proceeds from the 2000 Convertible Debt, together with its existing cash and available capital lease financing (subject to the limitations in the Indentures related to the Company's senior notes) will be sufficient to fund the Company's operating losses, debt service requirements, capital expenditures, possible acquisitions and other cash needs for our operations, including iPRIMUS.com, until at least June 30, 2001. The semi-annual interest payments due under the 1997 Senior Notes through August 1, 2000 have been pre-funded and will be paid from restricted investments. The Company is continually evaluating the expansion of its service offerings and plans to make further investments in and enhancements to its switches and distribution channels in order to expand its service offerings. In order to fund these additional cash requirements, the Company anticipates that it will be required to raise additional financing from public or private equity or debt sources. Additionally, if the Company's plans or assumptions change, including those with respect to the development of the network and the level of Primus' operations and operating cash flow, if its assumptions prove inaccurate, if it consummates additional investments or acquisitions, if it experiences unexpected costs or competitive pressures, or if existing cash and any other borrowings prove to be insufficient, the Company may be required to seek additional capital sooner than expected. Except as described herein, Primus presently has no binding commitment or binding agreement with respect to any material acquisition, joint venture or strategic investment. However, from time to time, the Company may be party to one or more non-binding letters of intent regarding material acquisitions which, if consummated, may be paid for with cash or through the issuance of a significant number of shares of the Company's common stock.
Year 2000
The Company's Year 2000 review involved (a) an assessment of the Year 2000 problems that may affect the Company, (b) the development of remedies to address the problems discovered in the assessment phase to the extent practical or feasible, (c) the testing of such remedies, and (d) the preparation of contingency plans to deal with worst case scenarios. As of the date of this report, the Company has not encountered any material business interruptions or adverse financial consequences related to the Year 2000 issue.
The Company currently estimates that the total historical and anticipated remaining costs related to the Year 2000 issue will be immaterial to the Company's financial condition.
Special Note Regarding Forward Looking Statements
Statements in this Annual Report on Form 10-K, including those concerning the Company's expectations of future sales, net revenue, gross profit, net income, network development, traffic development, capital expenditures, selling, general and administrative expenses, service introductions and cash requirements include certain forward-looking statements. As such, actual results may vary materially from such expectations. Factors, which could cause results to differ from expectations, include risks associated with:
Limited Operating History; Entry into Developing Markets. The Company was founded in February 1994, began generating revenue in March 1995. The Company intends to enter additional markets or businesses, including establishing an Internet business, where Primus has limited or no operating experience. Accordingly, the Company cannot provide assurance that its future operations will generate operating or net income, and the Company's prospects must be considered in light of the risks, expenses, problems and delays inherent in establishing a new business in a rapidly changing industry.
Limited Operating History; Entry into Internet and data business. Primus has recently begun targeting businesses and residential customers for Internet and data services through its subsidiary iPRIMUS.com and other recently acquired ISPs. The Company has been expanding and intends to continue to expand, its offering of data and Internet services worldwide. Primus anticipates offering a full-range of Internet protocol-based data and voice communications over the global broadband ATM+IP network which the Company is beginning to deploy over its existing network infrastructure. Primus has limited experience in the Internet business and cannot provide assurance that it will successfully establish or expand the business. Currently, the Company provides Internet services to business and residential customers in the United States, Australia, Canada, Brazil and Germany, and offers Internet transmission services in the Indian Ocean/Southeast Asia regions through its satellite earth station in London.
The market for Internet connectivity and related services is extremely competitive. Primus's primary competitors include other ISPs that have a significant national or international presence. Many of these carriers have substantially greater resources, capital and operational experience than Primus does. The Company also expects it will experience increased competition from traditional telecommunications carriers that expand into the market for Internet services. In addition, Primus will require substantial additional capital to make investments in its Internet operations, and it may not be able to obtain that capital on favorable terms or at all. The amount of such capital expenditures may exceed the amount of capital expenditures spent on the voice portion of its business going forward.
Further, even if Primus is able to establish and expand its Internet business, the Company will face numerous risks that may adversely affect the operations of its Internet business. These risks include:
. competition in the market for Internet services;
. Primus's limited operating history as an ISP;
. Primus's reliance on third parties to provide maintenance and support services for the Company's ATM+IP network;
. Primus's reliance on third-party proprietary technology, including Pilot's HDI security protocol, to provide certain services to Primus's customers;
. the Company's ability to recruit and retain qualified technical, engineering and other personnel in a highly competitive market;
. Primus's ability to adapt and react to rapid changes in technology related to the Internet business;
. uncertainty relating to the continuation of the adoption of the Internet as a medium of commerce and communications;
. vulnerability to unauthorized access, computer viruses and other disruptive problems due to the accidental or intentional actions of others;
. adverse regulatory developments;
. the potential liability for information disseminated over Primus's network; and
. the Company's need to manage the growth of its Internet business, including the need to enter into agreements with other providers of infrastructure capacity and equipment and to acquire other ISPs and Internet-related businesses on acceptable terms.
Finally, Primus expects to incur operating losses and negative cash flow from its Internet and data business as the Company expands, builds out and upgrades this part of the business. Any such losses and negative cash flow are expected to partially offset the expected positive cash flow generated by the voice business and effectively reduce the overall cash flow of Primus as a whole.
Managing Rapid Growth. The Company's strategy of rapid growth has placed, and is expected to continue to place, a significant strain on the Company. In order to manage its growth effectively, the Company must continue to implement and improve its operational and financial systems and controls, purchase and utilize additional transmission facilities, and expand, train and manage its employees, all within a rapidly-changing regulatory environment. Inaccuracies in the Company's forecast of traffic could result in insufficient or excessive transmission facilities and disproportionate fixed expenses.
Substantial Indebtedness; Liquidity. The Company currently has substantial indebtedness and anticipates that it and its subsidiaries will incur additional indebtedness in the future. The level of the Company's indebtedness (i) could make it more difficult for it to make payments of interest on its outstanding debt; (ii) could limit the ability of the Company to obtain any necessary financing in the future for working capital, capital expenditures, debt service requirements or other purposes; (iii) requires that a substantial portion of the Company's cash flow from operations, if any, be dedicated to the payment of principal and interest on its indebtedness and other obligations and, accordingly, will not be available for use in its business; (iv) could limit its flexibility in planning for, or reacting to, changes in its business; (v) results in the Company being more highly leveraged than some of its competitors, which may place it at a competitive disadvantage; and (vi) will make it more vulnerable in the event of a downturn in its business.
Historical and Future Operating Losses; Negative EBITDA; Net Losses. Since inception, Primus had cumulative negative cash flow from operating activities and cumulative negative EBITDA. In addition, Primus incurred net losses since inception and has an accumulated deficit of approximately $224 million as of December 31, 1999. The Company expects to continue to incur additional operating losses and negative cash flow as it expands its operations and continues to build-out and upgrade its network. There can be no assurance that the Company's revenue will grow or be sustained in future periods or that it will be able to achieve or sustain profitability or positive cash flow from operations in any future period.
Acquisition and Strategic Investment Risks. Acquisitions, a key element in the Company's growth strategy, involve operational risks, including the possibility that an acquisition does not ultimately provide the benefits originally anticipated by management, while the Company continues to incur operating expenses to provide the
services formerly provided by the acquired company, and financial risks including the incurrence of indebtedness by the Company in order to affect the acquisition and the consequent need to service that indebtedness.
Integration of Acquired Businesses. There can be no assurance that the Company will be successful in identifying attractive acquisition candidates, completing and financing additional acquisitions on favorable terms, or integrating the acquired business or assets into its own. There may be difficulty in integrating the service offerings, distribution channels and networks gained through acquisitions with the Company's own. Successful integration of operations and technologies requires the dedication of management and other personnel which may distract their attention from the day-to-day business, the development or acquisition of new technologies, and the pursuit of other business acquisition opportunities.
Intense Competition. The long distance telecommunications industry is intensely competitive and is significantly influenced by the marketing and pricing decisions of the larger industry participants. Competition in all of the Company's markets is likely to increase and, as deregulatory influences are experienced in markets outside the United States, competition in non-United States markets is likely to become similar to the intense competition in the United States. Many of the Company's competitors are significantly larger and have substantially greater financial, technical and marketing resources and larger networks than the Company, a broader portfolio of service offerings, greater control over transmission lines, stronger name recognition and customer loyalty, as well as long-standing relationships with the Company's target customers. In addition, many of the Company's competitors enjoy economies of scale that result in a lower cost structure for transmission and related costs which could cause significant pricing pressures within the industry.
Dependence on Transmission Facilities-Based Carriers. The Company's ability to maintain and expand its business is dependent upon whether the Company continues to maintain favorable relationships with the transmission facilities-based carriers to carry the Company's traffic.
International Operations. In many international markets, the existing carrier will control access to the local networks, enjoy better brand recognition and brand and customer loyalty, and have significant operational economies, including a larger backbone network and correspondent agreements. Moreover, the existing carrier may take many months to allow competitors, including the Company, to interconnect to its switches within its territory. There can be no assurance that the Company will be able to obtain the permits and operating licenses required for it to operate, obtain access to local transmission facilities or to market services in international markets. In addition, operating in international markets generally involves additional risks, including: unexpected changes in regulatory requirements, tariffs, customs, duties and other trade barriers; difficulties in staffing and managing foreign operations; problems in collecting accounts receivable; political risks; fluctuations in currency exchange rates; foreign exchange controls which restrict repatriation of funds; technology export and import restrictions; seasonal reductions in business activity.
Dependence on Effective Information Systems. The Company's management information systems must grow as the Company's business expands and are expected to change as new technological developments occur. There can be no assurance that the Company will not encounter delays or cost-overruns or suffer adverse consequences in implementing new systems when required.
Industry Changes. The international telecommunications industry is changing rapidly due to deregulation, privatization, technological improvements, expansion of infrastructure and the globalization of the world's economies. In order to compete effectively, the Company must adjust its contemplated plan of development to meet changing market conditions. The telecommunications industry is marked by the introduction of new product and service offerings and technological improvements. The Company's profitability will depend on its ability to anticipate, assess and adapt to rapid technological changes and its ability to offer, on a timely and cost-effective basis, services that meet evolving industry standards.
Network Development; Migration of Traffic. The long-term success of the Company is dependent upon its ability to design, implement, operate, manage and maintain the Network. The Company could experience delays or cost overruns in the implementation of the Network, or its ability to migrate traffic onto its Network, which could have a material adverse effect on the Company.
Dependence on Key Personnel. The loss of the services of K. Paul Singh, the Company's Chairman and Chief Executive Officer, or the services of its other key personnel, or the inability of the Company to attract and retain additional key management, technical and sales personnel (for which competition is intense in the telecommunications industry), could have a material adverse effect upon the Company.
Government Regulation. The Company's operations are subject to constantly changing regulation. There can be no assurance that future regulatory changes will not have a material adverse effect on the Company, or that regulators or third parties will not raise material issues with regard to the Company's compliance or non-compliance with applicable regulations, any of which could have a material adverse effect upon the company.
Natural Disasters. Many of the geographic areas where the Company conducts its business may be affected by natural disasters, including hurricanes and tropical storms. Hurricanes, tropical storms and other natural disasters could have material adverse effect on the business by damaging the network facilities or curtailing telephone traffic as a result of the effects of such events, such as destruction of homes and businesses.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's primary market risk exposures relate to changes in foreign currency exchange rates and to changes in interest rates.
Foreign currency - As noted above, although the Company's functional currency is the United States dollar, a significant portion of the Company's net revenue is derived from its sales and operations outside the United States. In the future, the Company expects to continue to derive a significant portion of its net revenue and incur a significant portion of its operating costs outside the United States, and changes in foreign currency exchange rates may have a significant effect on the Company's results of operations. The operations of affiliates and subsidiaries in foreign countries have been funded with investments and other advances. Due to the long-term nature of such investments and advances, the Company accounts for any adjustments resulting from translation as a charge or credit to "accumulated other comprehensive loss" within the stockholders' equity section of the consolidated balance sheet. The Company historically has not engaged in hedging transactions.
Interest rates - The Company is currently not exposed to material future earnings or cash flow exposures from changes in interest rates on long-term debt obligations since the majority of the Company's long-term debt obligations are at fixed rates. The Company is exposed to interest rate risk, as additional financing may be required due to operating losses and expansion of the Company's global Network. The interest rate that the Company will be able to obtain on additional financing will depend on market conditions at that time and may differ from the rates the Company has secured on its current debt. The estimated fair value of the Company's 1999, 1998 and 1997 Senior Notes (carrying value of $869 million), based on quoted market prices, at December 31, 1999 was $852 million.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE
None.
PART III
The information required by Part III will be provided in the Company's definitive proxy statement for the Company's 2000 annual meeting of stockholders (involving the election of directors), which definitive proxy statement will be filed pursuant to Regulation 14A not later than April 30, 2000 ("1999 Proxy Statement"), and is incorporated herein by this reference.
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information relating to directors of the Company is set forth under the caption entitled "Election of Directors" in the Company's 2000 Proxy Statement and is incorporated herein by reference. Information relating to the executive officers of the Company is set forth in the Company's 2000 Proxy Statement under the caption "Executive Officers, Directors and Key Employees" and is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information regarding compensation of officers and directors of the Company is set forth under the caption entitled "Executive Compensation" in the Company's 2000 Proxy Statement and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information regarding ownership of certain of the Company's securities is set forth under the captions entitled "Security Ownership of Certain Beneficial Owners" and "Security Ownership of Management" in the Company's 2000 Proxy Statement and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information regarding certain relationships and related transactions with the Company is set forth under the caption entitled "Certain Relationships and Related Transactions" in the Company's 2000 Proxy Statement and is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULE AND REPORTS ON FORM 8-K
a) Financial Statements and Schedules
The financial statements as set forth under Item 8 of this report on Form 10-K are included herein.
Financial Statement Schedules: Page ---- (II) Valuation and Qualifying Accounts S-1
All other financial statement schedules have been omitted since they are either not required, not applicable, or the information is otherwise included.
b) Reports on 8-K
Form 8-K dated October 13, 1999, was filed to announce the private sale of $250 million in principal amount of 12 3/4% Senior Notes due 2009 (the "12 3/4% Senior Notes due 2009").
Form 8-K dated October 15, 1999, was filed to announce the consummation of the sale to the public of 8,000,000 shares of common stock at a price of $22.50 per share, as well as to announce the consummation of the private sale of the 12 3/4% Senior Notes due 2009.
Form 8-K dated October 20, 1999, was filed to disclose the Company's unaudited pro forma financial results for the six months ended June 30, 1999.
c) Exhibit listing
Exhibit Number Description ------- -----------
3.1 Amended and Restated Certificate of Incorporation of Primus; Incorporated by reference to Exhibit 3.1 of the Registration Statement on Form S-8, No. 333-56557 (the "S-8 Registration Statement").
3.2 Amended and Restated Bylaws of Primus; Incorporated by reference to Exhibit 3.2 of the Registration Statement on Form S-1, No. 333-10875 (the "IPO Registration Statement").
4.1 Specimen Certificate of Primus Common Stock; Incorporated by reference to Exhibit 4.1 of the IPO Registration Statement.
4.2 Form of Indenture; Incorporated by reference to Exhibit 4.1 of the Registration Statement on Form S-1, No 333-30195 (the "1997 Senior Note Registration Statement").
4.3 Form of Indenture of Primus, as amended and restated on January 20, 1999, between Primus and First Union National Bank; Incorporated by reference to Exhibit 4.3 of the 1998 Form 10-K.
4.4 Form of Warrant Agreement of Primus; Incorporated by reference to Exhibit 4.2 of the 1997 Senior Note Registration Statement.
4.5 Indenture, dated May 19, 1998, between Primus and First Union National Bank; Incorporated by reference to Exhibit 4.4 of the Registration Statement on Form S-4, No 333-58547 (the "1998 Senior Note Registration Statement").
4.6 Specimen 9 7/8% Senior Note due 2008; Incorporated by reference to Exhibit A included in Exhibit 4.4 of the 1998 Senior Note Registration Statement.
4.7 Indenture, dated January 29, 1999, between Primus and First Union National Bank; Incorporated by reference to Exhibit 4.3 of the 1998 Form 10-K.
4.8 Specimen 11 1/4% Senior Note due 2009; Incorporated by reference to Exhibit A included in Exhibit 4.7.
4.9 Rights Agreement, dated as of December 23, 1998, between Primus and StockTrans, Inc., including the Form of Rights Certificate (Exhibit A), the Certificate of Designation (Exhibit B) and the Form of Summary of Rights (Exhibit C); Incorporated by reference to Exhibit 4.1 to the Company's Registration Statement on Form 8-A, No 000-29092 filed with the Commission on December 30, 1998.
4.10 Form of legend on certificates representing shares of Common Stock regarding Series B Junior Participating Preferred Stock Purchase Rights; Incorporated by reference to Exhibit 4.2 to the Company's Registration Statement on Form 8-A, No 000-29092 filed with the Commission on December 30, 1998.
4.11 Supplemental Indenture between Primus and First Union National Bank dated January 20, 1999; Incorporated by reference to Exhibit 4.3 to Amendment No. 1 to the Company's Registration Statement on Form S-4, No. 333-76965, filed with the Commission on May 6, 1999.
4.12 Amendment 1999-1 to the Primus Telecommunications Group, Incorporated Stock Option Plan; Incorporated by reference to Exhibit 10.14 to Post-Effective Amendment No. 1 to the Company's Registration Statement on Form S-4, No. 333-76965, filed with the Commission on August 2, 1999.
4.13 Specimen 11 3/4% Senior Note Due 2004; Incorporated by reference to Exhibit 4.3 to the Company's Registration Statement on Form S-4, No. 333-90179, filed with the Commission on November 2, 1999 (the "November S-4").
4.14 Indenture, dated October 15, 1999, between the Company and first Union National Bank; Incorporated by reference to the November S-4.
4.15 Specimen 12 3/4% Senior Note due 2009; Incorporated by reference to Exhibit A to Exhibit 4.14 hereto.
4.16 Indenture, dated February 24, 2000, between the Company and First Union National Bank.*
4.17 Specimen 5 3/4% convertible subordinated debenture due 2007; Incorporated by reference to Exhibit A to Exhibit 4.16 hereto.
10.1 Amendment No. 1 to Stockholder Agreement among Warburg, Pincus, K. Paul Singh, Primus, and TresCom, dated as of April 16, 1998; Incorporated by reference to Exhibit 10.1 of the Form 8-K for Amendments.
10.2 Switched Transit Agreement, dated June 5, 1995, between Teleglobe USA, Inc. and Primus for the provision of services to India; Incorporated by reference to Exhibit 10.2 of the IPO Registration Statement.
10.3 Hardpatch Transit Agreement, dated February 29, 1996, between Teleglobe USA, Inc. and Primus for the provision of services to Iran; Incorporated by reference to Exhibit 10.3 of the IPO Registration Statement.
10.4 Employment Agreement, dated June 1, 1994, between Primus and K. Paul Singh; Incorporated by reference to Exhibit 10.5 of the IPO Registration Statement. **
10.5 Primus 1995 Stock Option Plan; Incorporated by reference to Exhibit 10.6 of the IPO Registration Statement. **
10.6 Primus 1995 Director Stock Option Plan; Incorporated by reference to Exhibit 10.7 of the IPO Registration Statement. **
10.7 Registration Rights Agreement, dated July 31, 1996, among Primus, Quantum Industrial Partners LDC, S-C Phoenix Holdings, L.L.C., Winston Partners II LDC and Winston Partners LLC; Incorporated by reference to Exhibit 10.11 of the IPO Registration Statement.
10.8 Service Provider Agreement between Telstra Corporation Limited and Axicorp Pty., Ltd., dated May 3, 1995; Incorporated by reference to Exhibit 10.12 of the IPO Registration Statement.
10.9 Dealer Agreement between Telstra Corporation Limited and Axicorp Pty., Ltd. dated January 8, 1996; Incorporated by reference to Exhibit 10.13 of the IPO Registration Statement.
10.10 Hardpatch Transit Agreement dated October 5, 1995 between Teleglobe USA, Inc. and Primus regarding the provision of services to India; Incorporated by reference to Exhibit 10.14 of the IPO Registration Statement.
10.11 Master Lease Agreement dated as of November 21, 1997 between NTFC Capital Corporation and Primus Telecommunications, Inc.; Incorporated by reference to Exhibit 10.17 of Primus's Annual Report on Form 10-K for the year ended December 31, 1997 (the "1997 10-K"), as amended on Form 10-K/A dated April 30, 1998.
10.12 Primus Employee Stock Purchase Plan; Incorporated by reference to Exhibit 10.15 of the 1997 Senior Note Registration Statement. **
10.13 Primus 401(k) Plan; Incorporated by reference to Exhibit 4.4 of the Primus Registration Statement on Form S-8 (No. 333-35005).
10.14 Registration Rights Agreement, dated May 19, 1998, among Primus Telecommunications Group, Incorporated, Primus Telecommunications, Incorporated, Primus Telecommunications Pty. Ltd. and Lehman Brothers, Inc.; Incorporated by reference to Exhibit 10.23 of the 1998 Senior Note Registration Statement.
10.15 Primus Telecommunications Group, Incorporated-TresCom International Stock Option Plan Incorporated by reference to Exhibit 4.1 of the S-8 Registration Statement. **
10.16 Warrant Agreement between the Company and Warburg, Pincus Investors, L.P.; Incorporated by reference to Exhibit 10.6 to the TresCom For S-1.
10.17 Form of Indemnification Agreement between the Company and its directors and executive officers Incorporated by reference to Exhibit 10.23 to the TresCom Form S-1.
10.18 The Company's 1998 Restricted Stock Plan; Incorporated by reference to Exhibit 10.33 to Amendment No. 1 to the Company's Registration Statement on Form S-3, No. 333-86839, filed with the Commission on September 17, 1999.
10.19 Agreement for the Reciprocal Purchase of Capacity On the Systems of Each of the Company and Global Crossing Holdings Ltd. Effective as of May 24, 1999. *
10.20 Indefeasible Right of Use Agreement between Primus Telecommunications, Inc. and Qwest Communications Corporation dated December 30, 1999. ***
10.21 Common Stock Purchase Agreement between the Company and Pilot Network Services, Inc. dated December 28, 1999. *
10.22 Warrant to purchase up to 200,000 shares of common stock of Pilot Network Services, Inc. dated December 28, 1999. *
10.23 Loan Agreement between Primus Telecommunications, Inc. and NTFC Capital Corporation dated November 22, 1999. *
10.24 Resale Registration Rights Agreement among the Company, certain of its subsidiaries, Lehman Brothers Inc., Merrill Lynch, Pierce, Fenner & Smith, Incorporated and Morgan Stanley & Co. Incorporated dated February 24, 2000.*
10.25 Multi-Currency Credit Facility Agreement between Primus Telecommunication Limited and Ericsson I.F.S. *
21.1 Subsidiaries of the Registrant. *
23.1 Independent Auditors' Consent. *
27.1 Financial Data Schedule for the Company for the year ended December 31, 1999. *
------------------------------------------------------------------------ * Filed herewith ** Compensatory benefit plan *** Confidential treatment has been requested. The copy filed as an exhibit omits the information subject to the confidential treatment request.
SIGNATURES
Pursuant to the requirements of the Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on behalf by the undersigned, thereunto duly authorized.
PRIMUS TELECOMMUNICATIONS GROUP, INCORPORATED
By: /s/ K. Paul Singh Chairman of the Board, President and ----------------- K. Paul Singh Chief Executive Officer
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints K. Paul Singh and Neil L. Hazard, and each of them, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities to sign any and all amendments to this Form 10-K of the Securities and Exchange Commission for the fiscal year of Primus Telecommunications Group, Incorporated ended December 31, 1999, and to file the same, with all exhibits thereto, and other documents in connection therewith, with authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or either of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated.
INDEX TO FINANCIAL STATEMENTS, SCHEDULE AND EXHIBITS
Page ----
Independent Auditors' Report
Consolidated Financial Statements:
Consolidated Statements of Operations for the years ended December 31, 1999, 1998, and 1997
Consolidated Balance Sheets as of December 31, 1999 and 1998
Consolidated Statements of Stockholders' Equity for the years ended December 31, 1999, 1998, and 1997
Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998, and 1997
Consolidated Statements of Comprehensive Loss for the years ended December 31, 1999, 1998 and 1997
Notes to Consolidated Financial Statements
Consolidated Financial Statement Schedules:
Schedule II. Valuation and Qualifying Accounts Financial Statement Schedule S-1
Exhibits:
Exhibit 27.1 - Financial Data Schedule E-1
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of Primus Telecommunications Group, Incorporated
We have audited the accompanying consolidated balance sheets of Primus Telecommunications Group, Incorporated and subsidiaries (the "Company") as of December 31, 1999 and 1998, and the related consolidated statements of operations, stockholders' equity, comprehensive loss and cash flows for each of the three years in the period ended December 31, 1999. Our audits also included the financial statement schedule on page S-1. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Primus Telecommunications Group, Incorporated and subsidiaries as of December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
DELOITTE & TOUCHE LLP McLean, Virginia February 10, 2000, except for Note 17 as to which the date is March 13, 2000
PRIMUS TELECOMMUNICATIONS GROUP, INCORPORATED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share amounts)
See notes to consolidated financial statements.
PRIMUS TELECOMMUNICATIONS GROUP, INCORPORATED CONSOLIDATED BALANCE SHEETS (in thousands, except share amounts)
See notes to consolidated financial statements.
PRIMUS TELECOMMUNICATIONS GROUP, INCORPORATED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (in thousands)
See notes to consolidated financial statements.
PRIMUS TELECOMMUNICATIONS GROUP, INCORPORATED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)
See notes to consolidated financial statements.
PRIMUS TELECOMMUNICATIONS GROUP, INCORPORATED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS (in thousands)
See notes to consolidated financial statements.
PRIMUS TELECOMMUNICATIONS GROUP, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND BUSINESS
Primus Telecommunications Group, Incorporated ("Primus" or the "Company") is a facilities-based total service provider offering bundled international and domestic Internet, data and voice services to business and residential retail customers and other carriers located in the United States, Canada, Brazil, Mexico, Puerto Rico, the United Kingdom, continental Europe, Australia and Japan. The Company is incorporated in the state of Delaware and operates as a holding company of operating subsidiaries in North America, Europe and the Asia- Pacific region.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation--The consolidated financial statements include the accounts of the Company and its wholly-owned and majority-owned subsidiaries. All material intercompany profits, transactions, and balances have been eliminated in consolidation. There are minority shareholders representing outside ownership of 49% of the common stock of Matrix Internet, S.A. ("Matrix") and 49% of Cards & Parts Telecom GmbH ("Cards & Parts").
Revenue Recognition and Deferred Revenue--The Company records revenue from the sale of telecommunications services at the time of customer usage primarily based upon minutes of use. The Company records payments received in advance for prepaid calling card services and services to be provided under contractual agreements, such as Internet broadband and dial-up access, as deferred revenue in accrued expenses and other current liabilities until such related services are provided. Net revenue represents gross revenue net of estimated uncollectible amounts.
Cost of Revenue--Cost of revenue includes network costs that consist of access, transport, and termination costs. The majority of the Company's cost of revenue is variable, primarily based upon minutes of use, with transmission and termination costs being the most significant expense. Such costs are recognized when incurred in connection with the provision of telecommunications services.
Foreign Currency Translation--The assets and liabilities of the Company's foreign subsidiaries are translated at the exchange rates in effect on the reporting date, and income and expenses are translated at the average exchange rate during the period. The net effect of such translation gains and losses are reflected within accumulated other comprehensive loss in the stockholders' equity section of the balance sheet.
Cash and Cash Equivalents--Cash and cash equivalents are comprised principally of amounts in money market accounts, operating accounts, certificates of deposit, and overnight repurchase agreements, stated at cost which approximates market value, with original maturities of three months or less.
Restricted Investments -- Restricted investments consist of United States Federal Government-backed obligations which are recorded at amortized cost. These securities are classified as held-to-maturity and are restricted to satisfy certain interest obligations on the Company's 1997 Senior Notes.
Advertising Costs -- In accordance with Statement of Position 93-7, Reporting on Advertising Costs, costs for advertising are expensed as incurred except for direct response advertising costs, which are capitalized and amortized over the expected period of future benefits.
Property and Equipment--Property and equipment is recorded at cost less accumulated depreciation, which is provided on the straight-line method over the estimated useful lives of the assets. Cost includes major expenditures for improvements and replacements which extend useful lives or increase capacity of the assets as well as expenditures necessary to place assets into readiness for use. Expenditures for maintenance and repairs are expensed as incurred. The estimated useful lives of property and equipment are as follows: network equipment, including fiber optic and submarine cable--5 to 25 years, furniture and
equipment--5 years, leasehold improvements and leased equipment--shorter of lease or useful life. In accordance with Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, costs for internal use software that are incurred in the preliminary project stage and in the post-implementation stage are expensed as incurred. Costs incurred during the application development stage are capitalized and amortized over the estimated useful life of the software.
Fiber Optic and Submarine Cable Arrangements--The Company obtains capacity on certain fiber optic and submarine cables under two types of arrangements. The Indefeasible Right of Use Agreement ("IRU Agreement") basis provides the Company the right to use a cable for the estimated economic life of the asset according to the terms of the IRU Agreement with most of the rights and duties of ownership. The Company accounts for such agreements under Network Equipment and depreciates the recorded asset over the term of the IRU Agreement. The Company also enters into shorter-term arrangements with other carriers which provides the Company the right to use capacity on a cable but without any rights and duties of ownership. The Company accounts for such arrangements as operating leases.
Goodwill and Other Intangible Assets--Goodwill is amortized over 7 to 30 years on a straight-line basis, and customer lists over the estimated run-off of the customer bases not to exceed five years. The Company periodically evaluates the realizability of intangible and other long-lived assets. In making such evaluations, the Company compares certain financial indicators such as expected undiscounted future revenues and cash flows to the carrying amount of the assets. The Company believes that no impairments exist as of December 31, 1999.
Deferred Financing Costs--Deferred financing costs incurred in connection with the October 1999 Senior Notes, the January 1999 Senior Notes, the 1998 Senior Notes and the 1997 Senior Notes are reflected within other assets and are being amortized over the life of the respective Senior Notes using the straight-line method which does not differ materially from the effective interest method.
Stock-Based Compensation--The Company adopted Statement of Financial Accounting Standards No. 123 ("SFAS 123"), Accounting for Stock-Based Compensation. Under the provisions of SFAS 123, the Company continues to measure compensation expense for its stock-based employee compensation plans using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and has provided in Note 12 pro forma disclosures of the effect on net loss and loss per share as if the fair value- based method prescribed by SFAS 123 had been applied in measuring compensation expense.
Use of Estimates--The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of net revenue and expenses during the reporting period. Actual results may differ from these estimates.
Concentration of Credit Risk--Financial instruments that potentially subject the Company to concentration of credit risk principally consist of trade accounts receivable. The Company performs ongoing credit evaluations of its customers but generally does not require collateral to support customer receivables. The Company maintains its cash with high quality credit institutions, and its cash equivalents are in high quality securities.
Income Taxes--The Company recognizes income tax expense for financial reporting purposes following the asset and liability approach for computing deferred income taxes. Under this method, the deferred tax assets and liabilities are determined based on the difference between financial reporting and tax bases of assets and liabilities based on enacted tax rates. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.
Net Loss Per Share--The Company has computed basic and diluted net loss per share using the weighted average number of shares of common stock outstanding during the period. Potential common stock, for purposes of determining diluted net loss per share, would include, where applicable, the effects of dilutive stock options, warrants, and convertible securities, and the effect of such potential common stock would be computed using the treasury stock method or the if-converted method. None of the Company's outstanding options and warrants are considered to be dilutive.
New Accounting Pronouncements--In June 1998, Statement of Financial Accounting Standards No. 133 ("SFAS 133"), Accounting for Derivative Instruments and Hedging Activities was issued. SFAS 133 established standards for the accounting and reporting of derivative instruments and hedging activities and requires that all derivative financial instruments, including certain derivative instruments embedded in other contracts, be measured at fair value and recognized as assets or liabilities in the financial statements. SFAS 133 will be adopted by the Company during fiscal 2001, and the Company is currently evaluating the impact of such adoption. However, the Company does not believe the adoption of SFAS 133 will have a material effect on the Company's consolidated financial position or results of operations in fiscal year 2000.
Costs of Start-Up Activities--The Company expenses the costs of start-up activities and organization costs as incurred. The effect of adopting Statement of Position 98-5, Reporting on the Costs of Start-Up Activities, during fiscal year 1999 did not have a material effect on the financial position, results of operation or liquidity of the Company.
Reclassifications--Certain previous year amounts have been reclassified to conform with current year presentation.
3. ACQUISITIONS
In November 1999, the Company purchased substantially all of the assets of Digital Select, LLC ("Digital Select"), a provider of digital subscriber line ("DSL") high-speed Internet access and Web content services. The purchase price of $7.8 million was paid with $5.6 million in cash, the issuance of a $0.7 million short-term promissory note and 69,023 shares of the Company's common stock valued based on a 20 day trailing average of the last sale price of the Company's common stock.
In November 1999, the Company purchased substantially all of the assets of 1492 Technologies, LLC ("1492 Technologies"), an Internet Web site development and service firm. The purchase price of $0.6 million was paid for with $0.3 million in cash and 15,500 shares of the Company's common stock valued based on a 20 day trailing average of the last sale price of the Company's common stock.
In November 1999, the Company invested $12.1 million in cash in exchange for 51% of Matrix, Brazil's largest independent and fifth largest overall Internet service provider ("ISP").
In September 1999, the Company acquired TouchNet GmbH ("TouchNet"), a German ISP with a Point of Presence ("POP") in Munich, Germany, for a cash purchase price of $2.2 million. Through this acquisition, the Company acquired approximately 3,000 business customers in Germany.
In September 1999, the Company purchased 51% of Cards & Parts, a German wireless reseller for a cash purchase price of $4.3 million.
In June 1999, the Company acquired the global retail customer business of Telegroup, Inc. including the acquisition of selected Telegroup, Inc. foreign subsidiaries ("Telegroup"). The Company paid the $73.2 million purchase price for Telegroup, plus $23.3 million for certain current assets including accounts receivable, by issuing $45.5 million in aggregate principal of 11 1/4% senior notes due 2009 ("Telegroup Notes"), by issuing a $4.6 million short-term promissory note ("Telegroup Promissory Note") and paying $46.4 million in cash.
In June 1999, the Company acquired Telephone Savings Network Limited ("TelSN"), a Canadian reseller of local services to small- and medium-sized business customers, for a purchase price of $5.3 million comprised of $2.6 million in cash and 152,235 shares of the Company's common stock. In October 1999 and February 2000, pursuant to an earn-out provision of the purchase agreement, the Company issued an additional 57,391 shares of the Company's common stock. There are two other potential earn-out distributions through January 15, 2001.
In May 1999, the Company purchased the residential long distance customer base, customer support assets and residential Internet customer base and network of AT&T Canada and ACC Telenterprises ("AT&T Canada") for a purchase price of $37.5 million comprised of $27.9 million in cash and a $9.6 million, 8.5% promissory note due November 30, 2000 ("AT&T Promissory Note").
In May 1999, the Company acquired all of the outstanding shares of Tele- Communications Products/Internet Provider (TCP/IP) GmbH ("TCP/IP"), an independent German ISP with over 20 POPs in Germany, for a purchase price of $0.4 million in cash.
On March 31, 1999 the Company purchased the common stock of London Telecom Network, Inc. and certain related entities that provide long distance telecommunications services in Canada (the "LTN Companies"), for approximately $36.3 million in cash (including payments made in exchange for certain non- competition agreements). In addition, on March 31, 1999, the Company entered into an agreement to purchase for $14.6 million in cash substantially all of the operating assets of Wintel CNC Communications, Inc. and Wintel CNT Communications, Inc. (the "Wintel Companies"), which are Canada-based long distance telecommunications providers affiliated with the LTN Companies. The purchase price may be increased by up to $4.6 million in cash pursuant to an earn-out provision in the event the acquired company achieves certain levels of future operating results. Such amount will be recorded as additional cost of the acquired company when the amount to be paid, if any, becomes probable. At December 31, 1999, no amount has been accrued since the final outcome of the earn-out provision was not determinable.
In February 1999 the Company acquired GlobalServe Communications, Inc., ("GlobalServe") a privately held ISP based in Toronto, Canada. The purchase price of approximately $4.5 million was comprised of $2.3 million in cash and 142,806 shares of the Company's common stock. As a result of the acquisition, the Company now serves approximately 30,000 Internet customers in Canada.
On June 9, 1998 the Company acquired TresCom International, Inc. ("TresCom"), a long distance telecommunications carrier focused on international long distance traffic originating in the United States and terminating in the Caribbean and Central and South America regions. As a result of the acquisition, all of the approximately 12.7 million TresCom common shares outstanding were exchanged for approximately 7.8 million shares of the Company's common stock valued at approximately $138 million. An additional $11.7 million cash purchase obligation associated with a subsidiary of TresCom was paid during 1999.
In March 1998 the Company purchased a 60% controlling interest in Hotkey Internet Services Pty., Ltd. ("Hotkey"), a Melbourne, Australia-based ISP for approximately $1.4 million in cash. In February 1999, the Company purchased the remaining 40% for approximately $1.2 million, comprised of $0.4 million in cash and 57,025 shares of the Company's common stock.
Effective March 1, 1998 the Company acquired all of the outstanding stock of Eclipse Telecommunications Pty., Ltd. ("Eclipse"), a data communications provider in Australia. The Company paid approximately $1.8 million in cash and 27,500 shares of the Company's common stock for Eclipse.
The Company has accounted for all of these acquisitions using the purchase method of accounting and, accordingly the net assets and results of operations of the acquired companies have been included in the Company's financial statements since the acquisition dates. The purchase price, including direct costs, of the Company's acquisitions was allocated to assets acquired, including intangible assets and liabilities assumed, based on their respective fair values at the acquisition dates. The valuation of the Company's acquired assets and liabilities for the 1999 acquisitions are preliminary, and as a result, the allocation of the acquisition costs among tangible and intangible assets may change.
The following reflects the December 31, 1999 gross balances of goodwill and customer lists as of the acquisition date for the acquisitions that were completed in 1999 and 1998 (in thousands):
1999 Acquisitions Goodwill Customer List - ----------------- --------------- ---------------
Telegroup $ 53,667 $ 17,876 LTN and Wintel Companies 45,006 11,840 AT&T Canada 23,022 23,556 DigitalSelect 8,000 - Matrix Internet 4,504 3,468 TelSN 5,131 1,032 GlobalServe 4,467 1,385 Cards & Parts 4,016 - Other acquisitions 5,704 - --------------- --------------- Total $ 153,517 $ 59,157 =============== ===============
1998 Acquisitions - -----------------
Trescom $ 155,700 $ 25,000 Other acquisitions 3,111 459 --------------- --------------- Total $ 158,811 $ 25,459 =============== ===============
The following represents the unaudited pro forma results of operations of the Company for 1999 and 1998 as if the acquisitions were consummated on January 1, 1998 and January 1, 1999. The unaudited pro forma results of operations include certain pro forma adjustments, including the amortization of intangible assets relating to the acquisitions. The unaudited pro forma results of operations do not necessarily reflect the results that would have occurred had the acquisitions occurred at January 1, 1998 and January 1, 1999 or the results that may occur in the future.
4. PROPERTY AND EQUIPMENT
Property and equipment consist of the following (in thousands):
Depreciation and amortization expense for Property and Equipment for the years ended December 31, 1999, 1998, and 1997 was $30.4 million, $16.0 million and $4.9 million, respectively.
Equipment under capital leases totaled $29.1 million and $27.0 million with accumulated depreciation of $8.3 million and $4.3 million at December 31, 1999 and 1998, respectively.
5. GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill and other intangible assets consist of the following (in thousands):
Amortization expense for Goodwill and Other Intangible Assets for the years ended December 31, 1999, 1998 and 1997 was $24.6 million, $8.2 million and $1.8 million, respectively.
6. LONG-TERM OBLIGATIONS
Long-term obligations consist of the following (in thousands):
In October 1999, the Company completed the sale of $250 million in aggregate principal amount of 12 3/4% senior notes due 2009 ("October 1999 Senior Notes"). The October 1999 Senior Notes are due October 15, 2009. In addition, prior to October 15, 2002, the Company may redeem up to 35% of the original principal amount of the October 1999 Senior Notes at 112.750% of the principal amount thereof, plus accrued and unpaid interest through the redemption date. Interest is payable each October 15th and April 15th.
In June 1999, in connection with the Telegroup acquisition, the Company issued the Telegroup Notes, $45.5 million in aggregate principal amount of the Company's 11 1/4% senior notes due 2009 pursuant to the January 1999 Senior Notes indenture.
In January 1999, the Company completed the sale of $200 million aggregate principal amount of 11 1/4% senior notes due 2009 ("January 1999 Senior Notes"). The January 1999 Senior Notes are due January 15, 2009 with early redemption at the option of the Company at any time after January 15, 2004. In addition, prior to January 15, 2002, the Company may redeem up to 35% of the original principal amount of the January 1999 Senior Notes at 111.25% of the principal amount thereof, plus accrued and unpaid interest through the redemption date. Interest is payable each January 15th and July 15th.
During the year ended December 31, 1999, NTFC Capital Corporation and Ericsson Financing Plc has provided to the Company $30.0 million and $34.3 million, respectively, in financing to fund the purchase of network equipment, secured by the equipment purchased. At December 31, 1999, approximately $24.4 million was utilized through NTFC Capital Corporation. Borrowings under these credit facilities accrue interest at rates ranging from 10.93% to LIBOR plus 5.8% and are payable over a 5-year term.
Other long-term obligations include the $9.6 million, 8.5% AT&T Promissory Note due November 30, 2000.
As a result of the acquisition of TresCom, the Company had a $25 million revolving credit and security agreement (the "Revolving Credit Agreement") with a commercial bank secured by certain of the Company's accounts receivable. In January 1999, the Company voluntarily repaid in full and terminated the Revolving Credit Agreement.
On May 19, 1998 the Company completed the sale of $150 million 9 7/8% senior notes ("1998 Senior Notes") due 2008 with semi-annual interest payments due on May 15th and November 15th.
On August 4, 1997, the Company completed the sale of $225 million 11 3/4% senior notes ("1997 Senior Notes") due 2004 and warrants to purchase 392,654 shares of the Company's common stock. Interest payments are due semi-annually on February 1st and August 1st.
7. INCOME TAXES
The differences between the tax provision calculated at the statutory federal income tax rate and the actual tax provision for each period is shown in the table below (in thousands):
The significant components of the Company's deferred tax assets and liabilities are as follows (in thousands):
Deferred tax liabilities: Depreciation $ 11,685 $ 361 ---------- ---------- $ 11,685 $ 361 ---------- ----------
Net deferred taxes $ - $ 361 ========== ==========
During the year ended December 31, 1999, the valuation allowance increased by approximately $52.3 million primarily due to additional net operating loss carryforwards which are not more likely than not to be realized.
At December 31, 1999, the Company had operating loss carryforwards available to reduce future federal taxable income which expire as follows (in millions):
Year Primus TresCom -------------- -------------- --------------
2009 $ 0.3 $ 5.8 2010 1.7 5.4 2011 5.9 1.9 2012 28.0 11.6 2018 62.6 33.6 2019 102.5 - -------------- -------------- $201.0 $ 58.3 ============== ==============
Approximately $58.3 million of operating loss carryforwards relate to the acquisition of TresCom. Utilization of these operating losses is limited to the offset of future TresCom operating income. The Company's net operating loss carryforwards for state purposes are not significant and, therefore, have not been recorded as deferred tax assets.
No provision was made in 1999 for U.S. income taxes on the undistributed earnings of the foreign subsidiaries as it is the Company's intention to utilize those earnings in the foreign operations for an indefinite period of time or to repatriate such earnings only when tax effective to do so. It is not practicable to determine the amount of income or withholding tax that would be payable upon the remittance of those earnings.
8. FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts reported in the consolidated balance sheet for cash and cash equivalents, restricted investments, accounts receivable and accounts payable approximate fair value. The estimated fair value of the Company's 1999, 1998 and 1997 Senior Notes (carrying value of $869 million), based on quoted market prices, at December 31, 1999 was $852 million. The estimated fair value of the Company's 1998 and 1997 Senior Notes (carrying value of $373 million), based on quoted market prices, at December 31, 1998 was $375 million.
9. ADVERTISING
The Company expenses advertising costs as incurred except for direct-response advertising costs, which are capitalized and amortized over the expected period of future benefits. Direct response advertising consists primarily of direct- mail advertisements, newspaper and television advertising. These costs are amortized over the lesser of the life of the customers obtained from these efforts or twelve months following the provisioning of the customer. At December 31, 1999 and 1998, $16.8 million and $4.2 million were included in prepaid expenses and other current assets. Advertising expense for the years ended December 31, 1999, 1998 and 1997 was $24.8 million, $11.7 million, and $10.4 million, respectively.
10. COMMITMENTS AND CONTINGENCIES
Future minimum lease payments under capital lease obligations and non-cancelable operating leases as of December 31, 1999 are as follows (in thousands):
Capital Operating Year Ending December 31, Leases Leases - ------------------------ ------------- ------------- 2000 8,668 11,356 2001 8,968 8,910 2002 8,138 7,346 2003 5,117 5,466 2004 1,554 4,405 Thereafter - 3,481 ------------- ------------- Total minimum lease payments 32,445 40,964 ============= Less: Amount representing interest (5,326) ------------- 27,119 =============
Rent expense under operating leases was $9.2 million, $4.8 million, and $2.6 million for the years ended December 31, 1999, 1998 and 1997, respectively.
In December 1999, the Company agreed to purchase approximately $23.2 million of fiber capacity from Qwest Communications which will provide the Company with an ATM+IP based nationwide broadband backbone of nearly 11,000 route miles of fiber optic cable in the U.S. as well as private Internet peering at select sites in the U.S. and overseas. As of December 31, 1999, the Company has made no purchases under this agreement.
On December 9, 1999, Empresa Hondurena de Telecommunicaciones, S.A., based in Honduras, filed suit in Florida State Court in Broward County against TresCom and one of TresCom's wholly-owned subsidiaries, St. Thomas and San Juan Telephone Company, alleging that such entities failed to pay amounts due to plaintiff pursuant to contracts for the exchange of telecommunications traffic during the period from December 1996 through September 1998. The Company acquired TresCom in June 1998 and TresCom is currently the Company's subsidiary. Plaintiff is seeking approximately $14 million in damages, plus legal fees and costs. The Company filed an answer on January 25, 2000 and discovery has recently commenced. Because it is only in the early stages of discovery, the Company's ultimate legal and financial liability with respect to such legal proceeding cannot be estimated with any certainty at this time. The Company intends to defend the case vigorously. Management believes the ultimate resolution of this matter will not have an adverse effect on the Company's consolidated financial position or results of operations.
The Company is subject to certain other claims and legal proceedings that arise in the ordinary course of its business activities. Each of these matters is subject to various uncertainties, and it is possible that some of these matters may be decided unfavorably to the Company. Management believes that any liability that may ultimately result from the resolution of these matters will not have material adverse effect on the financial condition or results of operations or cash flows of the Company.
11. STOCKHOLDERS' EQUITY
In October 1999, the Company sold 8.0 million shares of the Company's common stock at a price of $22.50 per share. The net proceeds from the sale were approximately $169.3 million.
In December 1998, the Company adopted a Stockholders' Rights Plan (the "Rights Plan") under which preferred stock purchase rights have been granted to the Company's common stockholders of record at the close of business on December 31, 1998. The rights will become exercisable if a person or group becomes the beneficial owner of more than 20% of the outstanding common stock of the Company or announces an offer to become the beneficial owner of more than 20% of the outstanding common stock of the Company.
In June 1998, the Company issued 7,836,324 shares of its common stock, valued at $137.6 million, in exchange for all of the outstanding common shares of TresCom. Additionally, the Board amended the Company's Amended and Restated Certificate of Incorporation (the "Certificate") to increase the authorized Common Stock to 80,000,000 shares.
In October 1997, the Company issued 1,842,941 shares of its common stock pursuant to the exercise of certain warrants, which had been issued in connection with the Company's $16 million July 1996 private equity sale. In connection with such exercise, the Company received approximately $1.5 million.
In August 1997, the Company completed a Senior Notes and Warrants Offering. Warrants valued at $2,535,000 to purchase 392,654 shares of the Company's common stock at a price of $ 9.075 per share were issued.
12. STOCK-BASED COMPENSATION
In December 1998, the Company established the 1998 Restricted Stock Plan (the "Restricted Plan") to facilitate the grant of restricted stock to selected individuals who contribute to the development and success of the Company. The total number of shares of common stock that may be granted under the Restricted Plan is 750,000.
The Company sponsors an Employee Stock Option Plan (the "Employee Plan"). The total number of shares of common stock authorized for issuance under the Employee Plan is 5,500,000. Under the Employee Plan, awards may be granted to key employees of the Company and its subsidiaries in the form of Incentive Stock Options or Nonqualified Stock Options. The Employee Plan allows the granting of options at an exercise price of not less than 100% of the stock's fair value at the date of grant. The options vest over a period of up to three years, and no option will be exercisable more than ten years from the date it is granted.
The Company sponsors a Director Stock Option Plan (the "Director Plan") for non-employee directors. Under the Director Plan, an option is granted to each qualifying non-employee director to purchase 15,000 shares of common stock, which vests over a two-year period. The option price per share is the fair market value of a share of common stock on the date the option is granted. No option will be exercisable more than ten years from the date of grant. An aggregate of 338,100 shares of common stock was reserved for issuance under the Director Plan.
A summary of stock option activity during the three years ended December 31, 1999 is as follows:
The following table summarizes information about stock options outstanding at December 31, 1999:
The weighted average fair value at date of grant for options granted during 1999, 1998 and 1997 was $7.99, $7.38 and $5.45 per option, respectively. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:
1999 1998 1997 ---- ---- ---- Expected dividend yield 0% 0% 0% Expected stock price volatility 85% 97% 80% Risk-free interest rate 6.3% 4.6% 5.7% Expected option term 4 years 4 years 4 years
If compensation cost for the Company's grants for stock-based compensation had been recorded consistent with the fair value-based method of accounting per SFAS 123, the Company's pro forma net loss, and pro forma basic and diluted net loss per share for the years ending December 31, would be as follows:
1999 1998 1997 ---------- ---------- ---------- Net loss (amounts in thousands) As reported $(112,736) $(63,648) $ (36,239) Pro forma $(119,241) $(67,621) $ (37,111)
Basic and diluted net loss per share As reported $(3.72) $(2.61) $ (1.99) Pro forma $(3.93) $(2.77) $ (2.03)
13. EMPLOYEE BENEFIT PLANS
The Company sponsors a 401(k) employee benefit plan (the "401(k) Plan") that covers substantially all United States based employees. Employees may contribute amounts to the 401(k) Plan not to exceed statutory limitations. The 401(k) plan provides an employer matching contribution of 50% of the first 6% of employee annual salary contributions. The employer match is made in common stock of the Company and is subject to 3-year cliff vesting. The Company contributed Primus common stock valued at approximately $328,000, $119,000, and $45,000 during 1999, 1998, and 1997, respectively.
Effective January 1, 1998, the Company adopted an Employee Stock Purchase Plan ("ESPP"). The ESPP allows employees to contribute up to 15% of their compensation to be used toward purchasing the Company's common stock at 85% of the fair market value. An aggregate of 2,000,000 shares of common stock were reserved for issuance under the ESPP.
14. RELATED PARTIES
In June 1998, a subsidiary of the Company entered into a $2.1 million agreement for the design, manufacture, installation and the provision of training with respect to a satellite earth station in London. A Director of the Company is the Chairman and a stockholder of the company providing such services. During 1998, $1.2 million was paid for the above services. Pursuant to this agreement, in June 1999 the Company also contracted with this company to provide two satellite earth stations in Australia and to provide, operate and maintain a satellite link between the Company's router in Los Angeles, California and the two earth stations. An approximately $200,000 one-time charge is to be paid by the Company in addition to a monthly charge of $144,000.
15. OPERATING SEGMENT AND RELATED INFORMATION
The Company has three reportable operating segments based on management's organization of the enterprise into geographic areas - North America, Asia- Pacific and Europe. The Company evaluates the performance of its segments and allocates resources to them based upon net revenue and operating income/(loss). The accounting policies of the segments are the same as those described in the summary of significant accounting policies. Net revenue by reportable segment is reported on the basis of where services are provided. The Company has no single customer representing greater than 10% of its revenues. Operations and assets of the North America segment include shared corporate functions and assets, which the Company does not allocate to its other geographic segments for management reporting purposes.
Summary information with respect to the Company's segments is as follows (in thousands):
The above capital expenditures exclude assets acquired in business combinations and under terms of capital leases.
16. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
The following is a tabulation of the unaudited quarterly results of operations for the two years ended December 31, 1999 and 1998:
17. SUBSEQUENT EVENTS
In February 2000, the Company completed the sale of $250 million in aggregate principal amount of 5 3/4% Convertible Subordinated Debentures due 2007 ("February 2000 Debentures") with semi-annual interest payments. On March 13, 2000, the Company announced that the initial purchasers of the February 2000 Debentures had exercised their $50 million over-allotment option granted pursuant to a purchase agreement dated February 17, 2000. The debentures are convertible into the Company's common stock at a price of $49.7913 per share.
In February 2000, the Company acquired 51% of each of CS Communications Systems GmbH and CS Network GmbH ("Citrus"), a reseller of voice traffic and seller of telecommunications equipment and accessories for $0.4 million, comprised of $0.3 million in cash and 2,092 shares of the Company's common stock.
In February 2000, the Company acquired over 96% of the common stock of LCR Telecom Group, Plc ("LCR Telecom"), in exchange for 2,100,920 shares of the Company's common stock valued at $85.9 million. The purchase price is subject to adjustment and may be increased to a total of 2,463,000 shares. LCR Telecom operates principally in European markets and is an international telecommunications company providing least cost routing, international callback and other value added services, primarily to small- and medium-sized enterprises.
In January 2000, the Company acquired Infinity Online Systems ("Infinity"), an ISP based in Ontario, Canada, for $2.2 million, comprised of $1.1 million in cash and 29,919 shares of the Company's common stock.
In January 2000, in connection with a strategic business arrangement, the Company made a $15 million strategic investment in Pilot Network Services, Inc. ("Pilot") pursuant to which the Company purchased 919,540 shares, or 6.3%, of Pilot's common stock at a price of $16.3125 per share. The Company also received a warrant to purchase an additional 200,000 shares at $25.00 per share. K. Paul Singh, the Company's Chairman and Chief Executive Officer, has been elected to Pilot's Board of Directors. Pilot has agreed to configure the Company's network operations centers, hosting centers and data centers around the world with Pilot's proprietary Heuristic Defense Infrastructure(TM) (HDI) and to provide real time security on the Company's global network. In addition, Pilot will utilize the Company's network to provide secure access Web hosting, Application Service Provider (ASP) hosting and e-business services to its corporate clients.
SCHEDULE II PRIMUS TELECOMMUNICATIONS GROUP, INCORPORATED VALUATION AND QUALIFYING ACCOUNTS
Activity in the Company's allowance accounts for the years ended December 31, 1999, 1998 and 1997 was as follows (in thousands):
(1) Other additions represent the allowances for doubtful accounts, which were recorded in connection with business acquisitions.
S-1 | 29,107 | 195,540 |
100790_1999.txt | 100790_1999 | 1999 | 100790 | Item 1. Business
General-Union Carbide operates in two business segments of the chemicals and plastics industry, Specialties & Intermediates and Basic Chemicals & Polymers. Specialties & Intermediates converts basic and intermediate chemicals into a diverse portfolio of chemicals and polymers serving industrial customers in many markets. This segment also provides technology services, including licensing, to the oil and petrochemicals industries. The Basic Chemicals & Polymers segment converts hydrocarbon feedstocks, principally liquefied petroleum gas and naphtha, into ethylene or propylene used to manufacture polyethylene, polypropylene, ethylene oxide and ethylene glycol for sale to third-party customers, as well as ethylene, propylene, ethylene oxide and ethylene glycol for consumption by the Specialties & Intermediates segment. The profitability of the Basic Chemicals & Polymers segment of the chemicals and plastics industry is highly cyclical, whereas that of the Specialties & Intermediates segment is less cyclical. Consequently, Union Carbide's results are subject to the swings of the business cycle in both the highly volatile Basic Chemicals & Polymers segment and the less volatile Specialties & Intermediates segment. In addition to its business segments, the corporation's Other segment includes its noncore operations and financial transactions other than derivatives designated as hedges, which are included in the same segment as the item being hedged. See pages 1, 4, 5, and "Results of Operations" on pages 7 through 14 of the 1999 annual report to stockholders for further information about Union Carbide's businesses, and Note 6 on pages 30 and 31 of the 1999 annual report to stockholders for financial information about Union Carbide's business segments.
On August 3, 1999, the corporation and The Dow Chemical Company (Dow) entered into an Agreement and Plan of Merger providing for the merger of a subsidiary of Dow with and into the corporation. As a result of the merger, the corporation will become a wholly-owned subsidiary of Dow, and the corporation's shareholders will receive 0.537 of a share of Dow common stock for each share of UCC common stock they own as of the date of the merger. On March 6, 2000, Dow announced plans for a three-for-one split of its common stock, subject to the approval of Dow shareholders. If the record date for the stock split occurs prior to the merger, the number of shares of Dow common stock to be received for each share of UCC common stock will be proportionately adjusted. On December 1, 1999, UCC shareholders approved the merger agreement. The merger is subject to certain conditions including review by antitrust regulatory authorities in the United States, Europe and Canada. The transaction is intended to qualify as a tax- free reorganization for United States Federal income tax purposes and is expected to be accounted for under the pooling- of-interests method of accounting.
Union Carbide does not produce against a backlog of firm orders; production is geared primarily to the level of incoming orders and to projections of future demand. Inventories of finished products, work in process and raw materials are maintained to meet delivery requirements of customers and Union Carbide's production schedules.
At year-end 1999, 11,569 people were employed in the manufacturing facilities, laboratories and offices of the corporation and its consolidated subsidiaries around the world.
Raw Materials, Products and Markets-See information herein and in the 1999 annual report to stockholders on pages 4 and 5. All products and services are marketed throughout the world by the corporation's direct sales force, and where appropriate, augmented by a network of Union Carbide authorized distributors.
Union Carbide believes it has contracts or commitments for, or readily available sources of, hydrocarbon feedstocks and fuel supplies to meet its anticipated needs in all major product areas. The corporation's operations are dependent upon the availability of hydrocarbon feedstocks and fuels, which are purchased from diverse domestic and international sources, including independent oil and gas producers as well as integrated oil companies.
The availability and price of hydrocarbon feedstocks, energy and finished products are subject to plant interruptions and outages and to market and political conditions in the U.S. and elsewhere. Operations and products at times may be adversely affected by legislation, government regulations, shortages, or international or domestic events.
The business segments of Union Carbide are not dependent to a significant extent upon a single customer or a few customers.
Part I (Cont.)
Patents; Trademarks; Research and Development-Union Carbide owns a large number of United States and foreign patents that relate to a wide variety of products and processes, has pending a substantial number of patent applications throughout the world and is licensed under a number of patents. These patents expire at various times over the next 20 years. In the aggregate, such patents and patent applications are material to Union Carbide's competitive position. No one patent is considered to be material. Union Carbide also has a large number of trademarks. The UNION CARBIDE and UNIPOL trademarks are material; no other single trademark is material.
Essentially all of Union Carbide's research and development activities are company-sponsored. The principal research and development facilities of Union Carbide are indicated in the discussion of Properties (Item 2) of this Annual Report on Form 10-K. In addition to the facilities specifically indicated there, product development and process technology laboratories are maintained at some plants. Union Carbide expensed $154 million in 1999, $143 million in 1998, and $157 million in 1997 on company-sponsored research activities to develop new products, processes, or services, or to improve existing ones. Certain of Union Carbide's joint ventures conduct research and development within their business fields.
Environment-See Costs Relating to Protection of the Environment on page 14 of the 1999 annual report to stockholders and Note 17 on pages 42 and 43 thereof.
Insurance-Union Carbide's policy is to obtain public liability and other insurance coverage on terms and conditions and at a cost that management considers fair and reasonable. Union Carbide's management believes it has a prudent risk management policy in effect and it periodically reviews its insurance coverage as to scope and amount and makes adjustments as deemed necessary. There is no assurance, however, that Union Carbide will not incur losses beyond the limits, or outside the coverage, of its insurance. Such insurance is subject to substantial corporate retentions.
Competition-Each of the major product and service areas in which Union Carbide participates is highly competitive. In some instances competition comes from manufacturers of the same products as those produced by Union Carbide and in other cases from manufacturers of different products that may serve the same markets as those served by Union Carbide's products. Some of Union Carbide's competitors, such as companies principally engaged in petroleum operations, have more direct access to hydrocarbon feedstocks and some have greater financial resources than Union Carbide.
The Specialties & Intermediates segment is characterized by differentiated products and is less subject to external changes in supply/demand relationships than the Basic Chemicals & Polymers segment. In the Specialties & Intermediates segment, competition is based primarily on product functionality and quality, with the more unique products commanding more significant price premiums.
Products manufactured by the Specialties & Intermediates segment may compete with a few competitors in many products to many competitors in selected products. In all, approximately 24 other major specialty chemical companies manufacture products competitive with those of the Specialties & Intermediates segment.
The Basic Chemicals & Polymers segment is characterized by large volume commodity products and is subject to external changes in supply/demand relationships, including changes in the strength of the overall economy, customer inventory levels, industry manufacturing capacity and operating rates and raw material feedstock costs. Participants in this segment compete for business primarily on the basis of price and efficient delivery systems.
The Basic Chemicals & Polymers segment competes with at least 12 other major producers of basic chemicals.
See pages 4 and 5 of the 1999 annual report to stockholders for information about each segment's principal products.
Part I (Cont.)
Union Carbide is a major marketer of petrochemical products throughout the world. Products that the corporation markets are largely produced in the United States, while products marketed by the corporation's joint ventures are principally produced outside the United States. Competitive products are produced throughout the world.
Union Carbide's international operations face competition from local producers and global competitors and a number of risks inherent in carrying on business outside the United States, including regional and global economic conditions, risks of nationalization, expropriation, restrictive action by local governments and changes in currency exchange rates.
See Note 6 on pages 30 and 31 of the 1999 annual report to stockholders for a summary of business and geographic segment information.
Item 2.
Item 2. Properties
In management's opinion, current facilities, together with planned expansions, will provide adequate production capacity to meet Union Carbide's planned business activities. Capital expenditures are discussed on page 16 of the 1999 annual report to stockholders.
Listed on the following pages are the principal manufacturing facilities operated by Union Carbide worldwide. Research and engineering facilities are noted within each of the domestic and international descriptions below. Most of the domestic properties are held in fee. Union Carbide maintains numerous domestic sales offices and warehouses, the majority of which are leased premises, whose lease terms are scheduled to expire in five years or less. All principal international manufacturing properties are either owned or held under long- term leases. International administrative offices, technical service laboratories, sales offices and warehouses are owned in some instances and held under relatively short-term leases in other instances. The corporation's headquarters is located in Danbury, Connecticut and is leased.
Part I (Cont.)
Principal domestic manufacturing facilities and the principal products manufactured there are as follows:
Research and development for the Specialties & Intermediates segment is carried on at technical centers in Bound Brook and Somerset, New Jersey; Tarrytown, New York; Cary, North Carolina; Houston and Texas City, Texas; and South Charleston, West Virginia. Research and development for the Basic Chemicals & Polymers segment is carried on at technical centers in Bound Brook and Somerset, New Jersey; Houston, Texas; and South Charleston, West Virginia. Process and design engineering for both segments is conducted at technical centers in South Charleston, West Virginia and in Houston, Texas, in support of domestic and foreign projects.
Part I (Cont.)
Principal international manufacturing facilities and the principal products manufactured there are as follows:
Research and development for the Specialties & Intermediates segment is carried on at international facilities in Zwijndrecht, Belgium; Cubatao, Brazil; Montreal East, Canada; Jurong, Singapore; and Meyrin (Geneva), Switzerland.
Principal locations of the corporation's partnerships and corporate investments carried at equity and the principal products manufactured by those entities are as follows:
Specialties & Intermediates:
UOP LLC - a joint venture with Honeywell International, Inc., accounted for as a partnership, which is a leading worldwide supplier of process technology, catalysts, molecular sieves and adsorbents to the petrochemical and gas-processing industries. UOP LLC has manufacturing facilities in Mobile, Alabama; Des Plaines and McCook, Illinois; Shreveport, Louisiana; Tonawanda, New York; Leverkusen, Germany; Reggio di Calabria, Italy; and Brimsdown, United Kingdom. UOP has several joint ventures with manufacturing sites in Hiratsuka and Yokkaichi, Japan and Shanghai, China. Research and development is performed at locations in Des Plaines, Illinois and Mobile, Alabama.
Nippon Unicar Company Limited - a Japan-based producer of polyethylene and specialty polyethylene compounds and specialty silicone products. This joint venture with Tonen Chemical Corporation has manufacturing facilities in Kawasaki and Komatsu, Japan.
Aspell Polymeres SNC - a France-based producer of polyethylene and specialty polyethylene compounds. This partnership with Elf Atochem S.A., a subsidiary of Elf Aquitaine, has a manufacturing facility in Gonfreville, France.
World Ethanol Company - a U.S.-based partnership with Archer Daniels Midland Company that supplies ethanol worldwide. This partnership has manufacturing facilities in Texas City, Texas and Peoria, Illinois.
Part I (Cont.)
Univation Technologies, LLC - a U.S.-based joint venture, accounted for as a partnership, with ExxonMobil Chemical Company, a division of Exxon Mobil Corporation, for the licensing of polyethylene technology. Univation conducts research, development and commercialization activities on process technology and single site and other advanced catalysts for the production of polyethylene. The venture is also the sales agent for licensing of Union Carbide's UNIPOL technology. The company's headquarters is located in Houston, Texas. Research and development and engineering are performed at locations in Bound Brook, New Jersey; Baytown, Texas; Houston, Texas; and South Charleston, West Virginia. A catalyst manufacturing facility is located in Mont Belvieu, Texas.
Asian Acetyls, Co., Ltd. - a South Korea-based producer of vinyl acetate monomer used in the production of emulsion resins by customers in the coatings and adhesives industries. This corporate joint venture with BP Chemicals and Samsung Fine Chemicals Company has a manufacturing facility in Ulsan, South Korea.
OPTIMAL Chemicals (Malaysia) Sdn Bhd - a Malaysian corporate joint venture with Petroliam Nasional Berhad (PETRONAS) that is building a facility for the production of ethylene and propylene derivatives within a world-scale, integrated chemical complex in Kerteh, Terengganu, Malaysia. This corporate joint venture, along with two joint ventures in the corporation's Basic Chemicals & Polymers segment, OPTIMAL Olefins (Malaysia) Sdn Bhd and OPTIMAL Glycols (Malaysia) Sdn Bhd, form the OPTIMAL Group.
Basic Chemicals & Polymers:
Polimeri Europa S.r.l. - a Europe-based producer of olefins and polyethylene resins. This corporate joint venture with EniChem S.p.A. of Italy operates facilities at Brindisi, Ferrara, Gela, Priolo and Ragusa, Italy; Dunkirk, France; and Oberhausen, Germany. The venture is headquartered in Milan, Italy.
EQUATE Petrochemical Company K.S.C. - a corporate joint venture with Petrochemical Industries Company and Boubyan Petrochemical Company, which manufactures ethylene, polyethylene and ethylene glycol at its world-scale petrochemicals complex in Shuaiba, Kuwait.
Petromont and Company, Limited Partnership - a Canada-based olefins and polyethylene resins producer owned jointly with Ethylec Inc. This partnership has manufacturing facilities at Montreal and Varennes, Quebec, Canada.
Alberta & Orient Glycol Company Limited - a corporate joint venture with Mitsui & Co., Ltd., Japan, and Far Eastern Textile Ltd., Taiwan. This Canada-based producer of ethylene glycol has a manufacturing facility in Prentiss, Alberta, Canada.
OPTIMAL Olefins (Malaysia) Sdn Bhd and OPTIMAL Glycols (Malaysia) Sdn Bhd - Malaysian corporate joint ventures (part of the OPTIMAL Group) with PETRONAS that are building an ethane/propane cracker and an ethylene glycol facility, within a world-scale, integrated chemical complex in Kerteh, Terengganu, Malaysia.
Item 3.
Item 3. Legal Proceedings
See Note 17 of Notes to Financial Statements on pages 42 and 43 of the 1999 annual report to stockholders.
Part I (Cont.)
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
(a) Special Meeting of Shareholders held on December 1, 1999.
(c) Shareholders voted to adopt an agreement and plan of merger relating to a merger of a subsidiary of The Dow Chemical Company with and into the corporation.
The vote was:
FOR 99,929,931 shares or 97.66 percent of the shares voted AGAINST 2,398,978 shares or 2.34 percent of shares voted ABSTAIN 1,302,554 shares
Part II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
Market and dividend information for the corporation's common stock is contained on pages 18, 19 and 45 of the 1999 annual report to stockholders. Information about the stock exchanges where the stock is traded in the United States is listed on page 46 of the 1999 annual report to stockholders. The declaration of dividends is a business decision made from time to time by the Board of Directors based on the corporation's earnings and financial condition and other factors the Board considers relevant.
The number of stockholders of record of the corporation's common stock is contained on page 1 of the 1999 annual report to stockholders.
Item 6.
Item 6. Selected Financial Data
Information pertaining to consolidated operations is included under the captions "From the Income Statement" and "From the Balance Sheet" and dividend information is included under the caption "Other Data" in the Selected Financial Data on pages 18 and 19 of the 1999 annual report to stockholders.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
See the information in the 1999 annual report to stockholders, pages 7 through 17.
Item 7a.
Item 7a. Quantitative and Qualitative Disclosures About Market Risk
Information pertaining to Quantitative and Qualitative Disclosures About Market Risk is included under the caption "Interest Rate and Currency Risk Management" and "Foreign Operations" in Management's Discussion and Analysis on page 9 of the 1999 annual report to stockholders.
Item 8.
Item 8. Financial Statements and Supplementary Data
The consolidated balance sheet of Union Carbide Corporation and subsidiaries at December 31, 1999 and 1998 and the consolidated statements of income, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1999, together with the report thereon of KPMG LLP dated January 26, 2000, are contained on pages 20 through 44 of the 1999 annual report to stockholders.
Quarterly income statement data are contained on page 45 of the 1999 annual report to stockholders.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Union Carbide has not had any disagreements covered by this item with KPMG LLP, its independent auditors.
Part III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
For background information on the Directors of Union Carbide Corporation whose terms are expected to continue after the annual meeting of stockholders and persons nominated to become Directors, see pages 7 through 10 of the proxy statement for the annual meeting of stockholders to be held on April 26, 2000.
The principal executive officers of the corporation are as follows. Data is as of March 17, 2000.
There are no family relationships between any officers or directors of the corporation. There is no arrangement or understanding between any officer and any other person pursuant to which the officer was elected an officer. An officer is elected by the Board of Directors to serve until the next annual meeting of stockholders and until his successor is elected and qualified.
The table on the next page gives a summary of the positions held during at least the past five years by each officer. Each of the officers has been employed by the corporation for the past five years.
Part III (Cont.)
For additional information see "Section 16(a) Beneficial Ownership Reporting Compliance" on page 21 of the proxy statement for the annual meeting of stockholders to be held on April 26, 2000.
Item 11.
Item 11. Executive Compensation
See pages 17 through 19 of the proxy statement for the annual meeting of stockholders to be held on April 26, 2000.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
See pages 20 and 21 of the proxy statement for the annual meeting of stockholders to be held on April 26, 2000.
Item 13.
Item 13. Certain Relationships and Related Transactions
See page 10 of the proxy statement for the annual meeting of stockholders to be held on April 26, 2000.
Part IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
UNION CARBIDE CORPORATION
(a) The following documents are filed as part of this report:
1. The consolidated financial statements set forth on pages 20 through 43 and the Independent Auditors' Report set forth on page 44 of the 1999 annual report to stockholders are incorporated by reference in this Annual Report on Form 10-K.
2. The Report on Financial Statement Schedule of KPMG LLP appears on page 12 of this Annual Report on Form 10-K.
3. The following schedule should be read in conjunction with the consolidated financial statements incorporated by reference in Item 8 of this Annual Report on Form 10-K. Schedules other than those listed have been omitted because they are not applicable.
Page in this Annual Report on Form 10-K
Valuation and Qualifying Accounts (Schedule II), three years ended December 31, 1999 13
(b) The corporation filed the following Current Reports on Form 8-K for the three months ended December 31, 1999.
1. Current Report on Form 8-K dated October 25, 1999, contained the corporation's press release dated October 25, 1999.
2. Current Report on Form 8-K dated November 15, 1999, contained the corporation's press release dated November 15, 1999.
3. Current Report on Form 8-K dated December 1, 1999, contained the corporation's press release dated December 1, 1999.
(c) Exhibits - See Exhibit Index on pages 15 through 17 for exhibits filed with this Annual Report on Form 10-K.
Part IV (Cont.)
Report of Independent Auditors
The Board of Directors Union Carbide Corporation
Under date of January 26, 2000, we reported on the consolidated balance sheets of Union Carbide Corporation and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of income, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1999, as contained on pages 20 through 43 in the 1999 annual report to stockholders. These consolidated financial statements and our report thereon are incorporated by reference in the Annual Report on Form 10-K for the year 1999. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedule as listed in Item 14(a)3. This financial statement schedule is the responsibility of the corporation's management. Our responsibility is to express an opinion on this financial statement schedule based on our audits.
In our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
/s/ KPMG LLP KPMG LLP Stamford, Conn. January 26, 2000
Part IV (Cont.)
Schedule II-Valuation and Qualifying Accounts
Union Carbide Corporation and Consolidated Subsidiaries
Signatures
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Union Carbide Corporation
March 17, 2000
/s/John K. Wulff by: John K. Wulff Vice-President, Chief Financial Officer and Controller
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the corporation and in the capacities indicated on March 17, 2000.
Exhibit Index
Exhibit No.
Exhibit Index (Cont.)
Exhibit No.
Exhibit Index (Cont.)
Exhibit No.
Wherever an exhibit listed above refers to another exhibit or document (e.g., "See Exhibit 6 of . . ."), that exhibit or document is incorporated herein by such reference.
A copy of any exhibit listed above may be obtained on written request to the Secretary's Department, Union Carbide Corporation, 39 Old Ridgebury Road, Danbury, CT 06817-0001. The charge for furnishing any exhibit is 25 cents per page plus mailing costs.
UC-1981 PRINTED IN U.S.A. | 3,787 | 25,144 |
1045014_1999.txt | 1045014_1999 | 1999 | 1045014 | ITEM 1. BUSINESS
GENERAL
GameTech International, Inc., a Delaware corporation, ("GameTech" or the "Company"), designs, develops and markets interactive electronic bingo systems. The Company currently markets a fixed-base system with light-pen-activated monitors and portable hand-held systems that can be played anywhere within a bingo hall. GameTech had more than 6,000 fixed-base units and more than 40,000 hand-held units operating in Indian, charity and commercial bingo halls at October 31, 1999. Both bingo systems display electronic bingo card images that have been purchased and played by a player for each bingo game. The Company's electronic bingo units enable players to play substantially more bingo simultaneously than they can play on paper cards, leading to a greater spend per player and higher profit per bingo session for the bingo hall operator. GameTech installs the electronic bingo systems at no cost to the operator in exchange for a percentage of the sales generated by each unit. The Company typically enters into one to three year contracts pursuant to which the Company receives up to 30% of the revenues generated by GameTech units or charges fixed rates per bingo session.
The Company was founded in 1994 by executives previously involved in the bingo, slot machine, lottery and high technology software and hardware industries to pursue their belief that an advanced, interactive, electronic bingo system would be well received by both bingo hall operators and players. The Company believes its experienced management team, quality electronic bingo systems and its reputation for superior customer service and support enable it to compete effectively in the highly competitive bingo industry.
Electronic bingo systems such as GameTech's allow players to play more bingo per game than they can by hand, which provides bingo hall operators with the potential to increase profits commensurately. Nonprofit organizations sponsor bingo games for fund raising purposes, while Indian tribes, casinos and government-sponsored entities operate bingo games for profit. Bingo is a legal enterprise in 46 states (excluding Arkansas, Hawaii, Tennessee and Utah) and the District of Columbia. As of October 31, 1999, electronic bingo systems were permitted for use by charitable organizations in 38 states, and the Company had units in operation in charitable bingo halls in eight of those states. Under the Indian Gaming Regulatory Act ("IGRA"), in the 46 states where bingo is legal, electronic bingo may be played on tribal Indian lands as well. As of October 31, 1999, bingo was played on tribal Indian lands in 28 states and the Company had units in operation in Indian bingo halls in 13 of those states.
RECENT DEVELOPMENTS
On February 8, 1999, the Company acquired 100% of the common stock of Bingo Technologies Corporation ("BTC"). The purchase price of approximately $20.1 million, including transaction costs of $1.2 million, consisted of $10.0 million of cash, $4.0 million of unsecured promissory notes payable and the issuance of 1,866,938 shares of Common Stock. The acquisition included, among other things, goodwill of approximately $20.0 million that the Company is amortizing over a twelve-year period.
GameTech recently announced a new position of Director of International Markets to address opportunities in international markets. The Company currently has a small installed base in three countries outside of North America.
BUSINESS STRATEGY
The Company's growth strategies are to increase its revenues and earnings by capitalizing on the increasing acceptance of electronic bingo and to become the leading provider of electronic bingo units. To reach these objectives, the Company intends to:
MAINTAIN SUPERIOR CUSTOMER SERVICE. GameTech believes that its customer service programs enable it to maintain a high level of customer loyalty and satisfaction, which translates into long-term customer relationships. Approximately half of GameTech's employees are field technicians on call 24 hours a day to support customers and respond immediately to servicing calls. The Company believes that its dedication to superior customer service has contributed to the rapid acceptance of GameTech's products and its ability to attract and retain customers for the long term.
INCREASE PENETRATION WITH EXISTING CUSTOMERS. The Company closely tracks the utilization of its units to maximize revenues. As bingo player acceptance of electronic bingo units increases and utilization rates grow, management installs additional electronic bingo units at its customers' bingo halls. At a majority of the bingo halls where GameTech units have been in operation for more than six months, the number of units has been increased since the initial installation.
EXPAND CUSTOMER BASE IN EXISTING MARKETS. The Company estimates that approximately 5% of the more than $7 billion domestic bingo spend is currently played on electronic bingo units. In the states in which the Company has units installed in charitable bingo halls and for which data is available, GameTech units are used by less than 10% of the charitable halls located in those states. This low penetration level presents a significant growth opportunity for GameTech increasing its base of customers in its existing markets.
EXPAND INTO NEW MARKETS DOMESTICALLY. As of October 31, 1999, GameTech had charitable bingo hall customers in 25 of the 38 states, which currently allow charitable organizations to conduct electronic bingo. In addition, GameTech had Indian bingo hall customers in only 13 of the 28 states where bingo is currently played on Indian lands and is actively pursuing Indian bingo hall customers in two additional states. As part of its strategy to facilitate the expansion of the charity electronic bingo market, the Company is pursuing changes to legislation in several states to permit electronic bingo. In addition, the Company intends to expand the number of route operations to serve bingo halls that otherwise would be uneconomical to serve. The route operations move the Company's hand-held units between various charity bingo halls on days that the respective halls hold bingo sessions.
EXPAND INTERNATIONALLY. GameTech recently announced a new position of Director of International Markets to address opportunities in international markets. The Company currently has a small installed base in three countries outside of North America. GameTech is also pursuing expansion into the province of British Columbia, Canada. At the request of the British Columbia Lottery Corporation, the Company participated in a test of the hand-held bingo units in selected charitable bingo halls in the Province of British Columbia. GameTech is also evaluating opportunities to expand into other provinces in Canada and other countries.
DEVELOP NEW APPLICATIONS. GameTech maintains an ongoing product development program focused on enhancing its existing products and developing new products and applications for its technology. In July 1998, the Company introduced its Diamond operating system, which provides enhanced graphics to the fixed-base units. At the same time, the Company introduced the Diamond Plus fixed base unit, which incorporates picture-in-picture technology that allows bingo players to watch television while playing bingo.
DEVELOP STRATEGIC ALLIANCE/ACQUIRE COMPLEMENTARY COMPANIES. The Company selectively reviews opportunities to grow through the establishment of strategic alliances and acquisitions that could extend its presence into new geographic markets, expand its client base, add new products and/or provide
operating synergies. The Company also intends to pursue joint operating agreements or joint ventures for additional bingo opportunities.
PRODUCTS
The Company designs its bingo systems to generate maximum appeal to bingo players. The primary benefits to players of electronic bingo units are the ability to play up to 600 electronic bingo card images during one bingo game, significantly more than can be played on paper; to have the system simultaneously mark the numbers called, thereby reducing player error in missing or mismarking a number; and to have the system alert the player upon attaining a BINGO, thereby reducing the chance a player misses winning a prize. In addition, GameTech's units are designed to enhance the entertainment value of playing bingo. The Company's units allow the player to customize certain aspects of the user interface, and recently developed fixed-base units incorporating picture-in-picture and audio technology. The Company's hand-held units allow the player to play bingo electronically while sitting in the player's preferred seat or moving around the bingo hall. The ease of using GameTech's electronic bingo units makes playing bingo possible for players with physical disabilities that may prevent them from playing on paper, which normally involves marking multiple bingo cards by hand with an ink dauber. The Company believes that these aspects of GameTech's electronic bingo systems make them more appealing to players than paper cards or electronic bingo units offered by its competitors.
The Company currently markets two types of electronic bingo systems: a fixed-base bingo system and a portable, hand-held electronic bingo system. Many bingo hall operators use both fixed-base and hand-held units to satisfy varying customer preferences.
FIXED-BASE BINGO SYSTEM
The fixed-base bingo system consists of a local area network (the "LAN") of microcomputers including the master unit, the communications unit, the sales unit and the player's unit. All units in the fixed-base bingo system use microcomputer hardware and can be operated with light pens, touch screens or keyboards. Fixed-base units can be played in automatic mode or in manual mode, which requires the players to enter the numbers called. Players can switch between the two modes and, in either case, up to 600 electronic bingo card images can be marked simultaneously. A complete fixed-base bingo system consists of the following:
MASTER UNIT. The master unit is a file server that is located on the caller's stand and runs the LAN. All bingo game data is processed and stored through this unit.
COMMUNICATIONS UNIT. The communications unit is also located on the caller's stand and allows the caller to communicate with each player's unit by use of a state-of-the-art touch-screen. By simply touching the screen, the caller enters ball numbers drawn, game number, game patterns and wild numbers. The communications unit is connected to each player's unit for verification of 1,000,000 unique, non-duplicating electronic bingo card images and enables the winning electronic bingo card images and paper cards to be displayed on monitors within the bingo hall. The communications unit stores all data from the bingo system and contains a modem that allows the Company to access such data remotely. All files are protected against unauthorized access. Accordingly, the Company monitors utilization of its units and bills bingo hall operators without the bingo hall operators' assistance. Data from the system is also available to bingo hall operators to assist them in managing their halls.
SALES UNIT. The sales unit is a point-of-sale terminal where all customer purchases are made typically located near the entrance of a bingo hall. Player buy-in choices for the session are activated by the cashier using a light pen, and pricing and totals are calculated automatically. The player is given a
printed receipt with a nine-digit pack number which is itemized by date, session and number of electronic bingo card images purchased.
PLAYER'S UNIT. Each player's unit consists of a separate computer, monitor and light pen. Each player's unit is built into customized wooden tables with five units per table. Players enter the nine-digit pack numbers printed on their receipts to receive their electronic bingo card images. Players can cycle through all of their electronic bingo card images while play is proceeding. The player's unit marks the numbers called on each electronic bingo card image being played either automatically or after the player enters the number called. The unit always displays the player's three electronic bingo card images that are closest to a BINGO, and the free space at the center of any electronic bingo card image that is one number away from BINGO flashes to notify the player. The unit sounds an alert alarm and the screen flashes when BINGO is achieved.
HAND-HELD BINGO SYSTEMS
The Company has two hand-held bingo systems. The hand-held systems operate similarly to fixed-base systems except players must manually enter the numbers as they are called and each electronic bingo card image being played is then simultaneously marked. Each unit can mark up to 600 electronic bingo card images per game, and players can play several hand-held units during a bingo session. In one of the Company's hand-held systems, the master, communication and sales units are similar to, and can be shared with, those of fixed-base systems. The hand-held units are completely portable and can be played anywhere within a bingo hall. The hand-held units are capable of recognizing any bingo game format a bingo hall operator wishes to play and alerts the player both audibly and visually when BINGO has been achieved. Hand-held units are battery powered and battery packs are designed to last for 11 hours (most bingo sessions are four hours or less). Hand-held units are recharged between bingo sessions on charging carts.
PRODUCT DEVELOPMENT
GameTech has implemented an ongoing research and development program to enhance the features and capabilities of its bingo systems and to maintain a competitive advantage in the marketplace, as well as to extend its product line to new games and applications. Product development efforts produced the hand-held system, which was introduced in January 1996, and an improved version in April 1997. In July 1998, the Company introduced its Diamond operating system which provide enhanced graphics to the fixed base units and a point-of-sale system which allows vending of both fixed-base and hand-held electronic bingo units, as well as the sale of paper bingo cards, accessories and refreshments.
SALES, MARKETING AND DISTRIBUTION
The Company's marketing strategy is to target larger bingo hall operators and demonstrate the benefits of GameTech's bingo systems to both bingo hall operators and bingo players. Benefits of GameTech's electronic units for the players include the ease of marking numbers called, the decreased likelihood of missing a winning pattern and the ability to play substantially more bingo than can be played using only paper bingo cards.
The Company allocates its electronic bingo units based on utilization. This strategy is designed to maximize revenues from newly placed units. The Company's superior customer service orientation and quality products are designed to promote player loyalty and long-term relationships with bingo hall operators.
The Company's installation package typically includes the following:
- Installation by the Company at no cost to the bingo hall
- Training sessions for bingo hall staff
- Promotional sessions to introduce players to the system
- Advertising package and point of sale materials
- Ongoing maintenance program
The Company operates with both a sales force and a network of outside distributors. Sales personnel earn base salaries plus incentive commissions based on the revenues generated by the units they place. The Company's distributors are located throughout the United States and are compensated based on a percentage of the sales generated for the Company from their respective territories. Distributorships are generally granted pursuant to two- to three-year agreements, and distributors are typically selected based upon their financial stability and experience and are generally required to make an exclusive commitment to the Company.
TARGET MARKETS. There are approximately 275 Indian bingo halls and approximately 60,000 charities licensed to operate bingo games in the United States and Canada. At October 31, 1999, the Company had over 46,000 installed units at approximately 500 locations serving over 1,000 customers, including many charitable bingo halls where the Company has multiple customers. Revenues for the year ended October 31, 1999 were generated approximately 40% from fixed-base units and 60% from hand-held units. At October 31, 1999 the Company had fixed-base and hand-held units installed in bingo halls in 34 states.
As of October 31, 1999, GameTech operated in charitable bingo halls in 25 of the 38 states where electronic bingo is currently permitted in charitable bingo halls and in Indian bingo halls in 13 of the 28 states where bingo is currently played in Indian bingo halls. The Company is actively pursuing additional business in other states and Canada.
ADVERTISING AND PROMOTION. The Company places advertisements in selected gaming magazines and bingo magazines and newsletters and makes presentations at key trade shows, especially those devoted solely to bingo. The Company also plans to develop additional advertising and promotional programs to create awareness and interest in its electronic bingo products among hall operators and relevant segments of the consumer marketplace. GameTech is also exploring other cost-effective promotional strategies, including public relations and media programs.
PRICING ARRANGEMENTS. The Company installs its units at no cost to the bingo hall operator. The Company generates revenues by "participating" with bingo hall operators, receiving from 7% to 30% percent of the gross revenues derived from GameTech's electronic bingo systems, or by charging a fixed fee per unit per session. The Company maintains ownership of all software and substantially all hardware.
MATERIALS AND SUPPLIES
The Company uses a contract manufacturer in Taiwan to supply its Diamond hand-held units. All hardware components for the fixed-base bingo systems are sourced by the Company from numerous suppliers domestically and assembled at its facility in Arizona. The Company has not had any significant quality problems or delays in securing its hand-held units or the supply of fixed-base system components. The Company is currently evaluating Domestic suppliers.
TRADEMARKS AND PATENTS
The Company currently holds the following registered trademarks, service marks and patents:
The Company owns all rights to U.S. Patent No. 4,378,940 (the "940 Patent") issued on April 5, 1983 titled: "Electronic Device for Playing Bingo, Lotto and Allied Card Games." The 940 patent expires in December, 2000. On October 27, 1998, the PTO, in a response to a request for
reexamination sponsored by Fortunet, Inc. ("Fortunet"), rejected all 12 claims of the 940 patent. BTC contested the Examiner's decision and on March 23, 1999 the Patent Office reversed its initial rejection. In response, Fortunet, on May 23, 1999, filed a new request for reexamination and a petition to invoke the Commissioner's authority to amend the Examiner's decision on reversal due to "extraordinary circumstances." On August 11, 1999, the commissioner's office rejected the petition returning it unfiled. On July 24, 1999, the PTO granted a second request for reexamination which request is currently pending.
The Company has a pending patent application for an Electronic Bingo Data Crate. The crate provides information and charging interface between a plurality of player devices housed within and a master point of sale computer.
The Company has a pending patent application for Data Crate interface. This application pertains to the automatic interface between a comprehensive point of sale bingo hall cashier and accounting system.
The Company has the following trademarks: "TED"--U.S. registration #2,076,334 registered July 1, 1997, expiring July 1, 2008; "Bingo Card Minder"--U.S. registration #2,035,175 registered February 4, 1997, expiring February 4, 2007; "Bingo Technologies Corporation" with bingo ball logo--U.S. registration #75-358,442 registered December 15, 1998, expiring December 15, 2008. The Company has a common law trademark for "The Electronic Dauber" which is also listed on the U.S. Supplemental Register as #2,127,889 registered July 1, 1997, expiring July 1, 2007. The term of a federal trademark is 10 years, with 10-year renewal terms. However, between the fifth and sixth year after the date of initial registration, the registrant must file an affidavit setting forth certain information to keep the registration alive. If no affidavit is filed, the registration is canceled.
COMPETITION
The electronic bingo industry is characterized by intense competition based on, among other things, an electronic bingo system's ability to generate incremental sales for bingo hall operators through product appeal to players, ease of use and serviceability, support and training, distribution, name recognition and price. The Company competes primarily with other companies providing electronic bingo units, including Advanced Gaming Technology, Inc., Bingo Concepts, Bingo Magic, Cadillac Bingo, Easy Bingo, FortuNet, Inc. and Stuart Entertainment, Inc. and also competes with companies offering traditional paper bingo cards. Certain of the Company's competitors may have significantly greater financial and technical resources than the Company, as well as more established customer bases and distribution channels, which may allow them to move rapidly into the Company's markets and acquire significant market share. Increased competition may result in price reductions, reduced operating margins, conversion from lease to sale of the Company's units, and loss of market share, any of which could materially and adversely affect the Company's business, operating results or financial condition. Furthermore, the Company's success may benefit existing competitors and induce new competitors to enter the market. The Company has attempted to counter competitive factors by providing superior service and new, innovative and quality products, but there can be no assurance that the Company will continue to be a successful competitor in the electronic bingo industry. In addition, the Company competes with other similar forms of entertainment, including casino gaming and lotteries. The Company believes, however, that the quality of its fixed-base and hand-held bingo systems, combined with superior service and customer support, differentiate it from its competitors.
RESEARCH AND DEVELOPMENT
In fiscal 1999, the Company spent $1.2 million on Company-sponsored research and development activities, as compared to $638,000 in fiscal 1998 and $547,000 in fiscal 1997.
GOVERNMENT REGULATION
The Company is subject to regulation by authorities in all jurisdictions in which its electronic bingo units are installed. On tribal Indian lands, regulation is pursuant to the provisions of IGRA. Otherwise, the regulatory requirements vary from jurisdiction to jurisdiction and the licensing approval or finding of suitability processes with respect to the Company, its personnel and its products can be lengthy and expensive. Many jurisdictions have comprehensive licensing, reporting and operating requirements with respect to the manufacture, sale, use and operation of bingo and bingo-related products, including electronic bingo equipment. These requirements have a direct impact on the conduct of the day-to-day operations of the Company. In substantially all states where charitable bingo is legal, the state imposes limits on prizes on a per game, per session or annual basis. Many states license or otherwise regulate suppliers of bingo equipment, and some states prohibit the rental of bingo equipment while other states regulate whether equipment may be rented at a fixed or percentage rate. Generally, regulatory authorities may deny applications for licenses, other approvals or findings of suitability for any cause they may deem reasonable. There can be no assurance that the Company, its products or its personnel will receive or be able to maintain any necessary licenses, other approvals or findings of suitability. The loss of a license in a particular state will prohibit the Company from realizing revenues in that state. Any change in law or regulation by a state reducing prize limits, further regulating suppliers of bingo equipment, prohibiting rental of bingo equipment or restricting rental rates or the loss of one or more licenses held by the Company could have an adverse effect on the Company's business.
INDIAN GAMING
Gaming on Indian lands, including the terms and conditions under which gaming equipment can be sold or leased to Indian tribes, is or may be subject to regulation under the laws of the tribes, the laws of the host state and IGRA. Under IGRA, gaming activities are classified as Class I, II or III. Class I gaming includes social games played solely for prizes of minimal value or traditional forms of Indian gaming engaged in as part of, or in connection with, tribal ceremonies or celebrations. Class II gaming includes bingo and other card games authorized or not explicitly prohibited and played within the host state (but not including banking card games such as baccarat or blackjack). Class III gaming includes all forms of gaming that are not Class I or Class II, including slot machines, video lottery terminals and casino style games. Indian tribes may conduct Class II gaming under IGRA without having entered into a written compact with their host state if the host state permits Class II gaming, but must enter into a separate written compact with the state in which they are located in order to conduct Class III gaming activities. The Company is not aware of any state in which a tribal-state compact seeks to regulate bingo. Under IGRA, tribes are required to regulate all gaming under ordinances approved by the Chairman of the National Indian Gaming Conference ("NIGC"). Such ordinances may impose standards and technical requirements on gaming hardware and software, and may impose registration, licensing and background check requirements on gaming equipment suppliers and their officers, directors, and stockholders.
REGULATION OF ELECTRONIC BINGO SYSTEMS
The Company's electronic bingo products, including its fixed-base and hand-held units, are more heavily regulated than traditional paper bingo. Applicable federal, state, tribal and local regulations vary significantly by jurisdiction.
IGRA defines Class II gaming to include "the game of chance commonly known as bingo, whether or not electronic, computer or other technologic aids are used in connection therewith," and defines Class III gaming to include "electronic or electromechanical facsimiles of any game of chance or slot machines of any kind." The Company believes that both its fixed-base and hand-held units are Class II games. In the event that either is classified as a Class III device, such a designation would reduce the potential market for the devices (because only Indian gaming halls that had entered into a tribal-state
compact that permits Class III electronic gaming systems would be permitted to use the device), unless the Company could modify the systems to have them reclassified as a Class II game No assurance can be given that the Company would be able to make any such modifications in the event of such a classification.
Electronic bingo in charitable halls is less widely permitted than paper bingo, largely because many states' laws and regulations were written before electronic bingo was introduced. The Company believes that electronic bingo in charitable halls is currently permitted in at least 37 of the 50 states. Because many state laws and regulations are silent and/or ambiguous with respect to electronic bingo, changes in regulatory and enforcement personnel could impact the continued operation of electronic bingo in some of these states. In addition, some states require the inspection, approval or modification of electronic bingo systems before sale or use in those states.
APPLICATION OF FUTURE OR ADDITIONAL REGULATORY REQUIREMENTS
The Company intends to seek the necessary licenses, approvals and findings of suitability for the Company, its products and its personnel in other jurisdictions where significant bingo activities are anticipated. However, there can be no assurance that such licenses, approvals or findings of suitability will be obtained timely, if at all, and if obtained, will not be subsequently revoked, suspended or conditioned or that the Company will be able to obtain the necessary approvals for its future products as they are developed in a timely manner, or at all. If a license, approval or finding of suitability is required by a regulatory authority and the Company fails to seek or does not receive the necessary license or finding of suitability, the Company may be prohibited from distributing its products for use in the respective jurisdiction or may be required to distribute its products through other licensed entities at a reduced profit to the Company.
EMPLOYEES
As of October 31, 1999, the Company had approximately 200 full-time equivalent employees. The Company is not subject to collective bargaining agreements with its employees and the Company believes that its relations with its employees are good.
ITEM 2.
ITEM 2. FACILITIES
The Company operates from three leased locations: a 12,100-square-foot site in Tempe, Arizona under two leases that expire in September 2001 and May 2002, respectively; a 18,000-square-foot site in Carson City, NV under a lease which expires in October 2000; and a 5,400-square foot regional center in Cleveland, OH under a lease which expires in November, 2004. Monthly rent for these facilities is approximately $3,880, $2,925 and $23,200 and $4,500, respectively. The Company rents a small research and development facility for approximately $833 per month in Denver, Colorado under a lease that expires in May 2002. Additional research and development activities are carried out in San Diego, California and Las Vegas, Nevada at locations where the Company pays no rent, but does pay certain overhead costs. The Company pays no rent to these employees, but pays certain overhead costs related to, and believes the facilities are adequate for, the research and development carried on at such locations. The Company will be consolidating its operations in the second half of the fiscal year 2000 in a new 40,000-square foot headquarters site in Reno, NV under a ten-year lease. Monthly rent for this facility will be $38,000.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
On February 13, 1998, a securities class action complaint, WEISS V. GAMETECH INTERNATIONAL, INC., No. 98-0268 PHX-ROS, was filed in the United States District Court for the District of Arizona against the Company and certain officers and directors alleging that defendants violated Section 11 of the
Securities Act of 1933 (the "Securities Act") by making false misleading statements and omissions in the Company's Form S-1 Registration Statement in connection with the Company's public offering on November 25, 1997. Two other complaints making nearly identical factual allegations have been consolidated with the WEISS action for all purposes as IN RE GAMETECH, INC. SECURITIES LITIGATION, Master File No. Civ. 98-0268 PHX-ROS. On July 17, 1998, the Court appointed "lead plaintiff" and co-lead counsel.
On September 21, 1998, plaintiffs filed a consolidated complaint, alleging a claim against the Company and the individual defendants under Section 11 of the Securities Act and a claim against the individual defendants under Section 15 of the Securities Act, based upon the conduct alleged in the original complaints. Plaintiffs seek an unspecified amount of damages.
On November 5, 1998, defendants moved to dismiss the complaint. On June 3, 1999 Defendants' motion to dismiss was granted in part and denied in part by the Court. Defendants believe that there is no merit to plaintiffs' allegations and intend to defend the action vigorously.
In January 1995, a patent infringement action and demand for jury trial, FORTUNET INC., V. BINGO CARD MINDER CORP., AND STUART ENTERTAINMENT, INC., CV-S-95-0008 PMP (RJJ) was filed in the United States District Court, District of Nevada against the Company's wholly owned subsidiary, Bingo Card Minder Corporation ("BCMC"), and Stuart Entertainment, Inc. ("Stuart"). The complaint alleged that BCMC and Stuart, as individual entities, infringed upon U.S. Patent No. 4,455,025 (the "025 Patent"). On October 22, 1998, the action was severed and stayed by order of the Court pending completion of reexamination and any appeals therefrom. On May 19, 1999, Fortunet, Inc. ("Fortunet") appealed the Patent and Trademark Office's (the "PTO") decision of rejection of the 025 Patent to the United States Court of Appeals for the Federal Circuit.
The action against BCMC involves the BCM-2 device only, of which less than 2,000 are currently in operation throughout the United States. The Court has SUA SPONTE ruled that the BCM-2 does not infringe Fortunet's 4,642,462 patent (the "462 Patent"). Fortunet has not plead any specific damages but has plead punitive damages for willful infringement. In the event the 025 Patent is reinstated, the Company will vigorously contest the action.
In February 1997, BCMC filed a declaratory relief action for non-infringement, BINGO CARD MINDER CORP. V. FORTUNET, INC., C 97-00698 CAL in the United States District Court Northern District of California, against Fortunet's 025 and 462 Patents relative to BCMC's TED device. No relevant court dates have been set, and the Court in early 1997 approved a stipulated stay pending completion of the above case, which is stayed pending completion of the reexamination of Fortunet's patents. The PTO, on a second request for reexamination with respect to the 462 patent, recently determined that "a substantial new question of patentability" existed. As such, the 462 patent will now undergo renewed reexamination activity with the possible cancellation of some or all of the claims of the 462 patent. There are no relevant court dates as the action has been stayed pending reexamination.
In June 1997, a patent infringement and demand for jury trial, FORTUNET INC., V. BINGO TECHNOLOGIES CORPORATION; JOHN A. LARSEN, DBA OPPORTUNITY SOFTWARE AND BINGO CARD MINDER CORP., CV-S-97-00778-HDM (LRL), was commenced in the United States District Court, District of Nevada, against Bingo Technologies Corporation ("BTC"), John A. Larsen, dba Opportunity Software and BCMC. As no relevant court dates have been set, and the complaint lacks a definitive accused device, the Company believes, based upon representation of opposing counsel that the action involves BTC's sale of the "Max-Plus" units, alleging infringement of Fortunet's 462 and 025 Patents. Pursuant to stipulation, the Court has stayed the action pending the outcome of the appeal from the Patent Office rejection of the 025 patent (see above).
The Company believes that none of its products infringe any valid claim of either 025 or 462 Patents and intends to continue to defend against all actions vigorously. However, there can be no
assurance that favorable outcomes will be obtained or that if the action against the TED product is resolved in favor of the Plaintiff, such result would not have a material adverse effect on the Company's business, financial position, or results of operations or cash flow.
In May 1998, FORTUNET INC., V. BINGO TECHNOLOGIES CORPORATION; JOHN A. LARSEN, DBA OPPORTUNITY SOFTWARE AND BINGO CARD MINDER CORP., CV-S-98-00777-PMP (LRL) an action for declaratory relief for non-infringement and counterclaim, was filed in the United States District Court, District of Nevada, by BTC against Fortunet alleging that Fortunet's "Bingo Starr" portable hand-held bingo device infringed upon the claims of BTC's 4,378,940 patent (the "940 Patent" owned by the Company). On October 27, 1998, the PTO, in a response to a request for reexamination sponsored by Fortunet, rejected all 12 claims of the 940 patent. BTC contested the Examiner's decision and on March 23, 1999 the Patent Office reversed its initial rejection. In response, Fortunet, on May 23, 1999, filed a new request for reexamination and a petition to invoke the Commissioner's authority to amend the Examiner's decision on reversal due to "extraordinary circumstances." On August 11, 1999, the commissioner's office rejected the petition returning it unfiled. On July 24, 1999, the PTO granted a second request for reexamination. The action is presently stayed. The Company intends to pursue the case vigorously.
The Company believes that none of its products infringe any valid claim of either the 025 or 462 Patents and intends to continue to defend against all actions vigorously. However, there can be no assurance that favorable outcomes will be obtained or that if the action against the TED product is resolved in favor of the Plaintiff, such result would not have a material adverse effect on the Company's business, financial position, or results of operations or cash flow.
On June 14, 1999, GAMETECH INTERNATIONAL, INC. V. BETTINA CORPORATION, CV-N-99-00317-(ECR), a patent infringement action, was filed in the United States District Court, District of Nevada, by the Company against Bettina Corporation alleging that Bettina Corporation's "Bingo Magic" portable hand held device infringed upon the claims of the Company's 940 Patent. The Company has asked the Court for immediate injunctive relief, compensatory and punitive damages for willful infringement as well as costs and attorney's fees. Bettina Corporation, in its answer to the complaint, denies all causes of action and has asked the Court to find the 940 Patent invalid. The action is stayed pending re- examination of the 940 patent.
On January 7, 2000, K&B Sales, Inc. d/b/a Goodtime Bingo filed a third-party petition and request for injunctive relief against the Company, in cause no. DV99-3012H, pending in the District Court of Dallas County, Texas. At this time the Company has not been formally served with a copy of the Petition. On January 7, 2000, the Court entered a Temporary Restraining Order (the "Order") against GameTech and K&B, preventing both parties from removing or turning off GameTech's cardminding equipment in bingo halls serviced by K&B during the pendency of the Order. The Order expired by its terms on Friday, January 21, 2000.
The underlying dispute between GameTech and K&B involves the termination of K&B's Texas distributorship on January 6, 2000. K&B has made claims of breach of contract, interference with contract, illegal restraint of trade and conspiracy to commit tortious interference. K&B has also requested punitive damages. The Company denies all of these claims and intends to vigorously contest the lawsuit.
The Company is involved in various other legal proceedings arising out of its operations in the ordinary course of its business. The Company does not believe that any of their proceedings will have a material adverse effect on its business, financial condition, or result of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The Common Stock is listed for trading and quotation on the NASDAQ National Market System under the symbol "GMTC." The high and low prices of the Company's Common Stock from December 1, 1997 (the date of the Company's initial public offering) through October 31, 1999 is set forth below.
As of January 20, 2000, there were 130 stockholders of record of the Company's Common Stock. Shares held by all persons in street name are considered to be one stockholder of record.
The Company has paid no cash dividends to date and does not anticipate paying any cash dividends on its Common Stock in the foreseeable future. The Company intends to retain its earnings, if any, to finance the expansion of its business and for other general corporate purposes. Any payment of future dividends will be at the discretion of the Board of Directors of the Company and will depend upon, among other factors, the Company's earnings, financial condition, capital requirements, level of indebtedness, contractual restrictions with respect to the payment of dividends and other considerations that the Board of Directors deems relevant. The Company has a $10 million revolving line of credit with Wells Fargo Bank, N.A., that restricts payment of dividends without the prior consent of the bank.
SALES OF UNREGISTERED SECURITIES DURING THE YEAR ENDED OCTOBER 31, 1999
On various dates between November 1, 1998 and October 31, 1999, Company employees exercised options granted in partial compensation for their services to purchase an aggregate of 291,159 shares of Common Stock in private sales for an aggregate consideration of $235,300 in reliance upon Section 4(2) of the Securities Act of 1933, as amended, as transactions not involving a public offering.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected statement of operations data for the years ended October 31, 1997, 1998 and 1999 and the selected balance sheet data set forth below at October 31, 1998 and 1999 have been derived from the Company's financial statements, which have been audited by Ernst & Young LLP, independent auditors, and are included elsewhere herein. The selected statement of operations data for the years ended October 31, 1995 and 1996 and the selected balance sheet data set forth below at October 31, 1995, 1996 and 1997 have been derived from the Company's audited financial statements not included herein. The selected financial data set forth below should be read in conjunction with the Financial
Statements and Notes thereto and with 'Management's Discussion and Analysis of Financial Condition and Results of Operations,' appearing elsewhere in this report.
(a) See Note 1 of Notes to Financial Statements included elsewhere herein for information concerning the computation of diluted net income (loss) per share.
(b) Includes convertible subordinated debt to stockholders (including accrued interest) of $1,291,460, $1,530,845, and $1,526,000, on October 31, 1995, 1996, and 1997, respectively, which was converted into Common Stock on November 24, 1997.
(c) Gives retroactive effect to the 3,270,000 shares issued in conjunction with the Company's initial public offering which was completed on December 1, 1997.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the Financial Statements and Notes thereto included elsewhere in this Form 10-K.
OVERVIEW
GameTech has grown rapidly, and attributes its growth to the experience of its management team, and its ability to provide its customers with a combination of quality electronic bingo units and superior customer service and support. The Company product line and distribution network were enhanced as a result of its acquisition of BTC on February 8, 1999.
GameTech generates revenues by installing electronic bingo systems in bingo halls under revenue sharing agreements or by charging fixed rates per bingo session. The Company recognizes revenue as its bingo units are utilized by players. Revenue growth is affected by player acceptance of electronic bingo as an alternative to paper bingo and the Company's ability to expand operations into new markets. Fixed-base bingo units generate greater revenue per unit than hand-held bingo units, but also require greater initial capital investment.
The Company installs its electronic bingo systems at no charge to its customers and capitalizes the costs. During fiscal 1997, 1998 and 1999, the Company's capital expenditures were approximately $6.1 million, $5.7 million and $8.1 million, respectively, almost all of which represented investments in bingo equipment. The Company's cost of revenues consists primarily of the expense of providing customer service, including labor, service-related overhead and depreciation of the bingo systems installed at customer locations. The Company records depreciation of bingo equipment over a five-year estimated useful life using the straight line method of depreciation.
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, certain statement of operations data for the Company expressed as a percentage of revenues.
YEAR ENDED OCTOBER 31, 1999 COMPARED TO YEAR ENDED OCTOBER 31, 1998
REVENUES. Revenues increased $25.5 million, or 63.5%, to $41.7 million for the year ended October 31, 1999 from $16.2 million for the year ended October 31, 1998. This increase is due in part to the acquisition of BTC. Excluding revenue generated from products acquired from BTC, the revenue increase was $5.6 million or 34.6%. The number of units installed at October 31, 1999 was approximately 46,000, 17,500 excluding units resulting from the acquisition of BTC, compared to approximately 13,300 at October 31, 1998.
COST OF REVENUES. Cost of revenues increased $6.3 million, or 119%, to $11.6 million for the year ended October 31, 1999, from $5.3 million for the year ended October 31, 1998. The increase in cost of revenues was primarily due to the greater average number of units installed. As a percentage of revenues, cost of revenues decreased to 27.8% from 32.9%. Depreciation expense as a percent of revenue decreased 3.6% due primarily to the mix of units acquired in the BTC acquisition, as those units have a lower unit cost.
GENERAL AND ADMINISTRATIVE. General and administrative expenses increased $4.5 million, or 125%, to $8.1 million for the year ended October 31, 1999, from $3.6 million for the year ended October 31, 1998. Excluding costs resulting from the acquisition of BTC, including amortization of goodwill of $1.2 million, general and administrative costs increased $1.0 million or 27.8%. As a percentage of revenues, general and administrative expenses decreased to 19.4% from 22.5% in the prior period.
SALES AND MARKETING. Sales and marketing expenses increased $8.9 million, or 342%, to $11.5 million for the year ended October 31, 1999 from $2.6 million for the year ended October 31, 1998. The increase was primarily due to larger distributor commissions of $6.7 million. The increase in distributor commissions is due primarily to the distributor network acquired from BTC.
RESEARCH AND DEVELOPMENT. Research and development expenses increased $514,000, or 80.6%, to $1.2 million for the year ended October 31, 1999, from $638,000 for the year ended October 31, 1998. As a percentage of revenues, research and development expenses decreased to 2.8% from 3.9% in the prior period.
NON-RECURRING ACQUISITION RELATED CHARGES. The Company recorded a non-recurring charge in April 1999 in the amount of $1.1 million resulting from the acquisition of BTC and the Company's plan to close and transition its existing Arizona operations to Nevada. Employees from all areas of the Company, including manufacturing, development and administrative areas, were extended severance agreements. The acquisition related charges were comprised of $637,000 related to accruals for severance costs and non-cancelable operating lease commitments on vacated facilities, and $411,000 in write-offs of existing assets which the Company determined had no on-going value as a result of the acquisition.
INTEREST INCOME (EXPENSE). Net interest income decreased $978,000 to $390,000 of income for the year ended October 31, 1999 from $1.4 million for the year ended October 31, 1998. The decrease in net interest income was due primarily to the use of approximately $10.0 million of cash in the acquisition of BTC and $5.2 million of cash to retire debt from BTC.
PROVISION FOR INCOME TAXES. Provision for income taxes increased $2.6 million, or 200%, to $3.9 million for the year ended October 31, 1999 from $1.3 million for the year ended October 31, 1998. The Company's effective income tax rate was approximately 44.5% in 1999 and 38.6% in 1998. The rate change is due to the non-deductibility of goodwill that resulted from the acquisition of BTC.
NET INCOME. As a result of the factors discussed above, net income increased $2.8 million, or 135%, to $4.9 million for the year ended October 31, 1999 from $2.1 million for the year ended October 31, 1998.
YEAR ENDED OCTOBER 31, 1998 COMPARED TO YEAR ENDED OCTOBER 31, 1997
REVENUES. Revenues increased $3.6 million, or 28.6%, to $16.2 million for the year ended October 31, 1998 from $12.6 million for the year ended October 31, 1997. This increase in revenues was primarily due to a 104% increase in the average number of units installed to 9,712 during the year ended October 31, 1998 from 4,758 during the year ended October 31, 1997. The impact of the large increase in the number of units was partially offset by a competitive price adjustment made in the mid-year and the higher ratio of hand held units, which generate lower revenue per unit, versus fixed base units in the installed base.
COST OF REVENUES. Cost of revenues increased $2.1 million, or 65.6%, to $5.3 million for the year ended October 31, 1998, from $3.2 million for the year ended October 31, 1997. The increase in cost of revenues was primarily due to the greater average number of units installed. As a percentage of revenues, cost of revenues increased to 32.9% from 25.8%. The increase was primarily due to increased depreciation expense of $860,000 resulting from the higher number of installed units and increased personnel costs of $650,000 due to the hiring of additional personnel to enable the Company to service its customers and facilitate the Company's growth in installations. The increase in cost of revenues as a percent of revenue was due primarily to the competitive price adjustment made in mid-year and costs associated with expansion into new geographic territories that were not immediately offset by increased revenue, particularly with respect to route operations.
GENERAL AND ADMINISTRATIVE. General and administrative expenses increased $1.6 million, or 80.0%, to $3.6 million for the year ended October 31, 1998, from $2.0 million for the year ended October 31, 1997. The primary components of the $1.6 million increase consist of: higher personnel costs of $483,000 resulting from hiring additional personnel to help manage the Company's growth and increased legal fees of $839,000. As a percentage of revenues, general and administrative expenses increased to 22.5% from 15.9% in the prior period.
SALES AND MARKETING. Sales and marketing expenses increased $1.2 million, or 85.7%, to $2.6 million for the year ended October 31, 1998 from $1.4 million for the year ended October 31, 1997. The increase was primarily due to larger distributor commissions of $493,000 and higher personnel costs of $323,000 resulting from hiring additional salespersons to help achieve the increased installed units and revenue.
RESEARCH AND DEVELOPMENT. Research and development expenses increased $91,000, or 16.6%, to $638,000 for the year ended October 31, 1998, from $547,000 for the year ended October 31, 1997. As a percentage of revenues, research and development expenses decreased to 3.9% from 4.3% in the prior period.
INTEREST INCOME (EXPENSE). Net interest income increased $1.8 million to $1.4 million of income for the year ended October 31, 1998 from $450,000 of expense for the year ended October 31, 1997. The increase in net interest income was primarily due to interest on the net proceeds from the Company's initial public offering (IPO) on December 1, 1997 which was invested in interest bearing investments during the year ended October 31, 1998 compared to $4.9 million in average debt outstanding for the year ended October 31, 1997. The Company paid off approximately $3.4 million in debt with proceeds from the IPO in December 1997.
EQUITY IN NET LOSS OF AFFILIATE. Equity in net loss of affiliate of $2.0 million resulted from losses incurred by The Satellite Bingo Network ("TSBN") joint venture for the year ended October 31, 1998 and a write off of the Company's investment and advances to the joint venture with the discontinuance of the TSBN operation in February 1998. Since the Company financed this venture, it recorded 100% of the losses rather than its 50% ownership percentage.
PROVISION FOR INCOME TAXES. Provision for income taxes decreased $580,000, or 30.5%, to $1.3 million for the year ended October 31, 1998 from $1.9 million for the year ended October 31, 1997, primarily due to a decrease in pre-tax income. The Company's effective income tax rate remained at approximately 39% in each year.
NET INCOME. As a result of the factors discussed above, net income decreased $791,000, or 27.3%, to $2.1 million for the year ended October 31, 1998 from $2.9 million for the year ended October 31, 1997.
LIQUIDITY AND CAPITAL RESOURCES
Operating activities provided $9.3 million of cash in the year ended October 31, 1999 compared to $ 5.3 million in the year ended October 31, 1998. The $9.3 million consists primarily of $4.9 million of net income, $6.1 million of depreciation and amortization offset by changes to operating assets and liabilities. In 1998, the $5.3 million provided by operating activities consisted primarily of net income of $2.1 million, depreciation and amortization of $2.6 million and a $2.0 million loss from the discontinuance of TSBN's operations offset by changes to operating assets and liabilities.
Investing activities used $19.3 million of cash in the year ended October 31, 1999, compared to $11.5 million of cash in the year ended October 31,1998. The increase was primarily due to the $9.8 million used in the February 1999 acquisition of BTC and an increase in the capital expenditures of $2.4 million offset by a reduction in the net increase made in short-term investments of $2.8 million and no investment in affiliate in 1999 compared to a $1.5 million investment in 1998. In 1998, investing activities used cash of $11.5 million compared to $7.0 million in 1997. The increase was primarily due to a $4.1 million net increase in short-term investments.
Financing activities used cash of $5.5 million in the year ended October 31, 1999, compared to providing cash of $26.7 million in the year ended October 31, 1998. The $5.5 million used in 1999 is primarily the reduction of debt assumed in the acquisition of BTC. The $26.7 million in 1998 represents the net proceeds of approximately $32.5 million from its December 1997 IPO less the repayment of $3.4 million of debt in December 1997 and $2.8 million of cash used to repurchase 775,400 shares of Common Stock.
At October 31, 1999, the Company had cash and equivalents and short-term investments totaling $11.4 million. GameTech also has a $10.0 million line of credit (the "Revolving Credit Facility") with Wells Fargo Bank, N.A. ("Wells Fargo"), which has an interest rate based on the prime rate or LIBOR plus 2.0%, at the Company's option, on which there was no outstanding balance at October 31, 1999. The Revolving Credit Facility expires on March 31, 2000. The Company expects to renew the Revolving Credit Facility with similar terms. The Company believes that cash flow from operations and the $11.4 million in cash, cash equivalents and short-term investments at October 31, 1999, together with funds available under the Revolving Credit Facility, will be sufficient to support its operations and provide for budgeted capital expenditures of approximately $10.0 million and liquidity requirements through fiscal 2000. However, the Company's long term liquidity requirements will depend on many factors, including, but not limited to, the rate at which the Company expands its business, whether internally or through acquisitions and strategic alliances. In addition, strategic opportunities the Company may pursue will require it to fund its portion of operating expenses of such ventures, and may further require it to advance additional amounts should any partners in such ventures be unable to meet unanticipated capital calls or similar funding events. To the extent that the funds generated from the sources described above are insufficient to fund the Company's activities in the long term, the Company will be required to raise additional funds through public or private financing. No assurance can be given that additional financing will be available or that, if it is available, it will be on terms acceptable to the Company.
INFLATION AND GENERAL ECONOMIC CONDITION
Although the Company cannot accurately anticipate the effect of inflation on its operations, the Company does not believe that inflation has had, or is likely in the foreseeable future to have, a material effect on its business results of operations or financial condition.
YEAR 2000 RISKS
The Company experienced no significant Year 2000 compliance issues and Year 2000 issues did not have a material effect on its business, operations or financial condition.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
The Company's Revolving Credit Facility with Wells Fargo is a $10 million line of credit with an interest rate based on the prime rate or LIBOR plus 2.0%, at the Company's option. The line of credit expires on March 31, 2000.
Because the interest rate on the Revolving Credit Facility is variable, the Company's cash flow may be affected by increases in interest rates, in that the Company would be required to pay more interest in the event that both the prime and LIBOR interest rates increase. Management does not, however, believe that any risk inherent in the variable-rate nature of the loan is likely to have a material effect on the Company's interest expense or available cash. The Company currently maintains a zero balance on the Revolving Credit Facility. Even if the Company were to draw down on the line prior to its expiration and an unpredicted increase in both alternated rates occurred, it would not be likely to have a material effect on the Company's interest expense or available cash.
SENSITIVITY ANALYSIS. Assuming the Company had a $2 million balance outstanding as of October 31, 1999, the rate of interest calculated using the prime rate option would be 8.25%. The Company's monthly interest payment, if the rate stayed constant, would be $13,750. If the prime rate rose to 13%, which assumes an unusually large increase, the Company's monthly payment would be $21,667. A more likely increase of 1 or 2%, given the recent trend of decreasing or relatively low interest rates, would result in a monthly payment of $15,417 or $17,083, respectively. The Company does not believe the risk resulting from such fluctuations is material or that the payment required would have a material effect on cash flow.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and supplementary data are as set forth in the "INDEX TO FINANCIAL STATEMENTS" on page.
ITEM 9.
ITEM 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
For information required under Items 10, 11, 12 and 13 see the Company's definitive Proxy Statement relating to the Annual Meeting of Stockholders, which sections are to be filed with the Securities and Exchange Commission, are herein incorporated by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
This document includes various "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which represent the Company's expectations or beliefs concerning future events. Statements containing expressions such as "believes," "anticipates" or "expects" used in the Company's press releases and periodic reports on Forms 10-K and 10-Q filed with the Commission are intended to identify forward-looking statements. All forward-looking statements involve risks and uncertainties. Although the Company believes its expectations are based upon reasonable assumptions within the bounds of its knowledge of its business and operations, there can be no assurances that actual results will not materially differ from expected results. The Company cautions that these and similar statements included in this report are further qualified by important factors that could cause actual results to differ materially from those in the forward-looking statements. Such factors could include, without limitation, the following: increased competition in existing markets; a decline in the public participation in bingo; the limitation, conditioning or suspension of any of the Company's bingo permits or licenses; increases in or new taxes imposed on bingo revenues or bingo devices; a finding of unsuitability by regulatory officers with respect to the Company's officers, directors or key employees; loss or retirement of key executives; adverse economic or regulatory conditions in the Company's key markets; or adverse results of significant litigation matters. Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date thereof. The Company undertakes no obligation to publicly release any revisions to such forward-looking statements to reflect events or circumstances after the date hereof.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
EXHIBIT INDEX
GAMETECH INTERNATIONAL, INC.
CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED OCTOBER 31, 1997, 1998 AND 1999
CONTENTS
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders GameTech International, Inc.
We have audited the accompanying consolidated balance sheets of GameTech International, Inc. as of October 31, 1998 and 1999, and the related consolidated statements of operations, redeemable convertible preferred stock and stockholders' equity, and cash flows for each of the three years in the period ended October 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as 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 GameTech International, Inc. at October 31, 1998 and 1999 and the consolidated results of its operations and its cash flows for each of the three years in the period ended October 31, 1999, in conformity with accounting principles generally accepted in the United States.
Ernst & Young LLP
Reno, Nevada December 7, 1999
GAMETECH INTERNATIONAL, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
SEE ACCOMPANYING NOTES.
GAMETECH INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
SEE ACCOMPANYING NOTES.
GAMETECH INTERNATIONAL, INC. CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
SEE ACCOMPANYING NOTES.
GAMETECH INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
GAMETECH INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
(IN THOUSANDS)
SEE ACCOMPANYING NOTES.
GAMETECH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
OCTOBER 31, 1997, 1998 AND 1999
1. BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF BUSINESS
GameTech International, Inc. (the "Company") was incorporated in Delaware on April 18, 1994. The Company designs, develops and markets electronic bingo systems and rents them under operating type leases on long-term or month-to-month arrangements. The consolidated financial statements include the accounts of the Company and Bingo Technologies Corporation acquired in February 1999 (Note 2). All significant intercompany accounts and transactions have been eliminated.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
RECLASSIFICATION
Certain reclassifications have been made to prior years' amounts in order to conform to the current year's presentation.
CASH AND EQUIVALENTS
The Company considers all highly liquid investments with an original maturity of three months or less when purchased to be a cash equivalent.
SHORT-TERM INVESTMENTS
Short-term investments, which consist of interest bearing securities, are carried at fair value and are classified as available for sale. Unrealized gains and losses are not material.
BINGO UNITS, FURNITURE AND EQUIPMENT
Bingo units, furniture and equipment are stated at cost and depreciated using the straight-line method over the estimated useful lives of the assets. The estimated useful lives are as follows:
SUPPLIER DEPENDENCE
Certain of the Company's bingo units are purchased from only one supplier. Any interruption in this supply source could impact the Company's ability to meet customer demand and in turn adversely affect future operating results.
INTANGIBLE ASSETS
Goodwill, resulting primarily from the acquisition of Bingo Technologies Corporation (Note 2), is being amortized on a straight-line basis over twelve years. Amortization expense in fiscal years 1997,
GAMETECH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
1998 and 1999 was $58,000, $58,000 and $1,415,000, respectively. Other intangibles, consisting of capitalized software, distribution agreements and copyrights are being amortized over the respective useful lives of the assets ranging from three to five years. Amortization expense in fiscal years 1997, 1998, and 1999 was $43,000, $213,000 and $458,000, respectively.
INVESTMENT IN JOINT VENTURE
The Company had a 50 percent interest in The Satellite Bingo Network, LLC. ("TSBN") which was accounted for using the equity method. TSBN was formed on April 8, 1997, launched operations in December 1997 and ceased operations in February 1998. The Company funded the operating losses of TSBN and for financial reporting purposes had recorded 100 percent of the operating losses. For the fiscal year ended October 31, 1998, the Company recorded a loss of $2.0 million in connection with the write-off of the Company's investment in and advances to TSBN, which included the operating loss of $955,000.
LONG-LIVED ASSETS
The Company has adopted the provisions of the Financial Accounting Standards Board Statement of Financial Accounting Standards No. 121, ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF ("SFAS 121"). SFAS 121 requires impairment losses to be recognized for long-lived assets and identifiable intangibles used in operations when indicators of impairment are present and the estimated undiscounted cash flows are not sufficient to recover the assets' carrying amount. The impairment loss is measured by comparing the fair value of the asset to its carrying amount. The excess of cost over fair value of net assets of businesses acquired is included in impairment evaluations when events or circumstances exist that indicate the carrying amount of the acquired assets may not be recoverable.
REVENUE RECOGNITION, SIGNIFICANT CUSTOMERS AND CONCENTRATIONS OF CREDIT RISK
Revenues are based on either a percentage of gaming revenues earned per bingo unit at customer locations or a fixed rate per bingo session as defined in individual contracts.
The Company's customer base currently consists of Native American reservation gaming halls, casinos, and charity bingo operations located throughout the United States. The Company generally does not require collateral. Management believes that adequate allowances for credit losses have been provided.
No single customer comprised more than ten percent of total revenues during fiscal years 1997, 1998 and 1999.
INCOME TAXES
The Company accounts for income taxes under the provisions of Statement of Financial Accounting Standard No. 109, ACCOUNTING FOR INCOME TAXES.
GAMETECH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
ADVERTISING COSTS
Advertising costs are expensed as incurred. Advertising costs during the fiscal years 1997, 1998 and 1999 were not material.
STOCK BASED COMPENSATION
The Company grants stock options for a fixed number of shares to certain employees with an exercise price equal to or greater than the fair value of the shares at the date of grant. The Company accounts for stock option grants to employees in accordance with Accounting Principles Board Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES (APB 25), and, accordingly, recognizes no compensation expense for stock option grant to employees.
NET INCOME PER SHARE
Net income per share is computed in accordance with Statement of Financial Accounting Standards No. 128, EARNINGS PER SHARE which requires companies to present both basic and diluted net income per share. Basic earnings per share is based solely upon the weighted average number of common shares outstanding and excludes any dilutive effects of options, warrants and convertible securities. Dilutive earnings per share is based upon the weighted average number of common and common equivalent shares outstanding during the year. The difference between basic and diluted earnings per share is attributable to stock options, redeemable convertible preferred stock and convertible notes payable to officers.
CONCENTRATIONS OF CREDIT RISK
Financial instruments which potentially subject the Company to concentration of credit risk consist primarily of trade receivables. In the normal course of business, the Company provides credit terms to its customers. Accordingly, the Company performs ongoing credit evaluations of its customers and maintains allowances for possible losses which, when realized, have been within the range of management's expectations.
The Company's customer base consists primarily of bingo establishments in the United States. Although the Company is directly affected by the financial and operational well-being of the companies in this industry, management does not believe significant credit risk exists at present.
FAIR VALUES OF FINANCIAL INSTRUMENTS
The carrying amounts reported in the balance sheets for cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities approximate fair value because of the immediate or short-term maturity of these financial instruments. The fair value of bank credit lines and long-term debt is determined using current applicable interest rates as of the balance sheet dates and approximate the carrying value of such debt because the underlying instruments are variable subject to any increases or decreases in the bank's prime rate or LIBOR.
GAMETECH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. ACQUISITION OF BINGO TECHNOLOGIES CORPORATION
On February 8, 1999, the Company purchased all of the outstanding common stock of Bingo Technologies Corporation ("BTC"), pursuant to a Stock Purchase Agreement. The total purchase price for the acquisition of BTC was approximately $20.1 million, comprised of $10.0 million in cash, 1,866,938 shares of the Company's common stock with a fair market value of $6.1 million, and promissory notes totaling $4.0 million payable to BTC's stockholders. The acquisition was accounted for in accordance with the purchase method of accounting and, accordingly, the net assets acquired were included in the Company's consolidated balance sheet based upon their estimated fair values on the date of the Acquisition. The Company's consolidated statement of operations includes the revenues and expenses of the acquired business after the effective date of the transaction.
A summary of the purchase price allocation as of October 31, 1999 for the acquisition is as follows (in thousands):
GAMETECH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. ACQUISITION OF BINGO TECHNOLOGIES CORPORATION (CONTINUED)
The following unaudited pro forma information shows the results of the Company's operations as though the acquisition had occurred as of November 1, 1997 (in thousands):
The pro forma results of operations have been prepared for comparative purposes only and are not necessarily indicative of the actual results of operations that would have been achieved had the acquisition occurred on November 1, 1997, or the results of future operations of the Company. Furthermore, the pro forma results do not give effect to all costs savings or incremental costs that may occur as a result of the integration and consolidation of BTC.
3. BINGO UNITS, FURNITURE AND EQUIPMENT
Bingo units, furniture and equipment consist of the following (in thousands):
"Bingo units on-hand" are transferred to "Installed bingo units" when installed at a customer location, at which time a provision for depreciation is applied towards these units over a five year period.
Depreciation expense during the fiscal years ended October 31, 1997, 1998 and 1999 amounted to approximately $1.3 million, $2.2 million, and $4.5 million, respectively.
Office furniture and equipment includes assets under capital leases amounting to $182,000 at October 31, 1999, net of accumulated amortization of $218,000. Prior to the acquisition of BTC (Note 2), there were no assets under capital leases.
GAMETECH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. CREDIT AGREEMENTS
On August 19, 1998, the Company entered into a revolving line-of-credit agreement with a bank. The maximum amount available under the terms of the agreement is $10.0 million and borrowings bear interest based on the bank's prime rate or LIBOR plus 2.0 percent, at the Company's option. Interest is payable monthly and the agreement expires on March 31, 2000. The agreement is secured by substantially all of the Company's assets. The agreement contains certain restrictive covenants, which among other things require that specified financial balances and ratios be maintained, restricts the payment of dividends and the incurrence of additional indebtedness. At October 31, 1999, there was no outstanding balance under the line-of-credit.
5. LONG-TERM DEBT
Long-term debt consisted of the following:
Aggregate contractual future principal payments of long-term debt for the years following October 31, 1999 are $1.2 million in fiscal year 2000, $1.1 million in fiscal year 2001, and $935,000 in fiscal year 2002, $940,000 in fiscal year 2003 and $320,000 in fiscal year 2004.
6. COMMITMENTS AND CONTINGENCIES
LEASES
The Company leases administrative and manufacturing facilities under non-cancelable operating leases. Rent expense during fiscal years ended October 31, 1997, 1998 and 1999 amounted to approximately $118,000, $205,000, and $580,000, respectively.
GAMETECH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. COMMITMENTS AND CONTINGENCIES (CONTINUED)
Future minimum lease payments under these leases as of October 31, 1999 are as follows:
LITIGATION
The Company is involved in various legal proceedings arising out of its operations in the ordinary course of its business, including various complaints that have been filed alleging patent infringement. The Company does not believe that any of these proceedings will have a material adverse effect on its business, financial condition, or result of operations. However, an unfavorable outcome could have a material adverse effect on the Company's financial position and results of operations.
On February 13, 1998, a securities class action complaint, WEISS V. GAMETECH INTERNATIONAL, INC., No. 98-0268 PHX-ROS, was filed in the United States District Court for the District of Arizona against the Company and certain officers and directors alleging that defendants violated Section 11 of the Securities Act of 1933 (the "Securities Act") by making false misleading statements and omissions in the Company's Form S-1 Registration Statement in connection with the Company's public offering on November 25, 1997. Two other complaints making nearly identical factual allegations have been consolidated with the Weiss action for all purposes as IN RE GAMETECH, INC. SECURITIES LITIGATION, Master File No. Civ. 98-0268 PHX-ROS. On July 17, 1998, the Court appointed "lead plaintiff" and co-lead counsel.
On September 21, 1998, plaintiffs filed a consolidated complaint, alleging a claim against the Company and the individual defendants under Section 11 of the Securities Act and a claim against the individual defendants under Section 15 of the Securities Act, based upon the conduct alleged in the original complaints. Plaintiffs seek an unspecified amount of damages.
On November 5, 1998, defendants moved to dismiss the complaint. On June 3, 1999 Defendants' motion to dismiss was granted in part and denied in part by the Court. Defendants believe that there is no merit to plaintiffs' allegations and intend to defend the action vigorously. However, an unfavorable outcome could have a material adverse effect on the Company's financial position and results of operations.
7. STOCKHOLDERS' EQUITY
INITIAL PUBLIC OFFERING
In November 1997, the Company completed an initial public offering of 3,710,000 shares of its common stock, including 440,000 shares offered by certain stockholders of the Company, at a price of $11.00 per share. Such offering resulted in cash proceeds to the Company, net of underwriting discounts and offering expenses, of approximately $32.6 million.
GAMETECH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
7. STOCKHOLDERS' EQUITY (CONTINUED)
STOCK OPTIONS
The Company has elected to follow APB No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, in accounting for its employee stock options because, as discussed below, the alternative fair value accounting under SFAS No. 123, ACCOUNTING AND DISCLOSURE OF STOCK-BASED COMPENSATION, requires the use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized.
In August 1997, the Company adopted the 1997 Incentive Stock Plan (1997 Plan). Under the 1997 Plan, either incentive stock options ("ISO's") or nonqualified stock options ("NSO's"). NSO's may be granted to employees, directors and consultants to purchase the Company's stock at an exercise price determined by the board of directors at the date of grant. ISO's may be granted only to employees at an exercise price that equals or exceeds the fair value of such shares on the date such option is granted. The options generally have a term of ten years and vesting periods are determined at the discretion of the board of directors. The Company has reserved 4,000,000 shares of common stock for issuance under the 1997 Plan, which included options granted during the twelve months immediately preceding the adoption of the 1997 Plan. At October 31, 1999, options to purchase 1,068,841 shares of common stock were exercisable at exercise prices ranging from $0.11 to $6.00 per share under the 1997 Plan. In addition, at October 31, 1999, 1,905,400 shares of common stock were available for future grants under the 1997 Plan.
On July 9, 1998, the Company canceled 66,500 options held by certain employees issued under the 1997 Plan with an exercise price per share of $11.00 and granted 66,500 options with an exercise price per share of $4.00 to the same employees. The new options started a new vesting schedule from the new date of grant.
Pro forma information regarding net income and earnings per share is required by SFAS No. 123, and has been determined as if the Company had accounted for its employee stock options under the fair value method of that statement. The fair value for these options was estimated at the date of grant using a Black-Scholes pricing model with the following weighted-average assumptions for fiscal 1999: a risk-free interest rate of 6.2 percent, dividend yields of 0 percent, volatility factor of the expected market price of the Company's stock of .813 and a weighted-average life of the options of four years.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of the Company's employee stock options.
GAMETECH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
7. STOCKHOLDERS' EQUITY (CONTINUED)
For purpose of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options vesting period. The Company's pro forma information follows:
The effects of applying SFAS No. 123 for the years ended October 31, 1997, 1998, and 1999 are not likely to be representative of the effects on reported net income for future years.
A summary of the Company's stock option activity, and related information during the years ended October 31, 1997, 1998 and 1999 is presented below:
The following table summarizes information regarding stock options outstanding and exercisable at October 31, 1999:
The range of exercise prices of stock options outstanding and their weighted average remaining contractual life at October 31, 1999, were $.01 to $6.00 per share and 9.01 years, respectively.
GAMETECH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
8. NON-RECURRING ACQUISITION RELATED CHARGES
The Company recorded a non-recurring charge in April 1999 in the amount of $1.1 million resulting from the acquisition of BTC (Note 2) and the Company's plan to close and transition its existing Arizona operations to Nevada. Employees from all areas of the Company, including manufacturing, development and administrative areas, were extended severance agreements. The acquisition related charges were comprised of $637,000 related to accruals for severance costs and non-cancellable operating lease commitments on vacated facilities, and $411,000 in write-offs of existing assets which the Company determined had no on-going value as a result of the acquisition. Of the total accruals, $552,000 remained unpaid as of October 31, 1999.
9. INCOME TAXES
The income tax provisions consist of the following (in thousands):
GAMETECH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
9. INCOME TAXES (CONTINUED)
The significant components of the Company's deferred income tax assets and liabilities at October 31, 1998 and 1999 are as follows (in thousands):
The differences between the Company's provision for income taxes as presented in the accompanying statements of operations and provision for income taxes computed at the federal statutory rate is comprised of the items shown in the following table as a percentage of pre-tax earnings:
GAMETECH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. NET INCOME PER SHARE
A reconciliation of the shares used in the basic and fully diluted net income per share calculations are:
Net income used in the diluted earnings per share calculation was adjusted for the effect of interest expense on the convertible notes payable to officers, net of taxes of $112,000, and $8,000 in 1997 and 1998, respectively.
11. VALUATION AND QUALIFYING ACCOUNTS
12. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
RESTATEMENT OF UNAUDITED QUARTERLY FINANCIAL RESULTS
As described in Note 2 to the financial statements, the acquisition of Bingo Technologies Corporation ("BTC") was accounted for as a business combination using the purchase method of accounting. In accordance with Accounting Principles Board Opinion No. 16, "Accounting for Business Combinations," the cost of the BTC acquisition was allocated to the assets acquired and the liabilities assumed based on their estimated fair values using valuation methods believed to be appropriate at the time.
Subsequent to the issuance of the Company's financial results for the second and third quarters in fiscal year 1999, the charge made to in-process research and development ("IPR&D") was re-evaluated, and it was also determined that certain one-time acquisition-related charges related to the future
GAMETECH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
12. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) (CONTINUED)
closure of the Company's Arizona facility were misclassified and recorded in the incorrect quarter of 1999. As a result, the quarterly results for the second and third quarters of fiscal year 1999 have been restated to a) eliminate the amount previously expensed as IPR&D, with a corresponding increase to the amount capitalized as goodwill and b) reduce one-time acquisition-related charges from $4.5 million to $1.1 million. These charges, related primarily to the closure and transition of the Company's Arizona operations to Nevada, are being expensed as incurred.
RESTATEMENT OF UNAUDITED QUARTERLY FINANCIAL RESULTS (CONTINUED)
Summarized unaudited quarterly financial information for the years 1999 and 1998 are noted below (in thousands, except per share amounts):
THE ABOVE RESTATEMENTS DO NOT AFFECT PREVIOUSLY REPORTED NET CASH FLOWS FOR THE QUARTERLY PERIODS. | 13,415 | 87,619 |
1005188_1999.txt | 1005188_1999 | 1999 | 1005188 | ITEM 1. BUSINESS
Forward Looking Statements
This Annual Report on Form 10-K contains certain forward looking statements consisting of estimates with respect to the financial condition, results of operations and business of the Company that are subject to various factors which could cause actual results to differ materially from these estimates. These factors include: changes in general, economic and market conditions; the development of an interest rate environment that adversely affects the interest rate spread or other income anticipated from the Company's operations and investments; and depositor and borrower preferences.
General
North Central Bancshares, Inc. (the "Holding Company"), an Iowa corporation, is the holding company for First Federal Savings Bank of Iowa (the "Bank"), a federally chartered savings bank. Collectively, the Holding Company and the Bank are referred to herein as the "Company." The Holding Company was organized on December 5, 1995 at the direction of the Board of Directors of the Bank for the purpose of acquiring all of the capital stock to be issued by the Bank in connection with the conversion and reorganization of the Bank and North Central Bancshares, M.H.C. (the "MHC") from the mutual to the stock holding company structure (these transactions are collectively referred to as the "Conversion"). On March 20, 1996, upon completion of the Conversion, the Holding Company issued an aggregate of 4,011,057 shares of its Common Stock, par value $0.01 per share, of which 1,385,590 shares were issued in exchange for all of the Bank's issued and outstanding shares, except for shares owned by the MHC which were cancelled, and 2,625,467 shares were sold in Subscription and Community Offerings at a price of $10.00 per share, with gross proceeds amounting to $26,254,670. At this time, the Holding Company conducts business as a unitary savings and loan holding company and the principal business of the Holding Company consists of the operation of its wholly-owned subsidiary, the Bank.
The Holding Company's executive offices are located at the home office of the Company at 825 Central Avenue, Fort Dodge, Iowa. The Holding Company's telephone number is (515) 576-7531.
First Federal Savings Bank of Iowa
The Bank is a federally chartered savings bank that conducts its operations from its main office located in Fort Dodge, Iowa and seven branch offices located in Iowa. Four of the Bank's branches are located in north central Iowa in the cities of Fort Dodge, Nevada, Ames and Perry. On January 30, 1998, the Bank completed the acquisition of Valley Financial Corp., an Iowa corporation and the holding company for Valley Savings Bank, FSB (the "Acquisition"). See "Acquisition of Valley Financial Corp." As a result of the Acquisition, the Bank also has three branches in southeastern Iowa in the cities of Burlington and Mount Pleasant. The Bank is the successor to First Federal Savings and Loan Association of Fort Dodge, which was chartered originally in 1954, and on May 7, 1987 became a federally chartered savings bank. The Bank adopted its present name on February 27, 1998.
The Bank is a community-oriented savings institution that is primarily engaged in the business of attracting deposits from the general public in the Bank's market areas and investing such deposits in one- to four-family residential real estate mortgages, multi-family and commercial mortgages and, to a lesser extent, secured and unsecured consumer loans, with emphasis on second mortgage loans. The Bank's deposits are insured by the FDIC under the Savings Association Insurance Fund ("SAIF"). The Bank has been a member of the Federal Home Loan Bank ("FHLB") System since 1954. At December 31, 1999, the Bank had total assets of $367.6 million, total deposits of $271.8 million, and total shareholders' equity of $36.8 million.
The Bank's principal executive office is located at 825 Central Avenue, Fort Dodge, Iowa and its telephone number at that address is (515) 576-7531.
Acquisition of Valley Financial Corp.
As of the close of business on January 30, 1998, the Bank completed the Acquisition of Valley Financial Corp. ("Valley Financial"), pursuant to an Agreement and Plan of Merger, dated as of September 18, 1997, (the "Merger Agreement"). The Acquisition resulted in the merger of Valley Financial's wholly owned subsidiary, Valley Savings Bank, FSB ("Valley Savings") with and into the Bank, with the Bank as the resulting financial institution (the "Bank Merger"). Valley Savings, formerly headquartered in Burlington, Iowa, was a federally-chartered stock savings bank with three branch offices located in southeastern Iowa.
In connection with the Acquisition, each share of Valley Financial's common stock, par value $1.00 per share, issued and outstanding (other than shares held as treasury stock of Valley Financial) was cancelled and converted automatically into the right to receive $525.00 per share in cash pursuant to the terms and conditions of the Merger Agreement. As a result of the Acquisition, shareholders of Valley Financial were paid a total of $14,726,250 in cash. The source of funds for the Acquisition consisted of the Bank's accumulation of its cash flow from the maturity of short-term liquid investments, principal and interest on loans, sale of other investment securities, other cash receipts, net of operating expenses and other projected disbursements.
Market Area and Competition
The Company is an independent savings and loan company serving its primary market area of Webster, Story, Dallas, Henry and Des Moines Counties, which are located in the central, north central and south eastern parts of the State of Iowa. The Company's market area is influenced by agriculture as well as retail sales, professional services and public education. The Company is headquartered in Fort Dodge, the Webster County seat, where it operates two Company locations. The Company's Nevada branch operates in the city of Nevada, Iowa, the county seat for Story County. Nevada is located close to Ames, the location of Iowa State University, and is also located 35 miles from Des Moines, the state capital. The Company's Ames branch operates in the city of Ames, Iowa and is also located 30 miles from Des Moines. Burlington, the county seat of Des Moines County, is a strong retail center for southeastern Iowa. Mount Pleasant is the county seat of Henry County.
The unemployment rate for Webster County as of December 1999 was 2.2%, compared to the national rate of 4.1% and the State of Iowa rate of 2.2%. The unemployment rate for Story County was 1.8%, for Des Moines County was 1.9%, for Henry County was 2.2% and for Dallas County was 1.5%.
The Nevada, Iowa and Ames, Iowa markets have been a source of loan and depositor growth for the Company in recent periods, and the Company expects to continue to pursue lending and deposit growth opportunities in these markets, as well as the markets in Burlington, Mount Pleasant and Perry, Iowa. However, due to the loan demand in the Company's overall market area, increased competition, and the Company's decision to diversify its loan portfolio, the Company has originated and purchased loans (primarily multi-family and commercial real estate loans) from out of state. The Company intends to continue such originations and purchases pursuant to its underwriting standards for Company- originated loans.
The Company faces strong and increasing competition both in making loans and in attracting savings deposits. The Company's competition for loans comes principally from commercial banks, savings banks, other savings and loan associations, mortgage banking companies, finance companies and credit unions. The Company's most direct competition for savings deposits historically has come from commercial banks, savings banks, other savings and loan associations and credit unions. In addition, the Company faces increasing competition for savings deposits from non-bank institutions such as brokerage firms, insurance companies, money market mutual funds, other mutual funds (such as corporate and government securities funds) and annuities. Many such institutions have greater financial and marketing resources available to them than does the Company. Trends toward the consolidation of the banking industry, especially after enactment of the
Gramm-Leach-Bliley Act, and the lifting of interstate banking and branching restrictions may make it more difficult for relatively smaller institutions, such as the Bank, to compete effectively with large national and regional financial institutions.
While the Company is subject to competition from other financial institutions which may have greater financial and marketing resources, the Company believes that it benefits from its community bank orientation and can compete with other institutions by offering customers a high level of personal service and a wide range of competitively priced financial products. Further, management believes that the variety, depth and stability of the communities in which the Company is located support the service and lending activities conducted by the Bank.
Lending Activities
Loan Portfolio Composition. The principal components of the Company's loan portfolio are fixed- and adjustable-rate first mortgage loans secured by one- to four-family owner-occupied residential real estate, fixed- and adjustable-rate first mortgage loans secured by multi-family residential real estate and, to a lesser extent, secured and unsecured consumer loans, with emphasis on second mortgage loans. At December 31, 1999, the Company's loans receivable totalled $291.8 million, of which $164.1 million, or 56.3%, were one- to four-family residential real estate first mortgage loans and $91.1 million, or 31.2%, were other first mortgage loans, primarily multi-family and commercial real estate loans purchased by the Company. Consumer loans, consisting primarily of automobile loans and second mortgage loans, totalled $36.6 million, or 12.5%, of the Company's loan portfolio.
Savings associations, such as the Bank, are generally subject to the same limits on loans to one borrower as are imposed on national banks. Generally, under these limits, a savings association may not make a loan or extend credit to a single or related group of borrowers in excess of 15% of the association's unimpaired capital and surplus. Additional amounts may be lent, in the aggregate not exceeding 10% of unimpaired capital and surplus, if any such loan or extension of credit is fully secured by readily-marketable collateral. Such collateral is defined to include certain debt and equity securities and bullion, but generally does not include real estate. For the year ended December 31, 1999, it was the Company's policy to limit loans to one borrower to $2.5 million. At December 31, 1999, the Company's largest aggregate outstanding loan to one borrower was $2.5 million and the second largest borrower had an aggregate balance of $2.0 million. All such loans were first mortgage multi- family residential real estate loans and were performing as of that date.
Analysis of Loan Portfolio. Set forth below are selected data relating to the composition of the Company's loan portfolio by type of loan as of the dates indicated:
_______________________
(1) Includes interest-only construction loans that convert to permanent loans. (2) Second mortgage loans included $1.5 million, $1.4 million, $1.1 million, $862,000 and $724,000 (in actual dollars) of nonowner-occupied residential first mortgage loans at December 31, 1999, 1998, 1997, 1996 and 1995, respectively. (3) Other consumer loans included $1.6 million, $2.3 million, $269,000, $213,000 and $299,000 (in actual dollars) of commercial mortgage loans at December 31, 1999, 1998, 1997, 1996 and 1995, respectively.
Loan Maturity Schedule. The following table sets forth the maturity or period to repricing of the Company's loan portfolio at December 31, 1999. Overdraft lines of credit are reported as due in one year or less. Adjustable- rate loans are included in the period in which interest rates are next scheduled to adjust rather than in which they contractually mature, and fixed rate loans are included in the period in which the final contractual repayment is due.
________________________
(1) One- to four-family loans include $93.5 million of 7 year fixed rate loans that convert to adjustable rates at the beginning of the eighth year and are annually adjustable thereafter. $50.5 million of these loans with repricing periods greater than 5 years have been classified as fixed rate loans. $43.0 million of these loans with repricing periods less than 5 years have been classified as adjustable rate loans. (2) Includes second mortgage loans of $23.6 million at December 31, 1999.
The following table sets forth the dollar amounts of all fixed rate and adjustable rate loans in each loan category at December 31, 1999 due after December 31, 2000.
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(1) One- to four-family loans include $86.8 million of 7 year fixed rate loans that convert to adjustable rates at the beginning of the eighth year and are annually adjustable thereafter. $50.5 million of these loans with repricing periods greater than 5 years have been classified as fixed rate loans. $36.3 million of these loans with repricing periods less than 5 years have been classified as adjustable rate loans. (2) Includes second mortgage loans of $21.2 million at December 31, 1999.
One- to four-family Residential Real Estate Loans. Traditionally, the Company's primary lending activity consists of the origination of fixed- and adjustable-rate one- to four-family owner-occupied residential first mortgage loans, substantially all of which are collateralized by properties located in the Company's market area. The Company also originates one- to four-family, interest only construction loans that convert to permanent loans after an initial construction period that generally does not exceed nine months. At December 1999, 43.5% of the Company's residential real estate loans had fixed rates, and 56.5% had adjustable rates.
The Company originates loans for portfolio and sells loans in the secondary mortgage market. However, the Company's one- to four-family, fixed-rate, residential real estate loans originated for portfolio are generally originated and underwritten according to standards that qualify such loans to be included in Federal Home Loan Mortgage Corporation ("FHLMC") and Federal National Mortgage Association ("FNMA") purchase and guarantee programs and that otherwise permit resale in the secondary mortgage market. The Bank has sold fixed-rate loans with maturities equal to or in excess of 15 years in the secondary mortgage market.
For the year ended December 31, 1999, the Bank sold $475,000 of mortgage loans consisting of seven one- to four-family residential mortgage loans. One- to four-family loans are underwritten and originated according to policies approved by the Board of Directors. First Iowa Mortgage, Inc., the Bank's wholly owned mortgage banking subsidiary, sold $19.6 million of mortgage loans consisting of 207 one- to four-family residential mortgage loans.
Originations of one- to four-family fixed-rate first mortgage loans are monitored on an ongoing basis and are affected significantly by the level of market interest rates, the Company's interest rate gap position, and loan products offered by the Company's competitors. The Company's one- to four-family fixed-rate first mortgage loans amortize on a monthly basis with principal and interest due each month. To make the Company's fixed-rate loan portfolio more interest rate sensitive, the Company currently emphasizes the origination of fixed-rate loans with terms of 15 years or less to be held in portfolio. The Company also offers 5 and 7-year fixed-rate first mortgage loans that convert to adjustable-rate loans that adjust on an annual basis after the initial fixed- rate term. The overall maturity of these loans may be up to 30 years. The Company determines whether a customer qualifies for these loans based upon the initial fixed interest rate.
The Company's adjustable rate mortgage loans, or "ARM loans," are generally originated for terms of up to 30 years, with interest rates that adjust annually. The Company establishes various annual and life-of-the-loan caps on ARM loan interest rate adjustments. Currently, the Company offers ARM loans with annual rate caps of 1.5% and maximum life-of-loan caps of 11.95%. Prior to 1995, the Company's ARM loans originated for retention in its portfolio generally were based on the 11th District Cost of Funds Index, a lagging market index. At present, the interest rate on its ARM loans is calculated by using the weekly average yield on United States Treasury Securities adjusted to a constant maturity of one year. The Company currently offers one-year ARM loans with initially discounted rates, often known as "teaser rates." The Company determines whether a borrower qualifies for an ARM loan based on the fully indexed rate of the ARM loan at the time the loan is originated, rather than the introductory or "teaser" rate or the maximum life-of-the rate to which the loan could adjust. In addition, the Company establishes floors for each loan originated below which the loan may not adjust. One- to four-family residential ARM loans totalled $92.7 million, or 32.3%, of the Company's total net loan portfolio at December 31, 1999.
The primary purpose of offering ARM loans is to make the Company's loan portfolio more interest rate sensitive. ARM loans carry increased credit risk associated with potentially higher monthly payments by borrowers as general market interest rates increase. It is possible, therefore, that during periods of rising interest rates, the risk of default on ARM loans may increase due to the upward adjustment of interest costs to the borrower. Management believes that the Company's credit risk associated with its ARM loans is reduced because of the annual and lifetime interest rate adjustment limitations on such loans, although such limitations do create an element of interest rate risk. See "Discussion of Market Risk-- Interest Rate Sensitivity Analysis."
The Company's one- to four-family residential first mortgage loans customarily include due-on-sale clauses, which are provisions giving the Company the right to declare a loan immediately due and payable in the event, among other things, that the borrower sells or otherwise disposes of the underlying real property serving as security for the loan. Due-on-sale clauses are an important means of adjusting the rates on the Company's fixed rate mortgage loan portfolio, and the Company has generally exercised its rights under these clauses.
Regulations limit the amount that a savings institution may lend relative to the appraised value of the real estate securing the loan, as determined by an appraisal at the time of loan origination. See "Regulation-- Regulation of Federal Savings Associations--Real Estate Lending Standards." The Company's lending policies limit the maximum loan-to-value ratio on mortgage loans without private mortgage insurance to 80% of the lesser of the appraised value or the purchase price of the property to serve as collateral for the loan. The Company generally makes one- to four-family first real estate loans with loan-to-value ratios of up to 90%; however, for one- to four-family real estate loans with loan-to-value ratios greater than 80%, the Company requires the loan amount to be covered by private mortgage insurance. The Company requires fire
and casualty insurance, flood insurance, where applicable, an abstract of title, and a title opinion on all properties securing real estate loans originated by the Company.
Multi-family Residential and Commercial Real Estate Loans. The Company's loan portfolio contains loans secured by multi-family residential and commercial real estate. Such loans constituted approximately $91.1 million, or 31.8%, of the Company's total net loan portfolio at December 31, 1999. Of such loans, $83.6 million, or 91.8%, were purchased or originated by the Company and were secured by properties outside the State of Iowa (the "out of state" properties). There was no multi-family or commercial real estate loan more than 90 days past due at December 31, 1999. These loans are primarily secured by multi-family residences such as apartment buildings, and by commercial facilities, such as office buildings and retail buildings. Multi-family residential real estate loans are offered with fixed- and adjustable-rates and are structured in a number of different ways depending upon the circumstances of the borrower and the type of multi-family project. Fixed- rate loans generally amortize over 15 to 30 years, and generally contain call provisions permitting the Company to require that the entire principal balance be repaid at the end of five to fifteen years. Such loans are priced as five to fifteen year loans with maximum loan-to-value ratios of 80%. See "-- Purchased or Out of State Originated Loans."
All purchased or out of state originated loans in excess of $200,000 are approved by the Chief Executive Officer, Chief Operating Officer and the Board of Directors and are subject to the same underwriting standards as for loans originated by the Company. All purchased or out of state originated loans less than $200,000 are approved by the Chief Executive Officer and Chief Operating Officer and ratified by the Board of Directors and are subject to the same underwriting standards as loans originated by the Company. Before a loan is purchased, the Company obtains a copy of the original loan application, certified rent rolls, the original title insurance policy and personal financial statements of any guarantors of the loan. An executive officer or director of the Company also makes a personal inspection of the property securing the loan. Such purchases are made without recourse to the seller. The originating financial institution or mortgage banker may continue service the loans, remitting principal and interest to the Company. As of December 31, 1999, $21.5 million purchased or out of state originated loans were serviced by the Bank and $72.4 million were serviced by the originating financial institution or mortgage banker. The Company has a $2.5 million limit on the aggregate size of multi- family and commercial loans to any one borrower. Any exceptions to the limit must be specifically approved by the Board of Directors on a loan-by-loan basis within the Company's legal lending limit. See "Regulation -- Regulation of Federal Savings Associations -- Loans to One Borrower."
Loans secured by multi-family and commercial real estate generally involve a greater degree of credit risk than single-family residential mortgage loans and typically, such loans also have larger loan balances. This increased credit risk is a result of several factors, including the concentration of principal in a limited number of loans and borrowers, the effects of general economic conditions on income producing properties, and the increased difficulty of evaluating and monitoring these types of loans. Furthermore, the repayment of loans secured by multi-family and commercial real estate is typically dependent upon the successful operation of the related real estate property. If the cash flow from such real estate projects are reduced, the borrower's ability to repay the loan may be impaired.
Consumer Loans, Including Second Mortgage Loans. The Company also originates consumer loans, which primarily include second mortgage loans. As of December 31, 1999, second mortgage loans totalled $23.6 million, or 8.2%, of the Company's net total loan portfolio. The Company's second mortgage loans have fixed interest rates and are generally for terms of 3 to 5 years. The Company's second mortgage loans are secured by the borrower's principal residence generally with a maximum loan-to-value ratio, including the principal balances of both the first and second mortgage loans, of generally no more than 80%. The average principal amount of the Company's second mortgage loans is approximately $13,000. The Company also offers home equity lines of credit secured by second mortgage loans.
To a lesser extent, the Company also originates loans secured by automobiles, with fixed rates generally on a 80% loan-to-value basis for new cars. All of the Company's automobile loans were originated by the Company and generally have terms of up to five years.
In addition, the Company also makes other types of consumer loans, primarily unsecured signature loans for various purposes. The minimum loan amount for such loans is $1,000, the maximum loan amount for such loans is $7,500, and the average balance of such loans is approximately $2,500.
The Company originates a limited number of commercial business loans, which the Company includes with its consumer loan portfolio for reporting purposes. Such loans may be unsecured and are originated for any business purpose, such as for the purchase of computers and business equipment. The maximum loan amount for such unsecured loans is $7,500.
The Company's business plan calls for an increase in consumer lending for the foreseeable future, particularly second mortgage lending. The Company generally expects consumer loan demand will come from its mortgage loan customers. Consumer loans generally provide for shorter terms and higher yields as compared to residential first mortgage loans, but generally carry higher risks of default. At December 31, 1999, $102,000, or 0.28%, of the Company's consumer loan portfolio was on nonaccrual status.
Loan Originations, Solicitation, Processing, and Commitments. Loan originations are derived from a number of sources such as real estate agent referrals, existing customers, borrowers, builders, attorneys, and walk-in customers. Upon receiving a loan application, the Company obtains a credit report and employment verification to verify specific information relating to the applicant's employment, income, and credit standing. In the case of a real estate loan, an appraiser approved by the Company appraises the real estate intended to collateralize the proposed loan. An underwriter in the Company's loan department checks the loan application file for accuracy and completeness, and verifies the information provided. Pursuant to the Company's written loan policies, all first mortgage loans originated prior to 1998 were approved by the Chief Executive Officer. Beginning in 1998, the Chief Executive Officer approves all first mortgage loans greater than $150,000. All first mortgage loans less than $150,000 are approved by two members of senior management. The Loan Committee of the Board of Directors meets monthly to review a sampling of all loans originated in the month.
After a loan is approved, a loan commitment letter is promptly issued to the borrower. The commitment letter specifies the terms and conditions of the proposed loan including the amount of the loan, interest rate, amortization term, a brief description of the required collateral, and required insurance coverage. Commitments are typically issued for 60-day periods in the case of loans to refinance, loans to purchase existing real estate, and construction loans. The borrower must provide proof of fire and casualty insurance on the property serving as collateral, which insurance must be maintained during the full term of the loan. An abstract of title along with an attorney's title opinion is required on all first mortgage loans secured by real property in Iowa. At December 31, 1999, the Company had outstanding commitments to originate $1.4 million of loans. This amount does not include commitments to purchase loans, the undisbursed overdraft loan privileges or the unfunded portion of loans in process.
Purchased or Out of State Originated Loans. The Company's loan portfolio contains $94.0 million of loans secured by out of state properties. These loans represented 32.2% of the Company's total loan portfolio at December 31, 1999. Substantially all of the multi-family residential and commercial real estate loans in the Company's loan portfolio are purchased or originated out of state by the Company without recourse to the seller. The Company's investment in properties located in Wisconsin totalled $36.0 million and was primarily distributed between the Milwaukee and Madison areas. The Company's investment in properties in Colorado totalled $22.7 million and was primarily distributed between the Colorado Springs and Denver areas. At December 31, 1999, the Company's investment in properties located in California totalled $15.0 million and was distributed primarily in southern California. The remainder of the Company's purchased or out of state originated loans are distributed in various states. At December 31, 1999, the Company's multi-family residential and commercial real estate loans had an average balance of $410,000 and the largest loan had a principal
balance of $2.5 million. As of December 31, 1999 there were no multi-family or commercial real estate loan that was more than 90 days past due or on a nonaccrual status.
To supplement its origination of one- to four-family first mortgage loans, the Company also purchases loans secured by one- to four-family residences out of state. At December 31, 1999, $10.3 million, or 3.5%, of the Company's total loan portfolio consisted of purchased one- to four-family loans, of which $4.5 million were secured by properties located in Missouri and $1.9 million were secured by properties in Wisconsin. As of December 31, 1999 there were no purchased one- to four-family first mortgage loans that were on a nonaccrual status.
Loans purchased by the Company entail certain risks not necessarily associated with loans the Company originates. The Company's purchased loans are generally acquired without recourse with servicing retained by the seller or originator of the loans. Although the Company reviews each purchased loan using the Company's underwriting criteria for originations and a Company officer or director performs an on-site inspection of each purchased loan, the Company is dependent on the servicer of the loan for ongoing collection efforts and collateral review. In addition, the Company purchases loans with a variety of terms, including maturities, interest rate caps and indices for adjustment of interest rates that may differ from those offered at the time by the Company in connection with loans the Company originates. Finally, the market areas in which the properties which secure the purchased loans are located are subject to economic and real estate market conditions that may significantly differ from those experienced in the Company's market areas. If economic conditions continue to limit the Company's opportunities to originate loans in its market areas, the Company may increase its investment in out of state mortgage loans. There can be no assurance, however, that economic conditions in these out of state areas will not deteriorate in the future resulting in increased loan delinquencies and loan losses among the loans secured by property in these areas.
In an effort to reduce the risk of loss on out of state purchased loans, the Company only purchases loans that meet the underwriting policies for loans originated by the Company although specific rates and terms may differ from the rates and terms offered by the Company. The Company also requires appropriate documentation, and personal inspections of the underlying real estate collateral by an executive officer or director prior to purchase. The servicers of the loans generally conduct annual inspections of the underlying real estate collateral and copies of the reports of such inspections are typically provided to the Company.
Set forth below is a table of the Company's purchased or out of state originated loans by state of origin (including multi-family residential, commercial real estate and one- to four-family first mortgage loans) as of December 31, 1999.
Balance as of State December 31, 1999 ----- ----------------- (In thousands) Arizona $ 1,204 California 14,976 Colorado 22,708 Florida 289 Georgia 69 Illinois 249 Indiana 813 Kansas 817 Michigan 19 Minnesota 332 Missouri 5,406 Montana 101 Nebraska 556 Nevada 655 New Mexico 75 North Carolina 737 North Dakota 80 Ohio 806 Oregon 2,716 South Carolina 122 Tennessee 196 Texas 1,818 Utah 1,185 Virginia 47 Washington 1,942 Wisconsin 36,037 ------- Total $93,955 =======
Origination, Purchase and Sale of Loans. The table below shows the Company's originations, purchases and sales of loans for the periods indicated.
Loan Origination Fees and Other Income. In addition to interest earned on loans, the Company generally receives fees in connection with loan originations. Such loan origination fees, net of costs to originate, are deferred and amortized using an interest method over the contractual life of the loan. Fees deferred are recognized into income immediately upon prepayment of the related loan. At December 31, 1999, the Company had $106,000 of deferred loan origination fees, net. Such fees vary with the type of loans and commitments made. The Company typically charges a document preparation fee on fixed- and adjustable-rate first mortgage loans. In addition to loan origination fees, the Company also receives other fees, service charges (such as overdraft fees), and other income that consist primarily of deposit transaction account service charges and late charges. The Company recognized fees and service charges of $1.5 million, $1.2 million and $657,000 for the fiscal years ended December 31, 1999, 1998 and 1997, respectively.
Investment Activities
At December 31, 1999, the Company's investment portfolio is comprised of United States Treasury securities, United States Government agencies, municipal obligations, mortgage-backed securities, equity securities consisting of FHLMC preferred stock, FNMA preferred stock, FHLB stock, other common and preferred stocks and interest-earning deposits. At December 31, 1999, $4.5 million, or 11.8%, of the Company's investment portfolio, excluding equity securities, was scheduled to mature in one year or less, and $13.1 million, or 34.7%, was scheduled to mature within one to five years.
The Company is required under federal regulations to maintain a minimum amount of liquid assets that may be invested in specified short term securities and certain other investments. The Company generally has maintained a portfolio of liquid assets that exceeds regulatory requirements. Liquidity levels may be increased or decreased depending upon the yields on investment alternatives and upon management's judgment as to the attractiveness of the yields then available in relation to other opportunities and its expectation of the level of yield that will be available in the future, as well as management's projections as to the short term demand for funds to be used in the Company's loan origination and other activities. In addition, the Company's liquidity levels are affected by the level and source of its borrowed funds.
Investment Portfolio. The following table sets forth the carrying value of the Company's investment portfolio at the dates indicated.
Investment Portfolio Maturities. The following table sets forth the scheduled maturities, carrying values, market values and weighted average yields for the Company's investment portfolio at December 31, 1999.
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(1) Certain securities have call features which allows the issuer to call the security prior to maturity date.
Sources of Funds
General. Deposits are the major source of the Company's funds for lending and other investment purposes. In addition to deposits, the Company derives funds from FHLB advances, the amortization and prepayment of loans, the maturity of investment securities and operations. Scheduled loan principal repayments are a relatively stable source of funds, while deposit inflows and outflows and loan prepayments are influenced significantly by general interest rates and market conditions. The Company may use borrowings on a short-term basis to compensate for reductions in the availability of funds from other sources or on a longer term basis for general business purposes.
Deposits. During 1999, consumer and commercial deposits were attracted principally from within the Company's market area through the offering of a broad selection of deposit instruments including NOW accounts, savings accounts, money market savings, certificates of deposit and individual retirement accounts. The Company also offers these products in its new market area which it now serves as a result of the Acquisition. See "--Acquisition of Valley Financial Corp." Deposit account terms vary according to the minimum balance required, the period of time during which the funds must remain on deposit, and the interest rate, among other factors. The maximum rate of interest which the Company may pay is not established by regulatory authority. The Company regularly evaluates its internal cost of funds, surveys rates offered by competing institutions, reviews the Company's cash flow requirements for lending and liquidity, and executes rate changes when deemed appropriate. During 1999, the Company became a more active bidder for public funds in the State of Iowa. As a result, public fund deposits totalled $20.5 million at December 31, 1999. The Company does not obtain retail funds through brokers by solicitation of funds, nor by offering negotiated rates on certificates of deposit in excess of $100,000.
Deposit Portfolio. Deposits with the Company as of December 31, 1999 were represented by the various types of deposit programs described below.
The following table sets forth the change in dollar amount of deposits in the various types of deposit accounts offered by the Company between the dates indicated.
The following table sets forth the certificates of deposit in the Company classified by rates as of the dates indicated:
The following table sets forth the amount and maturities of certificates of deposit at December 31, 1999.
The following table indicates the amount of the Company's certificates of deposit of $100,000 or more by time remaining until maturity at December 31, 1999. This amount does not include savings accounts of greater than $100,000, which totalled approximately $981,000 at December 31, 1999.
The following table sets forth the savings activities of the Company for the periods indicated:
Borrowings
Deposits are the Company's primary source of funds. The Company may also obtain funds from the FHLB. FHLB advances are collateralized by selected assets of the Company. Such advances are made pursuant to several different credit programs, each of which has its own interest rate and range of maturities. The maximum amount that the FHLB will advance to member institutions, including the Bank, for purposes other than meeting withdrawals, fluctuates from time to time in accordance with the policies of the OTS and the FHLB. The maximum amount of FHLB advances to a member institution generally is reduced by borrowings from any other source.
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(1) Calculated using monthly weighted average interest rates.
Title Abstract Business
A component of the Company's operating strategy is to increase noninterest income through the expansion of its abstract company business conducted by First Iowa Title Services Inc. ("First Iowa"), a wholly owned subsidiary of the Company. On December 28, 1996, First Iowa purchased the assets of two abstract companies located in Webster and Calhoun Counties in Iowa. The abstract company in Calhoun County was subsequently sold on March 30, 1997. First Iowa currently provides real estate title abstracting services in Webster, Boone and Jasper Counties. These services include researching recorded documents at the county courthouse and providing a history of those documents as they pertain to specific parcels of real estate. This information is used to determine who owns specific parcels of real estate and what encumbrances are on those specific parcels. The abstract business performed by First Iowa replaces a significant portion of the function of a title insurance company. Iowa law prohibits Iowa insurance companies or companies authorized to do business in Iowa from issuing title insurance or insurance against loss or
damage by reason of defective title, encumbrance or otherwise. Institutions can purchase title insurance, for their own protection or to sell loans on the secondary market, but the cost of this insurance may not be passed on to the borrower. First Iowa had 19 employees as of December 31, 1999.
Insurance, Annuity and Mutual Fund Business
The Company has another wholly-owned subsidiary, First Federal Investment Services, Inc., ("First Federal Investment") formerly known as First Financial Service Corporation, which the Company began in 1971. On February 25, 2000, First Financial's name was changed to First Federal Investment Services, Inc. First Federal Investment's activities include the sale of life insurance on mortgage loans, and credit life, accident and health insurance on consumer loans made by the Company. In addition, First Federal Investment sells life insurance annuity products and mutual funds. First Federal Investment also originates leases for equipment such as computers, office equipment, light industrial equipment and commercial cleaning equipment. First Federal Investment has no employees. The subsidiary has executed a management agreement with the Company which provides its management and staff.
Mortgage Company Business
First Iowa Mortgage, Inc. (formerly known as Hearthstone Mortgage Company, Inc., "FIM") was acquired by the Company as part of the Acquisition and is a wholly-owned subsidiary of the Bank. FIM originates first mortgage loans and subsequently sells these loans and the mortgage servicing rights to investors. FIM currently operates in Ames, Iowa and at December 31, 1999 had 3 employees.
Multi-family Apartment Building
On July 13, 1995, the Company formed the Northridge Apartments Limited Partnership with the Fort Dodge Housing Corporation ("FDHC"), a non-profit Iowa corporation formed to acquire, develop and manage low- and moderate-income housing for residents of the Fort Dodge area. The FDHC is controlled by the Fort Dodge Municipal Housing Agency, an agency chartered by the City of Fort Dodge. The Northridge Partnership is a low-income housing tax credit project for certain federal tax purposes. A 44-unit apartment complex was completed on February 1, 1997. The tax credits for the year ended December 31, 1999 are approximately $154,000. The tax credits will continue for a seven-year period.
Personnel
At December 31, 1999, the Company had 106 full-time and 23 part-time employees (including the 19 employees of First Iowa and the 3 employees at FIM). None of the Company's employees is represented by a collective bargaining group. The Company believes its relationship with its employees to be good.
FEDERAL AND STATE TAXATION
Federal Taxation
General. The following is a general discussion of material tax matters and does not purport to be a comprehensive description of the tax rules applicable to the Holding Company or the Bank. The Bank has not been audited in the last five years. For federal income tax purposes, the Holding Company and the Bank will be eligible to file consolidated income tax returns and report their income on a calendar year basis using the accrual method of accounting and will be subject to federal income taxation in the same manner as other corporations with some exceptions, including particularly the Bank's tax reserve for bad debts, discussed below.
Bad Debt Reserves. The Bank, as a "small bank" (one with assets having an adjusted tax basis of $500 million or less) is permitted to maintain a reserve for bad debts with respect to "qualifying loans," which, in general, are loans secured by certain interests in real property, and to make, within specified formula limits, annual additions to the reserve which are deductible for purposes of computing the Bank's taxable income. Pursuant to the Small Business Job Protection Act of 1996, the Bank is now recapturing (taking into income) over a multi-year period a portion of the balance of its bad debt reserve as of December 31, 1995.
Distributions. To the extent that the Company makes "nondividend distributions" to shareholders, such distributions will be considered to result in distributions from the Company's "base year reserve," i.e. its reserve as "of December 31, 1987, to the extent thereof and then from its supplemental reserve for losses on loans, and an amount based on the amount distributed will be included in the Company's taxable income. Nondividend distributions include distributions in excess of the Company's current and accumulated earnings and profits, distributions in redemption of stock and distributions in partial or complete liquidation. However, dividends paid out of the Company's current or accumulated earnings and profits, as calculated for federal income tax purposes, will not constitute nondividend distributions and, therefore, will not be included in the Company's income.
The amount of additional taxable income created from a nondividend distribution is an amount that, when reduced by the tax attributable to the income, is equal to the amount of the distribution. Thus, approximately one and one-half times the nondividend distribution would be includable in gross income for federal income tax purposes, assuming a 34% federal corporate income tax rate.
Corporate Alternative Maximum Tax. The Internal Revenue Code (the "Code") imposes a tax on alternative minimum taxable income ("AMTI") at a rate of 20%. Only 90% of AMTI can be offset by net operating losses. AMTI is also adjusted by determining the tax treatment of certain items in a manner that negates the deferral of income resulting from the regular tax treatment of those items. Thus, the Company's AMTI is increased by an amount equal to 75% of the amount by which the Company's adjusted current earnings exceeds its AMTI (determined without regard to this adjustment and prior to reduction for net operating losses). The Company does not expect to be subject to the AMT.
Dividends-Received Deduction. The Holding Company may exclude from its income 100% of dividends received from the Bank as a member of the same affiliated group of corporations. The corporate dividends-received deduction is generally 70% in the case of dividends received from unaffiliated corporations with which the Holding Company and the Bank will not file a consolidated tax return, except that if the Holding Company or the Bank owns more than 20% of the stock of a corporation distributing a dividend, then 80% of any dividends received may be deducted.
State and Local Taxation
Iowa Taxation. The Holding Company and the Bank's subsidiaries will file Iowa corporation tax returns and the Bank will file an Iowa franchise tax return. The Bank currently files an Iowa franchise tax return, and the Holding Company and the Bank's subsidiaries file Iowa corporation tax returns, on a calendar year basis.
The State of Iowa imposes a tax on the Iowa franchise taxable income of thrift institutions at the rate of 5%. Iowa franchise taxable income is generally similar to federal taxable income except that interest from state and municipal obligations is taxable, and no deduction is allowed for state franchise taxes. The net operating loss carryback and carryforward rules are similar to the federal rules.
The state corporation income tax rate ranges from 6% to 12% depending upon Iowa corporation taxable income. Interest from federal securities is not deductible for purposes of the Iowa corporation income tax.
REGULATION
General
The Bank is subject to regulation, examination and supervision by the OTS, as its chartering agency, and the Federal Deposit Insurance Corporation ("FDIC"), as its deposit insurer. The Bank must file reports with the OTS and the FDIC concerning its activities and financial condition, and it must obtain regulatory approvals prior to entering into certain transactions, such as mergers with or acquisitions of other depository institutions. The OTS and the FDIC conduct periodic examinations to assess the Bank's compliance with various regulatory requirements. This regulation and supervision establishes a comprehensive framework of activities in which a savings association can engage and is intended primarily for the protection of the insurance fund and depositors. The Holding Company, as a savings and loan holding company, files certain reports with, and otherwise complies with, the rules and regulations of the OTS and of the Securities and Exchange Commission (the "SEC") under the federal securities laws.
The OTS and the FDIC have significant discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such policies, whether by the OTS, the FDIC or the Congress, could have a material adverse impact on the Company, the Bank, and the operations of both.
The following discussion is intended to be a summary of the material statutes and regulations applicable to savings associations and their holding companies, and it does not purport to be a comprehensive description of all such statutes and regulations.
Regulation of Savings and Loan Holding Companies
The Holding Company is a savings and loan holding company and is subject to OTS regulations, examinations, supervision and reporting requirements. In addition, the OTS has enforcement authority over the Holding Company and any of its non-savings association subsidiaries. Among other things, this authority permits the OTS to restrict or prohibit activities that are determined to be a serious risk to the financial safety, soundness or stability of a subsidiary savings association.
The Home Owners' and Loan Act ("HOLA"), as amended, prohibits a savings and loan holding company, directly or indirectly, or through one or more subsidiaries, from acquiring another savings association or holding company thereof, without prior written approval of the OTS; acquiring or retaining, with certain exceptions, more than 5% of a non-subsidiary savings association, a non- subsidiary holding company or a non-subsidiary company engaged in activities other than those permitted by HOLA; or acquiring or retaining control of a depository institution that is not insured by the FDIC. In evaluating an application by a holding company to acquire a savings association, the OTS must consider the financial and managerial resources and future prospects of the company and savings association
involved, the effect of the acquisition on the risk to the insurance funds, the convenience and needs of the community and competitive factors.
As a unitary savings and loan holding company "grandfathered" under the Gramm-Leach-Bliley Act, the Holding Company generally is not restricted under existing laws as to the types of business activities in which it may engage, provided that the Bank continues to satisfy the QTL test. Upon any nonsupervisory acquisition by the Company of another savings association or savings bank that meets the QTL test and is deemed to be a savings association by the OTS and that will be held as a separate subsidiary, the Holding Company would become a multiple savings and loan holding company and would be subject to limitations on the types of business activities in which it could engage. HOLA limits the activities of a multiple savings and loan holding company and its non-insured association subsidiaries primarily to activities permissible for bank holding companies under Section 4(c)(8) of the Bank Holding Company Act (the "BHC Act"), subject to the prior approval of the OTS, and to other activities authorized by OTS regulation.
The OTS is prohibited from approving any acquisition that would result in a multiple savings and loan holding company controlling savings associations in more than one state, subject to two exceptions: an acquisition of a savings association in another state (i) in a supervisory transaction, and (ii) pursuant to authority under the laws of the state of the association to be acquired that specifically permit such acquisitions. The conditions imposed upon interstate acquisitions by those states that have enacted authorizing legislation vary. Some states impose conditions of reciprocity, which have the effect of requiring that the laws of both the state in which the acquiring holding company is located (as determined by the location of its subsidiary savings association) and the state in which the association to be acquired is located, have each enacted legislation allowing its savings associations to be acquired by out-of- state holding companies on the condition that the laws of the other state authorize such transactions on terms no more restrictive than those imposed on the acquiror by the state of the target association. Some of these states also impose regional limitations, which restrict such acquisitions to states within a defined geographic region. Other states allow full nationwide banking without any condition of reciprocity. Some states do not authorize interstate acquisitions of savings associations.
Regulation of Federal Savings Associations
Business Activities. The Bank derives its lending and investment powers from the HOLA and the regulations of the OTS thereunder. Under these laws and regulations, the Bank may invest in mortgage loans secured by residential and commercial real estate, commercial and consumer loans, certain types of debt securities, and certain other assets. The Bank may also establish service corporations that may engage in activities not otherwise permissible for the Bank, including certain real estate equity investments and securities and insurance brokerage. These investment powers are subject to various limitations, including: (i) a prohibition against the acquisition of any corporate debt security that is not rated in one of the four highest rating categories; (ii) a limit of 400% of an association's capital on the aggregate amount of loans secured by nonresidential real estate property; (iii) a limit of 20% of an association's assets on commercial loans with the amount of commercial loans in excess of 10% of assets being limited to small business loans; (iv) a limit of 35% of an association's assets on the aggregate amount of consumer loans and acquisitions of certain debt securities; (v) a limit of 5% of assets on non-conforming loans (loans in excess of the specific limitations of HOLA); and (vi) a limit of the greater of 5% of assets or an association's capital on certain construction loans made for the purpose of financing what is or is expected to become residential property.
Loans to One Borrower. Under HOLA, savings associations are generally subject to the same limits on loans to one borrower as are imposed on national banks. Generally, under these limits, a savings association may not make a loan or extend credit to a single or related group of borrowers in excess of 15% of the association's unimpaired capital and surplus. Additional amounts may be lent, in the aggregate not exceeding 10% of unimpaired capital and surplus, if any such loan or extension of credit is fully secured by readily-marketable collateral. Such collateral is defined to include certain debt and equity securities and bullion, but generally does not include real estate. For the year ended December 31, 1999, the Bank generally imposed a $2.5 million limit on the aggregate size of loans to any one borrower. Any exception to the limit must be specifically approved by the Board of Directors on a loan-by-loan basis within the Bank's legal lending limit. At December 31, 1999, the Bank's largest aggregate amount of loans to one
borrower was $2.5 million, and the second largest borrower had an aggregate balance of $2.0 million. The Bank is in compliance with all applicable limitations on loans to one borrower.
QTL Test. HOLA requires a savings association to meet a qualified thrift lender, or "QTL" test. Under the QTL test, a savings association is required to maintain at least 65% of its "portfolio assets" in certain "qualified thrift investments" in at least 9 months of the most recent 12-month period. "Portfolio assets" means, in general, an association's total assets less the sum of (i) specified liquid assets up to 20% of total assets, (ii) goodwill and other intangible assets, and (iii) the value of property used to conduct the association's business. "Qualified thrift investments" includes various types of loans made for residential and housing purposes, investments related to such purposes, including certain mortgage-backed and related securities, consumer loans, small business loans, education loans and credit card loans. A savings association may also satisfy the QTL test by qualifying as a "domestic building and loan association" as defined in the Internal Revenue Code of 1986. At December 31, 1999, the Bank maintained 91.4% of its portfolio assets in qualified thrift investments, and it had more than 65% of its portfolio assets in qualified thrift investments in the requisite number of the prior 12 months.
A savings association that fails the QTL test must either operate under certain restrictions on its activities or convert to a bank charter. The initial restrictions include prohibitions against (i) engaging in any new activity not permissible for a national bank, (ii) paying dividends not permissible under national bank regulations, (iii) obtaining new advances from any FHLB, and (iv) establishing any new branch office in a location not permissible for a national bank in the association's home state. In addition, within one year of the date a savings association ceases to meet the QTL test, any company controlling the association would have to register under, and become subject to the requirements of, the BHC Act. If the savings association does not requalify under the QTL test within the three-year period after it failed the QTL test, it would be required to terminate any activity and to dispose of any investment not permissible for a national bank and would have to repay as promptly as possible any outstanding advances from an FHLB. A savings association that has failed the QTL test may requalify under the QTL test and be free of such limitations, but it may do so only once.
Capital Requirements. The OTS regulations require savings associations to meet three minimum capital standards: a tangible capital ratio requirement of 1.5% of total assets as adjusted under the OTS regulations, a leverage ratio requirement of 3% of core capital to such adjusted total assets, and a risk- based capital ratio requirement of 8% of total risk-based capital to total risk- weighted assets. In determining compliance with the risk-based capital requirement, a savings association must compute its risk-weighted assets by multiplying its assets and certain off balance sheet items by risk weights, which range from 0% for cash and obligations issued by the United States Government or its agencies to 100% for consumer and commercial loans, as assigned by the OTS capital regulation based on the risks the OTS believes are inherent in the type of asset. Tangible capital is defined, generally, as common stockholders' equity (including retained earnings), certain noncumulative perpetual preferred stock and related earnings and minority interests in equity accounts of fully consolidated subsidiaries, less intangibles (other than certain purchased mortgage servicing rights) and investments in an loans to subsidiaries engaged in activities not permissible for a national bank. Core capital is defined similarly to tangible capital, but core capital also includes certain qualifying supervisory goodwill and certain purchased credit card relationships. Supplementary capital currently includes cumulative and other perpetual preferred stock, mandatory convertible securities, subordinated debt and intermediate preferred stock and the allowance for loan and lease losses. The allowance for loan and lease losses includable in supplementary capital is limited to a maximum of 1.25% of risk-weighted assets, and the amount of supplementary capital that may be included as total capital cannot exceed the amount of core capital.
The OTS and the other federal banking agencies are required to take into account interest rate risk ("IRR") in their risk-based capital standards. The OTS adopted regulations, effective January 1, 1994, that set forth the methodology for calculating an IRR component to be incorporated into the OTS risk-based capital regulations. The OTS has indefinitely deferred the implementation of the IRR component in the computation of an institution's risk- based capital requirement. The OTS continues to monitor the IRR of individual institutions and retains the right to impose additional capital on individual institutions. At December 31, 1999, the Bank was not required to maintain any additional risk-based capital under this regulation.
At December 31, 1999, the Bank met each of its capital requirements, in each case on a fully phased-in basis. The table below presents the Bank's regulatory capital as compared to the OTS regulatory capital requirements at December 31, 1999:
A reconciliation between regulatory capital and GAAP capital at December 31, 1999 in the accompanying financial statements is presented below:
Limitation on Capital Distributions. Effective April 1, 1999, the OTS amended its capital distribution regulations to reduce regulatory burdens on savings associations. Under the amendments adopted by the OTS, certain savings associations will be permitted to pay capital distributions during a calendar year that do not exceed the association's net income for that year plus it retained net income for the prior two years, without notice to, or the approval of the OTS. However, a savings association subsidiary of a savings and loan holding company, such as the Bank, will continue to have to file a notice unless the specific capital distribution requires an application. In addition, the OTS can prohibit a proposed capital distribution, otherwise permissible under the regulation, if the OTS has determined that the association is in need of more than normal supervision or if it determines that a proposed distribution by an association would constitute an unsafe or unsound practice. Furthermore, under the OTS prompt corrective action regulations, the Bank would be prohibited from making any capital distribution if, after the distribution, the Bank failed to meet its minimum capital requirements, as described above. See"--Prompt Corrective Regulatory Action."
Liquidity. The Bank is required to maintain an average daily balance of liquid assets (cash, certain time deposits, bankers' acceptances, specified United States Government, state or federal agency obligations, shares of certain mutual funds and certain corporate debt securities and commercial paper) equal to a monthly average of not less than a specified percentage of its net withdrawable deposit accounts plus short-term borrowings. This liquidity requirement may be changed from time to time by the OTS to any amount within the range of 4% to 10% depending upon economic conditions and the savings flows of member institutions, and is currently 4%. OTS regulations also require each savings association to maintain an average daily balance of short-term liquid assets at a specified percentage of the total of its net withdrawable deposit account and borrowings payable in one year or less. Monetary penalties may be imposed for failure to meet these liquidity requirements. At December 31, 1999, the Bank's liquidity position was $31.7 million, or 10.84% of liquid assets, compared to $45.7 million or 17.58% at December 31, 1998. The Bank has never been subject to monetary penalties for failure to meets its liquidity requirements.
Assessments. Savings associations are required by OTS regulation to pay assessments to the OTS to fund the operations of the OTS. The general assessment, paid on a semi-annual basis, is computed upon the savings association's total assets, including consolidated subsidiaries, as reported in the association's latest quarterly Thrift Financial Report. The OTS adopted amendments to its regulations, effective January 1, 1999, that are intended to assess savings associations on a more equitable basis. The new regulations base the assessment for an individual
savings association on three components: the size of the association, on which the basic assessment would be based; the association's supervisory condition, which would result in an additional assessment based on a percentage of the basic assessment for any savings institution with a composite rating of 3, 4 or 5 in its most recent safety and soundness examination; and the complexity of the association's operations, which would result in an additional assessment based on a percentage of the basic assessment for any savings association that managed over $1 billion in trust assets, serviced for others loans aggregating more than $1 billion, or had certain off-balance sheet assets aggregating more than $1 billion. In order to avoid a disproportionate impact on the smaller savings institutions, which are those whose total assets never exceeded $100 million, the new regulations provide that the portion of the assessment based on assets size will be the lesser of the assessment under the amended regulations or the regulations before the amendment. Management believes that the change in its rate of OTS assessments under the amended regulations was not material.
Branching. Subject to certain limitations, HOLA and the OTS regulations permit federally chartered savings associations to establish branches in any state of the United States. The authority to establish such a branch is available (i) in states that expressly authorize branches of savings associations located in another state and (ii) to an association that qualifies as a "domestic building and loan association" under the Code, which imposes qualification requirements similar to those for a "qualified thrift lender" under HOLA. See "-- QTL Test." The authority for a federal savings association to establish an interstate branch network would facilitate a geographic diversification of the association's activities. This authority under HOLA and the OTS regulations preempts any state law purporting to regulate branching by federal savings associations.
Community Reinvestment. Under the Community Reinvestment Act ("CRA"), as implemented by OTS regulations, a savings association has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution's discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA requires the OTS, in connection with its examination of a savings association, to assess the association's record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications by such association. The CRA also requires all institutions to make public disclosure of their CRA ratings. The Bank received an "Outstanding" CRA rating in its most recent examination.
The CRA regulations establish an assessment system that bases an association's rating on its actual performance in meeting community needs. In particular, the assessment system focuses on three tests: (i) a lending test, to evaluate the institution's record of making loans in its service areas; (ii) an investment test, to evaluate the institution's record of investing in community development projects, affordable housing and programs benefitting low or moderate income individuals and businesses; and (iii) a service test, to evaluate the institution's delivery of services through its branches, ATMs and other offices.
Transactions with Related Parties. The Bank's authority to engage in transactions with its "affiliates" is limited by the OTS regulations and by Sections 23A and 23B of the Federal Reserve Act ("FRA"). In general, an affiliate of the Bank is any company that controls the Bank or any other company that is controlled by a company that controls the Bank, excluding the Bank's subsidiaries other than those that are insured depository institutions. The OTS regulations prohibit a savings association (i) from lending to any of its affiliates that is engaged in activities that are not permissible for bank holding companies under Section 4(c) of the BHC Act and (ii) from purchasing the securities of any affiliate other than a subsidiary. Section 23A limits the aggregate amount of transactions with any individual affiliate to 10% of the capital and surplus of the savings association and also limits the aggregate amount of transactions with all affiliates to 20% of the savings association's capital and surplus. Extensions of credit to affiliates are required to be secured by collateral in an amount and of a type described in Section 23A, and the purchase of low quality assets from affiliates is generally prohibited. Section 23B provides that certain transactions with affiliates, including loans and asset purchases, must be on terms and under circumstances, including credit standards, that are substantially the same or at least as favorable to the association as those prevailing at the time for comparable transactions with nonaffiliated companies. In the absence of comparable transactions, such transactions may only occur under terms and circumstances, including credit standards, that in good faith would be offered to or would apply to nonaffiliated companies.
The Bank's authority to extend credit to its directors, executive officers and 10% stockholders, as well as to entities controlled by such persons, is currently governed by the requirements of Sections 22(g) and 22(h) of the FRA and Regulation O of the Federal Reserve Board (the "FRB") thereunder. Among other things, these provisions require that extensions of credit to insiders (i) be made on terms that are substantially the same as, and follow credit underwriting procedures that are not less stringent than, those prevailing for comparable transactions with unaffiliated persons and that do not involve more than the normal risk of repayment or present other unfavorable features and (ii) not exceed certain limitations on the amount of credit extended to such persons, individually and in the aggregate, which limits are based, in part, on the amount of the association's capital. In addition, extensions of credit in excess of certain limits must be approved by the association's board of directors.
Enforcement. Under the Federal Deposit Insurance Act (the "FDI Act"), the OTS has primary enforcement responsibility over savings associations and has the authority to bring enforcement action against all "institution-affiliated parties," including any controlling stockholder or any stockholder, attorney, appraiser and accountant who knowingly or recklessly participates in any violation of applicable law or regulation or breach of fiduciary duty or certain other wrongful actions that causes or is likely to cause a more than a minimal loss or other significant adverse effect on an insured savings association. Civil penalties cover a wide range of violations and actions and range from $5,000 for each day during which violations of law, regulations, orders and certain written agreements and conditions continue, up to $1,000,000 per day for such violations if the person obtained a substantial pecuniary gain as a result of such violation or knowingly or recklessly caused a substantial loss to the institution. Criminal penalties for certain financial institution crimes include fines of up to $10 million and imprisonment for up to 30 years. In addition, regulators have substantial discretion to take enforcement action against an institution that fails to comply with its regulatory requirements, particularly with respect to its capital requirements. Possible enforcement actions range from the imposition of a capital plan and capital directive to receivership, conservatorship or the termination of deposit insurance. Under the FDI Act, the FDIC has the authority to recommend to the Director of OTS that enforcement action be taken with respect to a particular savings association. If action is not taken by the Director of the OTS, the FDIC has authority to take such action under certain circumstances.
Standards for Safety and Soundness. Pursuant to the FDI Act, as amended by Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") and the Riegle Community Development and Regulatory Improvement Act of 1994 (the "Community Development Act"), the OTS and the federal bank regulatory agencies have adopted a set of guidelines prescribing safety and soundness standards. The guidelines establish general standards relating to internal controls and information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, asset quality, earnings, and compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director or principal stockholder. In addition, the OTS adopted regulations that authorize, but do not require, the OTS to order an institution that has been given notice by the OTS that it is not satisfying any of such safety and soundness standards to submit a compliance plan. If, after being so notified, an institution fails to submit an acceptable compliance plan or fails in any material respect to implement an accepted compliance plan, the OTS must issue an order directing action to correct the deficiency and may issue an order directing other actions of the types to which an undercapitalized association is subject under the "prompt corrective action" provisions of FDICIA. If an institution fails to comply with such an order, the OTS may seek to enforce such order in judicial proceedings and to impose civil money penalties.
Real Estate Lending Standards. The OTS and the other federal banking agencies adopted regulations to prescribe standards for extensions of credit that (i) are secured by real estate or (ii) are made for the purpose of financing the construction of improvements on real estate. The OTS regulations require each savings association to establish and maintain written internal real estate lending standards that are consistent with safe and sound banking practices and appropriate to the size of the association and the nature and scope of its real estate lending activities. The standards also must be consistent with accompanying OTS guidelines, which include loan-to-value ratios for the different types of real estate loans. Associations are also permitted to make a limited amount of loans that do not
conform to the proposed loan-to-value limitations so long as such exceptions are reviewed and justified appropriately. The guidelines also list a number of lending situations in which exceptions to the loan-to-value standards are justified.
Prompt Corrective Regulatory Action. FDICIA establishes a system of prompt corrective action to resolve the problems of undercapitalized institutions. Under this system, the banking regulators are required to take certain supervisory actions against undercapitalized institutions, based upon the five categories of institutions established by FDICIA: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized," which are categories defined by the institution's regulatory capital ratios. Generally, a capital restoration plan must be filed with the OTS within 45 days of the date an association receives notice that it is "undercapitalized," "significantly undercapitalized," or "critically undercapitalized." In addition, various mandatory supervisory actions become immediately applicable to any undercapitalized institution, including restrictions on growth of assets and other forms of expansion. The OTS could also take any one of a number of discretionary supervisory actions, including the issuance of a capital directive and the replacement of senior executive officers and directors. Generally, subject to a narrow exception, FDICIA requires the applicable banking regulator to appoint a receiver or conservator for an institution that is critically undercapitalized. Under the OTS regulations, generally, a federally chartered savings association is treated as well capitalized if its total risk-based capital ratio is 10% or greater, its Tier 1 risk-based capital ratio is 6% or greater, and its leverage ratio is 5% or greater, and it is not subject to any order or directive by the OTS to meet a specific capital level. As of December 31, 1999, the Bank met the criteria for being considered "well capitalized" by the OTS.
When appropriate, the OTS can impose corrective action by a savings and loan holding company under the "prompt corrective action" provisions of FDICIA.
Insurance of Deposit Accounts. Pursuant to FDICIA, the FDIC established a risk-based assessment system for determining the deposit insurance assessments to be paid by insured depositary institutions. Under the assessment system, the FDIC assigns an institution to one of three capital categories based on the institution's financial information as of the reporting period ending seven months before the assessment period. The three capital categories consist of (i) well capitalized, (ii) adequately capitalized, or (iii) undercapitalized. The FDIC also assigns an institution to one of three supervisory subcategories within each capital group. The supervisory subgroup to which an institution is assigned is based on a supervisory evaluation provided to the FDIC by the institution's primary federal regulator and information that the FDIC determines to be relevant to the institution's financial condition and the risk posed to the deposit insurance funds. An institution's assessment rate depends on the capital category and supervisory category to which it is assigned. Under the regulation, there are nine assessment risk classifications (i.e., combinations of capital groups and supervisory subgroups) to which different assessment rates are applied. Assessment rates currently range from 0.0% of deposits for an institution in the highest category (i.e., well-capitalized and financially sound, with no more than a few minor weaknesses) to 0.27% of deposits for an institution in the lowest category (i.e., undercapitalized and substantial supervisory concern). The FDIC is authorized to raise the assessment rates as necessary to maintain the required reserve ratio of 1.25%. As a result of the Deposit Insurance Funds Act of 1996 (the "1996 Funds Act"), both the BIF and the SAIF currently satisfy the reserve ratio requirement. If the FDIC determines that assessment rates should be increased, institutions in all risk categories could be affected. The FDIC has exercised this authority several times in the past and could raise insurance assessment rates in the future. If such action is taken by the FDIC, it could have an adverse effect on the earnings of the Bank.
The 1996 Funds Act also provides that the FDIC cannot assess regular insurance assessments for an insurance fund unless required to maintain or to achieve the designated reserve ratio of 1.25%, except on those of its member institutions that are not classified as "well capitalized" or that have been found to have "moderately severe" or "unsatisfactory" financial, operational or compliance weaknesses. The Bank has not been so classified by the FDIC or the OTS.
In addition, the 1996 Funds Act expanded the assessment base for the payments on the FICO bonds. Beginning January 1, 1997, the deposits of both BIF- and SAIF-insured institutions were assessed for the payments on the FICO bonds. Until December 31, 1999, or such earlier date on which the last savings association ceases to exist, the rate of assessment for BIF-assessable deposits shall be one-fifth of the rate imposed on SAIF-assessable deposits. The
annual rate of assessments for the payments on the FICO bonds for the first, second, third and fourth quarters of the fiscal year 1999 were 0.0610%, 0.0588%, 0.0580% and 0.0592%, respectively.
Under the FDI Act, insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or the OTS. The management of the Bank does not know of any practice, condition or violation that might lead to termination of deposit insurance.
Privacy Protection. The OTS has recently proposed regulations implementing the privacy protection provisions of the Gramm-Leach-Bliley Act (the "GLB Act"). The proposed regulations would require each financial institution to adopt procedures to protect customers' and consumers' "nonpublic personal information" by November 13, 2000. The Bank would be required to disclose its privacy policy, including identifying with whom the Bank shares "nonpublic personal information," to customers at the time of establishing the customer relationship and annually thereafter. In addition, the Bank would be required to provide its customers with the ability to "opt-out" of having to share their personal information with unaffiliated third parties. The Bank intends to have a privacy protection policy in place prior to when the regulations are adopted in final form.
The GLB Act also provides for the ability of each state to enact legislation that is more protective of consumers' personal information. Currently, there are no privacy bills pending in the Iowa legislature. If any such bills are considered by the Iowa legislature, the Bank cannot predict what impact, if any, these bills would have.
Federal Home Loan Bank System. The Bank is a member of the FHLB of Des Moines, which is one of the regional FHLBs composing the FHLB System. Each FHLB provides a central credit facility primarily for its member institutions. The Bank, as a member of the FHLB of Des Moines, has been required to acquire and hold shares of capital stock in the FHLB of Des Moines in an amount at least equal to the greater of 1.0% of the aggregate principal amount of its unpaid residential mortgage loans and similar obligations at the beginning of each year or 1/20 of its advances (borrowings) from the FHLB of Des Moines. The Bank was in compliance with this requirement with an investment in FHLB of Des Moines stock at December 31, 1999 of $3.0 million. Any advances from a FHLB must be secured by specified types of collateral, and all long-term advances were required to be obtained only for the purpose of providing funds for residential housing finance.
Pursuant to the GLB Act, the foregoing minimum share ownership requirements will be replaced by regulations to be promulgated by the Federal Housing Finance Board. The GLB Act specifically provides that the minimum requirements in existence immediately prior to adoption of the GLB Act shall remain in effect until such regulations are adopted. Formerly, federal savings associations, such as the Bank, were also required to be members of the FHLB System. The new law removed the mandatary membership requirement and authorized voluntary membership for federal savings associations as is the case for all other eligible institutions.
In addition to changes to the membership and share ownership requirements, the GLB Act removed certain requirements governing advances made by FHLBs. Greater stock purchases required of non-QTL FHLB members when they receive advances were eliminated, as was the requirement that such members only apply for advances for housing finance purposes. A priority for making advances to QTL members and a 30% limit on total advances to non-QTL members was also removed. Further, the new law eliminated restrictions on obtaining new advances and having to repay advances after three years applicable to savings associations that are not QTLs.
The FHLBs are required to provide funds for the resolution of insolvent thrifts and to contribute funds for affordable housing programs. These requirements could reduce the amount of earnings that the FHLBs can pay as dividends to their members and could also result in the FHLBs imposing a higher rate of interest on advances to their members. If dividends were reduced, or interest on future FHLB advances increased, the Bank's net interest income would likely also be reduced.
Federal Reserve System. The Bank is subject to provisions of the FRA and the FRB's regulations pursuant to which depositary institutions may be required to maintain noninterest-earning reserves against their deposit accounts
and certain other liabilities. Currently, reserves must be maintained against transaction accounts (primarily NOW and regular checking accounts). The FRB regulations generally require that reserves be maintained in the amount of 3% of the aggregate of transaction accounts up to $46.5 million. The amount of aggregate transaction accounts in excess of $46.5 million are currently subject to a reserve ratio of 10%, which ratio the FRB may adjust between 8% and 12%. The FRB regulations currently exempt $4.9 million of otherwise reservable balances from the reserve requirements, which exemption is adjusted by the FRB at the end of each year. The Bank is in compliance with the foregoing reserve requirements. Because required reserves must be maintained in the form of either vault cash, a noninterest-bearing account at a Federal Reserve Bank, or a pass- through account as defined by the FRB, the effect of this reserve requirement is to reduce the Bank's interest-earning assets. The balances maintained to meet the reserve requirements imposed by the FRB may be used to satisfy liquidity requirements imposed by the OTS. FHLB System members are also authorized to borrow from the Federal Reserve "discount window," but FRB regulations require such institutions to exhaust all FHLB sources before borrowing from a Federal Reserve Bank.
Federal Securities Law
The Holding Company is registered with the SEC under Section 12(g) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). The Holding Company is subject to information, proxy solicitation, insider trading restrictions and other requirements under the Exchange Act.
ITEM 2.
ITEM 2. PROPERTIES
The Company conducts its business through its main office located in Fort Dodge, Iowa and seven full-service offices located in Fort Dodge, Nevada, Ames, Perry, Burlington and Mount Pleasant, Iowa. The following table sets forth certain information concerning the main office and each branch office of the Company and the offices of First Iowa Title Services and First Iowa Mortgage, Inc. at December 31, 1999. All of the offices of the Company are owned. In addition to the properties listed below, First Federal Investment Services, Inc. owns land in Fort Dodge, Iowa with a net book value of $99,000 and Northridge Apartments Limited Partnership owns a multi-family apartment building with a net book value of $1.8 million at December 31, 1999. The aggregate net book value of the Company's premises and equipment, on a consolidated basis was $5.4 million at December 31, 1999.
_____________________ (1) Does not include option to renew for an additional 3 years. (2) Does not include option to renew for an additional 5 years.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Registrant is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business. Such routine legal proceedings in the aggregate are believed by management to be immaterial to the Registrant's financial condition and results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the fourth quarter of the year ended December 31, 1999.
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
The information required by this Item is incorporated herein by reference to page 65 of the Company's 1999 Annual Report to Shareholders under the heading "Shareholder Information," which section is included in Exhibit 13.1 to this Report.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial and other data of the Company set forth below is derived in part from, and should be read in conjunction with, the Consolidated Financial Statements of the Company and Notes thereto presented elsewhere in this Annual Report on Form 10-K.
_______________________ (Notes on following page)
(1) Loans receivable, net represents total loans less discounts, loans in process, net deferred loan fees and allowance for loan losses. The allowance for loan losses at December 31, 1999, 1998, 1997, 1996 and 1995 was $2.8 million, $2.7 million, $2.2 million, $2.0 million and $1.7 million, respectively.
(2) Includes interest-bearing deposits with the Federal Home Loan Bank of Des Moines (the "FHLB").
(3) Efficiency ratio represents noninterest expense divided by the sum of net interest income before provision for loan losses plus noninterest income.
(4) Asset Quality Ratios are end of period ratios. With the exception of end of period ratios, all ratios are based on average monthly balances during the indicated periods and are annualized where appropriate.
(5) Tangible equity consists of stockholders' equity less goodwill and title plant. Goodwill and title plant at December 31, 1999, 1998, 1997, 1996 and 1995 was $6.8 million, $7.3 million, $1.1 million, $1.2 million and $1.1 million, respectively.
(6) Tangible assets consists of total assets less goodwill and title plant. Goodwill and title plant at December 31, 1999, 1998, 1997, 1996 and 1995 was $6.8 million, $7.3 million, $1.1 million, $1.2 million and $1.1 million, respectively.
(7) Nonperforming assets consists of nonaccrual loans, foreclosed real estate and other nonperforming assets.
(8) Basic earnings per share information is calculated by dividing net income by the weighted average number of shares outstanding. The weighted average number of shares outstanding for basic earnings per share computation for 1999, 1998, 1997, 1996 and 1995 were 2,562,940, 3,048,148, 3,184,269, 3,818,273 and 3,919,488, respectively.
(9) Diluted earnings per share information is calculated by dividing net income by the weighted average number of shares outstanding, adjusted for the effect of dilutive potential common shares outstanding which consists of stock options granted. The weighted average number of shares outstanding for diluted earnings per share computation for 1999, 1998, 1997, 1996 and 1995 were 2,621,542, 3,132,833, 3,241,069, 3,818,273 and 3,919,488, respectively.
(10) For 1996, excludes the one-time $817,000 (pre-tax) special assessment for the recapitalization of the Savings Association Insurance Fund ("SAIF").
(11) As of the close of business on January 30, 1998, the Company completed the Acquisition of Valley Financial Corp. Subsequent to January 30, 1998, the information contained in the Financial Selected Data tables reflect the effect of the Acquisition. Financial data prior to January 30, 1998, does not reflect the Acquisition and is based upon historical figures.
(12) Cash earnings excludes from net income the amortization of goodwill.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The information required by this Item is incorporated herein by reference to pages 7 through 30 of the Company's 1999 Annual Report to Shareholders under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations," which section is included in Exhibit 13.1 to this Report.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information required by this Item is incorporated herein by reference to pages 12 through 14 of the Company's 1999 Annual Report to Shareholders under the heading "Discussion of Market Risk--Interest Rate Sensitivity Analysis," which section is included in Exhibit 13.1 to this Report.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this Item is incorporated herein by reference to pages 31 through 63 of the Company's 1999 Annual Report to Shareholders under the headings "Independent Auditor's Report," "Consolidated Financial Statements" and "Notes to Consolidated Financial Statements," which section are included in Exhibit 13.1 to this Report.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None. PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information regarding Directors and Executive Officers of the Registrant is included under the headings "Information with Respect to Nominees and Continuing Directors," "Nominees for Election as Directors," "Continuing Directors," "Executive Officers" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's Proxy Statement for its Annual Meeting of Shareholders to be held on April 28,2000, which has been filed with the SEC and is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information relating to executive compensation is included under the headings "Executive Compensation" (excluding the Stock Performance Graph and the Compensation Committee Report) and "Directors' Compensation" in the Company's Proxy Statement for its Annual Meeting of Shareholders to be held on April 28, 2000, which has been filed with the SEC and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information relating to security ownership of certain beneficial owners and management is included under the headings "Principal Shareholders of the Company" and "Security Ownership of Management" in the Company's Proxy Statement for its Annual Meeting of Shareholders to be held on April 28, 2000, which has been filed with the SEC and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information regarding certain relationships and related transactions is included under the heading "Transaction with Certain Related Persons" in the Company's Proxy Statement for its Annual Meeting of Shareholders to be held on April 28, 2000, which has been filed with the SEC and is incorporated herein by reference. PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Financial Statements, Schedules and Exhibits
1. The consolidated balance sheets of North Central Bancshares, Inc. and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of income, equity and cash flows for the years ended December 31, 1999, 1998 and 1997, together with the related notes and the independent auditor's report of McGladrey & Pullen, LLP, independent certified public accounts.
2. Financial Statement Schedules have been omitted because they are not applicable or the required information is shown in the Consolidated Financial Statements or Notes thereto.
3. See Exhibit Index on following page.
(b) Reports on Form 8-K filed during the last quarter of 1999
None.
* Incorporated herein by reference to Registration Statement No. 33-80493 on Form S-1 of North Central Bancshares, Inc. (the "Registrant") filed with the Securities and Exchange Commission, (the "Commission") on December 18, 1995, as amended.
** Incorporated herein by reference to the Exhibits to the Annual Report on Form 10-K filed by Registrant for fiscal year 1995, filed with the Commission on March 29, 1996.
*** Incorporated herein by reference to the Amended Schedule 14A of Registrant filed with the Commission on August 19, 1996.
**** Incorporated herein by reference to the Annual Report on Form 10-K of the Registrant filed with the Commission on March 31, 1997.
***** Incorporated herein by reference to the Annual Report on Form 10-K of the Registrant filed with the Commission on March 31, 1998.
Conformed
SIGNATURES
Pursuant to the requirements of the Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant and has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
North Central Bancshares, Inc.
Date: March 27, 2000 /s/ David M. Bradley ------------------------ By: David M. Bradley Chairman, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. | 15,098 | 98,154 |
894537_1999.txt | 894537_1999 | 1999 | 894537 | Item 1. Business
The Company
Advanced Lumitech, Inc. ("ADLU" or "the Company") is a development stage company, which, through its subsidiary, Lumitech SA ("Swiss Lumitech"), has developed and patented a luminescent imaging media (the "Luminescent Product"), which can be used in a variety of products in numerous fields such as safety and signs, consumer electronics and color printing. The Company will market its Luminescence product and related products under the brand name `Brightec'. The Company plans to use only the most advanced and environmentally friendly luminescent materials in its products. Currently, the Company uses a new generation of high yield luminescent material, based on alkaline earth chemistry, which provides significantly greater luminescence than traditional zinc sulphide luminescent material.
The Company will manufacture, market and sell luminescent sheets and substances that are specially designed for state-of-the-art digital printing using pigments with the greatest light intensity. There are various categories and sizes of luminescent sheets, which will permit wide-spread applications in photography, color printing, textiles, decoration and different printing technologies. The luminescent substances are targeted for industrial and commercial applications such as paints, inks and compounds.
During the fourth quarter of 1999, the Company moved its corporate offices to the United States, assembled an executive team, identified preliminary market opportunities and established a sales and distribution network. Although the Company has not commenced commercial manufacturing or marketing of Brightec and has generated no revenues to date, it expects, although there are no assurances, that manufacturing, sales and marketing activities will commence in the second half of 2000. The manufacturing, marketing and selling of Brightec products is dependent upon the Company's successful raising of financing, as described in "Management's Discussion and Analysis - Liquidity and Capital Resources". As discussed in Note 1 to the Consolidated Financial Statements, these conditions, among others, raise substantial doubts about the Company's ability to continue as a going concern.
The Company was incorporated on April 16, 1986 as Hyena Capital, Inc., a Nevada corporation. For the period from incorporation to August 13, 1998, the Company had no operations of any kind. On August 13, 1998, the Company acquired 100% of the then outstanding common stock of Swiss Lumitech, a company founded in Switzerland in 1992, which had developed and patented the Luminescence technology.
For accounting purposes, the acquisition of Swiss Lumitech was treated as a reverse acquisition of the Company by Swiss Lumitech. However, the Company was the legal acquirer and accordingly, the acquisition was effected by the issuance of 4,000,000 newly issued common shares ($ 0.001 par value) of the Company. As a result of this transaction, the shareholders of Swiss Lumitech became majority shareholders of the Company, owning 80% of the Company's then issued 5,000,000 voting common shares. On August 14, 1998, the Company's Board of Directors authorized the change of the Company's name from Hyena Capital, Inc. to Advanced Lumitech, Inc. and authorized a five-for-one split of the Company's then issued common stock, increasing the Company's common stock to 25,000,000.
Prior to developing the Luminescence product, Swiss Lumitech's operations consisted of unrelated activities including the publication and marketing of a book written by Swiss Lumitech's co-founders. From that point until its acquisition by the Company, Swiss Lumitech engaged in the development of the Luminescence product and utilized it to develop a range of luminescent watches, which it distributed through an affiliated company, Lumitech BV (the "Netherlands Affiliate").
Strategy The Company's objective is to become the innovator and worldwide market leader in Luminescence products. The Company's strategy is to generate revenues from the commercial sale of the luminescent products, which will be sold under the brand name "Brightec". The Company's current business strategy is twofold. Initially, the Company expects to market and sell its luminescent sheets in retailing establishments through OEM's and over the internet. The Company expects this to provide short-term revenue to fund the research and development necessary to capitalize on the commercial marketplace.
Sales and Marketing The Company expects to market its products using both a direct sales and a broker network, who have access to retail channels, that reports to its Vice President of Sales. The Company also intends to sell its product over the internet using sites that are popular with its target markets. Currently, the Company does not have formal arrangements in place with distributors or third parties.
To deliver short-term revenue, the Company plans to capitalize on the rapidly growing ink-jet media market for recreational printing. It believes that its state of the art luminescence technology coupled with the ability of users to customize the product by using their own images will be a successful combination in the area of recreational printing that is being driven by personalization and creativity.
Research and Development Currently, the Company's development resources are focused on the final stages of commercialization of the luminescent sheets, including product testing and establishment of manufacturing capabilities in the U.S. In 1999, research and development expenses of approximately $674,000 were related to salaries and supplies to further develop the luminescence products and product testing. The Company intends to expend approximately the same amounts in FY 2000 for research and development activities to improve and broaden the Company's Luminescence products. In this regard, the Company expects to establish a laboratory in the U.S. and use its current lab in Switzerland for limited creative research. However, such expenditures are dependent on the Company's ability to successfully raise additional capital, as described in `Management's Discussion and Analysis -Liquidity and Capital Resources'. If the Company is unable to successfully raise such funds and is unable to invest further in research and development, the Company may be unable to develop new products or enter new markets and such inability may have an adverse effect on the Company's results of operations.
In 1999, the Company and Socol SA ("Socol"), a shareholder of the Company, which is a Swiss based private company which had worked with the Company in developing the Luminescence products, entered into a definitive collaboration agreement, the terms of which are set forth in a letter agreement (the "Socol Letter Agreement"). In the Letter Agreement, the Company agreed to issue 2,500,000 shares of its common stock to Socol; and Socol agreed to the following: (i) its agreement to accept such shares in full consideration for Socol's participation and efforts in connection with the Luminescence product, (ii) its disclaimer of any interest or right in or to the Company's Brightec products, the Luminescence product Patent or proprietary information and know how relating to said patents and Brightec
products and (iii) its agreement to transfer all know how relating to said patent and Brightec products and proprietary information to Lumitech. The Company also has a non-exclusive manufacturing agreement with Socol whereby Socol will provide to the Company certain luminescent substances at cost.
Manufacturing In 1999, the Company decided to outsource its manufacturing to a U.S based coating company. To this end, the Company entered into an agreement for the commercial manufacture of both the fluids and the luminescent sheets used in the manufacturing of the Luminescent Products. During the first half of this calendar year, the "know how" for the manufacture of the Luminescent Products will be transferred from Switzerland to the Company's U.S. based coating manufacturer. Formulation changes required for the scale up will be jointly handled between the two sites. The manufacturing process itself is being designed to allow multiple products to be generated from substantially the same product mix, thus allowing the Company to maintain lower levels of finished goods inventory than otherwise possible. The formulations of the fluids will continue to be provided by Socol. The plan, although there can be no assurances, is to be manufacturing products for sale by the end of the third quarter depending on the Company's ability to successfully raise additional capital, as described in `Management's Discussion and Analysis - Liquidity and Capital Resources'.
Source of Raw Materials To date, all materials in the Luminescent product have been purchased from third party suppliers through Socol. The Company anticipates that with its move to establish a U.S. based manufacturing process, the Company will assume responsibility for purchases from third parties. All raw materials used in the product are manufactured by leading companies in Europe, Japan and the U.S. The Company, although there can be no assurances, does not anticipate any problems obtaining materials used in the manufacturing process, including the luminescent pigments. The suppliers of these materials have assured the Company that they are capable of meeting the proposed manufacturing schedule and quantities.
Patents The Company first received a patent for the Luminescence product in France in August 1997 (the "Luminescence Technology Patent"). This patent covered the processes for all types of luminescent pictures (photographic, textile and decoration), as well as the products resulting from the implementation of such processes. The Company received a patent in Singapore in May 1999 and the European patent (including Germany, Austria, Belgium, Denmark, France, Spain, Greece, Ireland, Italy, Netherlands, Portugal, Great Britain, Sweden and Switzerland) has been approved for issuance as well as the patent for Poland. The Company expects that all of these patents will be delivered in the first half of 2000. The Company has also registered applications for the Luminescence Technology Patent in nine other countries including the United States of America, Canada, Brazil, Mexico Turkey, Federation of Russia, Japan, China and Hong Kong. The Company expects successful registration of the Luminescence Technology Patent in those remaining countries to take from six months to five years, depending on the country of application. The life of the Luminescence Technology Patent will vary from country to country, but at a minimum will extend to 2016. The inability to register the Luminescence product Patent in any of the above mentioned countries may have a material adverse effect on the Company's business, financial condition and results of operations.
On March 31, 1999, the Company and the co-inventor of the Luminescence product executed and delivered an agreement amending a prior agreement dated January 26, 1996 (the "Patent Assignment Agreement"). The Patent Assignment Agreement eliminates a requirement in the prior agreement that the Company pay royalties calculated as a percentage of product sales based upon the Luminescence product to the co-inventor and instead provides for the payment to said co-inventor of $160,000, and the issuance to said co-inventor of 800,000 shares of the Company's common stock. With respect to the cash payment obligation, the Company paid the co-inventor $25,000 in 1998 and $53,388 in 1999. The balance is payable from time to time as the Company's liquidity and other commitments permits. The 800,000 shares of the Company's common stock, with a value of $300,000 and the $160,000, payable in cash, were charged to expense in 1999. Accounts payable and accrued expenses at December 31, 1999 include approximately $78,000 of expenses related to the patent assignment agreement.
Seasonality Although it has not begun to market or sell its Brightec products, the Company does not anticipate any seasonality in its revenues.
Competition The Company is not aware of any competing product that offers the same features as Brightec. The Company does not intend for Brightec derived products to compete against other potentially cheaper, non-photographic quality products, based on existing zinc sulphide technology. Existing products, however, are manufactured using processes and technologies supported by companies which may have significantly greater resources and have been established and known in the luminescence field for a number of years. Although, such "glow in the dark" products are well known by the consumer and are already well established at certain of the Company's intended sales outlet channels, the Company believes its products are unique and will compete favorably with existing product offerings.
As in any technology industry, there are numerous new technologies being developed in imaging laboratories or by individual inventors, which technologies may render the Company's technology obsolete. The Company is not aware of any such competing technology under development or which has been developed.
Regulation No government authorization is required to offer the Company's products.
Employees As of December 31, 1999, the Company had 7 full time employees. As of March 31, 2000, the Company had 6 full time employees. The Company believes its future success will depend in part on its continued ability to recruit and retain highly qualified technical and managerial personnel.
Item 2.
Item 2. Properties
At December 31, 1999, the Company's only property was its office space located at 36 Avenue Cardinal Mermillod, Carouge, Switzerland. This office is leased under an agreement that allows the Company to terminate the lease at the end of each 12-month period. In conjunction with the Company's plan to launch its operations in the United States, the Company entered into a lease for its corporate office at 1601 Trapelo Road, Waltham, MA in January 2000. The Company currently occupies approximately 2,500 square feet at the Waltham location under the terms of a lease expiring in January 2002, with annual rent of approximately $83,000.
Item 3.
Item 3. Legal Proceedings
There are no material legal proceedings pending to which the Company is a party or to which any of its properties are subject.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
None
PART II
Item 5.
Item 5. Market for Registrant's Common Stock and Related Stockholder Matters
From inception to the date of the acquisition of Swiss Lumitech on August 13, 1998, there was no trading market for the Company's $.001 par value common stock. Since August 13, 1998, the Company's common stock has been traded Over-the-Counter Bulletin Board (US OTC-BB) under the symbol "ADLU".
The following table sets forth, on a per share basis, the range of high and low bid information for the common stock for each quarter since August 13, 1998 and reflect a five-for-one stock split effective August 14, 1998:
On March 31, 2000, the reported last sale price of the common stock on the US OTC-BB was $2.44 per share and there were 671 holders of record of common stock.
These price quotations represent prices between dealers and do not include retail mark ups, mark downs or commissions and may not necessarily represent actual transactions. Since its organization, the Company has not paid dividends on its capital stock. The Board of Directors does not contemplate declaring dividends in the near future.
The following securities were sold by the Company during the last three years and were not registered under the Securities Act of 1933, as amended (the "Securities Act").
In March 1999, the Company issued 800,000 shares of its common stock to Jacques-Charles Collet, the co-inventor of the Company's luminescence technology, in exchange for the co-inventor's release of all ownership rights in the technology. These shares were valued at approximately $300,000 based on the last price of the Company's common stock on the date of transfer.
In October 1999, the Company agreed to issue 2,500,000 shares of its common stock to Socol in exchange for the transfer of production processes and know-how to manufacture the Luminescent Products. These shares were valued at $1,875,000.
In November 1999, the Company sold a $375,000 unit of its common stock resulting in the issuance of 500,000 shares of its common stock and a warrant to purchase 500,000 shares of common stock at $1.00 per share.
In January 2000, the Company sold a $375,000 unit of its common stock resulting in the issuance of 500,000 shares of its common stock and a warrant to purchase 500,000 shares of common stock at $1.00 per share.
The Company relied on Regulation S and Regulation D promulgated under the Securities Act in connection with the security transactions described above.
Item 6.
Item 6. Selected Consolidated Financial Data
The following selected consolidated financial data for the five years ended December 31, 1999 have been derived from the Company's Consolidated Financial Statements, which have been audited by Ernst & Young LLP. The selected financial data presented below should be read in conjunction with the Company's Consolidated Financial Statements and Notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations", which is included elsewhere in this 10-K.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Factors That May Affect Future Results
Any statements contained in this Form 10-K that do not describe historical facts, including without limitation statements concerning expected revenues, earnings, product introductions and general market conditions, may constitute forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. Any such forward-looking statements contained herein are based on current expectations, but are subject to a number of risks and uncertainties that may cause actual results to differ materially from expectations. The factors that could cause actual future results to differ materially from current expectations include the following: the Company's ability to raise the financing required to support the Company's operations; the Company's ability to establish the intended operations; fluctuations in demand for the Company's products and services; the Company's ability to manage its growth; the Company's ability to develop, market and introduce new and enhanced products on a timely basis; the Company's lack of customers; and the ability of the Company to compete successfully in the future. Further information on factors that could cause actual results to differ from those anticipated is detailed in various filings made by the Company from time to time with the Securities and Exchange Commission. Any forward-looking statements should be considered in light of those factors.
General Advanced Lumitech, Inc. ("ADLU" or "the Company") is a development stage company, which, through its subsidiary, Lumitech SA ("Swiss Lumitech"), has developed and patented an exclusive new luminescent imaging media (the "Luminescent product"), which can be used in a variety of products in numerous fields such as safety and signs, consumer electronics and color printing. The Company will market its Luminescence product and related products under the brand name `Brightec'. The Company plans to use only the most advanced and environmentally friendly luminescent materials in its products. Currently, the Company uses a new generation of high yield luminescent material, based on alkaline earth chemistry, which provides significantly greater luminescence than traditional zinc sulphide luminescent material.
The Company will manufacture, market and sell luminescent sheets and substances that are specially designed for state-of-the-art digital printing using pigments with the greatest light intensity. There are various categories and sizes of luminescent sheets, which will permit wide-spread applications in photography, color printing, textiles, decoration and different printing technologies. The luminescent substances are targeted for industrial and commercial applications such as paints, inks and compounds.
During the fourth quarter of 1999, the Company moved its corporate offices to the United States, assembled an executive team, identified preliminary market opportunities and established a sales and distribution network. Although the Company has not commenced commercial manufacturing or marketing of Brightec and has generated no revenues to date, it expects manufacturing, sales and marketing activities to commence in the second half of 2000. The manufacturing, marketing and selling of Brightec products is dependent upon the Company's successful raising of financing, as described in "Management's Discussion and Analysis - Liquidity and Capital Resources'. If the Company is unable to successfully raise such funds or market Brightec or manufacture Brightec products, there is substantial doubt as to the Company's ability to continue as a going concern.
The Company was incorporated on April 16, 1986 as Hyena Capital, Inc., a Nevada corporation. For the period from incorporation to August 13, 1998, the Company had no operations of any kind. On August 13, 1998, the Company acquired 100% of the then outstanding common stock of Swiss Lumitech, a company founded in Switzerland in 1992, which had developed and patented the Luminescence Technology.
Prior to developing the Luminescence product, Swiss Lumitech's operations consisted of unrelated activities including the publication and marketing of a book written by Swiss Lumitech's co-founders. From that point until its acquisition by the Company, Swiss Lumitech engaged in the development of the Luminescence product and utilized it to develop a range of luminescent watches, which it distributed through an affiliated company, Lumitech BV (the "Netherlands Affiliate").
For accounting purposes, the acquisition of Swiss Lumitech was treated as a reverse acquisition of the Company by Swiss Lumitech. Accordingly, the following discussion reflects the combined operations of the Company and Swiss Lumitech from the inception date of Swiss Lumitech to December 31, 1999.
The Company's strategy is to generate revenues from the commercial sale of the luminescent sheets and substances, which will be sold under the brand name "Brightec". Initially, the Company will market and sell its luminescent sheets in retailing establishments through OEM's and over the internet. To deliver short-term revenue, the Company plans to capitalize on the rapidly growing ink-jet media market for recreational printing. This will provide a revenue stream to fund the research and development necessary to capitalize on the commercial marketplace. At December 31, 1999, the Company had not begun commercial marketing of Brightec and has accumulated losses of $5,811,742. The Company's current liabilities exceed its current assets by $749,066. The Company is in the process of raising approximately $5.0 million in a private placement of its shares and warrants. At December 31, 1999, the Company had successfully placed a $375,000 unit of its common stock resulting in the issuance of 500,000 shares of its common stock and a warrant to purchase 500,000 shares of its common stock at $1.00 per share. In January 2000, the Company placed the second unit for $375,000 resulting in the issuance of 500,000 shares of its common stock and a warrant to purchase 500,000 shares of its common stock at $1.00 per share. The Company believes it has the ability to complete the $5.0 million private placement, however, there can be no assurances that the Company will be able to raise the funds it requires. As a result of these factors, substantial doubt exists about the ability of the Company to continue to operate as a going concern and cannot be predicted at this time. The Company's ability to continue as a going concern is primarily dependent upon the Company's ability to obtain the necessary financing to enable it to successfully market Brightec and then upon future profitable operations. See `Liquidity and Capital and Capital Resources - Ability to Continue as a Going Concern'.
Results of Operation for Years ended 1999, 1998 and 1997.
Revenues: The Company had no revenues in 1999 or 1998 due to the change in the Company's operations as described above. During 1997, the Company's revenues and related cost of sales were generated exclusively from sales of Luminescence product watches to the Netherlands Affiliate. The Company expects future revenues, if any, to come from the sale of luminescent substances and sheets.
Gross Profit: Due to the Company's change in strategy described above, the Company recorded no revenues and therefore no gross profit in 1999 or 1998. For the year ended December 31, 1997, the Company recorded negative gross profit of $75,439, which was due in part to an inventory write-off of approximately $72,000 resulting from the disposal of all Luminescence product watches. The Company expects that future gross margins, if any, will result from the sale of Brightec products. Historical results are not indicative of expected future results.
Research and Development Expenses: Research and development expenses were $674,332 in 1999. The expenses in 1999 are related to salaries and supplies involved in the development efforts to further develop the luminescence product and related Brightec products and product testing. The Company intends to expend approximately the same funds in FY 2000 for research and development activities to improve and broaden the Company's Luminescence products. In this regard, the Company expects to establish a laboratory in the U.S. and maintain a creative laboratory in Switzerland.
Selling and Marketing Expenses: Selling and marketing expenses consist primarily of compensation, marketing and promotional materials and an allocation of facility related expenses. Selling and marketing expenses increased $196,307 in 1999 to $266,688 from $70,381 in 1998. Selling and marketing expenses increased $44,366 in 1998 to $70,381 from $26,015 in 1997. The increase in 1999 consists primarily of expenses incurred for marketing materials to support the launch of the Brightec brand name and expenses incurred in connection with establishing a sales and distribution network in the U.S. The increase in 1998 in selling and marketing expenses is primarily attributable to expenses incurred
for marketing materials to support the launch of the Brightec brand name. The Company expects that selling and marketing expenses will continue to increase in dollar amount as the Company introduces and promotes products.
General and Administrative: General and administrative expenses consist primarily of compensation of executive personnel, legal and accounting costs and an allocation of facility related expenses. General and administrative expenses increased $3,035,833 in 1999 to $3,256,907 from $221,074 in 1998. General and administrative expenses increased $153,899 in 1998 to $221,074 from $67,175 in 1997. The increase in general and administrative expenses in 1999 is due primarily to non-cash charges of $2,175,000 relating to the shares issued to the co-inventor and to Socol for the transfer of technology and know-how and approximately $800,000 in compensation expense related to the issuance of stock and stock options to consultants. The increase in general and administrative expenses in 1998 is primarily due to patent and patent application costs associated with the Company's Luminescence product and the costs of being a public company. The Company expects that, exclusive of the costs related to the agreement with the co-inventor and with Socol, general and administrative expenses will continue to increase in dollar amount as a result of an expansion in the Company's administrative staff to support its operations and as a result of being a public company.
Interest Expense Interest expense incurred on amounts due to related parties and the bank line of credit was $76,783, $48,660 and $50,902 in the years ended December 31, 1999, 1998 and 1997, respectively.
Income Taxes The Company has fully reserved for the tax benefits of its net operating losses at December 31, 1999 and 1998. At December 31, 1999 and 1998, the Company had federal net operating loss carryforwards of approximately $4.3 million and $0, respectively, which will expire in varying amounts through 2017 and foreign net operating losses of approximately $1.5 million at December 31, 1999 and 1998, which begin to expire in varying amounts through 2006, if not utilized. Utilization of net operating loss and tax credit carryforwards will be subject to substantial annual limitations provided by the Internal Revenue Code of 1986, as amended. The annual limitation may result in the expiration of net operating loss and tax credit carryforwards before full utilization
Liquidity and Capital Resources: Since inception, the Company has financed its working capital requirements primarily through private sales of its debt and equity securities. The Company has raised, from inception through December 31, 1999, cumulative net cash proceeds from the sale of common stock and exercise of stock options of approximately $1.5 million. The Company's net working capital deficit at December 31, 1999 was $749,066 compared to a deficit of $543,002 in 1998.
Cash and cash equivalents increased to $490,276 at December 31, 1999 from $207,938 at December 31, 1998. Net cash used in operating activities for the year ended December 31, 1999 was $677,818. The net cash used in operating activities during the year ended December 31, 1999 was principally the result of the net loss of $4,274,710, adjusted for non cash expenses of approximately $3,068,917 associated with stock based compensation, partially offset by an increase in accounts payable and accrued liabilities.
Net cash used in investing activities for the year ended December 31, 1999 was approximately $16,707, consisting of capital expenditures for property and equipment.
Net cash provided by financing activities for the year ended December 31, 1999 was approximately $855,746. The net cash provided of $855,746 was primarily the result of cash received in the Company's financing and cash received in the exercise of stock options.
Ability to Continue as a Going Concern At December 31, 1999, the Company had not begun to commercially market Brightec and generate revenues therefrom and the Company's operations to date have generated accumulated losses of $5,811,742. The Company's current liabilities exceed its current assets by $749,066 at December 31, 1999. Also, at December 31, 1999 the Company exceeded the borrowings available under the line-of-credit with a bank by approximately
$75,000. As of March 31, 2000 the Company has approximately $200,000 of funds available. These conditions raise substantial doubts about the Company's ability to continue as a going concern. The Company believes it has the ability to obtain additional funds from its principal stockholders or by raising additional debt or equity securities as described below. However, there can be no assurances that the Company will be able to raise the funds it requires, or that if such funds are available, that they will be available on commercially reasonable terms.
In order to generate future revenues from the sale of Brightec products, the Company anticipates making significant investments in personnel and resources over the next 12-month period. The Company also intends to repay a significant amount of debt, including the bank line-of-credit. The Company expects that it may require up to approximately $5.0 million of cash or available credit during the next 12-month period to finance payment of existing liabilities, including the bank line-of-credit, purchases of raw materials and operating expenses. The Company is continuing discussions with investors in its effort to obtain additional financing.
The ability of the Company to continue to operate as a going concern is primarily dependent upon the ability of the Company to raise the necessary financing, to effectively market and produce Brightec products, to establish profitable operations and to generate positive operating cash flows. If the Company fails to raise funds, or the Company's line-of-credit is reduced or terminated, or the Company is unable to generate operating profits and positive cash flows, there are no assurances that the Company will be able to continue as a going concern and it may be unable to recover the carrying value of its assets.
In November 1999, the Company successfully placed a $375,000 equity unit resulting in the issuance of 500,000 shares of its common stock and a warrant to purchase 500,000 shares of its common stock at $1.00 per share. In January 2000, the Company placed a second unit for $375,000 resulting in the issuance of 500,000 shares of its common stock and a warrant to purchase 500,000 shares of its common stock at $1.00 per share. Management believes that it will be successful in raising the necessary financing to fund the Company's operations through the 2000 calendar year. Accordingly, management believes that no adjustments or reclassifications of recorded assets and liabilities are necessary at this time.
Credit Availability The Company, through Swiss Lumitech, has borrowings under a line-of-credit with a Swiss bank. Pursuant to the terms of the bank line-of-credit, the Company may borrow up to $300,000, at the December 31, 1999 rate of exchange. At December 31, 1999 and 1998, the Company had exceeded such limit, but in each instance, the bank granted the Company a temporary extension, with no stated expiration date, to exceed the limit by the bank. The line-of-credit agreement contains terms and conditions, restricting Swiss Lumitech's ability to pledge its assets as security for separate borrowings and requiring the payment of interest each quarter. In addition, any and all accounts receivable generated by the Company are automatically pledged to the bank pursuant to the terms of the line-of-credit agreement. At December 31, 1999, the borrowings under the bank line-of-credit carries interest at 6.35%. The line-of-credit is guaranteed up to available borrowings by a relative of certain directors.
Should the Company's line-of-credit be reduced or terminated, or if the Company is unable to generate operating profits and positive cash flows, there are no assurances that the Company will be able to continue as a going concern and it may be unable to recover the carrying value of its assets. The Company does not believe the bank line-of-credit will be reduced or terminated in the near future and intends to repay it in full during 2000.
Commitments The Company had no material capital expenditure commitments as of December 31, 1999.
Effects of Inflation Management believes that financial results have not been significantly impacted by inflation and price changes.
Euro Currency The participating member countries of the European Union have adopted the Euro as its common legal currency on January 1, 1999. At this early stage of its assessment the Company cannot predict the impact of the conversion to the Euro.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
The Company faces exposure to financial market risks, including adverse movements in foreign currency exchange rates and changes in interest rates. These exposures may change over time as business practices evolve and could have a material adverse impact on the Company's financial results. The Company's primary exposure has been related to local currency revenue and operating expenses in Europe. Historically, the Company has not hedged specific currency exposures as gains and losses on foreign currency transactions have not been material to date.
Item 8.
Item 8. Financial Statements and Supplementary Data
ADVANCED LUMITECH, INC. Index to Consolidated Financial Statements
Report of Independent Auditors
Board of Directors and Stockholders Advanced Lumitech, Inc.
We have audited the accompanying consolidated balance sheets of Advanced Lumitech, Inc. (a development stage company) as of December 31, 1999 and 1998 and the related consolidated statements of operations, stockholders' deficit, and cash flows for each of the three years in the period ended December 31, 1999 and for the period from inception (February 7, 1992) to December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe our audits provide a reasonable basis for our opinion.
In our opinion, based on our audits, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Advanced Lumitech, Inc. (a development stage company) at December 31, 1999 and 1998 and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1999 and for the period from inception (February 7, 1992) to December 31, 1999, in conformity with accounting principles generally accepted in the United States.
The accompanying consolidated financial statements have been prepared assuming that the Company will continue to operate as a going concern. As more fully described in Note 1, the Company has incurred recurring operating losses since inception, has generated an accumulated deficit of $5,811,742 since inception and has a working capital deficit of $749,066 at December 31, 1999. In addition, the Company has limited cash resources and borrowings exceed the line-of-credit established with its bank. These conditions raise substantial doubt about the Company's ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 1. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty.
/s/ Ernst & Young LLP
Boston, Massachusetts April 5, 2000
ADVANCED LUMITECH, INC. (A DEVELOPMENT STAGE ENTERPRISE) CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated financial statements
ADVANCED LUMITECH, INC. (A DEVELOPMENT STAGE COMPANY) CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes to consolidated financial statements
ADVANCED LUMITECH, INC. (A DEVELOPMENT STAGE COMPANY) CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements
ADVANCED LUMITECH, INC. (A DEVELOPMENT STAGE COMPANY) CONSOLIDATED STATEMENTS OF STOCKHOLDERS' DEFICIT
See accompanying notes to consolidated financial statements
ADVANCED LUMITECH, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. The Company and its Ability to Continue as a Going Concern The Company is a development stage company, which, through its subsidiary, Swiss Lumitech, has developed and patented an exclusive new Luminescence product, which can be applied to a variety of objects in numerous applications. The Company will market the Luminescence product and related products under the brand name "Brightec". Although the Company believes it has developed the Brightec products to a marketable form, it has yet to commercially market the Brightec products and generate revenues therefrom.
From the period January 1, 1996 to December 31, 1997, the Company's business strategy was to sell watch dials, on to which the Luminescence product had been applied, to an affiliated company. Effective December 31, 1997, the Company ceased such activities and focused its efforts on further developing the Luminescence product and Brightec products and raising funds to finance its new business strategy. Accordingly, the Company is classified as a development stage company in accordance with Statement of Financial Accounting Standards No. 7, "Accounting and Reporting by Development Stage Enterprises."
The consolidated financial statements have been prepared on the basis that the Company will continue to operate as a going concern, including the realization of its assets and settlement of its liabilities at their carrying values in the ordinary course of business for the foreseeable future. At December 31, 1999, the Company has yet to commercially market Brightec and generate revenues therefrom and the Company's operations to date have generated accumulated losses of $5,811,742. At December 31, 1999, the Company's current liabilities exceed its current assets by $749,066 and the Company had outstanding advances of approximately $75,000 above the limit available to it under its line-of-credit arrangements with a Swiss bank.
In order to generate future revenues from the sale of Brightec products, the Company anticipates making significant investments in personnel and resources over the next 12-month period. The Company also intends to repay a significant amount of debt, including the bank line-of-credit. The Company expects that it may require up to approximately $5.0 million of cash or available credit during the next 12-month period to finance payment of existing liabilities, including the bank line-of-credit, purchases of raw materials and operating expenses. The Company is continuing discussions with institutional investors in its effort to obtain additional financing; however, there is no assurance that such financing can be obtained.
The ability of the Company to continue to operate as a going concern is primarily dependent upon the ability of the Company to raise the necessary financing, to effectively market and produce Brightec products, to establish profitable operations and to generate positive operating cash flows. If the Company fails to raise funds, or the Company's line-of-credit is reduced or terminated, or the Company is unable to generate operating profits and positive cash flows, there are no assurances that the Company will be able to continue as a going concern and it may be unable to recover the carrying value of its assets.
In November 1999, the Company sold an equity unit consisting of 500,00 shares of its common stock and a warrant to purchase 500,000 shares of common stock at $1.00 per share for cash of $375,000. In January 2000, the Company sold an equity unit consisting of 500,000 shares of its common stock and a warrant to purchase 500,000 shares of common stock at $1.00 per share for cash of $375,000. Management believes that it will be successful in raising the necessary financing to fund the Company's operations through the 2000 calendar year, however, there can be no assurances that such financing can be obtained. Accordingly, management believes that no adjustments or reclassifications of recorded assets and liabilities are necessary at this time.
2. Restatement of 1999 Third Quarter Results of Operations During the fourth quarter of 1999, the Company recorded a non cash charge of $893,917 for compensation expense associated with options and common stock granted to consultants, which principally vested upon grant in the third quarter ended September 30, 1999. A summary of the impact of such restatement for the three and nine-months ended September 30, 1999 is as follows:
3. Summary of Significant Accounting Policies Basis of Presentation: The accompanying consolidated financial statements include the accounts of Advanced Lumitech, Inc. and its wholly owned subsidiary, Lumitech SA. All significant intercompany accounts and transactions have been eliminated in consolidation.
Effective August 13, 1998, the Company acquired 100% of the then outstanding common stock of Swiss Lumitech for consideration of 4,000,000 newly issued common shares ($ 0.001 par value) of the Company. As a result of this transaction, the shareholders of Swiss Lumitech became majority shareholders of the Company, owning 80% of the Company's then issued 5,000,000 voting common shares before giving effect to the previously disclosed 5 for 1 stock split.
For accounting purposes, the acquisition of Swiss Lumitech was treated as a purchase (reverse acquisition) of the Company by Swiss Lumitech. In a reverse acquisition, the historical shareholders' equity of the acquiror prior to the merger is retroactively restated (a recapitalization) for the equivalent number of shares received in the merger after giving effect to any difference in par value of the issuers and acquirer's stock by an offset to paid in capital. All share and per-share information has been presented in the accompanying consolidated financial statements as if recapitalization had occurred as of the first day presented in the financial statements. Accordingly, the accompanying consolidated financial statements and related notes reflect the operations of the Company combined with the operations of Swiss Lumitech from February 7, 1992, the inception date of Swiss Lumitech, to December 31, 1999.
Use of Estimates: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Cash and Cash Equivalents: All short-term investments which have an original maturity of 90 days or less, and are valued at cost plus accrued interest which approximates market, are considered to be cash equivalents.
Revenue Recognition: The Company recognizes revenue upon product shipment or when title passes.
Concentrations of Credit Risk: Credit risk results from the possibility that a loss may occur from the failure of another party to perform according to the terms of a contract. Financial instruments that potentially subject the
Company to concentrations of credit risk consist principally of cash and cash equivalents. The Company places its available cash with high quality financial institutions to mitigate the risk of material loss in this regard. Accordingly, management believes the likelihood of incurring material losses due to concentration of credit risk is remote.
Office and Photographic Equipment: Office and photographic equipment are stated at cost, less accumulated depreciation, which is computed using the straight-line method over the estimated useful life of the related assets, which the Company has determined to be five years.
Foreign Currency: From inception to date, the Company's revenues and expenses have been generated and incurred by Swiss Lumitech, which operates within Switzerland. Accordingly, the functional currency of the Company is the Swiss Franc. Foreign currency denominated assets and liabilities are translated into U.S. dollar equivalents based on exchange rates prevailing at the end of each period. Revenues and expenses are translated at average exchange rates during the period. Aggregate foreign exchange gains and losses arising from the translation of foreign currency denominated assets and liabilities are included as a component of comprehensive loss. Such realized gains and losses have not been material to date.
Income Taxes: Deferred tax assets and liabilities are recognized based on temporary differences between the financial statements and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the temporary differences are expected to reverse. A valuation allowance is applied against net deferred tax assets if, based on available evidence, it is more likely than not that some or all to the deferred assets will not be realized.
Patent and Patent Applications: The Company capitalizes patent and patent application costs as incurred, if recoverability is reasonably assured. Such costs were $169,531 for the year ended December 31, 1999 and $216,535 for the period from February 7, 1992 to December 31, 1999. These costs have been expensed due to the uncertainty as to recoverability.
Stock Splits: On August 14, 1998, the Company's Board of Directors approved a 5-for-1 stock split of the Company's issued and outstanding common shares (the "Stock Split"). Accordingly, the Company's then issued and outstanding share capital of 5,000,000 shares was increased to 25,000,000. All share and per share information have been retroactively restated to reflect the stock split.
Earnings Per Share: Earnings per share are presented in accordance with Statement of Financial Accounting Standards No. 128, "Earnings per Share" ("SFAS 128"), which requires the presentation of "basic" earnings per share and "diluted" earnings per share. Basic earnings per share is computed by dividing income available to common shareholders by the weighted-average shares of common stock outstanding during the period. For purposes of computing diluted earnings per share the denominator includes both the weighted-average shares of common stock outstanding during the period and the weighted average number of potential shares of common stock, if any. There is no difference between basic and diluted net loss per share for the Company, since it has incurred losses since inception.
Segment Information: Effective January 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131"). SFAS 131, establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports. If also establishes standards for related disclosures about products and services, geographic areas and major customers. During the periods presented in the consolidated financial statements, the Company has operated in only one operating segment - Luminescence product development. Long-lived assets are principally located in Switzerland.
Stock Based Compensation: The Company has elected to follow Accounting Principles Board Opinion (APB) No. 25, "Accounting for Stock Issued to Employees" in accounting for its stock-based employee compensation plans, rather than the alternative fair value accounting method provided for under Statement of Financial Accounting Standard (SFAS) No. 123, "Accounting for Stock-Based Compensation," as this alternative requires the use of option
valuation models that were not developed for use in valuing employee stock options. Under APB No. 25, since the exercise price of options granted to employees under these plans equals the market price of the underlying stock on the date of grant, no compensation expense is recognized for such grants. Stock- based compensation represents the cost, based on SFAS 123, of granting options to consultants in 1999, measured under variable plan accounting and recognized over the vesting period of the options. The Company recognized compensation expense of $743,917 in 1999 and has $58,083 of unamortized deferred compensation at December 31, 1999. Under variable plan accounting, the value of unvested options will be re-measured and recognized in income at each reporting date until vesting occurs.
4. New Accounting Pronouncements In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). SFAS 133 will become effective in 2001. SFAS 133 requires that all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction. To date the Company has not utilized derivative instruments or hedging activities and, therefore, the adoption of SFAS 133 is not expected to have a material impact on the Company's financial position or results of operations.
5. Related Party Transactions The balance sheet classification "Accounts payable to affiliated companies" includes amounts owed to a Netherlands company whose principal shareholder is a shareholder of the Company (the "Netherlands Affiliate") for the repurchase of certain licenses granted by the Company to the Netherlands Affiliate for the use and exploitation of the Company's Luminescence product (the "Netherlands Affiliate Product Rights"). In addition, at December 31, 1997, accounts payable to affiliated companies include amounts owed to a separate entity ("Lumicorp") controlled by the Company's directors, for the repurchase of certain other rights relating to the Luminescence product (the "Lumicorp Product Rights"), which the Company had previously sold or licensed to these entities. At December 31, 1998, the Company had informally agreed to repurchase the Netherlands Affiliate Product Rights at the equivalent amount the Netherlands Affiliate had paid to acquire them, plus an additional $70,000 for costs and expenses the Netherlands Affiliate paid or incurred in the development of processes, products and markets. The Company repurchased the Lumicorp Product Rights during 1998 for the equivalent amount Lumicorp previously paid to acquire them. The decision to repurchase the Product Rights was a direct result of the change in the Company's strategy, as discussed in Note 1.
During 1999, the Company entered into a technology transfer agreement with Socol S.A. ("Socol"), whose major shareholder is a shareholder of the Company. This agreement, which is effective October 1999, provides for the transfer of production processes and know how developed by Socol using the Lumicorp Products rights to the Company in exchange for an obligation to issue 2.5 million shares of common stock with a value of $1,875,000. As of December 31, 1999, and from the effective date of October 30, 1999, the 2.5 million shares have been reflected in the accompanying financial statements as outstanding. The shares were issued in February 2000. The value of the shares has been expensed due to the uncertainty of the Company's ability to develop production capabilities and produce product on a commercially viable basis.
The balance sheet classification "Note payable to related party" represents amounts owed to a director of one of the Company's former significant suppliers. The note has no stated maturity and has an interest rate of 7%. The borrowings under this note payable are not secured.
The balance sheet classification "Notes payable to directors" represents amounts owed to the Company's directors, pursuant to three separate agreements (the "Director's Note Agreements"). The Director's Note Agreements have no stated maturity and have an interest rate of 7%. The borrowings under the Director's Note Agreements are not secured, and the note holders have agreed not to require payment in cash before January 1, 2001.
6. Income Taxes The Company has fully reserved for the tax benefits of its net operating losses at December 31, 1999 and 1998 because of uncertainty about realization. At December 31, 1999, the Company had net operating loss carryforwards for U.S. federal income tax purposes of approximately $4.3 million which will expire in varying amounts through 2017 and foreign net operating losses of approximately $1.5 million at December 31, 1999 which begin to expire in varying amounts through 2006, if not utilized. Utilization of net operating loss and tax credit carryforwards will be subject to substantial annual limitations provided by the Internal Revenue Code of 1986, as amended. The annual limitation may result in the expiration of net operating loss and tax credit carryforwards before full utilization.
7. Line of Credit The Company, through Swiss Lumitech, has a line-of-credit with a Swiss bank. Pursuant to the terms of the bank line-of-credit, the Company may borrow up to $300,000, at the December 31, 1999 rate of exchange. At December 31, 1999, the Company had exceeded such borrowing limit by approximately $75,000. However, the bank granted a temporary extension, with no stated expiration date, to exceed the limit by the bank. The line-of-credit agreement contains terms and conditions, restricting the Swiss Lumitech's ability to pledge its assets as security for other borrowings and requiring the payment of interest each quarter. In addition, all accounts receivable generated by the Company are automatically pledged to the bank pursuant to the terms of the line-of-credit agreement. At December 31, 1999, the borrowings under the bank line-of-credit carries interest at 6.35%. The line-of-credit is guaranteed up to the amount available under the line of credit by a relative of certain directors.
8. Accrued Expenses At December 31, 1999 and 1998, accrued expenses consists of the following:
December 31, 1999 1998 ------------------------
Selling and marketing expenses $391,329 $ 25,000 Professional fees 70,000 25,000 Employee related costs 53,770 -- Other 36,775 -- -------- -------- $551,874 $ 50,000 ======== ========
9. Common Stock At December 31, 1998, the Company and the co-inventor of the Luminescence product had agreed in principle to an amendment to their agreement that would, among other things, eliminate an obligation of the Company to pay the co-inventor royalties calculated as a percentage of sales of products based upon the Luminescence product, and instead provide for the issuance of common stock of the Company and the making of cash payments to said co-inventor. On March 31, 1999, the Company and the co-inventor entered into an agreement amending the earlier royalty agreement pursuant to which the Company (i) has paid the co-inventor $10,000 and $25,000 in 1999 and 1998, respectively, and committed to pay an additional $125,000 from time to time as the Company's liquidity and working capital requirements permit, and (ii) agreed to issue 800,000 shares of the Company's common stock to the co-inventor. The 800,000 shares of the Company's common stock were issued on March 31, 1999. The 800,000 shares of the Company's common stock, with a value of $300,000, and the $125,000 were charged to expense in the three months ended March 31, 1999. Accounts payable and accrued expenses at December 31, 1999 include the $78,000 of expenses related to the patent assignment agreement.
During 1999, the Company issued 2.5 million shares of common stock to Socol (see Note 5) valued at $1,875,000 in connection with a technology transfer agreement for production processes and know how. In 1999, the Company also issued 420,168 shares of common stock valued at $150,000 and options to purchase 2.1 million shares of common stock valued at $802,000 to various consultants for services.
In November 1999, the Company sold an equity unit consisting of 500,000 shares of its common stock and a warrant to purchase 500,000 shares of common stock at $1.00 per share for cash of $375,000. In January 2000, the Company sold an equity unit consisting of 500,000 shares of its common stock and a warrant to purchase 500,000 shares of common stock at $1.00 per share for cash of $375,000.
10. Stock Options Stock Option Plan. On September 10, 1999, the Board of Directors adopted the 1999 Stock Option/Stock Issuance Plan (the "Plan"). Pursuant to the Plan, options to purchase up to 5,000,000 shares of Common Stock were reserved for issuance to employees and consultants of the Company. Options granted under the Plan may be either Incentive Stock Options or Non-Qualified Stock Options for purposes of federal income tax law. Options are generally subject to vesting over a period of five years from the date of grant and are exercisable only to the extent vested from time to time. The selection of individuals to receive awards of options under the Plan and the amount and terms of such awards may be determined by the Board of Directors of the Company.
Option activity during 1999 was as follows:
The weighted-average fair value of options granted during fiscal year 1999 was $0.73.
Pursuant to the requirements of SFAS 123, pro forma net loss and basic and diluted net loss per share for fiscal 1999 were not materially different from the reported loss per share and the reported basic and diluted loss per share. Options exercisable of 1.1 million, held by a consultant, have been excluded from the calculation as they have been reflected in compensation expense.
The fair value for these options was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions for fiscal year 1999; risk-free interest rate of 6%; no dividend yield; the volatility factor of the expected market price of the Company's common stock of 250% and a weighted average expected life of the options of 4 years.
The Company has 8.0 million shares of common stock reserved at December 31, 1999 for the exercise of stock options, commitments to issue common stock and warrants at December 31, 1999.
11. Commitments The Company leases office space in Switzerland and the United States under operating leases. The Swiss lease is cancelable at the end of each 12-month period ending December. At December 31, 1999, lease commitments under this agreement amounted to $11,881. The U.S. lease expires in January 2002 and requires annual rent of $83,000. Future lease commitments are as follows:
Year ending December 31, 2000 $83,000 2001 83,000 2002 83,000
ITEM 9
ITEM 9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None
Part III
Item 10
Item 10 Directors and Executive Officers of the Registrant
The positions held by each Director and Officer of the Company as of March 31, 2000 are stated below:
Mr. Patrick Planche has been Chief Executive Officer, President and a director of the Company since August 1998. He is the President, a director and co-founder of the Company's wholly owned subsidiary, Lumitech S.A. which was organized in 1992 under the name OTWD On Time Diffusion S.A. Swiss Lumitech was engaged in the international publication and distribution of the book A Guide to Swatchwatches, before redirecting its activities in 1993 to the field of photoluminescence and graphic arts. Patrick Planche is the brother of Francois Planche.
Mr. Francois Planche has been secretary and a director of the Company since August 1998; and is a director and co-founder of the Company's wholly owned subsidiary, Swiss Lumitech. He is the author of the reference book, A Guide to Swatchwatches, which was published and distributed by Swiss Lumitech prior to its change in strategic direction in 1993 to the field of photoluminescence and graphic arts. Francois Planche is the brother of Patrick Planche.
Mr. Jose Canales la Rosa has been a director of the Company since August 1998; and, since 1997 has collaborated with Swiss Lumitech in the development of luminescent pictures for textiles, as well as the industrialization of manufacturing processes for luminescent printing sheets. Since 1987, Mr. Canales has been a co-director of Widemax B.V. (Holland), a leading company in the manufacture of textiles.
All directors are elected each year at the annual meeting of shareholders. All officers are elected at the first meeting of the Board following the annual meeting of shareholders and hold office for one year.
Compensation Committee Report on Executive Compensation
The Board of Directors of the Company has not constituted a Compensation Committee from its members and accordingly the following is the report of the entire Board of Directors. The Board is responsible for reviewing the compensation of the executive officers of the Company.
Compensation Philosophy. The Company has not developed a formal plan for the compensation management, as its primary focus, and application of working capital, is the development of its products and markets. In structuring any compensation program for management, however, the Board of Directors will seek to establish compensation policies that provide management with a performance incentive, and that align the interests of senior management with stockholder interests. Such program will include salary and annual incentives as its basic components and, in
establishing the total amount and mix of these components of compensation, the Board expects to consider the past performance and anticipated future contribution of each executive officer.
Salary. The salaries of the executive officers (including the Chief Executive Officer) are reviewed annually by the Board of Directors. The Board has not considered compensation levels for comparable positions at similar companies in determining compensation levels for management. Instead, compensation levels for executive officers have been based on the Board's assessment of the Company's liquidity and corresponding ability to compensate its executive officers at any level.
Annual Incentives. The Board historically has never approved or, thus far, even considered an executive incentive plan which would provide executive officers (including the Chief Executive Officer) with the opportunity to earn specified percentages of their base salary based upon targeted financial goals or the achievement of individual objectives and a subjective assessment of the executive's performance. There were no incentive awards or bonuses paid in the 1999 fiscal year.
Compensation of the Chief Executive Officer. Mr. Patrick Planche's salary for fiscal 1999 was determined by the Board based upon the Company's working capital limitations, and was not intended to reflect the Board's view of his value to the Company.
Item 11
Item 11 Executive Compensation
Director Compensation - --------------------- The Company does not currently pay cash compensation to its directors.
Executive Compensation - ---------------------- The following table sets forth the aggregate cash compensation paid by the Company with respect to the fiscal years ended December 31, 1999, 1998 and 1997 to the Chief Executive Officer.
Name and Position Year Salary Bonus Other - ----------------- ---- ------ ----- -----
Patrick Planche 1999 $ 7,500 $0 $0 Chief Executive Officer 1998 14,000 0 0 President and Treasurer 1997 8,000 0 0
Compensation of Executive Officers: There are no employment contracts or agreements in effect for any officer of the Company. The compensation for executive officers is reviewed annually. The Board has not considered compensation levels for comparable positions at similar companies in determining compensation levels for management. Instead, compensation levels for executive officers have been based on the Board's assessment of the Company's liquidity and corresponding ability to compensate its executive officers at any level.
Item 12
Item 12 Security Ownership of Certain Beneficial Owners
The following table sets forth certain information regarding the Company's Common Stock owned as of December 31, 1999 by (i) each person (or group of affiliated persons) known by the Company to be the beneficial owner of more than 5% of the Company's Common Stock (ii) each of the Company's directors, (iii) the Chief Executive Officer and each of the other individuals named in the Summary Compensation Table (hereinafter referred to as the "Named Executive Officers") and (iv) all current executive officers and directors as a group. Except as otherwise indicated in the footnotes to this table, the Company believes that each of the person or entities named in this table has sole voting and investment power with respect to all the shares or Common Stock indicated.
(1) As reported in, and based solely upon, a Schedule 13D, filed with the Securities and Exchange Commission on April 26, 1999, by Holding Canales B.V. and others (the "Canales Schedule 13D"). According to the Canales Schedule 13D, of the 4,000,000 shares of the Company's common stock owned by Holding Canales B.V., (the "Holding Canales Shares"), (i) Holding Canales B.V. beneficially owns all 4,000,000 of the Holding Canales Shares, (ii) Jose Canales la Rosa beneficially owns 2,040,000 of the Holding Canales Shares, (iii) Mexor B.V. beneficially owns 1,960,000 of the Holding Canales Shares, (iv) Orfedor S.A. beneficially owns 1,960,000 of the Holding Canales Shares, and (v) Dikran Meguerditch Gabrache beneficially owns 1,764,000 of the Holding Canales Shares. In each case, the beneficial owner listed above shares voting and dispositive power over such shares.
Item 13.
Item 13. Certain Relationships and Related Transactions
At December 31, 1998, a company controlled by Jose Canales la Rosa ("Canales"), one of the Company's directors, had agreed to terminate and cancel a license arrangement dated June 30, 1997 pursuant to which the he had obtained an exclusive license to use and exploit the Company's luminescence technology in a territory comprised of the European countries. Pursuant to said informal agreement, the Company agreed to the payment of $170,000 to Canales of which $70,000 was reimbursement for costs and expenses it paid or incurred in the development of processes, products and markets. By agreement dated March 31, 1999, Canales formally agreed to the termination of its exclusive license in consideration for which the Company confirmed its agreement to pay $70,000 in reimbursement of the costs and expenses of Canales, and further agreed to repay Canales the $100,000 paid by the him to the Company in 1997. Said agreement contemplates the payment for such amounts, without interest, at any time on or before March 31, 2004.
During 1999, the Company entered into a technology transfer agreement with Socol S.A. ("Socol") whose major shareholder is a shareholder of the Company, in which production processes and know how developed by Socol using the Lumicorp Products rights was acquired in exchange for an obligation to issue 2.5 million shares of common stock with a value of $1,875,000.
At December 31, 1999, the Company has amounts owed to two of the Company's directors, Francois Planche and Jose Canales la Rosa in the amounts of $115,000 and $166,500, respectively, pursuant to two separate agreements (the "Director's Note Agreements"). The Director's Note Agreements have no stated maturity and have an interest rate of 7%. The borrowings under the Director's Note Agreements are not secured, and the note holders have agreed not to require payment in cash before January 1, 2001.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(A) 1. Financial Statements
The financial statements are listed under Part II, Item 8 of this Report.
2. Financial Statement Schedules
None.
3. Exhibits
The exhibits are listed below under Part IV, Item 14(c) of this Report.
(B) Reports on Form 8-K
No reports on Form 8-K were filed during the quarter ended December 31, 1999.
(C) Exhibits
The following exhibits are filed as part of this report:
EXHIBIT NUMBER DESCRIPTION -------------- -----------
3.1 Articles of Incorporation of Advanced Lumitech, Inc. and all amendments and modifications thereto, filed with the Secretary of State of the State of Nevada as of March 29, 1999 (filed as Exhibit 3.1 to the Company's 1998 Form 10-K).
3.2 By-laws of Advanced Lumitech, Inc. (filed as Exhibit 3.2 to the Company's 1998 Form 10-K).
4 Specimen Certificate representing the Company's Common Stock (filed as Exhibit 4 to the Company's 1998 Form 10-K).
10.1 Merger Agreement dated as of August 12, 1998, by and among the company, Lumitech, S.A. and Patrick Planche, pursuant to which the Company acquired 100% of the issued and outstanding shares of the common stock of Lumitech, S.A. (filed as Exhibit 10.1 to the Company's 1998 Form 10-K)
10.2 Patent Assignment Agreement respecting the Company's luminescence technology dates as of January 16, 1996, as amended on March 31, 1999, between Jacques-Charles Collett and Lumitech S.A. (formerly known as OTWD On Time Diffusion S.A.) (Filed as Exhibit 10.2 to the Company's 1998 Form 10-K)
10.3 Agreement dated as of March 31, 1999, between Lumitech, S.A. and Luminescent Europe Technologies B.V. (the "Netherlands Affiliate"), providing for the termination for all rights and interests of the Netherlands Affiliate with respect to the Company's luminescence technology (filed as Exhibit 10.3 to the Company's 1998 Form 10-K).
10.4 Socol Agreement dated as of March 31, 1999, between the Company and Socol S.A., pursuant to which Socol disclaims any interest in the Company's Luminescence product technology (filed as Exhibit 10.4 to the Company's 1998 Form 10-K).
10.5 Credit Agreement dates as of August 6, 1997, as amended on September 9, 1998, between Lumitech, S.A. and Credit Suisse (filed as Exhibit 10.5 to the Company's 1998 Form 10-K).
10.6 Agreement dated as of December 28, 1998, between Lumitech, S.A. and Lumi Corp., providing for the termination of all rights and interests of Lumi Corp. with respect to the Company's luminescence technology (filed as Exhibit 10.6 to the Company's 1998 Form 10-K).
10.7 Lease by and between Boston Properties Limited Partnership and Advanced Lumitech, Inc. for corporate office space in Waltham, MA. (filed herewith)
10.8 Subscription Agreement (filed herewith)
10.9 Warrant Agreement (filed herewith)
23.1 Consent of Independent Auditors (filed herewith)
25 List of Subsidiaries
27 Financial Data Schedule (filed herewith)
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
ADVANCED LUMITECH, INC.
Date: April 14, 2000 /s/ Patrick Planche ------------------------------------- Patrick Planche Principal Executive, Financial and Accounting Officer
Date: April 14, 2000 /s/ Francois Planche ------------------------------------- Francois Planche Director
Date: April 14, 2000 /s/ Jose Canales la Rosa ------------------------------------- Jose Canales la Rosa Director | 11,470 | 75,038 |
779742_1999.txt | 779742_1999 | 1999 | 779742 | Item 1. Business.
New England Life Pension Properties IV; A Real Estate Limited Partnership (the "Partnership") was organized under the Uniform Limited Partnership Act of the Commonwealth of Massachusetts on October 16, 1985, to invest primarily in newly constructed and existing income-producing real properties.
The Partnership was initially capitalized with contributions of $2,000 in the aggregate from Fourth Copley Corp. (the "Managing General Partner") and CCOP Associates Limited Partnership (the "Associate General Partner") (collectively, the "General Partners") and $10,000 from Copley Real Estate Advisors, Inc. (the "Initial Limited Partner"). The Partnership filed a Registration Statement on Form S-11 (the "Registration Statement") with the Securities and Exchange Commission on November 12, 1985, with respect to a public offering of 60,000 units of limited partnership interest at a purchase price of $1,000 per unit (the "Units") with an option to sell up to an additional 60,000 Units (an aggregate of $120,000,000). The Registration Statement was declared effective on January 3, 1986.
The first sale of Units occurred on May 29, 1986, at which time the Initial Limited Partner withdrew its contribution from the Partnership. Investors were admitted to the Partnership thereafter at monthly closings; the offering terminated and the last group of subscription agreements was accepted by the Partnership on December 31, 1986. As of January 31, 1987, a total of 94,997 Units had been sold, a total of 17,207 investors had been admitted as limited partners (the "Limited Partners") and a total of $94,348,550 had been contributed to the capital of the Partnership. The remaining 25,003 Units were de-registered on February 23, 1987.
As of December 31, 1999, the Partnership had an investment in the real property described in E. below. In December 1988, the Partnership sold another one of its investments and received sale proceeds of $10,577,476 which were substantially reinvested. Seven other investments have been sold. One investment in Atlanta, Georgia was sold on August 6, 1993, resulting in sale proceeds of $7,917,000. Capital was distributed to the Limited Partners in October 1993, in the amount of $82 per Unit . A second investment in Rancho Cucamonga, California was sold on December 30, 1994, resulting in sale proceeds of $5,261,275. On January 26, 1995, capital of $5,224,835 ($55 per Unit) was distributed to the Limited Partners. A third investment located in Decatur, Georgia was sold on October 10, 1996, resulting in sale proceeds of $9,333,325. On October 24, 1996, capital of $9,214,709 ($97 per unit) was distributed to the Limited Partners. A fourth investment located in Las Vegas, Nevada was sold on October 24, 1997, resulting in sale proceeds of $22,983,007. On November 25, 1997, the Partnership made a capital distribution of $22,989,274 ($242 per Limited Partnership Unit) from the proceeds of the sale and prior sales proceeds previously held in reserves. A fifth investment located in Phoenix, Arizona was sold on September 23, 1998, resulting in net sale proceeds of $9,680,132. On October 29, 1998, the Partnership made a capital distribution of $9,689,694 ($102 per Limited Partnership Unit) from the proceeds of the sale and prior sales proceeds previously held in reserves. A sixth investment located in Fort Myers, Florida was sold on September 23, 1999, resulting in net proceeds of $12,773,052. On October 28, 1999, the Partnership made a capital distribution of $12,522,505 ($131.82 per Limited Partnership Unit) from the proceeds of the sale. A seventh investment located in Columbia, Maryland was sold on December 20, 1999 resulting in net proceeds of $13,423,827. On January 27, 2000 the Partnership made a capital distribution of $13,204,583 ($139.00 per Limited Partnership Unit) from the proceeds of the sale.
The Partnership has no current plan to renovate, improve or further develop any of its real property. In the opinion of the Managing General Partner, the properties are adequately covered by insurance. The Partnership has no employees. Services are performed for the Partnership by the Managing General Partner and affiliates of the Managing General Partner.
A. Apartment Complex in Fort Myers, Florida (" Reflections").
On August 1, 1986, the Partnership acquired a 60% interest in Lee Partners (the "Joint Venture"), a joint venture formed with Lee-Oxford Limited Partnership, a Maryland limited partnership ("Lee-Oxford"). As of December 31, 1998, the Partnership had contributed $8,190,145 to the capital of the Joint Venture out of a maximum commitment of $8,685,000. The joint venture agreement entitled the Partnership to receive 60% of all cash flow from operations, refinancing proceeds and net sale proceeds.
The Partnership also committed to make a loan for investment in the joint venture of up to $5,790,000 to Lee-Oxford, of which $5,460,097 had been funded as of December 31, 1998. Interest only on the loan was payable monthly at the rate of 10.5% per annum. The entire outstanding principal balance of the loan was to mature in December, 1999 or would be due on the sale of all or substantially all of the assets of the Joint Venture or the sale of
Lee-Oxford's interest in the Joint Venture. Lee-Oxford would apply any cash flow received from operations of the Joint Venture to interest payments on the loan and would apply proceeds of financings or sales received from the Joint Venture to payment of the interest on and principal of the loan. The Partnership agreed, effective January 1, 1988, that to the extent that Lee-Oxford's 40% share of the cash flow was not sufficient to pay interest currently due, interest due on the loan would accrue and compound at a rate of 10.5% per annum. The Partnership agreed, effective May 1, 1992, to extend the maturity date of the loan from August, 1996 to December, 1999, and the borrower agreed to pay interest, currently, at a minimum of 7% with the remainder accruing at 10.5% per annum compounded monthly. The loan was secured by Lee-Oxford's interest in the Joint Venture and by a guarantee of Oxford Development Corporation, an affiliate of Lee-Oxford.
The joint venture was restructured in the second quarter of 1996;the Partnership thereby obtained control over management and operating decisions. The ownership restructuring was accomplished with the establishment of a new partnership entity in which the Partnership is the general partner and Lee-Oxford is the limited partner. The new entity held a 42% interest in the Joint Venture, representing all of Lee-Oxford's prior direct ownership interest and 2% of the Partnership's prior direct interest. The Partnership also agreed to release the guarantee from Oxford Development Corporation upon payment to the Partnership of a total of $650,000, of which the final payment of $136,437 was paid during the first quarter of 1998.
The Joint Venture owned approximately 12.63 acres of land located in Fort Myers, Florida and had constructed a 282-unit apartment complex, consisting of 12 2- and 3-story buildings, thereon. The complex was approximately 94% occupied at the time of sale, discussed below.
On August 21, 1998 the Partnership sold a parcel of land to the City of Fort Myers. The Partnership received net proceeds totaling $67,881 and recognized a gain of $35,591.
The Joint Venture sold the Reflections Apartments on September 23, 1999, and the Partnership recognized a gain of $3,474,005 ($36.20 per Limited Partnership Unit). A disposition fee of $393,000 was accrued but not paid to AEW Real Estate Advisors, Inc.. On October 28, 1999, the Partnership made a capital distribution of $12,522,505 ($131.82 per Limited Partnership Unit) from the proceeds of the sale.
B. Office/Industrial Buildings in Phoenix, Arizona ("Metro Business Center").
On September 15, 1986, the Partnership acquired a 60% interest in Copley/Hewson Northwest Associates, a joint venture formed with an affiliate of The Hewson Company (the "Developer"). Effective January 1, 1990, as a result of operating deficits, the joint venture agreement was amended to reflect an increase of the Partnership's interest in the joint venture to 80% and a decrease in the Developer's interest to 20%. As of December 31, 1997, the Partnership had contributed $5,302,193 to the capital of the joint venture out of a maximum obligation of $5,580,000.
The Partnership also committed to make a loan for investment in the joint venture of up to $3,988,000 to the Developer, of which $3,534,796 had been funded as of December 31, 1997. Interest only on the loan was payable monthly at the rate of 10.5% per annum. The loan had a ten-year term and was not prepayable. The Developer was required to apply any cash flow received from operations of the joint venture to interest payments on the loan and to apply proceeds of refinancings or sales received from the joint venture to payments of interest on and principal of the loan. The loan was secured by the borrower's interest in the joint venture.
The joint venture agreement entitled the Partnership to receive 80% of net cash flow, refinancing proceeds and sale proceeds once the loan and accrued interest were repaid in full.
On January 1, 1996, a letter agreement was executed which modified certain terms of the Joint Venture Agreement. The letter agreement, which constituted an amendment to the Joint Venture Agreement, granted the Partnership full control over management decisions. The Partnership's control over any decision to sell the property, however, became effective on July 1, 1996.
Effective December 30, 1996, the property owned by the joint venture was distributed to the venture partners as tenants-in-common. The Partnership, however, retained its overall decision-making authority. The property interest distributed to the Developer was encumbered by the aforementioned loan. The note was amended to mature on February 1, 1997 and was secured by a recorded deed of trust. The note was subsequently amended to mature on March 31, 1998. In connection with the transaction, the Partnership obtained the option to purchase the tenancy-in-common interest of the Hewson affiliate at its fair market value beginning February 1, 1997.
On February 28, 1998, the Partnership executed a purchase and sale agreement to purchase the tenancy-in-common interest of the Developer. The Partnership finalized the acquisition on July 17, 1998. The purchase price was $7,113,255 and was paid by the Partnership as follows: (i) A portion of the purchase price was paid through the discharge of all outstanding amounts, including but not limited to accrued but unpaid interest, owed by the Developer to the Partnership under the loan made by the Partnership to the Developer in connection with the original acquisition of the property and (ii) the Partnership paid the remainder of the purchase price in cash in the amount of $2,210.
On September 23, 1998, the Partnership sold the Metro Business Center. The Partnership received net proceeds totaling $9,680,132. On October 29, 1998, the Partnership made a capital distribution of $9,689,694 ($102 per Limited Partnership Unit) from the proceeds of the sale.
C. Office, Industrial and Retail Buildings in Las Vegas, Nevada ("Palms Business Center").
On December 29, 1986, the Partnership acquired a 60% interest in Rancho Road Associates, a joint venture formed with an affiliate of Commerce Centre Partners. In the first quarter of 1990, the Partnership committed to increase its maximum commitment from $13,400,000 to $15,300,000. On October 2, 1991, the Partnership committed to increase its maximum commitment from $15,300,000 to $15,840,000. As of the date of sale, discussed below, the Partnership had contributed all of its commitment of capital to the joint venture. The additional funds were used to pay for higher than anticipated tenant finish costs and the costs of re-leasing the space vacated by tenants when leases expired. The joint venture agreement entitled the Partnership to receive a preferred cumulative compounded return of 11% per annum on its capital contribution, of which 9.5% per annum was due currently and up to 1.5% per annum could be accrued if sufficient cash was not available therefor. The entire unpaid accrued preferred return was due and payable at the end of the tenth year of the joint venture's operations. The joint venture agreement also entitled the Partnership to receive 60% of net cash flow and 60% of sale and refinancing proceeds following the return of the Partnership's equity capital.
As of January 1, 1995, the joint venture agreement was amended and restated granting the Partnership control over management and operating decisions. Additionally, the venture partner become entitled to receive 40% of the excess cash flow above a specified level until its cash investment of $360,000 was repaid in full, after which the Partnership would become entitled to all cash flow. Unpaid preferred returns of $2,936,919 were added to the Partnership's capital account. Future preferred return payments were to be made monthly in the amount of $121,125. to the extent operating revenues or extraordinary cash flows were available. To the extent such payments could not be made from such sources when due, payments could accrue at a rate of 9.5% per annum, compounded monthly, until paid.
The joint venture owned approximately 14.1 acres of land in Las Vegas, Nevada improved with 15 one-story buildings suitable for office, industrial and retail use and containing approximately 224,474 square feet of space. At the time of sale, approximately 86% of the available leasable area was leased.
On November 16, 1990, the joint venture filed a complaint against a tenant for failure to pay rent and fraud, totaling approximately $500,000. A judgment in the amount of $911,200 was recorded in 1995. The Joint Venture had not collected on or recognized the judgment as of the date of sale.
On October 26, 1994, the joint venture filed a complaint against Han Lee, Inc. for failure to pay rent totaling $69,171, including late charges. In August, 1995, a Judgment by Default in the amount of $83,856 was legally recorded. The Partnership has determined that the claim was not collectible at the time of sale.
On October 24, 1997, the Palms Business Center was sold. The Partnership received proceeds of $22,983,007. On November 25, 1997, the Partnership made a distribution to the Limited Partners of $22,989,274 ($242 per Unit) from the proceeds of this sale and from reserves established with the proceeds of prior sales.
D. Office/Research and Development Buildings in Columbia, Maryland ("Columbia Gateway Corporate Park").
On December 21, 1987, the Partnership acquired a 17% interest in a joint venture formed with an affiliate of the Partnership (the "Affiliate"), which had a 33% interest, and M.O.R. Gateway 51 Associates Limited Partnership.
As of April 20, 1989, the joint venture agreement was amended and restated reflecting an increase in the Partnership's interest in the joint venture to 34.75% and a decrease in the Affiliate's interest in the joint venture to 15.25%. In addition, the amended and restated joint venture agreement increased the Partnership's maximum commitment to contribute capital to the joint venture and reallocated the capital contributed to the joint venture
between the Partnership and the Affiliate. As of December 31, 1998, the Partnership had contributed $14,086,147 to the capital of the joint venture out of a maximum commitment of $14,598,000.
The joint venture agreement entitled the Partnership and the Affiliate to receive a preferred return on the their respective invested capital at the rate of 10.5% per annum. Such preferred return would be payable currently until the Partnership and the Affiliate had received an aggregate of $8,865,000; thereafter, if sufficient cash flow was not available therefore, the preferred return would accrue and bear interest at the rate of 10.5% per annum, compounded monthly. The joint venture agreement also entitled the Partnership to receive 34.75% of cash flow following payment of the preferred return and 34.75% of the net proceeds of sales and refinancings following return of the Partnership's and the Affiliate's equity. Ownership of the joint venture had been restructured whereby the Partnership and the Affiliate obtained full control over the business of the joint venture. The restructuring was effective January 1, 1998.
The joint venture owned approximately 20.85 acres of land in the Columbia Gateway Corporate Park in Columbia, Maryland. The intended development plan for this land was for a two-stage development of seven office and research and development buildings. The first phase of this development was completed by 1992 and included the construction of four, one-story buildings containing 142,545 square feet. The second phase of this development commenced in the spring of 1994 in which a building totaling 46,000 square feet was constructed and leased to a single tenant for a term of ten years. At the time of sale, the project was 100% leased.
On December 20, 1999, the Joint Venture sold its property. The Partnership received its 69.5% share of the net proceeds totaling $13,423,827. On January 27, 2000 the Partnership made a capital distribution of $13,204,583 ($139.00 per Limited Partnership Unit) from the proceeds of the sale.
E. Office/Research and Development Buildings in Frederick, Maryland ("270 Technology Center").
On December 22, 1987, the Partnership acquired a 50% interest in a joint venture formed with MORF Associates VI Limited Partnership. As of December 31, 1998, the Partnership had contributed $4,857,000 to the capital of the joint venture out of a maximum commitment of $5,150,000. The joint venture agreement entitles the Partnership to receive a preferred return on its invested capital at the rate of 10% per annum. Such preferred return was payable currently through September 30, 1988; presently, and until the termination of the joint venture's operations, to the extent that sufficient cash flow is not available therefor, the preferred return will accrue and bear interest at the rate of 10% per annum, compounded monthly. The joint venture agreement entitles the Partnership to receive 50% of the net proceeds of sales and financings after return of its equity and preferred return.
As of July 3, 1990, the joint venture sold approximately 3.9 acres of land to an unrelated third party. In return, the joint venture received approximately $500,000 and a parcel of land consisting of approximately .4 acres. The joint venture currently owns approximately 8 acres of land in the 270 Technology Center in Frederick, Maryland, together with two one-story research and development/office buildings, containing approximately 73,360 square feet of space, located thereon. As of December 31, 1999, the buildings were approximately 100% leased.
Item 2.
Item 2. Properties.
The following table sets forth the annual realty taxes for the Partnership's last remaining property and information regarding tenants who occupy 10% or more of gross leasable area (GLA) in the Partnership's last remaining property.
The following table sets forth for each of the last five years the gross leasable area, occupancy rates, rental revenue and net effective rent for the Partnership's last remaining property:
- -------------------------------------------------------------------------------- Net Rental Effective Gross Leasable Year-End Revenue Rent Property Area Occupancy Recognized ($/sf/yr)* - --------------------------------------------------------------------------------
Office/R&D Buildings in Frederick, MD 1995 73,360 98% $762,212 $10.66 1996 73,360 89% $769,262 $11.43 1997 73,360 70% $728,065 $11.99 1998 73,360 100% $827,808 $12.20 1999 73,360 100% $965,459 $13.16 - --------------------------------------------------------------------------------
* Net Effective Rent calculation is based on average occupancy during the respective year.
Following is a schedule of lease expirations for each of the next ten years for the Partnership's last remaining property based on the annual contract rent in effect at December 31, 1999:
- -------------------------------------------------------------------------------- TENANT AGING REPORT Percentage Total of # of Total Annual Gross Lease Square Contract Annual Property Expirations Feet Rent Rental - -------------------------------------------------------------------------------- Office/R&D Buildings in Frederick, MD 2000 0 0 $0 0% 2001 2 26,660 $290,634 41% 2002 3 31,195 $384,532 54% 2003 0 0 $0 0% 2004 1 3,105 $35,708 5% 2005 0 0 $0 0% 2006 0 0 $0 0% 2007 0 0 $0 0% 2008 0 0 $0 0% 2009 0 0 $0 0% - --------------------------------------------------------------------------------
The following table sets forth for the Partnership's last remaining property the: (i) federal tax basis, (ii) rate of depreciation, (iii) method of depreciation, (iv) life claimed, and (v) accumulated depreciation, with respect to each property or component thereof for purposes of depreciation:
SL= Straight Line DB= Declining Balance
Following is information regarding the competitive market conditions for the Partnership's last remaining property. This information has been gathered from sources deemed reliable. However, the Partnership has not independently verified the information and, as such, cannot guarantee its accuracy or completeness.
R&D/Office Buildings in Frederick, MD
The Frederick R&D market contains approximately 5 million square feet of office and r&d space with a vacancy hovering around 9%. The more competitive and narrower submarket for 270 Technology Park includes approximately 40 buildings in 2.3 million square feet with a reported vacancy of 11%. Current market rents range from $9.50 to $11.25 per square foot NNN for R&D and $10.00 to $13.30 per square foot NNN for office deals. This represents a 5-7% increase over levels one year ago primarily due to the strong absorption of space and land for build to suit project. By far the project which has had the most significant impact on our asset is the Bechtel 400-500,000 square feet build to suit, as Bechtel vacated over 35,000 square feet in MORF III & MORF VI. Other build to suit projects under development include MCI (50,000 square feet at 270 Technology Park) and First Nationwide (35,000 square feet at MIE).
Item 3.
Item 3.
Legal Proceedings
The Partnership is not a party to, nor are any of its properties subject to, any material pending legal proceedings. A joint venture in which the Partnership holds an interest has received judgements against two former tenants for defaults under leases. See Item 1.C.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this Annual Report on Form 10-K.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.
There is no active market for the Units. Trading in the Units is sporadic and occurs solely through private transactions.
As of December 31, 1999, there were 16,276 holders of Units.
The Partnership's Amended and Restated Agreement of Limited Partnership dated May 29, 1986, as amended to date (the "Partnership Agreement"), requires that any Distributable Cash (as defined therein) be distributed quarterly to the Partners in specified proportions and priorities. There are no restrictions on the Partnership's present or future ability to make distributions of Distributable Cash. For the year ended December 31, 1999, cash distributions paid in 1999 or distributed after year end with respect to 1999 to the Limited Partners as a group totaled $30,184,347, including $9,689,694 ($102 per Limited Partnership Unit) from the proceeds of property sales. For the year ended December 31, 1998, cash distributions paid in 1998 or distributed after year end with respect to 1998 to the Limited Partners as a group totaled $13,030,738, including $9,689,694 ($102 per Limited Partnership Unit) from the proceeds of a property sale.
Cash distributions exceeded net income in 1999 and 1998 and, therefore, resulted in a reduction of partners' capital. Reference is made to the Partnership's Statement of Partner's Capital (Deficit) and Statement of Cash Flows in Item 8 hereof.
Item 6.
Item 6. Selected Financial Data.
(1) Net income includes a gain on the sales of properties of $7,510,818. Cash distributions include a return of capital of $285.00 per Limited Partnership Unit.
(2) Net income includes a gain on the sale of property of $3,742,541. Cash distributions include a return of capital of $102.00 per Limited Partnership Unit.
(3) Net income includes a gain on the sale of property of $10,482,458. Cash distributions include a return of capital of $242.00 per Limited Partnership Unit.
(4) Net income includes a gain on the sale of a joint venture investment of $1,055,591. Cash distributions include a return of capital of $97.00 per Limited Partnership Unit.
(5) Cash distributions include $8.09 per Limited Partnership Unit that is attributable to a discretionary reduction of cash reserves, which had been previously accumulated through operating activities.
Item 7
Item 7
Management's Discussion and Analysis of Financial Condition and Results of Operations
Liquidity and Capital Resources
The Partnership completed its offering of units of limited partnership interest in December, 1986. A total of 94,997 Units were sold. The Partnership received proceeds of $85,677,259, net of selling commissions and other offering costs, which have been invested in real estate, used to pay related acquisition costs, or retained as working capital reserves. The Partnership made nine real estate investments. Eight investments have been sold: one each in 1988, 1993, 1994, 1996, 1997, 1998 and two in 1999. Capital of $67,430,770 ($709.82 per Limited Partnership Unit) has been returned to the limited partners through December 31, 1999.
On October 24, 1997, the Palms Business Center property was sold to an institutional buyer, which is unaffiliated with the Partnership for $23,200,000. The Partnership received net proceeds of $22,983,007, after closing costs and repayment of a loan from the venture partner. The Partnership recognized a gain of $10,482,458 ($109.24 per Limited Partnership Unit). A disposition fee of $696,000 was accrued but not paid to AEW Real Estate Advisors Inc. ("AEW"). On November 25, 1997, the Partnership made a capital distribution of $22,989,274 ($242 per Limited Partnership Unit) from the proceeds of the sale and prior sales proceeds held in reserves. This distribution reduced the adjusted capital contribution to $524 per Limited Partnership Unit.
On August 21, 1998, the Reflections joint venture sold a parcel of land to the City of Fort Myers. The Partnership received net proceeds totaling $67,881 and recognized a gain of $35,591.
On September 23, 1998, the Metro Business Center in Phoenix Arizona was sold to an institutional buyer which is unaffiliated with the Partnership. The gross sale price was $9,900,000. The Partnership received net proceeds totaling $9,680,132, after closing costs and recognized a gain of $3,706,950 ($38.63 per Limited Partnership Unit). A disposition fee of $297,000 was accrued but not paid to AEW. On October 29, 1998, the Partnership made a capital distribution of $9,689,694 ($102 per Limited Partnership Unit) from the proceeds of the sale and prior sales proceeds held in reserves. This distribution reduced the adjusted capital contribution to $422 per Limited Partnership Unit.
On September 23, 1999, the Reflections Apartments in Fort Myers, Florida was sold to a third party which is unaffiliated with the Partnership. The gross sale price was $13,100,000. The Partnership received net proceeds totaling $12,773,052, after closing costs and recognized a gain of $3,474,005 ($36.20 per Limited Partnership Unit). A disposition fee of $393,000 was accrued but not paid to AEW Real Estate Advisors, Inc. On October 28, 1999, the Partnership made a capital distribution of $12,522,505 ($131.82 per Limited Partnership Unit) from the proceeds of the sale. This distribution reduced the adjusted capital contribution to $290.18 per Limited Partnership Unit.
On December 20, 1999, the Columbia Gateway Corporate Park joint venture in which the Partnership and an affiliate own a 69.5% and 30.5% interest, respectively, sold its property to an unaffiliated third party for gross proceeds of $19,850,000, of which the Partnership's share was $13,795,750. The Partnership received its 69.5% share of the net proceeds, $13,423,827 after closing costs, and recognized a gain of $1,927,893 ($20.09 per Limited Partnership Unit) on the sale. A disposition fee of $413,872 was accrued but not paid to AEW Real Estate Advisors, Inc.. On January 27, 2000 the Partnership made a capital distribution of $13,204,583 ($139.00 per Limited Partnership Unit) from the proceeds of the sale.
At December 31, 1999, the Partnership had $ 17,597,405 in cash and cash equivalents, of which $15,044,857 was used for cash distributions to partners on January 27, 1999; the remainder will primarily be used for working capital reserves. The source of future liquidity and cash distributions to partners will be cash distributions from the Partnership's joint venture and invested cash and cash equivalents. Distributions of cash from operations for the first and second quarters of 1999 were made at the annualized rate of 5.75% on the adjusted capital contribution of $422 per Limited Partnership Unit. Distributions of cash from operations for the third and fourth quarter of 1999 were made at the annualized rate of 6.25% on the adjusted capital contribution of $422 per Limited Partnership Unit and the weighted average adjusted capital contribution of $328.87 per Limited Partnership Unit, respectively. Distributions of cash from operations relating to the first and second quarters of 1998 were made at the annualized rate of 5.5% on the adjusted capital contribution of $524 per Limited
Partnership Unit. Distributions of cash from operations for the third and fourth quarter of 1998 were made at the annualized rate of 6% on the adjusted capital contribution of $524 per Limited Partnership Unit and the weighted average adjusted capital contribution of $453.73 per Limited Partnership Unit, respectively. The fluctuation in distribution rates are a result of both the sales of the Partnership's real estate investments and the timing of cash flow from the Partnership's real estate investments held at the time of the distributions.
The carrying value of real estate investments in the financial statements at December 31, 1999 is at depreciated cost, or if the investment's carrying value is determined not to be recoverable through expected undiscounted future cash flows, the carrying value is reduced to estimated fair market value. The fair market value of such investments is further reduced by the estimated cost of sale for properties held for sale. Carrying value may be greater or less than current appraised value. At December 31, 1999, the appraised value of the remaining investment exceeded the related carrying value by an aggregate of approximately $1,400,000. The current appraised value of real estate investments has been estimated by the Managing General Partner and is generally based on a combination of traditional appraisal approaches performed by AEW and independent appraisers. Because of the subjectivity inherent in the valuation process, the estimated current appraised value may differ significantly from that which could be realized if the real estate were actually offered for sale in the marketplace.
Results of Operations
Form of Real Estate Investments
At December 31, 1999, the remaining investment in the portfolio is structured as a joint venture with a real estate development/management firm. The Palms Business Center, Reflections Apartments and Metro Business Center investments were originally structured as joint ventures. However, effective January 1, 1995, April 1, 1996 and July 1, 1996, respectively, the Partnership was granted full control over management decisions and the investments had been accounted for as wholly-owned properties since those dates. As previously stated, the Palms Business Center, the Metro Business Center and Reflections Apartments were sold on October 24, 1997, September 23, 1998 and September 23, 1999, respectively.
Operating Factors
The Palms Business Center was sold on October 24, 1997 and the Partnership recognized a gain of $10,482,458. At the time of the sale the Palms Business Center was 86% leased.
As mentioned above, the Columbia Gateway Corporate Park joint venture, in which the Partnership and an affiliate own a 69.5% and 30.5% interest, respectively, sold its property on December 20,1999. The Partnership recognized its share of the gain of $1,927,893. The property was 100% leased at the time of sale, consistent with December 31, 1998. At December 31, 1997 the property was 98% leased.
As discussed above, the Reflections Apartments investment was sold on September 23, 1999, and the Partnership recognized a gain of $3,474,005. At the time of the sale, occupancy at Reflections Apartments was 94%, consistent with occupancy at December 31, 1998 and December 31, 1997.
As discussed above, Metro Business Center was sold on September 23, 1998 and the Partnership recognized a gain of $3,706,950. At the time of sale the property was 100% leased consistent with December 31, 1997.
Occupancy at 270 Technology Center was 100% at December 31, 1999 and 1998, up from 70% at December31, 1997.
Investment Activity
1999 Compared to 1998
Interest on cash equivalents and short-term investments decreased by approximately $34,000 or 8% compared to 1998, primarily due to lower average investment balances as a result of sales in both 1999 and 1998.
Total real estate operations were $2,108,920 and $2,509,656 for the twelve months ended December 31, 1999 and 1998, respectively. The decrease of $400,736 is primarily due to a decrease in operating income from wholly owned properties of $547,746, primarily due to the sales of Metro Business Center in 1998 and Reflections Apartments in 1999. These decreases are partially offset by an increase in operating performance at Columbia Gateway Corporate Park attributable to decreases in rent concessions and the recovery of the prior year write off of bad debt. Operating performance at 270 Technology Center improved as well due to fewer rent concessions in 1999 and higher average occupancy for 1999.
The decrease in operating cash flow of approximately $1,188,000 between 1998 and 1999 is primarily due to the sales of Columbia Gateway Corporate Park and Reflections Apartments in 1999 and a decrease in operating liabilities.
1998 Compared to 1997
Interest on cash equivalents and short-term investments decreased by approximately $78,000 or 16% compared to 1997, primarily due to lower average investment balances as a result of sales in both 1998 and 1997.
Total real estate operations were $2,509,656 and $2,925,862 for the twelve months ended December 31, 1998 and 1997, respectively. The decrease of $416,206 is primarily due to a decrease in operating income from wholly -owned properties of $1,031,189, primarily due to the sale of Metro Business Center, offset by an increase of $614,983 in joint venture earnings, primarily due to improved performance at Columbia Gateway Corporate Park and 270 Technology Park
The decrease in operating cash flow of approximately $972,000 between 1997 and 1998 is primarily due to the sale of Rancho Road in October 1997 and a decrease in operating liabilities.
Portfolio Expenses
The Partnership management fee is 9% of distributable cash flow from operations after any increase or decrease in working capital reserves as determined by the Managing General Partner. General and administrative expenses primarily consist of real estate appraisal, printing, legal, accounting and investor servicing fees.
1999 Compared to 1998
General and administrative expenses decreased approximately $20,000 or 6% primarily due to decreases in legal, printing and appraisal fees. Management fees decreased in 1999 compared to 1998 by approximately $23,000 due to a decrease in distributable cash flow and a corresponding decrease in operating distributions to partners as a result of the sale of investments.
1998 Compared to 1997
General and administrative expenses increased approximately $7,400 or 2%, primarily due to an increase in legal fees for 1998 which was the result of fees incurred with the potential sale of Reflections Apartments. Offsetting this is a reduction in investor servicing fees. Management fees decreased in 1998 compared to 1997 by approximately $19,000 due to a decrease in distributable cash flow and a corresponding decrease in operating distributions to partners as a result of the sale of investments.
Inflation
By their nature, real estate investments tend not to be adversely affected by inflation. Inflation may tend to result in appreciation in the value of the real estate investments over time if rental rates and replacement costs increase. Declines in real property values during the period of the Partnership operations, due to market and economic conditions, have overshadowed the overall positive effect inflation may have on the value of the Partnership's investments.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
The Partnership was not party to derivative financial instruments or derivative commodity instruments at or during the year ended December 31, 1999. The Partnership's only other financial instruments (as defined by Financial Accounting Standards Board Statement No. 107) are its cash and cash equivalents for which cost approximates market value.
Item 8.
Item 8. Financial Statements and Supplementary Data.
The independent auditor's reports, financial statements and financial statement schedule listed in the accompanying index are filed as part of this report. See Index to the Financial Statements and Financial Statement Schedules on page 20.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
The Partnership has had no disagreements with its accountants on any matters of accounting principles or practices or financial statement disclosure.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant.
(a) and (b) Identification of Directors and Executive Officers.
The following table sets forth the names of the directors and executive officers of the General Partner and the age and position held by each of them as of December 31, 1999
(c) Identification of Certain Significant Employees.
None.
(d) Family Relationships.
None.
(e) Business Experience.
The Managing General Partner was incorporated in Massachusetts on October 16, 1985. The background and experience of the executive officers and directors of the Managing General Partner are as follows:
Alison Husid Cutler is a Portfolio Manager in AEW Institutional Real Estate Services, with responsibility for several real estate equity portfolios representing approximately $800 million in client capital. She has over 12 years of experience in real estate finance and investment management. Ms. Cutler joined the predecessor of AEW Capital Management, L.P. ("AEW Capital Management") in 1987 as Controller for a portfolio management team responsible for the acquisition, management, restructuring and disposition of client assets in New England and the western U.S. She later served as Asset Manager for a portfolio of assets in Arizona and the West Coast. Prior to joining AEW, Ms. Cutler worked for several years as a Senior Auditor with Peat Marwick, Main & Co. She is a Certified Public Accountant and a graduate of the University of Massachusetts (B.A.).
Pamela J. Herbst directs AEW Capital Management L.P.'s ("AEW Capital Management") Institutional Real Estate Services, with oversight responsibility for direct equity investing and the asset and portfolio management of existing core and core-plus commingled funds and separate accounts.. Ms. Herbst is a member of AEW Capital Management's Investment Policy Group and Operating Committee. She came to AEW Capital Management in December 1996 as a result of the firm's merger with Copley Real Estate Advisors, Inc., where she held various senior level positions in asset and portfolio management, acquisitions, and corporate operations since 1982. Ms. Herbst is a graduate of the University of Massachusetts (B.A.) and Boston University (M.B.A.).
J. Grant Monahon is AEW Capital Management's Chief Operating Officer and a member of the firm's Management Committee and Investment Policy Group. He has over 25 years of experience in real estate law and investments. Prior to joining the predecessor of AEW Capital Management in 1987, Mr. Monahon was a partner with a major Boston law firm. As the head of that firm's real estate finance department, he represented a wide variety of institutional clients, both domestic and international, in complex equity and debt transactions. He is the former Chairman of the General Counsel section of the National Association of Real Estate Investment Managers. Mr. Monahon is a graduate of Dartmouth College (B.A.) and Georgetown University Law Center (J.D.).
James J. Finnegan is the General Counsel of AEW Capital Management. Mr. Finnegan served as Vice President and Assistant General Counsel of Aldrich, Eastman & Waltch, L.P., a predecessor to AEW Capital
Management. Mr. Finnegan has over ten years of experience in real estate law, including seven years of experience in private practice with major New York City and Boston law firms. Mr. Finnegan also serves as AEW's securities and regulatory compliance officer. Mr. Finnegan is a graduate of the University of Vermont (B.A.) and Fordham University School of Law (J.D.).
Karin J. Lagerlund directs the Institutional Real Estate Services Portfolio Accounting Group at AEW Capital Management, overseeing portfolio accounting, performance measurement and client financial reporting for AEW's private equity investment portfolios. Ms. Lagerlund is a Certified Public Accountant and has over ten years experience in real estate consulting and accounting. Prior to joining AEW Capital Management in 1994, she was an Audit Manager at EY/Kenneth Leventhal LLP. Ms. Lagerlund is a graduate of Washington State University (B.A.).
(f) Involvement in Certain Legal Proceedings.
None.
Item 11.
Item 11. Executive Compensation.
Under the Partnership Agreement, the General Partners and their affiliates are entitled to receive various fees, commissions, cash distributions, allocations of taxable income or loss and expense reimbursements from the Partnership. See Notes 1, 2 and 6 to Notes to Financial Statements.
The following table sets forth the amounts of the fees and cash distributions and reimbursements of out-of-pocket expenses which the Partnership paid to or accrued for the account of the General Partners and their affiliates for the year ended December 31, 1999.
Amount of Compensation and Receiving Entity Type of Compensation Reimbursement - ---------------- -------------------- -------------
General Partners Share of Distributable Cash $ 33,020
AEW Real Estate Advisors, Inc. Management Fees and (formerly known as Copley Real Reimbursement of Expenses 325,709 Estate Advisors, Inc.)
New England Securities Servicing Fees and Corporation Reimbursement of Expenses 29,089 --------
TOTAL $387,818 ========
For the year ended December 31, 1999 the Partnership allocated $(6,429) of taxable loss to the General Partners.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
(a) Security Ownership of Certain Beneficial Owners
No person or group is known by the Partnership to be the beneficial owner of more than 5% of the outstanding Units at December 31, 1999. Under the Partnership Agreement, the voting rights of the Limited Partners are limited and, in some circumstances, are subject to the prior receipt of certain opinions of counsel or judicial decisions.
Except as expressly provided in the Partnership Agreement, the right to manage the business of the Partnership is vested exclusively in the Managing General Partner.
(b) Security Ownership of Management.
An affiliate of the General Partners of the Partnership owned 1,648 Units as of December 31, 1999.
(c) Changes in Control.
There exists no arrangement known to the Partnership the operation of which may at a subsequent date result in a change in control of the Partnership.
Item 13.
Item 13. Certain Relationships and Related Transactions.
The Partnership has no relationships or transactions to report other than as reported in Item 11 above.
PART IV
Item 14.
Item 14. Exhibits, Financial Statements, and Reports on Form 8-K.
(a) The following documents are filed as part of this report:
(1) Financial Statements--The Financial Statements listed on the accompanying Index to Financial Statements and Schedule, Financial Statement Index No. 2 and Financial Statement Index No. 3 are filed as part of this Annual Report.
(2) Financial Statement Schedule--The Financial Statement Schedule listed on the accompanying Index to Financial Statements and Schedule is filed as part of this Annual Report.
(3) Exhibits--The Exhibits listed in the accompanying Exhibit Index are filed as a part of this Annual Report and incorporated in this Annual Report as set forth in said Index.
(b) Reports on Form 8-K. During the last quarter of the year ended December 31, 1999, the Partnership filed one Current Report on Form 8-K dated October 7, 1999 reporting on Item No. 2 (Acquisition or Disposition of Assets) and Item No. 7 (Financial Statements and Exhibits), relating in both cases to the September 23, 1999 sale of Reflections Apartments.
(c) Reports on Form 8-K/A. The partnership filed one Current Report on Form 8-K/A dated December 7, 1999 reporting on Items No. 2 (Acquisition or Disposition of Assets) and No. 7 (Financial Statements and Exhibits), relating in both cases to the September 23, 1999 sale of Reflections Apartments.
New England Life Pension Properties IV;
A Real Estate Limited Partnership
Financial Statements * * * * * * *
December 31, 1999
NEW ENGLAND LIFE PENSION PROPERTIES IV A REAL ESTATE LIMITED PARTNERSHIP
INDEX TO FINANCIAL STATEMENTS AND SCHEDULE
Report of Independent Accountants
Financial Statements:
Balance Sheets - December 31, 1999 and 1998
Statements of Operations - Years ended December 31, 1999, 1998 and 1997
Statements of Partners' Capital (Deficit) - Years ended December 31, 1999, 1998 and 1997
Statements of Cash Flows - Years ended December 31, 1999, 1998 and 1997
Notes to Financial Statements
Financial Statement Schedule:
Schedule III - Real Estate and Accumulated Depreciation at December 31, 1999
All other schedules are omitted because they are not applicable.
Report of Independent Accountants
To the Partners of New England Life Pension Properties IV; A Real Estate Limited Partnership:
In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of New England Life Pension Properties IV; A Real Estate Limited Partnership (the "Partnership") at December 31, 1999 and 1998, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related financial statements. These financial statements and the financial statement schedule are the responsibility of Fourth Copley Corp., the Managing General Partner of the Partnership (the "Managing General Partner"); our responsibility is to express an opinion on these financial statements and the financial statement schedule based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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 the Managing General Partner, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
/s/ PricewaterhouseCoopers LLP Boston, Massachusetts March 21, 2000
NEW ENGLAND LIFE PENSION PROPERTIES IV; A REAL ESTATE LIMITED PARTNERSHIP
BALANCE SHEETS
December 31, ---------------------------- 1999 1998 ------------ ------------
Assets
Real estate investments: Joint ventures $ 4,608,955 $ 15,666,643 Property, net -- 9,106,457 ------------ ------------ 4,608,955 24,773,100
Cash and cash equivalents 17,597,405 5,932,931 Other net assets 97,603 -- ------------ ------------
$ 22,303,963 $ 30,706,031 ============ ============
Liabilities and Partners' Capital
Accounts payable $ 112,183 $ 145,103 Accrued management fee 24,390 32,314 Deferred management and disposition fees 4,436,165 4,229,398 ------------ ------------ Total liabilities 4,572,738 4,406,815 ------------ ------------
Partners' capital (deficit): Limited partners ($290.18 and $422 per unit, respectively; 120,000 units authorized, 94,997 units issued and outstanding) 17,734,394 26,341,929 General partners (3,169) (42,713) ------------ ------------ Total partners' capital 17,731,225 26,299,216 ------------ ------------
$ 22,303,963 $ 30,706,031 ============ ============
(See accompanying notes to financial statements)
NEW ENGLAND LIFE PENSION PROPERTIES IV; A REAL ESTATE LIMITED PARTNERSHIP
STATEMENTS OF OPERATIONS
Year ended December 31, ------------------------------------------ 1999 1998 1997 ------------ ------------ ------------
Investment Activity
Property rentals $ 1,487,638 $ 2,907,757 $ 4,981,451 Property operating expenses (951,623) (1,358,566) (2,028,830) Depreciation and amortization (83,830) (549,260) (921,501) ------------ ------------ ------------ 452,185 999,931 2,031,120
Joint venture earnings 1,661,176 1,515,033 900,050 Amortization (4,441) (5,308) (5,308) ------------ ------------ ------------
Total real estate operations 2,108,920 2,509,656 2,925,862
Gain on sale of joint venture 1,927,893 -- -- Gain on sales of property 3,474,005 3,742,541 10,482,458 ------------ ------------ ------------
Total real estate activity 7,510,818 6,252,197 13,408,320
Interest on cash equivalents and short-term investments 362,547 396,197 473,796 ------------ ------------ ------------
Total investment activity 7,873,365 6,648,394 13,882,116 ------------ ------------ ------------
Portfolio Expenses Management fee 310,709 333,771 352,468 General and administrative 306,275 325,912 318,489 ------------ ------------ ------------ 616,984 659,683 670,957 ------------ ------------ ------------
Net Income $ 7,256,381 $ 5,988,711 $ 13,211,159 ============ ============ ============
Net income per limited partnership unit $ 75.62 $ 62.41 $ 137.68 ============ ============ ============
Cash distributions per limited partnership unit $ 166.23 $ 138.76 $ 282.60 ============ ============ ============
Number of limited partnership units outstanding during the year 94,997 94,997 94,997 ============ ============ ============
(See accompanying notes to financial statements)
NEW ENGLAND LIFE PENSION PROPERTIES IV; A REAL ESTATE LIMITED PARTNERSHIP
STATEMENTS OF CASH FLOWS
(See accompanying notes to financial statements)
NEW ENGLAND LIFE PENSION PROPERTIES IV; A REAL ESTATE LIMITED PARTNERSHIP
STATEMENTS OF PARTNERS' CAPITAL (DEFICIT)
(See accompanying notes to financial statements)
NEW ENGLAND LIFE PENSION PROPERTIES IV; A REAL ESTATE LIMITED PARTNERSHIP
NOTES TO FINANCIAL STATEMENTS
Note 1 - Organization and Business
General
New England Life Pension Properties IV; A Real Estate Limited Partnership (the "Partnership") is a Massachusetts limited partnership organized for the purpose of investing primarily in newly constructed and existing income producing real properties. It primarily serves as an investment for qualified pension and profit sharing plans and other organizations intended to be exempt from federal income tax. The Partnership commenced operations in May, 1986 and acquired the one real estate investment it currently owns prior to the end of 1987. The Partnership intended to dispose of its investments within twelve years of their acquisition, and then liquidate; however, the Managing General Partner extended the holding period, having determined it to be in the best interest of the limited partners.
The Managing General Partner of the Partnership is Fourth Copley Corp., a wholly-owned subsidiary of AEW Real Estate Advisors, Inc. ("AEW"), formerly known as Copley Real Estate Advisors, Inc. ("Copley"). The associate general partner is CCOP Associates Limited Partnership, a Massachusetts limited partnership. Subject to the Managing General Partner's overall authority, the business of the Partnership is managed by AEW pursuant to an advisory contract.
On December 10, 1996, Copley's parent, New England Investment Companies, Limited Partnership ("NEIC"), a publicly traded master limited partnership, acquired certain assets subject to then existing liabilities from Aldrich Eastman & Waltch, Inc. and its affiliates and principals (collectively, "the AEW operations"). Simultaneously, a new entity, AEW Capital Management, L.P., was formed into which NEIC contributed its interest in Copley and its affiliates. As a result, the AEW operations were combined with Copley to form the business operations of AEW Capital Management, L.P. At the end of 1997, NEIC completed a restructuring plan under which it contributed all of its operations to a newly formed private partnership, NEIC Operating Partnership, L.P., in exchange for a general partnership interest in the newly formed entity. Accordingly, at December 31, 1998, AEW Capital Management, L.P. was wholly owned by NEIC Operating Partnership, L.P.. AEW is a subsidiary of AEW Capital Management, L.P. Effective April 1, 1998, NEIC changed its name to Nvest, L.P. and NEIC Operating Partnership, L.P. changed its name to Nvest Companies, L.P.
Prior to August 30, 1996, New England Mutual Life Insurance Company ("The New England") was NEIC's principal unit holder and owner of all of the outstanding stock of NEIC's general partner. On August 30, 1996, The New England merged with and into Metropolitan Life Insurance Company ("Met Life"). Met Life is the surviving entity and, therefore, through a wholly-owned subsidiary, became the owner of the units of partnership interest previously owned by The New England and of the stock of NEIC' s general partner.
At December 31, 1999 and 1998, an affiliate of the Managing General Partner owned 1,648 units of limited partnership interest, which were repurchased from certain qualified plans, within specified annual limitations provided for in the Partnership Agreement.
Management
AEW, as advisor, is entitled to receive stipulated fees from the Partnership in consideration of services performed in connection with the management of the Partnership and the acquisition and disposition of Partnership investments in real property. Partnership management fees are 9% of distributable cash flow from operations, as defined, before deducting such fees. Payment of 50% of management fees incurred is deferred until cash distributions to limited partners exceed a specified rate. Deferred management fees were $1,637,414 and $2,237,519 at December 31, 1999 and 1998, respectively. During 1999, the Partnership paid $918,738 of current and deferred management fees. AEW is also reimbursed for expenses incurred in connection with administering the Partnership
($15,000 in 1999, $15,000 in 1998 and $15,000 in 1997). Acquisition fees paid were based on 2% of the gross proceeds from the offering. Disposition fees are limited to the lesser of 3% of the selling price of the property, or 50% of the standard real estate commission customarily charged by an independent real estate broker. Payments of disposition fees are subject to the prior receipt by the limited partners of their capital contributions plus a stipulated return thereon. Deferred disposition fees were $2,798,751 and $1,991,879 at December 31, 1999 and 1998, respectively.
New England Securities Corporation, an indirect subsidiary of Met Life, is engaged by the Partnership to act as its unit holder servicing agent. Fees and out-of-pocket expenses for such services totaled $29,089, $37,823, and $25,155 in 1999, 1998 and 1997, respectively.
Note 2 - Summary of Significant Accounting Policies
Accounting Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires the Managing General Partner to make estimates affecting the reported amounts of assets and liabilities, and of revenues and expenses. In the Partnership's business, certain estimates require an assessment of factors not within management's control, such as the ability of tenants to perform under long-term leases and the ability of the properties to sustain their occupancies in changing markets. Actual results, therefore, could differ from those estimates.
Real Estate Joint Ventures
Investments in joint ventures, including loans made to venture partners, which are in substance real estate investments, are stated at cost plus (minus) equity in undistributed joint venture income (losses). Allocations of joint venture income (losses) were made to the Partnership's venture partners as long as they had substantial economic equity in the project. Economic equity is measured by the excess of the appraised value of the property over the Partnership's total cash investment plus accrued preferential returns thereon. Currently, the Partnership records an amount equal to 100% of the operating results of each joint venture, after the elimination of all inter-entity transactions, except for the one venture jointly owned by an affiliate of the Partnership, which has substantial economic equity in the project. Joint ventures are consolidated with the accounts of the Partnership if, and when, the venture partner no longer shares in the control of the business.
Property
Property includes land and buildings and improvements, which are stated at cost less accumulated depreciation, plus other operating net assets (liabilities). The Partnership's initial carrying value of a property previously owned by a joint venture equals the Partnership's carrying value of the predecessor investment on the conversion date.
Capitalized Costs, Depreciation and Amortization
Maintenance and repair costs are expensed as incurred. Significant improvements and renewals are capitalized. Depreciation is computed using the straight-line method based on estimated useful lives of the buildings and improvements. Leasing costs are also capitalized and amortized over the related lease terms.
Acquisition fees have been capitalized as part of the cost of real estate investments. Amounts not related to land are being amortized using the straight-line method over the estimated useful lives of the underlying property.
Certain tenant leases provide for rental increases over the respective lease terms. Rental revenue is being recognized on a straight-line basis over the lease terms.
Realizability of Real Estate Investments
The Partnership considers a real estate investment to be impaired when it determines the carrying value of the investment is not recoverable through expected undiscounted cash flows generated from the operations and disposal of the property. The impairment loss is based on the excess of the investment's carrying value over its estimated fair market value. For investments held for sale, the impairment loss also includes estimated costs of sale. Property held for sale is not depreciated during the holding period. Investments are considered to be held for disposition at the time management commits the Partnership to a plan to dispose of the investment.
Cash Equivalents
Cash equivalents are stated at cost plus accrued interest. The Partnership considers all highly liquid investments purchased with a maturity of ninety days or less to be cash equivalents; otherwise, they are classified as short-term investments.
Deferred Disposition Fees
Disposition fees due to AEW related to sales of investments are included in the determination of gains or losses resulting from such transactions. According to the terms of the advisory contract, payment of such fees has been deferred until the limited partners first receive their capital contributions, plus stipulated returns thereon.
Income Taxes
A partnership is not liable for income taxes and, therefore, no provision for income taxes is made in the financial statements of the Partnership. A proportionate share of the Partnership's income is reportable on each partner's tax return.
Per Unit Computations
Per unit computations are based on the number of units of limited partnership interest outstanding during the year. The actual per unit amount will vary by partner depending on the date of admission to, or withdrawal from, the Partnership.
Segment Data
Effective January 1, 1998, the Partnership adopted Financial Accounting Standards Board Statement No. 131, "Disclosure about Segments on an Enterprise and Related Information" (FAS 131). Based on the criteria established in FAS 131, the Managing General Partner has determined that the Partnership operates in one operating segment: investing in real estate properties which are domiciled in the United States of America.
Note 3 - Real Estate Joint Ventures
The Partnership had invested in seven real estate joint ventures, organized as general partnerships with a real estate management/development firm, and in one case, with an affiliate of the Partnership. One joint venture sold its property in 1994; another sold its property 1996. One joint venture investment was restructured into a wholly-owned property in 1995; and two joint venture investments were restructured into wholly-owned properties in 1996. The Partnership made capital contributions to the ventures, which are generally subject to preferential cash distributions at a specified rate and to priority distributions with respect to sale or refinancing proceeds. The Partnership also made loans to certain of its venture partners who, in turn, contributed the proceeds to the capital of the venture. The loans bear interest at a specified rate. The loans are in substance real estate investments and are accounted for accordingly. The joint venture agreements provide for the funding of cash flow deficits by the venture partners in proportion to their ownership interests, and for the dilution of their ownership share in the event a venture partner does not contribute proportionately.
The respective real estate management/development firms are responsible for day-to-day development and operating activities, although overall authority and responsibility for the business is shared by the venturers. The real estate development/management firms or their affiliates also provide various services to the respective joint ventures for a fee.
The following is a summary of cash invested in joint ventures, net of returns of capital and excluding acquisition fees:
Preferential December 31 Investment/ Rate of Ownership -------------------- Location Return Interest 1999 1998 -------- ------ -------- ---- ----
Columbia Gateway Corp. Park Columbia, Maryland 10.5% 68.11% $ -- $12,580,704
270 Technology Center Frederick, Maryland 10.0% 50% $ 4,857,000 $ 4,857,000
Columbia Gateway Corporate Park
On December 21, 1987, the Partnership entered into a joint venture with an affiliate of the Partnership and with an affiliate of the Manekin Corporation to construct and operate seven research and development/office buildings, of which six have been constructed to date. The Partnership committed to make a $14,598,000 capital contribution. The Partnership and New England Pension Properties V (the "Affiliate") collectively had a 50% interest in the joint venture. Ownership of the Columbia Gateway Corporate Park joint venture was restructured to give the Partnership and its Affiliate obtained additional voting rights in the joint venture effective January 1, 1998, and are entitled to 69.5% and 30.5%, respectively of the operating activity of the joint venture.
On December 20, 1999, the Columbia Gateway Corporate Park joint venture investment in which the Partnership and an affiliate own a 68.11% and 29.89% interest, respectively, sold its property to an unaffiliated third party for gross proceeds of $19,850,000, of which the Partnership's share was $13,795,750. The Partnership received its 69.5% share of the net proceeds, $13,423,827 after closing costs, and recognized a gain of $1,927,893 ($20.09 per Limited Partnership Unit) on the sale. A disposition fee of $413,872 was accrued but not paid to AEW Real Estate Advisors Inc.. On January 27, 2000 the Partnership made a capital distribution of $13,204,583 ($139.00 per Limited Partnership Unit) from the proceeds of the sale.
270 Technology Center
On December 22, 1987, the Partnership entered into a joint venture with an affiliate of the Manekin Corporation to construct and operate two research and development/office buildings. The Partnership committed to make a $5,150,000 capital contribution. The Partnership has a 50% interest in the joint venture. The minimum future rentals due to the venture under non-cancelable operating leases are: $716,204 in 2000, $553,154 in 2001, $211,774 in 2002, $37,928 in 2003 and $15,965 in 2004.
Reflections
On August 1, 1986, the Partnership entered into a joint venture with an affiliate of Oxford Development Corporation to construct and operate a multi-family apartment complex. The Partnership's commitment is for a total cash investment of $14,475,000, $5,790,000 of which is a loan to the venture partner. In May 1992, the Partnership agreed to extend the maturity of the loan from August, 1996 to December, 1999 and the venture partner agreed to pay interest at a minimum of 7% per annum with the unpaid amount subject to compounding at 10.5% per annum. The loan was secured by the venture partner's interest in the joint venture, as well as a guarantee from an affiliate of the venture partner. In the second quarter of 1996, the joint venture agreement was amended, whereby the Partnership's venture partner became an indirect limited partner. Accordingly, this investment has been accounted for as a wholly-owned property since April 1, 1996. (See Note 4.)
In connection with the ownership restructuring, the Partnership agreed to release the affiliate of the venture partner from its guarantee upon payment to the Partnership of $650,000. The Partnership received $250,000 at the time the agreement was executed. During the third quarter of 1996, the Partnership received an additional $263,563. The final payment of $136,437 was received during the first quarter of 1998. The first payment was accounted for as a reduction of previously accrued investment income. The second and third payments were accounted for as a reduction of the Partnership's investment in the property. (See Note 4.)
Metro Business Center
On September 15, 1986, the Partnership entered into a joint venture with an affiliate of Hewson Properties, Inc. (the "Developer"), to construct and operate four multi-tenant office/warehouse buildings. The Partnership committed to make a maximum cash investment of $9,568,000, $3,988,000 of which is a loan to the venture partner. The loan was to mature in October 1996 and was secured by the venture partner's interest in the joint venture. Effective January 1, 1996, the joint venture agreement was amended to grant the Partnership full control over management decisions, beginning July 1, 1996. As full control over the operation of this investment was not transferred until July 1, 1996, the Partnership accounted for this investment as a joint venture until that date.
Effective December 30, 1996, the property owned by the joint venture was distributed to the venture partners as tenants-in-common. The Partnership, however, retained its overall decision-making authority. The property interest distributed to the Developer was encumbered by the aforementioned loan. The note was amended to mature on February 1, 1997 and was secured by a recorded deed-of-trust which provided that the note would be due upon the sale of the collateral. The note was subsequently amended to mature on March 31, 1998. In connection with this transaction, the Partnership obtained the option to purchase the tenancy-in-common interest of the Hewson affiliate at its fair market value beginning February 1, 1997.
On February 28, 1998, the Partnership executed a purchase and sale agreement to purchase the tenancy-in-common interest of the Developer. The Partnership finalized the acquisition on July 17, 1998. The purchase price was $7,113,255 and was paid by the Partnership as follows: (i) A portion of the purchase price was paid through the discharge of all outstanding amounts, including but not limited to accrued but unpaid interest, owed by the Developer to the Partnership under the loan made by the Partnership to the Developer in connection with the original acquisition of the property and (ii) the Partnership paid the remainder of the purchase price in cash in the amount of $2,210.
On September 23, 1998, the Metro Business Center was sold to an institutional buyer which is unaffiliated with the Partnership. The gross sale price was $9,900,000. The Partnership received net proceeds totaling $9,680,132, after closing costs and recognized a gain of $3,706,950 ($38.63 per Limited Partnership Unit). A disposition fee of $297,000 was accrued but not paid to AEW. On October 29, 1998, the Partnership made a capital distribution of $9,689,694 ($102 per Limited Partnership Unit) from the proceeds of the sale.
Summarized Financial Information
The following summarized financial information is presented in the aggregate for the joint ventures:
Assets and Liabilities ----------------------
December 31, ------------------------------ 1999 1998 ----------- ----------- Assets Real property, at cost less accumulated depreciation of $1,039,331 and $2,743,676, respectively $ 3,939,825 $19,830,637 Other 634,949 888,075 ----------- ----------- $ 4,574,774 20,718,712
Liabilities 136,869 339,188 ----------- -----------
Net assets $ 4,437,905 $20,379,524 =========== ===========
Results of Operations ---------------------
Year ended December 31, ---------------------------------------- 1999 1998 1997 ---------- ---------- ---------- Revenue Rental income $2,959,645 $3,047,719 $2,691,155 Other income 118,802 119,729 3,233 ---------- ---------- ---------- 3,078,447 3,167,448 2,694,388 ---------- ---------- ----------
Expenses Operating expenses 662,137 723,908 596,471 Depreciation and amortization 318,707 488,068 854,025 ---------- ---------- ---------- 980,844 1,211,976 1,450,496 ---------- ---------- ---------- Net income $2,097,603 $1,955,472 $1,243,892 ========== ========== ==========
Liabilities and expenses exclude amounts owed and attributable to the Partnership and (with respect to one joint venture) its affiliate on behalf of their various financing arrangements with the joint ventures.
Note 4 - Property
Palms Business Center
Effective January 1, 1995, the Palms Business Center joint venture was restructured, giving the Partnership control over management decisions. Since that date, the investment was accounted for as a wholly-owned property. The carrying value of the joint venture investment at conversion ($12,519,961) was allocated to land, building and improvements, amount payable to venture partner and other net operating liabilities. The venture partner was entitled to received 40% of the excess cash
flow above a specified level until the initial obligation of $360,000 was repaid in full. The obligation was paid in full as of the date of sale (see discussion below).
The buildings and improvements (fifteen office/industrial buildings in Las Vegas, Nevada) were being depreciated over 25 years, beginning January 1, 1995.
The Palms Business Center was sold on October 24, 1997 to an institutional buyer, which is unaffiliated with the Partnership for $23,200,000. The Partnership received net proceeds of $22,983,007, after closing costs and payoff of the remaining initial obligation due to the venture partner, and recognized a gain of $10,482,458 ($109.24 per Limited Partnership Unit). A disposition fee of $696,000 was accrued but not paid to AEW Real Estate Advisors, Inc.. On November 25, 1997, the Partnership made a distribution to the limited partners in the aggregate amount of $22,989,274 ($242 per Limited Partnership Unit) with proceeds from this sale and partially from reserves established from the proceeds of previous sales.
Reflections
Effective April 1, 1996, the Reflections joint venture was restructured, whereby the Partnership's venture partner became an indirect limited partner. Accordingly, the investment has been accounted for as a wholly-owned property since that date. The carrying value of the joint venture investment at conversion ($10,469,511) was allocated to land, building and improvements and other net operating assets.
On August 21, 1998 the Partnership sold a parcel of land to the City of Fort Myers. The gross sale price was $74,731. The Partnership received net proceeds totaling $67,881 and recognized a gain of $35,591.
The buildings and improvements (a multi-family apartment complex in Fort Meyers, Florida) were being depreciated over 25 years, beginning April 1, 1996.
On September 23, 1999, the Reflections Apartments was sold to a third party which is unaffiliated with the Partnership. The gross sale price was $13,100,000. The Partnership received net proceeds totaling $12,773,052, after closing costs, and recognized a gain of $3,474,005 ($36.20 per Limited Partnership Unit). A disposition fee of $393,000 was accrued but not paid to AEW Real Estate Advisors, Inc. On October 28, 1999, the Partnership made a capital distribution of $12,522,505 ($131.82 per Limited Partnership Unit) from the proceeds of the sale.
Metro Business Center
Effective July 1, 1996, the Partnership obtained control over all management decisions related to the properties owned by the Metro Business Center joint venture (and subsequently by the tenants-in common). (See Note 3.) Since that date, the investment has been accounted for as a wholly-owned property. The carrying value of the joint venture investment at conversion ($5,889,261) was allocated to land, buildings and improvements, and other net operating assets.
As described above the Partnership sold the Metro Business Center on September 23, 1998 and recognized a gain of $3,706,950.
The buildings and improvements (four office/warehouse buildings in Phoenix, Arizona) were being depreciated over 25 years, beginning July 1, 1996.
The following is a summary of the Partnership's investment in property:
Assets and Liabilities ----------------------
December 31, --------------------------- 1999 1998 ----------- ----------- Land $ -- $ 1,538,883 Buildings and improvements and other capitalized costs -- 8,383,001 Accumulated depreciation and Amortization -- (932,007) Net operating liabilities -- 116,580 ----------- ----------- -- $ 9,106,457 =========== ===========
Note 5 - Income Taxes
The Partnership's income for federal income tax purposes differs from that reported in the accompanying statement of operations as follows:
Year ended December 31, ----------------------------------------- 1999 1998 1997 ----------- ----------- ----------- Net income per financial statements $ 7,256,381 $ 5,988,712 $13,211,159 Timing differences: Joint venture earnings 169,210 775,991 335,601 Depreciation and amortization (53,730) 549,260 926,809 Expenses (282,938) (244,327) 176,233 Gain (loss) on sale (4,722,636) (4,687,593) 1,008,333 ----------- ----------- ----------- Taxable income $ 2,366,287 $ 2,382,043 $15,658,135 =========== =========== ===========
Note 6 - Partners' Capital
Allocation of net income (losses) from operations and distributions of distributable cash from operations, as defined, are in the ratio of 99% to the limited partners and 1% to the general partners. Cash distributions are made quarterly.
Net sale proceeds and financing proceeds are allocated first to limited partners to the extent of their contributed capital plus a stipulated return thereon, as defined, second to pay disposition fees, and then 85% to the limited partners and 15% to the general partners. As a result of returns of capital from sales transactions, the adjusted capital contribution per limited partnership unit was reduced from $1,000 to $918 in 1993, to $863 in 1995, to $766 in 1996 to $524 in 1997 to $422 in 1998 and to $290.18 in 1999. No capital distributions have been made to the general partners. Income from a sale is allocated in proportion to the distribution of related proceeds, provided that the general partners are allocated at least 1%. Income or losses from a sale, if there are no residual proceeds after the repayment of the related debt, will be allocated 99% to the limited partners and 1% to the general partners.
Note 7 - Subsequent Event
Distributions of cash from operations relating to the quarter ended December 31, 1999 were made on January 27, 2000 in the aggregate amount of $493,217 ($5.14 per Limited Partnership Unit). In addition, a special capital distribution was made on January 27, 2000 funded from original working capital totaling $1,347,057 ($14.18 per Limited Partnership Unit). As discussed above, the Partnership also made a capital distribution of $13,204,583 ($139.00 per Limited Partnership Unit) from the proceeds of the Columbia Gateway Corporate Park sale.
NEW ENGLAND PENSION PROPERTIES IV; A REAL ESTATE LIMITED PARTNERSHIP REAL ESTATE AND ACCUMULATED DEPRECIATION Schedule III
AT DECEMBER 31, 1999
NEW ENGLAND PENSION PROPERTIES IV; A REAL ESTATE LIMITED PARTNERSHIP REAL ESTATE AND ACCUMULATED DEPRECIATION-WHOLLY OWNED PROPERTY SCHEDULE III NOTE A AT DECEMBER 31, 1999
NEW ENGLAND LIFE PENSION PROPERTIES IV; A REAL ESTATE LIMITED PARTNERSHIP SCHEDULE III NOTE B REAL ESTATE AND ACCUMULATED DEPRECIATION-JOINT VENTURES AT DECEMBER 31,1999
FINANCIAL STATEMENTS INDEX NO. 2
Auditor's Report and Financial Statements
of Morf 6 Venture
Independent Auditor's Report of Wolpoff and Company, LLP
Balance Sheet - December 31, 1999 and 1998
Statement of Income - For the Years ended December 31, 1999, 1998 and 1997
Statement of Partners' Capital - For the Years ended December 31, 1999, 1998 and
Statement of Cash Flows - For the Years ended December 31, 1999, 1998 and 1997
Notes to Financial Statements
MORF 6 VENTURE (A MARYLAND GENERAL PARTNERSHIP)
FINANCIAL REPORT
DECEMBER 31, 1999
WALPERT & WOLPOFF, LLP Certified Public Accountants ----------------------------
MORF 6 VENTURE (A MARYLAND GENERAL PARTNERSHIP)
CONTENTS
DECEMBER 31, 1999
INDEPENDENT AUDITOR'S REPORT ON FINANCIAL STATEMENTS
FINANCIAL STATEMENTS
Balance Sheet
Statement of Income
Statement of Partners' Capital
Statement of Cash Flows
Notes to Financial Statements
INDEPENDENT AUDITOR'S REPORT ON SUPPLEMENTARY INFORMATION
SUPPLEMENTARY INFORMATION
Schedule of Partners' Capital
Schedule of Changes in Partners' Capital - Income Tax Basis
[LETTERHEAD OF WALPERT & WOLPOFF, LLP]
To the Partners MORF 6 Venture (A Maryland General Partnership) Columbia, Maryland
INDEPENDENT AUDITOR'S REPORT ON FINANCIAL STATEMENTS
We have audited the balance sheet of MORF 6 Venture (A Maryland General Partnership) as of December 31, 1999 and 1998, and the related statements of income, partners' capital, and cash flows for each of the three years ended December 31, 1999, 1998, and 1997. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits,
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as 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 financial position of MORF 6 Venture (A Maryland General Partnership) as of December 31, 1999 and 1998, and the results of its operations and its cash flows for each of the three years ended December 31, 1999, 1998, and 1997, in conformity with generally accepted accounting principles.
/s/ Walpert & Wolpoff, LLP
WALPERT & WOLPOFF, LLP
Baltimore, Maryland January 12, 2000
MORF 6 VENTURE (A MARYLAND GENERAL PARTNERSHIP)
BALANCE SHEET
ASSETS
December 31, -------------------------- 1999 1998 ----------- ----------- PROPERTY, AT COST - Note 1 Buildings and Improvements $ 4,155,969 $ 4,088,945 Land and Land Improvements 630,335 630,335 Deferred Costs - Note 3 192,852 143,782 ----------- ----------- 4,979,156 4,863,062 Less Accumulated Depreciation and Amortization (1,039,331) (914,049) ----------- -----------
PROPERTY, NET 3,939,825 3,949,013 ----------- -----------
OTHER ASSETS Cash and Cash Equivalents - Note 1 64,047 113,865 ----------- -----------
Receivable From Tenants 24,307 24,973 Allowance for Doubtful Accounts (22,740) (22,870) ----------- ----------- 1,567 2,103 ----------- -----------
Prepaid Expenses 29,367 29,294 ----------- -----------
TOTAL OTHER ASSETS 94,981 145,262 ----------- -----------
$ 4,034,806 $ 4,094,275 =========== ===========
LIABILITIES AND PARTNERS' CAPITAL
LIABILITIES Accounts Payable and Accrued Expenses $ 89,598 $ 40,088 Tenant Security Deposits 25,638 22,445 Rents Received in Advance 13,208 12,076 ----------- -----------
TOTAL LIABILITIES 128,444 74,609
PARTNERS' CAPITAL - Note 2 3,906,362 4,019,666 ----------- -----------
$ 4,034,806 $ 4,094,275 =========== ===========
- ---------- The notes to financial statements are an integral part of this statement.
MORF 6 VENTURE (A MARYLAND GENERAL PARTNERSHIP)
STATEMENT OF INCOME
- ---------- The notes to financial statements are an integral part of this statement.
MORF 6 VENTURE (A MARYLAND GENERAL PARTNERSHIP)
STATEMENT OF PARTNERS' CAPITAL
Year Ended December 31, --------------------------------------- 1999 1998 1997 ----------- ----------- -----------
CAPITAL CONTRIBUTIONS - Note 2 Prior Years $ 4,857,000 $ 4,857,000 $ 4,857,000 ----------- ----------- -----------
CAPITAL PLACEMENT FEE - Notes 1 and 2 (38,250) (38,250) (38,250) ----------- ----------- -----------
DISTRIBUTIONS - Note 2 Prior Years (5,308,931) (4,567,931) (4,347,931) Current Year (780,000) (741,000) (220,000) ----------- ----------- ----------- (6,088,931) (5,308,931) (4,567,931) ----------- ----------- -----------
ACCUMULATED INCOME Prior Years 4,509,847 3,998,442 3,891,285 Current Year 666,696 511,405 107,157 ----------- ----------- ----------- 5,176,543 4,509,847 3,998,442 ----------- ----------- -----------
TOTAL PARTNERS' CAPITAL $ 3,906,362 $ 4,019,666 $ 4,249,261 =========== =========== ===========
- ---------- The notes to financial statements are an integral part of this statement.
MORF 6 VENTURE (A MARYLAND GENERAL PARTNERSHIP)
STATEMENT OF CASH FLOWS
- ---------- The notes to financial statements are an integral part of this statement.
MORF 6 VENTURE (A MARYLAND GENERAL PARTNERSHIP)
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1999
Note 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization
MORF 6 Venture (A Maryland General Partnership) (the Partnership) was formed on December 22, 1987, under the Maryland Uniform Partnership Act. The Partnership purchased all of the land and buildings from M.O.R.F. 6 Associates Limited Partnership, a general partner. The buildings were in service and partially leased upon date of purchase.
Cash and Cash Equivalents
The Partnership considers all highly liquid debt instruments purchased with a maturity of 3 months or less to be cash equivalents. The Partnership's cash is held in financial institutions with insurance provided by the Federal Deposit Insurance Corporation (FDIC) up to $100,000. Periodically during the year, the balance exceeded the FDIC insurance limitation.
Property
The Partnership owns and operates two office buildings in Frederick, Maryland, containing approximately 73,000 square feet of leasable area.
All property is recorded at cost. Information regarding the buildings is as follows:
Occupancy Square ---------------------------- Building Feet Tenants 12/31/99 12/31/98 12/31/97 -------- ---- ------- -------- -------- -------- 1 45,000 Multiple 100% 100% 51% 2 28,000 Multiple 100% 100% 100% ------ 73,000 100% 100% 70% ====== === === ===
During 1998 and 1997, tenant improvements completed in prior years were demolished in order to build out the space for new tenants. The loss on abandonment of tenant improvements is calculated as follows:
1999 1998 1997 -------- -------- --------- Cost $ -0- $ 65,466 $ 480,157 Accumulated Depreciation -0- (12,324) (107,672) -------- -------- --------- Abandonment of Tenant Improvements $ -0- $ 53,142 $ 372,485 ======== ======== =========
MORF 6 VENTURE (A MARYLAND GENERAL PARTNERSHIP)
NOTES TO FINANCIAL STATEMENTS - CONTINUED
DECEMBER 31, 1999
Note 1 - Depreciation (Cont.)
Building costs are being depreciated using the straight-line method over the estimated useful lives of 50 years. Beginning in January 1998, the Partnership changed depreciation methods for tenant improvements. Tenant improvements are being depreciated using the straight-line method over the life of the tenants' lease; in prior years the improvements were depreciated over 50 years.
Amortization
Various deferred costs are being amortized as follows:
Amortization 1999 1998 Period -------- -------- ------------ Leasing Commissions $185,134 $136,064 1 - 5 Years Organization Costs 7,718 7,718 Complete -------- --------
$192,852 $143,782 ======== ========
Rental Income
Rental income for major leases is being recognized on a straight-line basis over the term of the lease. The excess of the rental income recognized over the amount stipulated in the lease is shown as deferred rent receivable.
Income Taxes
Partnerships, as such, are not subject to income taxes. The individual partners are required to report their respective shares of partnership income and other tax items on their respective income tax returns.
Capital Placement Fee
The cost incurred for arranging the Partnership's equity has been treated as a reduction of partners' capital (see Note 2).
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect certain reported amounts and disclosures.
Note 2 - PARTNERS' CAPITAL
Capital Investment
New England Life Pension Properties IV (NELPP IV) has agreed to provide equity up to an amount of $5,150,000 to the Partnership. Of this amount, $5,004,841 was contributed, and in 1991, $293,000 was returned from proceeds of a 1990 land sale. An additional $175,060 was contributed in 1994, and in 1995, capital contributions of $29,901 were returned. Contributed capital totaled $4,857,000, at December 31, 1999, 1998, and 1997.
MORF 6 VENTURE (A MARYLAND GENERAL PARTNERSHIP)
NOTES TO FINANCIAL STATEMENTS - CONTINUED
DECEMBER 31, 1999
Note 2 - (Cont.)
NELPP IV is entitled to a cumulative priority return of 10%, compounded monthly, on invested capital. During 1999, 1998, and 1997, NELPP IV was paid $780,000, $741,000, and $220,000, respectively, under this agreement. As of December 31, 1999, 1998, and 1997, the unpaid priority return was $-0-, $-0-, and $228,089, respectively.
Capital Placement Fee
The Partnership incurred fees of $38,250 with Paine Webber Mortgage Finance, Inc. with respect to capital raised by the Partnership. This amount has been charged against capital.
Note 3 - RELATED PARTY TRANSACTIONS
Management Fees
The Partnership has entered into an agreement with Manekin, LLC, an affiliated entity, to act as management agent for the property. The management agreement provides for fees equal to 3% of rent and tenant expense billings. For the years ended December 31, 1999, 1998, and 1997, management fees of $29,100, $24,585, and $22,507, respectively, were incurred.
Leasing Commissions
Leasing commissions of $16,667, $20,583, and $54,802, were paid to related parties during 1999, 1998, and 1997, respectively.
Note 4 - TAX ACCOUNTING
Tax accounting differs from financial accounting as follows:
Current Prior Year Years Total --------- ---------- ----------
Financial Income $ 666,696 $4,509,847 $5,176,543 Additional Depreciation (49,590) (591,163) (640,753) Real Property Taxes Expensed for Tax -0- (28,347) (28,347) Prepaid Tenant Reimbursements 52,673 31,211 83,884 Rents Received in Advance (7,788) 12,076 4,288 Additional Gain on Sale of Land Recognized for Tax -0- 30,594 30,594 Allowance for Doubtful Accounts (130) 22,870 22,740 --------- ---------- ----------
Taxable Income $ 661,861 $3,987,088 $4,648,949 ========= ========== ==========
MORF 6 VENTURE (A MARYLAND GENERAL PARTNERSHIP)
NOTES TO FINANCIAL STATEMENTS - CONTINUED
DECEMBER 31, 1999
Note 5 - FUTURE MINIMUM LEASE PAYMENTS
The following is a schedule of future minimum lease payments to be received under noncancelable operating leases at December 31, 1999:
Year Ending December 31, 2000 $ 716,204 2001 553,154 2002 211,774 2003 37,928 2004 15,965 ----------
Total $1,535,025 ==========
[LETTERHEAD OF WALPERT & WOLPOFF, LLP]
To the Partners MORF 6 Venture (A Maryland General Partnership) Columbia, Maryland
INDEPENDENT AUDITOR'S REPORT ON SUPPLEMENTARY INFORMATION
Our audits were conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying supplementary information contained on pages 11 and 12 is presented for the purpose of additional analysis and is not a required part of the basic financial statements. Such information has not been subjected to the auditing procedures applied in the audits of the basic financial statements, and accordingly, we express no opinion on it.
/s/ Walpert & Wolpoff, LLP
WALPERT & WOLPOFF, LLP
Baltimore, Maryland January 12, 2000
MORF 6 VENTURE (A MARYLAND GENERAL PARTNERSHIP)
SCHEDULE OF PARTNERS' CAPITAL
YEAR ENDED DECEMBER 31, 1999
M.O.R.F. 6 New England Associates Life Pension Limited Properties IV Partnership Total ------------- ----------- -----
OWNERSHIP PERCENTAGE 50% 50% 100% =========== ===== ===========
CAPITAL CONTRIBUTIONS - Note 2 Prior Years $ 4,857,000 $ -0- $ 4,857,000 ----------- ----- -----------
CAPITAL PLACEMENT FEE - Notes 1 and 2 (38,250) -0- (38,250) ----------- ----- -----------
DISTRIBUTIONS - Note 2 Prior Years (5,308,931) -0- (5,308,931) Current Year (780,000) -0- (780,000) ----------- ----- ----------- (6,088,931) -0- (6,088,931) ----------- ----- -----------
ACCUMULATED INCOME Prior Years 4,509,847 -0- 4,509,847 Current Year 666,696 -0- 666,696 ----------- ----- ----------- 5,176,543 -0- 5,176,543 ----------- ----- -----------
TOTAL PARTNERS' CAPITAL $ 3,906,362 $ -0- $ 3,906,362 =========== ===== ===========
- ---------- See Independent Auditor's Report on Supplementary Information.
MORF 6 VENTURE (A MARYLAND GENERAL PARTNERSHIP)
SCHEDULE OF CHANGES IN PARTNERS' CAPITAL - INCOME TAX BASIS
YEAR ENDED DECEMBER 31, 1999
M.O.R.F. 6 New England Associates Life Pension Limited Properties IV Partnership Total ------------- ----------- -----
OWNERSHIP PERCENTAGE 50% 50% 100% =========== ===== ===========
CAPITAL CONTRIBUTIONS - Note 2 Prior Years $ 4,857,000 $ -0- $ 4,857,000 ----------- ----- -----------
CAPITAL PLACEMENT FEE - Notes 1 and 2 (38,250) -0- (38,250) ----------- ----- -----------
DISTRIBUTIONS - Note 2 Prior Years (5,308,931) -0- (5,308,931) Current Year (780,000) -0- (780,000) ----------- ----- ----------- (6,088,931) -0- (6,088,931) ----------- ----- -----------
ACCUMULATED INCOME - Note 4 Prior Years 3,987,088 -0- 3,987,088 Current Year 661,861 -0- 661,861 ----------- ----- ----------- 4,648,949 -0- 4,648,949 ----------- ----- -----------
TOTAL PARTNERS' CAPITAL $ 3,378,768 $ -0- $ 3,378,768 =========== ===== ===========
- ---------- See Independent Auditor's Report on Supplementary Information.
FINANCIAL STATEMENTS INDEX NO. 3
Auditor's Report and Financial Statements
of Gateway 51 Partnership
Independent Auditor's Report of Wolpoff and Company, LLP
Balance Sheet - December 31, 1998 and 1997
Statement of Income - For the Years ended December 31, 1998, 1997 and 1996
Statement of Partners' Capital - For the Years ended December 31, 1998, 1997 and
Statement of Cash Flows - For the Years ended December 31, 1998, 1997 and 1996
Notes to Financial Statements
GATEWAY 51 PARTNERSHIP
(A MARYLAND GENERAL PARTNERSHIP)
FINANCIAL REPORT
DECEMBER 31, 1998
GATEWAY 51 PARTNERSHIP (A MARYLAND GENERAL PARTNERSHIP)
CONTENTS
DECEMBER 31, 1998
INDEPENDENT AUDITOR'S REPORT ON FINANCIAL STATEMENTS
FINANCIAL STATEMENTS
Balance Sheet
Statement of Income
Statement of Partners' Capital
Statement of Cash Flows
Notes to Financial Statements
INDEPENDENT AUDITOR'S REPORT ON SUPPLEMENTARY INFORMATION
SUPPLEMENTARY INFORMATION
Schedule of Partners' Capital
Schedule of Changes in Partners' Capital - Income Tax Basis
[LETTERHEAD OF WOLPOFF & COMPANY, LLP]
To the Partners Gateway 51 Partnership (A Maryland General Partnership) Columbia, Maryland
INDEPENDENT AUDITOR'S REPORT ON FINANCIAL STATEMENTS
We have audited the balance sheet of Gateway 51 Partnership (A Maryland General Partnership) as of December 31, 1998 and 1997, and the related statements of income, partners' capital, and cash flows for each of the three years in the period ended December 31, 1998, 1997, and 1996. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as 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 financial position of Gateway 51 Partnership (A Maryland General Partnership) as of December 31, 1998 and 1997, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1998, 1997, and 1996, in conformity with generally accepted accounting principles.
/s/ Wolpoff & Company, LLP
WOLPOFF & COMPANY, LLP
Baltimore, Maryland January 13, 1999
GATEWAY 51 PARTNERSHIP (A MARYLAND GENERAL PARTNERSHIP)
BALANCE SHEET
ASSETS
December 31, -------------------------- 1998 1997 ------------ ----------- PROPERTY, AT COST - Note 1 Land $ 4,966,738 $ 4,966,738 Building and Improvements 11,892,943 11,614,717 Preliminary Development Costs 42,247 42,247 Deferred Costs - Note 3 809,323 663,719 ------------ ----------- 17,711,251 17,287,421 Less Accumulated Depreciation and Amortization 1,984,627 1,630,022 ------------ -----------
PROPERTY, NET 15,726,624 15,657,399 ------------ -----------
OTHER ASSETS Cash and Cash Equivalents - Note 1 421,833 558,136 ------------ ----------- Receivables From Tenants Rents and Expense Billings 106,282 -0- Deferred Rent Receivable - Note 1 202,228 73,447 Allowance for Doubtful Accounts (95,174) -0- ------------ ----------- 213,336 73,447 ------------ -----------
Prepaid Expenses 107,644 107,442 ------------ -----------
TOTAL OTHER ASSETS 742,813 739,025 ------------ -----------
$ 16,469,437 $16,396,424 ============ ===========
- ---------- The notes to financial statements are an integral part of this statement.
GATEWAY 51 PARTNERSHIP (A MARYLAND GENERAL PARTNERSHIP)
BALANCE SHEET
LIABILITIES AND PARTNERS' CAPITAL
December 31, -------------------------- 1998 1997 ----------- -----------
LIABILITIES Accounts Payable and Accrued Expenses $ 67,398 $ 34,935 Tenant Security Deposits 150,000 15,193 Prepaid Tenant Reimbursements 47,181 142,688 ----------- -----------
TOTAL LIABILITIES 264,579 192,816
PARTNERS' CAPITAL - Notes 1 and 2 16,204,858 16,203,608 ----------- -----------
$16,469,437 $16,396,424 =========== ===========
- ---------- The notes to financial statements are an integral part of this statement.
GATEWAY 51 PARTNERSHIP (A MARYLAND GENERAL PARTNERSHIP)
STATEMENT OF INCOME
The notes to financial statements are an integral part of this statement.
GATEWAY 51 PARTNERSHIP (A MARYLAND GENERAL PARTNERSHIP)
STATEMENT OF PARTNERS' CAPITAL
Year Ended December 31, 1998 1997 1996 ------------ ------------ ------------
CAPITAL CONTRIBUTIONS - Note 2 Prior Years $ 20,267,826 $ 20,267,826 $ 20,267,826 ------------ ------------ ------------
CAPITAL PLACEMENT FEE - Notes 1 and 2 Prior Years (202,678) (202,678) (202,678) ------------ ------------ ------------
DISTRIBUTIONS Prior Years (8,796,724) (8,048,893) (6,948,893) Current Year (1,411,817) (747,831) (1,100,000) ------------ ------------ ------------ (10,208,541) (8,796,724) (8,048,893) ------------ ------------ ------------
ACCUMULATED INCOME Prior Years 4,935,184 3,838,835 2,688,804 Current Year 1,413,067 1,096,349 1,150,031 ------------ ------------ ------------ 6,348,251 4,935,184 3,838,835 ------------ ------------ ------------
TOTAL PARTNERS' CAPITAL $ 16,204,858 $ 16,203,608 $ 15,855,090 ============ ============ ============
- ---------- The notes to financial statements are an integral part of this statement.
GATEWAY 51 PARTNERSHIP (A MARYLAND GENERAL PARTNERSHIP)
STATEMENT OF CASH FLOWS
- ---------- The notes to financial statements are an integral part of this statement.
GATEWAY 51 PARTNERSHIP (A MARYLAND GENERAL PARTNERSHIP)
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1998
Note 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization
Gateway 51 Partnership (A Maryland General Partnership) (the Partnership) was formed on December 21, 1987, under the Maryland Uniform Partnership Act. The agreement was amended and restated in 1989 to reflect changes in partner ownership percentages.
The partnership agreement was amended and restated effective January 1, 1998, whereby M.O.R. Gateway 51, Limited Partnership (M.O.R.) transferred 34.055% and 14.945% to New England Life Pension Properties IV (NELPP IV) and New England Pension Properties V (NEPP V), respectively. Subsequently, NELPP IV transferred a 0.695% partnership interest, NEPP V transferred a 0.305% partnership interest, and M.O.R. transferred a 1% partnership interest to NE/Gateway 51 Limited Partnership (NE/Gateway), bringing the ownership as of January 1, 1998, to the following:
NELPP IV 68.11% NEPP V 29.89% NE/Gateway 2.00%
Property
The Partnership owns 21 acres of land in Howard County, Maryland. The property has been developed with six office/research buildings. Plans call for a seventh building with approximately 15,000 square feet of space.
All property is recorded at cost. Information regarding the buildings is as follows:
Occupancy Square Date Placed ---------------------------- Building Footage Into Service Tenants 12/31/98 12/31/97 12/31/96 - -------- ------- ------------ ------- -------- -------- --------
A 46,840 3/1/91 Multiple 100% 92% 92% B 21,991 9/1/90 AVNET 100% 100% 100% C 38,225 7/15/91 EVI, Inc. 100% 100% 100% F 35,812 2/1/92 Multiple 100% 100% 82% D-E 45,951 8/8/94 Columbia National 100% 100% 100% -------
188,819 100% 98% 94% =======
Carrying costs, operating expenses, and depreciation begin as a charge against operations on the date the buildings were placed into service.
GATEWAY 51 PARTNERSHIP (A MARYLAND GENERAL PARTNERSHIP)
NOTES TO FINANCIAL STATEMENTS - CONTINUED
DECEMBER 31, 1998
Note 1 - (Cont.)
During 1997, tenant improvements completed in prior years were demolished in order to build out the space for new tenants. The loss on abandonment of tenant improvements is calculated as follows:
Cost $ 127,688 Accumulated Depreciation (47,510) ---------
Abandonment of Tenant Improvements $ 80,178 =========
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect certain reported amounts and disclosures.
Cash and Cash Equivalents
The Partnership considers all highly liquid debt instruments purchased with a maturity of 3 months or less to be cash equivalents.
The majority of the Partnership's cash is held in financial institutions with insurance provided by the Federal Deposit Insurance Corporation (FDIC) up to $100,000. Periodically during the year, the balance may have exceeded the FDIC insurance limitation.
Depreciation
Building costs are being depreciated using the straight-line method over the estimated useful lives of 50 years. Beginning in January 1998, the Partnership changed depreciation methods for tenant improvements. Tenant improvements are being depreciated using the straight-line method over the life of the tenants' lease; in prior years, the improvements were depreciated over 50 years.
Rental Income
Rental income for major leases is being recognized on a straight-line basis over the terms of the leases. The excess of the rental income recognized over the amount stipulated in the lease is shown as deferred rent receivable.
Amortization
Deferred costs are amortized as follows:
Amortization Amount Period -------- -------------
Organization Costs $ 13,555 Complete Leasing Costs and Commissions 795,767 Lease Terms --------
$809,322 ========
GATEWAY 51 PARTNERSHIP (A MARYLAND GENERAL PARTNERSHIP)
NOTES TO FINANCIAL STATEMENTS - CONTINUED
DECEMBER 31, 1998
Note 1 - (Cont.)
Income Taxes
Partnerships, as such, are not subject to income taxes. The partners are required to report their respective shares of partnership income and other tax items on their income tax returns (see Note 4).
Capital Placement Fee
Costs incurred for arranging the Partnership's equity have been treated as a reduction of partners capital (see Note 2).
Note 2 - PARTNERS' CAPITAL
Capital Investment
NELPP IV and NEPP V have agreed to provide equity of $14,598,000 and $6,402,000, respectively, totaling $21,000,000. As of December 31, 1998, 1997, and 1996, total capital contributions amounted to $20,267,826.
Cumulative Priority Return
NELPP IV and NEPP V are entitled to cumulative priority returns of 10.5%, compounded monthly on capital invested. The Partnership paid priority returns totaling $1,411,817, $747,831, and $1,100,000 during 1998, 1997, and 1996, respectively. As of December 31, 1998, 1997, and 1996, unpaid priority returns amounted to $10,855,114, $9,127,936, and $6,888,115, respectively.
Capital Placement Fee
The Partnership incurred fees of $202,678 with Paine Webber Mortgage Finance, Inc. with respect to capital raised by the Partnership. This amount has been charged against partners' capital.
Note 3 - RELATED PARTY TRANSACTIONS
Management Fees
The Partnership has entered into an agreement with Manekin Corporation, a related entity, to act as management agent for the property. The management agreement provides for a management fee equal to 3% of rent and tenant expense billings.
Leasing Commissions
Leasing commissions in the amount of $145,603, $105,387, and $80,786 were paid to related parties during 1998, 1997, and 1996, respectively.
GATEWAY 51 PARTNERSHIP (A MARYLAND GENERAL PARTNERSHIP)
NOTES TO FINANCIAL STATEMENTS - CONTINUED
DECEMBER 31, 1998
Note 4 - TAX ACCOUNTING
Tax accounting differs from financial accounting as follows:
Current Year Prior Years Total ------------ ----------- -----------
Financial Income $ 1,413,067 $ 4,935,184 $ 6,348,251 Additional Depreciation (87,820) (757,466) (845,286) Lease-Up Period Items Capitalized for GAAP -0- 4,264 4,264 Allowance for Doubtful Accounts 95,174 -0- 95,174 Deferred Rent Receivable (128,781) (73,447) (202,228) Prepaid Property Taxes (956) (105,026) (105,982) Prepaid Tenant Reimbursements (95,507) 142,688 47,181 ----------- ----------- -----------
Taxable Income $ 1,195,177 $ 4,146,197 $ 5,341,374 =========== =========== ===========
Note 5 - LEASES
The following is a schedule of future minimum lease payments to be received under noncancelable operating leases at December 31, 1998:
Year Ending December 31, 1999 $1,524,603 2000 827,454 2001 726,557 2002 736,016 2003 745,758 ----------
$3,814,630 ==========
To the Partners Gateway 51 Partnership (A Maryland General Partnership) Columbia, Maryland
INDEPENDENT AUDITOR'S REPORT ON SUPPLEMENTARY INFORMATION
Our audits were conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying supplementary information contained on pages 12 and 13 is presented for the purpose of additional analysis and is not a required part of the basic financial statements. Such information has not been subjected to the auditing procedures applied in the audits of the basic financial statements, and accordingly, we express no opinion on it.
/s/ Wolpoff & Company, LLP
WOLPOFF & COMPANY, LLP
Baltimore, Maryland January 13, 1999
GATEWAY 51 PARTNERSHIP (A MARYLAND GENERAL PARTNERSHIP)
SCHEDULE OF PARTNERS' CAPITAL
YEAR ENDED DECEMBER 31, 1998
- ---------- See Independent Auditor's Report on Supplementary Information.
GATEWAY 51 PARTNERSHIP (A MARYLAND GENERAL PARTNERSHIP)
SCHEDULE OF CHANGES IN PARTNERS' CAPITAL - INCOME TAX BASIS
YEAR ENDED DECEMBER 31, 1998
- ---------- See Independent Auditor's Report on Supplementary Information.
EXHIBIT INDEX Exhibit Page Number Number - ------ ------
10M. Promissory Note dated September 15, 1986 in the amount * of $3,720,000 from Hewson Properties, Inc. to the Registrant.
10U. General Partnership Agreement of MORF 6 Venture, dated * as of December 18, 1987, between M.O.R.F. 6 Associates Limited Partnership and the Partnership.
10MM. Assignment of Rents and Leases made and entered into as * of February 1, 1990 by and between Calibre Log Cabin, Ltd. and the Registrant.
10SS. Amended and Restated Pooling Agreement dated as of December * 1, 1995 by and among the Registrant, Montgomery-Oxford Associates Limited Partnership, Waters Landing-Oxford Associates Limited Partnership and related documents dated as of December 1, 1995 and May 14, 1996.
27. Financial Data Schedule
- -------- *Previously filed and incorporated herein by reference
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
NEW ENGLAND LIFE PENSION PROPERTIES IV; A REAL ESTATE LIMITED PARTNERSHIP
Date: March 29, 2000 By: /s/ Alison Husid Cutler ---------------------------- Alison Husid Cutler President of the Managing General Partner
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signature Title Date --------- ----- ----
President, Chief /s/ Alison Husid Cutler Executive Officer and - --------------------------- Director of the March 29, 2000 Alison Husid Cutler Managing General Partner
/s/ Pamela J. Herbst Vice President and - --------------------------- Director of the March 29, 2000 Pamela J. Herbst Managing General Partner
/s/ J. Grant Monahon Vice President and - --------------------------- Director of the March 29, 2000 J. Grant Monahon Managing General Partner
/s/ James J. Finnegan - --------------------------- Vice President of the March 29, 2000 James J. Finnegan Managing General Partner
/s/ Karin J. Lagerlund Treasurer and Principal - --------------------------- Financial and Accounting Karin J. Lagerlund Officer of the March 29, 2000 Managing General Partner | 16,283 | 109,479 |
352956_1999.txt | 352956_1999 | 1999 | 352956 | Item 1. Business
Introduction
FAFCO, Inc. ("FAFCO," the "Company" or "Registrant") designs, develops, manufactures, and markets solar heating systems for swimming pools and thermal energy storage systems for commercial and industrial cooling. Pool product sales amounted to 60% of net sales in 1999 compared to 53% of net sales in 1998 and 56% of net sales in 1997. Thermal energy storage sales amounted to 40% of net sales in 1999 compared to 47% of net sales in 1998 and 44% of net sales in 1997.
The Company manufactures products for the solar heating of water for low and medium temperature applications. From the inception of the Company's predecessor as a sole proprietorship in 1969 until 1976, efforts were largely devoted to the refinement of the Company's initial product, a solar heating system for swimming pools - a low temperature solar application. Since that time, the Company has focused on increasing its share of the pool heating market by extending its network of independent distributors, decreasing its manufacturing costs, and improving its initial product. In 1983, a passive domestic hot water heating system, the 444, was introduced (this product was discontinued in early 1994). In 1987, the Company introduced a thermal energy storage system based on the same heat exchanger technology as is used in its swimming pool heating systems. In 1993, the Company introduced a state-of-the-art control system for swimming pool solar heating systems (this product was discontinued in December 1996).
FAFCO, Inc. was incorporated under the laws of the State of California in 1972. Its principal executive offices are located at 2690 Middlefield Road, Redwood City, California. Its telephone number at that address is (650) 363-2690.
Safe Harbor Statement
This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual results could differ materially from those projected in the forward-looking statements as a result of the risk factors set forth on page 16 of the Annual Report under the heading "Factors Affecting Future Results" which is incorporated herein by reference and elsewhere in this Form 10-K.
Markets
Swimming Pool Heating
Low temperature solar applications developed because of the cost effectiveness of solar systems in heating a large volume of water to produce a small temperature change. The market for swimming pool heating developed for several reasons. First, pool owners normally use their pools when solar energy is abundant (during daylight hours and the summer swimming season). Second, pools already have two elements needed for low temperature water heating: storage (the pool water) and circulation (the existing pool pump and associated plumbing). Third, pool owners are an easily identifiable market.
Thermal Energy Storage
FAFCO also designs, develops, manufactures, and markets a static, glycol ice builder for the thermal storage market. Since the product's introduction, FAFCO has sold "ice banks" primarily to the commercial air conditioning market for use in off-peak air conditioning systems.
Products
Swimming Pool Heating
The FAFCO solar pool heating system is composed of six to twelve solar collectors, a sun sensor, an automatic control, and associated accessories. The collectors and sensor are typically mounted on the roof of a pool owner's home and connected to the pool pump and automatic control.
The customer sets the automatic control for the desired water temperature and, when the sensor detects that there is sufficient solar energy for the system to function efficiently, the automatic control directs the flow of water from the pool to the collectors. The water absorbs heat as it passes through the collectors and then flows back to the pool. When the desired water temperature is achieved or when there is insufficient solar energy, the automatic control redirects the flow of water back to the pool and water is drained from the collectors. When the water temperature drops and there is sufficient solar energy, the system is reactivated automatically.
In February 1996, the Company introduced a version of its solar pool heating system specifically designed for above-ground swimming pools. This system is composed of one or two solar collectors optimized for use in heating above-ground swimming pools and designed to lie flat on the ground or to be mounted on a rack on the ground.
In May 1996, the Company introduced a new and improved version of its solar collector that has a higher thermal performance due to its unique heat exchanger tube design. The tube design incorporates molded indentations, which enhance the heat transfer coefficient by increasing fluid turbulence.
The Company's solar collectors are composed entirely of a polyolefin material (a high molecular weight polymer compound) and made up of small round tubes formed side by side in a rectangular shape either one-by-two meters, four-by-eight feet, four-by-ten feet, four-by-twelve feet or four-by-twenty feet in size, with submanifolds and header pipes thermoformed on each end. This design provides for a maximum heating surface and even water flow in order to transfer 75% to 90% of the available solar energy to the pool water. The polyolefin material, which has been specially formulated by the Company, is black in color (to optimize solar energy absorption) and has the inherent advantages over other possible materials of lower cost, lighter weight, and higher resistance to the corrosive effects of pool chemicals and degradation resulting from ultraviolet radiation, heat, and other environmental effects.
In May 1993, the Company introduced a proprietary microprocessor-based control (AutoPool) for its solar pool heating systems. Prior to May 1993, the Company had a private label arrangement with an automatic control manufacturer. AutoPool has built-in "intelligence" that allows it to optimize the heating and filtration time for the swimming pool and can also control non-conventional solar swimming pool heaters. Because of lack of demand for the Company's AutoPool Control, this product was discontinued effective January 1, 1997. The Company has ongoing obligations to service and provide spare parts for AutoPool controls sold prior to that time.
Thermal Energy Storage
The Company's thermal energy storage ("IceStor?") systems utilize nighttime electric capacity to create stored cooling energy. This is normally done by storing inexpensive "off-peak" energy in the form of either chilled water or ice. The next day this stored cooling capacity is used in conjunction with a building's air conditioning equipment to significantly reduce electrical power requirements for cooling during times of high power demand and high electrical cost.
Cool storage systems offer power utilities a solution to a fundamental, long-term problem: increased peak demand for power during periods of limited available capacity (i.e., during business hours). IceStor? technology shifts power consumption to off-peak periods when there is available capacity and lower demand.
Marketing and Sales
Solar Systems
FAFCO markets its solar systems and controls in the United States through independent distributors who sell directly to end users. Distributors generally have sales, installation, and service personnel who are supported by extensive FAFCO marketing and technical materials as well as in-depth factory and field training programs.
The majority of sales personnel employed by the typical distributor are assigned to retrofit sales, which are sales to existing pool owners. Retrofit sales are generated through direct mail, customer referrals, canvassing, and, to a lesser extent, selected media advertising. The balance of the typical distributor's sales personnel are generally assigned to contractor accounts and seek referrals for new construction sales.
FAFCO usually provides direct mail literature and other advertising materials to distributors and mails or places these materials with local advertisers on the distributors' behalf and partially at the distributors' expense. In certain instances, distributors will also engage in direct mailing and advertising.
In the past, the Company has canceled several distributor agreements for reasons of inadequate performance by the distributor, primarily for failure to provide adequate sales, installation and service support for the Company's products. In such instances, the Company has generally been able to find qualified replacements.
All work relating to the installation of FAFCO solar systems is covered by a full one-year warranty provided by the distributor. The Company's solar collectors used to be covered by a ten-year limited warranty, which was changed to a ten-year full warranty beginning in 1991. Its automatic controls, pumps, and drain-down valves are covered by a three-year limited warranty. FAFCO warranties cover defects in materials and workmanship provided that the related products are used for their intended purpose.
FAFCO solar systems are designed to require only minimal maintenance, which can be performed either by the consumer using an owner's manual or by the distributor's service personnel.
Thermal Energy Storage Systems
The Company markets its IceStor? products through independent contractors who design and build heating and cooling systems for commercial and industrial applications. The Company has also licensed its IceStor? products for sale overseas, to design-and-build, heating, ventilating, and air-conditioning companies in Taiwan, Korea, Japan, and The Peoples Republic of China. These licensing agreements provide for licensees' assembly, sales, support, and maintenance of IceStor? products in those countries.
Sales by Geographic Area
The Company's net sales during 1999, 1998, and 1997 were geographically distributed approximately as follows:
One of the Company's customers, Ebara Corporation, accounted for 17.7% of the Company's fiscal 1999 net sales, 23.4% of the Company's fiscal 1998 net sales and 18.6% of the Company's fiscal 1997 net sales. During 1997, 1998 and 1999 Ebara Corporation was the licensee for the Company's IceStorT products in Japan, and, as such, purchased IceStorT products and components for assembly into products for resale to end users in Japan. No other customer accounted for 10% or more of the Company's net sales in fiscal 1997, 1998 or 1999. Any material cancellation, reduction or rescheduling of orders from a major customer, particularly Ebara Corporation, or the loss of any such customer would have a material adverse effect in the Company's financial condition and operation results.
Foreign sales of the Company's products are made through independent foreign distributors and licensees. Sales to foreign distributors and licensees are shipped directly from the Company's facilities in California and invoiced in U.S. dollars. Export sales are subject to certain controls and restrictions, including tariffs and import duties, and are subject to certain risks, including changing regulatory requirements of foreign jurisdictions and transportation delays and interruptions; however, the Company has not experienced any material difficulties in the past relating to such limitations.
Backlog
Sales to solar distributors are made against individual purchase orders rather than through volume purchase arrangements. The Company typically ships its products within one to five days of receipt of an order; therefore, the Company's backlog at any date is usually insignificant and is not a meaningful indicator of future sales. FAFCO distributors tend to order frequently in small quantities in order to minimize their inventory levels and match inventory levels with current installation schedules.
Sales of IceStor? products are made against individual purchase orders to general contractors or Heating, Ventilating, and Air Conditioning (HVAC) contractors for specific new construction projects or for retrofit in existing buildings. The Company typically ships these products within six weeks or less of receipt of an order; therefore, the Company's backlog with respect to IceStor? products at any date is also usually insignificant and not a meaningful indicator of future sales.
Government Tax Incentives
Although the Company's operations are not directly subject to extensive governmental regulations, the existence or lack of federal, state, and local tax incentives for the sale and installation of solar systems would have a substantial impact on the Company's business. There is currently no federal tax credit for solar heating systems and state solar tax credits are available only in a few states. The Company does not anticipate that solar tax credits will become available for solar heating systems in any additional states, nor does it anticipate a significant increase in sales due to existing or future tax credits.
Manufacturing
FAFCO's manufacturing activities consist primarily of the production of polyolefin heat exchangers used in solar heating applications and off-peak cooling applications and associated accessories. A total system approach is emphasized in order to ensure the effectiveness and reliability of the Company's products after they have been installed, eliminating the need for distributors to rely upon materials from other suppliers.
The Company's heat exchangers are produced from polyolefin resins using a patented extrusion and thermoforming process. Substantially all equipment used in these processes has been designed and built by the Company's research and development engineers.
The resins employed by the Company are a petroleum by-product. The market price of these resins has fluctuated over the years with an increase in 1990 and early 1991 due to tensions in the Middle East, followed by a stabilization after the completion of Desert Storm. It is expected that the price of the resins will continue to fluctuate as a result of domestic and international political and economic conditions.
FAFCO has qualified multiple sources of supply for all of its resins, materials, and subassemblies. However, certain materials and subassemblies are currently obtained from single sources. The Company believes these items could be supplied by the Company's other qualified sources if sufficient lead-time were provided. The Company attempts to maintain additional inventory of such materials to mitigate the risk of supply shortages; however, any prolonged inability to obtain such items would have a material adverse effect on the Company's results of operations. To date, the Company has not experienced any significant manufacturing problems or delays due to shortages of materials.
Quality assurance is performed by FAFCO at its manufacturing facility. Test and inspection procedures are a part of substantially all production and assembly operations. In addition, the Company uses it own diagnostic equipment and laboratory to continually test and inspect raw materials, work in process, and finished goods.
Competition
The Company's solar heating products currently compete directly with solar heating products offered by other domestic and international manufacturers of solar heating systems, and indirectly with conventional heating systems.
The Company believes that the principal competitive factors in the markets for FAFCO solar products are (i) product performance and reliability; (ii) marketing and technical support from the manufacturer for distribution channels; (iii) selling, installation, and service capabilities of distribution channels; and (iv) price. The Company believes that it competes favorably with respect to all of these factors. However, certain of its competitors may have greater financial, marketing, and technological resources than those of the Company.
A number of companies in the United States manufacture thermal energy storage systems of various types similar to the Company's IceStor? product. The industry is in the early stages of development and additional competitors are expected to enter the market over time.
At the present time, the Company believes that the main competitive factors in the thermal energy storage market are performance, reliability, and price. The Company believes that it competes favorably with respect to these factors. However, several of its competitors have greater financial, marketing, and technological resources than those of the Company.
Research and Development
For the years ended December 31, 1999, 1998, and 1997, the Company's research and development expenses were $327,600, $194,100, and $202,800, respectively.
The Company currently uses consulting engineers, in addition to staff engineers, who are responsible for existing product improvement, applications engineering, and new product research and development. The Company is exploring other potential revenue-producing uses for its polyolefin extrusions.
Patents, Trademarks and Licenses
FAFCO currently holds three United States patents and has two patents pending relating to certain aspects of its products and manufacturing technology. These patents expire at various times between March 2000 and July 2003. However, the Company believes that patent protection is secondary to such factors as ongoing product development and refinement, the knowledge and experience of its personnel, and their ability to design, manufacture, and successfully market the Company's products.
From time to time, the Company has registered as trademarks certain product names and marks in order to preserve its right to those product names and marks.
The Company has granted licenses to assemble and sell IceStor? systems in Taiwan, Korea, Japan, and the Peoples Republic of China to local manufacturers. See "Marketing and Sales" above.
Employees
At December 31, 1999, the Company had a total of 62 full-time employees, including nine in marketing, five in research and development, 36 in manufacturing, and 12 in general management and administration. The Company also uses temporary employees from agencies to fill seasonal needs. The Company has never had a work stoppage. To the Company's knowledge, no employees are represented by a labor organization.
Seasonality
Information regarding the seasonality of the Company's business is set forth in "Management's Discussion and Analysis of Financial Condition and Results of Operations - Seasonality" on page 16 of the Annual Report, which information is incorporated herein by reference.
Segment Information
Following the sale of the business of the Company's subsidiary, The Gregory Company, in 1988, the Company has only had continuing operations in the polymer heat exchanger segment.
Environmental Regulations
The Company is subject to a number of environmental regulations concerning potential air and water pollution. However, such regulations have not in the past had, and are not expected to have, any material adverse effect on the Company's business. However, there can be no assurance that compliance with existing or future regulations will not require the expenditure of funds or the modification of the Company's manufacturing process, which could have a material adverse effect on the Company's business or financial condition.
Item 2.
Item 2. Properties
The Company's principal executive offices and manufacturing facilities for its products are located in a single 42,500 square foot facility in Redwood City, California. A lease expiring in the year 2000 covers this facility. This lease has an option to extend through 2005. The Company has exercised its option to extend this lease through June, 2005. See Note 10 of Notes to Consolidated Financial Statements on page 12 of the Annual Report, which information is incorporated herein by reference.
The Company believes that its current facilities are adequate to meet its requirements for space in the near future. Manufacturing space is being fully utilized at the present time. However, additional demand can be accommodated by adding additional employee shifts.
Item 3.
Item 3. Legal Proceedings
There are presently no material pending legal proceedings to which the Company is a party or to which any of its property is subject, except for ordinary routine legal proceedings incidental to the Company's business.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
The Company did not submit any matter to a vote of security holders during the fourth quarter of its fiscal year ended December 31, 1999.
The executive officers of the Company are set forth below. All officers serve at the pleasure of the Board of Directors. There are no family relationships between any executive officers or directors.
Freeman A. Ford, age 59, serves as Chairman of the Board, President, and Chief Executive Officer. Mr. Ford, a co-founder of the Company, has served as Chairman of the Board since 1972, as Chief Executive Officer of the Company since May 1979, and as President since September 1984. Mr. Ford is also a Director of H.B. Fuller Company.
Alex N. Watt, age 58, serves as Executive Vice President and Secretary. Mr. Watt joined the Company as its Vice President-Finance and Chief Financial Officer in July 1984, and has served as Secretary since March 1985.
David Harris, age 44, serves as Vice President, Sales. Mr. Harris joined the Company in August 1981 as a sales representative and has held the positions of Pool Builder Manager, National Sales Manager-Pool Products, Pacific Northwestern Region Sales Manager, National Sales Manager-Solar Division, National Sales Manager, Vice President-Sales and Marketing (from June 1988 until April 1993) and President-Pool Products Division (from May 1993 until May 1995).
Nancy I. Garvin, age 54, serves as Vice President, Finance. Ms. Garvin joined the Company in May 1974 as an accounting clerk and has since held the positions of Accounting Manager and Controller with the Company.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
Information regarding the market for and market prices of the Company's Common Stock, the number of shareholders of record, and information regarding dividends is set forth under the heading "Common Stock Data" on page 15 of the Annual Report, which information is incorporated herein by reference.
Item 6.
Item 6. Selected Financial Data
Selected financial data for the Company is set forth in the table entitled "Five-Year Summary of Operations" on page 15 and in the last sentence of the text under the table entitled "Common Stock Data" on page 15 of the Annual Report, which information is incorporated herein by reference.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Information regarding Management's Discussion and Analysis of Financial Condition and Results of Operations is set forth under the heading "Management's Discussion and Analysis," on pages 16 and 17 of the Annual Report, which information is incorporated herein by reference.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
The following discussion about the Company's market risk exposure involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. The Company is exposed to market risk related to changes in interest rates, foreign currency exchange rates and equity security price risk. The Company does not use derivative financial instruments for any purpose, including hedging interest and foreign exchange risks.
The Company is exposed to financial market risks, including changes in foreign currency exchange rates and interest rates. The Company attempts to minimize its currency fluctuation risk by pricing its overseas product sales and license fees in United States dollars. A 10% change in the foreign currency exchange rates would not have a material impact on the Company's results of operations.
The Company maintains short-term investments consisting of variable interest accounts. However, due to the short-term nature of the Company's debt investments, the impact of interest rate changes would not have a material impact on the value of such investments.
The Company's interest rate exposure on rate debt obligations is currently relatively insignificant. As a result, the Company does not actively manage the risk associated with these obligations. The impact of interest rate changes would not have a material impact on the Company's results of operations.
The Company currently holds no marketable equity securities of other issuers that are subject to market price volatility.
Item 8.
Item 8. Financial Statements and Supplementary Data
The consolidated financial statements of the Company are set forth on pages 3 through 13 of the Annual Report, which information is incorporated herein by reference. The supplementary financial information requirements of Regulation S-K Item 302 do not apply to the Company, because the Company does not meet the tests set forth therein.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Not applicable.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
Information regarding directors and nominees for directors is to be set forth under the heading "Election of Directors - Nominees" in the Company's Proxy Statement, which information is incorporated herein by reference.
Information regarding the filing of reports by insiders under Section 16(a) of the Exchange Act is to be set forth under the heading "Election of Directors - Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's Proxy Statement, which information is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation
Information regarding the Company's remuneration of its executive officers and directors is to be set forth under the headings "Election of Directors - Executive Compensation" and "Election of Directors - Director Compensation" in the Company's Proxy Statement, which information is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Information regarding the security ownership of certain beneficial owners and management is to be set forth under the headings "Election of Directors - Security Ownership" and "Information Concerning Solicitation and Voting - Record Date and Outstanding Shares" in the Company's Proxy Statement, which information is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions
Information regarding certain relationships and related transactions is to be set forth under the headings "Election of Directors - Nominees" and "Election of Directors - Certain Transactions" in the Company's Proxy Statement, which information is incorporated herein by reference.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a) Documents filed as part of this report:
1. Financial Statements
The consolidated balance sheets for the years ended December 31, 1999 and 1998, the Consolidated Statement of Operations, of Shareholders' Equity and Cash Flows for each of the three years in the period ended December 31, 1999, and the notes thereto appear on pages 4 through 15 of the Annual Report.
2. Financial Statement Schedules
The following schedule for the years ended December 31, 1999, 1998, and 1997 is included in this report. Such schedule should be read in conjunction with the consolidated financial statements in the Annual Report.
Report of Independent Accountants on Financial Statement Schedule (see page17).
Schedule II - Valuation and Qualifying Accounts and Reserves (see page 18).
Schedule X - Supplementary Income Statement Information (see page 19).
Schedules not included in these financial statement schedules have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto.
3. Index to Exhibits
The following exhibits are filed as part of or incorporated by reference, to the extent indicated herein, in this Annual Report on Form 10-K.
Exhibit No. Description (footnotes appear at the end of the exhibit list)
* Denotes a management contract or compensatory plan or arrangement.
Report of Independent Accountants on Financial Statement Schedule
To the Board of Directors of FAFCO, Inc.
Our audits of the consolidated financial statements referred to in our report dated March 3, 2000 appearing on page 14 of the 1999 Annual Report to Shareholders of FAFCO, Inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedule listed in Item 14(a) of this Form 10-K. In our opinion, this Financial Statement Schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements.
Burr, Pilger & Mayer San Francisco, California
March 3, 2000
FAFCO, Inc.
Schedule II Valuation and Qualifying Accounts and Reserves
(1) Write-off of uncollectible accounts. (2) Cost of warranty claims processed. (3) Reclassification to allowance for short-term notes receivable.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: March 29, 2000 FAFCO, Inc.
/s/ Freeman A. Ford Freeman A. Ford, Chairman of Board, President and Chief Executive Officer
POWER OF ATTORNEY
Each person whose signature appears below constitutes and appoints Freeman A. Ford and Nancy I. Garvin, or either of them, his attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this Annual Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that either of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
CONSENT OF INDEPENDENT ACCOUNTANTS
We hereby consent to the incorporation by reference in the Registration Statements on Form S-8 (Nos. 2-75201, 2-86299, 2-95390 and 33-76220) and related prospectuses of FAFCO, Inc. of our report dated March 3, 2000, appearing on page 14 of the 1999 Annual Report to Shareholders, which is incorporated by reference in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our report on the Financial Statement Schedule, which appears on page 17 of this Form 10-K.
Burr, Pilger & Mayer San Francisco, California
April 5, 2000
INDEX TO EXHIBITS
* Denotes a management contract or compensatory plan or arrangement. | 4,730 | 31,251 |
895021_1999.html | 895021_1999 | 1999 | 895021 | Item 1. Business
Management has used best efforts in writing Centura's Form 10-K report in plain, easy to understand English. The Company and the Industry Overview Sections attempt to outline both the meaning and scope of the strategies currently employed at Centura. Although both these sections are compelling, the other information contained in this report is important and necessary in order to gain a thorough understanding of our business, markets, customers and competition. Accordingly, please read our entire Form 10-K report prior to making an investment in Centura, as these are complicated technologies and solutions that involve risks and uncertainties. References to "we", "us", "our" or "Centura" means Centura Software Corporation and its subsidiaries and divisions, and their predecessor companies and subsidiaries.
When used in this report, the words "anticipate", "believe", "estimate", "will", "may", "intend" and "expect" and similar expressions identify forward- looking statements. Forward-looking statements in this report include, but are not limited to, those relating to the general expansion of our business, particularly with respect to our e-business and information appliance initiatives and including our ability to develop multiple applications, our planned introduction of new products and services, the possibility of acquiring complementary businesses, products, services and technologies and our development of relationships with other providers of leading edge technologies. Although we believe that our plans, intentions and expectations reflected in these forward-looking statements are reasonable, we can give no assurance that these plans, intentions or expectations will be achieved.
Actual results, performance or achievements could differ materially from those contemplated, expressed or implied by the forward-looking statements contained in this report. Important factors that could cause actual results to differ materially from our forward-looking statements are set forth in this report, including under the headings "Risk Factors" in Item 1 and "Factors Affecting Operating Results" contained in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations." These factors are not intended to represent a complete list of the general or specific factors that may affect us.
Company Overview Centura is a leading provider of information appliance and e-business software solutions. We extend business information systems to the Internet and to wireless information devices, for business-to-business applications. Our family of products, which as a whole, provide end-to-end functionality in these environments, include a scalable Internet development environment (CTD), a dynamic wireless connectivity solution (eSNAPP) and a range of powerful, secure embeddable databases (SQLBase SafeGarde, Velocis, RDM and db.linux). In essence, we make the software our customers use to create sophisticated Web and wireless applications.
Industry Overview
We believe that the value of information resides in its accessibility and its security. Furthermore, we believe that Moore's law, the doubling of microprocessor power every 18 months and Metcalf's law, the doubling of bandwidth capacity every 12 months, will continue to be important industry drivers well into the new millennium. These two laws are the primary drivers behind the trend toward both the use of the Internet, which we refer to as the "4th wave" of computing, and what is commonly referred to as ubiquitous or Post PC devices ("Information Appliances"), which we refer to as the "5th wave" of computing.
We also note the following trends in the industry:
Expansion of the Internet and server-centric computing
Growth in the use of Information Appliances
Recognition of the need for secure access, encryption and authentication
Confirming recognition of the importance of component application development
Increasing use of wireless technologies
Increasing use of extensible markup language, or XML and wireless markup language, or WML as computer software languages that allow interoperability between applications.
Further, when analyzing the general direction of the industry it becomes apparent to us that the dominance of the PC era is over and that the use of a number of the technologies listed above will capture functionality previously performed by the PC. We believe that the increasing improvement of wireless technologies is an important trend. Currently, one of the factors that limits widespread, rapid adoption of wireless software applications is the inability to connect applications to the Internet in real-time with zero performance impairment. As wireless technologies improve, especially in the areas of power enhancement, bandwidth and the elimination of unintended disconnections or drop-off we believe the adoption of Information Appliances will be viral. Another important trend is interoperability. Businesses want to select architectures that do not limit them to one vendor.
The overriding trend is a "network effect" towards open architectures that allow information to be extended to, and interoperable with Information Appliances, independent of hardware or operating system configurations. Both XML/WML and component development promise significant progress towards solving the problem of interoperability.
Solutions to these business problems are emerging rapidly. International Data Corporation (IDC), a leading provider of information technology data, estimates that the e-business market, a subset of the Internet market, was $32 billion in 1998 and projects this market to grow to over $425 billion by 2002. In 1998, 66% of this market was business-to-business commerce and IDC estimates this to increase to 79% by 2002. Furthermore, IDC estimates that Information Appliances in 1997 was only 5% of a 33 million unit PC and appliance market and expects this to grow to over 68% of an 87 million unit market by 2002. Companies that take advantage of this speed by increasing their own velocity, in terms of adaptation and flexibility, will outpace the competition.
Centura's strategies, described below, attempt to incorporate the myriad of factors and trends as outlined above.
Business Objectives and Strategy Objectives
Our objective is to become a recognized leader in the e-business and Information Appliance markets and in doing so, to maximize the long-term value of Centura. Our plan is to use 4th wave (Internet or Web-based solutions) and 5th wave (Information Appliance) technologies, as described above, to enable businesses to engage in activities in ways that will enable them to generate additional revenues, save time and money, and in that manner add value to their business.
Strategy
By leveraging the technological underpinnings of the 4th and 5th waves of computing, our products enable businesses to extend access to business information outside the geographical confines of the enterprise to those who must use enterprise information as part of their daily activities. Our product strategy, therefore is two-fold:
e-business
software - We provide customers and partners the means to quickly develop and cost-effectively deploy Web-based e-business software applications. Moreover, we have structured our solutions to enable our customers to move their client/server business software applications to the Internet.
Information Appliance software
- We provide customers and partners the ability to extend the business processes necessary in conducting business to mobile hand-held computers and other "Post PC" devices.
We offer a full suite of products and services that enable businesses to develop and implement a complete, end-to-end e-business environment, encompassing the access to and utilization of enterprise data through the Web or through hand-held mobile computers, embedded devices and other Information Appliances.
The majority of our revenues have historically been derived from the licensing of software products for PC client/server systems. The licensing of such products in addition to e-business and Information Appliance application solutions are expected to account for substantially all of our revenues for the foreseeable future.
We offer our products through a combination of direct sales and sales channels, which consist of information systems integrators ("SIs"), independent software vendors ("ISVs") and distributors. For ease of further discussion we will collectively refer to SIs and ISVs as Value Added Resellers ("VARs").
We believe that our products, especially our Information Appliance software, can provide valuable solutions to the niche markets of healthcare, telecommunications, transport, logistics and field force automation and we focus our selling and channel development efforts in these markets. We also believe that solutions developed within these industries are analogous and applicable to a broader array of businesses and thus specific solutions within these markets are transferable to mobile solutions for business in general.
Through our consulting organization, Centura Solutions, we assist our customers in developing software solutions and train them on how best to use our products in their solutions. This ensures maximum customer satisfaction, efficiency, profitability and valuation.
We provide flexible support programs for customers ranging from small groups of developers to those who require unlimited access to qualified Centura technical engineers. Traditional service offerings are augmented with an informal support network through multiple Internet news groups, Centura-endorsed User Groups, and a strong presence on the Web. Company-certified training partners offer courses each year that provide customers with the right mix of classroom and on-site training. Customers can also study at their own pace with a specially developed computer-based training course.
We believe that the advent of 4th and 5th wave computing environments make data security vital to business, and therefore it is a key element of our product and solutions offerings. Our patent-pending SQLBase SafeGarde encryption process encrypts data at the file level within the database with virtually no reduction in database performance. This means that even if passcode protection levels of the operating system are breached, the data retrieved by the perpetrator will be incomprehensible.
Our business model focuses on sharing in the value created through the use of our software by our partners or end-user customers.
Products Our e-business and Information Appliance Solutions Sets (consisting of combinations of our products that together help our customers solve their application development needs) are comprised mainly of the following:
e-business Solution Sets
Centura Team Developer
"CTD" is a strategic Internet development environment for building enterprise scale business applications and components, under the distributed Internet application, or DNA Architecture. CTD2000, available in the first half of 2000, provides a rich and productive environment based on object oriented programming, fourth generation language ("4GL") functionality, native and standards-based database connectivity, and team development for building functional business logic components and browser-based applications, by leveraging software reuse, and standards such as COM Generation, XML, WML, HTML, and OLE DB. CTD includes all the elements required to build enterprise applications including SQLBase SafeGarde, Velocis Database Server, Report Builder, Team Object Manager, and the Object Nationalizer.
Velocis Database Server
Velocis is an embeddable and highly scalable Internet database server that takes full advantage of today's multiprocessor computer hardware with its support for Symmetrical Multiprocessing Support (SMP). Velocis supports both the relational and network (pointer based) database models. Velocis provides multiple programming interfaces including the industry standard Structured Query Language ("SQL"), Application Programming Interface (API) and a low-level C API. Its architecture is open, providing developers the means to write custom APIs. Velocis runs on multiple platforms including Windows, Linux and Unix and is self-maintaining thereby eliminating the need for a Database Administrator ("DBA"). Velocis is utilized in a multitude of software applications requiring a scalable Web-based host or other enterprise-level information systems, and we believe it is unsurpassed in the market with respect to speed and performance.
SQLBase SafeGarde
SQLBase Safegarde is an embeddable relational database management system, or RDBMS client/server database used primarily in desktop PC, workgroup server and company-wide LAN and Intranet software applications. SQLBase SafeGarde includes a very robust feature set while still maintaining a small footprint, and is self-maintaining, thereby eliminating the need for a DBA. SQLBase SafeGarde has the distinct capability to encrypt the data stored in the database at encryption levels of 56- and 128-bit data encryption standard, or DES. At the present time, we believe that it is the only encrypted database on the market, which encrypts the entire database at the database file level.
RDM
RDM is an embeddable database that requires no DBA and runs in multiple operating system environments, including real time operating systems, or RTOS. It is deployed mostly in applications where there is minimal human user interface or the primary database interface is managed by the electronic device within which it resides or other embedded software. We believe it is unsurpassed in the market with respect to speed and performance. It is capable of functioning in a range of environments with very large to extremely small memory capacity.
Information Appliance Solution Sets
eSNAPP
Centura's eSNAPP architecture provides dynamic real-time connectivity and synchronization framework for Windows, Windows CE, Palm OS and Linux. eSNAPP
supports always-connected, occasionally-connected, and connected-on-demand Information Appliance environments. It also enables Information Appliances to access and engage in business transactions, on a real-time or synchronized basis, with host or enterprise level information systems via direct access to enterprise databases or application logic, utilizing either wireless or hard-wired infrastructures.
db.linux
db.linux is an open-source, zero DBA, embeddable database engine suitable for developing applications deployed on Linux-based Information Appliance devices such as hand-held and palm-sized computers, embedded devices, and Internet Appliances. It is a high-performance, small footprint, developer- friendly product optimized for resource constrained environments. We have also constructed Platform Support Packs (PSPs) that provide platform specific functionality for a variety of traditional and real-time operating systems including PalmOS and WinCE. We are developing add on options, such as SafeGarde for db.linux, which provides 128-bit DES secure data access and storage for the db.linux database.
None of our products are exclusively reliant on any other of our products in order to function although we believe that in combination our products, or Solution Sets work most efficiently together.
Consulting Services
Our consulting organization, Centura Solutions Corporation. provides Application development support to businesses engaged in e-business and Information Appliance application development. Centura Solutions provides direct customer support and frequently participates with VAR partners by assisting them in achieving maximum functionality and advantage utilizing Centura products in deployments for end-users through various training programs and other fee-based arrangements. Centura Solutions is involved in both e- business and Information Appliance solution development. Through our acquisition of Raima Corporation in June 1999 we have been able to expand our consulting services. See Item 8 - Financial Statements and Supplementary Data - note 2 of notes to consolidated financial statements for further information regarding this acquisition.
Summary
We plan to incorporate our patent-pending SQLBase SafeGarde encryption capability into our key database products, making them extremely competitive products for e-business and Information Appliances environments, where security is paramount. We plan to make our e-business development environment available for the development of applications for Information Appliances. This will allow us to provide a complete and secure end-to-end e-business and Information Appliance development environment that we believe very few competitors will be able to offer. You should also read "Risk Factors".
Customers No customer accounted for more than 10% of net revenues during the fiscal years ended December 31, 1999, 1998, or 1997. We have established worldwide distribution channels that provide broad market coverage for products and services and address the specific needs of our varied customer base worldwide. Our data management and development environment solutions have been successfully implemented by numerous business and government entities, including:
Automatic Data Processing
IFS
BAAN
Lilly Software
CamData
NASDAQ
Citibank N.A
Norfolk Southern
Ford Motor Company
Nortel Networks
Fujitsu
SAP AG
Help Desk Software
Sattel Technologies
Hewlett-Packard
Siemens-Nixdorf Informations Systeme AG
Hitachi
United Parcel Service
Hughes Network Systems
Xerox
and the governments of Mexico, France, Australia, United Kingdom and the United States.
Our products have strong acceptance in several vertical markets, including Enterprise Resource Planning (ERP), finance, government, health care, insurance, logistics and transportation, retail and sales force automation.
Marketing, Distribution and Product Support To support our sales organizations and the e-business and Information Appliance business focus, we conduct comprehensive marketing programs and cooperative selling arrangements with our strategic partners. Our marketing programs include direct mail, public relations, advertising, seminars, trade shows, an active Web presence and other ongoing customer communication programs.
Our marketing message focuses on the customer's benefits of using Centura products to develop e-business environments and utilizing our e-business or Information Appliance product software. We believe our products provide customers with a faster time to market, a lower total cost of ownership with better security than comparable products offered by competitors, ultimately providing a better return on investment.
Accordingly, broad market acceptance of e-business, Web-based software applications and Information Appliance systems is critical to our future success. Our marketing and sales efforts are targeted to attract worldwide developers of applications for e-business and Information Appliance solutions. These developers include corporate developers and VARs who develop and install software applications. We use a combination of direct sales, telesales, alliances and an indirect channel to sell and support existing and new customers.
We have a worldwide field sales organization, which operates in Africa, Australia, Austria, Belgium, Brazil, Canada, Eastern Europe, France, Germany, Italy, Japan, Mexico, Middle East, the Netherlands, Scandinavia, Switzerland, the United Kingdom, and the United States.
We also distribute our products through major independent distributors that may sell such products to smaller VARs, resellers and dealers. We presently have a distribution agreement with DistribuPro, for distribution in North America. We also have a network of international distributors, including Computer 2000 AG GmbH, ADN, Nocom and Illion in Europe and Mitsubishi Corporation in Japan. Although many of our distributors carry competing product lines, we provide various forms of sales and marketing programs and incentives to channel partners to sell and support Centura products. Our distributors may from time to time be granted stock exchange or rotation rights. Such returns or exchanges are generally offset by an immediate replacement order of equal or greater value. Although we believe that, to date, we have provided adequate allowances for exchanges and returns, there can be no certainty that actual returns will not exceed the allowances we have provided, particularly concerning introduction of new products or enhancements.
In some markets, we have entered into multi-year master distribution agreements with unrelated companies that have also licensed the use of our name. These agreements are in place to increase our overall name recognition and penetration in such markets. While we believe that to date these agreements have increased our overall name recognition and penetration in these markets, there can be no certainty that this performance will continue or that these relationships will remain in place.
We have designed our products and established our marketing and sales channels to address worldwide market opportunities, including markets requiring double-byte enabled source code. Our software products support international data conventions, and some products have been localized into French, German and Japanese language editions.
Engineering and Product Development Since inception, we have made substantial investments in engineering and product development. During the year ended December 31, 1999, we spent $8.7 million on engineering and product development, net of capitalized software. This represents 17% of net revenues. During the year ended December 31, 1998, we spent $7.9 million on engineering and product development, net of capitalized software. This represents 15% of net revenues. During the year ended December 31, 1997, we spent $9.7 million on engineering and product development, net of capitalized software. This represents 17% of net revenues. Our products have been developed by our internal product development staff and, in certain instances, by strategic use of outside consultants and third party developers. We believe that timely development of new products and enhancements to existing products are essential for us to maintain our competitive position.
We are committed to continued development of new technologies for e-business and Information Appliance software. In addition, we plan to continue to offer upgrades to our current products. Delays or difficulties associated with new products or product enhancements could have a material adverse effect on our business, operating results and financial condition. You should also read "Risk Factors".
Competition The market for business software development solutions is intensely competitive and rapidly changing. Our products are specifically targeted toward the e-business and Information Appliance approaches to solving business process problems. Our current and prospective competitors offer a variety of products that have a similar focus.
e-Business competitive landscape
Centura faces competition from providers of e-business application development software, such as Allaire, IBM, Inprise's Borland.com division, Microsoft, Oracle, Silverstream and Sybase's Powersoft Division. The market for e-business application development environments is rapidly evolving and additional competitors or potential competitors are constantly emerging.
Information Appliance competitive landscape
The onset of the enabling of Information Appliances with complex enterprise business computing capabilities, commonly known as the 5th wave of computing, has led to the emergence of several competitors vying for a share of this rapidly expanding and potentially lucrative market. Potential competitors range from providers of connectivity and synchronization solutions, such as Aether, Citrix, Puma, Synchrologic and Tibco to providers of both connectivity-synchronization and small footprint embeddable databases such as IBM, Informix ("Cloudscape"), Microsoft, Object Store, Oracle, Point Base and Sybase's SQLAnywhere division.
In addition, as the 5th wave of technologies provide increasing technological capabilities for Information Appliances, many more competitors are likely to emerge. For example, systems integrators for Information Appliance solutions previously utilized in only limited niche market environments, such as in the market for enterprise data collection, and partnered with companies like Symbol, Telxon, Intermec and Fujitsu, become potential competitors in the broader use of Information Appliances for enterprise level business processes.
General competitive issues
The principal competitive factors affecting the market for our products include breadth of distribution and name recognition (visibility), product architecture, performance, functionality, price, product quality, and customer support. We have experienced increased competition during our fiscal years ended December 31, 1999, 1998, and 1997, resulting in loss of market share. We must continue to introduce enhancements to our existing products and offer new products on a timely basis in order to remain competitive. Even if we introduce such products in this manner we may not be able to compete effectively because of the significantly larger resources available to many of our competitors.
Intellectual Property We currently have one patent issued with respect to SQLWindows and CTD products and another pending with respect to SQLBase SafeGarde. As we develop our products, we continually look for opportunities to further patent our technology and have established comprehensive internal programs in an attempt to ensure that patents are prosecuted in all circumstances determined appropriate. We rely on a combination of trademark, copyright and trade secret protection and nondisclosure agreements to establish and protect our proprietary rights. Policing unauthorized use of our technology is expensive and difficult, and there can be no assurance that these measures will be successful. While our competitive position may be affected by our ability to protect proprietary information, we believe that ultimately factors such as our ability to effectively market products and services, provide technical expertise and innovation, our name recognition, and ongoing product support and enhancements may be more significant in terms of maintaining our competitive position.
Centura provides software products to customers under non-exclusive, non-transferable license agreements. As is customary in the software industry to protect intellectual property rights, we do not sell or transfer title to software products to customers. Under our current standard form of end user license agreement, licensed software may be used solely for the customer's internal operations and, except for limited deployment rights provided in certain development environment packages, only on designated computers at specified sites. We rely primarily on "shrink-wrap" licenses for the protection of products intended for single, one-time use or limited deployment. A shrink-wrap license agreement is a printed or downloadable license agreement included within packaged or downloaded software that sets forth the terms and conditions under which a purchaser of the license can use the product, and binds such purchaser by its acceptance and purchase of the software license to such terms and conditions. Shrink-wrap licenses typically are not signed by the licensee and therefore may be unenforceable under the laws of some jurisdictions.
We have entered into source code escrow agreements with a number of resellers and end users that require release of source code to such parties with a limited, nonexclusive right to use such code in the event that there is a bankruptcy proceeding by or against Centura, we cease to do business or we breach our contractual obligations to the customer. Centura licenses source code as part of development licenses for certain products and has, in certain cases, licensed other source code to customers for specific uses.
Centura provides open-source code for its db.linux products and manages code changes produced by an open community of developers. This is typically referred to in the software industry as an "Open Source Software Model". db.linux may be used and deployed on a royalty free basis, pursuant to the terms of the underlying license agreement. As the source code is open not only to developers, but to the general community, there can be no assurance that terms of the license agreement will not be breached or that implementation of this program will not result in a reduction of royalty license revenue which would otherwise have accrued to the benefit of Centura. db.linux is specifically designed to provide continuity to Centura's eSNAPP product as part of a complete Information Appliance Solution Set.
There can be no assurance that third parties will not assert infringement claims against us in the future with respect to current or future products or that any such assertion may not result in costly litigation or require us to obtain a license to intellectual property rights of third parties. There can be no assurance that such licenses will be available on reasonable terms, or at all. As the number of software products in the industry increases and the functionality of these products further overlap, Centura believes that software developers may become increasingly subject to infringement claims. Any such claims, with or without merit, can be time consuming and expensive to defend.
Employees As of December 31, 1999, we had 285 full-time employees, including 61 in engineering and product development, 6 in operations and manufacturing, 127 in sales and marketing, 30 in technical services and support and 61 in management information systems, finance and administration. We maintain competitive compensation, benefits, equity participation and work environment policies to assist in attracting and retaining qualified personnel. None of our employees are covered by collective bargaining agreements. We believe our relationship with our employees is good. We also believe that the success of our business will depend in large part on our ability to attract and retain qualified personnel. Competition for such personnel is intense, and there can be no assurance that we will be successful in attracting and retaining such personnel.
Recent Developments
In June 1999, we acquired Raima Corporation. See Item 8 - Financial Statements and Supplementary Data - note 2 of notes to the consolidated financial statements for further information regarding this acquisition, and Risk Factors - "Our restructuring efforts may not improve our operational performance".
In December 1999, we completed a private placement of series A cumulative convertible preferred stock. See Item 8 - Financial Statements and Supplementary Data - note 7 of notes to consolidated financial statements for further information regarding this financing and Risk Factors - "Conversion of the series A cumulative convertible preferred stock and exercise of the related warrants may dilute the interests of existing stockholders" and Risk Factors - "If we are deemed to have issued 20% or more of our outstanding common stock in connection with the private placement of our series A cumulative convertible preferred stock, we may be required to delist our shares from the NASDAQ SmallCap Market".
For additional information on the segments that we operate within, see Part II - note 12 of notes to consolidated financial statements. Risk Factors The volatility of our common stock price may harm our growth and ability to raise capital
.
Our common stock has a history of high volatility and our stock price may vary in response to quarterly variations in operating and financial results, as highlighted below, announcements of new products or customer contracts by us or our competitors, litigation and other factors, including sales of substantial blocks of our common stock. In addition, the stock market in general, and the market for technology stocks in particular, including our common stock, has experienced extreme price fluctuations. These market fluctuations may affect the price of our stock, often without necessarily any regard to whether we have experienced changes in our business, operating results, or financial condition. Fluctuations in the trading price or liquidity of our common stock may adversely affect our ability to raise capital through future equity financings, or to negotiate successful stock-for-stock acquisitions of other companies.
Fluctuations in our quarterly and annual results may adversely affect our stock price.
Our quarterly and annual operating results have fluctuated significantly in the past and may continue to do so in the future. On an annual basis, we reported a loss of $3.2 million in 1999, a profit of $2.1 million in 1998 and a loss of $0.6 million for 1997. Our future operating results may be below the expectations of public market analysts or investors. We also may not learn of, or be able to confirm, revenue or earnings shortfalls until late in the fiscal quarter or following the end of the quarter and consequently may not be able to adjust spending in a timely manner to compensate for the shortfalls. Accordingly, any significant shortfall in sales of our products or services in relation to our expectations or those of analysts or investors, could have an immediate adverse impact on the price of our common stock.
A number of factors are likely to cause variations in our quarterly and annual results. From time to time, our competitors or ourselves may announce new products, product versions, capabilities or technologies that have the potential to replace or shorten the life cycles of our existing products. The announcement of currently planned or other new products may also cause customers to delay their purchasing decisions in anticipation of such products. We may therefore occasionally experience a reduction in demand for our existing products and decreased sales.
In addition, our revenue recognition in some cases is dependent upon the business activities of our customers and the timely and accurate reporting of their activities to us, which makes predictability of the related revenue extremely uncertain. For example, many of our product licensing arrangements are subject to revenue recognition on a per-unit deployed basis including cases where our deferred obligation to such customers is gradually extinguished. Delays in the introduction or availability of new hardware and software products from third parties may also negatively affect sales of our products.
Seasonal factors, including year and quarter end purchasing and the timing of marketing activities, such as industry conventions and tradeshows, may cause our operating results to fluctuate. Although we have operated historically with little or no backlog of traditional boxed product shipments, we have experienced a seasonal pattern of product revenue, contributing to variation in quarterly worldwide product revenues and operating results. We have generally realized lower revenues in the first quarter as compared with the immediately preceding fourth quarter of any given year and lower European revenues in the third quarter as compared to the rest of the year. We have also experienced a pattern of recording a substantial portion of our revenues in the third month of a quarter. As a result, product revenues in any quarter are dependent on orders booked in the last month. Our staffing and other operating expenses are based in part on anticipated net revenues, a substantial portion of which may not be generated until the end of each quarter. Delays in the receipt or shipment of orders, including delays that may be occasioned by failures of third party product fulfillment firms to produce and ship products, or the actual loss of product orders, can cause significant variations in operating results from quarter to quarter.
Our restructuring efforts may not improve our operational performance.
We have restructured our operations and announced changes in strategic direction several times during the past three years:
In early 1997, we refocused our marketing and sales efforts away from databases and development tools products to a middleware connectivity product, and entered into an agreement to merge with InfoSpinner, Inc., the developer of the underlying product. That merger was not consummated, and we entered into a distribution agreement with InfoSpinner.
In the second half of 1997, however, we restructured and refocused operations on our core competencies, products and technologies and terminated our distribution arrangement with InfoSpinner. We continued to pursue this strategic direction throughout 1998.
In June 1999, we extended our offering of embedded database products by acquiring Raima Corporation, a Seattle-based vendor of cross-platform micro databases and data management tools. Through this acquisition we were further able to focus our efforts throughout 1999 on the Information Appliance and e-business markets.
We may or may not undertake other major restructuring efforts or changes in strategic direction in the future. It is uncertain whether our past or future strategic changes will improve our operational results.
The inability of our management team to achieve their objectives may cause our revenues to decline.
Recent changes in our management make it difficult to predict our likelihood of success in achieving our business goals. In the fourth quarter of 1997, we announced significant changes in senior management, including the appointment of Scott R. Broomfield as Chief Executive Officer, John W. Bowman as Chief Financial Officer, and the election of Messrs. Jack King, Phillip Koen, Jr., and Earl Stahl to Centura's board of directors, and the departure of Samuel M. Inman, III, Earl Stahl and Richard Gelhaus from their positions as officers of Centura. In February 1998, we announced the election of Messrs. William D. Nicholas and Peter Micciche to the board of directors and the appointment of Scott R. Broomfield to the position of Chairman. Mr. Nicholas subsequently resigned from the board of directors in December 1998. In April 1999, Mr. Inman resigned from the board of directors, and in November 1999, Mr. Stahl resigned from the board of directors.
A key addition to the senior management team is Joe Falcone, who joined Centura as Senior Vice President and Chief Technology Officer in November 1998. In July 1999, John W. Bowman became Executive Vice President and Chief Operating Officer and Richard Lucien became Vice President of Finance and Chief Financial Officer. In December 1999, Mr. Ed Borey, Jr. was elected to the board of directors.
Although we believe these recent changes in our management team to be critical to our long-term growth and competitive position, we cannot assure you that they will be successful in achieving their objectives or that successful execution of their objectives will improve our operating results.
Our inability to retain or attract key personnel may prevent our business from growing.
We are highly dependent on our executive officers and other key personnel, and the loss of these employees may harm our competitive position. Our future success will also depend largely on our ability to continue to attract highly skilled personnel. Competition is intense for employees with highly technical, management and other skills in the software industry, particularly in the San Francisco bay area, and it may be difficult to attract or retain qualified key employees. Without strong management and talented employees, we may not continue to develop successful new products or to obtain important strategic alliances.
The lack of timely market delivery of our products and services or the inability to achieve market acceptance may result in negative publicity and losses.
The markets for our software products and services are characterized by rapid technological developments, evolving industry standards, swift changes in customer requirements and computer operating environments, and frequent new product introductions and enhancements. If one or more competitors introduce products that better address customer needs, we may lose our market position and our revenues will decrease.
Our success depends on the ability of our primary products, including Centura's eSNAPP, SQLBase SafeGarde, RDM, Velocis Database Server, Centura Team Developer, to perform well in various business hardware and software application environments, and on the ability of our consulting organization to successfully assist customers in their solutions development. Any failure to deliver these products and services as scheduled or their failure to achieve market acceptance as a result of competition, rapid technological change, failure to timely release new versions or upgrades, failure of such upgrades to achieve market acceptance or otherwise, could result in negative publicity and decreased sales.
Like many software companies, we have in the past experienced delays in the development of new products and product versions, which resulted in loss or delays of product revenues. There can be no assurance that we will not experience further delays in connection with our current product development or future development activities.
We are also increasingly dependent on the efforts of third party "partners," including VARs and software developers to develop, implement, service and support our products. These third parties increasingly have opportunities to select from a very broad range of products from our competitors, many of whom have greater resources and market acceptance than us. In order for our products and services to succeed in the market, we must actively recruit and sustain relationships with these third parties.
Software errors in some of our products may cause our future sales to decrease.
Software products as complex as those offered by us may contain undetected errors when first introduced or as new versions are released. We have in the past discovered software errors in some of our new products and enhancements after their introduction. Although we have not experienced material adverse effects resulting from any such errors to date, errors could be found in new products or releases after commencement of commercial shipments, resulting in adverse product reviews and a loss of or delay in market acceptance.
If the computer industry shifts away from Information Appliance and e-business software, demand for our products may decrease significantly.
To date, substantially all of our revenues have been derived from the licensing of software products for PC client/server systems and other embedded software environments. Licensing of such products, in addition to the licensing of products for use in always, occasionally, connected-on-demand and Web-based host information system environments and related consulting and support services, is expected to continue to account for substantially all of our revenues for the foreseeable future. With the increasing focus on enterprise-wide systems that embrace the Web, some customers may opt for solutions that favor mainframe or mini-computer solutions with associated Web connectivity.
The market for Information Appliance and e-business software in general, and the segments of such market addressed by our products in particular, are relatively new. Our future financial performance will depend in part on the continued expansion of this market and these market segments and the growth in the demand for other products developed by us, as well as increased acceptance of our products by information technology professionals. We cannot assure you that the market for Information Appliance and e-business software in general, and the relevant segments of the market addressed by our products will continue to grow, that we will be able to respond effectively to the evolving requirements of the market and market segments, or that information technology professionals will accept our products. If we are not successful in developing, marketing, localizing and selling applications that gain commercial acceptance in these markets and market segments on a timely basis, our competitive position may suffer and our revenues may decrease.
Residual problems related to the year 2000 issue may interrupt our business and increase our operating expenses.
To date, our customers have not reported any problems with our software products as a result of the commencement of the year 2000 and we have not experienced any impairment in our internal operations resulting from the year 2000 issue. Nevertheless, computer experts have warned that there may still be residual consequences stemming from the change in centuries and, if these consequences become widespread, they could result in claims against us, a decrease in sales of our products and services, increased operating expenses and other business interruptions.
The Information Appliance and e-business software market is highly competitive, and we risk losing our market share to other companies.
The Information Appliance and e-business software market is intensely competitive and rapidly changing. Some of our products are specifically targeted at the emerging portion of this market relating to complete and secure integration solutions for always, occasionally, and connected-on-demand mobile enterprise, Information Appliance, intelligent device and Web-based host information system environments. Our current and prospective competitors offer a variety of solutions to address this market segment. Competitors include Aether Systems, Allaire, borland.com (Inprise), Citrix, IBM, Microsoft, Oracle, Puma, Silverstream, Tibco, Sybase's SQL Anywhere and Powersoft Divisions and Synchrologic. With the emergence of the Web as an important platform for application development and deployment and a variety of newly created Java based development tools, additional competitors or potential competitors have emerged with longer operating histories, significantly greater financial, technical, sales, marketing and other resources, greater name recognition, larger installed customer bases and established relationships with some of our customers.
Our competitors could in the future introduce products with more features and lower prices than our offerings. These companies could also bundle existing or new products with more established products to compete with us. Furthermore, as the Information Appliance and e-business markets expand, a number of companies, with significantly greater resources than us, could attempt to increase their presence in these markets by acquiring or forming strategic alliances with our competitors, or by introducing products specifically designed for these
markets.
Any termination or significant disruption of our relationships with any of our resellers or distributors, or the failure by such parties to renew agreements with us, could harm our sales.
We rely on relationships with value-added resellers and independent third party distributors for a substantial portion of our sales and revenues, particularly in international markets. We also maintain strategic relationships with a number of vertical software vendors and other technology companies for marketing or resale of our products. Some of our resellers and distributors also offer competing products. Most of our resellers and distributors are not subject to any minimum purchase requirements, they can cease marketing our products at any time, and they may from time to time be granted stock exchange or rotation rights. Moreover, the introduction of new and enhanced products may result in higher product returns and exchanges from distributors and resellers. In addition, the distribution channels through which client/server software products are sold have been characterized by rapid change, including consolidations and financial difficulties of distributors, resellers and other marketing partners including some of our current distributors. The bankruptcy, deterioration in financial condition or other business difficulties of a distributor or retailer could render our accounts receivable from such entity uncollectible. We cannot assure you that our distributors or resellers will continue to purchase our products in the same amounts, if at all, or to provide our products with adequate promotional support. Termination of any of our relationships with distributors or resellers could negatively affect our sales.
Our inability to compete successfully in international markets may reduce our revenues.
For the year ended December 31, 1999 our international sales were 55% of our net revenues, for the year ended December 31, 1998 our international sales were 54% of our net revenues and for the year ended December 31, 1997 our international sales were 58% of our net revenues. A key component of our strategy is continued expansion into international markets, and we currently anticipate that international sales, particularly in new and emerging markets, will continue to account for a significant percentage of total revenues. We will need to retain effective distributors, and hire, retain and motivate qualified personnel internationally to maintain and/or expand our international presence. However, we cannot assure that we will be able to successfully market, sell, localize and deliver our products in international markets.
There are also risks inherent in doing business on an international level, such as unexpected changes in regulatory requirements and government controls, problems and delays in collecting accounts receivable, tariffs, export license requirements and other trade barriers, difficulties in staffing and managing foreign operations, longer payment cycles, political and economic instability, fluctuations in currency exchange rates, seasonal reductions in business activity during summer months in Europe and other parts of the world, restrictions on the export of critical technology, and potentially adverse tax consequences, which could adversely impact the success of international operations. In addition, effective copyright and trade secret protection may be limited or unavailable under the laws of some foreign jurisdictions.
Also, sales of our products are denominated either in the local currency of the respective geographic region or in US dollars, depending upon the economic stability of that region and locally accepted business practices. Accordingly, any increase in the value of the US dollar relative to local currencies in those markets may negatively impact our competitive position and our revenues.
In some international markets we have entered into agreements with independent companies that have also licensed the use of our name. These agreements are in place to increase our opportunities and penetration in such markets. While we believe that to date these agreements have increased our penetration in such markets, there can be no certainty that this performance will continue nor that these relationships will remain in place. Failure to renew these agreements could adversely affect our business in these markets.
Our inability to adequately protect our proprietary technology, may result in us losing our competitive position.
We have one patent with respect to our SQLWindows and Centura Team Developer products and one patent pending with respect to our SQLBase SafeGarde product. The source code for our proprietary software is protected both as a trade secret and as a copyrighted work. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use our products or technology without authorization, or to develop similar technology independently. In addition, effective copyright and trade secret protection may be unavailable or limited in some foreign countries.
We generally enter into confidentiality or license agreements with our employees, consultants and vendors, and generally control access to and distribution of our software, documentation and other proprietary information. Despite efforts to protect proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that is regarded as proprietary. Policing such unauthorized use is difficult. There can be no assurance that the steps taken by us will prevent misappropriation of our technology or that such agreements will be enforceable. In addition, litigation may be necessary in the future to enforce intellectual property rights, to protect trade secrets or to determine the validity and scope of the proprietary rights of others. Such litigation could result in substantial costs and diversion of our resources.
Third parties may also claim infringement by us with respect to current or future products. We expect that we will increasingly be subject to such claims as the number of products and competitors in the Information Appliance and e- business markets grow and the functionality of such products overlaps with other industry segments. In the past, we have received notices alleging that our products infringe trademarks of third parties. We have historically dealt with and will in the future continue to deal with such claims in the ordinary course of business, evaluating the merits of each claim on an individual basis. There are currently no material pending legal proceedings against us regarding trademark infringement.
Any third party infringement claims, whether or not they are meritorious, could result in costly litigation or require us to enter into royalty or licensing agreements. Such royalty or license agreements, if required, may not be available on terms acceptable to us, or at all. If we were found to have infringed upon the proprietary rights of third parties, we could be required to pay damages, cease sales of the infringing products and redesign or discontinue such products.
Our inability to obtain additional financing on favorable terms may substantially harm the future growth of our business.
We may be required to seek additional equity financing to finance the acquisition of new products and technologies, capital equipment and continuing operations. If we need further financing, there can be no assurance that it will be available on reasonable terms or at all. Any additional equity financing will also result in dilution to our existing stockholders.
Our inability to monitor and respond to the need for additional personnel and upgraded systems may impair our ability to expand sales and generate increased revenue.
In recent years, we have experienced both expansion and contraction of our operations, each of which has placed significant demands on our administrative, operational and financial resources. To manage future growth, if any, we must continue to improve our financial and management controls, reporting systems and procedures on a timely basis and expand, train and manage our work force. There can be no assurance that we will be able to perform such actions successfully. We intend to continue to invest in improving our financial systems and controls in connection with higher levels of operations. Although we believe that our systems and controls are adequate for the current level of operations, we anticipate that we may need to add additional personnel and expand and upgrade our financial systems to manage any future growth. Our failure to do so effectively could negatively impact the growth of our sales and revenue.
Future issuance of our common stock according to option plans or exercise of warrants will dilute the beneficial ownership of our existing stockholders, and the sale of such shares could negatively affect our stock price.
As of December 31, 1999, we had outstanding warrants to purchase 1,937,000 shares of our common stock and options to purchase 7,895,000 shares of our common stock. Future issuance of such shares of our common stock according to any of these outstanding securities will dilute the beneficial ownership of our stockholders. In addition, sales, including block sales, of a significant number of shares of common stock, or the potential for such sales, could adversely affect the prevailing stock market price for our common stock. This effect may be particularly significant because these shares represent a large percentage of our total outstanding stock.
Conversion of the series A cumulative convertible preferred stock and exercise of the related warrants may dilute the interests of existing stockholders
. On December 30, 1999 we issued 12,500 shares of series A cumulative convertible preferred stock, an option to purchase an additional 6,000 shares of convertible preferred stock and warrants to purchase shares of common stock. The conversion price of the series A cumulative convertible preferred stock and the exercise price of the related warrants that we issued in 1999 are expected to be less than the current market price of our common stock on the date of conversion or exercise. So long as these securities remain outstanding and unconverted or unexercised, the terms under which we could obtain additional equity financing may be adversely affected. To the extent of any conversion or exercise of these securities, the interests of our existing stockholders will be diluted proportionately. Dilution will increase significantly if the price of our common stock remains consistently below the maximum conversion price of $5.82 or if the holders of preferred stock exercise their option to purchase additional shares of preferred stock, since either of these events will result in the conversion of larger amounts of Centura's common stock. In addition, as more shares of preferred stock are converted, Centura's common stock price may decline further.
If we are deemed to have issued 20% or more of our outstanding common stock in connection with the private placement of our series A cumulative convertible preferred stock, we may be required to delist our shares from the NASDAQ SmallCap Market.
In accordance with NASD Rules 4310 and 4460, which require stockholder approval of any transaction that would result in the issuance of securities representing 20% or more of an issuer's outstanding listed securities, we are not obligated to issue shares of our common stock upon conversion of the series A cumulative convertible preferred stock in excess of 19.99% of our outstanding common stock on December 30, 1999, the date of issuance of the preferred stock, or approximately 7,465,771 shares of common stock. However, if the NASD determines that we have issued 20% or more of our outstanding common stock in connection with our private placement of the preferred stock, or that we have violated any other NASD rule, we risk being delisted from the NASDAQ SmallCap Market.
We intend to seek stockholder approval of the securities issued in the private placement at our next stockholder meeting. In addition, the terms of the agreement pursuant to which we sold the preferred stock provide that we must solicit stockholder approval of the issuance of the preferred stock and the common stock issuable upon conversion of the preferred stock and upon exercise of the warrants. Following October 30, 2000, we have 90 days after the date which the shares of common stock underlying the preferred stock and warrants exceed 15% of our issued and outstanding capital stock immediately prior to the original date of issuance, or approximately 5,602,129 shares of common stock, to seek stockholder approval to issue additional shares of common stock in accordance with NASD Rules 4310 and 4460. If we fail to hold a meeting by that date, then, as partial relief, we must pay a cash penalty per share of preferred stock equal to the product of (1) $1,000 and (2) .02, multiplied by the quotient of (1) the number of days after the deadline which the stockholder meeting is not held; divided by (2) 30.
Directors and Executive Officers of Registrant
The following table sets forth information as of February 29, 2000, regarding the directors and executive officers of Centura:
Name Age Position ------------------------- ------ ---------------------------------------- Scott R. Broomfield....... 43 President and Chief Executive Officer (Principal Executive Officer), Chairman of the Board of Directors
John W. Bowman............ 45 Executive Vice President, and Chief Operating Officer
Joe Falcone............... 41 Senior Vice President, Engineering and Support, and Chief Technology Officer
Richard Lucien............ 42 Senior Vice President, Finance and Chief Financial Officer (Principal Finance and Accounting Officer)
Jack King (2)............. 67 Director
Edward Borey, Jr.(1)...... 49 Director
Phillip Koen, Jr.(1)...... 49 Director
Peter Micciche (2)........ 47 Director
Tom Clark................. 48 Director
------------------------
(1) Member of the Audit Committee of the Board of Directors.
(2) Member of the Compensation Committee of the Board of Directors.
Mr. Broomfield is the Chief Executive Officer and has served as a member of the Board of Directors at Centura Software Corporation since December 1997. Prior to joining Centura Mr. Broomfield was a principal with the firm of Hickey & Hill Incorporated from February 1993 to December 1997 where he advised companies needing operational and financial restructuring. Prior to Hickey & Hill, Mr. Broomfield was Operations Manager at Digital Equipment Corporation where he was responsible for taking the VAX 9000 Mainframe product from inception to shipment. Prior to this, he worked as Controller for their Silicon Valley manufacturing operations. There, he was responsible for financial planning, MIS financial systems, accounting, and all local merger and acquisition activity. Additional high-tech experience for Mr. Broomfield includes holding the Strategic Advisor position at E-Tech. Prior to their initial public offering, Mr. Broomfield played an integral role in the merger and acquisition team where he successfully completed the acquisition of PolyScan. He has also filled strategic advisor roles at Invision and Zitel presenting industry insights to advance the companies' vision. Mr. Broomfield serves on the board of directors of Cam Data Corporation, the largest supplier of microcomputer-based inventory management and point of sale solutions for small to medium retailers. His other associations and directorships include Business Executives for National Security, an organization of business leaders assembled to address issues surrounding our national security, and the Director of the Turnaround Management Association, NorCal Chapter. Mr. Broomfield has a BS in Psychology from Azusa Pacific University and an MBA, with honors, from Santa Clara University.
Mr. Bowman has served as Chief Operating Officer of Centura since July 1999. Mr. Bowman joined the Centura as Chief Financial Officer in December 1997. Prior to joining the Centura Mr. Bowman also served as a principal with the firm of Hickey & Hill from July 1997 to December 1997 where he assisted companies with executive management, strategy, operational and financial restructuring, business planning and business development. Prior to joining Hickey & Hill, Mr. Bowman was President of Country Club Foods, Inc. from November 1995 through June 1997 and from February 1992 through November 1995 served as Vice President of Finance for Spreckels Sugar Co., Inc. Prior to this, from 1978 through 1992, Mr. Bowman held various senior financial management positions at Unisys Corporation. Mr. Bowman holds a BS in Business Management from San Diego State University and an MBA in Finance from the University of California, Berkeley.
Mr. Falcone joined Centura in November, 1998 as Senior Vice President and CTO. Prior to joining Centura, Mr. Falcone was Director of the Windows Products Group at Inprise Corporation. Prior to joining Inprise, Mr. Falcone was Director of Research and Development for Tasking, Inc. From 1994 to 1997, he served in engineering management roles with Data General Corporation, Kronos, Inc., and Brainstorm Technology, Inc. From 1983 to 1994, Mr. Falcone held positions in research and development at Digital Equipment Corporation. From 1980 to 1983, Mr. Falcone was a Member of Technical Staff at Hewlett-Packard Laboratories. Mr. Falcone holds an AB degree in Computer Science from the University of California, Berkeley and an MS degree in Electrical Engineering from Stanford University.
Mr. Lucien has served as Senior Vice President, Finance and Chief Financial Officer of Centura since July 1999. Mr. Lucien joined Centura as Vice President, Corporate Controller in December 1997 and served as a consultant to the Company from July 1997 through December 1997. Prior to joining Centura, Mr. Lucien was Corporate Controller at Berkeley Systems, Inc., a software games and interactive media entertainment company, from February 1996 through June 1997 and was Director of Corporate Reporting at Spectrum HoloByte, Inc., a software games and interactive media entertainment company, from July 1994 through February 1996. Prior to this, Mr. Lucien served in the International Consulting Practice of Tohmatsu & Co., the Japanese affiliate of Delloitte, Touche, Tohmatsu, International, in Osaka, Japan, from July 1991 through March 1994. Prior to this, Mr. Lucien served in various financial management positions at Nellcor, Inc., a manufacturer of non-invasive medical instruments from June 1987 through 1990. Mr. Lucien began his professional career at Touche Ross & Co. in January 1985 and holds a BS degree in business administration from California State University, Hayward.
Mr. King has served on Centura's Board of Directors since December 1997. Since 1986, Mr. King has been President and CEO of Zitel Corporation, a company specializing in Year 2000 software conversion consulting, systems integration and "intelligence-based" technology solutions. Prior to joining Zitel, Mr. King held key executive and senior management positions at Dynamic Disk, Data Electronics, Memorex and Xerox Corporation. Mr. King holds a BS in Industrial Management from San Diego State University.
Mr. Borey has served on Centura's Board of Directors since December 1999. Mr. Borey is currently the Interim President for NextRx; a Washington based Medical Automation Company. Prior to joining NextRx, Mr. Borey held a series of key executive and senior management positions at Intermec Technologies, Intermec's media subsidiary, Paxar's Graphic Group, Monarch's Retail System Division, National Semiconductor and Lear Siegler. Mr. Borey holds a BS in Economics from University of New York, College at Oswego, an MA in Public Administration from the University of Oklahoma and an M.B.A in Finance from the University of Santa Clara.
Mr. Koen has served on Centura's Board of Directors since December 1997. Mr. Koen is currently serving as Chief Financial Officer of Equinix, Inc since July 1999. Prior to this Mr. Koen served as Chief Executive Officer and Chief Financial Officer of PointCast Corporation. and Chief Financial Officer of Etec Systems. From April 1989 to December 1993, Mr. Koen was the Vice President of Finance and then the Chief Financial Officer at Levelor Corporation. Mr. Koen holds a BA in Economics from Claremont Men's College and an MBA in General Management from the University of Virginia.
Mr. Micciche has served on Centura's Board of Directors since February 1998. Mr. Micciche is currently Senior Vice President, Sales at ChannelPoint, Inc since October 1998. Mr. Micciche served as President and CEO of SceneWare Corporation from 1994 to 1998. Prior to that Mr. Micciche was Vice-President and General Manager, North America at The ASK Group from December 1992 until May 1993, and was President of Cognos Corporation from December 1989 through December 1992. Mr. Micciche graduated from Boston College with a BS in Accounting and from Suffolk University with an MBA in Finance.
Mr. Clark has served on Centura's Board of Directors since July 1999. He is currently President and Chief Executive Officer of 3Times Software, a Redmond, Washington-based company specializing in Internet software and services. Mr. Clark has more than two decades experience in high technology companies, including 14 years as a corporate officer. Prior to his current position, Mr. Clark was an Executive Vice President of Data Dimensions, an information technology company, where he was in charge of the company's knowledge management products division. Prior to Data Dimensions, Mr. Clark was an Executive Vice President of Mosaix Inc. (a Customer Relationship Management software provider acquired by Lucent in 1999). At Mosaix, Mr. Clark served as President of the Professional Services division and earlier as Senior Vice President of Product Operations. Prior to Mosaix Mr. Clark was with Data I/O Corp, a company specializing in software and equipment for use with programmable Application- Specific-Integrated-Circuits (ASICs). Other experience includes serving as General Manager of the Software Development Products division at Tektronix Inc. Mr. Clark served as a Board member of Raima Corporation (acquired by Centura in June 1999) for five years. He holds a BS in Electrical Engineering from Ohio State University.
The Board of Directors elects our officers and such officers serve at the discretion of the Board of Directors. There are no family relationships among the officers or directors.
Item 2.
Item 2. Properties
We lease approximately 48,000 square feet of office, development and warehousing space in facilities in Redwood Shores, California, of which approximately 50% was sublet in September 1998.
As of December 31, 1999, we also have offices in the metropolitan areas of Chicago, Dallas, New York, Seattle, Washington, D.C., Berlin, Bruetten (Switzerland), Duesseldorf, Leuven (Belgium), London, Sydney (Australia), Mexico City, Sao Paulo, Milan, Maarssen (The Netherlands), Munich, Paris, Vienna and Tokyo. We believe that our facilities are adequate for our current needs and that suitable additional space will be available as needed.
Item 3.
Item 3. Legal Proceedings
As of December 31, 1999, to the best of our knowledge there were no pending actions, potential actions, claims or proceedings against us that could reasonably be expected to result in damages to us which would have a material adverse effect on our business, results of operations or financial condition. We exist in a volatile legal and regulatory environment and it is not possible to anticipate or estimate the potential adverse impact of unknown claims or liabilities against us, its officers and directors, and as such no estimate is made in our financial statements for such unknown claims or liabilities.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of our stockholders during the fiscal quarter ended December 31, 1999.
PART II
Item 5.
Item 5. Market for the Registrant's Common Equity and Related Shareholder Matters
Centura's common stock is quoted on The NASDAQ SmallCap Market under the trading symbol "CNTR". Our common stock began trading on The NASDAQ National Market on February 5, 1993 under the trading symbol "GPTA". The table below shows the 1999 and 1998 quarterly high and low sale prices per share of our common stock:
High Low --------- --------- 1999: Fourth quarter................................... $8.563 $0.625 Third quarter.................................... 1.000 0.563 Second quarter................................... 1.063 0.938 First quarter.................................... 1.281 0.906
1998: Fourth quarter................................... $1.438 $1.000 Third quarter.................................... 1.813 1.000 Second quarter................................... 2.875 1.563 First quarter.................................... 2.125 0.906
We have not paid any cash dividends and do not anticipate paying any cash dividends in the foreseeable future.
In December 1999, we completed a private placement of Series A Cumulative Convertible Preferred Stock. Under the terms of the private placement we are prohibited from declaring a cash dividend until at least 90% of the preferred stock has either been converted to shares of our common stock or redeemed for cash and from declaring a stock dividend within 30 days of December 30, 2005. See note 7 in the notes to the consolidated financial statements for further information on the private placement.
As of March 1, 2000, there were approximately 1,031 shareholders of record (not including beneficial holders of stock held in street name) of Centura's common stock.
Item 6.
Item 6. Selected Financial Data
The following consolidated financial data highlights some information from this Form 10-K. You will need to read Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations You should read the following discussion and analysis of the financial condition and results of operations along with our consolidated financial statements and notes to consolidated financial statements, as well as "Risk Factors".
Overview Products Centura is a leading provider of e-business and Information Appliance databases and development solutions. Our product lines and their main features are summarized below. You should also read Item 1, Business for a detailed description of our product lines.
Solution Sets
Product Category
Main Features
e-business solution set
Centura Team Developer
Application development environment
Web-centric e-business development environment
Velocis Database Server
Embedded database
Scalable, multi platform high performance database
SQLBase Safegarde
Embedded database
Fully encrypted application-embedded database
RDM
Embedded database
Multi-platform, high performance embedded database
Information Appliance solution set
eSNAPP
Connectivity software
Connectivity solution for Information Appliances
db.linux
Embedded database
Database for Information Appliances
We expect the majority of our net revenues to come from these products for the foreseeable future. If we do not deliver products as scheduled, or if the marketplace does not accept our products, our operating results, market share and financial condition could be adversely affected.
Our products are distributed in the United States and internationally through a corporate sales organization. We approach our markets through a combination of direct sales, where our sales force and consulting organization work directly with customers to provide e-business and Information Appliance solutions to business process problems, and through sales channels, which consist of information systems integrators, or SIs, independent software vendors, or ISVs and distributors. SIs and ISVs can collectively be considered Value Added Resellers or VARs.
You should read "Item 1.- Risk Factors; - "Our failure to timely deliver our products and services or to achieve market acceptance may result in negative publicity and losses," "Software errors in some of our products may cause our future sales to decrease", "If the computer industry shifts away from Information Appliances and e-business software, demand for our products may decrease significantly", and "The Information Appliance and e-business software market is highly competitive, and we risk losing our market share to other companies", for more information on our products, the marketplace and associated risks.
Revenue Recognition
Our revenue is derived from primarily two sources, across many industries: (1) product license revenue, derived primarily from product sales to resellers and end users, including large scale enterprises, and royalty revenue, derived primarily from initial license fees and ongoing royalties from product sales by Original Equipment Manufacturer, or OEMs; and (2) service and support revenue, derived primarily from providing software updates, support, training, and consulting services to end users.
We adopted the provisions of Statement of Position, or SOP 97-2, "Software Revenue Recognition" as amended by SOP 98-4, "Deferral of the Effective Date of Certain Provisions of SOP 97-2", effective January 1, 1998. We also adopted SOP 98-9, "Modification of SOP 97-2, Software Revenue Recognition With Respect to Certain Transactions", in the first quarter of 1999. Prior to 1998, we recognized revenue under SOP 91-1, "Software Revenue Recognition". Under SOP 97-2 and SOP 98-9, we recognize product revenue upon shipment if a signed contract exists, the fee is fixed and determinable, collection of resulting receivables is probable and product returns are reasonably estimable. For certain sales where the licensing fee is not due until the customer deploys the software, revenue is recognized when the customer reports to us that the software has been deployed. Estimated product returns are recorded upon recognition of revenue from customers having rights of return and are based on our historical experience with these customers. In 1997, our revenue recognition policy for licensing fees was the same as set forth above. If stock rotation requests from customers and distributors are significantly in excess of our estimates, our revenues and consequently results from operations will be adversely affected. You should read the information included in Part I, "Risk Factors - the Information Appliance and e-business software market is highly competitive and we risk losing our market share to other companies" of this Annual Report on Form 10-K.
For contracts with multiple obligations (e.g. deliverable products, maintenance and other services), we allocate revenue to the undelivered components of the contract based on objective evidence of its fair value, which is specific to us, or for products not yet being sold separately, the price established by management. We recognize revenue allocated to undelivered products when the criteria for product revenue set forth above are met. We recognize revenue from maintenance fees for ongoing customer support and product updates ratably over the period of the maintenance contract. Payments for maintenance fees are generally made in advance and are non-refundable. For revenue allocated to training and consulting services, or derived from the separate sales of these services, we recognize revenue as the related services are performed. When services are deemed essential to acceptance of the software being delivered, we defer revenue and recognize it over the period of the engagement on a percentage-of-completion basis, primarily based on labor hours incurred. In 1997, our revenue recognition policy for training, consulting and support services was the same as set forth above.
We recognize product revenue from royalty payments from OEMs as product is sold and reported to us.
We operate with virtually no order backlog as our products ship shortly after orders are received. Our quarterly product revenue is therefore dependent on orders booked and shipped within any given quarter. Our product revenue, and as a consequence, operating results have tended to be higher in the fourth quarter of any given year compared with the first quarter of the following year.
Historically, a substantial portion of our orders, and therefore revenue is booked in the third month of each quarter. Accordingly, any significant shortfall in orders of our products in relation to our expectations could have an immediate adverse impact on our business, operating results and financial condition.
You should also read "Part I, Item 1.- Business - Risk Factors - "Fluctuations in our quarterly and annual results may adversely affect our stock price".
Results of Operations The table below shows the consolidated statements of operations data as a percentage of net revenues for the periods indicated. The results of operations of Raima Corporation after June 7, 1999 are included in our consolidated statement of operations for the year ended December 31, 1999.
Years Ended December 31, --------------------------------- 1999 1998 1997 ---------- ---------- ----------- Net revenues: Product............................... 54% 63% 70% Service............................... 46% 38% 30% ---------- ---------- ----------- Total net revenues.................. 100% 100% 100% Cost of revenues: Product............................... 6% 9% 8% Service............................... 8% 8% 13% Amortization of acquired technology... 1% - - ---------- ---------- ----------- Total cost of revenues.............. 15% 17% 21% ---------- ---------- ----------- Gross profit...................... 85% 83% 79%
Operating expenses: Sales and marketing................... 56% 48% 45% Engineering and product development... 17% 15% 17% General and administrative............ 17% 13% 12% Amortization of goodwill.............. - - - Acquisition expense................... - - 1% Restructuring expense................. - - 2% ---------- ---------- ----------- Total operating expenses............ 90% 76% 77% ---------- ---------- ----------- Operating income (loss)........... (5%) 7% 2%
Other income (expense), net............. (1%) (4%) (3%) Provision for income taxes.............. - 1% - ---------- ---------- ----------- Net income (loss)....................... (6%) 4% (1%) ========== ========== ===========
Gross margin on product revenues........ 88% 86% 88% Gross margin on service revenues........ 83% 78% 57%
Net revenues Net product revenues
The following table presents our net product revenues by product line and the approximate percentage of total revenues for the years ended December 31, 1999, 1998, and 1997:
1999 1998 1997 ----------------- ----------------- ----------------- (in % of (in % of (in % of millions) Total millions) Total millions) Total
Embedded databases........ $20.5 74% $23.5 70% $24.5 60% Application development environment............. 4.9 18% 7.0 21% 10.7 26% Other tools and connectivity software... 2.4 9% 3.0 9% 5.5 14% -------- -------- -------- -------- -------- -------- Total net product revenue. $27.8 100% $33.5 100% $40.7 100% ======== ======== ======== ======== ======== ========
Net product revenues decreased $5.7 million, or 17% from 1998 to 1999, and decreased $7.2 million, or 18% from 1997 to 1998.
The decrease in overall product revenues from 1998 to 1999 is due to decreased revenues from embedded database and application development software. The embedded database software revenue decreased $3.0 million, or 13% from 1998 to 1999, primarily due to decreased sales of SQLBase, an embedded database product primarily utilized in desktop client/server applications, which declined 25% during this period. This decline was partially offset by revenue from the Velocis Database Server and RDM products, also embedded database products, which are primarily utilized in server centric and embedded device applications, respectively.
Application development software decreased $2.1 million, or 30% from 1998 to 1999 due principally to decreases in Centura Team Developer ("CTD") revenue, our flagship application environment. This decrease is due principally to the absence of significantly competitive new version releases of CTD in recent years.
The revenue from other tools and connectivity software decreased $0.6 million from 1998 to 1999 and includes revenue from ancillary products. There is no significant revenue reported from eSNAPP as this was only released in the latter part of the fourth quarter of 1999.
The decrease in product revenue from 1997 to 1998 is due principally to decreases in application development software revenue. Revenue from CTD declined $3.7 million, or 35% from 1997 to 1998. This decrease is again due principally to the absence of significantly competitive new version releases of CTD in recent years.
The revenue from other tools and connectivity software decreased $2.5 million from 1997 to 1998 and includes revenue from ancillary products, not central to our current strategic business direction.
The decline in embedded database revenue from 1997 to 1998 is due entirely to decreases in SQLBase revenue that declined 4% during this period.
We attribute the decrease in SQLBase revenue to a flattening, and in some markets a shrinking, of the market for desktop client/server applications as customers migrate these types of applications to scalable Web-centric environments. We anticipate that this trend will continue. We also anticipate that revenue from Velocis Database Server, together with Information Appliance-oriented product solution sets, which may include our current solution sets of RDM, db.linux and the eSNAPP connectivity architecture, will provide at least a partial offset to declines in SQLBase revenue.
We are developing new releases of CTD that will provide a robust 4GL, object oriented development environment for Web-centric applications development. We believe this product set will be competitive in the e-business, Web-centric application development environment market.
Delays or difficulties associated with new products or product enhancements could have a material adverse effect on our business, operating results and financial condition. You should also read Risk factor - If the computer industry shifts away from Information Appliances and e-business software, demand for our products may decrease, Risk Factor - The Information Appliance and e-business software market is highly competitive and we risk losing our market share to other companies and Risk Factor - The lack of timely market delivery of our products and service or the inability to achieve market acceptance may result in negative publicity and losses.
Net service revenues
The following table presents our service revenues, which primarily comprise fees that entitle our customers to the right to receive product revision upgrades and updates as and when they become available and telephone support and consulting services for the years ended December 31, 1999, 1998 and 1997.
1999 1998 1997 --------- --------- --------- (in millions) Total net service revenue... $23.2 $20.0 $17.2 ========= ========= =========
Net service revenues in 1999 increased $3.2 million, or 16% compared with 1998 and increased $2.8 million, or 16% in 1998 compared with 1997. The increase in net service revenues reflects our overall focus on customer retention and an increased emphasis on the utilization of consulting services. License maintenance and telephone support contracts are typically paid in advance, and revenue is recognized ratably over the term of the contract.
The following table presents our net revenues split by geographical regions:
1999 1998 1997 ----------------- ----------------- ----------------- (in % of (in % of (in % of millions) Total millions) Total millions) Total
North America............. $22.8 45% $24.5 46% $24.5 42% Europe.................... 22.9 45 24.2 45 27.6 48 Rest of World............. 5.3 10 4.8 9 5.8 10 -------- -------- -------- -------- -------- -------- Total net revenues........ $51.0 100% $53.5 100% $57.9 100% ======== ======== ======== ======== ======== ========
International sales represented 55%, 54% and 58% of our net revenues for the years ended December 31, 1999, 1998 and 1997, respectively. A key component of our strategy is continued expansion into international markets, and we currently anticipate that international sales, particularly in new and emerging markets, will continue to account for a significant percentage of total revenues. We will need to retain effective distributors, and hire, retain and motivate qualified personnel internationally to maintain and/or expand our international presence. However, we cannot guarantee that we will be able to successfully market, sell, localize and deliver our products in international markets. You should read the information included in Part I, "Risk Factors - The Information Appliance and e-business software market is highly competitive and we risk loosing our market share to other companies" and "If we fail to adequately protect our proprietary technology, we may lose our competitive position" for more information concerning the risks of doing business in international markets.
Cost and expenses
Cost of product revenues Cost of product revenues includes the cost of production and the amortization of capitalized software. The cost of production includes the cost of subcontracted production and royalties for third party software. The table below presents these costs for the years ended December 31, 1999, 1998 and 1997:
1999 1998 1997 --------- --------- --------- (in millions) Cost of production............ $2.3 $3.0 $2.1 Amortization of capitalized software.................... 1.0 1.7 2.7 --------- --------- --------- Total cost of product revenues $3.3 $4.7 $4.8 ========= ========= =========
As a percentage of net product revenues.................... 12% 14% 12% ========= ========= ========= As a percentage of net product revenues, excluding amortization of capitalized software.................... 8% 9% 5% ========= ========= =========
Cost of product revenue as a percentage of net product revenue decreased from 1998 to 1999 due to a decrease in royalties, and write-offs of development licenses in 1999 compare with 1998. The increase in cost of product revenue as a percentage of net product revenue in 1998 compared with 1997 is due primarily to an increase in 1998 of royalties and the write-off of development licenses for product that had been released from development.
We capitalize internal software development costs that are eligible for capitalization, from the time that a project reaches technological feasibility until the time that the products derived from the project are released for sale. Software purchased from third parties and included in our products is also capitalized, if technological feasibility for the project has been reached at the time of purchase. These capitalized costs are then amortized ratably over the useful life of the products, generally estimated to be two to three years.
The amortization of capitalized software costs has declined over the last two years. This decline is largely due to the software purchased from third parties and used in earlier versions of our current product lines, becoming fully amortized during 1997 and early 1998.
Cost of net service revenues
Cost of service consists primarily of personnel costs related to product license maintenance, training and technical support. The table below presents these costs for the years ended December 31, 1999, 1998 and 1997:
1999 1998 1997 --------- --------- --------- (in millions) Total cost of service revenues... $3.9 $4.4 $7.4 ========= ========= ========= As a percentage of net service revenues............... 17% 22% 43% ========= ========= =========
The decrease in the actual cost of service revenue as well as a decrease in the percentage of the cost of service revenues to service revenues is primarily due to a decrease in headcount in each of the respective years.
In August 1997, we completed an operational restructuring which included outsourcing certain support functions. The outsourcing activities enabled a lower infrastructural cost of service while maintaining adequate levels of support. In 1999, following a further review of the support functions, we were able to bring the functions previously outsourced back in-house with a reduced staff. We still lowered the cost of service but maintained the same or improved levels of support to our customers.
Amortization of acquired products The 1999 amortization expense associated with acquired technology of Raima Corporation was $0.3 million. In 1999, as part of the merger with Raima Corporation we capitalized $2.7 million of acquired technology. This intangible asset is being amortized over its estimated period of benefit of 5 years. See note 2 of notes to consolidated financial statements for further information regarding the acquisition of Raima Corporation in 1999.
Sales and Marketing expenses Sales and marketing expenses consist principally of salaries, sales commissions and costs of advertising and marketing campaigns. The table below presents these costs for the years ended December 31, 1999, 1998 and 1997.
1999 1998 1997 --------- --------- --------- (in millions) Total sales and marketing expenses. $28.4 $25.8 $26.2 ========= ========= ========= As a percentage of total net revenues......................... 56% 48% 45% ========= ========= =========
Sales and marketing expenses in 1999 increased $2.6 million, or 10% compared with 1998 and decreased $0.4 million, or 2% in 1998 compared with 1997.
The increase in the 1999 sales and marketing expense is primarily due to increased staffing as a result of the acquisition of Raima and one-time severance costs of $0.5 million, associated with a reorganization of the European sales and marketing organization in the third quarter of 1999.
The decrease in sales and marketing expenses in 1998 compared with 1997 was primarily due to reductions in staffing, including the elimination of portions of the field sales organization which focussed on the Foresite product which we discontinued in the fourth quarter of 1997.
Engineering and product development The table below presents engineering and product development expenses, capitalized internal software development costs, and net engineering and product development expenses in dollar amounts and as a percentage of net revenues for the years ended December 31, 1999, 1998 and 1997:
1999 1998 1997 --------- --------- --------- (in millions) Gross engineering and product development expenses............. $9.2 $8.6 $10.7 Capitalized software development costs........................... (0.5) (0.7) (1.0) --------- --------- --------- Net engineering and product development expenses.............. $8.7 $7.9 $9.7 ========= ========= =========
As a percentage of net revenues: Gross engineering and product development expenses............ 18% 16% 19% Net engineering and product development expenses............ 17% 15% 17%
Net engineering and product development expenses in 1999 increased $0.8 million, or 10% compared with 1998 and decreased $1.8 million, or 18% in 1998 compared with 1997. The increase in gross expenses in 1999 compared with 1998 is principally due to increases in personnel as we expanded our efforts to leverage core technologies into next generation products, and to increased personnel-related costs as a result of the additional workforce of Raima acquired in 1999.
The decrease in 1998 of gross engineering expenses compared with 1997 reflects a reduction in staffing and associated engineering costs as we reduced our emphasis on engineering work for the application development environment software, at that time.
We believe that the development of new products and the enhancement of existing products, are essential to our continued success, and we intend to devote substantial resources to new product development. To the extent that net revenues do not grow at the same rate, such increases could have a material adverse effect on the Company's business, results of operations and financial condition.
General and administrative expenses General and administrative expenses consist primarily of staffing and related expenses, rent and facilities expense, depreciation, and outside services. The table below presents these costs for the years ended December 31, 1999, 1998 and 1997:
1999 1998 1997 --------- --------- --------- (in millions) Total general and administrative expenses......................... $8.5 $6.9 $7.0 ========= ========= ========= As a percentage of total net revenues........................ 17% 13% 12% ========= ========= =========
General and administrative expenses in 1999 increased by $1.6 million, or 23% compared with 1998 and decreased $0.1 million, or 2% in 1998 compared with 1997.
The increase in 1999 compared with 1998 is primarily due to increased personnel related costs following the acquisition of Raima and charges associated with fully staffing the European finance and legal departments.
The decrease in 1998 compared with 1997 is due primarily to staffing reductions in the first half of 1998. In addition, during the third quarter of 1998, we began to sublease a portion of our office space, which resulted in a reduction of net rental expense in 1998.
Amortization of goodwill and workforce intangible The 1999 amortization expense associated with goodwill of Raima Corporation was $0.5 million. In 1999, as part of the merger with Raima Corporation we capitalized $3.0 million of goodwill, that is being amortized over its period of benefit of 5 years, and $0.7 million of workforce intangible that is being amortized over its period of benefit of 3 years. You should also read note 2 of notes to consolidated financial statements for more details on the 1999 acquisition of Raima Corporation.
Acquisition expense On January 6, 1997, in an effort to expand our product offerings into areas that compliment our core products, technology and Internet applications, we entered into a definitive agreement to acquire InfoSpinner, Inc. of Richardson, Texas. This agreement was not approved by a majority of our stockholders, so the proposed merger was unable to proceed. Costs incurred through the date of the stockholder vote were immediately expensed.
Restructuring expenses In 1997 we incurred $1.5 million of charges related to our restructuring efforts following the termination of our non-exclusive distribution agreement with Infospinner. These charges included the write-off of prepaid distribution royalties in connection with this terminated agreement and severance costs. Offsetting these charges was a $0.5 million reversal of existing restructuring reserves, originally recorded in 1995. There can be no assurance that we will not believe it appropriate to undertake other major restructuring efforts in the future or to what degree any of these efforts will result in improved operational performance, if at all.
Other income (expense), Net Other income (expense), net is comprised of interest income, interest expense, valuation of warrants, and gains or losses on foreign currency transactions, which are presented in the table below for the years ended December 31, 1999, 1998 and 1997:
1999 1998 1997 --------- --------- --------- (in millions) Net interest expense............... ($0.1) ($0.2) ($0.8) Imputed value of warrants issued... - (1.0) - Foreign exchange loss.............. (0.5) (0.3) (1.0) --------- --------- --------- Total other expense................ ($0.6) ($1.5) ($1.8) ========= ========= =========
Our gains or losses from foreign currency transactions have fluctuated from period to period, primarily as a result of fluctuating values of the U.S. dollar and instability in European and Latin American currency markets. Our foreign currency loss of for both 1999 and 1998 was principally due to the decline in the value of certain European currencies.
The costs of currency hedging are reflected in the reported gains and losses of foreign currency transactions. We anticipate that we will continue to hedge foreign currency denominated assets and liabilities in 2000. Nonetheless, a decrease in the value of foreign currencies relative to the value of the U.S. dollar could result in losses from foreign currency transactions.
Sales of our products are denominated both in local currencies of the respective geographic region and in U.S. dollars, depending upon the economic stability of that region and locally accepted business practices. Any increase in the value of the U.S. dollar relative to local currencies in these markets may negatively impact revenues, results of operations and financial condition. This impact is two-fold:
It may adversely impact our ability to contract for sales in U.S. dollars because our products and services may become more expensive to purchase in U.S. dollars for local customers doing business in the countries of the affected currencies.
The U.S. dollar value of a sale denominated in a region's local currency decreases in proportion to relative increases in the value of the U.S. dollar.
The 1998 non-cash charge of $1.0 million is associated with the issuance of warrants. The warrants were valued by an independent appraiser, using a modified Black-Scholes option pricing model. You should read note 10 of notes to the consolidated financial statements for more information on the issuance and valuation of these warrants.
Provision for income taxes
The provision for income taxes was $0.1 million in 1999, $0.3 million in 1998 and $0.1 million in 1997. The provision for income taxes relates primarily to foreign withholding taxes.
As of December 31, 1999 we had net operating loss carryforwards of approximately $74.8 million available to offset future federal taxable income which expire through 2019 and $20.3 million available to offset future state taxes, which expire through 2004. Due to cumulative ownership changes at December 31, 1999 our net operating loss carryforwards will be limited to approximately $11.4 million annually to offset future taxable income. At December 31, 1999 and 1998 a valuation allowance has been recorded for the net deferred tax asset balance due to the existence of uncertainty of our ability to realize the deferred tax asset.
Liquidity and capital resources:
Cash Flows
1999 1998 1997 --------- --------- --------- (in millions) Cash and cash equivalents at beginning of period............................. $6.4 $4.0 $6.7 Net cash (used in) provided by: Operating activities................ 0.5 1.2 (3.3) Investing activities................ (1.5) (1.9) (1.6) Financing activities................ 15.2 3.1 2.2 --------- --------- --------- Cash and cash equivalents at end of period............................. $20.6 $6.4 $4.0 ========= ========= =========
Net cash from operating activities decreased $0.9 million in 1999 compared with 1998. This decrease is primarily due to operating losses incurred in 1999, offset by a smaller reduction in accounts payable and a smaller increase in accounts receivable as compared with 1998.
Net cash from operating activities increased $4.6 million in 1998 compared with 1997. This increase is principally due to improved operating results.
Net cash used in investing activities decreased by $0.4 million in 1999 compared with 1998. This is primarily attributed to lower levels of property and equipment purchases in 1999 compared with 1998.
Net cash used in investing activities in 1998 increased by $0.3 million compared with 1997. Although property and equipment purchases were lower in 1998 than in 1997, maturities of investments in 1997 were higher than in 1998, which more than offset the relative higher levels of property and equipment purchases in that year compared with 1998.
Net cash provided by financing activities increased $12.2 million in 1999 compared with 1998. This is principally due to increased proceeds from the issuance of common stock and net proceeds from the issuance of mandatorily redeemable convertible preferred stock.
Net cash provided by financing activities increased $0.8 million in 1998 compared with 1997 principally due to increased proceeds from the issuance of common stock.
We believe that expected cash flows from operations and existing cash balances, will be sufficient to meet our currently anticipated working capital and capital expenditure requirements for the next 12 months. We may, however, choose to raise cash for operational or other needs sometime in the future. If we need further financing, there can be no assurance that it will be available on reasonable terms or at all. Any additional equity financing will result in dilution to our shareholders.
Working Capital
1999 1998 --------- --------- (in millions) Working capital including impact of deferred revenue.................... $14.0 $1.0 ========= ========= Working capital excluding impact of deferred revenue.................... $27.9 $14.3 ========= =========
Working capital, defined as current assets less current liabilities increased $13.0 million from December 31, 1998, primarily resulting from an increase in cash proceeds from the issuance of preferred and common stock.
Excluding the impact of deferred product and support revenue of $13.9 million at December 31, 1999, our working capital position increased by $13.6 million. This deferred product and support revenue of $13.9 reflects a delay in recognition of revenue in accordance with contractual agreements and requires minimal future monetary resources of Centura.
Our capital requirements may be affected by acquisitions of businesses, products and technologies that are complementary to our business strategy, which we consider from time to time. We regularly evaluate such opportunities. Any such transaction, if consummated, may reduce our working capital or require the issuance of our common stock.
At December 31, 1999 we had approximately $5.4 million in unsecured foreign currency contracts, denominated primarily in various European currencies, as part of a program to hedge the financial exposure arising from foreign denominated monetary assets and liabilities.
Equity Transactions and Debt Financing In December 1999, we completed a private placement of 12,500 shares of our cumulative convertible series A preferred stock resulting in net proceeds of $11.2 million, after deducting associated expenses, including the imputed value of warrants issued to our placement agent. You should also read note 7 of notes to the consolidated financial statements for more information on this private placement.
In June 1999, we acquired Raima Corporation, a vendor of cross-platform embedded databases and data management tools. We acquired Raima for $7.6 million consisting of 5.8 million shares of our stock valued at $6.0 million, $0.3 million of cash payable to former Raima shareholders as certain financial conditions were met at the time of acquisition, and acquisition costs of $1.3 million. You should also read note 2 of notes to the consolidated financial statements for more information on this acquisition.
In February 1998, Computer Associates, Inc., and Newport Acquisition Company, LLP entered into a Note Purchase and Sale Agreement (which we agreed to). Centura and Newport Acquisition Company then entered into a Note Conversion Agreement whereby a promissory note, plus accrued interest, in the amount of $12,251,000, payable to Computer Associates was acquired by Newport Acquisition Company, and immediately converted into 11,415,094 shares of Centura common stock.
In January 1998, we entered into a $5.0 million asset based loan facility with Coast Business Credit. This loan facility allows us to borrow up to $5.0 million, collateralized by our accounts receivable, combined with a $0.5 million capital equipment facility. Under the terms of the agreement the loan balance is restricted to a percentage of eligible accounts receivable as discussed in Item 8 - Financial Statements and Supplementary Data - note 4 - Short-term borrowings. The facility bears interest at a rate of 2.25% above the Bank of America Reference Rate, and provided for the ability to reduce interest costs based on the achievement of certain financial covenants. The facility matured in January 2000 and we had the option to extend the agreement for one year at our discretion.
At December 31, 1999, we had drawn $3.3 million on the loan facility and were paying an interest rate of 2.25% above the Bank of America Reference Rate or 10.75%.
In February 2000, we declined the option to extend the original agreement for an additional year and instead renegotiated the terms of the $5.0 million asset based loan facility with Coast Business Credit. Under this amended agreement, we continue to borrow up to $5.0 million, collateralized by our accounts receivable, combined with a $0.5 million capital equipment facility. The loan balance is now limited to the lower of $5.0 million, or 85% of our eligible receivables derived from customers located in the United States and the United Kingdom, plus 25% of our eligible receivables derived from approved customers located outside the United States and the United Kingdom. The interest rate is reduced to 2.0% above the Bank of America Reference Rate, with provisions for a reduced interest rate if we achieve certain financial covenants. This agreement matures at the end of January 2002, at which time we have the option to renew the agreement for an additional one-year term. If we choose to terminate this agreement prior to January 2002, we will incur an early termination fee of $50,000.
Year 2000 Issue To date, our customers have not reported any problems with our software products as a result of the commencement of the year 2000 and we have not experienced any impairment in our internal operations with the year 2000 issue. Nevertheless, computer experts have warned that there may still be residual consequences stemming from the change in centuries and, if these consequences become widespread, they could result in claims against us, a decrease in sales of our products and services, increased operating expenses and other business interruptions
Inflation We believes that inflation has not had a material impact on our operating results and do not expect inflation to have a material impact on our operating results in 2000.
Recent Accounting Pronouncements In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin, or SAB No. 101, "Revenue Recognition in Financial Statements". SAB 101 provides guidance for revenue recognition under certain circumstances. The staff accounting bulletin is effective no later than the second quarter of our fiscal year 2000. We are currently reviewing the effect SAB 101 will have on our consolidated results of operations, financial position and cash flows.
In June 1998, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards, or FAS No. 133, "Accounting for Derivative Instruments and Hedging Activities". FAS 133 establishes accounting and reporting standards for derivative instruments and for hedging activities. It requires us to measure all derivatives at fair value and to recognize them on the balance sheet as an asset or liability, depending on our rights or obligations under the applicable derivative contract. In July 1999, the FASB issued SFAS No. 137 that deferred the effective date of adoption of FAS 133 for one more year. We will adopt FAS 133 no later than the third quarter of fiscal year 2000. We are currently reviewing the effect of FAS 133 on our consolidated results of operations, financial position or cash flows.
Factors That May Affect Future Results
We have experienced in the past, and expect in the future to continue to experience, significant fluctuations in quarterly operating results. We have at times recognized a substantial portion of our net revenues in the last month or last few weeks of a quarter. We generally ship products as orders are received and, therefore, have little or no backlog. As a result, quarterly sales and operating results generally depend on a number of factors that are difficult to forecast, including, among others, the volume and timing of and ability to fulfill orders received within the quarter.
Operating results also may fluctuate due to the following factors:
demand for our products;
introduction, localization or enhancement of our products and our competitors' products;
market acceptance of new products;
reviews in the industry press concerning the our products or our competitors;
changes or anticipated changes in our pricing our competitors' pricing;
mix of distribution channels through which products are sold;
mix of products sold;
general economic conditions.
As a result, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as any indication of future performance.
In addition, because our staffing and other operating expenses are based in part on anticipated net revenues, a substantial portion of which may not be generated until the end of each quarter, delays in the receipt or shipment of orders and ability to achieve anticipated revenue levels can cause significant variations in operating results from quarter to quarter. We may be unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall. Accordingly, any significant shortfall in sales of our products in relation to our expectations could have an immediate adverse impact on our business, operating results and financial condition. In addition, we currently intend to increase our operating expenses to fund greater levels of sales and marketing operations and expand distribution channels. To the extent that such expenses proceed or are not subsequently followed by increased net revenues, our business, operating results and financial condition could be materially and adversely affected.
In the future, we may make acquisitions of complementary companies, products or technologies. Managing acquired businesses entails numerous operational and financial risks, including difficulties in assimilating acquired operations, diversion of management's attention to other business concerns, amortization of acquired intangible assets and potential loss of key employees or customers of acquired operations. There can be no assurance that we will be able to effectively complete or integrate acquisitions, and failure to do so could have a material adverse effect on our operating results. At this time, we have no understanding or agreement with any other entity regarding any potential acquisition or combination, the consummation of which is probable.
In addition, our quarterly operating results will depend on a number of other factors that are difficult to forecast, including factors listed in "Item 1. Business, - Risk Factors - Fluctuations in our quarterly and annual results may adversely affect our stock price".
Item 7A.
Item 7A. Quantitative and Qualitative Disclosure about Market Risk
We are exposed to market risk from changes in foreign currency exchange rates and interest rates that could impact our results of operations and financial condition.
We manage our exposure to foreign currency exchange risk using derivative financial instruments (forward contracts) as a risk management tool and not for speculative or trading purposes.
We use these foreign exchange contracts to reduce significant exposure to the risk that the eventual net cash flows resulting largely from the sale of products and services to non-U.S. customers will be adversely affected by changes in exchange rates. These instruments allow us to reduce our overall exposure to exchange rates as the gains and losses on the contracts offset the losses and gains on the assets, liabilities and assets being hedged.
Annual gains and losses in the future may differ materially from this analysis, however, based on the changes in the timing and amount of foreign currency exchange rate movements and our actual exposures and hedges.
At December 31, 1999, we have a total of $5.4 million in 30 day forward contracts. The US dollar equivalent at December 31, 1999 for each of the currencies held comprises; German Deutsche Marks ($1.5 million), British Pounds Sterling ($2.4 million), Netherland Guilders ($ 0.6 million), Italian Lire ($0.3 million) and Australian Dollar ($0.6 million). The carrying value of these financial instruments approximates their respective fair values.
While we hedge certain foreign currency transactions, the decline in value of non-U.S. dollar currencies may adversely impact our ability to contract for sales in U.S. dollars. Our products and services may become more expensive to purchase in U.S. dollars for local customers doing business in the countries of the affected currencies.
Our international business is also subject to risks customarily encountered in foreign operations, including changes in specific country's or region's political or economic conditions, trade protection measures, import or export licensing requirements, unexpected changes in regulatory requirements and natural disasters.
We are subject to interest rate risk on our investment portfolio, however our portfolio consists of only cash and cash equivalents at December 31, 1999, and thus our interest rate risk is immaterial.
We are further subject to interest rate risk on our asset based loan facility, however we believe that the adverse movements of interest rates would not have a material effect on our consolidated financial position, results of operations or cash flows.
Item 8.
Item 8. Financial Statements and Supplementary Data
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders
of Centura Software Corporation:
In our opinion, the consolidated financial statements listed in the index appearing under Item 14(a)(1) present fairly, in all material respects, the financial position of Centura Software Corporation and its subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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 the opinion expressed above.
PricewaterhouseCoopers LLP
San Jose, California
February 8, 2000
CENTURA SOFTWARE CORPORATION
CONSOLIDATED BALANCE SHEET
(in thousands, except per share data)
December 31, ---------------------- 1999 1998 ---------- ---------- ASSETS Current assets: Cash and cash equivalents............................ $20,614 $6,414 Accounts receivable, less allowances of $1,209 and $1,321......................................... 14,394 12,988 Other current assets................................. 4,970 3,627 ---------- ---------- Total current assets............................... 39,978 23,029 Property and equipment, net............................ 3,541 2,888 Capitalized software, net.............................. 1,035 1,542 Goodwill, net.......................................... 2,694 - Other intangible assets, net........................... 3,686 770 Other assets........................................... 546 1,143 ---------- ---------- $51,480 $29,372 ========== ==========
LIABILITIES, MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY Current liabilities: Current portion of long-term obligations............. $430 $ - Accounts payable..................................... 2,782 2,798 Accrued compensation and related expenses............ 1,759 1,567 Short-term borrowings................................ 3,302 2,663 Other accrued liabilities............................ 3,738 1,744 Deferred revenue..................................... 13,923 13,274 ---------- ---------- Total current liabilities.......................... 25,934 22,046 Other long-term liabilities............................ 501 53 ---------- ---------- Total liabilities.................................. 26,435 22,099 ---------- ----------
Commitments (note 8) Mandatorily redeemable convertible preferred stock..... 10,360 - ---------- ---------- Stockholders' equity: Preferred stock, no par value; 2,000 shares authorized; none issued and outstanding............ - - Common stock, par value $0.01 per share; 60,000 shares authorized; 37,535 shares and 29,598 shares issued and outstanding ..................... 375 296 Additional paid-in capital........................... 95,978 85,394 Accumulated other comprehensive loss................. (452) (426) Accumulated deficit.................................. (81,216) (77,991) ---------- ---------- Total stockholders' equity......................... 14,685 7,273 ---------- ---------- $51,480 $29,372 ========== ==========
The accompanying notes are an integral part of these consolidated financial statements.
CENTURA SOFTWARE CORPORATION
CONSOLIDATED STATEMENT OF OPERATIONS
(in thousands, except per share data)
Years Ended December 31, --------------------------------- 1999 1998 1997 ---------- ---------- ----------- Net revenues: Product............................... $27,769 $33,453 $40,714 Service............................... 23,261 20,044 17,232 ---------- ---------- ----------- Total net revenues.................. 51,030 53,497 57,946 ---------- ---------- ----------- Cost of revenues: Product............................... 3,251 4,652 4,779 Service............................... 3,871 4,382 7,439 Amortization of acquired technology... 312 - - ---------- ---------- ----------- Total cost of revenues.............. 7,434 9,034 12,218 ---------- ---------- ----------- Gross profit...................... 43,596 44,463 45,728 ---------- ---------- ----------- Operating expenses: Sales and marketing................... 28,395 25,776 26,224 Engineering and product development... 8,730 7,938 9,724 General and administrative............ 8,477 6,854 6,990 Amortization of goodwill and workforce intangible.................. 469 - - Acquisition expense................... - - 530 Restructuring expense................. - - 1,030 ---------- ---------- ----------- Total operating expenses............ 46,071 40,568 44,498 ---------- ---------- ----------- Operating income (loss)........... (2,475) 3,895 1,230 Other income (expense): Interest income....................... 265 338 234 Interest expense...................... (376) (505) (1,039) Imputed value of warrants issued...... - (990) - Foreign currency loss................. (505) (350) (1,012) ---------- ---------- ----------- Income (loss) before income taxes....... (3,091) 2,388 (587) Provision for income taxes.............. 134 273 62 ---------- ---------- ----------- Net income (loss)....................... ($3,225) $2,115 ($649) ========== ========== =========== Basic net income (loss) per share....... ($0.10) $0.08 ($0.04) ========== ========== =========== Basic weighted average common shares.... 33,066 27,390 15,439 ========== ========== =========== Diluted net income (loss) per share..... ($0.10) $0.08 ($0.04) ========== ========== =========== Diluted weighted average common shares.. 33,066 27,776 15,439 ========== ========== ===========
The accompanying notes are an integral part of these consolidated financial statements.
CENTURA SOFTWARE CORPORATION
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)
(in thousands, except per share data)
Accumulated Common Stock Additional Other Total --------------------- Paid in Comprehensive Accumulated Stockholders' Comprehensive Shares Amount Capital Loss Deficit Equity (Deficit)Income (Loss) ---------- ---------- ------------ ------------ ----------- --------------- ------------ Balances at December 31, 1996............. 13,728 $137 $62,910 ($513) ($79,457) ($16,923) $ -
Issuance of common stock under stock option plans.................... 472 5 669 - - 674 - Issuance of common stock under employee stock purchase plan.......... 132 1 278 - - 279 - Issuance of common stock for settlement of litigation accrual...... 1,452 15 6,518 - - 6,533 - Issuance of stock warrants.............. - - 103 - - 103 - Cumulative translation adjustment....... - - - 29 - 29 29 Net loss................................ - - - - (649) (649) (649) ---------- ---------- ------------ ------------ ----------- --------------- ------------ Balances at December 31, 1997............. 15,784 158 70,478 (484) (80,106) (9,954) ($620) ============ Issuance of common stock under stock option plans.................... 69 1 102 - - 103 - Issuance of common stock for conversion of note payable, net....... 11,415 114 11,949 - - 12,063 - Issuance of common stock for private placement, net................ 2,330 23 1,875 - - 1,898 - Issuance of stock warrants.............. - - 990 - - 990 - Cumulative translation adjustment....... - - - 58 - 58 58 Net income.............................. - - - - 2,115 2,115 2,115 ---------- ---------- ------------ ------------ ----------- --------------- ------------ Balances at December 31, 1998............. 29,598 296 85,394 (426) (77,991) 7,273 2,173 ============ Issuance of common stock under stock option plans.................... 1,017 10 1,604 - - 1,614 - Issuance of common stock pursuant to the exercise of stock warrants..... 1,096 11 1,614 - - 1,625 - Issuance of common stock in connection with acquisition...................... 5,800 58 5,922 - - 5,980 - Issuance of common stock for services related to acquisition................ 24 - 25 - - 25 - Issuance of stock warrants and preferred stock call option........... - - 1,355 - - 1,355 - Issuance of stock options for services.. - - 64 - - 64 - Cumulative translation adjustment....... - - - (26) - (26) (26) Net loss................................ - - - - (3,225) (3,225) (3,225) ---------- ---------- ------------ ------------ ----------- --------------- ------------ Balances at December 31, 1999............. 37,535 $375 $95,978 ($452) ($81,216) $14,685 ($3,251) ========== ========== ============ ============ =========== =============== ============
The accompanying notes are an integral part of these consolidated financial statements.
CENTURA SOFTWARE CORPORATION
CONSOLIDATED STATEMENT OF CASH FLOWS
(in thousands)
Years Ended December 31, ----------------------------- 1999 1998 1997 --------- --------- --------- Cash flows from operating activities: Net income (loss)............................... ($3,225) $2,115 ($649) Adjustments to reconcile net income (loss) to net cash used in operating activities: Depreciation and amortization................. 3,860 3,680 5,390 Loss on disposal of fixed assets.............. 47 236 - Issuance of stock warrants.................... - 990 103 Issuance of stock options for services........ 64 - - Provision for (reduction in) doubtful accounts, sales returns and allowances....... 180 (209) 187 Non-cash restructuring charges................ - - 166 Changes in assets and liabilities, net of acquisition: Accounts receivable......................... 202 (1,035) 1,643 Other current assets........................ 669 (279) (472) Other assets................................ (15) 802 (12) Accounts payable and accrued liabilities.... (146) (3,730) (2,407) Deferred revenue............................ (1,145) (1,344) (7,273) --------- --------- --------- Net cash provided by (used in)operating activities.............................. 491 1,226 (3,324) --------- --------- --------- Cash flows from investing activities: Net cash acquired from acquisition.............. 8 - - Maturities of investments....................... 60 375 2,065 Purchases of investments........................ - (114) - Acquisitions of property and equipment.......... (946) (1,415) (2,253) Capitalization of software costs................ (518) (664) (1,018) Capitalization of other intangibles............. (57) (109) (360) --------- --------- --------- Net cash provided by (used in)investing activities.............................. (1,453) (1,927) (1,566) --------- --------- --------- Cash flows from financing activities: Repayment of note payable....................... - - (368) Proceeds from short-term borrowings, net........ 639 1,082 1,581 Repayment of capital lease obligation........... (405) - - Proceeds from issuance of common stock, net..... 3,239 2,001 953 Proceeds from issuance of manditorily redeemable convertible preferred stock and detachable instruments, net............... 11,715 - - --------- --------- --------- Net cash provided by financing activities. 15,188 3,083 2,166 --------- --------- --------- Effect of exchange rate changes on cash and cash equivalents................................ (26) 58 29 --------- --------- --------- Net increase (decrease) in cash and cash equivalents..................................... 14,200 2,440 (2,695) Cash and cash equivalents at beginning of period.. 6,414 3,974 6,669 --------- --------- --------- Cash and cash equivalents at end of period........ $20,614 $6,414 $3,974 ========= ========= =========
Supplemental disclosure of cash flow information: Cash paid for income taxes...................... $47 $18 $60 ========= ========= =========
Cash paid for interest.......................... $347 $344 $204 ========= ========= ========= Non cash transactions: Equipment acquired through capital lease........ $1,300 $ - $ - ========= ========= ========= Issuance of common stock for conversion of note payable.................................. $ - $12,063 $ - ========= ========= ========= Issuance of common stock in settlement of litigation accrual............................ $ - $ - $6,533 ========= ========= ========= Issuance of common stock in connection with acquisition.............................. $5,980 $ - $ - ========= ========= =========
The accompanying notes are an integral part of these consolidated financial statements.
CENTURA SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Nature of operations and summary of significant accounting policies: Nature of operations
We develop, market and support software products, including embedded databases and application development environments. We offer products through a combination of direct sales and sales channels, which consist of system integrators, independent software vendors and distributors. We derive the majority of our product revenues from our embedded database products. Our customers are located primarily in North America and Europe.
Summary of significant accounting policies:
Basis of consolidations The consolidated financial statements include the financial statements of the parent company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
In May 1999, we reincorporated the company in the State of Delaware, as authorized by our stockholders. We are authorized to issue 60,000,000 shares of $0.01 par value common stock and 2,000,000 shares of preferred stock at no par value. The board of directors has the authority to issue the undesignated preferred stock in one or more series and to fix the rights, preferences, privileges and restrictions. Share and per share information for each of the three years in the period ended December 31, 1999 has been retroactively adjusted to reflect the reincorporation.
Use of estimates In order to prepare these financial statements under the guidelines of generally accepted accounting principles, we are required to make estimates and assumptions that affect:
the reported amounts of assets and liabilities;
disclosure of contingent assets and liabilities at the date of the financial statements;
revenues and expenses during the period reported.
Actual results could differ materially from estimates. Estimates are used in accounting for allowance for uncollectable receivables, sales returns, depreciation and amortization, taxes, restructuring accruals and contingencies.
Foreign currency translation Operations outside the United States prepare financial statements in their local currencies. The results of operations and cash flows are translated at average exchange rates during the period, and assets and liabilities are translated at end of period exchange rates. Translation adjustments are included as a separate component of accumulated other comprehensive loss in stockholders' equity. Gains and losses from foreign currency-denominated transactions recorded as part of our U.S. operations are included in other income (expense) and are not significant.
Cash and cash equivalents
We consider all highly liquid investments with original maturities of three months or less to be cash equivalents.
Fair value of financial instruments Our financial instruments, including cash, cash equivalents, accounts receivable, and accounts payable are carried at cost, which approximates their fair value because of the short-term maturity of these instruments. Capital lease obligations are carried at cost, which approximates fair value due to the proximity of the implicit rates of these financial instruments and the prevailing market rates for similar instruments.
We use foreign currency exchange contracts to manage and reduce our foreign currency exchange risk by generating cash flows which offset the cash flows of certain transactions in foreign currencies. Our financial instruments are not entered into for the purposes of trading or speculation. We generally do not require collateral to support our financial instruments. At December 31, 1999, we had $5.4 million in forward contracts denominated in four European currencies; German Deutsche Marks, British Pounds Sterling, Netherland Guilders, and Italian Lire, as well as the Australian Dollar. Unrealized gains and losses resulting from the impact of currency exchange rate movements on forward exchange contracts designated to offset certain non-U.S. dollar denominated assets are recognized as other income or expense in the period in which the exchange rates change and offset the foreign currency losses and gains on the underlying exposure.
Concentration of credit risk We are potentially subject to concentration of credit risk as we hold financial instruments such as cash, cash equivalents, consisting of demand accounts and money market accounts and accounts receivable. Concentrations of credit risk with respect to trade receivables are limited as we have a large number of customers that are spread across many industries and locations. We generally do not require collateral for our receivables and we maintain allowances for potential credit losses, which to date have been within management's estimates.
Our forward foreign exchange contracts contain market and credit risk not recognized in the consolidated financial statements. The market risk associated with these instruments resulting from currency exchange rate movements is expected to offset the market risk of the underlying transactions and assets. The credit risk is that our banking counterparties may be unable to meet the terms of the agreements. The potential risk of loss with any one party resulting from this type of credit risk is monitored. We do not expect any loss as a result of default by other parties. However, there can be no assurances that we will be able to mitigate market and credit risks as described above.
Property and equipment Property and equipment are stated at cost. Depreciation is calculated using the straight-line method over the estimated useful life of three years for computer equipment and five years for furniture and fixtures. Leasehold improvements are amortized over the life of the lease or the estimated useful life of five years, whichever is shorter.
For the year ended December 31, 1999 depreciation expense recorded was $2.0 million, for the year ended December 31, 1998 depreciation expense recorded was $1.7 million and for the year ended December 31, 1997 depreciation expense recorded was $2.4 million. Goodwill and purchased intangible assets
Goodwill represents the excess of the purchase price over the fair value of identifiable net assets acquired in our business combination accounted for as a purchase. We amortize goodwill on a straight-line basis over the period of future benefit of five years. The value attributed to acquired products and workforce from the business combination is being amortized on a straight line basis over the periods of future benefit of five years for acquired products and three years for the workforce.
Impairment of long-lived assets We evaluate the recoverability of long-lived assets whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. In the event the net book value of the long-lived asset exceeds the future undiscounted cash flows attributable to the assets, we recognize a loss.
Capitalized software development costs Engineering and product development costs are charged to expense as incurred. The costs incurred for development of computer software that will be sold, leased or otherwise marketed, however, are capitalized after the point in time that technological feasibility has been established. Costs that are capitalized include direct labor and related overhead.
Software development costs capitalized were $518,000 for the year ended December 31, 1999, $664,000 for the year ended December 31, 1998 and $1,018,000 for the year ended December 31, 1997.
Amortization of capitalized software development costs begins when the product is available for general release. Amortization is provided on a product- by-product basis using a straight-line method over the greater of the ratio of current revenues to total projected revenues or the remaining estimated economic life of the product, not exceeding three years. Unamortized capitalized software development costs determined to be in excess of net realizable value of the product are expensed immediately.
Amortization and adjustments are included in cost of product revenues and amounted to $1,025,000 for the year ended December 31, 1999, $1,695,000 for the year ended December 31, 1998 and $2,671,000, for the year ended December 31, 1997.
Revenue recognition Our revenue is derived from primarily two sources, across many industries: (1) product license revenue, derived primarily from product sales to resellers and end users, including large scale enterprises, and royalty revenue, derived primarily from initial license fees and ongoing royalties from product sales by Original Equipment Manufacturer, or OEMs; and (2) service and support revenue, derived primarily from providing software updates, support, training, and consulting services to end users.
We adopted the provisions of Statement of Position, or SOP 97-2, "Software Revenue Recognition" as amended by SOP 98-4, "Deferral of the Effective Date of Certain Provisions of SOP 97-2", effective January 1, 1998. We also adopted SOP 98-9, "Modification of SOP 97-2, Software Revenue Recognition With Respect to Certain Transactions", in the first quarter of 1999. Prior to 1998, we recognized revenue under SOP 91-1, "Software Revenue Recognition". Under SOP 97-2 and SOP 98-9, we recognize product revenue upon shipment if a signed contract exists, the fee is fixed and determinable, collection of resulting receivables is probable and product returns are reasonably estimable. For certain sales where the licensing fee is not due until the customer deploys the software, revenue is recognized when the customer reports to us that the software has been deployed. Estimated product returns are recorded upon recognition of revenue from customers having rights of return and are based on our historical experience with these customers. In 1997, our revenue recognition policy for licensing fees was the same as set forth above.
For contracts with multiple obligations (e.g. deliverable products, maintenance and other services), we allocate revenue to the undelivered components of the contract based on objective evidence of its fair value, which is specific to us, or for products not yet being sold separately, the price established by management. We recognize revenue allocated to undelivered products when the criteria for product revenue set forth above are met. We recognize revenue from maintenance fees for ongoing customer support and product updates ratably over the period of the maintenance contract. Payments for maintenance fees are generally made in advance and are non-refundable. For revenue allocated to training and consulting services, or derived from the separate sales of these services, we recognize revenue as the related services are performed. When services are deemed essential to acceptance of the software being delivered, we defer revenue and recognize it over the period of the engagement on a percentage-of-completion basis, primarily based on labor hours incurred. In 1997, our revenue recognition policy for training, consulting and support services was the same as set forth above.
We recognize product revenue from royalty payments from OEMs as product is sold and reported to us.
Net Income (loss) per common share Basic net income (loss) per common share is calculated by dividing the net income by the weighted average number of shares of common stock outstanding during the period. Diluted net income (loss) per share is calculated by dividing net income (loss) by the weighted average number of shares of common stock outstanding plus all additional common stock equivalents that would have been outstanding if potentially dilutive securities or common stock equivalents were converted into shares of common stock. Common stock equivalents consist of mandatorily redeemable convertible preferred stock, stock options and warrants. Common stock equivalents are excluded from the calculation if their effect is antidilutive.
The following table reconciles the number of shares used in the net income (loss) per share calculations:
Years Ended December 31, --------------------------------- 1999 1998 1997 ---------- ---------- ----------- (in thousands, except per share data)
Net income (loss)....................... ($3,225) $2,115 ($649) ========== ========== =========== Shares calculation: Weighted average basic shares outstanding........................... 33,066 27,390 15,439 Effect of dilutive securities........... - 386 - ---------- ---------- ----------- Total shares used to compute diluted net income (loss) per share............ 33,066 27,776 15,439 ========== ========== ===========
Net income (loss) per basic share........ ($0.10) $0.08 ($0.04) ========== ========== ===========
Net income (loss) per diluted share...... ($0.10) $0.08 ($0.04) ========== ========== =========== Antidilutive common stock equivalents at period end: Warrants............................. 1,860 2,686 100 Options.............................. 7,895 5,730 3,955 Mandatorily redeemable convertible preferred stock..................... 2,299 - - ---------- ---------- ----------- 12,054 8,416 4,055 ========== ========== ===========
In periods were we have reported a loss or in cases where stock options, warrants and mandatorily redeemable convertible preferred stock have an exercise price greater than the average market price of the common shares for the period, they are excluded from the earnings per share calculation as they are antidilutive.
Stock-based compensation We account for employee stock options in accordance with Accounting Principles Board, APB Opinion No. 25, "Accounting for Stock Issued to Employees". Under APB 25 we do not recognize any compensation expense related to employee stock options, as no options are granted at a price below the market price on the day of the grant.
We also comply with the disclosure provisions of Statement of Financial Accounting Standards, or FAS No.123, "Accounting for Stock- Based Compensation" which allows us to continue to apply APB 25 as long as certain pro forma disclosures are made that assume application of the fair value method under FAS 123. You should read note 9 for the pro forma disclosures required by FAS 123 and additional information on our stock option plans.
We account for stock issued to non-employees in accordance with the provisions of FAS 123 and Emerging Issues Task Force, or EITF 96-18, "Accounting for Equity Instruments That Are Issued for Acquiring, or in Conjunction With Selling, Goods or Services".
Advertising expense
We expense the costs of producing advertisements at the time production occurs, and expense the cost of communicating the advertising in the period in which the advertising space is used. Advertising expenses totaled $1.4 million for year ended December 31, 1999, $2.1 million for the year ended December 31, 1998 and $2.2 million for the year ended December 31, 1997.
Comprehensive income Comprehensive income (loss) is comprised of net income (loss) and other comprehensive earnings such as our foreign currency translation gain (loss). The foreign currency translation adjustments are not currently adjusted for income taxes as they relate to indefinite investments in non-United States subsidiaries.
Recent accounting pronouncements In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin, or SAB No. 101, "Revenue Recognition in Financial Statements". SAB 101 provides guidance for revenue recognition under certain circumstances. The staff accounting bulletin is effective no later than the second quarter of our fiscal year 2000. We are currently reviewing the effect SAB 101 will have on our consolidated results of operations, financial position and cash flows.
In June 1998, the Financial Accounting Standards Board, or FASB, issued FAS No. 133, "Accounting for Derivative Instruments and Hedging Activities". FAS 133 establishes accounting and reporting standards for derivative instruments and for hedging activities. It requires us to measure all derivatives at fair value and to recognize them on the balance sheet as an asset or liability, depending on our rights or obligations under the applicable derivative contract. In July 1999, the FASB issued FAS No. 137 that deferred the effective date of adoption of FAS 133 for one more year. We will adopt FAS 133 no later than the third quarter of fiscal year 2000. We are currently reviewing the effect of FAS 133 on our consolidated results of operations, financial position or cash flows.
Reclassifications Certain prior year amounts have been reclassified to conform to the 1999 presentation.
Note 2. Acquisition:
On June 7, 1999 we acquired Raima Corporation. We issued 5.8 million shares of Centura common stock in exchange for all the outstanding shares and stock options, all of which were vested, of Raima Corporation. Each of these Raima shares was converted to 0.768 shares of Centura common stock. This acquisition was accounted for using the purchase method of accounting. As such, results of operations have been included in the consolidated financial statements since the date of the acquisition. The total purchase price of $7.6 million is allocated to assets acquired, including tangible and intangible assets and liabilities assumed, based on their respective estimated fair values at the date of acquisition. The estimate of fair value of the net assets acquired is based on an independent appraisal and management estimates. The purchase consideration included 5.8 million shares valued at approximately $6.0 million, using the average stock price of our stock two days prior, the day of and two days after the consummation date, $0.3 million of cash payable to former Raima shareholders as certain financial conditions were met at the time of the acquisition and acquisition costs, including financial advisory and legal fees and other direct transaction costs, of $1.3 million.
The total purchase price is allocated as follows:
Amortiza- Fair tion value period --------- --------- (in millions) (years) Net assets.............................. $1.2 n/a Acquired products....................... 2.7 5 Acquired workforce...................... 0.7 3 Goodwill................................ 3.0 5 --------- Total purchase price.................... $7.6 =========
The following table shows unaudited pro forma information as if Centura and Raima had been combined as of the beginning of the periods presented. This unaudited pro forma data is presented for illustrative purposes only and is not necessarily indicative of the combined financial position or results of operations of future periods or the results that actually would have resulted had we been a combined company with Raima for the entire specified periods. The unaudited pro forma results include the effects of the amortization of the intangible assets stemming from the purchase price allocation.
Year Ended December 31, --------------------- 1999 1998 ---------- ---------- (in thousands, except per share data)
Net revenue.................................. $55,855 $62,081 ========== ========== Net income (loss)............................ (3,291) 624 ========== ========== Basic income (loss) per share................ $0.09 $0.02 ========== ========== Basic weighted average common shares......... 35,591 33,190 ========== ========== Diluted net income (loss) per share.......... $0.09 $0.02 ========== ========== Diluted weighted average common shares....... 35,591 33,576 ========== ==========
Note 3. Balance sheet detail: Allowance for doubtful accounts consists of the following:
December 31, -------------------------------- 1999 1998 1997 ---------- --------------------- (in thousands)
Balance at beginning of period........ $1,195 $1,265 $1,140 Charged to costs and expenses......... 195 - 530 Deductions............................. (259) (70) (405) ---------- ---------- ---------- $1,131 $1,195 $1,265 ========== ========== ==========
Allowance for sales returns and other allowances consists of the following:
December 31, -------------------------------- 1999 1998 1997 ---------- --------------------- (in thousands)
Balance at beginning of period. ....... $126 $356 $1,686 Credited to costs and expenses......... (15) (209) (343) Deductions............................. (33) (21) (987) ---------- ---------- ---------- $78 $126 $356 ========== ========== ==========
Property and equipment, net consists of the following:
December 31, --------------------- 1999 1998 ---------- ---------- (in thousands)
Computer equipment...................... $19,855 $17,261 Furniture and fixtures.................. 1,737 2,024 Leasehold improvements.................. 1,975 2,105 ---------- ---------- 23,567 21,390 Less: accumulated depreciation and amortization.......................... (20,026) (18,502) ---------- ---------- $3,541 $2,888 ========== ==========
Goodwill, net consists of the following:
December 31, --------------------- 1999 1998 ---------- ---------- (in thousands)
Goodwill................................ $3,033 $ - Less: accumulated amortization.......... (339) - ---------- ---------- $2,694 $ - ========== ==========
Capitalized software, net consists of the following:
December 31, --------------------- 1999 1998 ---------- ---------- (in thousands)
Internally developed software........... $8,324 $7,806 Purchased software...................... 3,852 3,852 ---------- ---------- 12,176 11,658 Less: accumulated amortization.......... (11,141) (10,116) ---------- ---------- $1,035 $1,542 ========== ==========
Other intangible assets, net consists of the following:
December 31, --------------------- 1999 1998 ---------- ---------- (in thousands)
Acquired workforce...................... $670 $ - Acquired products....................... 2,670 - Other................................... 961 903 ---------- ---------- 4,301 903 Less: accumulated amortization.......... (615) (133) ---------- ---------- $3,686 $770 ========== ==========
Deferred revenue consists of the following:
December 31, --------------------- 1999 1998 ---------- ---------- (in thousands)
Deferred product revenue................ $1,484 $4,602 Deferred support revenue................ 12,439 8,672 ---------- ---------- $13,923 $13,274 ========== ==========
Note 4. Short-term borrowings: In January 1998, we entered into a $5.0 million asset based loan facility with Coast Business Credit. This loan facility allows us to borrow up to $5.0 million, collateralized by our accounts receivable, combined with a $0.5 million capital equipment facility. Under the terms of the agreement the loan balance is limited to the lower of $5.0 million or 70% of our eligible receivables derived from customers located in the United States plus 60% of our eligible receivables derived from customers outside the United States, with advances against account debtors located in the United Kingdom and the European continent limited to $1.0 million each. The facility bears interest at a rate of 2.25% above the Bank of America Reference Rate, and provided for the ability to reduce interest costs based on the achievement of certain financial covenants. The facility matured in January 2000 and we had the option to extend the agreement for one year at our discretion.
At December 31, 1999, we had drawn $3.3 million on the loan facility and were paying an interest rate of 2.25% above the Bank of America Reference Rate or 10.75%.
In February 2000, we declined the option to extend the original agreement for an additional year and instead renegotiated the terms of the $5.0 million asset based loan facility with Coast Business Credit. Under this amended agreement, we continue to borrow up to $5.0 million, collateralized by our accounts receivable, combined with a $0.5 million capital equipment facility. The loan balance is now limited to the lower of $5.0 million, or 85% of our eligible receivables derived from customers located in the United States and the United Kingdom, plus 25% of our eligible receivables derived from approved customers located outside the United States and the United Kingdom. The interest rate is reduced to 2.0% above the Bank of America Reference Rate, with provisions for a reduced interest rate if we achieve certain financial covenants. This agreement matures at the end of January 2002, at which time we have the option to renew the agreement for an additional one-year term. If we chose to terminate this agreement prior to January 2002, we will incur an early termination fee of $50,000.
Note 5. Restructuring charges: In June 1999 we completed the acquisition of Raima Corporation, see note 2 for further information. At the time of the Raima acquisition we established a $0.6 million accrual for anticipated charges related to employee separation and the termination of exclusive distribution agreements for Raima products. During 1999, $0.2 million of charges related to separation of approximately 30 employees have been charged to the accrual and at December 31, 1999, $0.4 million of anticipated charges related to exiting exclusive distribution agreements is included in other current liabilities.
In 1997, we incurred $1.5 million of charges related to our restructuring efforts following the termination of our non-exclusive distribution agreement with Infospinner. These charges included the write-off of $0.6 million of prepaid distribution royalties and $0.5 million of other assets in connection with this terminated agreement, and $0.4 million of severance costs. Offsetting these charges was a $0.5 million reversal of existing restructuring reserves, originally recorded in 1995. We paid all remaining obligations related to these charges during 1998.
Note 6. Long-term debt: In February 1998, Computer Associates, Inc., and Newport Acquisition Company, LLP entered into a Note Purchase and Sale Agreement (which we agreed to). Centura and Newport Acquisition Company then entered into a Note Conversion Agreement whereby a promissory note, plus accrued interest, in the amount of $12,251,000, payable to Computer Associates was acquired by Newport Acquisition Company, and immediately converted into 11,415,094 shares of Centura common stock.
Note 7. Mandatorily redeemable convertible preferred stock: In December 1999, we completed a private placement of 12,500 shares of our Series A Preferred Stock resulting in net proceeds of $11.2 million, after deducting expenses associated with the offering.
Of the $11.2 million of net value ascribed to the private placement, $8.8 million has been allocated to the preferred stock, $1.7 million to the option to purchase additional shares of preferred stock, and $0.7 million to the warrants to purchase 214,776 shares of common stock. The net value of the preferred stock is recorded in the balance sheet at year-end as mandatorily redeemable preferred stock. $1.5 million of the net value allocated to the option to purchase additional shares of preferred stock was recorded as mandatorily redeemable convertible preferred stock, as this represents the redemption value of this option at year-end. The remaining $0.2 million is recorded as additional paid-in capital. The net value of the warrants to purchase 214,776 shares of common stock is recorded as additional paid-in capital.
The value of the Rochon warrants of approximately $0.5 million (as discussed in the warrant subtitle in this note) and direct cash costs related to the private placement of approximately $0.8 million were allocated to the fair value of the preferred shares, the option to purchase additional preferred shares (as discussed in the call option subtitle in this note) and the warrants to purchase 214,776 shares of common stock (as discussed in the warrants subtitle in this note) based on each instrument's estimated fair value to the total estimated fair value of all the instruments or $12.5 million.
The rights of the preferred stockholders are summarized below:
Dividends
Each share of Preferred Stock shall be entitled to receive cumulative annual dividends at the rate of 4.5% per annum. Such dividends are due and payable in-kind quarterly in arrears on the last day of March, June, September and December of each year commencing on March 31, 2000. Dividends accumulate daily on each share of Preferred Stock, whether or not declared, until each such share of Preferred Stock has been converted or redeemed. To the extent dividends are not paid on the applicable Dividend Payment Date, such dividends shall be cumulative and shall compound quarterly until the date of payment of such dividend. At December 31, 1999 no dividends have been earned or paid.
We are prohibited from declaring a cash dividend until at least 90% of the preferred stock has either been converted to shares of our common stock or redeemed for cash and from declaring a stock dividend within 30 days of December 30, 2005.
Redemption
The preferred stock is redeemable at the option of the holders at a premium, upon the occurrence of events defined in the Certificate of Designation, Preferences and Rights of Series A Cumulative Convertible Preferred Stock (the "Certificate"). Examples of such events are: a change in ownership or voting control of Centura, a delisting of Centura's common stock from the NASDAQ Small Cap or National Market or the inability to register the underlying common stock using Form S-3. The redemption amount differs depending on the nature of the event. For example, in the event of a change in control, the redemption amount is 112.5% of the cumulative face value of the Preferred Stock, outstanding at the time of the event. In the event of a delisting from the NASDAQ Small Cap or National Market, Centura's inability to register the underlying common stock using Form S-3, or other events specified in the Certificate, the redemption premium is 125% of the cumulative face value of the preferred stock, outstanding at the time of the event.
Centura may, at its option, at any time, redeem the outstanding shares of Preferred Stock at a redemption price equal to 121% of the cumulative face value, then outstanding, provided that if Centura chooses to do this it must redeem all of the shares of Preferred Stock then outstanding, including earned but unpaid dividends.
Conversion
The holders of the Preferred Stock can convert shares of preferred stock into Centura common stock in whole or in part at any time, subject to certain restrictions that are described in the Certificate. The number of shares of common stock available to the holders of the preferred stock is determined by dividing the face value of any preferred stock to be converted by $5.82.
Centura may, at its option and sole discretion, on any date beginning 10 trading days after a registration statement on Form S-3 has become effective and ending on October 30, 2000, can require that some or all of the outstanding shares of Preferred Stock be converted into shares of Centura common stock. In this case, the number of shares of Centura common stock available to the holders of the Preferred Stock is determined by dividing the face value of any preferred stock to be converted by the lesser of $5.82, or the lowest of the daily weighted average trading prices on the NASDAQ Small Cap or National Market 10 days prior to the conversion date.
Voting
The preferred stock has no voting rights.
Accretion
We will accrete to 125% of the face value of the preferred stock over 150 days, the shortest period for which an event that is out of our control could trigger redemption by the holders of the preferred stock. This accretion will have an impact on our net income (loss) per share calculation in the future.
Call option
The purchasers of the 12,500 Preferred Shares also received a call option to purchase additional Preferred Shares in certain circumstances. This call option was valued at $1,863,000 using a risk free rate of 5.95% and a volatility factor of 90%. The call option expires on March 30, 2001.
Under the terms of the call option, the purchasers of the Preferred Shares have a 90-day window from December 31, 2000 to March 30, 2001 to purchase up to 6,000 additional Preferred Shares at $1,000 per share, with the same rights and preferences as the original preferred shares issued. The call option can only be exercised if the value of their initial preferred stock holding declines by at least $1.0 million and then only to such an extent that the purchasers cannot hold more than the original 12,500 of preferred stock at any point in time. Such a decline could occur when the preferred shares are converted to shares of common stock or the preferred stock is redeemed.
The additional preferred shares from the call option have a maximum conversion price of $5.82 that could result in the potential issuance of 1,031,000 shares of common stock. The provisions applicable to the issuance of the initial preferred stock also apply to the call option.
Warrants
In addition to the above mentioned call option the purchasers of the 12,500 Preferred Shares also received warrants to purchase 214,776 shares of common stock, at an exercise price of $5.82 per share. These warrants were valued at $763,000, as discussed in note 10.
Also related to this transaction, in consideration for services rendered in relation to the issuance of the preferred stock the placement agent, Rochon Capital Group, LLP received warrants to purchase 133,958 shares of common stock at an exercise price of $4.67 per share. These warrants were valued at $498,000 as discussed in note 10 and are included in the expense deducted from the gross proceeds received.
Note 8. Leases and lease commitments: We lease certain office space and equipment. The table below presents future minimum rental commitments under noncancelable leases (in thousands) as at December 31, 1999:
Capital Operating Leases Leases ---------- ---------- 2000.................................... $485 $3,348 2001.................................... 485 3,052 2002.................................... - 2,380 2003.................................... - 908 2004.................................... - 778 Thereafter.............................. - 122 ---------- ---------- Total minimum lease obligations....... 970 $10,588 ========== Less: Amount representing interest...... (76) ---------- Present vale of minimum lease obligations 894 Less: Current portion.................... (430) ---------- Capital lease obligations, non current... $464 ==========
Rent expense was $2,368,000 for the year ended December 31, 1999, $3,542,000 for the year ended December 31, 1998 and $3,235,000 for the year ended December 31, 1997.
We lease approximately 48,000 square feet of office, development and warehousing space in facilities in Redwood Shores, California, of which 50% was sublet in September 1998 for the remaining term of our lease, until August 2002. Rental income related to this sublease is expected to be approximately $841,000 for each year ended December 31, 2000 and 2001 and approximately $561,000 for the year ended December 31, 2002.
Property and equipment at December 31, 1999 includes a capital equipment lease for $1.3 million which had a related accumulated amortization of $433,000 at December 31, 1999.
Note 9. Stock-based compensation: Stock option plans We have stock-based compensation plans under which outside directors, officers, employees and consultants can receive stock options.
The options are exercisable in installments beginning one year from the date of grant and expire 10 years after the date of the grant. The options generally vest over a three year period with a one year cliff vest for the first year and then monthly vesting thereafter. The plans generally permit the issuance of either incentive stock options or non-qualified stock options. Unexercised options generally expire three months after termination of employment.
During 1997 we granted holders of stock options the opportunity to exchange previously granted stock options for new stock options exercisable at $1.50 per share, the fair market value of common stock on the date of exchange. The remaining original terms of the stock options were not changed. In 1997, 2,844,000 options were exchanged in the repricing.
The following table presents the status of our stock options and related transactions for the years presented:
Option Shares ------------------------ Weighted Average Available Outstanding Exercise Price ----------- ------------ --------------- (in thousands, except per share data) Balances at December 31, 1996..... 1,550 2,835 $5.65 Shares authorized................. 1,500 - - Shares discontinued............... (545) - - Options granted................... (5,382) 5,382 $2.00 Options exercised................. - (472) $1.43 Options canceled.................. 3,790 (3,790) $4.90 ----------- ------------ Balances at December 31, 1997..... 913 3,955 $1.92 Shares authorized................. 2,915 - - Shares discontinued............... (266) - - Options granted................... (3,792) 3,792 $1.69 Options exercised................. - (69) $1.48 Options canceled.................. 1,219 (1,219) $2.38 ----------- ------------ Balances at December 31, 1998..... 989 6,459 $1.70 Shares authorized................. 3,200 - - Shares discontinued............... (222) - - Options granted................... (4,308) 4,308 $1.63 Options exercised................. -- (1,017) $1.59 Options canceled.................. 1,855 (1,855) $1.58 ----------- ------------ Balances at December 31, 1999..... 1,514 7,895 $1.70 =========== ============
The following table summarizes the status of stock options outstanding and exercisable at December 31, 1999:
Options Outstanding Options Exercisable ------------------------------------ ---------------------- Number Weighted- Number Outstanding Average Weighted- Exercisable Weighted- at Remaining Average at Average Range of December 31, Contractual Exercise December 31, Exercise Exercise Prices 1999 Life (Years) Price 1999 Price ------------------- ------------ ------------ ---------- ----------- ---------- (shares in thousands) $0.50 to $1.03..... 3,694 9.38 $0.98 497 $1.02 $1.25 to $1.91..... 3,077 7.49 $1.79 2,298 $1.83 $2.03 to $10.75.... 1,124 9.36 $3.83 196 $2.11 ------------ ----------- 7,895 8.64 $1.70 2,991 $1.72 ============ ===========
At December 31, 1998, there were 1,948,000 options exercisable at a weighted average exercise price of $1.70 and at December 31, 1997, there were 943,000 options exercisable at a weighted average exercise price of $2.02.
In 1992 we established an Employee Stock Purchase Plan or ESPP. Under the terms of the ESPP eligible employees may have up to 10% of eligible compensation deducted from their pay to purchase common stock. The per share purchase price is 85% of the lower of the opening or closing per share trading price of common stock on the NASDAQ Small Cap Market during a predetermined 3 month period. In 1997, 132,000 shares were purchased under the ESPP. No shares were purchased during the years ended December 31, 1999 or 1998. At December 31, 1999, there are 1,006,000 shares available for purchase under the ESPP.
Centura has a Savings Plan as allowed under Section 401(k) of the Internal Revenue Code. This plan provides employees with tax deferred salary deductions, Company matching contributions up to limited amounts and a number of investment options. The Plan allows for contributions by Centura as determined annually by the Board of Directors. We have not contributed to the Plan since its inception.
Pro forma fair value disclosures Had we recognized compensation expense for the above stock option plans based on the fair value on the grant date under the methodology prescribed by FAS 123, our results from operations and earnings per share for the three years ended December 31, 1999 would have been impacted as shown in the following table:
Years Ended December 31, ----------------------------- 1999 1998 1997 --------- --------- --------- (in thousands, except per share data) Net income (loss): As reported....................... ($3,225) $2,115 ($649) Pro-forma......................... ($6,135) ($2,349) ($5,512) Basic net income (loss) per share: As reported....................... ($0.10) $0.08 ($0.04) Pro-forma......................... ($0.19) ($0.09) ($0.36) Diluted net income (loss) per share: As reported....................... ($0.10) $0.08 ($0.04) Pro-forma......................... ($0.19) ($0.08) ($0.36)
The fair value of stock options used to compute pro forma net income and income (loss) per share disclosures is the estimated fair value at grant date using the Black Scholes option-pricing model with the following weighted average assumptions:
Years Ended December 31, ----------------------------- 1999 1998 1997 --------- --------- --------- Dividend yield..................... -% -% -% Expected volatility................ 90.00% 62.77% 65.00% Risk-free interest rate............ 5.43% 5.48% 6.20% Expected life (years).............. 2 4 4 Fair value of stock options granted $1.45 $0.93 $0.91
The fair value of the shares granted under the ESPP is considered to have an immaterial impact on this calculation.
Note 10. Capital Stock: As of December 31, 1999, there were 60,000,000 shares of common stock, par value $0.01, authorized.
Warrants We issued warrants to purchase shares of our common stock, in conjunction with certain financing activities, as follows:
Warrants outstanding Date of December 31, Exercise Description Grant Shares 1999 Price Value --------------------------------------- -------------- ---------- ------------ --------- ---------- Pacific Business Funding warrants...... June 1997 100,000 100,000 $2.090 $103,000 Computer Associates warrants........... February 1998 500,000 500,000 1.906 300,000 Rochon Capital Group, Ltd warrants..... February 1998 238,679 - 2.120 141,000 Private placement warrants............. February 1998 582,548 582,548 1.250 n/a(1) Rochon Capital Group, Ltd warrants .... February 1998 71,698 - 2.120 de minimus Newport Acquisition Company warrants(2) June 1998 893,320 246,384 1.810 393,800 Newport Acquisition Company warrants(2) June 1998 300,000 82,744 2.090 155,300 Preferred Stockholder warrants......... December 1999 214,776 214,776 5.850 763,000 Rochon Capital Group, Ltd warrants .... December 1999 133,958 133,958 4.670 498,000 ------------ 1,860,410 ============
(1) See private placement subtitle in this footnote for discussion of accounting for these warrants.
(2) Fair value determined is based on a modified Black-Scholes option pricing model.
In general, we calculate the minimum fair value of all warrants on the date of grant using the Black-Scholes option pricing model, as prescribed by FAS 123 with the following underlying assumptions and other data obtained from the respective warrant contract:
Fiscal Risk-free Year of Interest Description Expiration Volatility rate --------------------------------------- -------------- ---------- ------------ Pacific Business Funding warrants...... 2002 55.00% 6.33% Computer Associates warrants........... 2004 65.00% 5.50% Rochon Capital Group, Ltd warrants..... 2003 65.00% 5.50% Private placement warrants............. 2003 n/a n/a Rochon Capital Group, Ltd warrants .... 2003 65.00% 5.50% Newport Acquisition Company warrants(2) 2003 62.77% 5.51% Newport Acquisition Company warrants(2) 2003 62.77% 5.48% Preferred Stockholder warrants......... 2004 90.00% 6.30% Rochon Capital Group, Ltd warrants .... 2004 90.00% 6.30%
For purposes of the fair value calculation of the warrants, the expected life of the warrants is equal to the term of the warrants.
The expense related to the Pacific Funding Corporation warrants, was included in general and administrative expense in 1997, the year the warrants were granted. The charge for the Computer Associates, Rochon Capital Group, Ltd and Newport Acquisition Company warrants was included in other income (expense) in 1998, the year the warrants were granted. The value for the preferred stockholder warrants is included in the amount allocated for the preferred stock transaction and the charge for the Rochon Capital Group, Ltd warrants was included in the related expenses associated with the issuance of the preferred stock.
Shares reserved for future issuance The following table summarizes shares of common stock reserved for future issuance:
At December 31, --------- (in thousands) Stock option plans........................ 9,409 Employee stock purchase plan.............. 1,006 Preferred stock conversion................ 2,299 Preferred stockholders' call option....... 1,103 Warrants.................................. 1,860 --------- 15,677 =========
The preferred stock conversion and preferred stockholders' call option are explained in note 7.
Private placement
In February 1998, we completed a private placement of 2,330,191 shares of our common stock and warrants to purchase 582,548 shares of our common stock, for net proceeds of approximately $1,898,000. As the warrants were issued to the purchasers of the common stock and the proceeds for each were recorded within common stock and additional paid-in capital, a separate independent valuation was not performed for the warrants.
Shareholder rights plan
In August 1994, we adopted a Shareholder Rights Plan under which one Preferred Share Purchase "Right" was distributed for each outstanding share of common stock. Each Right entitles shareholders to purchase a fraction of a share of Preferred Stock at an exercise price of $60.00 upon certain events. The Rights expire on August 3, 2004, unless earlier redeemed by Centura.
The Rights become exercisable if a person acquires 15% or more of our common stock or announces a tender offer that would result in such person owning 15% or more of our common stock. If the Rights become exercisable, the holder of each Right (other than the person whose acquisition triggered the exercisability of the Rights) will be entitled to purchase, at the Right's then current exercise price, a number of shares of our common stock having a market value of twice the exercise price. In addition, if we were to be acquired in a merger or we sell more than 50% of our assets or earning power, each Right will entitle its holder to purchase, at the Right's then current exercise price, common stock of the acquiring company having a market value of twice the exercise price. The Rights are redeemable by Centura at a price of $.01 per Right at any time within ten days after a person has acquired 15% or more of our common stock.
Note 11. Income taxes:
Income (loss) before income taxes is attributable to the following jurisdictions:
Years Ended December 31, ----------------------------- 1999 1998 1997 --------- --------- --------- (in thousands) Domestic......................... ($2,520) $3,981 $360 Foreign.......................... (571) (1,593) (947) --------- --------- --------- ($3,091) $2,388 ($587) ========= ========= =========
The provision for income taxes on income (loss) before income taxes primarily consists of foreign withholding taxes payable.
The difference between income taxes at the statutory federal income tax rate and income taxes reported in the income statement are primarily the result of foreign withholding taxes. A reconciliation of the income tax provision to the amount computed by applying the statutory federal income tax provision rate to income (loss) before income tax provision is summarized below as follows:
Years Ended December 31, ----------------------------- 1999 1998 1997 --------- --------- --------- Federal statutory rate.............. (34%) 34% (34%) State tax, net of federal impact.... (6%) 6% (6%) Foreign withholding taxes........... 4% 11% 11% Net operating loss not benefited.... 40% (40%) 40% --------- --------- --------- 4% 11% 11% ========= ========= =========
The acquisition of Raima was structured as a tax-free exchange of stock, therefore the differences between the recognized fair values of acquired net assets and their historical tax bases are not deductible for tax purposes. A deferred tax liability of $1,242,000 has been recognized for the differences between the assigned fair values of the intangible assets (excluding goodwill) for book purposes and the tax bases of the assets.
Deferred income taxes result from temporary differences in the recognition of certain expenses for financial and income tax reporting purposes. The net deferred tax asset consisted of the following:
December 31, ------------------- 1999 1998 --------- --------- (in thousands) Deferred tax assets: Net operating losses................. $26,632 $25,961 Nondeductible reserves............... 1,412 983 Credit carryforwards................. 2,339 1,974 Deferred revenue..................... 865 949 Depreciation......................... 1,734 469 --------- --------- Gross deferred tax asset........... 32,982 30,336 Less: valuation allowance............ (31,740) (30,336) --------- --------- Net deferred tax asset............. 1,242 -
Deferred tax liabilities: Non deductible intangible assets..... (1,242) - --------- --------- Total net deferred tax assets.......... $ - $ - ========= =========
As of December 31, 1999, we had net operating loss carryforwards of approximately $74.8 million available to offset future federal taxable income which expire through 2019 and $20.3 million available to offset future state taxes, which expire through 2004. Due to cumulative ownership changes at December 31, 1999 our net operating loss carryforwards will be limited to approximately $11.4 million annually to offset future taxable income. At December 31, 1999 and 1998, a valuation allowance has been recorded for the net deferred tax asset balance due to the uncertainty of our ability to realize the deferred tax asset.
Note 12. Segment information: The table below presents external revenue for groups of similar products:
Years Ended December 31, ----------------------------- 1999 1998 1997 --------- --------- --------- (in thousands)
Embedded databases................. $20,534 $23,459 $24,511 Application development environment...................... 4,934 7,026 10,725 Other tools and connectivity software............ 2,301 2,968 5,478 --------- --------- --------- Total net product revenue.......... $27,769 $33,453 $40,714 ========= ========= =========
No one customer has accounted for more than 10% of consolidated annual revenues.
The following table presents a summary of operations by geographic region:
North Rest of America Europe World Total --------- --------- --------- --------- (in thousands) Year ended December 31, 1999: Total net revenues.............. $22,809 $22,937 $5,284 $51,030 Long lived assets at year end... $10,899 $454 $149 $11,502
Year ended December 31, 1998: Total net revenues.............. $24,534 $24,146 $4,817 $53,497 Long lived assets at year end... $5,590 $676 $77 $6,343
Year ended December 31, 1997: Total net revenues.............. $24,473 $27,650 $5,823 $57,946 Long lived assets at year end... $8,203 $809 $122 $9,134
Revenues have been allocated to geographic regions based primarily upon destination of product shipment.
Note 13. Related party transactions:
We recognized $282,000 of net revenue for the year ended December 31, 1999, from Cam Data Corporation. Our Chief Executive Officer, Scott R. Broomfield has served on the board of directors of Cam Data Corporation, since July 1999.
We recognized revenue of $750,000 for the year ended December 31, 1997, from Computer Associates International, Inc., which held a floating rate subordinated convertible debenture.
Item 9.
Item 9. Change in and Disagreements with Accountants on Accounting and Financial Disclosure
Not applicable.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
Information regarding the executive officers and directors of the Company required by this item is contained in "Part I, Item 1. Directors and Executive Officers of Registrant".
Additional information required by this item is incorporated by reference from the Company's Proxy Statement for the 2000 Annual Meeting of Shareholders to be held June 15, 2000, a copy of which will be filed with the Securities and Exchange Commission no later than 120 days from the end of the Company's last fiscal year.
Item 11.
Item 11. Executive Compensation
Incorporated by reference from the Proxy Statement for the 2000 Annual Meeting of Shareholders to be held June 15, 2000, a copy of which will be filed with the Securities and Exchange Commission.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Incorporated by reference from the Proxy Statement for the 2000 Annual Meeting of Shareholders to be held June 15, 2000, a copy of which will be filed with the Securities and Exchange Commission.
Item 13.
Item 13. Certain Relationships and Related Party Transactions
Incorporated by reference from the Proxy Statement for the 2000 Annual Meeting of Shareholders to be held June 15, 2000, a copy of which will be filed with the Securities and Exchange Commission.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a) The following documents are filed as part of this Report:
(1) Financial Statements. The following financial statements of the Company are contained in Item 8 of this Annual Report on Form 10-K:
1. Report of PricewaterhouseCoopers LLP, Independent Accountants.
2. Consolidated Balance Sheets at December 31, 1999 and 1998.
3. Consolidated Statements of Operations for each of the three years in the period ended December 31, 1999.
4. Consolidated Statements of Shareholders' Equity (Deficit) at December 31, 1999, 1998 and 1997.
5. Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1999.
6. Notes to Consolidated Financial Statements.
(2) Financial Statement Schedules. The following financial statement schedules of the Company for the year ended December 31, 1999, 1998 and 1997 is contained in Item 8 of this Annual Report on Form 10-K:
1. Report of PricewaterhouseCoopers LLP, Independent Accountants. Refer to Item 14(a)(1)1 above.
Schedules not listed above have been omitted because they are either inapplicable or the required information has been given in Management's Discussion and Analysis of Financial Condition and Results of Operations or in the financial statements or the notes thereto.
(3) Exhibits. Refer to Item 14(c) below.
(b) Reports on Form 8-K.
Not applicable.
(b) Exhibits:
Exhibit Number Exhibit Description --------- ------------------------------------------------------- 2.1 Agreement and Plan of Reorganization, dated as of March 15, 1999, by and among the Company, Centura Subsidiary Corporation and Raima Corporation (Incorporated by reference from the Company's Registration Statement on Form S-4, No. 333-77643).
3.1.1 Certificate of Incorporation (Incorporated by reference from the Company's Registration Statement on Form S-4, No. 333-77643).
3.1.2 Certification of Designation, Preferences and Rights of Series A Cumulative Convertible Preferred Stock (Incorporated by reference from the Company's Current Report on Form 8-K filed with the Commission on January 5, 2000).
3.2 Bylaws of the Registrant (Incorporated by reference from the Company's Registration Statement on Form S-4, No. 333-77643).
4.1 Preferred Shares Rights Agreement, dated as of August 3, 1994, between the Company and Chemical Trust Company of California (Incorporated by reference from the Company's Registration Statement on Form 8-A filed with the Commission on August 10, 1994).
4.2 Amendment to Preferred Shares Rights Agreement effective February 27, 1998 (Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.1 Lease Agreement dated February 4, 1992 between the Company and Bohannon Associates (Incorporated by reference from the Company's Registration Statement on Form S-1, No. 33-55566, declared effective by the Commission on February 4, 1993).
10.2 Form of Lease Agreement between the Company and EOP-Northwest Properties, LLC.
10.3 Form of Directors' and Officers' Indemnification Agreement (Incorporated by reference from the Company's Registration Statement on Form S-1, No. 33-55566, declared effective by the Commission on February 4, 1993).
10.4 1986 Incentive Stock Option Plan, as amended, and forms of agreements thereunder (Incorporated by reference from the Company's Registration Statement on Form S-8, No. 33-62194, filed with the Commission on May 5, 1993 and from the Company's Registration Statement on Form S-8, No. 33-83850, filed with the Commission on September 9, 1994).
10.5 1991 United Kingdom Sub Plan and forms of agreements thereunder (Incorporated by reference from the Company's Registration Statement on Form S-1, No. 33-55566, declared effective by the Commission on February 4, 1993).
10.6 1992 Employee Stock Purchase Plan and forms of agreements thereunder, as amended on September 24, 1996 (Incorporated by reference from the Company's Registration Statement on Form S-1, No. 33-55566, declared effective by the Commission on February 4, 1993).
10.7 1992 Directors' Stock Option Plan and forms of agreements thereunder (Incorporated by reference from the Company's Registration Statement on Form S-1, No. 33-55566, declared effective by the Commission on February 4, 1993).
10.8 1996 Executive Officers' Compensation Plan (Incorporated by reference from the Company's Annual Report on Form 10-Q for the year ended December 31, 1995).
10.9 1995 Stock Option Plan and forms of agreements thereunder, as amended on September 24, 1996 (Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996).
10.10 Loan Agreement Secured by Property and Securities dated August 31, 1996 between the Company and Earl and Ann Stahl (Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1995).
10.11 1996 Directors' Stock Option Plan and forms of agreements thereunder (Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996).
10.12 1997 Executive Retention Program (Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1997).
10.13 Lease Agreement, dated October 14, 1996, between Westport Investment and the Registrant (Incorporated by reference from the Company's Quarterly Report on Form 10-Q/A for the quarter ended June 30, 1997).
10.14 Letter Agreement dated November 5, 1997 between the Registrant and Hickey & Hill Incorporated, and form of Nonstatutory Stock Options issued to new Executives (Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.15 Settlement Agreements and Mutual Releases between the Registrant and Sam M. Inman, III and between the Registrant and Earl Stahl (Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.16 Loan and Security Agreement dated January 19, 1998 between the Registrant and Coast Business Credit, a division of Southern Pacific Bank (Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.17 Common Stock and Warrant Purchase Agreement dated February 27, 1998 between the Registrant and certain Purchasers of the Registrant's Common Stock (Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.18 Note Conversion Agreement dated February 27, 1998 between the Registrant and Newport Acquisition Company No. 2, LLC (Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.19 Warrant Purchase Agreement dated February 27, 1998 between the Registrant and Computer Associates International, Inc. (Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.20 Investor Rights Agreement dated February 27, 1998 between the Registrant and Newport Acquisition Company No. 2, LLC (Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.21 Common Stock Purchase Warrants issued to Rochon Capital Group, Ltd. On February 27, 1998 (Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.22 1998 Employee Stock Option Plan and form of Nonstatutory Option Agreements thereunder (Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.23 Amendment to Investor Rights Agreement dated February 27, 1998 between the Registrant and Newport Acquisition Company No. 2, LLC (Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1998).
10.24 Subscription Agreement dated December 30, 1999 by and among the Company, Leonardo, L.P. and Peconic Fund, Ltd. (Incorporated by reference to the Company's Registration Statement on Form S-3, Registration No. 333-95591).
10.25 Registration Rights Agreement dated December 30, 1999 by and among the Company, Leonardo, L.P. and Peconic Fund, Ltd. (Incorporated by reference to the Company's Registration Statement on Form S-3, Registration No. 333-95591).
10.26 Common Stock Purchase Warrant issued to Leonardo, L.P. on December 30, 1999 (Incorporated by reference to the Company's Registration Statement on Form S-3, Registration No. 333-95591).
10.27 Common Stock Purchase Warrant issued to Peconic Fund, Ltd. on December 30, 1999 (Incorporated by reference to the Company's Registration Statement on Form S-3, Registration No. 333-95591).
10.28 Common Stock Purchase Warrant issued to Phillip L. Neiman on December 30, 1999 (Incorporated by reference to the Company's Registration Statement on Form S-3, Registration No. 333-95591).
10.29 Common Stock Purchase Warrant issued to Prateek Sharma on December 30, 1999 (Incorporated by reference to the Company's Registration Statement on Form S-3, Registration No. 333-95591).
21.1 List of Subsidiaries.
23.1 Consent of PricewaterhouseCoopers LLP, Independent Accountants.
24.1 Power of Attorney.
27.1 Financial Data Schedules at December 31, 1999 and for the year ended December 31, 1999.
CENTURA SOFTWARE CORPORATION
SIGNATURES
Pursuant to the requirements of Section 13 and 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
CENTURA SOFTWARE CORPORATION
(Registrant)
Date: March 29, 2000
By:
/s/ SCOTT R. BROOMFIELD
Scott R. Broomfield
President, Chief Eexecutive Officer and Chairman of the Board of Directors
(Principal Executive Officer)
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Scott R. Broomfield, John W. Bowman, Richard Lucien or any one of them, with the power to substitution, his attorney-in-fact and agents, to sign any and all amendments to this Annual Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorney-in-fact, or substitute or substitutes may do or cause to be done by virtue thereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
By: /s/ SCOTT R. BROOMFIELD ------------------------------------------- Scott R. Broomfield, PRESIDENT, CHIEF EXECUTIVE Date: March 29, 2000 OFFICER AND CHAIRMAN OF THE BOARD OF DIRECTORS (PRINCIPAL EXECUTIVE OFFICER)
By: /s/ JOHN W. BOWMAN ------------------------------------------- John W. Bowman, EXECUITIVE VICE PRESIDENT, Date: March 29, 2000 AND CHIEF OPERATING OFFICIER
By: /s/ RICHARD LUCIEN ------------------------------------------- Richard Lucien, SENIOR VICE PRESIDENT, FINANCE Date: March 29, 2000 AND CHIEF FINANCE OFFICER (PRINCIPAL FINANCE AND ACCOUNTING OFFICER)
By: /s/ JACK KING ------------------------------------------- Date: March 29, 2000 Jack King, DIRECTOR
By: /s/ ED BOREY, JR ------------------------------------------- Date: March 29, 2000 Ed Borey, Jr, DIRECTOR
By: /s/ PHILIP KOEN, JR. ------------------------------------------- Date: March 29, 2000 Philip Koen, Jr., DIRECTOR
By: /s/ PETER MICCICHE ------------------------------------------- Date: March 29, 2000 Peter Micciche, DIRECTOR
By: /s/ TOM CLARK ------------------------------------------- Date: March 29, 2000 Tom Clark, DIRECTOR
CENTURA SOFTWARE CORPORATION
INDEX OF EXHIBITS
Exhibit Number Exhibit Description --------- ------------------------------------------------------- 2.1 Agreement and Plan of Reorganization, dated as of March 15, 1999, by and among the Company, Centura Subsidiary Corporation and Raima Corporation (Incorporated by reference from the Company's Registration Statement on Form S-4, No. 333-77643).
3.1.1 Certificate of Incorporation (Incorporated by reference from the Company's Registration Statement on Form S-4, No. 333-77643).
3.1.2 Certification of Designation, Preferences and Rights of Series A Cumulative Convertible Preferred Stock (Incorporated by reference from the Company's Current Report on Form 8-K filed with the Commission on January 5, 2000).
3.2 Bylaws of the Registrant (Incorporated by reference from the Company's Registration Statement on Form S-4, No. 333-77643).
4.1 Preferred Shares Rights Agreement, dated as of August 3, 1994, between the Company and Chemical Trust Company of California (Incorporated by reference from the Company's Registration Statement on Form 8-A filed with the Commission on August 10, 1994).
4.2 Amendment to Preferred Shares Rights Agreement effective February 27, 1998 (Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.1 Lease Agreement dated February 4, 1992 between the Company and Bohannon Associates (Incorporated by reference from the Company's Registration Statement on Form S-1, No. 33-55566, declared effective by the Commission on February 4, 1993).
10.2 Form of Lease Agreement between the Company and EOP-Northwest Properties, LLC. (see page)
10.3 Form of Directors' and Officers' Indemnification Agreement (Incorporated by reference from the Company's Registration Statement on Form S-1, No. 33-55566, declared effective by the Commission on February 4, 1993).
10.4 1986 Incentive Stock Option Plan, as amended, and forms of agreements thereunder (Incorporated by reference from the Company's Registration Statement on Form S-8, No. 33-62194, filed with the Commission on May 5, 1993 and from the Company's Registration Statement on Form S-8, No. 33-83850, filed with the Commission on September 9, 1994).
10.5 1991 United Kingdom Sub Plan and forms of agreements thereunder (Incorporated by reference from the Company's Registration Statement on Form S-1, No. 33-55566, declared effective by the Commission on February 4, 1993).
10.6 1992 Employee Stock Purchase Plan and forms of agreements thereunder, as amended on September 24, 1996 (Incorporated by reference from the Company's Registration Statement on Form S-1, No. 33-55566, declared effective by the Commission on February 4, 1993).
10.7 1992 Directors' Stock Option Plan and forms of agreements thereunder (Incorporated by reference from the Company's Registration Statement on Form S-1, No. 33-55566, declared effective by the Commission on February 4, 1993).
10.8 1996 Executive Officers' Compensation Plan (Incorporated by reference from the Company's Annual Report on Form 10-Q for the year ended December 31, 1995).
10.9 1995 Stock Option Plan and forms of agreements thereunder, as amended on September 24, 1996 (Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996).
10.10 Loan Agreement Secured by Property and Securities dated August 31, 1996 between the Company and Earl and Ann Stahl (Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1995).
10.11 1996 Directors' Stock Option Plan and forms of agreements thereunder (Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996).
10.12 1997 Executive Retention Program (Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1997).
10.13 Lease Agreement, dated October 14, 1996, between Westport Investment and the Registrant (Incorporated by reference from the Company's Quarterly Report on Form 10-Q/A for the quarter ended June 30, 1997).
10.14 Letter Agreement dated November 5, 1997 between the Registrant and Hickey & Hill Incorporated, and form of Nonstatutory Stock Options issued to new Executives (Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.15 Settlement Agreements and Mutual Releases between the Registrant and Sam M. Inman, III and between the Registrant and Earl Stahl (Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.16 Loan and Security Agreement dated January 19, 1998 between the Registrant and Coast Business Credit, a division of Southern Pacific Bank (Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.17 Common Stock and Warrant Purchase Agreement dated February 27, 1998 between the Registrant and certain Purchasers of the Registrant's Common Stock (Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.18 Note Conversion Agreement dated February 27, 1998 between the Registrant and Newport Acquisition Company No. 2, LLC (Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.19 Warrant Purchase Agreement dated February 27, 1998 between the Registrant and Computer Associates International, Inc. (Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.20 Investor Rights Agreement dated February 27, 1998 between the Registrant and Newport Acquisition Company No. 2, LLC (Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.21 Common Stock Purchase Warrants issued to Rochon Capital Group, Ltd. On February 27, 1998 (Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.22 1998 Employee Stock Option Plan and form of Nonstatutory Option Agreements thereunder (Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.23 Amendment to Investor Rights Agreement dated February 27, 1998 between the Registrant and Newport Acquisition Company No. 2, LLC (Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1998).
10.24 Subscription Agreement dated December 30, 1999 by and among the Company, Leonardo, L.P. and Peconic Fund, Ltd. (Incorporated by reference to the Company's Registration Statement on Form S-3, Registration No. 333-95591).
10.25 Registration Rights Agreement dated December 30, 1999 by and among the Company, Leonardo, L.P. and Peconic Fund, Ltd. (Incorporated by reference to the Company's Registration Statement on Form S-3, Registration No. 333-95591).
10.26 Common Stock Purchase Warrant issued to Leonardo, L.P. on December 30, 1999 (Incorporated by reference to the Company's Registration Statement on Form S-3, Registration No. 333-95591).
10.27 Common Stock Purchase Warrant issued to Peconic Fund, Ltd. on December 30, 1999 (Incorporated by reference to the Company's Registration Statement on Form S-3, Registration No. 333-95591).
10.28 Common Stock Purchase Warrant issued to Phillip L. Neiman on December 30, 1999 (Incorporated by reference to the Company's Registration Statement on Form S-3, Registration No. 333-95591).
10.29 Common Stock Purchase Warrant issued to Prateek Sharma on December 30, 1999 (Incorporated by reference to the Company's Registration Statement on Form S-3, Registration No. 333-95591).
21.1 List of Subsidiaries (See page )
23.1 Consent of PricewaterhouseCoopers LLP, Independent Accountants.
24.1 Power of Attorney (See page ).
27.1 Financial Data Schedules at December 31, 1999 and for the year ended December 31, 1999. | 29,602 | 203,130 |
804138_1999.txt | 804138_1999 | 1999 | 804138 | Item 1. Business.
Company Background
We have been a Delaware corporation since May 25, 1999. Prior to this, we were a Maryland corporation that was formed in 1986. We have elected to be treated for United States federal income tax purposes as a real estate investment trust or "REIT." We are a self-administered and self-managed company in the business of owning, acquiring, developing and managing manufactured home communities. As of December 31, 1999, we held interests as owner, ground lessee or mortgage lender (including participating mortgages) in 22 manufactured home communities and two recreational vehicle parks with a total of 4,520 developed homesites (sites with homes in place), 2,510 undeveloped homesites and 180 recreational vehicle sites. In addition, we manage 16 communities for affiliates and third-party owners. Our shares of common stock are listed on the New York Stock Exchange ("NYSE") under the symbol "AIC."
We primarily conduct our business through our subsidiary Asset Investors Operating Partnership and where appropriate its other subsidiary companies (which we collectively refer to as the Operating Partnership). As of December 31, 1999, we owned 85% of the Operating Partnership. The Operating Partnership also owns 27% of the common stock of Commercial Assets, Inc., a publicly-traded REIT that is listed on the American Stock Exchange under the symbol "CAX." Commercial Assets is also engaged in the ownership, acquisition and development of manufactured home communities. In addition to acquiring and managing manufactured home communities for our own account, we also perform these services for Commercial Assets, for which we are paid a management fee by Commercial Assets.
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Our principal executive offices are located at 3410 S. Galena Street, Suite 210, Denver, Colorado 80231 and our telephone number is (303) 614-9400.
Proposed Merger with Commercial Assets
In August 1999, we agreed to merge with Commercial Assets. We agreed to issue 0.4075 shares of our common stock for each share of Commercial Assets common stock. Alternatively, Commercial Assets stockholders may elect to receive $5.75 per share in cash for up to 3,549,868 shares of Commercial Assets common stock with any remaining shares of Commercial Assets common stock receiving 0.4075 shares of our common stock. The merger requires the approval by a majority of our outstanding shares of common stock and two-thirds of the outstanding shares of Commercial Assets common stock. We own 27% of the outstanding shares of Commercial Assets common stock and have agreed to vote these shares in favor of the merger. Commercial Assets' officers and directors and our officers and directors have agreed to elect to receive Asset Investors common stock for all shares of Commercial Assets common stock that they own. The stockholders meetings to vote on the merger are expected to occur during the second quarter of 2000.
Industry Background
A manufactured home community is a residential subdivision designed and improved with sites for the placement of manufactured homes and related improvements and amenities. Manufactured homes are detached, single-family homes which are produced off-site by manufacturers and installed on sites within the community. Manufactured homes are available in a variety of designs and floor plans, offering many amenities and custom options.
Modern manufactured home communities are similar to typical residential subdivisions containing centralized entrances, paved streets, curbs and gutters and parkways. The communities frequently provide a clubhouse for social activities and recreation and other amenities, which may include golf courses, swimming pools, shuffleboard courts and laundry facilities. Utilities are provided by or arranged for by the owner of the community. Community lifestyles, primarily promoted by resident managers, include a wide variety of social activities that promote a sense of neighborhood. The communities provide an attractive and affordable housing alternative for retirees, empty nesters and start-up or single-parent families. Manufactured home communities are primarily characterized as "all age" communities and "adult" communities. In adult communities, as least 80% of the tenants must be at least 55 years old, and in all age communities there is no age restriction on tenants.
The owner of a home in our communities leases from us the site on which the home is located. Typically, the leases are on a month-to-month or year-to-year basis, renewable upon the consent of both parties or, in some instances, as provided by statute. In some circumstances, we offer a 99-year lease to tenants in order to enable the tenant to have some benefits of an owner of real property, including creditor protection laws in some states. These leases can be cancelled, depending on state law, for non-payment of rent, violation of community rules and regulations or other specified defaults. Generally, rental rate increases are made on an annual basis. The size of these rental rate increases depends upon the policies that are in place at each community. Rental increases may be based on fixed dollar amounts, percentage amounts, inflation indexes, or they may depend entirely on local market conditions. We own interests in the underlying land, utility connections, streets, lighting, driveways, common area amenities and other capital improvements and are responsible for enforcement of community guidelines and maintenance. Each homeowner within the manufactured home communities is responsible for the maintenance of his or her home and leased site, including lawn care in some communities.
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The ownership of manufactured home communities, once fully occupied, tends to be a stable, predictable asset class. The cost and effort involved in relocating a home to another manufactured home community generally encourages the owner of the home to resell it within the community.
Financial Information about Industry Segments
We operate in one industry segment, the ownership and management of real estate. See the consolidated financial statements including their notes in Item 8 of this report on Form 10-K.
Growth and Operating Strategies
We measure our economic profitability based on Funds From Operations ("FFO"), less an annual capital replacement reserve of at least $50 per developed homesite. This reserve is management's estimate based on its experience in owning, operating and managing manufactured home communities. We believe that the presentation of FFO, when considered with the financial data determined in accordance with generally accepted accounting principles, provides a useful measure of our performance. However, FFO does not represent cash flow and is not necessarily indicative of cash flow or liquidity available to us, nor should it be considered as an alternative to net income as an indicator of operating performance. The Board of Governors of the National Association of Real Estate Investment Trusts (also known as NAREIT) defines FFO as net income (loss), computed in accordance with generally accepted accounting principles, excluding gains and losses from debt restructuring and sales of property, plus real estate related depreciation and amortization (excluding amortization of financing costs), and after adjustments for unconsolidated partnerships and joint ventures. We calculate FFO beginning with the NAREIT definition and include adjustments for:
o the minority interest in the Operating Partnership owned by persons other than us, o costs we incurred in order to become self-managed, o amortization of property and investment management contracts, and o nonrecurring income, net.
We believe that the presentation of FFO provides investors with measurements which help facilitate an understanding of our ability to make required dividend payments, capital expenditures and principal payments on our debt. Since FFO excludes unusual and nonrecurring expenses as well as depreciation and other real estate related expenses, FFO may be materially different from net income. Therefore, FFO should not be considered as an alternative to net income or net cash flows from operating activities, as calculated in accordance with generally accepted accounting principles, as an indication of our operating performance or liquidity.
FFO is not necessarily indicative of cash available to fund our cash needs, including our ability to make distributions. We use FFO in measuring our operating performance because we believe that the items that result in a difference between FFO and net income do not impact the ongoing operating performance of a real estate company. Also, we believe that other real estate companies, analysts and investors utilize FFO in analyzing the results of real estate companies. Our basis of computing FFO is not necessarily comparable with that of other REITs.
Our primary objective is to maximize stockholder value by increasing the amount and predictability of FFO on a per share basis, less a reserve for capital replacements. We seek to achieve this objective primarily by:
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o improving net operating income from our existing portfolio of manufactured home communities; o acquiring additional communities at values that are accretive on a per share basis; o earning increased management fees as Commercial Assets invests in more manufactured home communities; and o as Commercial Assets' FFO increases, our share of their FFO similarly increases.
Company Policies
Management has adopted specific policies to accomplish our objective of increasing the amount and predictability of our FFO on a per share basis, less a reserve for capital replacements. These policies include:
o selectively acquiring manufactured home communities that have potential long-term appreciation of value through, among other things, rent increases, expense efficiencies and in-park homesite development; o developing and maintaining resident satisfaction and a reputation for quality communities through maintenance of the physical condition of our communities and providing activities that improve the community lifestyle; o improving the profitability of our communities through aggressive management of occupancy, community development and maintenance and expense controls; o using debt leverage to increase our financial returns; o reducing our exposure to interest rate fluctuations by utilizing long-term, fixed-rate, fully-amortizing debt to pay off higher cost, short term debt; o ensuring the continued maintenance of our communities by providing a minimum $50 per homesite per year for capital replacements; o seeking to reduce our exposure to downturns in regional real estate markets by diversifying our portfolio of communities since currently 71% of our properties are in Florida and 17% are in Arizona; and; o recruiting and retaining capable community management personnel.
Future Acquisitions
Our acquisition of interests in manufactured home communities takes many forms. In many cases we acquire fee title to the community. When a community has a significant number of unleased homesites, we seek a stable return from the community during the development and lease-up phase while also seeking to participate in future increased earnings after development is completed and the sites are leased. We seek to accomplish this goal by making loans to development companies in return for participating mortgages that are non-recourse to the borrowers and secured by the property. In general, our participating mortgages earn interest at fixed rates and, in addition, participate in a profits or revenues from the community. This profit participation right generally entitles us to 50% of the net income and cash flow generated by the community.
We believe that acquisition opportunities for manufactured home communities are attractive at this time because of:
o the increasing acceptability of and demand for manufactured homes, as shown by the growth in the number of individuals living in manufactured homes; and o the continued constraints on development of new manufactured home communities.
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We are actively seeking to acquire additional communities on our own behalf and on behalf of Commercial Assets, and we are currently engaged in various stages of negotiations relating to the possible acquisition of a number of communities. The acquisition of interests in additional communities could also result in our becoming increasingly leveraged as we incur debt in connection with these transactions.
When evaluating potential acquisitions, we consider such factors as:
o the location and type of property; o the value of the homes located on the leased land; o the improvements, such as golf courses and swimming pools, at the property; o the current and projected cash flow of the property and our ability to increase cash flow; o the potential for capital appreciation of the property; o the terms of tenant leases, including the potential for rent increases; o the tax and regulatory environment of the community in which the property is located; o the potential for expansion of the physical layout of the property and the number of sites; o the occupancy and demand by residents for properties of a similar type in the vicinity; o the credit of the residents in a community; o the prospects for liquidity through sale, financing or refinancing of the property; o the competition from existing manufactured home communities; o the potential for the construction of new communities in the area; and o the replacement cost of the property.
In order to allocate investments between us and Commercial Assets, the companies have agreed that Commercial Assets will invest at least $50 million of its cash resources in the acquisition of communities before we invest any further cash in the acquisition of communities. Thereafter, the companies will make a determination with respect to each acquisition on a case-by-case basis. As of December 31, 1999, Commercial Assets had invested $70 million in communities (including participating mortgages and real estate joint ventures). Accordingly, the companies are determining acquisitions on a case-by-case basis.
Fees and Earnings from Commercial Assets
We manage Commercial Assets and own 27% of Commercial Assets' common stock. Under the terms of our management agreement with Commercial Assets, we receive the following fees:
o Acquisition Fees equal to 0.5% of the cost of each real estate-related asset acquired by Commercial Assets; o Base Fees equal to 1% per year of the net book value of Commercial Assets' real estate-related assets; o Incentive Fees equal to 20% of the amount by which Commercial Assets' FFO, less an annual capital replacement reserve of at least $50 per developed homesite, exceeds (a) Commercial Assets' average net worth, multiplied by (b) 1% over the ten year United States Treasury rate.
In the third quarter of 1998, Commercial Assets entered the manufactured home community business and began acquiring interests in manufactured home communities identified by us. As of December 31, 1999, Commercial Assets had acquired interests in 12 communities at a cost of $70 million (including participating mortgages and real estate joint ventures). Commercial Assets paid us $565,000 in Base Fees and $205,000 in Acquisition Fees during 1999 and
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$87,000 in Base Fees and $124,000 in Acquisition Fees in 1998. No Incentive Fees were paid by Commercial Assets during 1999 or 1998.
The management agreement has a term of one-year, subject to annual renewal. The management agreement was amended for 1999 to provide that Incentive Fees were based upon Commercial Assets' FFO, less an annual capital replacement reserve of at least $50 per developed homesite, instead of its REIT income. Both your management and Commercial Assets believe that this amendment causes our Incentive Fees to be tied more closely to the economic profitability of Commercial Assets as Commercial Assets is now engaged in the manufactured home community business. Commercial Assets has renewed the management agreement for 2000 with the same terms as those used in 1999. If our merger with Commercial Assets is approved then the management agreement will terminate.
Expansion of Existing Communities
We will seek to increase the number of homesites and the amount of earnings generated from our existing portfolio of manufactured home communities through marketing campaigns aimed at increasing occupancy. We will also seek expansion through future acquisitions and expansion of the number of sites available to be leased to residents if justified by local market conditions and permitted by zoning and other applicable laws. As of December 31, 1999, we held interests in 11 communities with approximately 2,510 undeveloped homesites.
Competition
There are numerous housing alternatives that compete with our manufactured home communities in attracting residents. Our properties compete for residents with other manufactured home communities, multifamily rental apartments, single family homes and condominiums. The number of competitors in a particular area could have a material effect on our ability to attract and maintain residents and on the rents we are able to charge for homesites. In acquiring assets, we compete with other REITs, pension funds, insurance companies, and other investors, many of which have greater financial resources than we do. In addition, Commercial Assets is also involved in acquiring manufactured home communities.
Taxation of the Company
We have elected to be taxed as a REIT under the Internal Revenue Code of 1986, as amended (the "Code"), and we intend to operate in a manner which will allow us to avail ourselves of the beneficial tax provisions applicable to REIT's. Our qualification as a REIT depends on our ability to meet the various requirements imposed by the Code, such as specifications relating to actual operating results, distribution levels and diversity of stock ownership. In addition, our ability to qualify as a REIT depends in part upon the actions of third parties over which we have no control, or only limited influence. For instance, our qualification depends upon the conduct of certain entities with which we have a direct or indirect relationship, in our capacity as a lender, lessor, or holder of non-controlling equity interests. Our qualification also depends upon Commercial Assets' continued qualification as a REIT.
If we qualify for taxation as a REIT, we will generally not be subject to Federal corporate income tax on our net income that is currently distributed to stockholders. This treatment substantially eliminates the "double taxation" (at the corporate and stockholder levels) that generally results from investment in a corporation. If we fail to qualify as a REIT in any taxable year, we will be subject to Federal income tax at regular corporate rates on our taxable income (including any applicable alternative minimum tax). We have a net operating loss ("NOL") carryover of approximately $95 million which may, subject to some
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restrictions and limitations, be used to offset taxable income in the event that we fail to qualify as a REIT. Additionally, even if we qualify as a REIT, we may be subject to certain state and local income and other taxes, and to Federal income and excise taxes on our undistributed income.
If in any taxable year we fail to qualify as a REIT and as a result, incur a tax liability, we might need to borrow funds or liquidate certain investments in order to pay the applicable tax. In this situation, we would not be compelled to make distributions as required for entities claiming REIT status under the Code. Moreover, unless we would be entitled to relief under certain statutory provisions, we would be disqualified from treatment as a REIT for the four taxable years following the year during which qualification is lost. Although we currently intend to operate in a manner designed to qualify as a REIT, it is possible that future economic, market, legal, tax or other considerations may cause us to fail to qualify as a REIT, or may cause the Board of Directors to revoke the REIT election.
We and our stockholders may be subject to state or local taxation in various state or local jurisdictions, including those in which we or they transact business or reside. The state and local tax treatment conferred upon us and our stockholders may not conform to the Federal income tax treatment.
Regulations
General
Manufactured home communities, like other housing alternatives, are subject to various laws, ordinances and regulations, including regulations relating to recreational facilities such as swimming pools, clubhouses and other common areas. We believe that we have obtained the necessary permits and approvals to operate each of our properties in conformity with these laws.
Americans with Disabilities Act
Our current properties and any newly acquired communities must comply with the Americans with Disabilities Act (the "ADA"). The ADA generally requires that public facilities, such as clubhouses, swimming pools and recreation areas be made accessible to people with disabilities. Many of our communities have public facilities. In order to comply with the ADA requirements, we have made improvements at our communities in order to remove barriers to access. If we should ever fail to comply with ADA regulations we could be fined or we could be forced to pay damages to private litigants. We have made those changes required by the ADA which we believe are appropriate, and we believe that our properties are in compliance with the requirements of the ADA. We believe that any further costs related to ADA compliance can be recovered by cash flow from the individual properties without causing any material adverse effect. If ongoing changes involve a greater expenditure than we currently anticipate, or if the changes must be made on a more accelerated basis than we anticipate, our ability to make expected distributions could be adversely affected.
Rent Control Legislation
State and local laws, principally in Florida, might limit our ability to increase rents on some of our properties, and thereby, limit our ability to recover increases in operating expenses and the costs of capital improvements. Enactment of rent control laws has been considered from time to time in jurisdictions in which we operate. We presently expect to maintain manufactured home communities and may purchase additional properties in markets that are either subject to rent control laws or in which such legislation may be enacted.
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Insurance
We believe that our properties are covered by adequate fire, flood and property insurance policies. It is our policy to purchase insurance policies which contain commercially reasonable deductibles and limits from reputable insurers. We also believe that we have obtained adequate title insurance policies insuring fee title to properties we have acquired.
Capital Resources
We have used our available cash balances, our FFO and our long-term and short-term financing arrangements to provide working capital to support our operations, to pay dividends and to acquire assets. Future acquisitions will be financed by the most appropriate sources of capital, perhaps including our available cash balances; undistributed FFO; long-term, secured debt; short-term, secured debt; or the issuance of additional equity securities, including interests in the Operating Partnership. This flexibility allows us to offer more choices of "acquisition currency" to potential sellers of manufactured home communities including the ability to defer some or all of the tax consequences of a sale. We believe that this flexibility may offer sellers an incentive to enter into transactions with us on favorable terms.
Without further stockholder approval, we are authorized to issue up to 50,000,000 shares of common stock. As of March 17, 2000, 5,632,569 shares of common stock were outstanding. The Board of Directors is authorized to issue additional classes of stock (including preferred stock) without stockholder approval. Depending upon the terms set by the Board of Directors, the authorization and issuance of preferred stock or other new classes of stock could adversely affect existing stockholders. Future offerings of stock may result in the reduction of the net tangible book value per outstanding share and a reduction in the market price of the stock. We are unable to estimate the amount, timing or nature of such future offerings as any such offerings will depend on general market conditions or other factors. As of March 17, 2000, we have not authorized or issued additional classes of stock.
Restrictions on and Redemptions of Common Stock
To qualify to be taxed as a REIT, we must comply with certain ownership limitations with respect to shares of our common stock. Our Certificate of Incorporation provides that shares of common stock generally may not be owned by a person if the ownership of shares by such person would exceed 9.8% of our outstanding shares or would result in the imposition of a tax on us.
Our Certificate of Incorporation empowers the Board of Directors, at its option, to redeem shares of common stock or to restrict transfers of shares to comply with the requirements described above. The redemption price we would pay if the Board of Directors exercises this option to redeem shares would be the fair market value of the common stock as reflected in the latest quotations on the New York Stock Exchange. Our Certificate of Incorporation also provides that if anyone acquires shares of our common stock in a manner or in a volume that would result in our disqualification as a REIT under the Code, that acquisition is deemed void to the fullest extent permitted under the law and the acquirer will be deemed never to have had an interest in the shares. Furthermore, if a transaction is determined to be void or invalid, the acquirer may be deemed to have acted as agent on our behalf in acquiring such shares and may be deemed to hold such shares on our behalf.
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Each stockholder is required, upon demand, to disclose to the Board of Directors in writing any information with respect to the direct and indirect ownership of shares of our common stock as the Board of Directors deems necessary or prudent in order to protect our tax status.
Employees
Our employees perform various acquisition and management functions. Brandywine Financial Services Corporation and its affiliates provide our properties with employees that perform property management, maintenance and sales services. Mr. Bruce Moore was the founder and Chief Executive Officer of Brandywine prior to becoming our President and Chief Operating Officer in February 1998. In addition to our 11 employees, approximately 260 Brandywine employees devote their full-time attention to our communities. We reimburse Brandywine for the costs of these employees. None of these employees are represented by a union, and we have never experienced a work stoppage. We believe that we maintain satisfactory relations with our employees. As of January 1, 2000, we acquired Brandywine's interests in the companies which provide property management, maintenance and sales services to our properties. Accordingly, we now have approximately 270 employees.
Item 2.
Item 2. Properties.
The manufactured home communities in which we have interests are primarily located in Florida and Arizona and are concentrated in or around four metropolitan areas. We hold interests in these communities as owner, ground lessee or mortgage lender (including participating mortgages). The following table sets forth the states in which the communities in which we held an interest on December 31, 1999 are located:
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The following table sets forth information as of January 1, 2000 regarding each manufactured home community in which we held an interest and those manufactured home communities which we manage for others:
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Owned Properties. At December 31, 1999, we owned 18 manufactured home communities and two recreational vehicle parks containing approximately 3,990 developed homesites and 180 recreational vehicle sites. These properties contain, on average, 220 homesites, with the largest property containing 380 homesites. These properties offer residents a range of amenities, including swimming pools, clubhouses and tennis courts.
At December 31, 1999, 15 of these properties are encumbered by mortgage indebtedness totaling $53,994,000. These properties represent approximately 87% of our developed homesites. The 15 properties securing our mortgage indebtedness have a combined net book value of $96,184,000 and the indebtedness has a weighted average interest rate of 7.4% and a weighted average maturity of 9.2 years. As of December 31, 1999, 95% of our outstanding debt was long-term and 5% was short-term debt. See the financial statements included elsewhere in this report on Form 10-K for additional information about our indebtedness.
Properties Involving Participating Mortgages. At December 31, 1999, we held $22,475,000 in a participating mortgage involving seven manufactured home communities containing 535 developed homesites and 2,183 undeveloped homesites. The participating mortgage bears interest ranging from 10% to 13% and matures in 2018. Through 2002, interest is payable based on the net cash flow of the secured properties. As additional compensation, we receive 50% of both (a) any profits and net cash flows from the properties in excess of the stated interest rate and (b) any net sales proceeds from the properties in excess of the amount of the mortgage. The mortgage may be prepaid at any time; however, our 50% share of profits and net cash flows continues until the properties are sold. Effective January 1, 2000, we purchased six of the properties securing the mortgage in exchange for the cancellation of $24,851,000 of the participating mortgage and other loans, the payment of $765,000, the issuance of 44,572 units of limited partnership interests in our Operating Partnership valued at $496,000 and the assumption of $10,704,000 of third-party debt.
Item 3.
Item 3. Legal Proceedings.
In September 1999, four Commercial Assets stockholders, individually and as purported representatives of all Commercial Assets stockholders, except us and our affiliates, filed three purported class action lawsuits in the Court of Chancery in the State of Delaware against Commercial Assets, the members of the board of directors and specified officers of us and Commercial Assets. These lawsuits alleged that the defendants breached their fiduciary duties to the Commercial Assets stockholders in connection with our proposed merger with Commercial Assets on the terms then proposed and the recent reincorporation of Commercial Assets from Maryland to Delaware. In October 1999, the plaintiffs filed an amended complaint. In November 1999, the Court of Chancery approved consolidation of these lawsuits as a single lawsuit.
In March 2000, the parties entered into a settlement agreement which will amend the merger agreement in the following respects:
o Commercial Assets stockholders, other than us and the officers and directors of Asset Investors and Commercial Assets, may elect to receive $5.75 per share in cash, subject to proration, for up to 3,549,868 shares of Commercial Assets common stock as opposed to 0.4075 shares of Asset Investors common stock; and o the percentage of votes of the Commercial Assets common stock necessary to approve the merger was increased from a simple majority to two-thirds.
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The settlement agreement is subject to the approval of the Court of Chancery. If approved by the Court of Chancery, the settlement agreement will release the defendants from further liability relating to the merger.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
No matters were submitted to a vote of our stockholders during the fourth quarter of 1999.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.
Our common stock is listed on the NYSE under the symbol "AIC." The high and low closing sales prices of the shares of common stock as reported on the NYSE Composite Tape and certain dividend information for the periods indicated were as follows:
As of March 17, 2000, 5,632,569 shares of common stock were issued and outstanding and were held by 2,198 stockholders of record. We estimate there were an additional 10,000 beneficial owners on that date whose shares were held by banks, brokers or other nominees.
We, as a REIT, are required to distribute annually to stockholders at least 95% of our "REIT taxable income," which, as defined by the Code and Treasury regulations, is generally equivalent to net taxable ordinary income. We measure economic profitability and intend to pay regular dividends to our stockholders based on FFO, less an annual reserve for capital replacements of at least $50 per developed homesite, during the relevant period. The future payment of dividends, however, will be at the discretion of the Board of Directors and will depend on numerous factors including, our financial condition, capital requirements, the annual distribution requirements under the provisions of the Code applicable to REITs, and such other factors as the Board of Directors deems relevant.
On April 20, 1999, 11,500 shares of common stock were issued to non-executive directors in lieu of annual director fees as a private placement of our securities. The $13-1/16 per share value was equal to the closing stock price on April 20, 1999.
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Item 6.
Item 6. Selected Financial Data.
Our selected financial data set forth below has been derived from and should be read in conjunction with our audited consolidated financial statements including their notes. Financial data as of December 31, 1999 and 1998, and for each of the three years in the period ended December 31, 1999, is included elsewhere in this report on Form 10-K.
Operating and Balance Sheet Data (in thousands, except per share data):
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Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
The following discussion and analysis of consolidated results of operations and financial condition should be read in conjunction with our consolidated financial statements included elsewhere in this report. In 1997, we decided to change our business from the ownership of high-risk, residential collateralized mortgage-backed securities to the ownership, acquisition, development and management of manufactured home communities. This decision helped us to avoid the volatility incurred by other owners of these securities following the capital market crisis in the third quarter of 1998. Since May 1997, we have been focused on the investment of our capital in the acquisition of manufactured home communities. We have also been focused on the investment of Commercial Assets' capital in the acquisition of manufactured home communities since August 1998. As of December 31, 1999, Commercial Assets has not yet substantially invested its capital in manufactured home communities.
Inflation
We do not believe that changes in inflation rates would have a material adverse effect on our business. In fact, we believe that inflation may positively impact our business, in light of the fact that manufactured home communities represent a more affordable housing choice for many people than other alternatives available, increased inflation rates may allow us to demand increased rents without losing tenants.
Comparison of 1999 to 1998
Rental Property Operations
Rental and other property revenues from our owned properties totaled $14,987,000 in 1999 compared to $10,479,000 in 1998, an increase of $4,508,000, or 43.0%. The increase consisted of:
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Property operating expenses from our owned properties totaled $5,262,000 in 1999 compared to $4,039,000 in 1998, an increase of $1,223,000, or 30.3%. The increase consisted of:
We refer to properties which we owned throughout both 1998 and 1999 as "same store" properties.
Interest income on participating mortgages was $2,976,000 in 1999 compared to $3,174,000 in 1998. The $198,000 decrease was primarily due to a decrease in the amount invested in these mortgages during 1999.
Depreciation expense increased from $2,685,000 in 1998 to $3,870,000 in 1999 due to acquisitions of manufactured home communities during 1998 and 1999.
Service Operations
During 1999, we earned $207,000 in property management income as compared to $156,000 during 1998. The $51,000 increase is primarily due to an increase in the number of properties that we manage for Commercial Assets.
Fee revenue from managing Commercial Assets was $564,000 in 1999 and $155,000 in 1998. The $409,000 increase is due to Commercial Assets' investments in communities beginning in August 1998. We do not earn fees on cash and short-term investments held by Commercial Assets which is what Commercial Assets primarily held in 1998.
Amortization of management contracts decreased from $2,894,000 for 1998 to $2,757,000 for 1999 due to our acquisition in February 1998 of two communities which we previously managed.
Equity in Earnings of Commercial Assets
Income from our 27% interest in Commercial Assets was $872,000 for 1999 and $975,000 for 1998. Commercial Assets reported to us that its 1999 net income decreased by $917,000 from 1998 primarily due to: (1) $1,229,000 increase in depreciation on acquired manufactured home communities, (2) $559,000 increase in management fees paid to us and (3) $500,000 of nonrecurring expenses in 1998 related to its decision to not invest in marinas; partially offset by $120,000 of nonrecurring expenses in 1999 related to its reincorporation. Due to our 27% interest in Commercial Assets, however, during 1999 and 1998, $205,000 and $56,000, respectively, of the management fees paid by Commercial Assets to us have been reported by us as equity in earnings of Commercial Assets in accordance with generally accepted accounting principles.
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General and Administrative Expenses
Our general and administrative expenses were $1,530,000 in 1999 and $1,393,000 in 1998. The $137,000 increase is primarily due to increases in the number of personnel.
Interest and Other Income
Interest and other income was $241,000 in 1999 and $871,000 in 1998. The $630,000 decrease occurred primarily because prior to June 1998, we had $20 million in cash which we had invested in manufactured home communities by June 30, 1998.
Interest Expense
Interest expense was $3,846,000 during 1999 and $2,485,000 during 1998. The $1,361,000 increase is primarily due to borrowings used to acquire manufactured home communities after June 1998.
Income Tax Benefit
A subsidiary recorded a loss for income tax purposes in 1999. As a result, it can carry back the tax loss for a refund of income taxes paid by the subsidiary in 1997.
Loss from Early Extinguishment of Debt
In 1999, we prepaid a $2.2 million note payable and paid a $75,000 prepayment penalty.
Reincorporation Expenses
In 1999, we incurred $120,000 of nonrecurring expenses related to our reincorporation in Delaware.
Cost Incurred to Acquire Management Contract
In 1998, we issued 120,000 OP Units to our former manager because we achieved certain returns from our investments in manufactured home communities. We expensed in 1998 the $2,092,000 value assigned to the OP Units. We did not have these costs in 1999.
Comparison of 1998 to 1997
Rental Property
Income from rental properties totaled $6,929,000 during 1998 and $1,479,000 during 1997. The $5,450,000 increase between 1997 and 1998 was due to our acquisition of communities during those years. Our first acquisition of manufactured home communities occurred in May 1997, and as of December 31, 1997, we had invested $69 million in 19 communities. During 1998, we had invested an additional $60 million in seven communities.
Service Operations
During 1998, we earned $156,000 in property management income versus $69,000 during 1997. Property management income increased by $87,000 because property management contracts were not acquired until May 1997. Amortization of
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management contracts increased from $744,000 in 1997 to $2,894,000 in 1998 due to our acquisition of property management contracts in May 1997 and our acquisition of the Commercial Assets management agreement in November 1997. Similarly, fee revenue from managing Commercial Assets was $155,000 in 1998 and $0 in 1997.
Equity in Earnings of Commercial Assets
Income from our 27% interest in Commercial Assets for 1998 was $975,000 compared to $3,663,000 for 1997. Prior to November 1997, Commercial Assets received income from a portfolio of collateralized mortgage backed securities. It resecuritized its portfolio in November 1997 and temporarily invested the proceeds in short-term investments while considering alternative investments. Commercial Assets announced that it intended to invest in manufactured home communities in the third quarter of 1998, and as of December 31, 1998, it had invested $23 million in communities. Commercial Assets reported to us that the $10,265,000 decrease in Commercial Assets' net income during 1998 as compared to 1997 was due to: (1) a $3,954,000 decrease as a result of lower yields during 1998 on short-term investments and interests in manufactured home communities compared to yields on collateralized mortgage backed securities during 1997, (2) a $5,786,000 nonrecurring gain on the sale of the bonds recognized in 1997, and (3) a non-recurring $500,000 expense in 1998 related to the cost of investigating marina investments.
Non-agency MBS Bonds
In March 1997, we sold our portfolio of unrated credit support debt interests in non-conforming residential mortgage loan securitizations known as "non-agency MBS bonds" in order to reduce risk associated with this type of investment and to maximize long-term, risk-adjusted returns to stockholders. Consequently, income from non-agency MBS bonds decreased to $50,000 for 1998 compared with $2,966,000 for 1997. Revenues from non-agency MBS bonds subsequent to March 1997 represent income from a residual interest retained from the sale.
General and Administrative Expenses
Our general and administrative expenses were $1,393,000 for 1998 compared to $1,612,000 for 1997. Expenses decreased in 1998 by $219,000 primarily because of (1) $570,000 of management fees to our former manager during 1997 and (2) $100,000 of nonrecurring costs in 1997 related to our reverse stock split. The cost decrease was partially offset by $500,000 in personnel and related expenses incurred in 1998 as a result of our becoming self-administered and self-managed in November 1997.
Interest and Other Income
Interest and other income for 1998 was $871,000 compared to $1,808,000 for 1997. The $937,000 decrease occurred because the proceeds we received in 1997 from the sale of our non-agency MBS bonds were temporarily invested until they were used to acquire manufactured home communities. By June 1998, we had used substantially all of the proceeds to acquire communities.
Interest Expense
Interest expense increased in 1998 by $2,117,000 as compared to 1997 due to borrowings used to acquire manufactured home communities as follows: (1) $479,000 on approximately $11 million of debt assumed in connection with the 1997 acquisitions of four manufactured home communities, (2) $1,288,000 on
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approximately $40 million borrowed in mid-1998 in connection with the acquisition of four additional communities and (3) $382,000 of amortized loan costs related to the 1998 borrowings.
Costs Incurred to Acquire Management Contract
During 1998, we achieved annualized returns before depreciation on certain of our real estate investments in excess of 9% for a period of six months. Pursuant to the November 1997 acquisition of our management contract, we issued 120,000 OP Units to the former manager and recognized a $2,092,000 expense for additional consideration paid to the former manager. During 1997, we recognized $6,553,000 of expense related to the purchase of our management contract.
Gain on Sale of Bonds
In connection with the 1997 resecuritization of our non-agency MBS bonds, a $7,359,000 gain was recognized, reduced by both $1,472,000 of incentive fees paid to our former manager related to the gain and an additional fee of $600,000 incurred in exchange for the former manager agreeing to continue as a loss mitigation advisor on the non-agency MBS bonds. In addition, during the fourth quarter of 1997, we entered into a transaction for the sale of interests in other bonds that had no carrying value on our books. As a result of this transaction, a gain of $1,197,000 was recognized in 1997. We had no gains in 1998.
NOL and Capital Loss Carryovers
At December 31, 1999, our NOL carryover for income tax purposes was approximately $95,000,000 and our capital loss carryover for income tax purposes was approximately $20,000,000. Subject to some limitations, the NOL carryover may be used to offset all or a portion of our REIT taxable income, and as a result, to reduce the amount of income that we must distribute to stockholders to maintain our status as a REIT. The NOL carryover is scheduled to expire between 2007 and 2009 and the capital loss carryover is scheduled to expire in 2000 and 2001.
Dividend Distributions
During 1999, we distributed $6,591,000 ($1.00 per share) to holders of common stock and OP Units compared to 1998 distributions of $4,916,000 ($0.75 per share) and 1997 distributions of $7,749,000 ($1.45 per share). Sixty-eighty percent of 1999 dividends, eighty percent of 1998 dividends and seventy-five percent of 1997 dividends constituted return of capital distributions for federal income tax purposes and are not taxable to the stockholders to the extent of their tax basis in their stock.
LIQUIDITY AND CAPITAL RESOURCES
As of December 31, 1999, we had cash and cash equivalents of $570,000. Our principal activities that demand liquidity include our normal operating activities, payments of principal and interest on outstanding debt, acquisitions of or additional investments in properties, payments of dividends to stockholders and distributions made to limited partners in the Operating Partnership.
Our net cash provided by operating activities was $5,764,000 during 1999 compared to $6,841,000 during 1998. The $1,077,000 decrease was primarily a result of a $1.6 million increase in other assets and a $0.6 million increase in accrued interest on participating mortgages; partially offset by a $1.3 million increase in income before depreciation, amortization, minority interest and non-cash costs incurred to acquire management contracts.
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In 1999, the net cash used in investing activities was $5,410,000, compared with $58,897,000 in 1998. In 1998, we purchased $57,832,000 of manufactured home communities. During 1999, we used only $858,000 to purchase manufactured home communities; however, we invested $5,500,000 in participating mortgages.
Net cash used by financing activities was $1,210,000 in 1999 compared with 1998 in which $31,680,000 was provided by financing activities. In 1998, we borrowed funds in connection with our acquisition of manufactured home communities. In 1999, we did not have significant acquisitions of manufactured home communities. Rather, we borrowed $11 million of long-term debt to refinance short-term and long-term debt and fund $5.5 million of investments in participating mortgages. Also in 1999, we paid dividends and distributions of $1.00 per share and OP Unit. In 1998, we paid $0.75 per share and OP Unit.
We have a line of credit with a bank which matures in September 2000. The line of credit is secured by 1,015,674 shares of our Commercial Assets common stock. Advances under this line of credit bear interest at the 30-day LIBOR rate plus 1.75%. The line of credit is limited to the lesser of (1) $5,000,000, (2) 65% of the product of the trading price of Commercial Assets common stock times 1,015,674 or (3) 65% of the purchase price of certain unpledged real estate. As of December 31, 1999, the limit was $3,053,000 and $2,610,000 was outstanding on this line of credit.
As of December 31, 1999, 88% of our real estate and 65% of our total assets was encumbered by debt. We had total outstanding indebtedness of $56.6 million, all of which was secured by various manufactured home communities or shares of Commercial Assets common stock. Of our indebtedness, $54.0 million, or 95.4%, was secured long-term notes payable and $2.6 million, or 4.6%, was secured short-term financing. As of December 31, 1999, $6.1 million of the secured long-term notes payable and all of the secured short-term financing bears interest at variable rates based on the 30-day London Interbank Offered Rate. The weighted-average interest rate on our secured long-term notes payable was 7.4% at December 31, 1999. The weighted-average interest rate on our secured short-term financing was 7.6% at December 31, 1999. Our secured long-term notes payable had a weighted average maturity of 9.2 years at December 31, 1999.
We expect to meet our long-term liquidity requirements in excess of 12 months through long-term, secured borrowings, the issuance of OP Units and other equity securities and cash generated by operations.
Proposed Merger with Commercial Assets. In August 1999, we agreed to merge with Commercial Assets. We agreed to issue 0.4075 shares of our common stock for each share of Commercial Assets common stock. Alternatively, Commercial Assets stockholders may elect to receive $5.75 per share in cash for up to 3,549,868 shares of Commercial Assets common stock with any remaining shares of Commercial Assets common stock receiving 0.4075 shares of our common stock. Based on the 7,606,903 shares of Commercial Assets common stock not already held by us, we will issue approximately 3,100,000 shares of our common stock if all Commercial Assets stockholders elect to receive shares of our common stock in the merger. If Commercial Assets stockholders elect to receive the maximum amount of cash, then we will issue approximately 1,653,000 shares of our common stock and pay $20,412,000 cash to Commercial Assets stockholders in the merger.
The merger must be approved by a majority of the outstanding shares of our common stock and two-thirds of the outstanding shares of Commercial Assets common stock. We own 27% of the outstanding shares of Commercial Assets common
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stock and have agreed to vote these shares in favor of the merger. The stockholders meetings to vote on the merger are expected to occur in the second quarter of 2000.
At December 31, 1999, we had an investment in Commercial Assets with a recorded amount of $19,486,000. Based on the $13.625 share price of our common stock on August 31, 1999 (the last trading day before the public announcement of the merger), our summary pro forma balance sheet at December 31, 1999 would have been as follows under the two alternatives available to Commercial Assets stockholders. The column titled "All Shares" assumes all Commercial Assets stockholders elect to receive shares of our common stock. The column titled "Shares and Cash" assumes Commercial Assets stockholders elect to receive the maximum amount of cash. All amounts are in thousands.
The source of the funds to be paid to Commercial Assets stockholders who elect to receive cash in the merger (up to a maximum of $20,412,000) is Commercial Assets' $17.2 million of cash and short-term investments at December 31, 1999 and $10.1 million in additional non-recourse, secured long-term notes payable borrowed by Commercial Assets in January 2000. Additional pro forma information at December 31, 1999 would be as follows:
FUNDS FROM OPERATIONS
We measure our economic profitability based on FFO, less an annual capital replacement reserve of at least $50 per developed homesite. We believe that the presentation of FFO, when considered with the financial data determined in
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accordance with generally accepted accounting principles, provides a useful measure of our performance. However, FFO does not represent cash flow and is not necessarily indicative of cash flow or liquidity available to us, nor should it be considered as an alternative to net income as an indicator of operating performance. The Board of Governors of NAREIT defines FFO as net income (loss), computed in accordance with generally accepted accounting principles, excluding gains and losses from debt restructuring and sales of property, plus real estate related depreciation and amortization (excluding amortization of financing costs), and after adjustments for unconsolidated partnerships and joint ventures. We calculate FFO beginning with the NAREIT definition and include adjustments for:
o the minority interest in the Operating Partnership owned by persons other than us, o costs we incurred in order to become self-managed, o amortization of property and investment management contracts, and o nonrecurring income, net.
We believe that the presentation of FFO provides investors with measurements which help facilitate an understanding of our ability to make required dividend payments, capital expenditures and principal payments on our debt. Since FFO excludes unusual and nonrecurring expenses as well as depreciation and other real estate related expenses, FFO may be materially different from net income. Therefore, FFO should not be considered as an alternative to net income or net cash flows from operating activities, as calculated in accordance with generally accepted accounting principles, as an indication of our operating performance or liquidity.
FFO is not necessarily indicative of cash available to fund our cash needs, including our ability to make distributions. We use FFO in measuring our operating performance because we believe that the items that result in a difference between FFO and net income do not impact the ongoing operating performance of a real estate company. Also, we believe other real estate companies, analysts and investors utilize FFO in analyzing the results of real estate companies. Our basis of computing FFO is not necessarily comparable with that of other REITs.
For 1999, 1998 and 1997, our FFO was as follows (in thousands):
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For 1999, 1998 and 1997, our net cash flows were as follows (in thousands):
YEAR 2000 COMPLIANCE
Year 2000 issues have arisen because many existing computer programs and chip-based embedded technology systems use only the last two digits to refer to a year, and therefore do not properly recognize a year that begins with "20" instead of the familiar "19". If not corrected, many computer applications could fail or create erroneous results. The following disclosure provides information regarding the current status of our Year 2000 compliance program.
Our hardware and software systems are currently Year 2000 compliant. Upon failure of any system, data included in critical software (such as rent-rolls and certain record-keeping systems) could be transferred to alternative commercially available software at a reasonable cost and within a reasonable time period. Consequently, we would be able to continue our business operations without any material interruption or material effect on our business, results of operations or financial condition. We have not experienced any Year 2000 problems through March 17, 2000.
Disruptions in the economy generally resulting from Year 2000 issues could also materially adversely affect us. Moreover, because a large number of our tenants may be dependent on social security payments to pay their rents, a failure of the Social Security Administration to cause their systems to be Year 2000 compliant may result in a material adverse effect on our operations. The Social Security Administration has announced that they will have their systems Year 2000 compliant before January 1, 2000. We have received oral representations from our third party vendors indicating that they are substantially Year 2000 compliant. We have not experienced any Year 2000 problems through March 17, 2000.
We believe that the cost of modification or replacement of our less essential accounting and reporting software and hardware that is not currently compliant with Year 2000 requirements, if any, will not be material to our financial position or results of operations.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Our principal exposure to market risk is through our various debt instruments and borrowings. The following is a list of these debt instruments and borrowing arrangements.
We have $37.8 million of fixed rate, fully amortizing, non-recourse, secured long-term notes payable. We do not have significant exposure to changing interest rates on these notes as the rates are fixed and the notes are fully amortizing.
We have $7.6 million of fixed rate, non-recourse, secured long-term notes payable that mature in October 2000. The rates on these notes range from 7.5% to 8.25% with a weighted average rate of 7.7%. We intend to refinance the notes during 2000 with long-term, fully amortizing, fixed rate debt. Therefore, changes in interest rates would affect the cost of funds borrowed in the future to refinance the existing debt. If the interest rate on the refinanced debt was 1.0% greater than the weighted average rate on the existing debt, our annual net
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income and cash flows would decrease by $76,000 due to an increase in interest expense on these notes, based on the outstanding balances at December 31, 1999. We believe that the effect, if any, of near-term changes in interest rates on our financial position, results of operations or cash flows for 2000 would not be material as the existing debt is fixed rate through September 2000.
We have a $2.5 million fixed rate, partially amortizing, non-recourse, secured long-term note payable that matures in April 2009. We do not have significant exposure to changes in interest rates since the interest rate is fixed and the balance due at maturity is $2 million.
We have a $6.1 million of recourse, secured long-term note payable that bears interest at the 30-day London Interbank Offered Rate ("LIBOR") plus 2.5%. If LIBOR increased immediately by 1%, our annual net income and cash flows would decrease by $61,000 due to an increase in interest expense on this note payable, based on the outstanding balance at December 31, 1999.
We have a recourse, secured line of credit that bears interest at LIBOR plus 1.75%. As of December 31, 1999, the outstanding balance was $2.6 million. If LIBOR increased immediately by 1%, then our annual net income and cash flows would decrease by $26,000 due to an increase in interest expense on this line of credit, based on the outstanding balance at December 31, 1999.
Item 8.
Item 8. Financial Statements and Supplementary Data.
The report of independent auditors, consolidated financial statements and schedules listed in the accompanying index are filed as part of this report and incorporated herein by reference. See "Index to Financial Statements" on page.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
We have had no changes in nor any disagreements with our accountants relating to accounting or financial disclosure.
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PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant.
Information with respect to our directors and executive officers appears below and was furnished in part by each such person.
Each of our executive officers serves for a term of one year and until his or her successor is elected and qualified or until his or her earlier resignation or removal by the Board of Directors. Each of our directors serves for a term of three years. There are no family relationships among any of our directors and executive officers.
Terry Considine has been our Chairman of the Board of Directors and Chief Executive Officer since April 1998. From September 1996 to April 1998, Mr. Considine served as Co-Chairman of the Board of Directors and Co-Chief Executive Officer of the Company. Mr. Considine also serves as Chairman of the Board of Directors and Chief Executive Officer of Commercial Assets, Inc. ("CAX"). He is the sole owner of Considine Investment Co. and has also been the Chairman of the Board of Directors and Chief Executive Officer of Apartment Investment and Management Company
Thomas L. Rhodes has been our Vice Chairman of the Board of Directors of the Company since April 1998. From September 1996 to April 1998, Mr. Rhodes served as Co-Chairman of the Board of Directors and Co-Chief Executive Officer of the Company. Mr. Rhodes also serves as Vice Chairman of the Board of Directors of CAX. Mr. Rhodes has also been a Director of AIMCO since July 1994. Mr. Rhodes has served as the President and a Director of National Review magazine since 1992. From 1976 to 1992, he held various positions at Goldman, Sachs & Co. and was elected a General Partner in 1986. He currently serves as a Director of Delphi Financial Group, Inc. and its subsidiaries, Delphi International, Ltd., Oracle Reinsurance and The Lynde and Harry Bradley Foundation. Mr. Rhodes is Trustee of The Heritage Foundation.
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Bruce E. Moore was appointed our President and Chief Operating Officer in February 1998. He also serves as President and Chief Operating Officer of Commercial Assets. Mr. Moore is the founder and was the Chief Executive Officer of Brandywine Financial Services Corporation and its affiliates ("Brandywine"), a private real estate firm specializing in various aspects of the real estate industry, including asset management, consulting, development, property management, brokerage and capital formation. He is a certified public accountant, holds a Masters in Accounting and a Bachelor of Science in Economics from the Wharton School of the University of Pennsylvania. Mr. Moore is a director and past president of the Media Youth Center, and a past advisory-board member for the Department of Recreation and Intercollegiate Athletics for the University of Pennsylvania. In addition, Mr. Moore is a member of the National Association of Real Estate Investment Trusts and the International Council of Shopping Centers.
Robert G. Blatz has functioned as our Executive Vice President since February 1999 and was appointed to this position in September 1999. From June 1998 until joining the Company he served as a Senior Associate for Coopers & Lybrand (predecessor to PricewaterhouseCoopers) as a consultant for management and financial systems. From May 1993 to June 1998, he was with the Heritage Foundation, a public policy organization, most recently as its Vice President and Chief Financial Officer. From May 1983 to May 1993, he served as an officer in the United States Army, in a variety of positions and assignments. Mr. Blatz received a BS from the United States Military Academy and an MBA from The George Washington University.
Joseph W. Gaynor joined the Company as Vice President of Development in January 2000. From January 1986 through December 1999, Mr. Gaynor served as General Counsel to Brandywine Corporation and its affiliates ("Brandywine"), a private real estate firm specializing in various aspects of the real estate industry, including development and property management of retail centers and manufactured home communities. In 1995, Mr. Gaynor became the President of an affiliate of Brandywine in charge of new development. In May 1997, Mr. Gaynor became President of Community Acquisition and Development Corporation, the managing member of several limited liability companies which owned, leased and operated manufactured home communities in which either the Company or Commercial Assets had interests in. Prior to 1995, Mr. Gaynor was a senior partner in the law firm of Gaynor, Decker & Young, P.A. and specialized in the development of retail shopping centers, hotels, marinas and manufactured home communities. Mr. Gaynor received his B.S. with honors from Rutgers University, earned his J.D. from Stetson University College of Law and was admitted to the Florida Bar in 1971. He is a past Chairman of St. Petersburg Downtown Redevelopment Committee and Port Authority, a past Chairman of the Board of Operation PAR, Inc. (Parental Awareness and Responsibility), a past Chairman of the Tampa Bay Area Partnership for a Drug Free Florida, and a past Chairman of the Pinellas Partnership for a Drug-Fee Workplace.
David M. Becker has functioned as our Chief Financial Officer, Treasurer and Secretary since December 1997 and was appointed to such positions in February 1998. Since December 1997, Mr. Becker has also served as Chief Financial Officer, Secretary and Treasurer of Commercial Assets and was appointed to such positions in April 1998. From September 1995 until joining the Company, he was both the Chief Financial Officer of Westfield Development Company, Inc. and Vice President-Finance of The Frederick Ross Co., related companies involved in commercial real estate development, brokerage and management. Prior to September 1995, he held various executive positions with CONCORD Services, Inc., a privately-held company involved in multiple businesses, including trading, manufacturing and finance. CONCORD Services, Inc. declared bankruptcy in February 1995. In addition, Mr. Becker was Chief Financial Officer and General Counsel of Ramtron International Corporation, a publicly-held semiconductor
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manufacturer, from October 1989 until July 1994. Mr. Becker is an attorney and certified public accountant. He received a B.A. from the University of Northern Iowa and a J.D. from the University of Denver.
Bruce D. Benson has served as a Director of the Company and CAX since October 1996 and previously served as a Director of the Company from February 1992 through November 1993. In February 1998, Mr. Benson became the Chairman of the Company's compensation committee. For the past 32 years, he has been President and owner of Benson Mineral Group, Inc., a domestic oil and gas production company located in Denver, Colorado. He is also Chairman, Chief Executive Officer and President of United States Exploration, Inc., an oil and gas exploration company listed on the American Stock Exchange. He serves on numerous Boards of Trustees and Boards of Directors, including Chairman, Denver Zoological Foundation; Past Chairman and Past President, Boy Scouts of America, Denver Area Council; Trustee and Past President of the Board of Trustees, Berkshire School, Sheffield, Massachusetts; Past Trustee, Smith College, Northampton, Massachusetts; Past Chairman, Colorado Commission on Higher Education; and past member, Board of Directors, University of Colorado Foundation; and Chairman of the Total Learning Environmental Capital Campaign of the University of Colorado. In 1994, he was the Republican nominee for the Governor of Colorado.
Elliot H. Kline has served as a Director of the Company since September 1988, as a member of its compensation committee since February 1998, as a member of its audit committee since December 1988 and as Chairman of the audit committee since November 1990. Dr. Kline has served as Executive-in-Residence at Arizona State University-West since August 1993. Dr. Kline served as President of In The Interim Management Consulting, a firm specializing in consulting to universities, from 1989 to 1993. Dr. Kline served as the Dean of the College of Business Administration at the University of Denver from 1987 to 1989; as the Dean and a Professor of the School of Business and Public Administration at the University of the Pacific from 1977 to 1987; and as the Director and an Associate Professor of the Institute of Public Affairs and Administration at Drake University from 1970 to 1977.
Richard L. Robinson has served as a Director of the Company since January 1990, as a member of its audit committee since August 1993 and as a member of its compensation committee since February 1998. Mr. Robinson has served as Chairman of the Board of Directors and Chief Executive Officer of Robinson Dairy, Inc., a Denver-based institutional dairy products manufacturer and distributor, since 1975 and prior thereto served in various executive positions with that company for 20 years. Mr. Robinson also serves as a Director of US Exploration. He is active in numerous civic and charitable organizations, is past Chairman of the Greater Denver Chamber of Commerce and a past President of the State Board of Agriculture, the governing body for the Colorado State University System.
Tim Schultz has served as Director of the Company and as a member of its audit committee since July 1994. In February 1998, Mr. Schultz became a member of the Company's compensation committee. He is President and Executive Director of the Boettcher Foundation, a Colorado not-for-profit, charitable corporation, and from August 1994 until November 1995, he was Chairman and President of Colorado Open Lands, a Colorado not-for-profit corporation. From 1990 until August 1994, he was employed by the law firm of Arnold & Porter as a Consultant-Corporate/Government Relations with responsibilities ranging from serving as Chairman of a large land trust to representing clients' needs in connection with state and local government issues. From May 1987 to July 1990, Mr. Schultz served as Executive Director of the State of Colorado Department of Local Affairs and from November 1983 to May 1987, as Commissioner of Agriculture for the State of Colorado Department of Agriculture, both cabinet level positions. From 1987 to 1991, he served as Chairman of the Colorado Economic Development Commission.
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William J. White has served as Director of the Company and member of its audit committee since December 1996, and became a member of its compensation committee in February 1998. Mr. White has served as Chairman of Bigelow and Co., an investment-banking firm located in Denver, Colorado that specializes in municipal and corporate finance, since 1995. From 1992 through 1995, Mr. White was President and owner of First Denver Financial Corporation and in 1991 and 1992, was President of Affiliated Capital Markets, a division of Affiliated National Bank. Prior to these positions, Mr. White served in various positions culminating as Chairman of Kirchner Moore and Company, an investment-banking firm. Mr. White serves on the Board of Directors of Guaranty Bank and Trust Company.
There are no arrangements or understandings pursuant to which any of our directors or executive officers were selected as directors or officers. Except as described above, none of our directors or executive officers have been involved in any legal proceedings during the past five years that are material to an evaluation of the ability or integrity of such persons.
Compliance With Section 16(a) of the Exchange
Our executive officers and directors, and persons who own more than 10% of the Company's common stock, are required under the Securities Exchange Act of 1934 to file reports of ownership and changes in ownership of securities of the Company with the Securities and Exchange Commission and the New York Stock Exchange, Inc. Copies of those reports also must be furnished to us. Based solely upon a review of the copies of reports furnished to us, we believe that for the year ended December 31, 1999, all filing requirements were timely met by our executive officers, directors and beneficial owners of more than ten percent of our stock except as follows: Mr. Blatz was late filing his report on Form 3 relating to ownership of equity interests. Mr. White was late filing one report on Form 4 relating to a change in beneficial ownership.
11. Executive Compensation.
In 1999, none of Messrs. Considine, Rhodes or Moore received any compensation in his capacity as Chief Executive Officer, Vice Chairman and President and Chief Operating Officer, respectively. Mr. Blatz received total salary and bonus in 1999 of $101,000 as the Executive Vice President-Operations. Mr. Becker received total salary and bonus in 1999 of $150,000 as the Chief Financial Officer, Treasurer and Secretary.
In their capacity as executive officers, each of Messrs. Moore, Blatz and Becker received options to acquire shares of our common stock. Neither Messrs. Considine nor Rhodes, each of whom is a stockholder of the Company and Commercial Assets, was at any time on or prior to December 31, 1999 granted options to acquire shares of our common stock other than in his capacity as an executive officer. Mr. Moore, a stockholder in the Company, was not at any time on or prior to December 31, 1999 granted options to acquire shares of our common stock other than in his capacity as an executive officer.
The following table sets forth, in summary form, the compensation paid by the Company to each individual who served as its Chief Executive Officer, President and two executive officers of the Company during 1999 whose salary exceeded $100,000 (the "Named Executive Officers"):
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SUMMARY COMPENSATION TABLE
The following tables set forth certain information regarding stock options granted to the Named Executive Officers during 1999:
OPTION GRANTS IN LAST FISCAL YEAR
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AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR END OPTION VALUES
Director Compensation
During 1999, each of our non-employee directors received 2,300 shares of our common stock, plus an additional $300 for each meeting of the Board of Directors or committee thereof attended. In addition, all directors are reimbursed for expenses related to their attendance at Board of Directors and committee meetings.
Under the existing 1998 Stock Incentive Plan, on the date of the 1999 annual stockholders meeting, all of our non-employee directors received an automatic grant of options to acquire 2,800 shares of the Company's common stock with an exercise price equal to the closing price of the Company's common stock on such date. Such options were immediately exercisable and have a term of 10 years.
Under the 1998 Stock Incentive Plan, all of our non-employee directors will automatically receive annual grants of market-price options to acquire 2,800 shares of the Company's common stock on the date of each annual stockholders meeting. These options will be immediately exercisable upon grant and have a term of ten years.
Compensation Committee Interlocks and Insider Participation
During 1999, Messrs. Benson, Kline, Robinson, Schultz and White served on the compensation committee. Mr. Considine served as Chairman of the Board and Chief Executive Officer of the Company and Commercial Assets, and Mr. Rhodes served as Vice Chairman of the Board of the Company and Commercial Assets. Mr. Considine is Chairman of the Board and Chief Executive Officer of Apartment Investment and Management Company ("AIMCO") and Mr. Rhodes serves on the compensation committee of AIMCO.
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Compensation Committee Report on Executive Compensation
The five directors who are not members of management constitute the compensation committee. The compensation committee:
o determines the compensation of the Chief Executive Officer and the Vice Chairman; o reviews and approves the compensation of other corporate officers holding executive positions; o reviews the general compensation and benefit practices of the Company; and o administers our compensation and stock incentive plans.
The compensation committee considers various factors including:
o recruitment, motivation and retention of our management team; o alignment of management financial rewards with stockholder objectives for total return (dividend income plus share price appreciation); and o reasonability in consideration of all the facts, including total return, the size and complexity of the Company and the practices of other real estate investment trusts.
Compensation of senior management is comprised of Base Compensation, Discretionary Compensation and Incentive Compensation. The policy of the compensation committee is to set Base Compensation at or below the median paid by comparable companies to executive officers with comparable responsibilities, to utilize Discretionary Compensation, generally cash and not more than Base Compensation, to reward specific achievements, and to make the chief financial reward Incentive Compensation which is tied directly to the creation of stockholder value.
BASE COMPENSATION. The compensation committee determined 1999 Base Compensation for the Chief Executive Officer and the Vice Chairman, reviewed and approved 1999 Base Compensation for other senior management based upon the recommendation of the Chief Executive Officer and Vice Chairman and considered such 1999 Base Compensation reasonable. Base Compensation for the Chief Executive Officer and Vice Chairman for 1998-2000 consists of options to purchase 300,000 and 100,000 shares, respectively, of the Company's common stock at $19.375 per share.
DISCRETIONARY COMPENSATION. For 1999, the compensation committee considered, among other things:
o the achievement of the 1999 objective for per share Adjusted Funds From Operations; o our growth in size and complexity during 1999; o the number and size of 1999 acquisitions by Commercial Assets and their financings; o the achievement of a proposed merger agreement with Commercial Assets; and o our total return for 1999 as compared to the Morgan Stanley REIT Index.
No Discretionary Compensation was awarded to senior management.
INCENTIVE COMPENSATION. The compensation committee bases Incentive Compensation primarily by reference to "Excess Value Added," calculated as the amount, if any, by which our total return exceeds total returns achieved by other real estate investment trusts (as measured by Morgan Stanley REIT Index) multiplied by the weighted average market value of our stock and OP Units outstanding during the measurement period.
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In 1999, our total return was a negative 6% which was less than the negative 5% Total Return of the Morgan Stanley REIT Index. The compensation committee awarded no Incentive Compensation in 1999 to either the Chief Executive Officer or Vice Chairman and approved no awards to other senior management.
CHIEF EXECUTIVE OFFICER AND VICE CHAIRMAN. In determining the compensation for the Chief Executive Officer and Vice Chairman, the compensation committee considered, among other things, our 1999 financial performance:
o Total Return for 1999 of a negative 6%; o investment of $47 million by Commercial Assets in manufactured home communities in 1999; o agreement to merge with Commercial Assets; and o increase in leasing of previously unleased homesites from 44 in 1998 to 147 in 1999.
EQUITY TRANSACTIONS IN SUPPORT OF COMPENSATION OBJECTIVES
The compensation committee has determined that we are well served by the alignment of interest that occurs when senior management has the same financial interests as do other stockholders. To promote this end, the compensation committee and the Board of Directors have:
o structured Board annual compensation to be paid in stock options and annual director's fees paid in stock with meeting fees paid in cash; o structured Base Compensation of Chief Executive Officer, Vice Chairman and President for 1998-2000 entirely in options to acquire stock at 100% of then current value; and o granted to other senior management options to acquire stock at 100% of then current value which are fully vested only after three or five years.
Date: March 14, 2000 BRUCE D. BENSON (Chairman) ELLIOT H. KLINE RICHARD L. ROBINSON TIM SCHULTZ WILLIAM J. WHITE
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Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
The table below sets forth, as of March 17, 2000, the number of shares of our common stock beneficially owned by (1) each person known by us to be a beneficial owner of more than 5% of our common stock; (2) all directors, individually, and each executive officer that holds our common stock, individually; and (3) all of our directors and executive officers as a group, which information was furnished in part by each such person.
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Item 13.
Item 13. Certain Relationships and Related Transactions.
Transactions involving former manager. Prior to November 1997, our daily activities were performed by Financial Asset Management LLC ("FAM"), pursuant to a management agreement (the "AIC Management Agreement"). FAM provided similar services to Commercial Assets pursuant to a separate agreement (the "CAX Management Agreement," and collectively with the AIC Management Agreement, the "Management Agreements"). Messrs. Considine, Rhodes and Benson are principal owners of FAM.
In November 1997, our stockholders approved the purchase of FAM's assets and operations, including the Management Agreements, in exchange for (i) 676,696 OP Units and (ii) the issuance of up to 240,000 additional OP Units if we achieve certain performance goals. In 1998, FAM distributed the 676,696 OP Units to its owners. Messrs. Considine, Rhodes and Benson received 204,286, 138,458, and 63,839 OP Units, respectively, from this distribution.
In August 1998, we issued 120,000 of the above described 240,000 OP Units to FAM as a result of the achievements of investment and return goals. FAM distributed these OP Units and Messrs. Considine, Rhodes and Benson received 36,227, 29,433, and 11,321 OP Units, respectively, from this distribution.
If the average share price of our common stock exceeded $20.00 for a 90-day period prior to June 17, 1999, then we were required to issue to FAM the remaining 120,000 OP Units described above. The average share price of our common stock did not exceed $20.00 for the required time period and this obligation to issue OP Units has expired.
Transactions involving Messrs. Moore and Gaynor. During 1999, two property management companies (collectively, "AIC Property Management") received property management and accounting fees of $672,000 from communities in which we own an interest and $172,000 from communities in which Commercial Assets owns an interest. We own 50% of AIC Property Management and Community Management Investors Corporation ("CMIC") owns 50% of AIC Property Management. Mr. Moore owns 35% and Mr. Gaynor owns 20% of CMIC. In order for AIC Property Management to provide the above services, AIC Property Management utilized staff and resources of Brandywine Financial Services Corporation and its affiliates ("Brandywine"). Mr. Moore is the founder and was the Chief Executive Officer of Brandywine prior to his appointment as our President and Chief Operating Officer. Effective January 1, 2000, we purchased CMIC's 50% interest in AIC Property Management for a $2,120,000 promissory note that matures March 31, 2000. The note bears interest at 8.5%.
Brandywine Commercial Services Corporation ("Services Corp."), an affiliate of Brandywine, provides maintenance services to both our communities and Commercial Assets communities. Mr. Moore owned 50% of Services Corp. during 1999. Services Corp. received fees of $1,725,000 from our communities and $658,000 from Commercial Assets communities for maintenance services provided during 1999. Effective January 1, 2000, we purchased 100% of Services Corp.'s assets and operations for $30,000 and the assumption of leases on equipment used by Services Corp.
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Brandywine Home Sales Corporation ("Sales Corp."), an affiliate of Brandywine, provides real estate brokerage services in both our communities and Commercial Assets communities. Sales Corp. receives commissions from us, Commercial Assets or the homeowner depending on the circumstances. Mr. Moore owned 50% of Sales Corp. during 1999. Sales Corp. received sales commissions during 1999 as follows:
From our communities $ 45,000 From Commercial Assets communities $ 46,000 From homeowners $293,000
Effective January 1, 2000, we purchased 100% of Sales Corp.'s activities and its inventory of homes located at our communities for (a) $100,000 cash, (b) the assumption of $487,000 in the third-party debt, and (c) the cancellation of $64,000 in loans from us.
Effective January 1, 2000, we purchased four communities and undeveloped homesites at three other communities from entities in which Mr. Gaynor owns 31% (the "CADC Properties"). During 1999, we held participating mortgages secured by the CADC properties. The purchase price for the CADC Properties was $36,816,000 and was paid as follows:
o Issuance of 44,572 OP Units at an assigned value of $496,000, o Cancellation of $24,851,000 in loans from us involving the CADC Properties, o Assumption of $10,704,000 in third-party debt, and o $765,000 cash.
Other Transactions. Asset Investors Equity, Inc. ("AIE") and AIC Manufactured Housing Corp. ("AICMHC" and collectively with AIE, the "Service Subsidiaries") engage in activities and receive fees that would not otherwise be permitted under the tax rules governing REITs. In order to allow us to maintain our REIT status for federal income tax purposes, Messrs. Considine and Rhodes, directly or indirectly, equally own some or all of the outstanding voting common stock of the Service Subsidiaries. We own all of the outstanding non-voting common stock of each of the Service Subsidiaries.
Messrs. Considine and Rhodes acquired all of the outstanding voting common stock of AICMHC in 1997 for $27,000. This represents 5% of the outstanding capital stock of AICMHC. We acquired the remaining 95%, in the form of non-voting common stock, for $509,485. Messrs. Considine and Rhodes each acquired their shares of AICMHC's voting common stock in exchange for a $13,500 promissory note bearing 7% interest. Messrs. Considine and Rhodes have paid interest through December 31, 1999 and paid $5,000 in interest during 1999.
Messrs. Considine and Rhodes owned 70% of the outstanding voting common stock of AIE through June 1999. This represented 3.5% of the outstanding capital stock of AIE. AICMHC owned the remaining outstanding shares of voting common stock which represented 1.5% of the outstanding capital stock of AIE. We own the remaining 95% of AIE's capital stock in the form of non-voting common stock. In June 1999, Messrs. Considine and Rhodes sold all of their shares of AIE's voting common stock to AICMHC in exchange for AICMHC's assumption of the outstanding balances on their promissory notes to AIE totaling $168,000. The promissory notes were originally issued in connection with Messrs. Considine's and Rhodes's purchase of AIE voting common stock. All distributions by AIE to Messrs. Considine and Rhodes prior to the June 1999 sale were used by them to pay interest and principal on these notes.
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We lease a recreational vehicle park which we would not otherwise be permitted to operate under the tax rules governing REITs to AIC RV Management Corp. ("AIC RV Management"), an entity that is owned equally by Messrs. Considine and Rhodes. During 1999, AIC RV Management paid aggregate lease payments of $366,000 to us. As of December 31, 1999, AIC RV Management has $80,000 in loans from us which bear interest at a rate of 10% per annum.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.
(a)(1) The financial statements listed in the Index to Financial Statements on Page of this report are filed as part of this report.
(a)(2) The financial statement schedules listed in the Index to Financial Statements on Page of this report are filed as part of this report. All other schedules are omitted since they are not applicable, not required, or the information required to be set forth therein is included in the financial statements, or in notes thereto.
(a)(3) The Exhibit Index is included on page 36 of this report.
(b) Reports on Form 8-K for the quarter ended December 31, 1999:
No current reports on Form 8-K were filed by the Company during the fourth quarter of 1999.
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ASSET INVESTORS CORPORATION Page
Financial Statements:
Report of Independent Auditors.................................... Consolidated Balance Sheets as of December 31, 1999 and 1998...... Consolidated Statements of Income for the years ended December 31, 1999, 1998 and 1997................................ Consolidated Statements of Stockholders' Equity for the years ended December 31, 1999, 1998 and 1997.......................... Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998 and 1997................................ Notes to Consolidated Financial Statements........................
Financial Statement Schedules:
Schedule III -- Real Estate and Accumulated Depreciation..........
Schedule IV -- Mortgage Loans on Real Estate......................
COMMERCIAL ASSETS, INC. (a significant unconsolidated subsidiary of the Company)
Financial Statements:
Report of Independent Auditors.................................... Consolidated Balance Sheets as of December 31, 1999 and 1998...... Consolidated Statements of Income for the years ended December 31, 1999, 1998 and 1997.............................. Consolidated Statements of Stockholders' Equity for the years ended December 31, 1999, 1998 and 1997.................. Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998 and 1997.................. Notes to Consolidated Financial Statements........................
Financial Statement Schedules:
Schedule III -- Real Estate and Accumulated Depreciation..........
Schedule IV -- Mortgage Loans on Real Estate......................
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REPORT OF INDEPENDENT AUDITORS
Board of Directors and Stockholders Asset Investors Corporation
We have audited the accompanying consolidated balance sheets of Asset Investors Corporation and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1999. Our audits also included the consolidated financial statement schedules listed in the accompanying index. These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Asset Investors Corporation and subsidiaries as of December 31, 1999 and 1998, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects the information set forth therein.
/s/Ernst & Young LLP
Denver, Colorado January 21, 2000, except for Note I, as to which the date is March 7, 2000
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ASSET INVESTORS CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except per share data)
See Notes to Consolidated Financial Statements.
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ASSET INVESTORS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (in thousands, except per share data)
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ASSET INVESTORS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (in thousands)
See Notes to Consolidated Financial Statements.
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ASSET INVESTORS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)
See Notes to Consolidated Financial Statements.
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ASSET INVESTORS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A. The Company
Asset Investors Corporation ("AIC" and, together with its subsidiaries, the "Company") is a Delaware corporation that owns and operates manufactured home communities and has elected to be taxed as a real estate investment trust ("REIT"). Prior to May 25, 1999, AIC was a Maryland corporation. Effective May 25, 1999, AIC's stockholders approved its reincorporation in Delaware. AIC's Common Stock, par value $.01 per share ("Common Stock"), is listed on the New York Stock Exchange under the symbol "AIC." In May 1997, AIC contributed its net assets to Asset Investors Operating Partnership, L.P. (the "Operating Partnership") in exchange for the sole general partner interest in the Operating Partnership and substantially all of the Operating Partnership's initial capital. AIC owns 85% of the Operating Partnership as of December 31, 1999. The Company also owns 27% of the common stock of Commercial Assets, Inc. ("Commercial Assets") and the non-voting stock of both AIC Manufactured Housing Corp. ("AICMHC") and Asset Investors Equity, Inc. ("AIE"). Commercial Assets is a publicly-traded REIT (American Stock Exchange, Inc.: CAX) formed by the Company in August 1993. AICMHC owns interests in manufactured home community management contracts and AIE manages Commercial Assets.
Prior to 1997, the Company owned debt interests in residential mortgage loan securitizations collateralized by pools of non-conforming (non-agency guaranteed) single-family mortgage loans ("non-agency MBS bonds"). In February 1997, the Company decided to resecuritize the Company's asset base and redeploy its assets in an attempt to both reduce risks associated with the Company's non-agency MBS bonds and maximize long-term, risk-adjusted returns to stockholders. In 1997, the Company received $67,671,000 cash proceeds from the resecuritization of the non-agency MBS bonds and has invested these proceeds in manufactured home communities.
Prior to November 1997, the Company and Commercial Assets were managed by Financial Asset Management LLC ("FAM"). An investor group led by Terry Considine, Thomas L. Rhodes and Bruce D. Benson acquired FAM in September 1996. Mr. Considine is the Chairman and Chief Executive Officer of both the Company and Commercial Assets. Mr. Rhodes is Vice Chairman and Mr. Benson is a director of both the Company and Commercial Assets. In November 1997, the Company's stockholders approved the acquisition of the assets and operations of FAM in order to become a self-managed and self-administered REIT. The $11,692,000 purchase price was paid by issuing 676,700 limited partnership units of the Operating Partnership ("OP Units") plus up to 240,000 additional OP Units if certain performance goals, including investment and share price targets, were achieved by the Company within a specified time period. During the third quarter of 1998, the Company achieved the first set of performance goals by realizing annualized returns before depreciation in excess of 9% on its real estate investments for a period of six months. As a result of achieving these goals, the Company issued 120,000 OP Units and expensed $2,092,000 as additional cost of acquiring the management contract. The issuance of the remaining 120,000 OP Units was contingent upon the Company having a 90-day average per share price in excess of $20.00 by June 1999. The Company's average share price did not meet this requirement and the Company's commitment to issue these additional OP Units has expired.
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B. Summary of Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of the Company, the Operating Partnership and all majority owned subsidiaries. The minority interest in the Operating Partnership represents the OP Units which are redeemable at the option of the holder. When a holder elects to redeem OP Units, the Company determines whether such OP Units will be redeemed for cash or shares of Common Stock. The holders of OP Units receive the same amount per OP Unit in distributions as the holders of Common Stock receive in dividends. As of December 31, 1999, 1,000,000 OP Units were outstanding. All significant intercompany balances and transactions have been eliminated in consolidation. The Company's investment in Commercial Assets is recorded under the equity method.
Rental Properties and Depreciation
Rental properties are recorded at cost less accumulated depreciation, unless considered impaired. If events or circumstances indicate that the carrying amount of a property may be impaired, the Company will make an assessment of its recoverability by estimating the future undiscounted cash flows, excluding interest charges, of the property. If the carrying amount exceeds the aggregate future cash flows, the Company would recognize an impairment loss to the extent the carrying amount exceeds the fair value of the property. As of December 31, 1999, management believes that no impairments exist based on periodic reviews. No impairment losses were recognized for 1999, 1998 and 1997.
Depreciation is computed using the straight line method over an estimated useful life of 25 years for land improvements and buildings and five years for furniture and other equipment. Significant renovations and improvements, which improve or extend the useful life of the asset, are capitalized and depreciated over the remaining estimated life. In addition, the Company capitalizes direct and indirect costs (including interest, taxes and other costs) in connection with the development of additional homesites within its manufactured home communities. Maintenance, repairs and minor improvements are expensed as incurred.
Investments in Participating Mortgages
The Company has loans secured by real estate which provide for an interest rate return plus up to 50% of net profits, cash flows and sales proceeds from the secured real estate. The Company accounts for these investments as loans when (a) the Company does not have an interest in the borrower and either (b) the borrower has a substantial equity investment in the real estate collateral or (c) the Company has recourse to other substantial tangible assets of the borrower. As such, the Company records interest income based on the rate provided for in the loan and records its share of any net profits or gains from the sale of the underlying real estate when realized. If the above requirements are not met, then the loan is accounted for as an equity investment in real estate under the equity method of accounting.
Amortization
Included in other assets is the cost related to the acquisition of management contracts, which is being amortized over a period of three years.
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Revenue Recognition
The Company derives its income from the rental of homesites. The leases entered into by residents for the rental of the site are generally for terms not longer than one year and the rental revenues associated with the leases are recognized when earned and due from residents. Property management revenues for services provided to communities not owned by the Company are recognized when earned.
Interest on participating mortgages is recorded based upon outstanding balances and interest rates per the terms of the mortgages. In addition, the Company evaluates the collectibility of any unpaid interest and provides reserves as necessary. As of December 31, 1999 and 1998, the reserve for uncollected interest on the participating mortgages was $0 and $149,000, respectively.
Deferred Financing Costs
Fees and costs incurred in obtaining financing are capitalized. Such costs are amortized over the terms of the related loan agreements and are charged to interest expense.
Interest Rate Lock Agreements
Interest rate lock agreements related to planned refinancings of identified variable rate indebtedness are accounted for as anticipatory hedges. Upon the refinancing of such indebtedness, any gain or loss associated with the termination of the interest rate lock agreement is deferred and recognized over the life of the refinanced indebtedness.
Income Taxes
AIC has elected to be taxed as a REIT as defined under the Internal Revenue Code of 1986, as amended (the "Code"). In order for AIC to qualify as a REIT, at least 95% of its gross income in any year must be derived from qualifying sources. The activities of AICMHC and AIE are not qualifying sources.
As a REIT, AIC generally will not be subject to federal income taxes at the corporate level if it distributes at least 95% of its REIT taxable income to its stockholders. REITs are also subject to a number of other organizational and operational requirements. If AIC fails to qualify as a REIT in any taxable year, its taxable income will be subject to federal income tax at regular corporate rates (including any applicable alternative minimum tax). Even if AIC qualifies as a REIT, it may be subject to certain state and local income taxes and to federal income and excise taxes on its undistributed income.
At December 31, 1999, AIC's net operating loss ("NOL") carryover was approximately $95,000,000 and its capital loss carryover was approximately $20,000,000. The NOL carryover may be used to offset all or a portion of AIC's REIT income, and as a result, to reduce the amount that AIC must distribute to stockholders to maintain its status as a REIT. The NOL carryover is scheduled to expire between 2007 and 2009, and the capital loss carryover is scheduled to expire in 2000 and 2001.
Earnings Per Share
Basic earnings per share are based upon the weighted-average number of shares of Common Stock outstanding during each year. Diluted earnings per share reflect the effect of dilutive, unexercised stock options of 6,000, 19,000 and 39,000 for 1999, 1998 and 1997, respectively. Stock options and shares issued for non-recourse notes receivable of 339,000, 108,000 and 0 for 1999, 1998 and 1997, respectively, have been excluded from diluted earnings per share as their effect would be anti-dilutive. In November 1997, the Company's stockholders approved a
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one-for-five reverse split of the Common Stock. Accordingly, all historical weighted-average share and per share amounts have been restated to reflect the reverse stock split.
Capitalized Interest
Interest is capitalized on development projects during periods of construction or development. During 1999, 1998 and 1997, capitalized interest was $94,000, $32,000 and $0, respectively.
Treasury Stock
The Company owns 27% of Commercial Assets' common stock. During 1999, Commercial Assets purchased 114,000 shares of the Company's Common Stock. Consequently, the Company has an interest in 30,000 shares of its Common Stock and has recorded this as treasury stock.
Statements of Cash Flows
For purposes of reporting cash flows, cash maintained in bank accounts, money market funds and highly-liquid investments with an initial maturity of three months or less are considered to be cash and cash equivalents. The Company made interest payments of $3,631,000, $1,975,000 and $349,000 for 1999, 1998 and 1997, respectively.
Non-cash operating, investing and financing activities for 1999, 1998 and 1997 were as follows (in thousands):
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Use of Estimates
The preparation of the financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Reclassifications
Certain reclassifications have been made in the 1998 and 1997 consolidated financial statements to conform to the classifications used in the current year. Such reclassifications have no material effect on the amounts as originally presented.
Non-agency MBS Bonds
The Company's non-agency MBS bonds were acquired at a significant discount to par value. The amortized cost of the non-agency MBS bonds was equal to the outstanding principal amount net of unamortized discount and allowances for credit losses. Earnings from non-agency MBS bonds were recognized based upon the relationship of cash flows received during the period and estimates of future cash flows to be received over the life of the bonds. The Company classified its non-agency MBS bonds as available-for-sale, carried at fair value in the financial statements. Unrealized holding gains on available-for-sale securities were excluded from earnings and reported as a net amount in stockholders' equity until realized.
C. Proposed Merger with Commercial Assets
The Company and Commercial Assets have agreed to merge, subject to approval by both (a) a majority of the Company's outstanding shares and (b) two-thirds of the outstanding shares of Commercial Assets. The Company has agreed to vote its shares of Commercial Assets common stock in favor of the merger. The Company owns approximately 27% of the outstanding shares of Commercial Assets common stock. The Company will issue 0.4075 shares of its Common Stock for each outstanding share of Commercial Assets common stock. Alternatively, Commercial Assets stockholders may elect to receive $5.75 per share in cash for up to 3,549,868 shares of Commercial Assets common stock with any remaining shares of Commercial Assets common stock receiving 0.4075 shares of the Company's Common Stock. Commercial Assets' and the Company's officers and directors have agreed to elect to receive shares of the Company's Common Stock for all shares of Commercial Assets common stock that they own. The stockholder meetings to vote on the merger are expected to occur in the second quarter of 2000.
D. Real Estate
Real estate at December 31, 1999 and 1998 is as follows (in thousands):
1999 1998 ----------- ---------- Land $ 13,260 $ 11,226 Land improvements and buildings 102,291 90,268 Furniture and other equipment 442 447 ---------- --------- 115,993 101,941 Less accumulated depreciation (7,248) (3,378) ---------- --------- Real estate, net $ 108,745 $ 98,563 ========== =========
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Land improvements and buildings consist primarily of infrastructure, roads, landscaping, clubhouses, maintenance buildings and common amenities.
During 1999, the Company purchased two manufactured home communities and one recreational vehicle park with 450 developed homesites, 100 undeveloped homesites and 120 recreational vehicle sites. Total investment was $13,592,000 consisting of $11,973,000 by the cancellation of participating mortgages, $858,000 cash and $761,000 of assumed liabilities and other costs. During 1998, the Company acquired seven manufactured home communities with approximately 1,730 developed sites and 230 undeveloped homesites. Total investment was $59,977,000 consisting of $57,832,000 cash and $2,145,000 of OP Units.
E. Investments in Participating Mortgages
As of December 31, 1997, the Company had non-recourse notes receivable of $15,872,000 from joint ventures in which the Company owned a 50% joint venture interest. Effective January 1, 1998, the Company sold its interest in the various joint ventures to the other venturer and consolidated the various notes into a single note secured by a number of manufactured home communities. The note bears 10% interest and matures in 20 years. In addition, the Company receives additional interest up to 50% of the borrower's profit from such communities. As of December 31, 1999, the outstanding balance of these participating mortgages was $22,475,000. In January 2000, the Company purchased the manufactured home communities by canceling the mortgages and paying additional consideration. See Note T.
The following table presents unaudited summary financial information of the borrower with respect to the above participating mortgage as of and for the years ended December 31, 1999 and 1998 (in thousands):
In addition, the Company had non-recourse mortgage loans secured by two manufactured home communities and one recreational vehicle park in Arizona. The mortgage loans bore interest rates ranging from 10% to 15%. The Company received additional interest of 3% of gross revenues, increasing to 11% of gross revenues in the event of a refinancing of the debt on the communities, and 50% of net proceeds from a sale or refinancing of the communities. In August 1999, the Company purchased the manufactured home communities and the recreational vehicle park in exchange for the payment of $858,000, the cancellation of the three loans with a carrying amount of $11,973,000 and $761,000 of assumed liabilities and other costs.
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During 1999 and 1998, the Company had earnings of $2,976,000 and $3,174,000 from the participating mortgages.
F. Investment in Commercial Assets
On December 31, 1999 and 1998, the Company owned 2,761,126 shares (approximately 27%) of the common stock of Commercial Assets. In November 1997, Commercial Assets sold or resecuritized its entire portfolio of commercial mortgage loan securitizations of multi-family real estate ("CMBS bonds") and temporarily invested the proceeds until it determined which type of real estate assets to invest in. During the third quarter of 1998, Commercial Assets began investing in manufactured home communities, and through 1999, it had invested approximately $70,000,000 for interests in 12 communities, including investments in both participating mortgages and real estate joint ventures.
Summarized financial information of Commercial Assets as reported by Commercial Assets is (in thousands):
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G. Secured Long-Term Notes Payable
The following table summarizes the Company's secured long-term notes payable (in thousands):
In 1998, the Company entered into an interest rate lock agreement in connection with expected debt financing. The agreement had an aggregate notional value of $32,200,000, fixed the interest rate on the expected debt at 6.8% and was settled in September 1998. The Company realized a loss on the hedge of $802,000 which was deferred and is being amortized over the terms of the related notes payable as a charge to interest expense.
During 1999, the Company repaid a $2,230,000 long-term note payable and paid a prepayment penalty of $75,000. The penalty is recorded as loss from early extinguishment of debt in the consolidated statements of income.
Real estate assets which secure the long-term notes payable had a net book value of $96,184,000 at December 31, 1999. The Company had $16,000 in escrow for real estate taxes on the long-term notes payable at December 31, 1999.
Scheduled principal payments after December 31, 1999 for the secured long-term notes payable are (in thousands):
2000 $ 8,990 2001 6,895 2002 1,212 2003 1,295 2004 1,383 Thereafter 34,219 --------- $ 53,994 =========
H. Secured Short-Term Financing
The Company has a revolving line of credit with a bank that bears interest at the 30-day London Interbank Offered Rate ("LIBOR") plus 1.75% per annum (7.58% at December 31, 1999). The line of credit is secured by 1,015,674 shares of the common stock of Commercial Assets held by the Company and matures in September 2000. The line of credit is limited to the lesser of (1) $5,000,000, (2) 65% of the product of the trading price of Commercial Assets common stock times 1,015,674 or (3) 65% of the purchase price of certain unpledged real estate. As of December 31, 1999, the limit was $3,053,000 and $2,610,000 was outstanding on this line of credit.
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I. Commitments and Contingencies
In connection with a participating mortgage on a manufactured home community, the Company entered into an earn-out agreement with respect to 142 unoccupied homesites. The Company advances an additional $17,000 pursuant to the participating mortgage for each newly occupied homesite either in the form of cash or 946 OP Units, as determined by the borrower. At December 31, 1999, there were 113 unoccupied homesites subject to the earnout. The Company advanced the following in cash and OP Units for newly occupied homesites (in thousands):
Year Ended December 31, ------------------------------------------- 1999 1998 1997 ----------- ---------- ---------- Cash $ 265 $ 116 $ -- OP Units -- 17 17 ------ ----- ----- $ 265 $ 133 $ 17 ====== ===== =====
In connection with the acquisition of the assets and operations of its former manager in November 1997, the Company entered in an agreement to issue additional OP Units upon the achievement of certain performance goals by the Company. Per the terms of the agreement, the Company was required to issue an additional 120,000 OP Units if the Company's average stock price exceeded $20.00 per share for any 90-day period prior to June 17, 1999. The $20.00 average stock price was not achieved and the commitment to issue additional OP Units expired.
At December 31, 1999, there were 2,510 undeveloped homesites in properties which the Company has an interest in. In connection with efforts to lease such sites, a sales corporation markets an inventory of homes located in the various properties to potential tenants. The Company's President owns 50% of the sales corporation. A portion of the cost of this home inventory was financed by the sales corporation with a line of credit guaranteed by the Company. As of December 31, 1999, $5,459,000 was outstanding under the line of credit. The terms of the line of credit require monthly payments of interest and payment of principal upon sale of the inventory. If the inventory is not sold within one year, monthly payments of principal are also required. In January 2000, the Company acquired the assets and operations of the sales corporation. See Note T.
In September 1999, four Commercial Assets stockholders, individually and as purported representatives of all Commercial Assets stockholders, except Asset Investors and its affiliates, filed three purported class action lawsuits in Delaware against Commercial Assets, the members of the board of directors and certain officers of the Company and Commercial Assets. These lawsuits alleged that the defendants breached their fiduciary duties to the Commercial Assets stockholders in connection with the proposed merger of Asset Investors and Commercial Assets and Commercial Assets' recent reincorporation in Delaware. In November 1999, these lawsuits were consolidated into a single lawsuit. On March 7, 2000, the parties entered into a settlement agreement, subject to the court's approval, which amended the merger agreement as follows:
o Commercial Assets stockholders, other than Asset Investors and the officers and directors of Asset Investors and Commercial Assets, may elect to receive $5.75 per share in cash for up to 3,549,868 shares of Commercial Assets common stock with any remaining shares receiving 0.4075 shares of the Company's Common Stock; and o the percentage of votes of Commercial Assets common stock needed to approve the merger was increased from a majority to two-thirds.
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J. Operating Segments
Investments in manufactured home communities constitute substantially all of the Company's portfolio, and as such, management of the Company assesses the performance of the Company as one operating segment.
K. Fair Value of Financial Instruments
The following methods and assumptions were used to estimate the fair value of each type of financial instrument. The estimates of fair value have been determined by the Company using available market information and valuation methodologies.
o Cash and cash equivalents, accounts payable and accrued liabilities, and secured short-term financing - the carrying amounts approximate fair value because of the short maturity of these instruments. o Investment in Commercial Assets - the fair value was determined based upon the closing price of Commercial Assets common stock on the American Stock Exchange, Inc. as of the end of each year. o Secured long-term notes payable - based upon borrowing rates currently available to the Company, the carrying value of secured long-term notes payable approximates their fair value.
The carrying values and fair values of the Company's investment in Commercial Assets at December 31, 1999 and 1998 are as follows (in thousands):
L. Common Stock and Dividends
The Company paid dividends to stockholders and distributions to holders of OP Units as follows (in thousands):
The Company's Certificate of Incorporation permits the Board of Directors to issue classes of preferred and common stock without further stockholder approval. As of December 31, 1999, the Company has not issued any classes of stock other than Common Stock.
M. Non-agency MBS Bonds
In March 1997, the Company resecuritized its portfolio of retained interests in prior securitizations that are in the form of non-agency MBS bonds by transferring them to a trust in which it retained the residual interest and having the trust sell non-recourse debt securities representing senior interests in the trust's assets. The Company realized net proceeds of $67,671,000 and
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recorded a net gain of $5,287,000 from the sale. The Company's retained residual interest in the trust represents the first-loss class of the portfolio and, accordingly, no carrying value was assigned to it because it was not practical to estimate its fair value given the high risk and unpredictable nature of the future cash flow expected to be attributed to the retained residual interests. During 1997, the Company recognized $2,966,000 of interest income from the non-agency MBS bonds of which $966,000 was from the retained residual interest. As of December 31, 1998 and 1997, the Company did not believe that it would receive any incremental, material cash flows. Given that circumstance, the Company estimated the fair value of its retained residual interests at zero at those subsequent reporting dates. Consistent with those estimates, the Company has not received any material cash flows from the resecuritized assets. The trustee has notified the Company that its retained residual interest has been eliminated because of the extent of allocated realized losses on the underlying assets of the trust (non-agency MBS bonds). Therefore, the value of the retained residual interest was determined to be zero at December 31, 1999.
N. Income Tax Benefit
In connection with the Company's resecuritization of its former bond portfolio in 1997, a consolidated corporate subsidiary incurred income taxes from the resecuritization. These taxes were netted against the gain from sale in 1997. The subsidiary recorded a loss for tax purposes during 1999 and can carryback the tax loss for a refund of taxes incurred in 1997. Accordingly, the Company has recorded an income tax benefit of $400,000 in 1999.
O. Stock Option Plan
The Company has a Stock Incentive Plan (the "Stock Plan") for the issuance of up to 3,000,000 qualified and non-qualified stock options and shares of Common Stock to its directors, officers, employees and consultants. As of December 31, 1999 and 1998, 902,000 and 833,000, respectively, related to outstanding stock options. The exercise price for stock options may not be less than 100% of the fair market value of the shares of Common Stock at the date of grant. Stock options granted through December 31, 1997 have 5-year terms and stock options granted after 1997 have 10-year terms. All outstanding stock options are non-qualified stock options.
Presented below is a summary of the changes in stock options for the three years ended December 31, 1999.
As of December 31, 1999, outstanding options have the following ranges of exercise prices and weighted average remaining lives:
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Options granted to date vest over various periods up to five years. As of December 31, 1999, 1998 and 1997, 374,000, 151,000 and 138,000, respectively, of the outstanding options were exercisable. As of December 31, 1999, 1998 and 1997, the weighted average exercise price of exercisable options was $18.06, $14.95 and $14.16, respectively.
The Company has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25) and related Interpretations in accounting for its employee stock options rather than the alternative fair value accounting provided for under SFAS No. 123, "Accounting for Stock-Based Compensation." Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized.
Pro forma information regarding net income and earnings per share is required by SFAS 123, and has been determined as if the Company had accounted for its employee stock options under the fair value method of that Statement. The fair value for these options was estimated at the date of grant using an option-pricing model with the following weighted average assumptions:
Option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
During 1999, 1998 and 1997, the estimated weighted-average grant-date fair value of options granted was $2.08 per option, $3.59 per option and $2.76 per option, respectively. The Company assumed lives of five to ten years and risk-free interest rates equal to the Five- or Ten-Year U.S. Treasury rates on the date the options were granted depending on option term. In addition, the expected
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stock price volatility and dividends rates were estimated based upon historical experience over the three years ended December 31, 1999.
For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The Company's pro forma information follows (in thousands except for per share data):
P. Savings Plan
The Company has a 401(k) defined-contribution employee savings plan, which provides substantially all employees the opportunity to accumulate funds for retirement. The Company may, at its discretion, match a portion of the contributions from participating employees. During 1999 and 1998, the Company matched $19,000 and $17,000, respectively, of employee contributions. The Company did not match any portion of employee contributions during 1997.
Q. Recent Accounting Developments
In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133. Accounting for Derivative Instruments and Hedging Activities ("Statement 133"). Statement 133 requires recording all derivative instruments as assets or liabilities, measured at fair value. Statement 133 is effective beginning after 2000. The Company has elected not to early adopt the provisions of Statement 133 as of December 31, 1999 and when Statement 133 is adopted, the Company does not expect Statement 133 to have a significant impact on its financial position and results of operations.
R. Other Matters
Prior to November 1997, FAM (the former manager) provided all personnel and related overhead necessary to conduct the Company's activities in exchange for various fees provided for in a management agreement (the "AIC Management Agreement"). In November 1997, the Company's stockholders approved the purchase of FAM's assets and operations for $11,692,000 in connection with the Company becoming a self-managed and self-administered REIT. The initial purchase price and related costs were allocated $6,553,000 to the AIC Management Agreement and $5,936,000 to a management agreement pursuant to which the Company manages Commercial Assets (the "Commercial Assets Management Agreement"). The Company expensed the amount allocated to the AIC Management Agreement in 1997 and is amortizing the cost of the Commercial Assets Management Agreement over three years. In addition to the initial purchase price, FAM received 120,000 additional OP Units in August 1998 because the Company had annualized returns before depreciation in excess of 9% on certain of its real estate investments. These OP Units were valued at $2,073,000 and were expensed in 1998.
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During 1999 and 1998, the Company earned the following management fees under the Commercial Assets Management Agreement (net of elimination for the Company's 27% ownership of Commercial Assets) (in thousands): 1999 1998 ----------- ----------- Base fees $ 414 $ 64 Acquisition fees 150 91 Incentive fees -- -- ------ ------ $ 564 $ 155 ====== ======
As of December 31, 1999, the net book value of the Commercial Assets Management Agreement was $1,764,000 and is included in other assets.
S. Selected Quarterly Financial Data (Unaudited)
Presented below is selected quarterly financial data for 1999 and 1998 (in thousands, except per share data).
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T. Subsequent Events
In January 2000, the Company purchased for $36,816,000 the four manufactured home communities and the undeveloped homesites at three additional manufactured home communities which secured the Company's participating mortgage. The purchase price was paid as follows:
(in thousands) Cancellation of participating mortgages and loans $ 24,851 Assumption of debt 10,704 Issuance of 44,572 OP Units 496 Cash 765 --------- $ 36,816 =========
In January 2000, the Company purchased for $2,120,000 the 50% interest that it did not already own in the property management companies that manage the Company's and Commercial Assets' properties. Mr. Bruce E. Moore, the Company's President and Chief Operating Officer, owned a 17.5% interest in these companies.
In January 2000, the Company purchased for $657,000 the assets, primarily manufactured home inventory, and activities of a real estate brokerage company that provides brokerage services at the Company's and Commercial Assets' properties. Mr. Moore, the Company's President and Chief Operating Officer, owned 50% of this company. The purchase price was equal to the historical cost of the inventory held by this company.
In January 2000, the Company purchased for $30,000 the assets of the company which provides maintenance services to the Company's and Commercial Assets' properties. Mr. Moore, the Company's President and Chief Operating Officer, owned 50% of this company.
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ASSET INVESTORS CORPORATION SCHEDULE III REAL ESTATE AND ACCUMULATED DEPRECIATION December 31, 1999 (In Thousands Except Site Data)
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ASSET INVESTORS CORPORATION SCHEDULE III REAL ESTATE AND ACCUMULATED DEPRECIATION For the Years Ended December 31, 1999, 1998 and 1997 (in thousands)
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ASSET INVESTORS CORPORATION SCHEDULE IV MORTGAGE LOANS ON REAL ESTATE December 31, 1999 (in thousands)
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ASSET INVESTORS CORPORATION SCHEDULE IV MORTGAGE LOANS ON REAL ESTATE For the Years Ended December 31, 1999, 1998 and 1997 (in thousands)
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REPORT OF INDEPENDENT AUDITORS
Board of Directors and Stockholders Commercial Assets, Inc.
We have audited the accompanying consolidated balance sheets of Commercial Assets, Inc. and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1999. Our audits also included the consolidated financial statement schedules listed in the accompanying index. These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Commercial Assets, Inc. and subsidiaries as of December 31, 1999 and 1998, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
/s/ERNST & YOUNG LLP Denver, Colorado January 21, 2000, except for Note O, as to which the date is March 7, 2000
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COMMERCIAL ASSETS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)
See Notes to Consolidated Financial Statements.
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COMMERCIAL ASSETS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data)
See Notes to Consolidated Financial Statements.
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COMMERCIAL ASSETS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
For the Years Ended December 31, 1999, 1998 and 1997
(In thousands)
See Notes to Consolidated Financial Statements.
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COMMERCIAL ASSETS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands)
See Notes to Consolidated Financial Statements.
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COMMERCIAL ASSETS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A. Organization
Commercial Assets, Inc. ("CAX" and, together with its subsidiaries, the "Company") is a Delaware corporation that has interests in manufactured home communities and has elected to be taxed as a real estate investment trust ("REIT"). Prior to June 10, 1999, the Company was a Maryland corporation. Effective June 10, 1999, the Company's stockholders approved its reincorporation in Delaware. The Company's common stock, par value $.01, (the "Common Stock") is listed on the American Stock Exchange under the symbol "CAX."
Prior to 1998, the Company owned subordinate classes of Commercial Mortgage Backed Securities ("CMBS bonds"). In November 1997, the Company resecuritized its subordinate CMBS bond portfolio. This resulted in the Company receiving $77,693,000 cash and retaining a residual interest in an owner trust arising from the resecuritization. In the third quarter of 1998, the Company decided to invest in manufactured home communities and as of December 31, 1999 has invested approximately $70 million in 12 manufactured home communities (including investments in participating mortgages and real estate joint ventures) with 1,840 developed homesites and 1,370 undeveloped homesites.
The Company's daily operations are performed by a manager pursuant to an agreement currently in effect through December 2000 ("the Management Agreement"). Since November 1997, Asset Investors Corporation (together with its subsidiaries, "Asset Investors") has been the manager. Asset Investors owns 27% of the Company's Common Stock. No change was made to the Management Agreement during 1998. For 1999, the Incentive Fee was amended to provide that it is based on Funds From Operations, less an annual capital replacement reserve of at least $50 per developed homesite, instead of the Company's REIT income. In general, FFO is net income plus depreciation, amortization and real estate acquisition fees. The Management Agreement has been extended to December 31, 2000 with the same terms as 1999 except that the Management Agreement will automatically terminate if the Company merges with Asset Investors. The Management Agreement is subject to the approval of a majority of the Company's independent directors and can be terminated by either party, without cause, with 60 days' notice. Since the Company has no employees, officers of Asset Investors are also officers of the Company.
B. Proposed Merger with Asset Investors
The Company and Asset Investors have agreed to merge, subject to the approval by both (a) a majority of Asset Investors' outstanding shares and (b) two-thirds of the Company's outstanding shares. Asset Investors owns approximately 27% of the Company's outstanding shares and has agreed to vote these shares in favor of the merger. Asset Investors will issue 0.4075 shares of its common stock for each outstanding share of the Company's Common Stock. Alternatively, the Company's stockholders may elect to receive $5.75 per share in cash for up to 3,549,868 shares of the Company's Common Stock with any remaining shares receiving 0.4075 shares of Asset Investors common stock. Asset Investors and the officers and directors of Asset Investors and the Company have agreed to elect to receive shares of Asset Investors common stock for all shares of the Company's Common Stock that they own. The stockholder meetings are expected to occur in the second quarter of 2000.
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C. Summary of Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. The Company's investment in Asset Investors is recorded under the equity method.
Real Estate and Depreciation
Rental properties are recorded at cost less accumulated depreciation, unless considered impaired. If events or circumstances indicate that the carrying amount of a property may be impaired, the Company will make an assessment of its recoverability by estimating the future undiscounted cash flows, excluding interest charges, of the property. If the carrying amount exceeds the aggregate future cash flows, the Company would recognize an impairment loss to the extent the carrying amount exceeds the fair value of the property. As of December 31, 1999, management believes that no impairment losses exist based on periodic reviews. No impairment losses were recognized in 1999 or 1998.
Depreciation is computed using the straight line method over an estimated useful life of 25 years for land improvements and buildings. Significant renovations and improvements, which improve or extend the useful life of the asset, are capitalized and depreciated over the remaining estimated life. Maintenance, repairs and minor improvements are expensed as incurred.
Investments in Participating Mortgages
The Company has loans secured by real estate which provide for an interest rate return plus up to 50% of net profits, cash flows and sales proceeds from the underlying real estate. The Company accounts for these investments as loans when (a) the Company does not have an interest in the borrower and either (b) the borrower has a substantial equity investment in the real estate collateral or (c) the Company has recourse to other substantial tangible assets of the borrower. As such, the Company records interest income based on the rate provided for in the loan and records its share of any net profits or gains from the sale of the underlying real estate when realized. If the above requirements are not met, then the loan is accounted for as an equity investment in real estate under the equity method of accounting.
Investments in Real Estate Joint Ventures
Investments in real estate joint ventures in which the Company does not control the joint venture's activities are accounted for under the equity method of accounting.
Investment in and Note Receivable from Westrec
The Company classifies its investment in and note receivable from Westrec as available-for-sale and carries this at estimated fair value in the financial statements. The Company believes that the contractual amounts provided for in the note receivable and the agreement under which the Company can sell its shares of Westrec common stock approximates fair value at December 31, 1999.
Revenue Recognition
The Company derives its income from the rental of homesites. The leases entered into by residents for the rental of the site are generally for terms not longer than one year and the associated rental revenues are recognized when earned and due from residents.
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Interest on participating mortgages is recorded based upon outstanding balances and interest rates per the terms of the mortgages. In addition, the Company evaluates the collectibility of any unpaid interest and provides reserves as necessary. As of December 31, 1999, there is no reserve for uncollected interest on the participating mortgages. Rent on ground leases is recognized when earned and due from lessee.
Deferred Financing Costs
Fees and costs incurred in obtaining financing are capitalized. These costs are amortized over the terms of the related loan and are charged to interest expense.
Capitalized Interest
Interest is capitalized on development projects during periods of construction or development. During 1999, capitalized interest was $417,000. There was no capitalized interest in 1998 or 1997.
CMBS Bonds
Earnings from CMBS bonds was comprised of coupon interest and the amortization of the purchase discount. Amortization of the purchase discount was recognized by the interest method using a constant effective yield and assumed an estimated rate of future prepayments, defaults and credit losses which was adjusted for actual experience. The allowance for credit losses was equal to the undiscounted total of future estimated credit losses. In the event the Company adjusted the estimate of future credit losses, such adjustments would be included in current period earnings.
The Company classifies its CMBS bonds as available-for-sale. Accordingly, the CMBS bonds are carried at fair value in the financial statements. Unrealized holding gains and losses on available-for-sale securities are excluded from earnings and reported as a net amount in stockholders' equity until realized. If the fair value of a CMBS bond declines below its amortized cost basis and the decline is considered to be "other than temporary," the amount of the write-down would be included in the Company's income. The decline in fair value is considered to be other than temporary if the cost basis exceeds the related projected cash flow from the CMBS bond discounted at a risk-free rate of return.
Fair Value of Financial Instruments
The fair value of the Company's financial instruments generally approximate their carrying basis or amortized cost.
Income Taxes
The Company intends to operate in a manner that will permit it to qualify for the income tax treatment accorded to a REIT. If it so qualifies, the Company's net income, with certain limited exceptions, will not be subject to federal or state income tax at the corporate level. Accordingly, no provision for taxes has been made in the financial statements.
In order to maintain its status as a REIT, the Company is required, among other things, to distribute annually to its stockholders at least 95% of its REIT income and to meet certain asset, income and stock ownership tests.
Ninety percent of dividends paid in 1999 represented ordinary taxable income to stockholders and 10% represented a return of capital for income tax purposes (unaudited). Regular and special dividends paid in 1998 and 1997 represented
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ordinary taxable income to the stockholders (unaudited). In addition, the Company paid a capital gains dividend of $.17 per share in 1997 (unaudited).
Earnings Per Share
Basic earnings per share for 1999, 1998 and 1997 are based upon the weighted-average number of shares of Common Stock outstanding during each such year. Diluted earnings per share reflect the effect of dilutive, unexercised stock options of 0, 15,000 and 39,000 in 1999, 1998 and 1997, respectively. Stock options of 62,000, 43,000 and 28,000 for 1999, 1998 and 1997, respectively, have been excluded from diluted earnings per share as their effect would be anti-dilutive.
Treasury Stock
Treasury stock is recorded at cost. In addition, the Company purchased 114,000 shares of Asset Investors' common stock during 1999. Because Asset Investors owns 27% of the Company's Common Stock, the Company is deemed to have an interest in 48,000 shares of the Company's Common Stock and has also recorded this as treasury stock.
Statements of Cash Flows
For purposes of reporting cash flows, cash maintained in bank accounts, money market funds and highly-liquid investments are considered to be cash and cash equivalents. The Company paid $565,000 in interest during 1999. The Company paid no interest in 1998 or 1997.
Non-cash operating, investing and financing activities for 1999, 1998 and 1997 were as follows (in thousands):
Use of Estimates
The preparation of the financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Reclassifications
Certain reclassifications have been made in the 1998 and 1997 consolidated financial statements to conform to the classifications currently used. The effect of such reclassifications on amounts previously reported is immaterial.
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D. Short-term Investments
The Company has short-term investments consisting of mortgage-backed bonds guaranteed by Federal Home Loan Mortgage Corporation and Federal National Mortgage Association. These investments are classified as available-for-sale, and the fair market value at December 31, 1999 approximates the carrying value of $12,502,000. During 1999 and 1998, the Company had no unrealized gains (losses) on these investments. The Company had $22,411,000 and $16,085,000 in proceeds from the sale of short-term investments during 1999 and 1998, respectively, and realized no gains (losses) from such sales. The Company determined its basis in these sold investments using the specific identification method. At December 31, 1999, these investments had the following maturities:
Amount Maturity ------------------- --------------- $3,395,000 2000 $9,107,000 2003
E. Investments in Manufactured Home Communities
During 1999, the Company acquired eight manufactured home communities with approximately 1,450 developed homesites and 500 undeveloped homesites. The Company had participating mortgages on three of these communities in 1998. The total investment was $52,257,000 consisting of $34,292,000 cash, $8,587,000 of assumed debt, $8,978,000 by canceling participating mortgages and $400,000 of estimated initial capital expenditures. During 1998, the Company paid $12,671,000 to acquire two manufactured home communities with approximately 310 developed homesites and 790 undeveloped homesites. These investments are recorded as real estate.
The Company made $8,959,000 of participating mortgages in 1998 involving three manufactured home communities and adjacent land involving approximately 310 developed homesites and 210 undeveloped homesites. These non-recourse mortgages were secured by the three manufactured home communities, adjacent land, commercial real estate, two additional manufactured home communities and one recreational vehicle park. These investments are recorded as participating mortgages. In 1999, the Company cancelled these participating mortgages in connection with the purchase of these manufactured home communities and the adjoining land.
The following unaudited pro-forma information has been prepared assuming the acquisition of the manufactured home communities had been completed at the beginning of the periods presented. The unaudited pro-forma information is presented for informational purposes only and is not necessarily indicative of what would have occurred if the restructurings and the acquisitions had been completed as of those dates. In addition, the pro-forma information is not intended to be a projection of future results.
The unaudited, pro-forma results of operations for 1999 and 1998 are as follows (in thousands, except per share data):
1999 1998 -------- -------- Revenues $ 6,927 $ 5,775 ======== ========
Net income $ 1,252 $ 391 ======== ========
Basic and diluted earnings per share $ .12 $ .04 ======== ========
The Company is actively seeking to acquire additional communities and currently is engaged in negotiations relating to the possible acquisition of a number of communities. At any time, these negotiations are at various stages of
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completion, which may include outstanding contracts to acquire certain manufactured home communities, subject to satisfactory completion of the Company's due diligence review.
F. Real Estate
Real estate at December 31, 1999 and 1998, is as follows (in thousands):
Land improvements and buildings consist primarily of infrastructure, roads, landscaping, clubhouses, maintenance buildings and common amenities.
Two manufactured home communities have been leased to a third party. The first lease involves a community acquired by the Company at a cost of $1.4 million and is for a term of 50 years. The Company receives initial annual lease payments equal to 9% of its cost. The annual lease payments increase by 4% per annum over the prior year's lease payments until the annual lease payment equals 13% of the Company's cost. In addition, the Company receives additional rent equal to 50% of the lessee's net cash flow from the property. In the event of a sale of the property, the Company receives all proceeds until it has realized its total purchase price of the property plus a 13% per annum rate of return. The Company then receives 50% of any sales proceeds in excess of such amount. The Company terminated the lease on January 1, 2000 by canceling $187,000 in loans to the lessee.
The other leased community involves two phases and has been leased to the same third party for 50 years. Annual lease payments on the first phase during 1999 was $890,000 and increases in later years by 4% per annum. There are no lease payments on the second phase until the sites are developed, at which time, the annual lease payments on the second phase will be equal to 10% times the costs incurred in developing this phase. In addition, the lessee pays to the Company additional rent equal to 50% of the lessee's net cash flow from the property. In the event of a sale, the Company receives 50% of any sales proceeds in excess of the Company's cost. The Company terminated the lease on January 1, 2000 by canceling $186,000 in loans to the lessee.
G. Investments in Participating Mortgages
During 1998, the Company made investments in participating mortgages secured by three manufactured home communities and adjoining land. The non-recourse notes accrued interest at 15% per annum and paid interest at 9% per annum through August 1999, with the pay rate increasing 1% each year thereafter to a maximum of 12% per annum. The loans were scheduled to mature in September 2007. The Company also received additional interest of 50% of the net profits and cash flows from the properties. In August 1999, the Company purchased the three communities and adjoining land by canceling the participating mortgages and releasing additional collateral pledged on the mortgages.
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The following table provides unaudited summary financial information of the borrower with respect to these participating mortgages for the period from August 1998 (date of participating mortgages) to December 31, 1998 and January 1999 to August 1999 (date the Company acquired the properties):
The Company also has investments in participating mortgages secured by individual homes and homesites within two manufactured home communities. These mortgages accrue interest at 10% and pay interest from the cash flows from the homes and homesites. The Company also receives additional interest equal to 50% of the net profits and cash flows from the homes and homesites.
As of December 31, 1999, the Company had investments in participating mortgages of $2,148,000. During 1999 and 1998, the Company had income of $920,000 and $451,000, respectively, from participating mortgages.
H. Investments in Real Estate Joint Ventures
The Company has a $1,304,000 investment in a joint venture involving a manufactured home community. The Company receives a priority return from the venture until the Company has received an amount equal to 9% times $1,250,000 for 1999. The Company's subsequent annual priority return increases by 5% over the prior year's amount. The other venturer then receives a similar percentage return on its $300,000 investment in the venture. In the event the property is sold, the Company receives all proceeds until it has received its investment plus 20% per annum. The other venturer then receives all proceeds until it has received its investment plus 20% per annum. Any excess sales proceeds are then shared equally. The Company did not record any income from this real estate joint venture in 1999 or 1998 as the property is under development.
In November 1999, the Company invested $624,000 in a joint venture involving a manufactured home community. The Company receives a priority annual return from the venture equal to 9% times $690,000 through 2000. After 2000, the Company's priority return increases by 4% annually. Thereafter, the Company receives 20% of any profits and cash flows of the venture in excess of the above priority returns. During 1999, the Company recorded $10,000 in income from this joint venture.
I. Investment in Asset Investors
During 1999, the Company purchased 114,000 shares (approximately 2%) of the common stock of Asset Investors. The Company has recorded its investment in Asset Investors under the equity method because Asset Investors manages the Company and owns approximately 27% of the Company's Common Stock. In 1999, the Company recorded $23,000 in equity in earnings of Asset Investors.
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J. CMBS Bonds
In November 1997, the Company resecuritized its portfolio of retained interests in prior securitizations that are in the form of CMBS bonds. Nine bonds were sold, one bond was redeemed and the remaining two CMBS bonds were resecuritized by transferring the bonds and related restricted cash to an owner trust in which the Company retained a residual interest. In a private placement, the trust then sold debt securities representing senior interests in the trust's assets. The Company recorded the resecuritization of its portfolio as a sale. The Company received $77,693,000 in cash proceeds and recorded a $5,786,000 gain from the sale. The Company determined its basis in the CMBS bonds using the specific identification method. The Company paid $426,000 in incentive fees to its manager in connection with the sale. These incentive fees were netted against the gain.
The estimated fair value of the residual interest retained by the Company was $2,000,000. During 1999 and 1998, the Company received $141,000 and $403,000, respectively, of which $78,000 and $242,000, respectively, was recorded as a reduction in the net book value of the retained residual interest. The net book value at December 31, 1999 was $1,753,000 which approximates fair value. The Company had no unrealized gains (losses) on its CMBS bonds at December 31, 1999 and 1998. The maturity dates of the CMBS bonds range from 2001 to 2004 and the Company had no sales of CMBS bonds during 1999 or 1998.
In 1997, three mortgages underlying one of the Company's CMBS bonds were prepaid. As a result of the prepayment, the Company recognized $482,000 of income from a prepayment penalty received and $2,305,000 of income from accelerated discount amortization.
K. Investment in and Note Receivable from Westrec
Prior to deciding to acquire manufactured home communities, the Company evaluated acquiring interests in marinas and, in connection with this, acquired a 12% interest in Westrec Marina Management Inc. ("Westrec") for approximately $2,500,000 and made a loan to an affiliate of Westrec. In the third quarter of 1998, the Company decided to invest in manufactured home communities instead of marinas. The Company has recorded its investment in and note receivable from Westrec at the sum of the amount for which the Company can re-sell its interest in Westrec plus the outstanding balance of the note receivable. In 1998, the Company expensed $500,000 for due diligence, legal, and other costs incurred in connection with investigating investments in marinas.
L. Secured Long-Term Notes Payable
The following table summarizes the Company's secured long-term notes payable (in thousands):
Real estate assets which secure the long-term notes payable had a net book value of $35,326,000 at December 31, 1999. The Company had $522,000 in escrow for real estate taxes and property improvements at December 31, 1999.
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Scheduled principal payments after December 31, 1999 for the secured long-term notes payable are (in thousands):
2000 $ 1,218 2001 2,098 2002 2,453 2003 419 2004 449 Thereafter 13,805 --------- $ 20,442 =========
M. Stock Option Plan
The Company has a Stock Incentive Plan for the issuance of non-qualified stock options to its directors and officers, employees and consultants which as of December 31, 1999, permitted the issuance of up to an aggregate of 3,000,000 shares of Common Stock, of which 331,000 and 454,000 related to outstanding stock options as of December 31, 1999 and 1998, respectively. The exercise price for stock options may not be less than 100% of the fair market value of the shares of Common Stock at the date of the grant. The stock options have various terms ranging up to 10 years.
Presented below is a summary of the changes in stock options for the three years ended December 31, 1999. As of December 31, 1999, the outstanding options have exercise prices ranging from $5.625 to $6.625 and have a remaining weighted-average life of 3.0 years. Weighted Average Exercise Price Shares -------------- ------ Outstanding - December 31, 1996 $ 6.80 648,000 Granted 6.30 87,000 Forfeited 7.30 (13,000) Exercised 6.12 (5,000) ------ ---------- Outstanding - December 31, 1997 6.74 717,000 Granted 6.62 38,000 Forfeited 7.50 (290,000) Expired 7.25 (11,000) ------ ---------- Outstanding - December 31, 1998 6.23 454,000 Granted 6.50 38,000 Expired 6.32 (161,000) ------ ---------- Outstanding - December 31, 1999 $ 6.22 331,000 ====== ==========
Options granted to date vest over various periods up to two years. As of December 31, 1999, 1998 and 1997, 331,000, 445,000 and 660,000, respectively, of the outstanding options were exercisable and the weighted average exercise price of exercisable options was $6.22, $6.22 and $6.78, respectively.
The Company has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25) and related Interpretations in accounting for its employee stock options rather than the alternative fair value accounting provided for under SFAS No. 123, "Accounting for Stock-Based Compensation." Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized.
Pro forma information regarding net income and earnings per share is required by SFAS No. 123, and has been determined as if the Company had accounted for its employee stock options under the fair value method of that Statement. The fair
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value for these options was estimated at the date of grant using an option-pricing model with the following weighted average assumptions:
Option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
During 1999, 1998 and 1997, the estimated weighted-average, grant-date fair value of options granted was $.26, $.41 and $.47, respectively. The Company assumed lives of five to ten years and risk-free interest rates equal to the Five- or Ten-Year U.S. Treasury rate on the date the options were granted depending on option term. In addition, the expected stock price volatility and dividend growth rates were estimated based upon historical averages over the two years ended December 31, 1999, adjusted for changes based upon the Company's investment in manufactured home community assets.
For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The Company's pro forma information follows (in thousands except for per share data):
N. Management Fees
The Company operates under a management agreement, pursuant to which the manager advises the Company on its business and oversees its daily operations, subject to the supervision of the Company's Board of Directors. Asset Investors has been the manager since November 1997. The Management Agreement provides that the manager receives a "Base Fee," an "Acquisition Fee" and an "Incentive Fee." The Base Fee is payable quarterly in an amount equal to 1% per annum of the Company's average net book value of real estate-related assets. The Acquisition Fee equals 0.5% of the cost of each real estate-related asset acquired. For 1997 and 1998, the Incentive Fee equals 20% of the amount by which the Company's REIT taxable income exceeds the amount calculated by multiplying the Company's "average net worth" by the "Ten-Year United States Treasury rate" plus 1%. During 1999, the Incentive Fee was amended to provide that this fee was based on the Company's Funds From Operations, less an annual capital replacement reserve of at least $50 per developed homesite, instead of REIT income. In general, Funds From Operations is equal to net income plus depreciation, amortization and acquisition fees. In 1997, the manager also received "Administrative Fees" on each CMBS bond outstanding. Administrative Fees were terminated in connection with the November 1997 restructuring of the CMBS bond portfolio. The Management Agreement has been extended through December 31, 2000. The terms are the same as provided for in 1999.
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Fees paid to the manager during 1999, 1998 and 1997 were (in thousands):
Acquisition Fees incurred in 1997 were capitalized as part of the cost of acquiring CMBS bonds. In addition, the Company incurred $426,000 of Incentive Fees in 1997 relating to the gain on the restructuring of the CMBS bonds. Acquisition Fees incurred in 1999 and 1998 were expensed because such fees were paid to Asset Investors, owner of 27% of the Company's Common Stock.
O. Commitments and Contingencies
In connection with the acquisition of a manufactured home community, the Company entered into an earn-out agreement with respect to 154 unoccupied homesites. The Company will pay $17,000 to the former owner for each newly occupied homesite. During 1999 and 1998, the Company paid $17,000 and $0, respectively, for homesites that became occupied.
The Company has agreed to acquire from time-to-time homesites subject to ground leases. The purchase price for each homesite will be equal to the base annual rent provided for in the ground lease divided by 9%. The Company is not required to acquire these homesites in groups of less than 10. The maximum number of homesites the Company might purchase is approximately 500 for total consideration of approximately $20 million. The Company purchased no homesites during 1999 or 1998.
The Company has agreed to invest up to an additional $680,000 in a real estate joint venture in four equal, annual installments of $170,000 beginning in November 2000.
In connection with the acquisition of a property, the Company entered into an earn-out agreement whereby it will pay the former owner an amount equal to the increase in the property's net operating income divided by 9.5% until the Company pays a total of $2,160,000. No amount was paid during 1999.
In September 1999, four of the Company's stockholders, individually and as purported representatives of the Company's stockholders, except Asset Investors and its affiliates, filed three purported class action lawsuits in Delaware against the Company, the members of the board of directors and certain officers of Asset Investors and the Company. These lawsuits alleged that the defendants breached their fiduciary duties to the Company's stockholders in connection with the Company's proposed merger with Asset Investors and the Company's recent reincorporation in Delaware. In November 1999, these lawsuits were consolidated into a single lawsuit. On March 7, 2000, the parties entered into a settlement agreement, subject to the court's approval which, amended the merger agreement as follows:
o the Company's stockholders, other than Asset Investors and the officers and directors of Asset Investors and the Company, may elect to receive $5.75 in cash per share for up to 3,549,868 shares of the Company's Common Stock with any remaining shares to receive 0.4075 shares of Asset Investors common stock; and o the percentage of votes of the Company's Common Stock needed to approve the merger was increased from a majority to two-thirds.
P. Operating Segments
Investments in manufactured home communities constitute substantially all of the Company's investments. Management assesses the performance of the Company as one operating segment.
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Q. Fair Value of Financial Instruments
The following methods and assumptions were used to estimate the fair value of each type of financial instrument. The estimates of fair value have been determined by the Company using available market information and valuation methodologies.
o Cash and cash equivalents, accounts payable and accrued liabilities, and secured short-term financing - the carrying amounts approximate fair value because of the short maturity of these instruments. o Investment in Asset Investors - the fair value was determined based upon the closing price of Asset Investors common stock on the New York Stock Exchange, Inc. as of the end of 1999. o Secured long-term notes payable - based upon borrowing rates currently available to the Company, the carrying value of its secured long-term notes payable approximates their fair value.
The carrying values and fair values of the Company's investment in Asset Investors at December 31, 1999 is as follows (in thousands):
------------------------------ Carrying Value Fair Value -------------- ---------- Investment in Asset Investors $ 1,396,000 $ 1,270,000 =========== ===========
R. Other Matters
The Company's Charter authorizes the Board of Directors to issue 25,000,000 shares, par value $.01 per share, of preferred stock. The Board of Directors is authorized to fix the terms of the preferred stock, including preferences, powers and rights (including voting rights) senior to the Common Stock. To date, the Company has not issued any shares of preferred stock.
S. Selected Quarterly Financial Data (unaudited)
Presented below is selected quarterly financial data for the years ended December 31, 1999 and 1998 (in thousands, except per share data).
T. Recent Accounting Developments
In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133. Accounting for Derivative Instruments and Hedging Activities ("Statement 133"). Statement 133 requires recording all derivative instruments as assets or liabilities, measured at fair value. Statement 133 is effective beginning after 2000. The Company has elected not to early adopt the provisions of Statement 133 as of December 31, 1999 and when Statement 133 is adopted, the Company does not expect Statement 133 to have a significant impact on its financial position and results of operations.
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COMMERCIAL ASSETS, INC. SCHEDULE III REAL ESTATE AND ACCUMULATED DEPRECIATION December 31, 1999 (In Thousands Except Site Data)
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COMMERCIAL ASSETS, INC. SCHEDULE III REAL ESTATE AND ACCUMULATED DEPRECIATION For the Years Ended December 31, 1999, 1998 and 1997 (in thousands)
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COMMERCIAL ASSETS, INC. SCHEDULE IV MORTGAGE LOANS ON REAL ESTATE December 31, 1999 (in thousands)
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COMMERCIAL ASSETS, INC. SCHEDULE IV MORTGAGE LOANS ON REAL ESTATE For the Years Ended December 31, 1999, 1998 and 1997 (in thousands)
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EXHIBIT INDEX
Exhibit No. Description
2.1 Agreement and Plan of Merger, dated as of March 15, 1999, between Asset Investors Corporation, a Maryland corporation and Asset Investors Corporation, a Delaware corporation (incorporated herein by reference to Exhibit 2.1 to the Registrant's Current Report on Form 8-K, dated May 26, 1999, Commission File No. 1-9360, filed on May 26, 1999).
2.2 Agreement and Plan of Merger, dated as of August 31, 1999, by and between the Registrant and Commercial Assets, Inc. (incorporated herein by reference to Exhibit 2.1 to the Current Report on Form 8-K dated August 31, 1999, Commission File No. 1-9360, filed on September 3, 1999).
2.3 Form of Mobile Home Park Purchase and Sale Agreement dated as of May 13, 1997, entered into in connection with the acquisition of six manufactured home communities (incorporated herein by reference to Exhibit 2.1 to the Current Report on Form 8-K dated May 14, 1997, Commission File No. 1-9360, filed on May 28, 1997).
2.1(a) Royal Palm Joint Venture Agreement dated as of May 13, 1997, by and between Royal Palm Village, LLC and Asset Investors Operating Partnership, LP (incorporated herein by reference to Exhibit 2.1(a) to the Current Report on Form 8-K dated May 14, 1997, Commission File No. 1-9360, filed on May 28, 1997).
2.1(b) Form of Assignment and Assumption Agreement dated as of May 13, 1997, entered into in connection with the acquisition of Prime-Forest Partners (incorporated herein by reference to Exhibit 2.1(b) to the Current Report on Form 8-K dated May 14, 1997, Commission File No. 1-9360, filed on May 28, 1997).
2.2 Promissory Note dated as of July 30, 1997, by and between the Registrant and Lost Dutchman Parks, LLC (incorporated herein by reference to Exhibit 2.2 to the Current Report on Form 8-K dated July 30, 1997, Commission File No. 1-9360, filed on August 12, 1997).
2.2(a) Combination Deed of Trust, Assignment of Rents, Security Agreement and Fixture Financing Statement dated as of July 30, 1997, by and between the Registrant and Lost Dutchman Parks, LLC (incorporated herein by reference to Exhibit 2.2(a) to the Current Report on Form 8-K dated July 30, 1997, Commission File No. 1-9360, filed on August 12, 1997).
2.2(b) Assumption Agreement and Note Modification dated as of July 30, 1997, by and between the Registrant and Lost Dutchman Parks, LLC (incorporated herein by reference to Exhibit 2.2(b) to the Current Report on Form 8-K dated July 30, 1997, Commission File No. 1-9360, filed on August 12, 1997).
2.2(c) Commitment Letter dated as of July 10, 1997, by and between the Registrant and Lost Dutchman Parks, LLC (incorporated herein by reference to Exhibit 2.2(c) to the Current Report on
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Form 8-K dated July 30, 1997, Commission File No. 1-9360, filed on August 12, 1997).
2.3 Form of Joint Venture Agreement dated as of September 30, 1997, between Asset Investors Operating Partnership, L.P. and Community Acquisition and Development Corporation (incorporated herein by reference to Exhibit 2.3 to the Current Report on Form 8-K dated October 30, 1997, Commission File No. 1-9360, filed on November 13, 1997).
2.3(a) Earn-Out Agreement dated October 30, 1997, between Community Casa del Mar Joint Venture, Wilder Corporation of Delaware and AIC Community Management Partnership (incorporated herein by reference to Exhibit 2.3(a) to the Current Report on Form 8-K dated October 30, 1997, Commission File No. 1-9360, filed on November 13, 1997).
2.3(b) Form of Agreement of Sale dated as of August 22, 1997, between Community Acquisition and Development Partnership and Wilder Corporation of Delaware (incorporated herein by reference to Exhibit 2.3(b) to the Current Report on Form 8-K dated October 30, 1997, Commission File No. 1-9360, filed on November 13, 1997).
2.4 Contribution Agreement dated as of February 27, 1998, between Asset Investors Operating Partnership, L.P. and Roth Associates of New Jersey (incorporated herein by reference to Exhibit 2.4 to the Current Report on Form 8-K dated February 27, 1998, Commission File No. 1-9360, filed on March 13, 1998).
2.4(a) Contribution Agreement dated as of February 27, 1998, between Asset Investors Operating Partnership, L.P. and Salem Farm Mobile Home Park, Inc. (incorporated herein by reference to Exhibit 2.4(a) to the Current Report on Form 8-K dated February 27, 1998, Commission File No. 1-9360, filed on March 13, 1998).
2.5 Agreement of Sale dated as of April 13, 1998, between Community Acquisition Joint Venture and Serendipity Properties, Inc., (incorporated herein by reference to Exhibit 2.5 to the Registrant's Current Report on Form 8-K dated May 29, 1998, Commission File No. 1-9360, filed on June 12, 1998).
2.5(a) Assignment of Agreement of Sale dated as of May 20, 1998, between Community Acquisition Joint Venture and Asset Investors Operating Partnership, L.P. (incorporated herein by reference to Exhibit 2.5(a) to the Registrant's Current Report on Form 8-K dated May 29, 1998, Commission File No. 1-9360, filed on June 12, 1998).
2.6 Purchase Agreement with Escrow Instructions, as amended, dated as of April 14, 1998 between Brentwood West Partners, LLP and Parkbridge Capital Group, Inc. (incorporated herein by reference to Exhibit 2.6 to the Registrant's Current Report on Form 8-K dated May 29, 1998, Commission File No. 1-9360, filed on June 12, 1998).
2.6(a) Conditional Assignment of Contract dated as of April 17, 1998, between Parkbridge Capital Group, Inc. and Community
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Acquisition Development Corporation. (incorporated herein by reference to Exhibit 2.6(a) to the Registrant's Current Report on Form 8-K dated May 29, 1998, Commission File No. 1-9360, filed on June 12, 1998).
2.6(b) Assignment of Agreement of Sale dated as of June 1, 1998, between Community Acquisition Joint Venture and Asset Investors Operating Partnership, L.P. (incorporated herein by reference to Exhibit 2.6(b) to the Registrant's Current Report on Form 8-K dated May 29, 1998, Commission File No. 1-9360, filed on June 12, 1998).
2.7 Agreement of Sale dated as of May 13, 1998, between HFIC, INC. and Gulfstream Harbor, Inc. and Gulfstream Harbor II Inc. (incorporated herein by reference to Exhibit 2.7 to the Registrant's Current Report on Form 8-K dated July 16, 1998, Commission File No. 1-9360, filed on July 30, 1998).
2.7(a) Assignment of Agreement of Sale dated as of July 15, 1998, between HFIC, INC. and AIOP Gulfstream Harbor, LLC., AIOP Gulfstream Outlot I, L.L.C., AIOP Gulfstream Outlot II, L.L.C. and AIOP Gulfstream Outlot III, L.L.C. (incorporated herein by reference to Exhibit 2.7(a) to the Registrant's Current Report on Form 8-K dated July 16, 1998, Commission File No. 1-9360, filed on July 30, 1998).
2.8 Contribution Agreement dated effective as of January 1, 2000, by and among Asset Investors Operating Partnership, L.P., CADC Holding L.L.C. and Community Acquisition and Development Corporation (incorporated herein by reference to Exhibit 2.8 to the Registrant's Current Report on Form 8-K dated January 31, 2000, Commission File No. 1-9360, filed on February 15, 2000).
2.8(a) Purchase and Sale Agreement dated effective as of January 1, 2000, by and between Asset Investors Operating Partnership, L.P. and Community Acquisition and Development Corporation (incorporated herein by reference to Exhibit 2.8(a) to the Registrant's Current Report on Form 8-K dated January 31, 2000, Commission File No. 1-9360, filed on February 15, 2000).
2.8(b) Purchase and Sale Agreement dated effective as of January 1, 2000, by and between Prime Forest Partners and Community Acquisition and Development Corporation (incorporated herein by reference to Exhibit 2.8(b) to the Registrant's Current Report on Form 8-K dated January 31, 2000, Commission File No. 1-9360, filed on February 15, 2000).
2.8(c) Purchase and Sale Agreement dated effective as of January 1, 2000, by and between Asset Investors Operating Partnership, L.P. and Community Acquisition and Development Corporation (incorporated herein by reference to Exhibit 2.8(c) to the Registrant's Current Report on Form 8-K dated January 31, 2000, Commission File No. 1-9360, filed on February 15, 2000).
2.8(d) Asset Purchase Agreement dated effective as of January 1, 2000, by and between AIC Homesales Corp. and Community Acquisition and Development Corporation (incorporated herein by reference to Exhibit 2.8(d) to the Registrant's Current Report on Form 8-K dated January 31, 2000, Commission File No. 1-9360, filed on February 15, 2000).
3.1 Amended and Restated Certificate of Incorporation of Asset Investors Corporation (incorporated herein by reference to Exhibit 3.1 to the Registrant's Current Report on Form 8-K, dated May 26, 1999, Commission File No. 1-9360, filed on May 26, 1999).
3.2 Amended and Restated By-laws of Asset Investors Corporation (incorporated herein by reference to Exhibit 3.2 to the
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Registrant's Current Report on Form 8-K, dated May 26, 1999, Commission File No. 1-9360, filed on May 26, 1999).
10.1* Form of Indemnification Agreement between the Registrant and each Director of the Registrant (incorporated herein by reference to Appendix A to the Proxy Statement of the Registrant, Commission File No. 1-9360, dated May 18, 1987).
10.2* 1998 Stock Incentive Plan of the Registrant (incorporated herein by reference to Exhibit 10.3 to the Quarterly Report on Form 10-Q of the Registrant for the quarter ended June 30, 1998, Commission File No. 1-9360, filed on August 14, 1998).
10.4 Trust Agreement dated as of March 26, 1997, among the Registrant, as depositor, Asset Investors Secured Financing Corporation and Wilmington Trust Company, as Owner Trustee (incorporated herein by reference to Exhibit 10.5(a) to the Quarterly Report on Form 10-Q of the Registrant for the quarter ended March 31, 1997, Commission File No. 1-9360, filed on May 14, 1997).
10.4(a) Pooled Certificate Transfer Agreement between the Registrant and Asset Investors Secured Financing Corporation dated as of March 26, 1997 (incorporated herein by reference to Exhibit 10.5(b) to the Quarterly Report on Form 10-Q of the Registrant for the quarter ended March 31, 1997, Commission File No. 1-9360, filed on May 14, 1997).
10.4(b) Indenture, dated as of March 27, 1997, between Structured Mortgage Trust 1997-1 and State Street Bank and Trust Company (incorporated herein by reference to Exhibit 10.5(c) to the Quarterly Report on Form 10-Q of the Registrant for the quarter ended March 31, 1997, Commission File No. 1-9360, filed on May 14, 1997).
10.4(c) Note Purchase Agreement, dated as of March 26, 1997, among Structured Mortgage Trust 1997-1, Asset Investors Secured Financing Corporation and Bear, Stearns & Co. Inc. (incorporated herein by reference to Exhibit 10.5(d) to the Quarterly Report on Form 10-Q of the Registrant for the quarter ended March 31, 1997, Commission File No. 1-9360, filed on May 14, 1997).
10.4(d) Trust Certificate issued to Asset Investors Secured Financing Corporation evidencing its ownership of the Structured Mortgage Trust 1997-1 (incorporated herein by reference to Exhibit 10.5(e) to the Quarterly Report on Form 10-Q of the Registrant for the quarter ended March 31, 1997, Commission File No. 1-9360, filed on May 14, 1997).
10.5 Asset Contribution Agreement dated as of September 8, 1997 between the Registrant, Asset Investors Operating Partnership, L.P., and Financial Asset Management, LLC (incorporated herein by reference to Exhibit 10.6 to the Quarterly Report on Form 10-Q of the Registrant for the quarter ended September 30, 1997, Commission File No. 1-9360, filed on November 12, 1997).
10.6 Loan Agreement dated as of July 16, 1998, by and among AIOP Brentwood West, L.L.C.; AIOP Lost Dutchman Notes, L.L.C.; AIOP Mullica, L.L.C.; AIOP Gulfstream Harbor, L.L.C.; AIOP Gulfstream Outlot I, L.L.C.; AIOP Gulfstream Outlot II, L.L.C.; AIOP Gulfstream Outlot III, L.L.C.; and AIOP Serendipity, L.L.C., and Salomon Brothers Realty Corp. and LaSalle National Bank (incorporated herein by reference to Exhibit 10.7 to the Registrant's Current Report on Form 8-K
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dated July 16, 1998, Commission File No. 1-9360, filed on July 30, 1998).
10.6(a) Promissory Note dated as of July 16, 1998, between AIOP Lost Dutchman Notes, L.L.C.; AIOP Brentwood West, L.L.C.; AIOP Mullica, L.L.C.; AIOP Gulfstream Harbor, L.L.C.; AIOP Gulfstream Outlot I, L.L.C.; AIOP Gulfstream Outlot II, L.L.C.; AIOP Gulfstream Outlot III, L.L.C.; and AIOP Serendipity, L.L.C., and Salomon Brothers Realty Corp. (incorporated herein by reference to Exhibit 10.7(a) to the Registrant's Current Report on Form 8-K dated July 16, 1998, Commission File No. 1-9360, filed on July 30, 1998).
10.6(b) Pledge Agreement and Limited Recourse Guaranty dated as of July 16, 1998 by and among the Registrant, Asset Investors Operating Partnership, L.P. and Salomon Brothers Realty Corp. (incorporated herein by reference to Exhibit 10.7(b) to the Registrant's Current Report on Form 8-K dated July 16, 1998, Commission File No. 1-9360, filed on July 30, 1998).
10.7 Credit Agreement dated as of September 1, 1998, between U.S. Bank National Association and Asset Investors Operating Partnership, L.P. and the Registrant (incorporated herein by reference to Exhibit 10.7 to the Annual Report on Form 10-K of the Registrant for the fiscal year ended December 31, 1998, Commission File No. 1-9360, filed on March 24, 1999).
10.7(a) Promissory Note dated as of September 1, 1998, between U.S. Bank National Association and Asset Investors Operating Partnership, L.P. and the Registrant (incorporated herein by reference to Exhibit 10.7 to the Annual Report on Form 10-K of the Registrant for the fiscal year ended December 31, 1998, Commission File No. 1-9360, filed on March 24, 1999).
10.8 Loan Agreement dated December 1, 1998, between AIOP Lost Dutchman Notes, L.L.C., Asset Investors Operating Partnership, L.P., the Registrant and U.S. Bank National Association (incorporated herein by reference to Exhibit 10.8 to the Annual Report on Form 10-K of the Registrant for the fiscal year ended December 31, 1998, Commission File No. 1-9360, filed on March 24, 1999).
10.8(a) Promissory Note dated December 30, 1998, between AIOP Lost Dutchman Notes, L.L.C., Asset Investors Operating Partnership, L.P., the Registrant and U.S. Bank National Association (incorporated herein by reference to Exhibit 10.8(a) to the Annual Report on Form 10-K of the Registrant for the fiscal year ended December 31, 1998, Commission File No. 1-9360, filed on March 24, 1999).
10.9 Form of Promissory Note to General Electric Capital Assurance Company entered into in connection with the financing of manufactured home communities (incorporated herein by reference to Exhibit 10.9 to the Annual Report on Form 10-K of the Registrant for the fiscal year ended December 31, 1998, Commission File No. 1-9360, filed on March 24, 1999).
10.9(a) Schedule of Promissory Notes to General Electric Capital Assurance Company entered into in connection with the financing of eight manufactured home communities.
10.10 Amended and Restated Loan Agreement dated as of January 1, 1998, by and between Community Acquisition and Development Corporation, Community Casa del Mar Joint Venture, Community Sunlake Joint Venture, Community Brentwood Joint Venture, Community Savanna Club Joint Venture, Community Blue Heron
- 40 -
Pines Corporation, Community Sunlake Corporation, Community Brentwood Corporation, Community Savanna Club Corporation, Royal Palm Village, LLC and Asset Investors Operating Partnership, L.P. (incorporated herein by reference to Exhibit 10.10 to the Annual Report on Form 10-K of the Registrant for the fiscal year ended December 31, 1998, Commission File No. 1-9360, filed on March 24, 1999).
10.10(a) Revolving Credit Promissory Note dated as of January 1, 1998 between Community Acquisition and Development Corporation, Community Casa del Mar Joint Venture, Community Sunlake Joint Venture, Community Brentwood Joint Venture, Community Savanna Club Joint Venture, Community Blue Heron Pines Corporation, Community Sunlake Corporation, Community Brentwood Corporation, Community Savanna Club Corporation, Royal Palm Village, LLC and Asset Investors Operating Partnership, L.P. (incorporated herein by reference to Exhibit 10.10(a) to the Annual Report on Form 10-K of the Registrant for the fiscal year ended December 31, 1998, Commission File No. 1-9360, filed on March 24, 1999).
10.11* Secured Promissory Note dated September 13, 1999 between Robert G. Blatz and Asset Investors Operating Partnership, L.P.
10.12 Acquisition Agreement, dated effective as of January 1, 2000, by and among AIC Community Management Holding Corp., AIC Management Holdings, LLC and Community Management Investors Corporation (incorporated herein by reference to Exhibit 10.0 to the Registrant's Current Report on Form 8-K dated January 19, 2000, Commission File No. 1-9360, filed on January 31, 2000).
10.12(a) Promissory Note, dated January 1, 2000, by and among AIC Community Management Holding, LLC, Manufactured Housing Corp. and Community Management Investors Corporation (incorporated herein by reference to Exhibit 10.1(a) to the Registrant's Current Report on Form 8-K dated January 19, 2000, Commission File No. 1-9360, filed on January 31, 2000).
21.1 List of Subsidiaries
23.1 Consent of Independent Auditors - Ernst & Young LLP.
27.1 Financial Data Schedule.
* Management contract or compensatory plan or arrangement.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
ASSET INVESTORS CORPORATION (Registrant)
Date: March 28, 2000 By /s/Terry Considine ------------------------------------ Terry Considine Chairman and Chief Executive Officer
Date: March 28, 2000 By /s/Thomas L. Rhodes ------------------------------------ Thomas L. Rhodes Vice Chairman
Date: March 28, 2000 By /s/Bruce E. Moore ------ ----------------------------- Bruce E. Moore President and Chief Operating Officer
Date: March 28, 2000 By /s/David M. Becker ------------------------------------ David M. Becker Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Name Capacity Date
/s/Terry Considine Director March 28, 2000 - ----------------------------- Terry Considine
/s/Thomas L. Rhodes Director March 28, 2000 - ----------------------------- Thomas L. Rhodes
/s/Bruce D. Benson Director March 25, 2000 - ----------------------------- Bruce D. Benson
/s/Bruce E. Moore Director March 28, 2000 - ----------------------------- Bruce E. Moore
/s/Elliot H. Kline Director March 26, 2000 - ----------------------------- Elliot H. Kline
/s/Richard L. Robinson Director March 24, 2000 - ----------------------------- Richard L. Robinson
/s/Tim Schultz Director March 28, 2000 - ----------------------------- Tim Schultz
/s/William J. White Director March 26, 2000 - ----------------------------- William J. White
- 42 - | 28,652 | 184,932 |
1046861_1999.html | 1046861_1999 | 1999 | 1046861 | Item 1. Business
(a) General development of business
Energy East Corporation is a holding company that was organized under the laws of the State of New York in 1997. It is a super-regional energy services and delivery company with operations in New York, Connecticut, Massachusetts, Maine, New Hampshire and New Jersey and offices in New York and Connecticut. On May 1, 1998, the company became the parent of New York State Electric & Gas Corporation. Because Energy East did not become the holding company for NYSEG until May 1, 1998, the January through April 1998 and the 1997 consolidated financial statements represent the accounts of NYSEG on a consolidated basis as predecessor of Energy East.
On February 8, 2000, the company completed its merger with Connecticut Energy Corporation (CNE). CNE is a holding company primarily engaged in the retail distribution of natural gas through its wholly-owned subsidiary, The Southern Connecticut Gas Company. The company accounted for the acquisition using the purchase method; consequently its consolidated financial statements will include CNE's results beginning with February 2000.
The following general developments have occurred in the company's business since January 1, 1999:
Regulatory and Rate Matters
(See Item 7 - Energy Delivery Business.)
(b) Financial information about segments
(See Item 8 - Note 14 to the Consolidated Financial Statements.)
(c) Narrative description of business
(See Item 7 - Merger Agreements, and Energy Delivery Business.)
Disposition of Assets
(See Item 7 - Energy Delivery Business, Sale of Coal-fired Generation Assets, Nine Mile Point 2 and Item 8 - Notes 7 and 8 to the Consolidated Financial Statements.)
(i) Principal business
The company's principal energy delivery business is purchasing, transmitting and distributing electricity and purchasing, transporting and distributing natural gas in New York. After completing its merger with CNE in February 2000, the company began purchasing, transporting and distributing natural gas in Connecticut. The company also generates electricity from its nuclear and hydroelectric stations.
The company's New York service territory, 99% of which is located outside the corporate limits of cities, is in the central, eastern and western parts of the state. It has an area of approximately 19,900 square miles and a population of 2,500,000. The company's Connecticut service territory extends along the southern Connecticut coast from Westport to Old Saybrook. It has an area of approximately 488 square miles and a population of 776,000. The larger cities in New York in which the company serves both electricity and natural gas are Binghamton, Elmira, Auburn, Geneva, Ithaca and Lockport. In Connecticut the larger cities in which it serves natural gas are Bridgeport and New Haven. The company provides delivery service to approximately 825,000 electricity customers and 408,000 natural gas customers. The service territories reflect diversified economies, including high-tech firms, light industry, colleges and universities, agriculture and recreational facilities. No customer accounts for 5% or more of either electric or natural gas revenues. The company's operating revenues derived from electricity deliveries were 83% in 1999, 87% in 1998 and 83% in 1997. Its operating revenues derived from natural gas deliveries were 14% in 1999, 12% in 1998 and 15% in 1997.
The 1999 peak load of 2,431 megawatts (mw) was set on January 14, 1999. This is 92 mw more than the previous year peak of 2,339 mw set on December 30, 1998.
The 1999 maximum peak daily sendout for natural gas of 400,713 dekatherms was set on January 13, 1999. This is 37,209 dekatherms more than the previous year peak of 363,504 dekatherms set on December 30, 1998.
(ii) Other operations
XENERGY Enterprises, Inc.
XENERGY Enterprises includes the following businesses:
XENERGY provides energy services, information systems and energy consulting nationwide.
Energy East Solutions sells electricity and natural gas in wholesale and retail markets in the Northeast and mid-Atlantic regions.
Cayuga Energy generates and sells electricity in the wholesale market at times of high demand.
Energy East Telecommunications operates a fiber optic network in Central New York.
Energy East Enterprises, Inc.
Energy East Enterprises includes the following businesses:
CMP Natural Gas delivers natural gas in southern and central Maine.
New Hampshire Gas operates a propane air distribution system in Keene, New Hampshire.
Seneca Lake Storage, Inc. is developing high deliverability gas storage in New York State.
CNE non-utility operations
CNE's non-utility operations include the following businesses:
CNE Energy Services Group, Inc. provides energy commodities and services to business customers throughout New England.
CNE Development Corporation participates in a natural gas purchasing cooperative.
CNE Venture-Tech, Inc. invests in technologically advanced energy-related products.
(iii) New product or segment
(See (ii) Other operations.)
(iv) Sources and availability of raw materials
Electric
(See Item 7 - Energy Delivery Business, Sale of Coal-fired Generation Assets and Nine Mile Point 2.)
After completing the sale of its coal-fired generation assets, the company satisfied the majority of its power requirements for 1999 through generation from its nuclear and hydroelectric stations and by purchases under long-term contracts from non-utility generators (NUGs) and the New York Power Authority. For its remaining power requirements, the company has assumed the risk of market prices that fluctuate and uses electricity contracts, both physical and financial, to manage its exposure to fluctuations in the market price of electricity.
Nuclear
In March 2000 Niagara Mohawk Power Corporation, the operator of Nine Mile Point 2, in which the company has an 18% interest, began installing reload No. 7 into the reactor core at Nine Mile Point 2. This refueling will support Nine Mile Point 2 operations through the spring of 2002. Enrichment services are under contract with the U.S. Enrichment Corporation for 100% of the enrichment requirements through 2000 and 75% of the requirements through 2002. Fuel fabrication services are under contract through 2004. Approximately 64% of the uranium and conversion requirements are under contract through 2002.
Natural Gas
(See Item 7 - Energy Delivery Business.)
The company's natural gas supply mix includes long-term, short-term and spot natural gas purchases transported under both firm and interruptible transportation contracts. During 1999 about 60% of the company's New York natural gas supply was purchased from various suppliers under long-term and short-term sales contracts and 40% was purchased in the monthly or daily spot natural gas market. About 84% of the 1999 Connecticut natural gas supply was purchased from various suppliers under long-term and short-term sales contracts and 16% was purchased in the monthly or daily spot natural gas market. The company expects to purchase its New York and Connecticut natural gas supplies for 2000 in similar proportions as were purchased in 1999. The company uses natural gas futures and options contracts to manage its exposure to fluctuations in natural gas commodity prices.
(v) Franchises
The company has, with minor exceptions, valid franchises from the municipalities in which it renders service to the public. In 1999 the company obtained authorization from the Public Service Commission of the State of New York for natural gas distribution service in the town of Skaneateles.
(vi) Seasonal business
Sales of electricity are highest during the winter months primarily due to space heating usage and fewer daylight hours. Sales of natural gas are highest during the winter months primarily due to space heating usage.
(vii) Working capital items
The company has been granted, through the ratemaking process, an allowance for working capital to operate its ongoing electric and natural gas utility services.
(viii) Single customer - Not applicable
(ix) Backlog of orders - Not applicable
(x) Business subject to renegotiation - Not applicable
(xi) Competitive conditions
(See Item 7 - Energy Delivery Business and Accounting Issues.)
(xii) Research and development
Expenditures on research and development were $5 million in 1999, $6 million in 1998 and $11 million in 1997, principally for internal research programs and for contributions to research administered by the Electric Power Research Institute, the Empire State Electric Energy Research Corporation (prior to 1999), the New York Gas Group and the New York State Energy Research and Development Authority. These expenditures are designed to improve existing technologies and to develop new technologies for the production, delivery and customer use of energy.
(xiii) Environmental matters
(See Item 3 - Legal proceedings, Item 7 - Energy Delivery Business, Sale of Coal-fired Generation Assets and Item 8 - Notes 8, 9 and 13 to the Consolidated Financial Statements.)
The company is subject to regulation by the federal government and by state and local governments with respect to environmental matters and is also subject to the New York State Public Service Law requiring environmental approval and certification of proposed major transmission facilities.
From time to time environmental laws, regulations and compliance programs may require changes in the company's operations and facilities and may increase the cost of energy delivery service. Historically, rate recovery has been authorized for environmental compliance costs.
Capital additions to meet environmental requirements during the three years ended December 31, 1999, were approximately $23 million, primarily for the company's coal-fired generation plants, which were sold in 1999. As a result, future capital additions to meet environmental requirements are not expected to be material.
Water and air quality
The company is required to comply with federal and state water and air quality statutes and regulations including the Clean Water Act. The Water Act requires that generating stations be in compliance with federally issued National Pollutant Discharge Elimination System Permits or state issued State Pollutant Discharge Elimination System (SPDES) Permits, which reflect water quality considerations for the protection of the environment. Nine Mile Point 2 has a SPDES Permit. The company owns two natural gas-fired peaking generating stations, which have the required federal or state operating permits and are in compliance with the permits.
Waste disposal
Niagara Mohawk has contracted with the U.S. Department of Energy for disposal of high level radioactive waste (spent fuel) from Nine Mile Point 2. The company is reimbursing Niagara Mohawk for its 18% share of the costs under the contract (currently approximately $1 per megawatt hour of net generation). The DOE's schedule for start of operations of their high level radioactive waste repository will be no sooner than 2010. The company has been advised by Niagara Mohawk that the Nine Mile Point 2 Spent Fuel Storage Pool has a capacity for spent fuel that is adequate until 2014. If further DOE schedule slippage should occur, construction of pre-licensed dry storage facilities would extend the on-site storage capability for spent fuel at Nine Mile Point 2 beyond 2014.
(xiv) Number of employees The company had 3,838 employees as of February 29, 2000.
(d) Financial information about geographic areas Not applicable
Item 2.
Item 2. Properties
(See Item 7 - Energy Delivery Business, Sale of Coal-fired Generation Stations and Nine Mile Point 2.)
The company's electric system includes nuclear, hydroelectric and internal combustion generating stations, substations and transmission and distribution lines, all of which are located in the State of New York. Generating facilities are:
(1) The company's 18% share of the generating capability. The company has agreed to sell its 18% interest in Nine Mile Point 2.
The company also owns two natural gas-fired peaking generating stations, Carthage and South Glens Falls, which are operated by Cayuga Energy and located in the State of New York. Each station has a generating capability of 63 mw.
The company owns 430 substations in New York having an aggregate transformer capacity of 13,436,948 kilovolt-amperes. The transmission system consists of 4,384 circuit miles of line. The distribution system consists of 33,891 pole miles of overhead lines and 2,153 miles of underground lines.
The company's New York natural gas system consists of 74 miles of transmission pipeline and 7,056 miles of distribution pipeline. Its Connecticut natural gas system consists of 3,573 miles of distribution pipeline.
NYSEG's and Southern's first mortgage bond indentures constitute direct first mortgage liens on substantially all of their respective properties.
Item 3.
Item 3. Legal proceedings
(See Item 7 - Energy Delivery Business.)
Since the Public Service Commission of the State of New York has allowed the company to recover in rates remediation costs for certain of the sites referred to in the next sentence, there is a reasonable basis to conclude that the company will be permitted to recover in rates any remediation costs that it may incur for all of the sites referred to in the next sentence. Therefore, the company believes that the ultimate disposition of the matters referred to below in (b), (d), (e), (f), (g), the first paragraph in (a) and the first two paragraphs in (c) will not have a material adverse effect on its results of operations or financial position.
As a result of the company's merger with CNE on February 8, 2000, the matters referred to in (j) below now relate to the company. All costs identified as recorded and deferred in (j) below are reflected in the company's financial records beginning in February 2000. Since the Connecticut Department of Public Utility Control has allowed recovery in rates of certain remediation costs of the type referred to below in (j), the company believes that the ultimate disposition of the matters referred to below in (j) will not have a material adverse effect on its results of operations or financial position.
(a) In June 1991 the New York State Department of Environmental Conservation (NYSDEC) notified the company that it had been identified as a potentially responsible party (PRP) at the Pfohl Brothers Landfill, an inactive hazardous waste disposal site in Cheektowaga, New York. The Pfohl Site is listed on the National Priorities List and the New York State Registry of Inactive Hazardous Waste Disposal Sites. The expected remediation costs at the Pfohl Site are estimated to be $37 million to $55 million. In May 1995 the company agreed to participate in a process for allocating remedial costs at the Pfohl Site with other PRPs. In October 1997 the PRPs agreed upon an allocation formula under which the company would be responsible for approximately $296,000 to $440,000.
Five actions were commenced against the company and approximately 24 other defendants in the New York State Supreme Court, Erie County (State Court) (in January 1995, April 1995, June 1995, January 1997 and October 1997), claiming $103.5 million in damages for personal injuries, wrongful death and loss of companionship allegedly caused by exposure to hazardous chemicals from the Pfohl Site. In December 1997 the action commenced in October 1997 was removed to the United States District Court for the Western District of New York (District Court). The company believes that the actions against it are without merit and will defend them vigorously.
In November 1997 a class action was commenced in the State Court against the company and approximately 23 other defendants claiming unspecified damages for personal injuries allegedly caused by exposure to hazardous chemicals from the Pfohl Site. This action was transferred to the District Court. The company believes this action against it is without merit and will defend it vigorously.
In 1995 four actions were commenced against approximately 11 defendants, and in 1996, an action was commenced against 13 defendants for personal injuries, wrongful death and loss of companionship allegedly caused by exposure to hazardous chemicals from the Pfohl Site. The company was not named as a defendant in those actions. However, the defendants in those actions consequently commenced actions against the company and certain other parties in the District Court at various times in 1995 and 1996, alleging that the company and such other parties are liable for all or a part of any damages recovered by the plaintiffs. Recovery in the actions against the company and such other parties depends on, among other things, whether the plaintiffs recover money damages against the defendants. The company believes that the actions against it are without merit and will defend them vigorously.
In October 1998 an action was commenced against the company and approximately 24 other defendants in the State Court claiming damages due to the lost use, value, and enjoyment of their property as a result of contamination from the Pfohl Site. The plaintiffs seek damages that total $6.4 million in the aggregate. The company believes that the action against it is without merit and will defend it vigorously.
In September 1999 the District Court granted a motion by the defendants to dismiss the claims of 26 plaintiffs based on the statute of limitations in the actions referred to in the four prior paragraphs.
(b) In January 1992 the NYSDEC notified the company that it had been identified as a PRP at the Peter Cooper Corporation's Landfill Site (Peter Cooper Site) in the village of Gowanda, New York. The Peter Cooper Site is listed on the National Priorities List and the New York State Registry. Three other PRPs were identified in the NYSDEC letter. The company believes that remediation costs at the Peter Cooper Site might rise to $16 million. In May 1992 the company notified the NYSDEC that it believed it had no responsibility for the alleged contamination at the Peter Cooper Site, and it declined to conduct remediation or finance remediation costs.
In June 1999 the U.S. Environmental Protection Agency (EPA) notified the company and 18 other companies that they are PRPs with respect to the Peter Cooper Site, and offered them the opportunity to perform a remedial investigation and feasibility study at the site. Along with approximately 12 other companies, the company indicated to EPA its willingness to consider performing the study for a portion of the Peter Cooper Site. Although the company is still discussing the possibility of performing the study with the EPA and the other parties, the company believes that the ultimate disposition of this matter will not have a material adverse effect on its financial position or results of operations.
(c) In July 1992 the NYSDEC notified the company that it had been identified as a PRP at the Bern Metals Removal Site in Buffalo, New York, which the NYSDEC defined to include an adjacent property known as the Universal Iron & Metal Site. The Bern Metals/Universal Iron Site is listed on the New York State Registry. The NYSDEC also identified eight other PRPs for the site. In December 1992 the company declined to negotiate with NYSDEC to finance or conduct a Remedial Investigation and Feasibility Study (RI/FS) for the site.
The total cost of remediation is estimated to be $2.7 million. Without admitting any liability or responsibility, the company, in October 1997, entered into an Order on Consent with NYSDEC and four other PRPs pursuant to which it and such PRPs will, subject to NYSDEC approval, design the remedy for the Bern Metal/Universal Iron Site. The NYSDEC subsequently inquired whether the company and 15 other PRPs were willing to implement the remedy. In December 1998 the company and six other PRPs, who completed the remedial design, responded that the NYSDEC should first look to the other PRPs who have yet to finance any work at the site.
In September 1996 the company and 55 other parties were named as third-party defendants by Niagara Frontier Transportation Authority (NFTA) claiming contributions for costs that might be recovered against NFTA in an action filed by EPA in the District Court. NFTA is seeking contributions for response costs incurred by EPA at the Universal Iron Site. The company believes that the action against it is without merit and will defend it vigorously.
(d) In April 1992 the EPA notified the company that the EPA had reason to believe that the company was a PRP for the Clinton-Bender Removal Site (Clinton-Bender Site) in Buffalo, New York. Five other PRPs have been identified by the EPA. Nine private residential lots and one commercial property at the Clinton-Bender Site were contaminated with lead, allegedly due to run-off from the adjacent Bern Metals Site. The company and four other PRPs performed removal actions at the Clinton-Bender Site at a cost of approximately $3.2 million. The company along with the other participating parties are seeking to recover from other PRPs, not participating in the remedial action at the Clinton-Bender Site, costs that the company and other participating parties have incurred or will incur.
(e) In February 1993 NYSDEC notified the company and 19 other parties that they had been identified as PRPs for remediation of hazardous wastes at the Booth Oil Site in North Tonawanda, New York. The Booth Oil Site is listed on the New York State Registry. According to NYSDEC, the Booth Oil Site is contaminated with polychlorinated biphenyls (PCBs), lead, and other substances. The company estimates that the present value of costs for remedial alternatives range from $10.0 million to $21.7 million. The company and more than 20 other PRPs have tentatively agreed on an allocation under which the company's share of a cleanup settlement will be between $160,000 and $700,000.
(f) In June 1994 the company was served with a summons and complaint joining it as a defendant in an action that was filed in the United States District Court for the Northern District of New York. The plaintiffs are five companies that have been required by the EPA to conduct remedial activities at the Rosen Brothers Site in the City of Cortland, New York. The Rosen Site is allegedly contaminated with hazardous substances including heavy metals, solvents and PCBs. The Rosen Site is listed on the National Priorities List and the New York State Registry. The plaintiffs allege that the company was a contributor of transformers that may have contained PCBs.
In August 1994 the EPA notified the company that the EPA had reason to believe that the company was a PRP for the Rosen Site and requested that it participate in the RI/FS then being prepared for the Rosen Site by other named PRPs.
The company received an order from the EPA in March 1998 ordering the company and 15 other parties to perform certain removal actions at the Rosen Site. The company contributed approximately $45,000 toward the $730,000 total cost of the removal actions.
In September 1998 the company, along with approximately 12 other parties, entered into a consent decree with the EPA under which the company and the other settling parties will perform the selected remedy and reimburse the EPA for approximately $692,000 of past costs. The estimated total present worth cost of the remedy is $3,140,000. The company's share of the remediation costs is still being negotiated.
(g) The company responded in October 1995 to a request for information by the EPA concerning alleged disposal of PCBs at facilities owned or operated by PCB Treatment, Inc. in Kansas City, Kansas and Kansas City, Missouri. In September 1996 the company entered into an Order on Consent with the EPA under which the company and at least nine other companies will perform the first phase of remedial activity, a Removal Site Evaluation and Engineering Evaluation/Cost Analysis, at the two facilities operated by PCB Treatment, Inc. The company's obligation under this Order on Consent has been completed at a cost of $90,000. In September 1997 the EPA notified 1,251 entities, including the company, of their potential remediation liability at the two facilities. The company's share of remediation costs at the two facilities is likely to be less than $250,000.
(h) In August 1997 the company was notified by the NYSDEC that they were contemplating enforcement action against the company with respect to violations of regulations concerning opacity of air emissions at all of its New York coal-fired stations. The company is in the process of negotiating a consent order with NYSDEC to resolve the NYSDEC's demand for a penalty of approximately $650,000. The company sold its New York coal-fired stations in 1999 and has notified the buyer of its responsibility for any such penalty.
(i) The company received a letter in October 1999 from the Office of the Attorney General of New York State alleging that the company may have constructed and operated major modifications to certain emission sources at the Goudey and Greenidge generating stations, which it formerly owned, without obtaining the required prevention of significant deterioration or new source review permits. The Goudey and Greenidge plants were sold to The AES Corporation in May 1999. The letter requested that the company and AES provide the Attorney General's Office with a large number of documents relating to this allegation. On January 13, 2000, the company received a subpoena from the NYSDEC ordering production of similar documents.
The company furnished documents pursuant to such requests. The company believes it has complied with the applicable rules and regulations and there is no basis for the Attorney General's allegation.
(j) The company has identified coal tar residue at three sites in Connecticut where gas was manufactured in the past. In September 1997 the company received a letter from the Connecticut Department of Environmental Protection (DEP) informing it that the three sites had been entered on the Connecticut inventory of hazardous waste sites.
The company and the DEP have entered into a Consent Order with respect to one of the sites. Pursuant to the Consent Order, the company has agreed to undertake an investigation of the site and its immediate surrounding area to determine potential sources of contamination and to remediate contamination that may be found to have emanated or be emanating from the site as a result of the company's activities at the site. As a result of this Consent Order, the company has recorded and deferred $405,000 for costs related to the site investigation. Since the investigation has not yet been completed, the company cannot predict the cost, if any, of any remediation for the site.
The company has also elected to proceed with the rehabilitation of a bulkhead located at the site at an estimated cost of $2 million. In addition, the company estimates it will incur approximately $905,000 in the next 12 months, which has been recorded and deferred, for pilot studies, remediation design work and legal fees associated with the site and the Consent Order. The company anticipates that additional costs for this rehabilitation will be incurred, but cannot estimate such costs at this time.
Although the company cannot estimate the cost to investigate and remediate the remaining two sites, it does not expect that such costs will have a material adverse effect on its results of operations or financial position.
Item 4.
Item 4. Submission of matters to a vote of security holders - Not applicable
* * * * * * * * * * * *
Executive officers of the Registrant
Name
Age
Positions, offices and business
experience -January 1995 to date
Wesley W. von Schack
Chairman, President and Chief Executive Officer, April 1998 to date; Chairman, President and Chief Executive Officer of NYSEG, September 1996 to April 1999; Chairman, President, Chief Executive Officer and a Director of DQE, Inc. and Duquesne Light Company to August 1996.
Kenneth M. Jasinski
Executive Vice President and General Counsel, April 1999 to date; Senior Vice President and General Counsel, April 1998 to April 1999; Executive Vice President of NYSEG, April 1998 to April 1999; Partner of Huber Lawrence & Abell (attorneys at law) to April 1998.
Michael I. German
Senior Vice President, April 1998 to date; President and Chief Operating Officer of NYSEG, April 1999 to date; Executive Vice President and Chief Operating Officer of NYSEG, April 1998 to April 1999; Executive Vice President of NYSEG, May 1997 to April 1998; Senior Vice President-Gas Business Unit of NYSEG to May 1997.
Robert D. Kump
Vice President and Treasurer, November 1999 to date; Treasurer, October 1998 to November 1999; Treasurer of NYSEG, February 1996 to date; Director of Financial Services of NYSEG, February 1995 to February 1996; Manager-Investor Relations of NYSEG to February 1995.
Robert E. Rude
Vice President and Controller, November 1999 to date; Controller, October 1998 to November 1999; Executive Director, Corporate Planning of NYSEG, October 1998 to date; Director, Corporate Planning and Rates of NYSEG to October 1998.
Daniel W. Farley
Secretary, April 1998 to date; Vice President and Secretary of NYSEG.
The company has entered into employment agreements with Wesley W. von Schack and Kenneth M. Jasinski each for a term ending April 22, 2003, and the company and NYSEG have entered into an employment agreement with Michael I. German for a term ending February 28, 2003. Mr. von Schack's agreement provides for his employment as Chairman, President and Chief Executive Officer of the company, Mr. Jasinski's agreement provides for his employment as Executive Vice President and General Counsel of the company and Mr. German's agreement provides for his employment as Senior Vice President of the company and President and Chief Operating Officer of NYSEG. Each agreement provides for automatic one-year extensions unless either party to an agreement gives notice that such agreement is not to be extended.
Each officer holds office for the term for which he is elected or appointed, and until his successor shall be elected and shall qualify. The term of office for each officer extends to and expires at the meeting of the Board of Directors following the next annual meeting of shareholders.
PART II
Item 5.
Item 5. Market for Registrant's common equity and related stockholder matters
See Item 8 - Note 16 to the Consolidated Financial Statements.
Item 6.
Item 6. Selected financial data
All per share and shares outstanding amounts have been restated to reflect the two-for-one common stock split effective April 1, 1999.
Reclassifications: Certain amounts included in Selected financial data have been reclassified to conform with the 1999 presentation.
(1) Includes the effect of the extraordinary loss related to the early extinguishment of debt that decreased net income by $18 million and earnings per share by 15 cents and the nonrecurring benefit from the sale of the company's coal-fired generation assets net of the writeoff of Nine Mile Point 2 that increased net income by $14 million and earnings per share by 12 cents.
(2) Depreciation and amortization includes accelerated amortization of Nine Mile Point 2 related to the sale of the company's coal-fired generation assets, authorized by the PSC. (See Item 8 - Note 7 to the Consolidated Financial Statements.)
(3) Includes the effect of fees related to an unsolicited tender offer that decreased net income by $17 million and earnings per share by 12 cents.
(4) Includes the effect of the writedown of the investment in EnerSoft Corporation that decreased net income by $10 million and earnings per share by 7 cents.
Item 7.
Item 7.
Management's discussion and analysis of financial condition and results of operations
The company has implemented a series of strategies to profitably grow its energy infrastructure in the Northeast. During 1999 the company successfully completed the sale of its coal-fired generation assets, announced merger agreements with four energy companies in the Northeast and entered into an agreement to sell its 18% interest in Nine Mile Point 2. The company completed its merger with Connecticut Energy Corporation (CNE) on February 8, 2000.
The company's major focus remains on promoting competition, providing superior customer service, offering an array of competitive products and services, profitably growing its energy infrastructure and building shareholder value.
Liquidity and Capital Resources
Merger Agreements
Three of the definitive merger agreements entered into by the company on the following dates during 1999 are still pending: CMP Group, Inc. on June 14, CTG Resources, Inc. on June 29 and Berkshire Energy Resources (Berkshire Energy) on November 9. Each of the companies will become a wholly-owned subsidiary of the company. The transactions will be accounted for using the purchase method and are expected to close by the end of the second quarter of 2000. In connection with the mergers the company intends to register as a holding company with the Securities and Exchange Commission (SEC) under the Public Utility Holding Company Act of 1935.
Connecticut Energy Merger: The company completed its merger with CNE on February 8, 2000. The transaction had an equity market value of $433 million. Under the agreement 50% of the common stock of CNE (5.2 million shares) was converted into 9.4 million shares of Energy East common stock, and 50% of the common stock of CNE was exchanged for $218 million in cash, which was $42.00 per CNE share. The company assumed approximately $149 million of CNE long-term debt.
CMP Group Merger: The company will acquire all of the common stock of CMP Group for $29.50 per share in cash. The transaction has an equity market value of approximately $957 million. The company will also assume approximately $113 million of CMP Group preferred stock and long-term debt.
On October 7, 1999, CMP Group shareholders approved the merger agreement. Orders approving the merger were issued by the Maine Public Utilities Commission on January 4, 2000, and the Nuclear Regulatory Commission on February 4, 2000. The merger is subject to, among other things, the approvals of various regulatory agencies, including the SEC and Federal Energy Regulatory Commission (FERC). All necessary filings have been made.
CTG Resources Merger: This transaction values CTG Resources' common equity at approximately $355 million, and the company will assume approximately $220 million of CTG Resources' long-term debt.
Under the agreement, 45% of the common stock of CTG Resources will be converted into the company's common stock with a value of $41.00 per CTG Resources share, and 55% will be converted into $41.00 in cash per CTG Resources share, subject to restrictions on the minimum and maximum number of shares to be issued. Shareholders will be able to specify the percentage of the consideration they wish to receive in stock and in cash, subject to proration.
On October 18, 1999, CTG Resources shareholders approved the merger agreement. The Connecticut Department of Public Utility Control (DPUC) issued an order approving the merger on January 19, 2000. The merger is subject to, among other things, the approvals of various regulatory agencies, including the SEC. All necessary filings have been made.
Berkshire Energy Resources Merger: The company will acquire all of the common stock of Berkshire Energy for $38.00 per share in cash. The transaction has an equity market value of approximately $96 million. The company will also assume approximately $40 million of Berkshire Energy preferred stock and long-term debt. On February 29, 2000, Berkshire Energy shareholders approved the merger agreement. The merger is subject to, among other things, SEC approval. All necessary filings have been made.
Energy Delivery Business
The company's energy delivery business consists of its electricity distribution, transmission and generation operations and its natural gas distribution, transportation and storage operations in New York. After completing its merger with CNE in February 2000, the company began distributing natural gas in Connecticut.
Sale of Coal-fired Generation Assets: The company accepted offers totaling $1.85 billion from The AES Corporation and Edison Mission Energy in August 1998 for its seven coal-fired stations and associated assets and liabilities, which were placed up for auction earlier in 1998. The company completed the sale of its Homer City generation assets to Edison Mission Energy in March 1999, and the sale of its remaining coal-fired generation assets to AES in May 1999.
The proceeds from the sale of those assets - net of taxes and transaction costs - in excess of the net book value of the generation assets, less funded deferred taxes, were used to write down the company's 18% investment in Nine Mile Point 2 by $374 million. This treatment is in accordance with the company's restructuring plan approved by the Public Service Commission of the State of New York (PSC) in January 1998. The company wrote down its 18% investment by an additional $102 million due to the required writeoff of funded deferred taxes related to Nine Mile Point 2. Both writedowns are reflected in depreciation and amortization for 1999.
Now that the sale of its coal-fired generation assets is complete, approximately 60% of the company's power requirements are satisfied through generation from its nuclear and hydroelectric stations and by purchases under long-term contracts from non-utility generators (NUGs) and the New York Power Authority. At year-end the company had electricity contracts for calendar year 2000 for half of its remaining power requirements. For the remainder, the company assumed the risk of market prices that fluctuate, since it has capped the prices it can charge customers.
The company uses electricity contracts, both physical and financial, to manage its exposure to fluctuations in the market price of electricity. These contracts allow the company to fix the cost of physical electricity purchases. The cost or benefit of electricity contracts is included in the amount expensed for electricity purchased when the electricity is sold.
Nine Mile Point 2: The company announced in June 1999 that it has agreed to sell its 18% interest in Nine Mile Point 2 to AmerGen Energy Company, a joint venture of PECO Energy Company and British Energy. In the same announcement, Niagara Mohawk Power Corporation announced the sale of Nine Mile Point 1 and its 41% interest in Nine Mile Point 2 to AmerGen. At closing, the company will receive $27.9 million in proceeds, subject to adjustments, based on its 18% ownership share. The company may be entitled to additional payments through 2012 under a financial sharing agreement. A power purchase agreement with AmerGen requires the company to purchase 17.1% of all electricity from Nine Mile Point 2 at negotiated prices for three years.
AmerGen will assume full responsibility for the decommissioning of its ownership share of Nine Mile Point 2. The decommissioning fund will be pre-funded to a fixed amount by the sellers, with all potential costs above the fixed amount paid by AmerGen.
In December 1999 Rochester Gas and Electric Corporation (RG&E), a Nine Mile Point 2 cotenant, exercised its right of first refusal in connection with the sale of the plants, and stated that it would match AmerGen's offer and accept the terms and conditions of the AmerGen agreements. RG&E has contracted with a subsidiary of Entergy Corporation to lease, operate and maintain the plants. The PSC began settlement negotiations in January 2000 seeking modifications to the proposed terms of the sale of the company's and Niagara Mohawk's interests in the Nine Mile Point units, whether to AmerGen or RG&E. The company cannot predict the effect of this event on the sale of Nine Mile Point 2.
Issues have been raised regarding worsening performance at the Nine Mile Point units, which are operated by Niagara Mohawk. On September 30, 1999, the Nuclear Regulatory Commission issued a Plant Performance Review on the Nine Mile Point units. The NRC stated that it would increase its scrutiny of the operation of the Nine Mile Point nuclear units over the next six months as a result of the worsening performance of those units and weaknesses in areas such as plant maintenance, work planning and scheduling and engineering support.
Niagara Mohawk has made significant management changes at Nine Mile Point, including the hiring of PECO Energy for managerial advice, because performance of the units has not reached expected levels. The company supports these efforts to improve performance at Nine Mile Point 2 and continues to believe that the sale of the plants is in the best interests of customers and the company's shareholders.
If the operating performance of Nine Mile Point 2 continues to deteriorate and it becomes apparent that significant expenditures would be required to improve performance, the company intends to take whatever actions it believes are appropriate to protect the interests of its customers and shareholders, including support for the potential shut down of the unit.
Based on its agreement to sell Nine Mile Point 2 to AmerGen the company wrote off $82 million, its remaining nuclear generation investment after the writedowns discussed earlier, in accordance with Statement of Financial Accounting Standards No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of. (See Sale of Coal-fired Generation Assets.)
New York Independent System Operator: The New York Independent System Operator (ISO) began operating on November 18, 1999. The ISO and the New York State Reliability Council were formed to restructure the New York Power Pool in response to FERC Order 888. FERC Orders 888 and 889 were issued to foster the development of competitive wholesale electricity markets by opening up transmission services and to address the resulting stranded costs. The ISO administers a new, centralized energy and ancillary services market. The company is unable to predict the effect of the restructuring on its financial position or results of operations.
Electric Retail Access Program: Since August 1, 1999, all of the company's electricity customers have been able to choose their electricity supplier. Already approximately 31,000 customers have chosen another supplier, a strong indication of the company's commitment to promote competition.
The company is responsible for delivering customers' electricity on its transmission and distribution system. Rates charged for use of the company's transmission system are subject to FERC approval, while rates for the use of its distribution system are subject to PSC approval. The PSC approved the company's distribution rates in January 1998. The company's transmission rate case, which was filed with the FERC in March 1997, has not yet been approved. The company charges its filed rate, which was accepted by the FERC subject to refund based on the FERC final order.
Competitive Electric Metering: On June 16, 1999, the PSC issued an Order Providing for Competitive Metering, which calls for opening up competition for electric metering services among a limited number of large customers (50 kilowatts or more) in New York State. The services include installation and maintenance of electric meters, meter reading and meter data retrieval and storage. The PSC has delayed the effective date of the tariffs filed by the company to April 1, 2000. The company does not anticipate that this order will have a material effect on its financial position or results of operations.
NUG Initiatives: The company continues to seek ways to provide relief to its customers from onerous NUG contracts that the company was ordered to sign by the PSC. The company expensed approximately $354 million in 1999 for NUG power, and estimates that its purchases will total $349 million in 2000, $359 million in 2001 and $387 million in 2002, unless it is able to change the NUG contracts.
Petition to the FERC on NUGs: The company petitioned the FERC in 1995, asking for relief from having to pay approximately $2 billion more than its avoided costs for power purchased over the term of two NUG contracts. The FERC denied that petition and the company's subsequent request for a rehearing. The company believes that the overpayments under the two contracts violate the Public Utility Regulatory Policies Act of 1978.
The company commenced an action in the United States District Court for the Northern District of New York in August 1997. The complaint asks the District Court to either reform the two NUG contracts by reducing the price the company must pay for electricity under the contracts, or send the matter back to the FERC or to the PSC with direction that they modify such contracts. The complaint also seeks repayment of all monies paid above the company's avoided costs. The case is still pending before the District Court.
Auction of NUG Contract Rights: On November 4, 1999, the company announced that it intends to sell - through competitive bidding - entitlements to 470 mw of natural gas-fired energy, capacity and certain other benefits under three of its power purchase agreements with NUGs.
The contracts are with Saranac Power Partners (240 mw) in Plattsburgh, New York, Lockport Energy Associates (175 mw) in Lockport, New York, and Indeck Energy Services of Silver Springs, New York (55 mw). The agreements expire on June 21, 2009, October 8, 2007, and April 11, 2006, respectively. Over the remaining terms of the contracts it is estimated that the company's customers will pay over $2 billion dollars above the competitive market price. After receiving final bids in February 2000 the company determined that the bids were not acceptable and canceled the auction process without selling any entitlements.
Allegheny Hydros: On December 18, 1999, the company sent a letter to Allegheny Hydro No. 8 and Allegheny Hydro No. 9 demanding that they each provide adequate assurance that they will perform their individual contractual obligations under two power purchase agreements with the company, including the obligation to pay back overpayments made by the company over the course of the agreements. Such overpayments are the cumulative difference between the rate the company pays for power under the agreements and the company's actual avoided costs. At the end of 1999, this cumulative overpayment was more than $111 million and is expected to grow to approximately $2.7 billion by 2030 when both agreements expire.
In a letter dated January 17, 2000, Allegheny responded to the company's demand letter and argued against the company's right to demand assurances. On January 18, 2000, Allegheny filed a complaint in the United States District Court for the Southern District of New York (Southern District Court) asking for declaratory relief, including a declaration that the company is not entitled to demand adequate assurances of Allegheny's performance under the agreements. Allegheny's deadline for providing adequate assurances expired on January 19, 2000. In a letter dated January 20, 2000, the company notified Allegheny's lenders that Allegheny's failure to provide adequate assurances amounted to a repudiation of the agreements and advised that the company would terminate the agreements at the end of 15 days after the lenders received the notice dated January 20, 2000.
On February 3, 2000, the company entered into a letter agreement with Allegheny and its lenders, under which the parties agreed to jointly petition for an expedited trial on the merits, in exchange for the company's agreement to suspend its right to terminate the power purchase agreements. If a trial does not begin, or is not scheduled to begin, on or before December 31, 2000, the company will have the ability to reinstate its right to terminate. Consistent with the February 3, 2000 agreement, Allegheny filed a complaint in the Supreme Court of the State of New York, County of New York (New York Supreme Court) on February 7, 2000, seeking declaratory relief, including a declaration that the company is not entitled to demand adequate assurances of Allegheny's performance under the agreements, and on February 8, 2000, Allegheny filed a Notice of Dismissal of its complaint in the Southern District Court.
On March 3, 2000, Allegheny's lenders filed a complaint in the New York Supreme Court seeking declaratory relief and damages in an unspecified amount, including a declaration that the company's actions in demanding assurances are in violation of the agreements, certain financing agreements and the Public Utility Regulatory Policies Act of 1978. Pursuant to the February 3, 2000 agreement, Allegheny, the company and the lenders must use their best reasonable efforts to consolidate the lenders' action with Allegheny's suit.
Electric Restructuring Plan: The company's restructuring plan, which included a five-year electric rate price cap, was approved by the PSC, with minor modifications, in January 1998.
The restructuring plan will save customers an estimated $725 million over five years. Specifically the plan:
Eliminated a 7% increase in electricity prices previously approved by the PSC.
Reduces prices 5% each year in the five years of the plan for eligible industrial, commercial and public authority customers who are heavy users of electricity.
Caps the overall average prices for all other customers for four years and reduces their prices 5% at the beginning of the fifth year.
Allowed all of the company's retail customers to choose their electricity supplier by August 1, 1999.
The company submitted a tariff filing in compliance with the restructuring plan in January 1999. On July 15, 1999, and September 17, 1999, the PSC issued orders relating to the compliance filing. Those orders addressed issues related to the company's retail access credit (the amount backed out of a customer's bill when that customer participates in retail access), suppliers' obligations and customer identification.
As a result of the orders, the company's retail access credit was maintained at its current value. The PSC determined that retail access suppliers are responsible for energy, capacity and some ancillary services for their own customers and the company may require a deposit from residential customer applicants who fail to provide adequate identification. The PSC also concluded that costs for line losses, installed reserves and certain ancillary services are being recovered through the company's delivery charge and are not part of the retail access credit. The company submitted filings in compliance with the orders on July 29, 1999, and October 7, 1999.
In September 1999 the company reached settlement on the remaining issues in the restructuring plan. The settlement established the electric rate structure for the remaining three years of the price cap period. In February 2000 the PSC approved the September settlement. Tariffs in compliance with the PSC's order approving the settlement were filed and became effective March 3, 2000.
Natural Gas Franchises: The company continues to grow its natural gas business in New York by expanding natural gas service in existing franchise areas and by pursuing new franchises. During the last five years, the company added 26 new franchises to its natural gas service area.
Natural Gas Rate Agreements: The company's natural gas rate agreement filed with the PSC cut prices for most customers by reducing natural gas revenues by $25.6 million, or 2.1%, over the four years ending September 30, 2002. The PSC issued an order in December 1998 that includes certain modifications made by the PSC, which were accepted by the company after clarifications from the PSC Staff, and one modification by the company that maintains present rates for certain areas. The PSC accepted the company's clarifications and modification.
On January 28, 2000, the Connecticut DPUC issued a final decision approving a $502,000 annual revenue increase and denying a request to implement performance-based ratemaking at this time. The additional revenue amounts to approximately a 0.2% increase over current rates for firm sales customers. In February 2000 the company requested reconsideration of the DPUC's denial of the performance-based ratemaking proposal. The DPUC denied the company's request for reconsideration and informed it that it will consider the company's performance-based ratemaking proposal when the DPUC establishes rate design in connection with the company's latest rate proceeding. The rate design phase will not commence until a final decision is issued in the generic cost of service proceeding currently pending before the DPUC. The decision in the cost of service proceeding is expected to be issued in June 2000. The DPUC initiated the generic cost of service proceeding in 1999 to review cost of service methodologies in an effort to promote a more competitive and equitable natural gas industry within Connecticut.
Role of Natural Gas Local Distribution Companies: The PSC, on November 3, 1998, issued a "Policy Statement Concerning the Future of the Natural Gas Industry in New York State and Order Terminating Capacity Assignment." The policy statement includes the PSC's vision for furthering competition in the natural gas industry in New York State. The PSC believes the most effective way to establish a competitive gas market is for natural gas utilities to exit the merchant function over a period of three to seven years. The PSC also established guidelines and began several proceedings related to implementing its policy statement. The company is participating in each of the proceedings and continues to believe the competitive marketplace should decide who will be the suppliers of natural gas.
In compliance with the PSC's Order, effective April 1, 1999, the company ceased assigning certain capacity costs to customers who switch from fully bundled sales service to transportation service. Any capacity costs that may be stranded as a result of terminating capacity assignment are being recovered from all applicable customers via a surcharge.
Natural Gas Commodity Prices: The company uses risk management techniques such as natural gas futures and options contracts to manage its exposure to fluctuations in natural gas commodity prices. Such contracts allow the company to fix margins on sales of natural gas generally expected to occur over the next 18 months. The cost or benefit of natural gas futures and options contracts is included in the commodity cost when the related sales commitments are fulfilled. Gains and losses resulting from the use of those contracts for 1999, 1998 and 1997 were not material to the company's financial position or results of operations.
Other Matters
Accounting Issues
Statement 71: Statement of Financial Accounting Standards No. 71, Accounting for the Effects of Certain Types of Regulation, allows companies that meet certain criteria to capitalize as regulatory assets incurred costs that are probable of recovery in future periods. Those companies record as regulatory liabilities obligations to refund previously collected revenue or obligations to spend revenue collected from customers on future costs.
Although the company believes it will continue to meet the criteria of Statement 71 for its regulated electricity and natural gas operations in New York State and Connecticut, the company cannot predict what effect a competitive market or future PSC or Connecticut DPUC actions will have on its ability to continue to do so. If the company can no longer meet the criteria of Statement 71 for all or a separable part of its regulated operations, it may have to record as expense or revenue certain regulatory assets and liabilities. The company may also have to record as a loss an estimated $1.4 billion, on a present value basis at December 31, 1999, of above-market costs on its power purchase contracts with NUGs. These items are currently recovered in rates.
Statement 133: The FASB issued Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, in June 1998 and No. 137, Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133, in June 1999. Statement 133 establishes standards for the accounting and reporting for derivative instruments and for hedging activities. Statement 133 requires that all derivatives be recognized as either assets or liabilities on a company's balance sheet at their fair value. Statement 137 delayed for one year the effective date for implementing Statement 133, to fiscal years beginning after June 15, 2000. The company will adopt Statement 133 as of January 1, 2001. Based on the company's current risk management strategies, this adoption is not expected to have a material effect on its financial position or results of operations.
Year 2000 Readiness Disclosure
Many of the company's computer systems, which include mainframe systems and special-purpose systems, refer to years in terms of their final two digits only. Such systems, if not corrected, may interpret the year 2000 as the year 1900 and could cause the company to, among other things, experience energy delivery problems, report inaccurate data or issue inaccurate bills.
The company worked diligently to address this problem by reviewing its mainframe and special-purpose systems; identifying potentially affected software, hardware, and date-sensitive components, often referred to as embedded chips, of various equipment; determining and taking appropriate corrective action; and, when appropriate, testing its systems.
The company's mainframe systems consist of the hardware and software components of NYSEG's and CNE's information technology systems. The company believes it identified, took appropriate corrective action and tested its mainframe systems and that those systems are now able to process year 2000 and beyond transactions.
The company's special-purpose systems consist of its non-information technology systems and the information technology systems of its subsidiaries other than NYSEG and CNE. The company identified items in its special-purpose systems that may have been affected by the Year 2000 problem. Items identified include software, hardware and embedded chips in systems such as those that control the acquisition and the delivery of electricity and natural gas to customers and those in its communication systems. The company believes it fixed, eliminated, replaced or found no problem with all of the special-purpose items it identified that affect its electricity and natural gas delivery systems and its communication systems.
Even though the company's computer systems did not experience problems on January 1, 2000, and February 29, 2000, and the company believes it has taken corrective action with respect to its own Year 2000 issues, the Year 2000 issue could adversely affect it if there are items in its computer systems that may be affected by the Year 2000 problem, that were not identified in its review of those systems and that have not been put into application to date.
Through December 31, 1999, the company spent approximately $12.4 million on Year 2000 readiness, including contingency plan preparations, and believes that amount was adequate to address its Year 2000 issues. The amount was expensed as incurred and was financed entirely with internally generated funds. Addressing the Year 2000 issue has not caused the company to delay any significant information system projects.
Investing and Financing Activities
The company's financial strength provides the flexibility required to compete in the emerging competitive energy market and continue expanding its products and services, including its energy infrastructure, in the Northeast.
Investing Activities: The company sold its seven coal-fired generating stations and associated assets and liabilities for $1.85 billion. (See Energy Delivery Business - Sale of Coal-Fired Generation Assets.)
Capital spending, including nuclear fuel, totaled $83 million in 1999, $137 million in 1998 and $130 million in 1997. Capital spending in all three years was financed entirely with internally generated funds and was primarily for the extension of energy delivery service, necessary improvements to existing facilities and compliance with environmental requirements.
Capital spending, including nuclear fuel but excluding the pending merger transactions, is projected to be $126 million in 2000. It is expected to be paid for entirely with internally generated funds and will be primarily for the same purposes described above.
Financing Activities: The company's financing-related activities during 1999 consisted of:
The redemption, at par, of $25 million of NYSEG's 7.40% Series preferred stock and
$50 million of NYSEG's adjustable rate preferred stock.
The purchase, at a discount, of the following amounts of these series of NYSEG's preferred stock: $7.2 million of 3.75%, $2.8 million of 4 1/2% (Series 1949), $1.4 million
of 4.15%, $4.8 million of 4.40%, and $3.1 million of 4.15% (Series 1954).
The redemption, at a premium, of $25 million of NYSEG's 6.30% Series preferred stock.
The redemption, at a premium, of $50 million of NYSEG's 7 5/8% Series first mortgage bonds due November 1, 2001.
The purchase, on the open market, at premiums, of $77 million of NYSEG's
9 7/8% Series first mortgage bonds due May 1, 2020 and $77 million of NYSEG's
9 7/8% Series first mortgage bonds due November 1, 2020. Those purchases were financed with the issuance of $163 million of unsecured notes, which were redeemed in January 2000 with cash and commercial paper. The company incurred a $27 million charge in the fourth quarter of 1999, including premiums of $9 million for early redemption and the writeoff of $18 million of unamortized debt expense and debt issuance costs, as a result of the purchase of the bonds. That amount is reflected as an extraordinary loss on early extinguishment of debt on the income statement.
The repurchase of 16.6 million shares of the company's common stock.
The company raised its common stock dividend in January 2000 to a new annual rate of 88 cents per share. The dividend had been raised to an annual rate of 84 cents per share in January 1999.
A two-for-one stock split on common stock outstanding was effective April 1, 1999.
On April 1, 1999, the holders of a majority of the votes of shares of NYSEG's serial preferred stock consented to increase the amount of unsecured debt NYSEG may issue by up to an additional $1.2 billion.
The company uses short-term, unsecured notes to finance certain refundings and for other corporate purposes. The company had $163 million of short-term debt outstanding at December 31, 1999, and $78 million outstanding at December 31, 1998, all of which was issued by NYSEG. The weighted average interest rate on short-term debt was 7.2% at December 31, 1999, and 6.2% at December 31, 1998.
NYSEG also has a revolving credit agreement with certain banks that provides for borrowing up to $200 million until December 31, 2001. There were no amounts outstanding under this agreement during 1999 or 1998.
CNE and The Southern Connecticut Gas Company (Southern) have credit lines with certain banks that renew annually and provide for borrowing up to $70 million. Southern has committed lines of $50 million until the end of June 2000, and CNE and Southern share a committed line of $20 million until December 29, 2000. There was $40 million outstanding under these lines at December 31, 1999.
Southern expects to file an application with the DPUC in the second quarter of 2000 requesting authorization to issue up to $200 million of secured medium-term notes. The proceeds from the debt issuance will be used to pay down short-term debt incurred to redeem, at a premium, $77 million of first mortgage bonds, and for other general corporate purposes. This redemption is due to a provision in Southern's bond purchase agreements that gave the bondholders the right to have the bonds redeemed as a result of Energy East's acquisition of CNE.
The company uses interest rate swap agreements to manage the risk of increases in variable interest rates. It records amounts paid and received under the agreements as adjustments to the interest expense of the specific debt issues.
The company expects to issue long-term debt prior to the completion of the CMP Group, CTG Resources and Berkshire Energy merger transactions. The proceeds from the debt issuance, along with the proceeds from the sale of its generation assets and internally generated funds, will be used to fund the cash portion of the consideration for the merger transactions and to fund the company's ongoing share repurchase program. (See Merger Agreements and Energy Delivery Business - Sale of Coal-Fired Generation Assets.) In anticipation of this debt issuance, in June 1999 the company entered into a $500 million, one-year interest rate hedge on the benchmark 30-year Treasury Bond.
Forward-looking Statements
This Form 10-K contains certain forward-looking statements that are based upon management's current expectations and information that is currently available. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements in certain circumstances. Whenever used in this report, the words "estimate," "expect," "believe," or similar expressions are intended to identify such forward-looking statements.
In addition to the assumptions and other factors referred to specifically in connection with such statements, factors that could cause actual results to differ materially from those contemplated in any forward-looking statements include, among others, unanticipated Year 2000 issues, the deregulation and unbundling of energy services; the company's ability to compete in the rapidly changing and increasingly competitive electricity and natural gas utility markets; its ability to control non-utility generator and other costs; changes in fuel supply or cost and the success of its strategies to satisfy its power requirements now that all of its coal-fired generation assets have been sold; its ability to expand its products and services, including its energy infrastructure in the Northeast; its ability to integrate the operations of CNE, CMP Group, CTG Resources and Berkshire Energy with its operations; market risk; the ability to obtain adequate and timely rate relief; nuclear or environmental incidents; legal or administrative proceedings; changes in the cost or availability of capital; growth in the areas in which it is doing business; weather variations affecting customer energy usage; and other considerations that may be disclosed from time to time in its publicly disseminated documents and filings. The company undertakes no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise.
Results of Operations
*Percent change is not meaningful.
All per share and shares outstanding amounts have been restated to reflect the two-for-one common stock split effective
April 1, 1999.
Earnings Per Share
In 1999 the company's earnings per share increased 37 cents, including 15 cents from the extraordinary loss related to the early extinguishment of debt and a nonrecurring benefit of 12 cents from the sale of the company's coal-fired generation assets net of the writeoff of Nine Mile Point 2.
Earnings per share for 1999 increased primarily due to investment income realized on the net proceeds from the sale of the generation assets, fewer shares outstanding as a result of the share repurchase program, higher transmission wheeling revenues, higher pension income, cost control efforts and higher retail electricity deliveries (a record high for the company) and natural gas deliveries caused by an improved economy and weather. Those increases were partially offset by lower wholesale electricity deliveries as a result of the sale of the company's coal-fired generation plants and lower retail prices.
The company's earnings per share increased in 1998 primarily due to higher wholesale electricity prices and deliveries, higher pension income, cost control efforts and fewer shares outstanding as a result of the share repurchase program. Those increases were partially offset by lower retail natural gas deliveries, primarily because of unusually warm winter weather, and lower retail electricity prices. The 1997 earnings per share include the effect of a nonrecurring charge of 12 cents per share.
Other Items
Other income and deductions increased in 1999 primarily due to interest income realized on the net proceeds from the sale of the generation assets.
Preferred stock dividends decreased in 1999 due to redemptions and repurchases of preferred stock.
Operating Results for the Energy Delivery Business
Operating Revenues
: Operating revenues for 1999 decreased $246 million primarily due to lower wholesale electricity deliveries because, without its coal-fired generation plants, the company had less power to sell. Lower retail electricity and natural gas prices also reduced revenues. Those decreases were partially offset by higher transmission wheeling revenues and higher retail electricity and natural gas deliveries caused by an improved economy and weather.
The 1998 operating revenues increased $336 million. Revenues increased due to higher wholesale electricity and natural gas deliveries and higher wholesale electricity prices. Those increases were partially offset by lower natural gas retail deliveries, primarily due to warmer weather, and lower retail electricity prices.
Operating Expenses: Operating expenses for 1999 decreased $220 million, excluding the nonrecurring benefit from the sale of the company's coal-fired generation assets, which includes the related accelerated amortization of Nine Mile Point 2, net of the writeoff of Nine Mile Point 2. That decrease was primarily due to lower fuel and other costs associated with the generation assets that were sold, higher pension income and cost control efforts. Those decreases were partially offset by increased purchases of electricity to meet retail customers' needs.
The 1998 operating expenses increased $292 million due to an increase in electricity purchased for wholesale deliveries, partially offset by a decrease in other operating and maintenance costs, primarily due to higher pension income, cost control efforts and the effect of a 1997 nonrecurring charge, and a decrease in the cost of natural gas purchased.
Item 7A.
Item 7A. Quantitative and qualitative disclosures about market risk
Market risk represents the risk of changes in value of a financial instrument, derivative or non-derivative, caused by fluctuations in interest rates and prices. The following discussion of the company's risk management activities includes " forward-looking" statements that involve risks and uncertainties. Actual results could differ materially from those contemplated in the "forward-looking" statements. The company handles market risks in accordance with established policies, which may include various derivative transactions.
The financial instruments held or issued by the company are for purposes other than trading or speculation. Quantitative and qualitative disclosures are discussed by the following market risk exposure categories:
Interest Rate Risk
Commodity Price Risk
Other Market Risk
Interest Rate Risk: The company is exposed to risk resulting from interest rate changes on its variable-rate debt and commercial paper. The company uses interest rate swap agreements to manage the risk of increases in certain variable rate issues. It records amounts paid and received under those agreements as adjustments to the interest expense of the specific debt issues. The company believes that there is no material market risk associated with these agreements. (See Item 8
Item 8. Financial statements and supplementary data
(All per share and shares outstanding amounts have been restated to reflect the two-for-one common stock split effective April 1, 1999.)
Energy East Corporation
Consolidated Statements of Income
The notes on pages 34 through 50 are an integral part of the financial statements.
Energy East Corporation
Consolidated Balance Sheets
The notes on pages 34 through 50 are an integral part of the financial statements.
Energy East Corporation
Consolidated Balance Sheets
The notes on pages 34 through 50 are an integral part of the financial statements.
Energy East Corporation
Consolidated Statements of Cash Flows
The notes on pages 34 through 50 are an integral part of the financial statements.
Energy East Corporation
Consolidated Statements of Changes in Common Stock Equity
(Thousands, except per share amounts)
(1) Par value of $.01 at December 31, 1999 and 1998, and $6.66 2/3 at January 1 and December 31, 1997.
The notes on pages 34 through 50 are an integral part of the financial statements.
Notes to Consolidated Financial Statements
Note 1. Significant Accounting Policies
Principles of consolidation: These financial statements consolidate the company's majority-owned subsidiaries after eliminating intercompany transactions.
Depreciation and amortization: The company determines depreciation expense using straight-line rates, based on the average service lives of groups of depreciable property in service. The company's depreciation accruals were equivalent to 3.4% of average depreciable property for 1999 and 1998 and 3.5% for 1997. Amortization expense includes the amortization of certain regulatory assets and the accelerated amortization of Nine Mile Point 2 authorized by the PSC. (See Note 7. Sale of Coal-fired Generation Assets.)
Revenue recognition: The company recognizes revenues upon delivery of energy and energy-related products and services to its customers.
Accounts receivable: The company has an agreement that expires in November 2002 to sell, with limited recourse, undivided percentage interests in certain of its accounts receivable from customers. The agreement allows the company to receive up to $152 million from the sale of such interests.
At December 31, 1999 and 1998, accounts receivable on the consolidated balance sheets are shown net of $152 million of interests in accounts receivable sold. All fees related to the sale of accounts receivable are included in other income and deductions on the consolidated statements of income and amounted to approximately $9 million in 1999, 1998 and 1997. Accounts receivable on the consolidated balance sheets are also shown net of an allowance for doubtful accounts of $7 million at December 31, 1999, and $9 million at December 31, 1998. Bad debt expense was $12 million in 1999, $18 million in 1998 and $17 million in 1997.
Temporary investments: The company has temporary investments in various securities, including cash equivalents and debt instruments, that are classified as available-for-sale. The temporary investments have various maturity dates ranging from less than 30 days through August 2005. There were unrealized losses on the temporary investments, net of taxes, of $1 million at December 31, 1999. The investments will be used to fund the company's pending mergers and its ongoing share repurchase program.
Income taxes: The company files a consolidated federal income tax return. Deferred income taxes reflect the effect of temporary differences between the amount of assets and liabilities recognized for financial reporting purposes and the amount recognized for tax purposes. Investment tax credits (ITC) are amortized over the estimated lives of the related assets.
Utility plant: The company charges repairs and minor replacements to operating expense accounts and capitalizes renewals and betterments, including certain indirect costs. The original cost of utility plant retired or otherwise disposed of and the cost of removal less salvage are charged to accumulated depreciation.
Regulatory assets and liabilities: Pursuant to Statement of Financial Accounting Standards No. 71, Accounting for the Effects of Certain Types of Regulation, the company capitalizes, as regulatory assets, incurred costs that are probable of recovery in future electric and natural gas rates. It also records, as regulatory liabilities, obligations to refund previously collected revenue or to spend revenue collected from customers on future costs. In accordance with its current rate agreements in New York State, the company no longer defers most costs that were previously subject to deferral accounting.
Unfunded future federal income taxes and deferred income taxes are amortized as the related temporary differences reverse. Unamortized loss on debt reacquisitions is amortized over the lives of the related debt issues. Demand-side management program costs, other regulatory assets and other regulatory liabilities are amortized over various periods in accordance with the company's current New York State rate agreements. The company earns a return on all regulatory assets for which funds have been spent.
Consolidated statements of cash flows: The company considers all highly liquid investments with a maturity date of three months or less when acquired to be cash equivalents. Those investments are included in cash and cash equivalents on the consolidated balance sheets.
Total income taxes paid were $647 million in 1999, $97 million in 1998 and $111 million in 1997.
Interest paid, net of amounts capitalized, was $123 million in 1999, $119 million in 1998 and $117 million in 1997.
Risk management: The company uses natural gas futures and options contracts to manage its exposure to fluctuations in natural gas commodity prices. Such contracts allow the company to fix margins on sales of natural gas generally expected to occur over the next 18 months. The cost or benefit of natural gas futures and options contracts is included in the commodity cost when the related sales commitments are fulfilled.
The company uses electricity contracts, both physical and financial, to manage its exposure to fluctuations in the market price of electricity. These contracts allow the company to fix the cost of physical electricity purchases. The cost or benefit of electricity contracts is included in the amount expensed for electricity purchased when the electricity is sold.
The company uses interest rate swap agreements to manage the risk of increases in variable interest rates. It records amounts paid and received under the agreements as adjustments to the interest expense of the specific debt issues.
In June 1999 the company entered into a $500 million, one-year interest rate hedge on the benchmark 30-year Treasury Bond in anticipation of its expected issuance of long-term debt related to its pending mergers.
Gains and losses resulting from the use of risk management techniques in 1999 and 1998 were not material to the company's financial position or results of operations. The company does not hold or issue financial instruments for trading or speculative purposes.
Estimates: Preparation of the consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Reclassifications: Certain amounts have been reclassified on the consolidated financial statements to conform with the 1999 presentation.
Note 2. Common Stock Split
In January 1999 the company declared a two-for-one stock split on common stock outstanding. Shareholders of record at the close of business on March 12, 1999, were entitled to the shares on April 1, 1999. All per share amounts and shares outstanding in the consolidated financial statements have been restated to reflect the stock split.
Note 3. Income Taxes
Year ended December 31
(Thousands)
Current
$646,757
$98,427
$111,829
Deferred, net
Accelerated depreciation
(379,422)
20,684
29,070
Pension expense
37,311
12,410
Miscellaneous
(16,423)
10,308
(18,695)
ITC
(83,187)
(4,653)
(5,056)
Total
205,036
137,176
117,713
Less amount classified as extraordinary item
(9,458)
-
-
Total Before Extraordinary Item
$214,494
$137,176
$117,713
The company's effective tax rate differed from the statutory rate of 35% due to the following:
Year ended December 31
(Thousands)
Tax expense at statutory rate
$149,273
$118,987
$105,792
Depreciation not normalized
123,435
16,776
16,854
ITC amortization
(77,919)
(6,354)
(6,359)
Other, net
10,247
7,767
1,426
Total
205,036
137,176
117,713
Less amount classified as extraordinary item
(9,458)
-
-
Total Before Extraordinary Item
$214,494
$137,176
$117,713
The increase in depreciation not normalized and ITC amortization are the result of the sale of coal-fired generation assets and the writeoff of Nine Mile Point 2. (See Note 7. Sale of Coal-fired Generation Assets and Note 8. Nuclear Generation Assets.)
The company's deferred tax liabilities consisted of the following:
Note 4. Long-term Debt
All of the company's consolidated long-term debt at December 31, 1999 and 1998, was issued by its subsidiaries.
At December 31, 1999, long-term debt and capital lease payments (in thousands) that will become due during the next five years are:
$2,606
$22,527
$151,844
$1,198
$717
(1) NYSEG's first mortgage bond indenture constitutes a direct first mortgage lien on substantially all of its utility plant. The mortgage also provides for a sinking and improvement fund. This provision requires the company to make an annual cash deposit with the Trustee equal to 1% of the principal amount of all bonds delivered and authenticated by the Trustee before January 1 of that year (excluding any bonds issued on the basis of the retirement of bonds). Pursuant to the terms of the mortgage, the company satisfied the requirement in 1999 by crediting "bondable value of property additions" against the amount of cash to be deposited. The company redeemed, in June 1999, $50 million of 7 5/8% Series first mortgage bonds, due November 1, 2001, and purchased, in November 1999, $77 million of 9 7/8% Series first mortgage bonds, due May 1, 2020, and $77 million of 9 7/8% Series first mortgage bonds, due November 1, 2020. Those transactions resulted in an after-tax extraordinary loss on early extinguishment of debt of $18 million, or 15 cents per share.
(2) Fixed-rate pollution control notes totaling $306 million were issued to secure the same amount of tax-exempt pollution control revenue bonds issued by a governmental authority. The interest rates range from 5.70% to 6.15%.
Adjustable-rate pollution control notes totaling $132 million were issued to secure the same amount of tax-exempt adjustable-rate pollution control revenue bonds (Adjustable-rate Revenue Bonds) issued by a governmental authority. The Adjustable-rate Revenue Bonds bear interest at rates ranging from 4.01% to 4.38% through dates preceding various annual interest rate adjustment dates. On the annual interest rate adjustment dates the interest rates will be adjusted, or at the company's option, subject to certain conditions, a fixed rate of interest may become effective. Bond owners may elect, subject to certain conditions, to have their Adjustable-rate Revenue Bonds purchased by the Trustee. The company has entered into interest rate swaps to manage the risk of increases in the interest rates on the Adjustable-rate Revenue Bonds, and such swaps are reflected in the above interest rates.
Multi-mode pollution control notes totaling $175 million were issued to secure the same amount of tax-exempt multi-mode pollution control refunding revenue bonds (Multi-mode Revenue Bonds) issued by a governmental authority. The Multi-mode Revenue Bonds have a structure that allows the interest rates to be based on a daily rate, a weekly rate, a commercial paper rate, an auction rate, a term rate or a fixed rate. Bond owners may elect, while the Multi-mode Revenue Bonds bear interest at a daily or weekly rate, to have their bonds purchased by the Registrar and Paying Agent. The maturity dates of the Multi-mode Revenue Bonds are February 1, 2029, June 1, 2029, and October 1, 2029, and can be extended subject to certain conditions. At December 31, 1999, the interest rate for the multi-mode pollution control notes was at the daily rate. The weighted average interest rate for all three series was 3.15%, excluding letter of credit fees, for the year ended December 31, 1999.
NYSEG has irrevocable letters of credit that support certain payments required to be made on the Adjustable-rate Revenue Bonds and Multi-mode Revenue Bonds, and that expire on various dates. If the company is unable to extend the letter of credit related to a particular series of Adjustable-rate Revenue Bonds, that series will have to be redeemed unless a fixed rate of interest becomes effective. Multi-mode Revenue Bonds are subject to mandatory purchase when there is any change in the interest rate mode and in certain other circumstances. Payments made under the letters of credit in connection with purchases of Adjustable-rate Revenue Bonds and Multi-mode Revenue Bonds are repaid with the proceeds from the remarketing of those Bonds. To the extent the proceeds are not enough, the company is required to reimburse the bank that issued the letter of credit.
Note 5. Preferred Stock of Subsidiary
At December 31, 1999 and 1998, NYSEG's serial cumulative preferred stock was:
(1) At December 31, 1999, there were 2,353,411 shares of $100 par value preferred stock, 10,800,000 shares of $25 par value preferred stock and 1,000,000 shares of $100 par value preference stock authorized but unissued.
(2) On April 1, 1999, the company purchased, at a discount, the following amounts of these series of preferred stock: $7.2 million of 3.75%, $2.8 million of 4 1/2% (Series 1949), $1.4 million of 4.15%, $4.8 million of 4.40%, and $3.1 million of 4.15% (Series 1954).
(3) Redeemed February 1, 1999.
(4) Redeemed December 10, 1999.
Note 6. Bank Loans and Other Borrowings
The company uses short-term, unsecured notes to finance certain refundings and for other corporate purposes. The weighted average interest rate on short-term debt, all of which belonged to NYSEG, was 7.2% at December 31, 1999, and 6.2% at December 31, 1998.
NYSEG has a revolving credit agreement with certain banks that provides for borrowing up to $200 million through December 31, 2001. The revolving credit agreement does not require compensating balances. The company had no outstanding loans under this agreement at December 31, 1999 or 1998. At the company's option, the interest rate on borrowings is related to the prime rate, the London Interbank Offered Rate or the interest rate applicable to certain certificates of deposit. The agreement provides for payment of a commitment fee, which was .125% at December 31, 1999 and 1998.
Note 7. Sale of Coal-fired Generation Assets
The company accepted offers totaling $1.85 billion from The AES Corporation and Edison Mission Energy in August 1998 for its seven coal-fired stations and associated assets and liabilities, which were placed up for auction earlier in 1998. The company completed the sale of its Homer City generation assets to Edison Mission Energy in March 1999, and the sale of its remaining coal-fired generation assets to AES in May 1999.
The proceeds from the sale of those assets - net of taxes and transaction costs - in excess of the net book value of the generation assets, less funded deferred taxes, were used to write down the company's 18% investment in Nine Mile Point 2 by $374 million. This treatment is in accordance with the company's restructuring plan approved by the PSC in January 1998. The company wrote down its investment by an additional $102 million due to the required writeoff of funded deferred taxes related to Nine Mile Point 2. These writedowns are reflected in depreciation and amortization on the 1999 consolidated statement of income. (See Note 8. Nuclear Generation Assets.)
Note 8. Nuclear Generation Assets
The company has an 18% interest in the output and costs of Nine Mile Point 2, which is operated by Niagara Mohawk Power Corporation. Ownership of Nine Mile Point 2 is shared with Niagara Mohawk 41%, Long Island Power Authority 18%, Rochester Gas and Electric Corporation (RG&E) 14% and Central Hudson Gas & Electric Corporation 9%. The company's 18% share of the rated capability is 210 mw. The company's share of operating expenses is included in various categories on the consolidated statements of income.
The company announced in June 1999 that it has agreed to sell its 18% interest in Nine Mile Point 2 to AmerGen Energy Company, a joint venture of PECO Energy Company and British Energy. In the same announcement, Niagara Mohawk announced the sale of its interest in Nine Mile Point 2 to AmerGen. At closing, the company will receive $27.9 million in proceeds, subject to adjustments, based on its 18% ownership share. The company may be entitled to additional payments through 2012 under a financial sharing agreement. A power purchase agreement with AmerGen requires the company to purchase 17.1% of all electricity from Nine Mile Point 2 at negotiated prices for three years.
AmerGen will assume full responsibility for the decommissioning of its ownership share of Nine Mile Point 2. The decommissioning fund will be pre-funded to a fixed amount by the sellers, with all potential costs above the fixed amount paid by AmerGen.
In December 1999 RG&E, a Nine Mile Point 2 cotenant, exercised its right of first refusal in connection with the sale of the plants, and stated that it would match AmerGen's offer and accept the terms and conditions of the AmerGen agreements. RG&E has contracted with a subsidiary of Entergy Corporation to lease, operate and maintain the plants. The PSC began settlement negotiations in January 2000 seeking modifications to the proposed terms of the sale of the company's and Niagara Mohawk's interests in the Nine Mile Point units, whether to AmerGen or RG&E. The company cannot predict the effect of this event on the sale of Nine Mile Point 2.
Based on its agreement to sell Nine Mile Point 2 to AmerGen the company wrote off $82 million, its remaining nuclear generation investment after the writedowns discussed in Note 7, in accordance with Statement of Financial Accounting Standards No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of. (See Note 7. Sale of Coal-fired Generation Assets.)
Nuclear insurance: Niagara Mohawk maintains public liability and property insurance for Nine Mile Point 2. The company reimburses Niagara Mohawk for its 18% share of those costs.
The public liability limit for a nuclear incident is approximately $8.9 billion. Should losses stemming from a nuclear incident exceed the commercially available public liability insurance, each licensee of a nuclear facility would be liable for up to $84 million per incident, payable at a rate not to exceed $10 million per year. The company's maximum liability for its 18% interest in Nine Mile Point 2 would be approximately $15 million per incident. The $84 million assessment is subject to periodic inflation indexing and a 5% surcharge should funds prove insufficient to pay claims associated with a nuclear incident. The Price-Anderson Act also requires indemnification for precautionary evacuations whether or not a nuclear incident actually occurs.
Niagara Mohawk has obtained property insurance for Nine Mile Point 2 totaling approximately $2.8 billion through the Nuclear Insurance Pools and Nuclear Electric Insurance Limited (NEIL). In addition, the company has purchased NEIL insurance coverage for the extra expense that would be incurred by purchasing replacement power during prolonged accidental outages. Under NEIL programs, should losses resulting from an incident at a member facility exceed the accumulated reserves of NEIL, each member, including the company, would be liable for its share of the deficiency. The company's maximum liability per incident under the property damage and replacement power coverage is approximately $2 million.
Nuclear plant decommissioning costs: Based on the results of a 1995 decommissioning study, the company's 18% share of the cost to decommission Nine Mile Point 2 is $167 million in 2000 dollars ($422 million in 2026 when Nine Mile Point 2's operating license will expire). The estimated liability for decommissioning Nine Mile Point 2 using the Nuclear Regulatory Commission's minimum funding requirement is approximately $102 million in 2000 dollars. The company's electric rates in New York State currently include an annual allowance for decommissioning of $4 million, which approximates the minimum funding requirement as set forth in the 1995 decommissioning study. Decommissioning costs are charged to depreciation and amortization expense and are recovered over the expected life of the plant.
The company has established a Qualified Fund under applicable provisions of the federal tax law to comply with NRC funding regulations. The balance in the fund, including reinvested earnings, was approximately $27 million at December 31, 1999, and $21 million at December 31, 1998. Those amounts are included on the consolidated balance sheets in other property and investments, net. The related liability for decommissioning is included in other liabilities - other. The investments are recorded at market value and changes in market value are reflected in the decommissioning liability. At December 31, 1999, the external trust fund investments were classified as available-for-sale.
Note 9. Environmental Liability
From time to time environmental laws, regulations and compliance programs may require changes in the company's operations and facilities and may increase the cost of electric and natural gas service.
The U.S. Environmental Protection Agency and the New York State Department of Environmental Conservation (NYSDEC), as appropriate, notified the company that it is among the potentially responsible parties who may be liable for costs incurred to remediate certain hazardous substances at nine waste sites, not including its sites where gas was manufactured in the past, which are discussed below. With respect to the nine sites, seven sites are included in the New York State Registry of Inactive Hazardous Waste Sites and three of the sites are also included on the National Priorities list.
Any liability may be joint and several for certain of those sites. The company recorded an estimated liability of $1 million related to five of the nine sites. The ultimate cost to remediate the sites may be significantly more than the estimated amount. Factors affecting the estimated remediation amount include the remedial action plan selected, the extent of site contamination and the portion attributed to the company.
The company has a program to investigate and perform necessary remediation at its sites where gas was manufactured in the past. In 1994 and 1996, the company entered into Orders on Consent with the NYSDEC. These Orders require the company to investigate and, where necessary, remediate 34 of its 38 sites. Eight sites are included in the New York State Registry.
The company's estimate for all costs related to investigation and remediation of the 38 sites ranges from $77 million to $175 million at December 31, 1999. That estimate is based on both known and potential site conditions and multiple remediation alternatives for each of the sites. The estimate has not been discounted and is based on costs in 1996 dollars that the company expects to incur through the year 2017. The estimate could change materially based on facts and circumstances derived from site investigations, changes in required remedial action, changes in technology relating to remedial alternatives and changes to current laws and regulations.
The liability to investigate and perform remediation, as necessary, at the known inactive gas manufacturing sites, reflected on the company's consolidated balance sheets was $77 million at December 31, 1999, and $79 million at December 31, 1998. The company recorded a corresponding regulatory asset, net of insurance recoveries, since it expects to recover the net costs in rates.
Note 10. Fair Value of Financial Instruments
The carrying amounts and estimated fair values of some of the company's financial instruments included on its consolidated balance sheets are shown in the following table. The fair values are based on the quoted market prices for the same or similar issues of the same remaining maturities.
The carrying amounts for cash and cash equivalents, temporary investments, notes payable and interest accrued approximate their estimated fair values.
Special deposits may include restricted funds set aside for preferred stock and long-term debt redemptions. The carrying amount approximates fair value because the special deposits have been invested in securities that mature within one year.
Note 11. Retirement Benefits
The sale of generation assets resulted in a curtailment gain and a settlement gain, which were the result of the termination of certain generation employees. The curtailment gain reduced the expected years of future service under the pension benefit plan and the settlement gain reduced the postretirement benefit obligation.
The company's postretirement benefits were unfunded as of December 31, 1999 and 1998.
The company assumed a 7% annual rate of increase in the costs of covered health care benefits for 2000 that gradually decreases to 5% by the year 2003.
The net periodic benefit cost for postretirement benefits represents the cost the company charged to expense for providing health care benefits to retirees and their eligible dependents. The amount of postretirement benefit cost deferred was $8 million as of December 31, 1999, and $10 million as of December 31, 1998. The company expects to recover any deferred postretirement costs by March 2003. The transition obligation for postretirement benefits is being amortized over a period of 20 years.
A 1% increase or decrease in the health care cost inflation rate from assumed rates would have the following effects:
1% Increase
1% Decrease
Effect on total of service and interest
cost components
$5 million
$(4 million)
Effect on postretirement
benefit obligation
$43 million
$(34 million)
Note 12. Stock-Based Compensation
The company applies Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, to account for its stock-based compensation plans. Compensation expense would have been the same in 1999, 1998 and 1997 had it been determined consistent with Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation.
The company may grant options and stock appreciation rights (SARs) to senior management and certain other key employees under its stock option plan. Options granted in 1997 vested in 1997, while those granted in 1998 vest over three years and those granted in 1999 vest over either two-year or three-year periods, subject to, with certain exceptions, continuous employment. All options expire 10 years after the grant date. Of the 6.6 million shares authorized, unoptioned shares totaled 3.6 million at December 31, 1999, and 4.7 million at December 31, 1998.
During 1999 1,122,412 options/SARs were granted with a weighted-average exercise price of $26.68. 3,118 options with a weighted-average exercise price of $16.90 and 102,362 SARs with a weighted-average exercise price of $18.70 were exercised in 1999. 30,000 options/SARs with an exercise price of $18.43 were forfeited in 1999. The 2,277,858 options/SARs outstanding at December 31, 1999, had a weighted-average exercise price of $21.75. Of those outstanding at December 31, 1999, 206,170 options/SARs with exercise prices ranging from $10.88 to $14.69 and a weighted-average remaining life of seven years had a weighted-average exercise price of $10.88 and 2,071,688 options/SARs with exercise prices ranging from $17.94 to $28.72 and a weighted-average remaining life of nine years had a weighted-average exercise price of $22.83. Of those exercisable at December 31, 1999, 206,170 options/SARs with exercise prices ranging from $10.88 to $14.69 had a weighted-average price of $10.88 and 645,172 options/SARs with exercise prices ranging from $17.94 to $28.72 had a weighted-average exercise price of $22.97.
During 1998 1,100,616 options/SARs were granted with a weighted-average exercise price of $18.43. 22,876 options with a weighted-average exercise price of $10.88 and 189,356 SARs with a weighted-average exercise price of $10.93 were exercised in 1998. 36,000 options/SARs with an exercise price of $17.94 were forfeited in 1998. The 1,290,926 options/SARs outstanding at December 31, 1998, had a weighted-average exercise price of $17.14. Of those outstanding at December 31, 1998, 226,310 options/SARs with exercise prices ranging from $10.88 to $17.07 and a weighted-average remaining life of eight years had a weighted-average exercise price of $10.98, and 1,064,616 options/SARs with exercise prices ranging from $17.94 to $28.72 and a weighted-average remaining life of nine years had a weighted-average exercise price of $18.45. Of those exercisable at December 31, 1998, 226,310 options/SARs with exercise prices ranging from $10.88 to $17.07 had a weighted-average exercise price of $10.98, and 484 options/SARs with exercise prices ranging from $17.94 to $28.72 had an exercise price of $19.63.
During 1997 840,958 options/SARs were granted with a weighted-average exercise price of $10.91. 15,866 options and 386,550 SARs with an exercise price of $10.88 were exercised in 1997. The 438,542 options/SARs outstanding at December 31, 1997, had a weighted-average exercise price of $10.95. 433,584 outstanding options/SARS with a weighted-average exercise price of $10.88 were exercisable at December 31, 1997.
The company recorded compensation expense for options/SARs of $(4.8) million in 1999, $9.2 million in 1998 and $4.9 million in 1997.
The company's Long-term Executive Incentive Share Plan provides participants cash awards if certain shareholder return criteria are achieved. There were 178,588 performance shares outstanding at December 31, 1999, and 217,154 outstanding at December 31, 1998. Compensation expense was $1.0 million for 1999 and $5.2 million for 1998.
Note 13. Commitments
Capital spending: The company has commitments in connection with its capital spending program. Capital spending, including nuclear fuel but excluding the pending merger transactions, is projected to be $126 million in 2000 and is expected to be paid for entirely with internally generated funds. The program is subject to periodic review and revision. The company's capital spending will be primarily for the extension of energy delivery service, necessary improvements to existing facilities and compliance with environmental requirements.
Non-utility generator power purchase contracts: The company expensed approximately $354 million in 1999, $326 million in 1998 and $324 million in 1997 for NUG power. The company estimates that NUG power purchases will total $349 million in 2000, $359 million in 2001 and $387 million in 2002, unless it is able to change the NUG contracts.
Note 14. Segment Information
Selected financial information for the company's business segments is presented in the following table. The company's "Energy Delivery" segment consists of its electricity distribution, transmission and generation operations and its natural gas distribution, transportation and storage operations in New York. "Other" includes the company's energy services businesses, natural gas and propane air distribution operations outside of New York, corporate assets and intersegment eliminations.
Note 15. Merger Agreements
Three of the four definitive merger agreements entered into by the company on the following dates during 1999 are still pending: CMP Group, Inc. on June 14, CTG Resources, Inc. on June 29 and Berkshire Energy Resources (Berkshire Energy) on November 9. Each of the companies will become a wholly-owned subsidiary of the company. The transactions will be accounted for using the purchase method and are expected to close by the end of the second quarter of 2000. In connection with the mergers the company intends to register as a holding company with the Securities and Exchange Commission (SEC) under the Public Utility Holding Company Act of 1935.
Connecticut Energy Merger: The company completed its merger with CNE on February 8, 2000. The transaction had an equity market value of $433 million. Under the agreement 50% of the common stock of CNE (5.2 million shares) was converted into 9.4 million shares of Energy East common stock, and 50% of the common stock of CNE was exchanged for $218 million in cash, which was $42.00 per CNE share. The company assumed approximately $149 million of CNE long-term debt.
Since the acquisition was accounted for using the purchase method, the company's consolidated financial statements will include CNE's results beginning with February 2000. The purchase price was allocated to the assets acquired and liabilities assumed based on values on the date of purchase. The estimated cost in excess of the fair value of the net assets acquired of $290 million will be reflected as goodwill on the balance sheet.
CNE is a holding company primarily engaged in the retail distribution of natural gas through its wholly-owned subsidiary, The Southern Connecticut Gas Company. CNE also has non-utility subsidiaries that provide an array of energy-related products and services.
CMP Group Merger: The company will acquire all of the common stock of CMP Group for $29.50 per share in cash. The transaction has an equity market value of approximately $957 million. The company will also assume approximately $113 million of CMP Group preferred stock and long-term debt.
On October 7, 1999, CMP Group shareholders approved the merger agreement. Orders approving the merger were issued by the Maine Public Utilities Commission on January 4, 2000, and the Nuclear Regulatory Commission on February 4, 2000. The merger is subject to, among other things, the approvals of various regulatory agencies, including the SEC and Federal Energy Regulatory Commission (FERC). All necessary filings have been made.
CTG Resources Merger: This transaction values CTG Resources' common equity at approximately $355 million, and the company will assume approximately $220 million of CTG Resources' long-term debt.
Under the agreement, 45% of the common stock of CTG Resources will be converted into the company's common stock with a value of $41.00 per CTG Resources share, and 55% will be converted into $41.00 in cash per CTG Resources share, subject to restrictions on the minimum and maximum number of shares to be issued. Shareholders will be able to specify the percentage of the consideration they wish to receive in stock and in cash, subject to proration.
On October 18, 1999, CTG Resources shareholders approved the merger agreement. The Connecticut Department of Public Utility Control issued an order approving the merger on January 19, 2000. The merger is subject to, among other things, the approvals of various regulatory agencies, including the SEC. All necessary filings have been made.
Berkshire Energy Resources Merger: The company will acquire all of the common stock of Berkshire Energy for $38.00 per share in cash. The transaction has an equity market value of approximately $96 million. The company will also assume approximately $40 million of Berkshire Energy preferred stock and long-term debt. The merger is subject to, among other things, SEC approval. All necessary filings have been made.
Note 16. Quarterly Financial Information (Unaudited)
(1) The company's common stock is listed on the New York Stock Exchange. The number of shareholders of record was 31,484 at December 31, 1999.
(2) Includes the effect of a nonrecurring benefit from the sale of generation assets net of the writeoff of Nine Mile Point 2 that increased net income by $10 million and earnings per share by 9 cents.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Shareholders and Board of Directors,
Energy East Corporation and Subsidiaries
Albany, New York
In our opinion, the consolidated financial statements listed in the index appearing under Item 14(a)(1) on page 53 present fairly, in all material respects, the financial position of Energy East Corporation ("the Company") and its subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 14(a)(2) on page 53 presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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 the opinion expressed above.
PricewaterhouseCoopers LLP
New York, New York
January 28, 2000, except as to Note 15, which is as of February 8, 2000
ENERGY EAST CORPORATION
SCHEDULE II - Consolidated Valuation and Qualifying Accounts
(Thousands)
Years Ended December 31, 1999, 1998 and 1997
Classification
Beginning
of Year
Additions
Write-offs (a)
Adjustments
End
of Year
Allowance for Doubtful
Accounts - Accounts
Receivable
$9,279
$12,446
$(15,080)
-
$6,645 (b)
Deferred Tax Asset
Valuation Allowance
$2,001
-
-
$(810) (c)
$1,191
Allowance for Doubtful
Accounts - Accounts
Receivable
$6,801
$17,517
$(15,039)
-
$9,279 (b)
Deferred Tax Asset
Valuation Allowance
$1,611
$390
-
-
$2,001
Allowance for Doubtful
Accounts - Accounts
Receivable
$6,806
$17,345
$(17,350)
-
$6,801 (b)
Deferred Tax Asset
Valuation Allowance
$1,385
$226
-
-
$1,611
(a) Uncollectible accounts charged against the allowance, net of recoveries.
(b) Represents an estimate of the write-offs that will not be recovered in rates.
(c) Reversal of Federal net operating loss.
Item 9.
Item 9. Changes in and disagreements with accountants on accounting and financial disclosure
None
PART III
Item 10.
Item 10. Directors and executive officers of the Registrant
Incorporated herein by reference to the information in Proposal 1 under the captions "Election of Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the company's Proxy Statement dated March 28, 2000. The information regarding executive officers is on pages 11 and 12 of this report.
Item 11.
Item 11. Executive compensation
Incorporated herein by reference to the information in Proposal 1 under the captions "Stock Performance Graph," "Executive Compensation," "Employment, Change in Control and Other Arrangements," "Directors' Compensation" and "Report of Executive Compensation and Succession Committee" in the company's Proxy Statement dated March 28, 2000.
Item 12.
Item 12. Security ownership of certain beneficial owners and management
Incorporated herein by reference to the information in Proposal 1 under the caption "Security Ownership of Certain Beneficial Owners and Management" in the company's Proxy Statement dated March 28, 2000.
Item 13.
Item 13. Certain relationships and related transactions
Incorporated herein by reference to the information in Proposal 1 under the caption "Election of Directors" in the company's Proxy Statement dated March 28, 2000.
PART IV
Item 14.
Item 14. Exhibits, financial statement schedule, and reports on Form 8-K
(a) The following documents are filed as part of this report:
Schedules other than those listed above have been omitted since they are not required, are inapplicable or the required information is presented in the Consolidated Financial Statements or notes thereto.
Exhibits
(a)(1) The following exhibits are delivered with this report:
Exhibit No.
(A)10-14 -
Company Deferred Compensation Plan for New York State Electric & Gas Corporation's Long-Term Executive Incentive Share Plan.
(A)10-23 -
Company Deferred Compensation Plan - Salaried Employees.
21 -
Subsidiaries.
23 -
Consent of PricewaterhouseCoopers LLP to incorporation by reference into certain registration statements.
27 -
Financial Data Schedule.
99-1 -
Form 11-K for New York State Electric & Gas Corporation Tax Deferred Savings Plan for Salaried Employees.
99-2 -
Form 11-K for New York State Electric & Gas Corporation Tax Deferred Savings Plan for Hourly Paid Employees.
(a)(2) The following exhibits are incorporated herein by reference:
Exhibit No.
Filed in
As Exhibit No.
2-1 -
Agreement and Plan of Share Exchange between New York State Electric & Gas Corporation and the Company - Registration
No. 333-37997
2-1
2-2 -
Agreement and Plan of Merger, dated as of April 23, 1999, by and among Connecticut Energy Corporation, the Company and Merger Co., as amended by the First Amendment to Agreement and Plan of Merger, dated as of July 15, 1999 - Registration No. 333-83437
2.1
2-3 -
Agreement and Plan of Merger, dated as of June 14, 1999, by and among CMP Group, Inc., the Company and EE Merger Corp. - Company's Current Report on Form 8-K dated June 14, 1999 -
File No. 1-14766
2-4 -
Agreement and Plan of Merger, dated as of June 29, 1999, by and among CTG Resources, Inc., the Company and Oak Merger Co. - Company's Current Report on Form 8-K dated June 29, 1999 -
File No. 1-14766
2-5 -
Agreement and Plan of Merger, dated as of November 9, 1999, by and among Berkshire Energy Resources, the Company and Mountain Merger LLC - Company's 10-Q for the quarter ended September 30, 1999 - File No. 1-14766
3-1 -
Restated Certificate of Incorporation of the Company pursuant to Section 807 of the Business Corporation Law filed in the Office of the Secretary of State of the State of New York on April 23, 1998 - Post-effective Amendment No.1 to Registration No. 033-54155
4-1
3-2 -
Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on April 26, 1999 - Company's 10-Q for the quarter ended March 31, 1999 -
File No. 1-14766
3-3
Exhibit No.
Filed in
As Exhibit No.
3-3 -
By-Laws of the Company as amended April 23, 1999 - Company's
10-Q for the quarter ended March 31, 1999 - File No. 1-14766
3-4
10-1 -
Asset Purchase Agreement among Pennsylvania Electric Company, NGE Generation, Inc., New York State Electric & Gas Corporation and Mission Energy Westside, Inc. dated as of August 1, 1998 - Company's 10-K for the year ended December 31, 1998 -
File No. 1-14766
10-1
10-2 -
Asset Purchase Agreement among NGE Generation, Inc., New York State Electric & Gas Corporation and AES NY, L.L.C. dated as of August 3, 1998 - Company's 10-K for the year ended December 31, 1998 - File No. 1-14766
10-2
(A)10-3 -
Form of Deferred Compensation Plan for Directors - New York State Electric & Gas Corporation's 10-K for the year ended December 31, 1989 -File No. 1-3103-2
10-22
(A)10-4 -
Deferred Compensation Plan for Directors Amendment No. 1 - New York State Electric & Gas Corporation's 10-K for the year ended December 31, 1993 - File No. 1-3103-2
10-23
(A)10-5 -
Amended and Restated Director Share Plan- New York State Electric & Gas Corporation's 10-Q for the quarter ended June 30, 1998 -
File No. 1-3103-2
10-47
(A)10-6 -
Deferred Compensation Plan for the Director Share Plan - New York State Electric & Gas Corporation's 10-K for the year ended December 31, 1996 - File No. 1-3103-2
10-20
(A)10-7 -
Amended and Restated Supplemental Executive Retirement Plan - New York State Electric & Gas Corporation's 10-Q for the quarter ended June 30, 1998 - File No. 1-3103-2
10-48
(A)10-8 -
Company Annual Executive Incentive Plan - Company's 10-Q for the quarter ended September 30, 1999 - File No. 1-14766
10-40
(A)10-9 -
Amended and Restated New York State Electric & Gas Corporation Annual Executive Incentive Plan - New York State Electric & Gas Corporation's 10-Q for the quarter ended September 30, 1999 -
File No. 1-3103-2
10-40
(A)10-10 -
Amended and Restated Long-Term Executive Incentive Share Plan - New York State Electric & Gas Corporation's 10-Q for the quarter ended June 30, 1998 - File No. 1-3103-2
10-50
(A)10-11 -
Long-Term Executive Incentive Share Plan Amendment No. 1 - New York State Electric & Gas Corporation's 10-Q for the quarter ended September 30, 1998 - File No. 1-3103-2
10-55
(A)10-12 -
Long-Term Executive Incentive Share Plan Amendment No. 2 - New York State Electric & Gas Corporation's 10-K for the year ended December 31, 1999 - File No. 1-3103-2
10-15
(A)10-13 -
New York State Electric & Gas Corporation Long-Term Executive Incentive Share Plan Deferred Compensation Agreement - New York State Electric & Gas Corporation's 10-K for the year ended December 31, 1995 - File No. 1-3103-2
10-44
(A)10-15 -
Form of Severance Agreement for Vice Presidents - New York State Electric & Gas Corporation's 10-K for the year ended December 31, 1993- File No. 1-3103-2
10-48
(A)10-16 -
Form of Severance Agreement for Vice Presidents Amendment No. 1 - New York State Electric & Gas Corporation's 10-K for the year ended December 31, 1995 - File No. 1-3103-2
10-52
(A)10-17 -
Form of Severance Agreement for Vice Presidents Amendment No. 2 - New York State Electric & Gas Corporation's Schedule 14D-9, dated July 30, 1997
Exhibit No.
Filed in
As Exhibit No.
(A)10-18 -
Form of Severance Agreement for Vice Presidents Amendment No. 3 - New York State Electric & Gas Corporation's Schedule 14D-9, dated July 30, 1997
(A)10-19 -
Form of Amendment to the Company's Severance Agreements - New York State Electric & Gas Corporation's 10-Q for the quarter ended June 30, 1998 - File No. 1-3103-2
10-51
(A)10-20 -
Employee Invention and Confidentiality Agreement (Existing Executive) - New York State Electric & Gas Corporation's Schedule 14D-9, dated July 30, 1997
(A)10-21 -
Employee Invention and Confidentiality Agreement (Existing Executive) Amendment No. 1 - New York State Electric & Gas Corporation's Schedule 14D-9, dated July 30, 1997
(A)10-22 -
New York State Electric & Gas Corporation Deferred Compensation Plan for Salaried Employees - New York State Electric & Gas Corporation's 10-K for the year ended December 31, 1995 -
File No. 1-3103-2
10-53
(A)10-24 -
Employment Agreement dated April 23, 1999, for W. W. von Schack - Company's 10-Q for the quarter ended June 30, 1999 -
File No. 1-14766
10-37
(A)10-25 -
Employment Agreement dated April 23, 1999, for K. M. Jasinski - Company's 10-Q for the quarter ended June 30, 1999 -
File No. 1-14766
10-38
(A)10-26 -
Amended and Restated Employment Agreement dated April 23, 1999, for M. I. German - Company's 10-Q for the quarter ended June 30, 1999 - File No. 1-14766
10-39
(A)10-27 -
1997 Stock Option Plan - New York State Electric & Gas Corporation's Schedule 14D-9, dated July 30, 1997
(A)10-28 -
1997 Stock Option Plan Amendment No. 1 - Company's 10-Q for the quarter ended June 30, 1998 - File No. 1-14766
10-1
(A)10-29 -
Non-Statutory Stock Option Award Agreement - New York State Electric & Gas Corporation's Schedule 14D-9, dated July 30, 1997
(A)10-30 -
Non-Statutory Stock Option Award Agreement Amendment No. 1 - Company's 10-Q for the quarter ended June 30, 1998 -
File No. 1-14766
10-2
(A)10-31 -
Restricted Stock Plan - Company's 10-K for the year ended December 31, 1998 - File No. 1-14766
10-36
_____________________________
(A) Management contract or compensatory plan or arrangement.
(b) Reports on Form 8-K
None
Signatures
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
ENERGY EAST CORPORATION
Date: March 27, 2000
By /s/Wesley W. von Schack
Wesley W. von Schack
Chairman, President and
Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
PRINCIPAL EXECUTIVE OFFICER, PRINCIPAL FINANCIAL OFFICER AND PRINCIPAL ACCOUNTING OFFICER
Date: March 27, 2000
By /s/Wesley W. von Schack
Wesley W. von Schack
Chairman, President, Chief
Executive Officer and Director
Signatures (Cont'd)
Date: March 27, 2000
By /s/Richard Aurelio
Richard Aurelio
Director
Date: March 27, 2000
By /s/James A. Carrigg
James A. Carrigg
Director
Date: March 27, 2000
By /s/Alison P. Casarett
Alison P. Casarett
Director
Date: March 27, 2000
By /s/Joseph J. Castiglia
Joseph J. Castiglia
Director
Date: March 27, 2000
By /s/Lois B. DeFleur
Lois B. DeFleur
Director
Signatures (Cont'd)
Date: March 27, 2000
By /s/Paul L. Gioia
Paul L. Gioia
Director
Date: March 27, 2000
By /s/John M. Keeler
John M. Keeler
Director
Date: March 27, 2000
By /s/Ben E. Lynch
Ben E. Lynch
Director
Date: March 27, 2000
By /s/Walter G. Rich
Walter G. Rich
Director
EXHIBIT INDEX
*2-1 -
Agreement and Plan of Share Exchange between New York State Electric & Gas Corporation and the Company.
*2-2 -
Agreement and Plan of Merger, dated as of April 23, 1999, by and among Connecticut Energy Corporation, the Company and Merger Co., as amended by the First Amendment to Agreement and Plan of Merger, dated as of July 15, 1999.
*2-3 -
Agreement and Plan of Merger, dated as of June 14, 1999, by and among CMP Group, Inc., the Company and EE Merger Corp.
*2-4 -
Agreement and Plan of Merger, dated as of June 29, 1999, by and among CTG Resources, Inc., the Company and Oak Merger Co.
*2-5 -
Agreement and Plan of Merger, dated as of November 9, 1999, by and among Berkshire Energy Resources, the Company and Mountain Merger LLC.
*3-1 -
Restated Certificate of Incorporation of the Company pursuant to Section 807 of the Business Corporation Law filed in the Office of the Secretary of State of the State of New York on April 23, 1998.
*3-2 -
Certificate of Amendment of the Certificate of Incorporation filed in the Office of the Secretary of State of the State of New York on April 26, 1999.
*3-3 -
By-Laws of the Company as amended April 23, 1999.
*10-1 -
Asset Purchase Agreement among Pennsylvania Electric Company, NGE Generation, Inc., New York State Electric & Gas Corporation and Mission Energy Westside, Inc. dated as of August 1, 1998.
*10-2 -
Asset Purchase Agreement among NGE Generation, Inc., New York State Electric & Gas Corporation and AES NY, L.L.C. dated as of August 3, 1998.
*(A)10-3 -
Form of Deferred Compensation Plan for Directors.
*(A)10-4 -
Deferred Compensation Plan for Directors Amendment No. 1.
*(A)10-5 -
Amended and Restated Director Share Plan.
*(A)10-6 -
Deferred Compensation Plan for the Director Share Plan.
*(A)10-7 -
Amended and Restated Supplemental Executive Retirement Plan.
*(A)10-8 -
Company Annual Executive Incentive Plan.
*(A)10-9 -
Amended and Restated New York State Electric & Gas Corporation Annual Executive Incentive Plan.
*(A)10-10 -
Amended and Restated Long-Term Executive Incentive Share Plan.
*(A)10-11 -
Long-Term Executive Incentive Share Plan Amendment No. 1.
*(A)10-12 -
Long-Term Executive Incentive Share Plan Amendment No. 2.
*(A)10-13 -
New York State Electric & Gas Corporation Long-Term Executive Incentive Share Plan Deferred Compensation Agreement.
(A)10-14 -
Company Deferred Compensation Plan for New York State Electric & Gas Corporation's Long-Term Executive Incentive Share Plan.
*(A)10-15 -
Form of Severance Agreement for Vice Presidents.
*(A)10-16 -
Form of Severance Agreement for Vice Presidents Amendment No. 1.
*(A)10-17 -
Form of Severance Agreement for Vice Presidents Amendment No. 2.
*(A)10-18 -
Form of Severance Agreement for Vice Presidents Amendment No. 3.
*(A)10-19 -
Form of Amendment to the Company's Severance Agreements.
*(A)10-20 -
Employee Invention and Confidentiality Agreement (Existing Executive).
*(A)10-21 -
Employee Invention and Confidentiality Agreement (Existing Executive) Amendment No. 1.
*(A)10-22 -
New York State Electric & Gas Corporation Deferred Compensation Plan for Salaried Employees.
(A)10-23 -
Company Deferred Compensation Plan - Salaried Employees.
*(A)10-24 -
Employment Agreement dated April 23, 1999, for W. W. von Schack.
*(A)10-25 -
Employment Agreement dated April 23, 1999, for K. M. Jasinski.
*(A)10-26 -
Amended and Restated Employment Agreement dated April 23,1999, for M. I. German.
EXHIBIT INDEX (Cont'd)
*(A)10-27 -
1997 Stock Option Plan.
*(A)10-28 -
1997 Stock Option Plan Amendment No. 1.
*(A)10-29 -
Non-Statutory Stock Option Award Agreement.
*(A)10-30 -
Non-Statutory Stock Option Award Agreement Amendment No. 1.
*(A)10-31 -
Restricted Stock Plan.
21 -
Subsidiaries.
23 -
Consent of PricewaterhouseCoopers LLP to incorporation by reference into certain registration statements.
27 -
Financial Data Schedule.
99-1 -
Form 11-K for New York State Electric & Gas Corporation Tax Deferred Savings Plan for Salaried Employees.
99-2 -
Form 11-K for New York State Electric & Gas Corporation Tax Deferred Savings Plan for Hourly Paid Employees.
_____________________________
* Incorporated by reference.
(A) Management contract or compensatory plan or arrangement. | 19,840 | 126,706 |
70684_1999.txt | 70684_1999 | 1999 | 70684 | ITEM 1. BUSINESS
(a) General Development of Business
Life Insurance and Annuity Operations
National Western Life Insurance Company (hereinafter referred to as "National Western," "Company," or "Registrant") is a life insurance company, chartered in the State of Colorado in 1956, and doing business in forty-three states and the District of Columbia. National Western also accepts applications from and issues policies to residents of various countries in Central and South America, the Caribbean, and the Pacific Rim. Such policies are accepted and issued in the United States. The Company's operations are generally segmented as follows: domestic life insurance, international life insurance, and annuity operations. During 1999, the Company recorded approximately $479 million in premium revenues, universal life, and investment annuity contract deposits. New life insurance issued during 1999 approximated $1.6 billion, and the total amount in force at year-end 1999 was $9.7 billion. As of December 31, 1999, the Company had total consolidated assets of $3.7 billion.
Competition: The life insurance business is highly competitive, and National Western competes with over 1,500 stock and mutual companies. Best's Agents Guide To Life Insurance Companies, an authoritative life insurance publication, lists companies by total admitted assets, net premiums written, and life insurance in force. As of December 31, 1998, the most recent date for which information is available, National Western ranked 153 in total admitted assets, 179 in net premiums written, and 226 in life insurance in force among over 1,500 life insurance companies domiciled in the United States.
Life insurance companies compete not only on product design and price, but on policyowner service and marketing and sales efforts. National Western believes that its products, premium rates, policyowner service, and marketing efforts are generally competitive with those of other life insurance companies selling similar types of insurance. Mutual insurance companies may have certain competitive advantages over stock companies in that the policies written by them are participating policies and their profits inure to the benefit of their policyholders. The Company no longer writes participating policies, and such policies represent a minor portion of the Company's life insurance in force at December 31, 1999.
There has been an ongoing consolidation of companies within the life insurance industry in recent years. It appears this consolidation process will continue as entities acquire other insurance companies, blocks of insurance business, or even related businesses. The reasons for the consolidations are numerous and include, among others, strengthening market share, diversifying into other lines of insurance, improving marketing and distribution channels, and economies of scale. For whatever reasons, this consolidation trend in the insurance industry will likely continue to affect competition.
In addition to competition within the life insurance industry, National Western and other insurance companies face competition from other industries. Banks, brokerage firms, and other financial institutions also market insurance products or other competing products such as mutual funds. The continued growth and popularity of mutual funds and equity holdings has attracted large amounts of investment funds. Many mutual funds also allow tax deferred features through individual retirement accounts, 401(k) plans, and other qualified methods which compete directly with the Company's tax deferred annuity products.
In 1999 Federal legislation was enacted, the Financial Services Modernization Act, which allows affiliations of banks and insurance companies through holding companies. Although this legislation does not allow a bank to engage in insurance underwriting through a subsidiary of the bank, it could significantly affect competition through increased involvement of banks in the marketing and distribution of insurance products. Insurance companies that are significantly larger than National Western may have a competitive advantage, as they may be able to form affiliations more easily with large, dominant banking institutions.
Along with the potential increased competition resulting from the new legislation, technology and the Internet are affecting how life insurance companies do business. As consumers become more comfortable with purchases and transactions over the Internet, insurance companies will have to evaluate the extent to which they need to integrate the Internet into their marketing and distribution of products. While insurance products can be complex and typically require more conventional sales methods, certain insurance products are more like commodities which can be readily sold over the Internet. Insurance companies that are able to address the needs of consumers through the use of current technologies and the Internet may have competitive advantages over those companies that are not able to integrate new technologies into their businesses.
Financial strength ratings of insurance companies also directly affect competitive positions within the industry. Most insurance companies obtain one or more ratings from independent rating agencies. National Western is rated "A- (excellent)" by A.M. Best Company. A.M. Best's ratings evaluate factors affecting the overall performance of an insurance company in order to provide an opinion of the Company's financial strength, operating performance, and ability to meet its obligations to policyholders. Ratings range from A++ (superior) to F (in liquidation). The "A-" rating identifies companies which have, on balance, demonstrated excellent financial strength, operating performance, and market profile when compared to the standards established by A.M. Best. These companies, in the opinion of A.M. Best, have a strong ability to meet their ongoing obligations to policyholders. National Western has also been assigned an "A+ (strong)" by Standard and Poor's Corporation. A Standard & Poor's rating is an opinion of the financial security characteristics of an insurance organization with respect to its ability to pay under its insurance policies and contracts in accordance with their terms. Ratings range from AAA (extremely strong) to CC (extremely weak) and R (regulatory action regarding solvency).
In general, the above-described ratings are developed and based on factors that are of more importance to policyholders, agents, and marketing organizations than to investors. The use of these financial strength ratings are very important in the marketing efforts for insurance companies. While upgrades in ratings could be very positive for marketing efforts, declines in ratings could adversely affect product sales and persistency of policies currently in force.
Agents and Employees: National Western has 239 employees at its principal executive office. Its insurance operations are conducted primarily through broker-agents, which numbered 8,774 at December 31, 1999. The agency operations are supervised by Senior Vice Presidents of domestic and international marketing. The Company's agents are independent contractors who are compensated on a commission basis. General agents receive overriding first-year and renewal commissions on business written by agents under their supervision.
Many of the domestic marketing agents are contracted through independent marketing organizations. These organizations have well developed agent networks and extensive experience, financial resources, and success in marketing life insurance and annuity products. The international marketing broker-agents are a significantly smaller group than the domestic force. However, these broker-agents have been carefully selected and are proven producers, many of whom have been with the Company for 20 or more years.
A significant portion of the Company's universal life and investment annuity contracts were sold through three marketing agencies in recent years. Combined business from these agencies accounted for approximately 29% of total direct premium revenues and universal life and investment annuity contract deposits for 1999. These same three marketing agencies accounted for 26% and 17% of total direct premium revenues and universal life and investment annuity contract deposits for 1998 and 1997, respectively.
Types of Insurance Written: National Western offers a broad portfolio of individual whole life, universal life and term insurance plans, endowments, and annuities, including standard supplementary riders. Annuities sold include flexible premium deferred annuities, single premium deferred annuities, and single premium immediate annuities. These products can be tax qualified or nonqualified annuities. Although the Company sells equity-indexed annuities, no variable life or annuity products are currently offered. Except for a small employee health plan and a small number of existing individual accident and health policies, the Company does not write any new policies in the accident and health markets. Distributions of the Company's direct premium revenues and deposits by types of products are provided below:
The underwriting policy of the Company requires medical examination of applicants for ordinary insurance in excess of certain prescribed limits. These limits are graduated according to the age of the applicant and the amount of insurance desired. The Company has no maximum for issuance of life insurance on any one life. However, the Company's general policy is to reinsure that portion of any risk in excess of $200,000 on the life of any one individual. Also, following general industry practice, policies are issued on substandard risks.
Geographical Distribution of Business: For the year 1999, insurance and annuity policies held by residents of the State of Texas accounted for 10% of premium revenues, universal life, and investment annuity contract deposits from direct business, while policies held by residents of Ohio, California, and Michigan accounted for approximately 10%, 8%, and 7%, respectively. All other states of the United States accounted for 51% of premium revenues and deposits from direct business. The remaining 14% of premium revenues and deposits were derived from the Company's policies issued to foreign nationals, primarily in Central and South America, almost all of which was for individual life insurance. A distribution of the Company's direct premium revenues and deposits by domestic and international markets is provided below:
Approximately 68% of the direct life insurance premiums collected during 1999 was sold through international insurance brokers acting as independent contractors. Foreign business is solicited by various independent brokers, primarily in Central and South America, and forwarded to the United States for acceptance and issuance. The Company maintains strict controls on the business it accepts from such foreign independent brokers, as well as its underwriting procedures for such business. Except for a small block of business, a currency clause is included in each foreign policy stating that premium and claim "dollars" refer to lawful currency of the United States. Traditional and universal life products are sold in the international market to individuals in upper socioeconomic classes. By marketing exclusively to this group, sales typically produce a higher average policy size, strong persistency, and claims experience similar to that in the United States.
Investments: State insurance statutes prescribe the nature, quality, and percentage of the various types of investments which may be made by insurance companies and generally permit investments in qualified state, municipal, federal, and foreign government obligations, corporate bonds, preferred and common stock, real estate, and real estate first lien mortgages where the value of the underlying real estate exceeds the amount of the mortgage lien by certain required percentages.
The following table shows the distribution of the Company's investments:
The following table shows investment results for the periods indicated:
Regulation: The Company is subject to regulation by the supervisory agency of each state or other jurisdiction in which it is licensed to do business. These agencies have broad administrative powers, including the granting and revocation of licenses to transact business, the licensing of agents, the approval of policy forms, the form and content of mandatory financial statements, capital, surplus, and reserve requirements, as well as the previously mentioned regulation of the types of investments which may be made. The Company is required to file detailed financial reports with each state or jurisdiction in which it is licensed, and its books and records are subject to examination by each. In accordance with the insurance laws of the various states in which the Company is licensed and the rules and practices of the National Association of Insurance Commissioners, examination of the Company's records routinely takes place every three to five years. These examinations are supervised by the Company's domiciliary state, with representatives from other states participating. The most recent completed examination of National Western covered the five-year period ended December 31, 1997. The examination was conducted by the Colorado Division of Insurance. A final report disclosing the examination results was received by the Company in February, 2000. The report contained no financial adjustments and no issues which had an impact on the operations of the Company. However, the report did include recommendations for improvements in the Company's facultative reinsurance documentation and disaster recovery plans.
Regulations that affect the Company and the insurance industry are often the result of efforts by the National Association of Insurance Commissioners (NAIC). The NAIC is an association of state insurance commissioners, regulators, and support staff that acts as a coordinating body for the state insurance regulatory process. The NAIC and state insurance regulators periodically re-examine existing laws and regulations. The NAIC has recently completed a comprehensive process of codifying statutory accounting practices and procedures. Other than specific individual state laws, the codification results will be the only source of prescribed statutory accounting practices. The Company's state of domicile, Colorado, is currently in the process of adopting the new codified statutory accounting practices and procedures. Insurance companies must adopt these new statutory accounting practices in 2001, which may result in significant changes to existing practices used in the preparation of statutory financial statements. The Company will perform a review of the entire newly codified statutory accounting practices and procedures during 2000. This review process may not be fully completed until the latter portion of the year. Based on a preliminary review, National Western does not anticipate a material impact to its capital and surplus position as a result of implementation of the new prescribed statutory accounting procedures.
Also of particular importance, the NAIC has established risk-based capital (RBC) requirements to help state regulators monitor the financial strength and stability of life insurers by identifying those companies that may be inadequately capitalized. Under the NAIC's requirements, each insurer must maintain its total capital above a calculated threshold or take corrective measures to achieve the threshold. The threshold of adequate capital is based on a formula that takes into account the amount of risk each company faces on its products and investments. The RBC formula takes into consideration four major areas of risk which are: (i) asset risk which primarily focuses on the quality of investments; (ii) insurance risk which encompasses mortality and morbidity risk; (iii) interest rate risk which involves asset/liability matching issues; and (iv) other business risks. The Company has calculated its RBC level and has determined that its capital and surplus is significantly in excess of the threshold requirements. Additionally, it is anticipated that the Company's RBC level will remain significantly in excess of threshold requirements after implementation of the new statutory accounting procedures as described above.
In addition to RBC requirements, insurance companies are also monitored by the NAIC through its Insurance Regulatory Information System (IRIS). IRIS consists of two systems, the original IRIS system and the Financial Analysis and Solvency Tracking System. The original IRIS consists of two phases. The first is a statistical phase during which key financial ratio results are generated from the NAIC data base, which contains financial information obtained from insurers' statutory annual statements. The second, an analytical phase, is a review of the annual statements and financial ratios by experienced financial examiners. The ratios of companies are compared against usual ranges to identify trends or areas requiring additional review or analysis. All of the Company's ratios for 1999 were within usual ranges, with one exception. National Western exceeded a ratio which measures the percentage change in product mix from 1998 to 1999. Based on statutory financial statements, the Company's 1999 change in product mix reflected a change which exceeded the IRIS threshold. Although this ratio was slightly above the IRIS threshold, it merely reflects the Company's increased sales of group annuities as opposed to individual annuities in 1999 compared to the previous year.
The RBC regulation and IRIS system developed by the NAIC are examples of its involvement in the regulatory process. Additionally, new regulations are routinely published by the NAIC as model acts or model laws. The NAIC encourages adoption of these model acts by all states to provide uniformity and consistency among state insurance regulations.
While the insurance industry is primarily regulated by state governments, Federal regulation also affects the industry in various areas such as pension regulations, securities laws, and Federal taxation. For example, annuity and insurance products have certain income tax advantages for policyholders compared to other savings investments such as certificates of deposits and taxable bonds. Unlike many other investments, increases in the contract values of annuity and life insurance products are not subject to income taxation until these values are actually paid to and received by the policyholder. At various times, the Federal government has considered revising or eliminating this income tax deferral. Such a change, if ever enacted, could have an adverse effect on the Company's ability to sell certain annuity and insurance products.
Additionally, current tax law reflects an individual capital gains tax rate of 20%. Because many consumers purchase annuities and life insurance for their tax deferral advantages over other investments or retirement products, a reduction in the Federal income tax rate for capital gains could diminish the appeal of life and annuity products and increase the attractiveness of competing products. Although National Western has not experienced any negative impact on its sales, changes could have the potential to adversely impact Company and industry wide sales.
There have also been various proposals in past years to modify the existing Federal income tax laws. Some proposals outline measures to implement a "flat tax" structure that would lower the marginal tax rates for many taxpayers. Other proposals call for eliminating the existing income tax and implementing a "consumption based tax." Adoption of any of these new methods, particularly a consumption based tax, could have adverse effects on the insurance industry, as the value of annuity and life insurance products with income tax deferral advantages would be lessened or minimized. However, it is impossible to predict what changes, if any, will be made to the existing Federal income tax structure and the timing of any such changes.
Discontinued Brokerage Operations
In addition to life insurance and annuity operations, the Company had a brokerage operations segment through its wholly owned subsidiary, The Westcap Corporation (Westcap). However, during 1995 Westcap closed its sales offices and approved a plan to cease all brokerage operations. Declines in both sales revenues and earnings were the principal reasons for ceasing brokerage operations. The declines resulted primarily from adverse bond market conditions and adverse publicity about litigation. Subsequently on April 12, 1996, Westcap and its wholly owned subsidiary, Westcap Enterprises, Inc., separately filed voluntary petitions for reorganization under Chapter 11 of the U.S. Bankruptcy Code. The bankruptcy reorganization was completed in January, 1999, National Western retained 100% continuing ownership of the reorganized Westcap, and the subsidiary is now operating as a real estate management company. The brokerage segment is reported as discontinued operations throughout this report and in the accompanying financial statements. The bankruptcy and ultimate settlement are more fully described in Item 3, Legal Proceedings, and in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations.
(b) Financial Information About Industry Segments
A summary of financial information for the Company's industry segments follows:
Additional information concerning these industry segments is included in Item 1.(a).
(c) Narrative Description of Business
Included in Item 1.(a).
(d) Financial Information About Geographic Areas
Included in Item 1.(a) and Note 14, Segment and Other Operating Information, of the accompanying financial statements.
ITEM 2.
ITEM 2. PROPERTIES
The Company leases approximately 72,000 square feet of office space in Austin, Texas. This lease expires in 2010 and specifies lease payments that gradually increase over the term of the lease. Currently, lease payments are $487,500 per year plus taxes, insurance, maintenance, and other operating costs. Lease costs and related operating expenses for office facilities of the Company's subsidiaries are not significant in relation to the Company's consolidated financial statements.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Westcap Corporation Bankruptcy Proceedings
The Chapter 11 bankruptcy reorganization of the Company's wholly owned subsidiary, The Westcap Corporation (Westcap), was completed in the first quarter of 1999. Pursuant to the reorganization plan, National Western retained 100% continuing ownership of the reorganized Westcap, and the subsidiary is now operating as a real estate management company. No losses were reported for discontinued brokerage operations in 1999, as the entire $14,125,000 settlement payment was accrued and reported as a loss in the third quarter of 1998. Any additional losses will depend on the results of The City Colleges lawsuit filed against National Western on March 28, 1994, for alleged federal or state securities law "control person" violations relating to Westcap, and which is pending in the United States District Court, Western District of Texas. This suit is described in more detail below.
Westcap Related Litigation
On March 28, 1994, the Community College District No. 508, County of Cook and State of Illinois (The City Colleges) filed a complaint in the United States District Court for the Northern District of Illinois, Eastern Division, against National Western Life Insurance Company (the Company or National Western) and subsidiaries of The Westcap Corporation (Westcap), a wholly owned subsidiary of the Company. The suit sought rescission of securities purchase transactions by The City Colleges from Westcap between September 9, 1993, and November 3, 1993, alleged compensatory damages, punitive damages, injunctive relief, declaratory relief, fees, and costs. National Western was named as a "controlling person" of the Westcap defendants. Westcap filed Chapter 11 bankruptcy, and The City Colleges filed a claim in the bankruptcy court against Westcap. The claim was tried before the bankruptcy court, and in September, 1997, a $56,173,000 judgment was entered against Westcap favorable to The City Colleges. Westcap appealed this decision to the United States District Court for the Southern District of Texas (Houston Division). On July 24, 1998, the United States District Court affirmed the orders of the bankruptcy court with respect to their underlying conclusion that Westcap is liable to The City Colleges under the Texas Securities Act, but the Court vacated the orders and remanded them to the bankruptcy court to determine the correct amount of damages in a manner consistent with the Court's opinion and the Texas Securities Act. The bankruptcy court on November 16, 1998, entered an order allowing a claim of The City Colleges against the Westcap estate of $51,738,868. Westcap has appealed the bankruptcy court's and District Court's judgment to the Fifth Circuit Court of Appeals. Oral argument on the appeal was held on February 29, 2000, and no ruling has yet been rendered.
While Westcap is a wholly owned subsidiary of the Company, the Company is not a party to the bankruptcy or the judgment against Westcap by the bankruptcy court or the United States District Court. The lawsuit against the Company was stayed in September, 1994, pending resolution of The City Colleges' claim against Westcap. Following the judgment against Westcap in the bankruptcy court, on December 2, 1997, the stay was lifted by the United States District Court in Illinois, and The City Colleges filed an amended complaint seeking to hold the Company liable for the claim allowed in the bankruptcy court against Westcap under the "control person" provision of the Texas Securities Act. The suit seeks approximately $56 million plus fees and costs. The maximum sought by City Colleges will be determined by the final amount allowed The City Colleges in the Westcap bankruptcy appeal, discussed above. The Company filed jurisdictional and venue motions to have the case transferred to the United States District Court for the Western District of Texas, which motions were agreed to by the Plaintiff, and the case is now pending in the United States District Court for the Western District of Texas, where the parties have engaged in discovery activities. The case is set for trial in September, 2000. The Company believes it has reasonable and adequate defenses to the suit. Although the alleged damages, if sustained, would be material to the Company's financial statements, a reasonable estimate of any actual losses which may result from the suit cannot be made at this time. Accordingly, no provision for any liability that may result from this suit has been recognized in National Western's financial statements.
Other Litigation
On September 30, 1999, National Western Life Insurance Company (the Company), National Annuity Programs, Inc. (NAP), Robert L. Myer (Myer), and certain affiliates of Myer executed a Definitive Compromise Settlement Agreement (Agreement) of the declaratory judgment lawsuit pending between them in the District Court of Travis County, Texas. The declaratory judgment action was filed by the Company and sought court construction of a general agent manager contract and amendments thereto (Contract) between the Company and NAP entered into in 1983 and amended thereafter, a declaration that the contract was enforceable, but had been breached by NAP, and for damages from NAP. The Company alleged tortious interference by Myer with the Contract, conspiracy, and damages. NAP and Myer had counter-claimed for declaratory judgment, breach of contract, indemnity, fraud, statutory violations, damages, and attorneys' fees from the Company.
By the settlement each party dismissed with prejudice all claims asserted by them in the pending lawsuit. NAP and Myer released the Company from any claim for any funds and other rights arising under the Contract and from all negligence and other claims arising prior to the Agreement. The Company released NAP, Myer, and Myer affiliates from all negligence and other claims, excluding any claims arising under the reinsurance contract between the Company and NAP Life Insurance Company, a Myer affiliate. The Company acquired NAP, and Myer indemnified and held the Company harmless from all claims of any nature asserted against NAP based on its acts or omissions prior to the Agreement, except for claims by policyholders and agents relating to the sale of the Company's products. The Company indemnified Myer for NAP acts or omissions occurring after September 30, 1999. The Company will pay or cause to be paid or released all valid claims for unpaid commissions to sub- agents of NAP who wrote business for the Company under the Contract. The Company completed such payments to these agents in 1999 in the aggregate amount of $820,000.
As a result of the settlement, accrued bonus commissions relating to the NAP contract totaling $8,482,000 were released, as they are no longer considered a liability to NAP and will not be paid. Accordingly, the release of these accrued commissions from liabilities in 1999 resulted in additional income of $8,482,000, before taxes. It is anticipated that any future renewal premiums received by the Company on currently issued and in force annuity policies written by NAP sub-agents under the Contract could generate additional commissions for such sub-agents. The payment of such future commissions is subject to and conditioned upon receipt of such renewal premiums by the Company and compliance by the sub-agents with the terms of the agents' contracts with the Company and NAP.
By separate Commutation Agreement dated September 30, 1999, the Company and NAP Life Insurance Company ("NAP Life"), an affiliate of Robert L. Myer, canceled and terminated the Specific Benefit Reinsurance Agreement between them dated March 1, 1988, whereby the Company had ceded fifty percent (50%) of the premiums, reserves, and liabilities on a portion of its policies of insurance. The effect of the Commutation Agreement did not have a significant impact on the financial statements of the Company, as the cost to National Western to terminate the agreement totaled $182,000.
National Western Life Insurance Company is also currently a defendant in several other lawsuits, substantially all of which are in the normal course of business. In the opinion of management, the liability, if any, which may arise from these lawsuits would not have a material adverse effect on the Company's financial position.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the Company's security holders during the fourth quarter of 1999.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
(a) Market Information
The principal market on which the common stock of the Company trades is The Nasdaq Stock Market under the symbol NWLIA. The high and low sales prices for the common stock for each quarter during the last two years are shown in the following table:
(b) Equity Security Holders
The number of stockholders of record on December 31, 1999, was as follows:
(c) Dividends
The Company has never paid cash dividends on its common stock. Payment of dividends is within the discretion of the Company's Board of Directors and will depend on factors such as earnings, capital requirements, and the operating and financial condition of the Company. Presently, the Company's capital requirements are such that it intends to follow a policy of retaining any earnings in order to finance the development of business and to meet regulatory requirements for capital. A strong capital position is important not only for the protection of existing policyholders, but also in the successful marketing of Company products to new customers.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following five-year financial summary includes comparative amounts taken from the audited financial statements.
Earnings Information:
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
National Western Life Insurance Company is a life insurance company, chartered in the State of Colorado in 1956, and doing business in forty-three states and the District of Columbia. It also accepts applications from and issues policies to residents of various Central and South American, Caribbean, and Pacific Rim countries. A distribution of the Company's direct premium revenues and deposits by domestic and international markets is provided below:
Insurance Operations - Domestic
The Company's domestic operations concentrate marketing efforts on federal employees, seniors, and specific employee groups in private industry, as well as individual sales. The products marketed are annuities, universal life insurance, and traditional life insurance, which includes both term and whole life products. The majority of products sold are the Company's annuities, which include single and flexible premium deferred annuities, single premium immediate annuities, and equity-indexed annuities. Most of these annuities can be sold as tax qualified or nonqualified products.
National Western markets and distributes its domestic products primarily through independent marketing organizations (IMOs). These IMOs assist the Company in recruiting, contracting, and managing agents. The Company currently has over 80 IMOs contracted for sales of life and annuity products.
Insurance Operations - International
The Company's international operations focus marketing efforts on foreign nationals in upper socioeconomic classes with substantial financial resources. Insurance sales are from countries in Central and South America, the Caribbean, and the Pacific Rim. Marketing to numerous countries in these different regions provides diversification that helps to minimize large fluctuations in sales that can occur due to various economic, political, and competitive pressures that may occur from one country to another. Products sold in the international market are almost entirely universal life and traditional life insurance products. However, certain annuity and investment contracts are also available in this market.
International sales production is from broker-agents, many of whom have been selling National Western products for 20 or more years. The Company continues to expand its sales networks in specifically targeted South American and Pacific Rim countries which have higher growth potential than other countries.
There are inherent risks of conducting international business that are not present within the domestic market. The risks involved with international business are reduced substantially by the Company in several ways. As previously described, the Company focuses its marketing efforts on a specific niche group, which is foreign nationals in upper socioeconomic classes who have substantial financial resources. This targeted customer base coupled with National Western's conservative, yet competitive, underwriting practices have historically resulted in claims experience similar to that in the United States. The Company also minimizes exposure to foreign currency risks, as almost all foreign policies require payment of premiums and claims in United States dollars. Finally, the Company's experience in the international market and its strong broker-agent relationships, which in many cases exceed 20 years, help minimize risks and problems when selling products to foreign nationals.
Other
In addition to the life insurance business, the Company had a brokerage operations segment through its wholly owned subsidiary, The Westcap Corporation (Westcap). However, during 1995 Westcap closed its sales offices and approved a plan to cease all brokerage operations. Subsequently on April 12, 1996, Westcap and its wholly owned subsidiary, Westcap Enterprises, Inc., separately filed voluntary petitions for reorganization under Chapter 11 of the U.S. Bankruptcy Code. The bankruptcy reorganization was completed in January, 1999, National Western retained 100% continuing ownership of the reorganized Westcap, and the subsidiary is now operating as a real estate management company. Accordingly, the brokerage segment is reported as discontinued operations throughout this report and in the accompanying financial statements.
INVESTMENTS IN DEBT AND EQUITY SECURITIES
Investment Philosophy
The Company's investment philosophy is to maintain a diversified portfolio of investment grade debt and equity securities that provide adequate liquidity to meet policyholder obligations and other cash needs. The prevailing strategy within this philosophy is the intent to hold investments in debt securities to maturity. However, the Company manages its portfolio, which entails monitoring and reacting to all components which affect changes in the price, value, or credit rating of investments in debt and equity securities.
Investments in debt and equity securities are classified and reported as either securities held to maturity or securities available for sale. The Company does not maintain a portfolio of trading securities. The reporting category chosen for the Company's securities investments depends on various factors including the type and quality of the particular security and how it will be incorporated into the Company's overall asset/liability management strategy. At December 31, 1999, approximately 26% of the Company's total debt and equity securities, based on fair values, were classified as securities available for sale. These holdings provide flexibility to the Company to react to market opportunities and conditions and to practice active management within the portfolio to provide adequate liquidity to meet policyholder obligations and other cash needs.
Securities the Company purchases with the intent to hold to maturity are classified as securities held to maturity. Because the Company has strong cash flows and matches expected maturities of assets and liabilities, the Company has the ability to hold the securities, as it would be unlikely that forced sales of securities would be required prior to maturity to cover payments of liabilities. As a result, securities held to maturity are carried at amortized cost less declines in value that are other than temporary. However, certain situations may change the Company's intent to hold a particular security to maturity, the most notable of which is a deterioration in the issuer's creditworthiness. Accordingly, a security may be sold to avoid a further decline in realizable value when there has been a significant change in the credit risk of the issuer.
Securities that are not classified as held to maturity are reported as securities available for sale. These securities may be sold if market or other measurement factors change unexpectedly after the securities were acquired. For example, opportunities arise that allow the Company to improve the performance and credit quality of the investment portfolio by replacing an existing security with an alternative security while still maintaining an appropriate matching of expected maturities of assets and liabilities. Examples of such improvements are as follows: improving the yield earned on invested assets, improving the credit quality, changing the duration of the portfolio, and selling securities in advance of anticipated calls or other prepayments. Securities available for sale are reported in the Company's financial statements at fair value. Any unrealized gains or losses resulting from changes in the fair value of the securities are reflected in accumulated other comprehensive income.
As an integral part of its investment philosophy, the Company performs an ongoing process of monitoring the creditworthiness of issuers within the investment portfolio. Review procedures are also performed on securities that have had significant declines in fair value. The Company's objective in these circumstances is to determine if the decline in fair value is due to changing market expectations regarding inflation and general interest rates or other factors. Additionally, the Company closely monitors financial, economic, and interest rate conditions to manage prepayment and extension risks in its mortgage-backed securities portfolio.
The Company's overall conservative investment philosophy is reflected in the allocation of its investments, which is detailed below as of December 31, 1999 and 1998. The Company emphasizes investment grade debt securities, with smaller holdings in mortgage loans and policy loans.
Portfolio Analysis
The Company maintains a diversified debt securities portfolio which consists of various types of fixed income securities including primarily corporate, mortgage-backed securities, and public utilities. Investments in mortgage-backed securities include primarily U.S. government agency pass-through securities and collateralized mortgage obligations (CMOs). As of December 31, 1999, 1998, and 1997, the Company's debt securities portfolio consisted of the following mix of securities based on amortized cost:
An important aspect of the Company's investment philosophy is managing the credit quality of its investments in debt securities. Thorough credit analysis is performed on potential corporate investments including examination of a company's credit and industry outlook, financial ratios and trends, and event risks. National Western continues to follow its conservative investment philosophy by minimizing its holdings of below investment grade debt securities, as these securities generally have greater default risk than higher rated corporate debt. These issuers usually are more sensitive to adverse industry or economic conditions than are investment grade issuers. The Company's small holdings of below investment grade debt securities are summarized below.
The Company's holdings of below investment grade debt securities have increased from $44,974,000 at December 31, 1998, to $70,900,000 at December 31, 1999. This increase is due to downgrades of investment grade debt securities as opposed to purchases of such holdings. Historically, the Company's strong credit risk management and commitment to quality has resulted in minimal defaults in the debt securities portfolio. At December 31, 1999, 1998, and 1997, no securities were in default and on nonaccrual status.
During 1999 the Company recorded permanent impairment writedowns totaling $4,403,000 related to two separate securities. The writedowns were reflected as realized losses in the accompanying financial statements. The Company is closely monitoring these securities as well as its other below investment grade holdings. While additional losses are not anticipated based on the current status and condition of these securities, continued credit deterioration of some securities is possible, which may result in further writedowns. Recently, credit deterioration of issuers has been due primarily to an increasing amount of acquisition activity and stock repurchase programs which cause companies to become more leveraged and less creditworthy.
Although there is some exposure to below investment grade debt securities, the Company is firmly committed to minimizing credit risks and maintaining a high quality portfolio. This commitment is reflected in the high average credit rating of the Company's portfolio. In the table below, investments in debt securities are classified according to credit ratings by Standard and Poor's (S&P), a nationally recognized statistical rating organization (NRSRO). If securities were not rated by S&P, the equivalent rating of another NRSRO or the National Association of Insurance Commissioners was used.
Another important part of the Company's investment philosophy is managing the cash flow stability of the portfolio. Because expected maturities of securities may differ from contractual maturities due to prepayments, extensions, and calls, the Company takes steps to manage and minimize these risks. The Company continues to reduce its exposure to prepayment and extension risks by lowering its holdings of mortgage-backed securities. This strategy began in 1994 when mortgage-backed securities totaled 47.6% of the entire portfolio, but now total only 20.9% at December 31, 1999. The majority of this reduction has been achieved by shifting investments into corporate securities, as corporate holdings have increased from 32.5% in 1994 to 55.6% in 1999. Also, most of these additions have been noncallable corporates, which help reduce prepayment and call risks.
As indicated above, the Company's holdings of mortgage-backed securities are also subject to prepayment risk, as well as extension risk. Both of these risks are addressed by specific portfolio management strategies. The Company has substantially reduced both prepayment and extension risks by investing primarily in collateralized mortgage obligations, which have more predictable cash flow patterns than pass-through securities. These securities, known as planned amortization class I (PAC I) CMOs, are designed to amortize in a more predictable manner than other CMO classes or pass-throughs. Using this strategy, the Company can more effectively manage and reduce prepayment and extension risks, thereby helping to maintain the appropriate matching of the Company's assets and liabilities.
As of December 31, 1999, CMOs represent approximately 94% of the Company's mortgage-backed securities. The CMOs in the Company's portfolio have been modeled and subjected to detailed, comprehensive analysis by the Company's investment staff. The overall structure of the CMO as well as the individual tranche being considered for purchase have been evaluated to ensure that the security fits appropriately within the Company's investment philosophy and asset/liability management parameters. The Company's investment mix between mortgage-backed securities and other fixed income securities helps effectively balance prepayment, extension, and credit risks.
The amortized cost and estimated fair values of investments in debt securities at December 31, 1999, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
At December 31, 1999, the Company's debt and equity securities were classified as follows:
As detailed above, debt securities classified as held to maturity comprise the majority of the Company's securities portfolio, while equity securities continue to be a small component of the portfolio. Unrealized losses totaling $91,090,000 on the securities portfolio at December 31, 1999, is a reflection of market interest rates at year-end. The fair values, or market values, of fixed income debt securities correlate to external market interest rate conditions. Because the interest rates are fixed on almost all of the Company's debt securities, market values typically increase when market interest rates decline, and decrease when market interest rates rise. This correlation between market values and interest rates is reflected in the tables below.
As reflected above, changes in interest rates typically have a significant impact on the market values of the Company's debt securities. The Company would expect similar results in the future from any significant upward or downward movement in market rates. The substantial increase in unrealized losses during 1999 is due to a significant increase in interest rates. Market interest rates of the ten-year U.S. Treasury bond rose approximately 180 basis points from year-end 1998. However, because the majority of the Company's debt securities are classified as held to maturity, which are recorded at amortized cost, changes in market values have relatively small effects on the Company's financial statements. Also, the Company has the intent and ability to hold these securities to maturity, and it is unlikely that sales of such securities would be required, which would realize market gains or losses.
Changes in fair values of securities due to changes in market interest rates is an example of market risk. Market risk is the risk of change in market values of financial instruments due to changes in interest rates, currency exchange rates, commodity prices, or equity prices. The most significant market risk exposure for National Western is interest rate risk. The Company manages interest rate risk through on-going cash flow testing required for insurance regulatory purposes. Computer models are used to perform cash flow testing under various commonly used stress test interest rate scenarios to determine if existing assets would be sufficient to meet projected liability outflows. Management strives to closely match the durations of its assets and liabilities. Sensitivity analysis allows the Company to measure the potential gain or loss in fair value of its interest-sensitive instruments and to seek to protect its economic value and achieve a predictable spread between what is earned on invested assets and what is paid on liabilities. The Company seeks to minimize the impact of interest risk through surrender charges that are imposed to discourage policy surrenders. Interest rate changes can be anticipated and risk may be limited due to management actions regarding asset and liability instruments. However, potential changes in the values of financial instruments indicated by hypothetical interest changes will likely be different from actual changes experienced, and the differences may be material.
Market risk-sensitive assets of the Company include debt securities, equity securities which are almost entirely preferred stocks, mortgage loans, policy loans, and index options. The Company does not maintain a securities trading portfolio. Market risk-sensitive liabilities include policy liabilities for deferred and immediate investment annuity contracts and supplemental contracts. Sensitivity analysis expresses the potential gain or loss in fair value, over a selected time period, from one or more selected hypothetical changes in interest rates which are reasonably possible in the near term. The following table illustrates the market risk sensitivity of the Company's interest rate-sensitive assets. The table shows the effect of a change in interest rates on the fair value of the portfolio. The data is prepared using models that measure the change in fair value arising from an immediate and sustained change in interest rates in increments of 100 basis points.
The debt securities portfolio includes primarily noncallable corporate bonds, mortgage-backed securities, and asset-backed securities. Expected maturities of debt securities may differ from contractual maturities due to call or prepayment provisions. The model assumes that prepayments on mortgage-backed securities are influenced by agency and pool types, the level of interest rates, loan age, refinancing incentive, month of the year, and underlying coupon. During periods of declining interest rates, principal payments on mortgage-backed securities and collateralized mortgage obligations increase as the underlying mortgages are prepaid. Conversely, during periods of rising interest rates, the rate of prepayment slows. Both of these situations can expose the Company to the possibility of asset/liability cash flow and yield mismatch. The model uses a proprietary method of sampling interest rate paths along with a mortgage prepayment model to derive future cash flows. The initial interest rates used are based on the current U.S. Treasury yield curve as well as current mortgage rates for the various types of collateral in the portfolio.
Mortgage loans were modeled by discounting scheduled cash flows through the scheduled maturities of the loans, starting with interest rates currently being offered for similar loans to borrowers with similar credit ratings. Policy loans were modeled by discounting estimated cash flows using U.S. Treasury Bill interest rates as the base rates at December 31, 1999. The estimated cash flows include assumptions as to whether such loans will be repaid by the policyholders or settled upon payment of death or surrender benefits on the underlying insurance contracts. As a result, these assumptions incorporate both Company experience and mortality assumptions associated with such contracts.
In addition to the securities analyzed above, the Company invests in index options which are derivative financial instruments used to hedge the equity return component of the Company's equity-indexed annuities. The values of these options are primarily impacted by equity price risk, as the options' fair values are dependent on the performance of the S&P 500 Composite Stock Price Index (S&P 500 Index). However, increases or decreases in investment returns from these options are substantially offset by corresponding increases or decreases in amounts paid to equity-indexed annuity policyholders, subject to minimum guaranteed policy interest rates. An example of this equity price risk is reflected in the decline in the value of the Company's index options during the third quarter of 1999. The S&P 500 Index declined approximately 6.6%, which resulted in a net decrease in investment income totaling $13.1 million for the quarter ended September 30, 1999. Subsequently, during the fourth quarter of 1999, the S&P 500 Index increased significantly, which increased investment income from unrealized mark-to-market gains on the index options and reversed the declines of the previous quarter.
The Company's market risk liabilities, which include policy liabilities for investment annuity and supplemental contracts, are managed for interest rate risk through cash flow testing as previously described. As part of this cash flow testing, the Company has analyzed the potential impact on net earnings of both a 100 basis point increase and decrease in the U.S. Treasury yield curve as of December 31, 1999. A 100 basis point interest rate decline would decrease net earnings for 2000 by approximately $300,000, based on the Company's projections. A 100 basis point increase in interest rates would increase net earnings by approximately $200,000, based on the Company's projections. These estimated impacts to earnings are net of tax effects determined at a tax rate of 35% and are also net of the estimated effects of deferred policy acquisition costs.
The Company has modeled these scenarios, as a change in market interest rates could pose potential risks to the current profitability levels of this business. These movements in interest rates are also reasonably possible near-term scenarios given the current interest rate environment. The risks from such changes are primarily due to changes in interest rate spreads, which are the differences between investment income earned and credited interest paid to policyholders. Also, the changes in interest rates can effect the level of surrenders and timing of cash flows related to policy liabilities.
The above-described scenarios produce estimated changes in cash flows as well as cash flow reinvestment projections. Estimated cash flows in the Company's model assume cash flow reinvestments which are representative of the Company's current investment strategy. Calls and prepayments include scheduled maturities and those expected to occur which would benefit the security issuers. Assumed policy surrenders consider differences and relationships between credited interest rates and market interest rates as well as surrender charges on individual policies. The impact to earnings also includes the expected effects on amortization of deferred policy acquisition costs. The model considers only investment annuity and supplemental contracts in force at December 31, 1999, and does not consider new product sales or the possible impact of interest rate changes on sales.
MORTGAGE LOANS AND REAL ESTATE
Investment Philosophy
In general, the Company seeks loans on high quality, income-producing properties such as shopping centers, freestanding retail stores, office buildings, industrial and sales or service facilities, selected apartment buildings, motels, and health care facilities. The location of these loans is typically in growth areas that offer a potential for property value appreciation. These growth areas are found primarily in major metropolitan areas, but occasionally in selected smaller communities.
The Company seeks to minimize the credit and default risk in its mortgage loan portfolio through strict underwriting guidelines and diversification of underlying property types and geographic locations. In addition to being secured by the property, mortgage loans with leases on the underlying property are often guaranteed by the lessee, in which case the Company approves the loan based on the credit strength of the lessee. This approach has proven to result in higher quality mortgage loans with fewer defaults.
The Company's direct investments in real estate are not a significant portion of its total investment portfolio, and the majority of real estate owned was acquired through mortgage loan foreclosures. However, the Company also participates in several real estate joint ventures and limited partnerships. The joint ventures and partnerships invest primarily in income-producing retail properties. While not a significant portion of the Company's investment portfolio, these investments have produced favorable returns.
Portfolio Analysis
The Company held net investments in mortgage loans totaling $183,902,000 and $174,921,000, or 5.7% and 5.6% of total invested assets, at December 31, 1999 and 1998, respectively. The loans are real estate mortgages, substantially all of which are related to commercial properties and developments and have fixed interest rates.
The diversification of the mortgage loan portfolio by geographic region of the United States and by property type as of December 31, 1999 and 1998, was as follows:
As of December 31, 1999, the allowance for possible losses on mortgage loans was $4,104,000. This balance reflects a net reduction of $536,000 during 1999 which was recognized as a realized gain on investments. The allowance was adjusted primarily as a result of the complete repayment of an impaired mortgage loan resulting in an allowance reduction totaling $895,000, partially offset by an unrelated general increase totaling $359,000. No additions were made to the allowance during 1998. Management believes that the allowance for possible losses is adequate. However, while management uses available information to recognize losses, future additions to the allowance may be necessary based on changes in economic conditions, particularly in the West South Central region which includes Texas, Louisiana, Oklahoma, and Arkansas, as this area contains the highest concentrations of the Company's mortgage loans.
The Company currently places all loans past due three months or more on nonaccrual status, thus recognizing no interest income on the loans. At December 31, 1999, the Company had mortgage loan principal balances on nonaccrual status of $3,014,000. At December 31, 1998, the Company had no mortgage loans on nonaccrual status. The Company had mortgage loan principal balances with restructured terms totaling $8,572,000 and $12,096,000 at December 31, 1999 and 1998, respectively. For the year ended December 31, 1999, the reductions in interest income due to nonaccrual and restructured mortgage loans totaled approximately $192,000. For the year ended December 31, 1998, the reductions in interest income due to nonaccrual and restructured mortgage loans were not significant.
The contractual maturities of mortgage loan principal balances at December 31, 1999, are as follows:
The Company owns real estate that was acquired through foreclosure and through direct investment totaling approximately $11,388,000 and $13,553,000 at December 31, 1999 and 1998, respectively. This small concentration of properties represents less than one percent of the Company's entire investment portfolio. The real estate holdings consist primarily of income-producing properties which are being operated by the Company. The Company recognized operating income on these properties of approximately $1,037,000 and $740,000 for the years ended December 31, 1999 and 1998, respectively. The increase in operating income is primarily due to the sale of a property in 1999 that had been generating operating losses. While operating income could continue to improve again in 2000, the Company does not anticipate significant changes in overall operating results. Additionally, exclusive of the operating results, the sale of the property also produced a realized gain on investments totaling $1,419,000 in 1999.
The Company monitors the conditions and market values of these properties on a regular basis. The Company makes repairs and capital improvements to keep the properties in good condition and will continue this maintenance as needed. No realized losses were recognized due to declines in values of properties during 1999 or 1998.
RESULTS OF OPERATIONS
Consolidated Operations
Summary of Consolidated Operating Results
A summary of operating results, net of taxes, for the years ended December 31, 1999, 1998, and 1997 is provided below:
Consolidated Operating Results: For the year ended December 31, 1999, the Company recorded net earnings of $59,225,000 compared to net earnings of $34,893,000 and $41,572,000 for 1998 and 1997, respectively. Earnings for 1999 include additional income totaling $5,513,000, net of taxes, from the resolution of pending litigation relating to a former general agency. Additionally, the Company recorded realized gains on investments, net of taxes, totaling $2,912,000 for 1999 compared to gains of $1,550,000 for 1998 and losses of $1,032,000 for 1997. The gains in 1999 were primarily from sales and calls of investments in debt securities and a sale of investment real estate. While earnings for 1999 were significantly higher than the previous years, earnings for 1998 were abnormally low due to several nonrecurring items, the most significant of which was the bankruptcy settlement of the Company's wholly owned subsidiary, The Westcap Corporation, totaling $14,125,000. This settlement was reflected as a loss from discontinued brokerage operations in 1998. Losses on discontinued brokerage operations totaled $1,000,000 in 1997.
The other nonrecurring items affecting earnings for 1998 include a lawsuit settlement and a pension plan related transaction. Parties involved in the Diffie, et al vs. National Western Life Insurance Company and National Annuity Programs, Inc. class action litigation filed a joint motion in District Court for preliminary approval of a settlement agreement among the parties. This settlement was approved by the Court in January, 1999, and, as a result, the Company paid $5,000,000 to settle the litigation. This amount was accrued in the Company's financial statements in 1998, thereby reducing earnings $3,250,000, after taxes. Also during 1998, the Company transferred pension obligations and administrative responsibilities of its nonqualified defined benefit plan to a pension administration firm. The financial effects of the transaction resulted in additional pension expense in 1998 totaling $1,653,000, net of taxes, as the amount paid upon transfer exceeded the recorded pension liabilities as required for financial reporting purposes. However, as a result of the transfer, substantially all future pension and administrative liabilities and expenses under the plan are now the responsibility of the new firm.
Excluding the nonrecurring items and related tax effects described above, 1999 earnings grew by over 9% compared to 1998. The growth in earnings is primarily due to increases in investment income over policy contract interest and higher realized gains on investments. Earnings for 1998, excluding the nonrecurring items, also exceeded comparable 1997 earnings by over 17%. The higher earnings are due primarily to increases in universal life and annuity contract revenues, increases in investment income over policy contract interest, and higher realized gains on investments.
Net Investment Income: A detail of net investment income is provided below:
As indicated by the table above, net investment income increased substantially in both 1998 and 1999. Much of this increase is attributable to growth in invested assets from continued strong premium production. The net cash flow from operations continued to be invested primarily in high quality debt securities. However, increases in net investment income from index options has also been significant, as this income has grown from $18,000 in 1997 to $8,057,000 and $10,719,000 in 1998 and 1999, respectively.
Index options are derivative financial instruments used to hedge the equity return component of the Company's equity-indexed annuity products, which were first introduced for sale in 1997. Any gains or losses from the sale or expiration of the options, as well as period-to-period changes in fair values, are reflected as net investment income. Increases or decreases in income from these options are substantially offset by corresponding increases or decreases in amounts paid to equity-indexed annuity policyholders, subject to minimum guaranteed policy interest rates.
While net investment income for debt securities and index options continues to grow, income for mortgage loans and policy loans continues to steadily decline. This correlates directly to lower holdings in these investments as the Company has placed less emphasis on these investments, particularly mortgage loan originations, than in prior years. Much of this decline is due to current competitive market conditions for mortgage loans.
An analysis of net investment income also involves a review of market interest rates. Interest rates continued to decline in 1998 and 1997 from 1996 rates. In 1999, interest rates reversed this trend by increasing significantly. However, changes in market rates affect the Company's portfolio yield slowly because of the relatively small volume of new investment purchases during a year in comparison to the size of the overall investment portfolio. As a result, although yields on new investment purchases did increase during 1999, the Company's overall yield on average invested assets declined from 1998. Yields were also somewhat affected by the change in the mix of the investment portfolio. Mortgage loans have typically had significantly higher yields than the Company's investments in debt securities. However, average mortgage loan holdings in 1997 and 1998 have declined. Also, matured or prepaid mortgage loans are typically replaced with loans with lower interest rates.
Detailed below is the Company's investment performance for 1999, 1998, and 1997. This analysis excludes index options, as these derivative financial instruments are used solely for hedging purposes for the Company's equity- indexed annuity products. Income from the options offsets interest credited to policyholders for the equity return component on these products.
Realized Gains and Losses on Investments: The Company realized gains of $4.5 million in 1999 compared to realized gains of $2.4 million in 1998 and losses of $1.6 million in 1997. The gains in 1999 consist primarily of gains from sales and calls of debt securities totaling $6,250,000, offset by permanent impairment writedowns of $4,403,000. The Company also recognized gains totaling $1,963,000 on real estate, the majority of which was from the sale of a real estate property owned by the Company's subsidiary, NWL 806 Main, Inc. The gains in 1998 were primarily from gains on debt securities totaling $1.3 million, substantially all of which related to securities that were called. Realized gains in 1998 also include $300,000 related to a deficiency settlement agreement on a mortgage loan that was foreclosed in 1994. The losses in 1997 were primarily from net losses on debt securities totaling $1.2 million and writedowns on real estate and mortgage loans totaling $1.2 million, primarily related to a single foreclosure.
Universal Life and Investment Annuity Contract Interest: The Company closely monitors its credited interest rates, taking into consideration such factors as profitability goals, policyholder benefits, product marketability, and economic market conditions. Rates are established or adjusted after careful consideration and evaluation of these factors against established objectives. Average credited rates, calculated based on policy reserves for the Company's universal life and investment annuity business, have generally declined since 1996, which is consistent with declines in market interest rates. However, as previously described for net investment income, market interest rates rose in 1999. As market interest rates fluctuate, the Company's credited interest rates are often adjusted accordingly, while also taking into consideration other factors as described above. Raising policy credited rates can typically have an impact sooner than higher market rates have on the Company's investment portfolio yield, making it more difficult to maintain the current interest spread. The difference between yields earned over policy credited rates is often referred to as the interest spread.
Contract interest totaled $162.3 million, $158.9 million, and $145.2 million in 1999, 1998, and 1997, respectively. The increase is primarily attributable to interest totaling $20,480,000 and $12,980,000 in 1999 and 1998, respectively, for the Company's equity-indexed annuity products. As previously described, the Company purchases index options to provide the potential higher interest to be credited on these products. The income provided by the index options substantially offsets the interest credited to the policyholders, subject to minimum guaranteed policy interest rates. Because of this hedging program, the Company separately analyzes average credited rates on its other products. Excluding the Company's equity-indexed annuity products, average credited rates for 1999, 1998, and 1997 were 5.51%, 5.67%, and 5.68%, respectively. The Company's interest rate spread has been approximately 2% in recent years, although this spread has declined slightly in 1999 and 1998 for the reasons previously described above.
Federal Income Taxes: Federal income taxes on earnings from continuing operations for 1999, 1998, and 1997 reflect effective tax rates of 34.1%, 26.1%, and 33.8%, respectively, which are lower than the expected Federal rate of 35%. The 1998 and 1997 effective tax rates are significantly lower due to tax benefits totaling $4,944,000 and $350,000, respectively, resulting from the Company's subsidiary brokerage losses. Correspondingly, losses on discontinued operations for 1998 and 1997 totaling $14,125,000 and $1,000,000 do not include any tax benefits relating to the brokerage subsidiary. This tax reporting treatment is in accordance with the Company's tax allocation agreement with its subsidiaries. On a consolidated basis, Federal income taxes reflect consistent effective tax rates of 34.1%, 33.2%, and 34.3% for 1999, 1998, and 1997, respectively.
Discontinued Brokerage Operations: On April 12, 1996, The Westcap Corporation and its wholly owned subsidiary, Westcap Enterprises, Inc., separately filed voluntary petitions for reorganization under Chapter 11 of the U.S. Bankruptcy Code in the United States Bankruptcy Court, Southern District of Texas, Houston Division. As a result of brokerage losses and the resulting bankruptcy, National Western's investment in Westcap was completely written off during 1995. However, a $1,000,000 cash infusion was made to Westcap on March 18, 1997, for operational expenses incurred during its bankruptcy. This contribution was reflected as a loss from discontinued operations in 1997. Losses from the discontinued brokerage operations have been reflected separately from continuing operations of the Company in the accompanying consolidated financial statements.
By order dated August 28, 1998, the United States Bankruptcy Court, Southern District of Texas, Houston Division, confirmed and approved the Third Amended Joint Consensual Plan of Reorganization (the Plan) of The Westcap Corporation and Westcap Enterprises, Inc. Pursuant to the Plan, National Western received credit for the $1,000,000 previously contributed to Westcap in bankruptcy in March, 1997, and paid an additional $14,125,000 to compromise and settle (i) all claims of Westcap against National Western, and (ii) all claims and litigation of certain settling creditors of Westcap who have alleged federal or state securities law "control person" violations by National Western relating to Westcap's brokerage business, in exchange for full and complete releases from all of such claims, litigation, and alleged violations. The bankruptcy reorganization was completed in January, 1999, National Western retained 100% continuing ownership of the reorganized Westcap, and the subsidiary is now operating as a real estate management company.
Although the $14,125,000 settlement was paid by National Western on January 13, 1999, the settlement payment was reflected in the accompanying financial statements as a loss from discontinued operations in 1998. Any additional losses will depend on the results of The City Colleges lawsuit filed against National Western on March 28, 1994, for alleged federal or state securities law "control person" violations relating to Westcap, and which is pending in the United States District Court, Western District of Texas, as more fully described in Item 3, Legal Proceedings. National Western believes it has reasonable and adequate defenses to this suit and, accordingly, no amounts have been accrued in National Western's financial statements for potential losses relating to such suit.
Segment Operations
Summary of Segment Earnings
A summary of segment earnings from continuing operations for the years ended December 31, 1999, 1998, and 1997 is provided below. The segment earnings exclude realized gains and losses on investments, net of taxes, and discontinued brokerage operations.
Domestic Life Insurance Operations
The Company's domestic life insurance operations concentrate marketing efforts on Federal employees, seniors, and specific employee groups in private industry, as well as individual sales. The products marketed are universal life insurance and traditional life insurance, which includes both term and whole life products. National Western markets and distributes its domestic products primarily through independent agents and brokers and independent marketing organizations (IMOs). The IMOs also assist the Company in recruiting, contracting, and managing agents as well as providing additional financial resources for product marketing. Geographically, the domestic life insurance operations market products in most of the United States, which encompasses 43 states and the District of Columbia. The states in which the Company does not conduct business are primarily in the northeast and include Connecticut, Delaware, Massachusetts, New Hampshire, New Jersey, New York, and Vermont.
Earnings for the domestic life insurance operating segment were $8,209,000, $6,395,000, and $5,901,000 for 1999, 1998, and 1997, respectively. The increase in 1999 earnings is primarily a result of higher universal life insurance revenues, lower other operating expenses, and lower policy benefits, which consists substantially of life insurance death claims. The slight increase in earnings in 1998 is due to increases in revenues and other income and lower amortization of deferred policy acquisition costs. However, these items were offset substantially by increases in other operating expenses and policy benefits.
A comparative analysis of results of operations for the Company's domestic life insurance segment is detailed below:
Revenues from domestic life insurance operations include life insurance premiums on traditional type products and revenues from universal life insurance. The Company's current marketing efforts focus more on universal life insurance, and, as a result, revenues from these products continue to increase over traditional products. Revenues from traditional products are simply premiums collected, while revenues from universal life insurance consist of policy charges for the cost of insurance, policy administration fees, and surrender charges assessed during the period. A comparative detail of premiums and contract revenues is provided below:
Actual universal life insurance deposits collected for the years ended December 31, 1999, 1998, and 1997 are detailed below. Deposits collected on these nontraditional products are not reflected as revenues in the Company's statements of earnings, as they are recorded directly to policyholder liabilities upon receipt, in accordance with generally accepted accounting principles.
Other income for 1999, 1998, and 1997 totaled $40,000, $750,000, and $43,000, respectively. The significant increase in 1998 was primarily due to proceeds totaling $444,000 received from the U.S. government in 1998 related to previous litigation involving a failed savings and loan institution. The litigation involved the Company's previous investment in bonds of the financial institution and subsequent losses incurred upon its failure. The financial institution had also purchased life insurance from National Western, the cash values of which served as collateral for the bonds.
Policy benefits were significantly lower in 1999 totaling $15.5 million compared to $17.9 million and $18.2 million for 1998 and 1997, respectively. These benefits consist primarily of life insurance death claims which are subject to fluctuations from period to period.
Amortization of deferred policy acquisition costs has decreased from $5.1 million in 1997 to $3.0 million and $3.4 million in 1998 and 1999, respectively. These expenses represent the amortization of the costs of acquiring or producing new business, which consist primarily of agents' commissions. The majority of such costs are amortized in direct relation to the anticipated future gross profits of the applicable blocks of business. Amortization is also impacted by the level of policy surrenders.
Universal life insurance contract interest has remained relatively constant at $9.8 million, $10.0 million, and $9.7 million in 1999, 1998, and 1997, respectively. This is consistent with the relative stable size of this block of business along with minimal adjustments of policy credited rates.
Other operating expenses were significantly higher in 1998, totaling $10.8 million compared to $8.6 million in both 1999 and 1997. The increase in expenses is due to higher pension expenses from the transfer of the Company's nonqualified defined benefit plan as previously described and other increases primarily in salaries, agent conventions, and marketing related expenses such as travel and printing costs.
International Life Insurance Operations
The Company's international life insurance operations focus marketing efforts on foreign nationals in upper socioeconomic classes with substantial financial resources. Insurance sales are primarily from countries in Central and South America, the Caribbean, and the Pacific Rim. Marketing to numerous countries in these different regions provides diversification that helps to minimize large fluctuations in sales that can occur due to various economic, political, and competitive pressures that may occur from one country to another. Historically, the top three countries in insurance sales have been Argentina, Chile, and Peru. Products sold in the international market include both universal life and traditional life insurance products. The Company minimizes exposure to foreign currency risks, as almost all foreign policies require payment of premiums and claims in United States dollars. Sales production from the international market is from independent broker-agents, many of whom have been selling National Western products for 20 or more years.
Earnings for the international life insurance operating segment were $6,798,000, $6,397,000, and $7,143,000 for 1999, 1998, and 1997, respectively. Higher 1999 earnings are due to increases in universal life insurance contract revenues, primarily cost of insurance and surrender charge revenues. The higher revenues were tempered by higher policy benefits and universal life insurance contract interest. Earnings in 1998 were lower than 1999 and 1997 primarily due to higher operating expenses, reinsurance costs, and amortization of deferred policy acquisition costs, offset significantly by lower policy benefits. A comparative analysis of results of operations for the Company's international life insurance segment is detailed below:
As with domestic operations, revenues from the international life insurance segment include both premiums on traditional type products and revenues from universal life insurance. The international operations' marketing efforts are also focused more on universal life insurance, and, as a result, revenues from these products continue to increase over traditional products. Cost of insurance revenues continue to increase as the international block of business grows. Additionally, surrender charge revenues were 27.0% higher in 1999 compared to 1998, which corresponds directly to an unusually high increase in universal life insurance policy surrenders of 27.5%. A comparative detail of premiums and contract revenues is provided below:
Actual universal life insurance deposits collected for the years ended December 31, 1999, 1998, and 1997 are detailed below. Deposits collected on these nontraditional products are not reflected as revenues in the Company's statements of earnings, as they are recorded directly to policyholder liabilities upon receipt, in accordance with generally accepted accounting principles. Deposits continue to grow, which corresponds to the previously described increases in cost of insurance revenues.
Policy benefits, which consist primarily of life insurance death claims, were abnormally high in 1997 at $17.1 million compared to $16.5 million and $14.1 million for 1999 and 1998, respectively. As previously described for domestic life insurance operations, mortality claims fluctuate from period to period. These deviations, which can at times be significant, are not uncommon in the life insurance industry. Additionally, the Company utilizes reinsurance to help minimize its exposure to adverse mortality experience. The Company's general policy is to reinsure amounts in excess of $200,000 on the life of any one individual.
Universal life insurance contract interest has risen steadily from $12.6 million in 1997 to $13.4 million and $13.9 million in 1998 and 1999, respectively. The increases in contract interest are consistent with growth in the universal life insurance business and have been minimally affected by adjustments of policy credited rates.
Amortization of deferred policy acquisition costs were higher in 1998, totaling $15.8 million compared to $14.6 million and $13.6 million in 1999 and 1997, respectively. Changes in anticipated future gross profits resulted in retrospective adjustments to deferred policy acquisition costs, which produced higher amortization in 1998 relative to 1999 and 1997.
Other operating expenses totaled $9.4 million, $9.6 million, and $7.7 million in 1999, 1998, and 1997, respectively. The increase in expenses is attributable to the same reasons as previously described for domestic life insurance operations.
Annuity Operations
The Company's annuity operations are almost exclusively in the United States. Like the Company's domestic life insurance operations, annuities are marketed in 43 states and the District of Columbia using independent agents, brokers, and independent marketing organizations (IMOs). For most of these organizations, annuity sales are much more significant than life insurance sales and are the primary focus of their business operations. Although some of the Company's annuities are available in the international market, current sales are insignificant to total annuity sales.
Annuities sold include single and flexible premium deferred annuities, single premium immediate annuities, and equity-indexed annuities. These products can be tax qualified or nonqualified annuities. In recent years the majority of annuities sold have been nonqualified deferred annuities. The Company also continues to collect additional premiums on existing two-tier annuities, as a large portion of the two-tier block of business are flexible premium annuities on which renewal premiums continue to be collected. However, the Company has not sold two-tier annuities since 1992.
Earnings for the annuity operating segment were $38,068,000, $27,508,000, and $28,389,000 for 1999, 1998, and 1997, respectively. Earnings for 1999 were up significantly from 1998 and 1997 primarily due to income resulting from a lawsuit settlement totaling $5,513,000, net of taxes. Earnings were also enhanced from increases in net investment income over annuity contract interest. Additionally, 1998 earnings were negatively impacted by a class action lawsuit settlement totaling $3,250,000, net of taxes. A comparative analysis of results of operations for the Company's annuity segment is detailed below:
Revenues from annuity operations include primarily surrender charges and recognition of deferred revenues relating to immediate or payout annuities. Annuitizations result in transfers of policies from deferred to immediate or payout status. The deferred revenues related to these annuities are amortized into income during the payout period. Surrender charge revenues were down 13.6% in 1999 compared to 1998 primarily due to reductions in surrender charges from two-tier annuities. Although total annuity policy surrenders were actually up 4.0% from 1998 to 1999, the mix of surrender types was significantly different. While single-tier annuity policy surrenders increased in 1999, two-tier annuity policy surrenders, which typically have much higher surrender charges, declined over 21%. This decline in surrenders and related income from two-tier annuities is not unexpected and could continue, since this is a closed block of business. The Company has not sold two-tier annuities since 1992. A comparative detail of the components of premiums and annuity contract revenues is provided below.
Actual annuity deposits collected for the years ended December 31, 1999, 1998, and 1997 are detailed below. Deposits collected on these nontraditional products are not reflected as revenues in the Company's statements of earnings, as they are recorded directly to policyholder liabilities upon receipt, in accordance with generally accepted accounting principles.
Although annuity sales increased significantly in 1998 from prior years, sales in 1999 totaling $389.6 million were down 9.6%. However, this level of production is still significantly higher than 1997 and 1996 sales. The strong growth in 1998 was primarily attributable to the Company's new equity-indexed annuity product, as it was first introduced in late 1997. Sales continue to be strong in the Company's other deferred annuity products, as deposits collected have increased from $187.8 million in 1998 to $205.6 million in 1999. Additionally, immediate annuities continue to grow, as 1999 and 1998 reflected increases of 47.5% and 65.0%, respectively.
Although sales were lower in 1999, equity-indexed annuities are a major portion of the Company's total annuity production. The Company's equity- indexed annuities are flexible premium deferred annuities which combine the features associated with traditional fixed annuities, with the option to have interest rates that are linked in part to an equity index, the S&P 500 Index. These annuities are long-term contracts designed as planning vehicles for retirement security. These annuities are attractive to customers, as they have guaranteed minimum interest rates, coupled with the potential for significantly higher returns based on an equity index component. Also, because the Company does not offer variable products or mutual funds, these products provide a key equity-based alternative to the Company's existing fixed annuity products. In conjunction with the sale of these annuities, the Company uses an investment hedging program to offset the potential higher returns that could be paid on these products. Specifically, the Company purchases index options from highly rated banks and brokerage firms. These index options act as hedges to match closely the returns based on the S&P 500 Index which may be paid to policyholders.
Although sales of these annuities continue to be strong, production declined in 1999 primarily due to volatility in the stock market. This volatility affects both the immediate demand for these annuities and the pricing of these products. Increased product costs from stock market volatility, particularly costs of index options used to hedge the equity return component of these annuities, can reduce potential credited interest to policyholders.
Net investment income for 1999, 1998, and 1997 totaled $191,328,000, $182,347,000, and $166,348,000, respectively. The increases in investment income of 4.9% and 9.6% in 1999 and 1998, respectively, are consistent with the growth in annuity segment assets of 5.7% and 10.8% for the same periods. The large increases in net investment income in 1999 and 1998 over 1997 are due to the substantial increase in premium production, primarily from sales of the Company's equity-indexed annuities, which resulted in increases in invested assets. Net investment income also includes $10,719,000 and $8,057,000 of income from index options for 1999 and 1998, respectively. Income from index options totaled only $18,000 in 1997, as sales of equity- indexed annuities were minimal in 1997.
Other income was relatively insignificant in 1998 and 1997, totaling $270,000 and $277,000, respectively. However, other income for 1999 totaled $8,863,000, which includes $8.5 million in income relating to litigation involving an independent marketing organization. As more fully described in Item 3, Legal Proceedings, National Western Life Insurance Company, National Annuity Programs, Inc. (NAP), and others executed a settlement agreement for a pending declaratory judgment lawsuit. NAP was an independent marketing general agency under contract with the Company that hired and supervised agents marketing annuity products on behalf of the Company. The contract was entered into in 1983 and amended in 1994. The Company alleged that during the course of the contract NAP violated its terms and conditions, among other things. By the settlement, each party dismisses with prejudice all claims asserted by them in the lawsuit. The Company was also released from any claims for any funds and other rights arising under the contract. Additionally, the Company paid in 1999 all valid claims for unpaid commissions to sub-agents of NAP who wrote business for the Company under the contract.
As a result of the settlement, accrued bonus commissions relating to the NAP contract totaling $8,482,000 were released, as they are no longer considered a liability to NAP and will not be paid. Accordingly, the release of these accrued commissions from liabilities in 1999 resulted in additional income of $8,482,000, before taxes. It is anticipated that any future renewal premiums received by the Company on currently issued and in force annuity policies written by NAP sub-agents under the Contract could generate additional commissions for such sub-agents. The payment of such future commissions is subject to and conditioned upon receipt of such renewal premiums by the Company and compliance by the sub-agents with the terms of the agents' contracts with the Company and NAP.
Annuity contract interest for 1999, 1998, and 1997 totaled $138.6 million, $135.5 million, and $122.9 million, respectively. While general increases in contract interest are expected due to the growth in the size of the annuity block of business, higher interest is also due to increases in equity-indexed annuities in force and the higher credited rates that may be paid on these policies. The increases in 1999 and 1998 are largely due to increases in annuities in force from sales of equity-indexed annuities and higher credited interest that were paid on these policies. Contract interest on equity- indexed annuities totaled $20,480,000 and $12,980,000 in 1999 and 1998, respectively. Amounts for 1997 were insignificant, as sales of these annuities were minimal in 1997. Although contract interest is higher due to equity-indexed annuities, net investment income also includes an additional $10,719,000 and $8,057,000 in 1999 and 1998 from index options which are used to hedge the equity return component of these products. Differences between income from index options and contract interest credited to policyholders will occur for several reasons, some of which may only be timing differences between the recognition of income and expenses. One reason is that the costs of the index options are essentially amortized against net investment income as the options are marked to fair value each reporting period. The costs of options are covered by additional income earned on debt securities purchased with equity-indexed annuity premiums. Other differences are due to asset fees charged against policyholder contract interest, surrenders and death benefits on annuities within the annual hedging period, and inherent differences between index option fair values and policy liability reserving treatments related to minimum guaranteed interest rates.
The impact of these equity-indexed annuity issues on earnings from annuity operations was experienced by the Company in the third and fourth quarters of 1999. Because of the volatility and large declines in the S&P 500 Index during the third quarter of 1999, the Company recorded significant decreases in investment income resulting from unrealized mark-to-market losses on the options. The S&P 500 Index decline also resulted in lower interest credited to equity-indexed annuity contracts. However, primarily because of policy liability reserving treatments related to minimum guaranteed interest rates, the reduction in annuity contract interest expense was much less than the decline in investment income, which significantly reduced third quarter 1999 earnings. The Company's fourth quarter 1999 earnings were significantly higher, largely a result of improvement in stock market conditions from the 1999 third quarter. The increased earnings in the fourth quarter essentially offset the lower earnings performance of the third quarter, which coincides with the fluctuations of the S&P 500 Index. For the fourth quarter of 1999, the S&P 500 Index reversed its poor performance of the previous quarter. The S&P 500 Index increased significantly, which increased the Company's investment income from unrealized mark-to-market gains on index options and produced the improved earnings performance.
In summary, the Company's equity-indexed annuity products are long-term policies with contractual periods of either nine or fifteen years. The Company routinely analyzes the profitability of its equity-indexed annuity products under numerous economic scenarios, including both positive and negative equity market conditions. Although earnings may not be level or constant from period to period for this product due to timing of market conditions and policy liability reserving methods, the Company anticipates the equity-indexed annuities will be profitable over the long-term contractual periods of the policies.
Amortization of deferred policy acquisition costs represents the amortization of the costs of acquiring or producing new business, primarily agents' commissions, the majority of which are amortized in direct relation to the anticipated future gross profits of the applicable blocks of business. Amortization is also impacted by the level of policy surrenders. Amortization for 1999, 1998, and 1997 was relatively consistent totaling $21.1 million, $21.6 million, and $21.3 million, respectively.
Other operating expenses totaled $9,772,000, $15,145,000, and $11,223,000 for 1999, 1998, and 1997, respectively. Expenses for 1998 were unusually high primarily due to two nonrecurring items as previously described in the summary of consolidated operating results. Additional pension expenses were incurred in 1998 related to the Company's transfer of its nonqualified defined benefit plan to a pension administration firm. Also included in 1998 expenses is a $5,000,000 lawsuit settlement for the Diffie, et al vs. National Western Life Insurance Company and National Annuity Programs, Inc. class action litigation. The litigation involved various issues regarding sales of the Company's annuities.
Other Operations
National Western's primary business encompasses its domestic and international life insurance operations and its annuity operations. However, National Western also has small real estate and other investment operations through the following wholly owned subsidiaries: NWL Investments, Inc., NWL Properties, Inc., NWL 806 Main, Inc., NWL Services, Inc., and NWL Financial, Inc. Also, during January, 1999, the Company's wholly owned subsidiary, The Westcap Corporation, completed its Chapter 11 bankruptcy reorganization. With the reorganization complete, National Western transferred its investment real estate holdings to Westcap, and the subsidiary is now operating as a real estate management company. Earnings for these other operations totaled $3,238,000, $2,224,000, and $1,821,000 for 1999, 1998, and 1997, respectively. Earnings were higher in 1999 primarily due to income from the real estate properties that were transferred from National Western to Westcap.
Most of the income from the Company's subsidiaries is from a life interest in the Libbie Shearn Moody Trust. This asset was owned by National Western Life Insurance Company prior to 1997 but was transferred to NWL Services, Inc. in 1997. Gross income distributions from the Trust totaled $3,595,000, $3,451,000, and $3,335,000 in 1999, 1998, and 1997, respectively.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity
The liquidity requirements of the Company are met primarily by funds provided from operations. Premium deposits and revenues, investment income, and investment maturities are the primary sources of funds, while investment purchases and policy benefits are the primary uses of funds. Primary sources of liquidity to meet cash needs are the Company's securities available for sale portfolio, net cash provided by operations, and bank line of credit. The Company's investments consist primarily of marketable debt securities that could be readily converted to cash for liquidity needs. The Company may also borrow up to $60 million on its bank line of credit for short-term cash needs.
A primary liquidity concern for the Company's insurance operations is the risk of early policyholder withdrawals. Consequently, the Company closely evaluates and manages the risk of early surrenders or withdrawals. The Company includes provisions within annuity and universal life insurance policies, such as surrender charges, that help limit early withdrawals. The Company also prepares cash flow projections and performs cash flow tests under various market interest rate scenarios to assist in evaluating liquidity needs and adequacy. The Company currently expects available liquidity sources and future cash flows to be adequate to meet the demand for funds.
In the past, cash flows from the Company's insurance operations have been more than adequate to meet current needs. Cash flows from operating activities were $118 million, $131 million, and $144 million in 1999, 1998, and 1997, respectively. The lower cash flow in 1999 is largely a result of lawsuit and bankruptcy settlement payments as described in detail in Item 3, Legal Proceedings. Net cash flows from the Company's deposit product operations, which include universal life and investment annuity products, totaled $47 million in 1999 and $113 million in 1998. However, these operations incurred net cash outflows in 1997 totaling $51 million. The cash outflows in 1997 were due to low annuity production along with increased policy surrenders. Although surrenders have increased, significant annuity production generated strong positive cash flow in 1999 and 1998.
The Company also has significant cash flows from both scheduled and unscheduled investment security maturities, redemptions, and prepayments. These cash flows totaled $187 million, $159 million, and $144 million in 1999, 1998, and 1997, respectively. The Company again expects significant cash flows from these sources in 2000 at levels consistent with the past two years.
Capital Resources
The Company relies on stockholders' equity for its capital resources, as there has been no long-term debt outstanding in 1999 or recent years. The Company does not anticipate the need for any long-term debt in the near future. There are also no current or anticipated material commitments for capital expenditures in 2000.
Stockholders' equity totaled $475.5 million at December 31, 1999, reflecting an increase of $37 million from 1998. The increase in capital is primarily from net earnings of $59 million, reduced by net unrealized losses on investment securities totaling $22 million. The significant decline in values of investment securities is a direct result of increased interest rates at December 31, 1999, which lowered the market values of the Company's holdings in its securities available for sale portfolio. Book value per share at December 31, 1999, was $135.84, reflecting an 8.4% increase for the year.
CHANGES IN ACCOUNTING PRINCIPLES
Deposit Accounting
In October, 1998, the American Institute of Certified Public Accountants (AICPA) issued Statement of Position (SOP) 98-7, "Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk." The SOP specifies classifications for insurance and reinsurance contracts for which deposit accounting is appropriate and specifies accounting methods for each. For each insurance and reinsurance contract accounted for under deposit accounting, a deposit asset or liability should be recognized at inception and should be measured based on consideration paid or received, less any premiums or fees to be retained by the insurer or reinsurer, irrespective of the experience of the contract. The Company anticipates that this SOP will not have a significant effect on its financial statements, as the Company's current insurance and reinsurance contracts all transfer insurance risk. SOP 98-7 is effective for all fiscal years beginning after June 15, 1999. The Company currently plans to implement the SOP in the first quarter of 2000.
Derivative Instruments and Hedging Activities
In June, 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities." In June, 1999, SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133," was issued deferring SFAS No. 133, which will now be effective for all fiscal quarters of all fiscal years beginning after June 15, 2000. SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The statement defines several designations of derivatives based on the instrument's intended use and specifies the appropriate accounting treatment for changes in the fair value of the derivative based on its resulting designation.
The Company currently sells equity-indexed annuities that contain an equity return component for policyholders which is an embedded derivative instrument. The Company purchases index options, which are also derivative instruments, to hedge this equity return component. The index options are reported at fair value in the Company's financial statements, which is in accordance with SFAS No. 133 requirements. The Company also uses a fair value approach in recording policy liabilities for the equity-indexed annuities. However, there is currently no specific, authoritative interpretation of SFAS No. 133 with respect to accounting for equity-indexed annuity liabilities. Additional guidance in 2000 regarding this issue may result in a definitive method significantly different from that currently used by the Company. As a result, the ultimate implementation of SFAS No. 133 could have a significant effect on the Company's results of operations. The Company expects to implement the new statement in the first quarter of 2001.
REGULATORY AND OTHER ISSUES
Statutory Accounting Practices
Regulations that affect the Company and the insurance industry are often the result of efforts by the National Association of Insurance Commissioners (NAIC). The NAIC is an association of state insurance commissioners, regulators, and support staff that acts as a coordinating body for the state insurance regulatory process. The NAIC has recently completed a comprehensive process of codifying statutory accounting practices and procedures. Other than specific individual state laws, the codification results will be the only source of prescribed statutory accounting practices. The Company's state of domicile, Colorado, is currently in the process of adopting the new codified statutory accounting practices and procedures. Insurance companies must adopt these new statutory accounting practices in 2001, which may result in significant changes to existing practices used in the preparation of statutory financial statements. The Company will perform a review of the entire newly codified statutory accounting practices and procedures during 2000. This review process may not be fully completed until the latter portion of the year. Based on a preliminary review, National Western does not anticipate a material impact to its capital and surplus position as a result of implementation of the new prescribed statutory accounting procedures.
Risk-Based Capital Requirements
The NAIC established risk-based capital (RBC) requirements to help state regulators monitor the financial strength and stability of life insurers by identifying those companies that may be inadequately capitalized. Under the NAIC's requirements, each insurer must maintain its total capital above a calculated threshold or take corrective measures to achieve the threshold. The threshold of adequate capital is based on a formula that takes into account the amount of risk each company faces on its products and investments. The RBC formula takes into consideration four major areas of risk which are: (i) asset risk which primarily focuses on the quality of investments; (ii) insurance risk which encompasses mortality and morbidity risk; (iii) interest rate risk which involves asset/liability matching issues; and (iv) other business risks.
Due to statutory laws prohibiting public dissemination of certain RBC information, the Company has chosen not to publish its RBC ratios or levels. However, the Company's current statutory capital and surplus is significantly in excess of the threshold RBC requirements.
Year 2000 Issues
The Year 2000 problem, also known as Y2K, was the result of concerns that many computer software systems would not be able to distinguish the year 2000 from the year 1900. The Y2K problem arose because many existing computer programs use only the last two digits to refer to a year, resulting in these programs' inability to recognize "00" in the date field as the year 2000. If not corrected, many computer systems may not have been able to process date- sensitive data accurately beyond the year 1999, resulting in possible system failures or generation of erroneous results. National Western was cognizant of these problems for many years, as life insurance and annuity products can have very long life spans. Thus, many of our systems were originally developed to process and administer our insurance products into the next century. National Western worked to alleviate or eliminate Year 2000 problems for many years. The Company's Year 2000 plan included staff review and analysis of internal systems, embedded chip technology, and external vendor interfaces.
National Western incurred no significant Y2K related issues and did not experience any disruptions in its operations during the transition into 2000. The Company did not encounter any significant problems with respect to its systems, and it was not necessary to implement any contingency or business continuity plans. Likewise, with respect to external vendors, service providers, and other third parties, National Western did not experience any significant Y2K related problems. Total costs incurred related to the Company's Year 2000 plan did not exceed $250,000. Although no problems are anticipated, the Company will continue to monitor its systems as the year progresses.
FORWARD-LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements. Certain information contained herein or in other written or oral statements made by or on behalf of National Western Life Insurance Company or its subsidiaries are or may be viewed as forward-looking. Although the Company has used appropriate care in developing any such information, forward-looking information involves risks and uncertainties that could significantly impact actual results. These risks and uncertainties include, but are not limited to, matters described in the Company's SEC filings such as exposure to market risks, anticipated cash flows, future capital needs, and statutory or regulatory related issues. However, National Western, as a matter of policy, does not make any specific projections as to future earnings, nor does it endorse any projections regarding future performance that may be made by others. Whether or not actual results differ materially from forward-looking statements may depend on numerous foreseeable and unforeseeable events or developments. Also, the Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future developments, or otherwise.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
This information is included in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, in the Investments in Debt and Equity Securities section.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this item is reported in Attachment A beginning on page __. See Index to Financial Statements and Schedules on page __ for a list of financial information included in Attachment A.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
There have been no changes in auditors or disagreements with auditors which are reportable pursuant to Item 304 of Regulation S-K.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
(a) Identification of Directors
The following information as of January 31, 2000, is furnished with respect to each director. All terms expire in June of 2000.
Family relationships among the directors are: Mr. Robert Moody and Mr. McLeod are brothers-in-law and Mr. Robert Moody is the father of Ms. Frances Moody, Mr. Ross Moody, and Mr. Russell Moody.
(b) Identification of Executive Officers
The following is a list of the Company's executive officers, their ages, and their positions and offices as of January 31, 2000.
(c) Identification of Certain Significant Employees
None.
(d) Family Relationships
There are no family relationships among the officers listed except that Mr. Robert Moody is the father of Mr. Ross Moody. There are no arrangements or understandings pursuant to which any officer was elected. All officers hold office for one year and until their successors are elected and qualified, unless otherwise specified by the Board of Directors.
(e) Business Experience
All of the executive officers listed above have served in various executive capacities with the Company for more than five years.
(f) Involvement in Certain Legal Proceedings
There are no events pending, or during the last five years, under any bankruptcy act, criminal proceedings, judgments, or injunctions material to the evaluation of the ability and integrity of any director or executive officer except as described below:
In January, 1994, a United States District Court Judge vacated and withdrew the judgment which had been entered in Case No. H-86-4269, W. Steve Smith, Trustee vs. Shearn Moody, Jr., et al, United States District Court for the Southern District of Texas. The Judge also dismissed the case with prejudice. The judgment had been entered against Robert L. Moody and The Moody National Bank of Galveston, of which he was Chairman of the Board. Robert L. Moody is also Chairman of the Board of National Western Life Insurance Company. The case arose out of complex bankruptcy and related proceedings involving Robert L. Moody's brother, Shearn Moody, Jr. Subsequently, a global settlement of Shearn Moody, Jr.'s bankruptcy and related legal proceedings was reached and executed. As part of the global settlement, the Bankruptcy Trustee recommended, and other interested parties agreed not to oppose or object to, the Judge's vacating and withdrawing the judgment and dismissing the case with prejudice. This case and settlement did not involve the Company and had no effect on its financial statements.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
(b) Summary Compensation Table
(c) Option/SAR Grants Table
During 1995 the Company adopted the National Western Life Insurance Company 1995 Stock and Incentive Plan (the Plan). The purpose of the Plan is to align the personal financial incentives of key personnel with the long-term growth of the Company and the interests of the Company's stockholders through the ownership and performance of the Company's Class A, $1.00 par value, common stock, to enhance the Company's ability to retain key personnel, and to attract outstanding prospective employees and directors. The Plan is effective as of April 21, 1995, and will terminate on April 20, 2005, unless terminated earlier by the Board of Directors. The number of shares of Class A, $1.00 par value, common stock which may be issued under the Plan, or as to which stock appreciation rights or other awards may be granted, may not exceed 300,000. These shares may be authorized and unissued shares or treasury shares.
All of the employees of the Company and its subsidiaries are eligible to participate in the Plan. In addition, directors of the Company, other than Compensation and Stock Option Committee members, are eligible for restricted stock awards, incentive awards, and performance awards. Company directors, including members of the Compensation and Stock Option Committee, are eligible for nondiscretionary stock options.
The Committee approved the issuance of nonqualified stock options to selected officers of the Company during 1998 and 1997 totaling 48,500 and 21,900, respectively. Additionally, during 1998 the Committee granted 10,000 nonqualified, nondiscretionary stock options to Company directors. No nonqualified stock options were issued in 1999. The directors' stock options vest 20% annually following one full year of service to the Company from the date of grant. The officers' stock options vest 20% annually following three full years of service to the Company from the date of grant. The exercise prices of the stock options were set at the fair market values of the common stock on the dates of grant.
(d) Aggregated Option/SAR Exercises and Fiscal Year-End Option/SAR Value Table
(e) Long-Term Incentive Plan Awards Table
None.
(f) Defined Benefit or Actuarial Plan Disclosure
The Company currently has two employee defined benefit plans for the benefit of its employees and officers. A brief description and formulas by which benefits are determined for each of the plans are detailed as follows:
Qualified Defined Benefit Plan - This plan covers all full-time employees and officers of the Company and provides benefits based on the participant's years of service and compensation. The Company makes annual contributions to the plan that comply with the minimum funding provisions of the Employee Retirement Income Security Act.
Annual pension benefits for those employees who became eligible participants prior to January 1, 1991, are calculated as the sum of the following:
(1) 50% of the participant's final 5-year average annual compensation at December 31, 1990, less 50% of their primary social security benefit determined at December 31, 1990; this net amount is then prorated for less than 15 years of benefit service at normal retirement date. This result is multiplied by a fraction which is the participant's years of benefit service at December 31, 1990, divided by the participant's years of benefit service at normal retirement date.
(2) 1.5% of the participant's compensation earned during each year of benefit service after December 31, 1990.
Annual pension benefits for those employees who become eligible participants on or subsequent to January 1, 1991, are calculated as 1.5% of their compensation earned during each year of benefit service.
Non-Qualified Defined Benefit Plan - This plan covers those officers who were in the position of senior vice president or above prior to 1991 and other employees who have been designated by the President of the Company as being in the class of persons who are eligible to participate in the plan. This plan also provides benefits based on the participant's years of service and compensation. However, no minimum funding standards are required.
The benefit to be paid pursuant to this Plan to a Participant who retires at his normal retirement date shall be equal to (a) minus (b) minus (c) where:
(a) is the benefit which would have been payable at the participant's normal retirement date under the terms of the Qualified Defined Benefit Plan as of December 31, 1990, as if that Plan had continued without change, and,
(b) is the benefit which actually becomes payable under the terms of the Qualified Defined Benefit Plan at the participant's normal retirement date, and,
(c) is the actuarially equivalent life annuity which may be provided by an accumulation of 2% of the participant's compensation for each year of service on or after January 1, 1991, accumulated at an assumed interest rate of 8.5% to his normal retirement date.
In no event will the benefit be greater than the benefit which would have been payable at normal retirement date under the terms of the Qualified Defined Benefit Plan as of December 31, 1990, as if that plan had continued without change.
The estimated annual benefits payable to the named executive officers upon retirement, at normal retirement age, for the Company's defined benefit plans are as follows:
During 1998 the Company transferred the pension obligations and administrative responsibilities of the non-qualified defined benefit plan to a pension administration firm. Upon transfer, the Company made a payment to the firm to cover current and future liabilities and administration of the plan. However, as more fully described in Note 7, Pension Plans, of the accompanying financial statements, National Western retains certain contingent liabilities with respect to the plan.
(g) Compensation of Directors
All directors of the Company currently receive $18,000 a year and $500 for each board meeting attended. They are also reimbursed for actual travel expenses incurred in performing services as directors. An additional $500 is paid for each committee meeting attended. However, a director attending multiple meetings on the same day receives only one meeting fee. The amounts paid pursuant to these arrangements are included in the summary compensation table under Item 11(b). The directors and their dependents are also insured under the Company's group insurance program.
During 1995 the Company adopted the National Western Life Insurance Company 1995 Stock and Incentive Plan (the Plan), as more fully described in Item 11(c). Directors of the Company, other than Compensation and Stock Option Committee members, are eligible for restricted stock awards, incentive awards, and performance awards. Nonemployee directors, including members of the Compensation and Stock Option Committee, are eligible for nondiscretionary stock options. On May 19, 1995, the Committee approved the issuance of 7,000 nonqualified, nondiscretionary stock options to nonemployee Company directors, with each such director receiving 1,000 stock options. On June 19, 1998, the stockholders approved the issuance of 10,000 nonqualified, nondiscretionary stock options to all Company directors, with each such director receiving 1,000 stock options.
Directors of the Company's subsidiary, NWL Investments, Inc., receive $250 annually. Nonemployee directors of the Company's subsidiary, NWL Services, Inc., receive $1,000 per board meeting attended.
(h) Employment Contracts and Termination of Employment and Change-in-Control Arrangements
Two of the named executive officers, Arthur W. Pickering and Richard M. Edwards, had bonus compensation contracts with the Company during 1999. The contracts consisted of several components in which certain levels of Company performance relating to annuity account balances, life insurance persistency rates, life insurance premiums, and annuity contract deposits were required in order to earn bonuses. Compensation bonuses paid to Mr. Pickering and Mr. Edwards are disclosed in part (b) of this item.
(i) Report on Repricing of Options/SARs
None.
(j) Compensation Committee Interlocks and Insider Participation
The Company's Board of Directors performs the functions of an executive compensation committee. The Board is responsible for developing and administering the policies that determine executive compensation. Additionally, a separate Compensation and Stock Option Committee, comprised of outside, independent directors, determines compensation for the three highest- paid Company executives. The committee also performs various projects relating to executive compensation at the request of the Board of Directors. Those directors serving on the committee include Arthur O. Dummer, Harry L. Edwards, and E. J. Pederson.
Mr. Robert Moody, Mr. Ross Moody, and Mr. Charles Milos serve as directors and also serve as officers and employees of National Western Life Insurance Company. Mr. Ross Moody serves as an officer and director of the Company's wholly owned subsidiaries, The Westcap Corporation, NWL 806 Main, Inc., NWL Investments, Inc., NWL Properties, Inc., NWL Financial, Inc., and NWL Services, Inc. Mr. Charles Milos serves as an officer and director of The Westcap Corporation and as an officer of NWL 806 Main, Inc., NWL Investments, Inc., NWL Properties, Inc., NWL Financial, Inc. and NWL Services, Inc. Mr. Robert Moody is an officer and Mr. Arthur Dummer is an officer and director of NWL Services, Inc. Mr. Harry Edwards serves as a director and was formerly an officer of National Western Life Insurance Company.
The Donner Company, 100% owned by Mr. Dummer, who is a director of National Western Life Insurance Company and an officer and director of NWL Services, Inc., was paid $80,902 in 1999 pursuant to an agreement between The Donner Company and a reinsurance intermediary relating to a reinsurance contract between the Company and certain life insurance reinsurers.
No compensation committee interlocks exist with other unaffiliated companies.
(k) Board Compensation Committee Report on Executive Compensation
The Company's Board of Directors determines and approves executive compensation, along with developing and administering the policies that determine executive compensation.
Executive compensation, including that of the chief executive officer, is comprised primarily of a base salary. The salary is adjusted annually based on a performance review of the individual as well as the performance of the Company as a whole. The president and chief executive officer make recommendations annually to the Board of Directors regarding such salary adjustments. The review encompasses the following factors: (1) contributions to the Company's short and long-term strategic goals, including financial goals such as Company revenues and earnings, (2) achievement of specific goals within the individual's realm of responsibility, (3) development of management and employees within the Company, and (4) performance of leadership within the industry. These policies are reviewed periodically by the Board of Directors to ensure the support of the Company's overall business strategy and to attract and retain key executives.
As previously described, a separate Compensation and Stock Option Committee, comprised of outside, independent directors, determines compensation for the three highest-paid Company executives. The committee also performs various projects relating to executive compensation at the request of the Board of Directors. The policies used by the Compensation and Stock Option Committee in determining compensation are similar to those described above for all other Company executives.
(1) Performance Graph
The following graph compares the change in the Company's cumulative total stockholder return on its common stock with the Nasdaq - U.S. Companies Index and the Nasdaq Insurance Stock Index. The graph assumes that the value of the Company's common stock and each index was $100 at December 31, 1994, and that all dividends were reinvested.
For the purpose of this electronic filing, the coordinates of the graph have been provided below:
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
(a) Security Ownership of Certain Beneficial Owners
Set forth below is certain financial information concerning persons who are known by the Company to own beneficially more than 5% of any class of the Company's common stock on December 31, 1999:
(b) Security Ownership of Management
The following table sets forth as of December 31, 1999, information concerning the beneficial ownership of the Company's common stock by all directors, named executive officers, and all directors and executive officers of the Company as a group:
(c) Changes in Control
None.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
(a) Transactions with Management and Others
The Donner Company, 100% owned by Mr. Arthur Dummer, who is a director of National Western Life Insurance Company, was paid $80,902 in 1999 pursuant to an agreement between The Donner Company and a reinsurance intermediary relating to a reinsurance contract between the Company and certain life insurance reinsurers.
Moody Insurance Group, Inc., was paid $348,284 in commissions in 1999 pursuant to an agency contract with National Western Life Insurance Company. Moody Insurance Group, Inc. is wholly owned by Mr. Robert L. Moody, Jr. Mr. Robert L. Moody, Jr., is an employee of the Company and the son of Mr. Robert L. Moody, who serves as a director and chief executive officer of the Company, the brother of Mr. Ross R. Moody, who serves as a director and president of the Company, and the brother of Mr. Russell S. Moody and Ms. Frances A. Moody, who serve as directors of the Company. The commissions paid were based on premiums and deposits totaling approximately $15,624,000 from sales of National Western life insurance and annuity products by Moody Insurance Group, Inc., and Mr. Robert L. Moody, Jr., in 1999. In addition, Mr. Robert L. Moody, Jr., personally received $498 in commissions in 1999 pursuant to an agency contract between himself and the Company.
(b) Certain Business Relationships
None.
(c) Indebtedness of Management
The Company holds three mortgage loans issued to Gal-Tex Hotel Corporation, which is owned 50% by the Libbie Shearn Moody Trust and 50% by The Moody Foundation. The first mortgage loan in the amount of $2,166,000 was issued in 1988 and originally matured in May of 1998. It was extended during 1998 to May of 2003 and pays interest of 8%. The loan is secured by property consisting of a hotel located in Kingsport, Tennessee. The second mortgage loan in the amount of $7,915,000 was issued in 1994, will mature in October of 2004, and pays interest of 8.75%. The loan is secured by property consisting of a hotel located in Houston, Texas. The third mortgage loan in the amount of $1,704,000 was issued in 1995, will mature in January of 2006, and pays interest of 9%. The loan is secured by property consisting of a hotel located in Woodstock, Virginia. Each of these loans is current as to principal and interest payments.
The Company's wholly owned subsidiary, NWL Services, Inc., is the beneficial owner of a life interest (1/8 share), previously owned by Mr. Robert L. Moody, in the trust estate of Libbie Shearn Moody. The trustee of this estate is The Moody National Bank of Galveston. The Moody National Bank is ultimately controlled by the Three R Trust, Galveston, Texas, whose ultimate beneficiaries are the children of Robert L. Moody, who are Robert L. Moody, Jr., Ross R. Moody, Russell S. Moody, and Frances A. Moody. The Moody Foundation is a private charitable foundation governed by a Board of Trustees of three members. Mr. Robert L. Moody and Mr. Ross R. Moody are members of the Board of Trustees.
(d) Transactions with Promoters
None.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) 1. Listing of Financial Statements
See Attachment A, Index to Financial Statements and Schedules, on page __ for a list of financial statements included in this report.
(a) 2. Listing of Financial Statement Schedules
See Attachment A, Index to Financial Statements and Schedules, on page __ for a list of financial statement schedules included in this report.
All other schedules are omitted because they are not applicable, not required, or because the information required by the schedule is included elsewhere in the financial statements or notes.
(a) 3. Listing of Exhibits
Exhibit 2 - Order Confirming Third Amended Joint Consensual Plan Of Reorganization Proposed By The Debtors And The Official Committee Of Unsecured Creditors (As Modified As Of August 28, 1998) (incorporated by reference to Exhibit 2 to the Company's Form 8-K dated August 28, 1998).
Exhibit 3(a) - Restated Articles of Incorporation of National Western Life Insurance Company dated April 10, 1968 (incorporated by reference to Exhibit 3(a) to the Company's Form 10-K for the year ended December 31, 1995).
Exhibit 3(b) - Amendment to the Articles of Incorporation of National Western Life Insurance Company dated July 29, 1971 (incorporated by reference to Exhibit 3(b) to the Company's Form 10-K for the year ended December 31, 1995).
Exhibit 3(c) - Amendment to the Articles of Incorporation of National Western Life Insurance Company dated May 10, 1976 (incorporated by reference to Exhibit 3(c) to the Company's Form 10-K for the year ended December 31, 1995).
Exhibit 3(d) - Amendment to the Articles of Incorporation of National Western Life Insurance Company dated April 28, 1978 (incorporated by reference to Exhibit 3(d) to the Company's Form 10-K for the year ended December 31, 1995).
Exhibit 3(e) - Amendment to the Articles of Incorporation of National Western Life Insurance Company dated May 1, 1979 (incorporated by reference to Exhibit 3(e) to the Company's Form 10-K for the year ended December 31, 1995).
Exhibit 3(f) - Bylaws of National Western Life Insurance Company as amended through April 24, 1987 (incorporated by reference to Exhibit 3(f) to the Company's Form 10-K for the year ended December 31, 1995).
Exhibit 10(a) - National Western Life Insurance Company Non-Qualified Defined Benefit Plan dated July 26, 1991 (incorporated by reference to Exhibit 10(a) to the Company's Form 10-K for the year ended December 31, 1995).
Exhibit 10(b) - National Western Life Insurance Company Officers' Stock Bonus Plan effective December 31, 1992 (incorporated by reference to the Company's Form S-8 registration dated January 27, 1994).
Exhibit 10(c) - National Western Life Insurance Company Non-Qualified Deferred Compensation Plan, as amended and restated, dated March 27, 1995 (incorporated by reference to Exhibit 10(c) to the Company's Form 10-K for the year ended December 31, 1995).
Exhibit 10(d) - First Amendment to the National Western Life Insurance Company Non-Qualified Deferred Compensation Plan effective July 1, 1995 (incorporated by reference to Exhibit 10(d) to the Company's Form 10-K for the year ended December 31, 1995).
Exhibit 10(e) - National Western Life Insurance Company 1995 Stock and Incentive Plan (incorporated by reference to Exhibit 10(e) to the Company's Form 10-K for the year ended December 31, 1995).
Exhibit 10(f) - First Amendment to the National Western Life Insurance Company Non-Qualified Defined Benefit Plan effective December 17, 1996 (incorporated by reference to Exhibit 10(f) to the Company's Form 10-K for the year ended December 31, 1996).
Exhibit 10(g) - Second Amendment to the National Western Life Insurance Company Non-Qualified Defined Benefit Plan effective December 17, 1996 (incorporated by reference to Exhibit 10(g) to the Company's Form 10-K for the year ended December 31, 1996).
Exhibit 10(h) - Second Amendment to the National Western Life Insurance Company Non-Qualified Deferred Compensation Plan effective December 17, 1996 (incorporated by reference to Exhibit 10(h) to the Company's Form 10-K for the year ended December 31, 1996).
Exhibit 10(i) - Third Amendment to the National Western Life Insurance Company Non-Qualified Deferred Compensation Plan effective December 17, 1996 (incorporated by reference to Exhibit 10(i) to the Company's Form 10-K for the year ended December 31, 1996).
Exhibit 10(j) - Fourth Amendment to the National Western Life Insurance Company Non-Qualified Deferred Compensation Plan effective June 20, 1997 (incorporated by reference to Exhibit 10(j) to the Company's Form 10-K for the year ended December 31, 1997).
Exhibit 10(k) - First Amendment to the National Western Life Insurance Company 1995 Stock and Incentive Plan effective June 19, 1998 (incorporated by reference to Exhibit 10(k) to the Company's Form 10-Q for the quarter ended June 30, 1998).
Exhibit 10(l) - Joint Motion For Preliminary Approval Of Settlement Agreement, To Authorize Class Notice, To Enjoin Other Actions And To Schedule Fairness Hearing (incorporated by reference to Exhibit 10(l) to the Company's Form 8-K dated September 8, 1998).
Exhibit 10(m) - Fifth Amendment to the National Western Life Insurance Company Non-Qualified Deferred Compensation Plan effective July 1, 1998 (incorporated by reference to Exhibit 10(l) to the Company's Form 10-Q for the quarter ended September 30, 1998).
Exhibit 10(n) - Sixth Amendment to the National Western Life Insurance Company Non-Qualified Deferred Compensation Plan effective August 7, 1998 (incorporated by reference to Exhibit 10(n) to the Company's Form 10-K for the year ended December 31, 1998).
Exhibit 10(o) - Third Amendment to the National Western Life Insurance Company Non-Qualified Defined Benefit Plan effective August 7, 1998 (incorporated by reference to Exhibit 10(o) to the Company's Form 10-K for the year ended December 31, 1998).
Exhibit 10(p) - Exchange Agreement by and among National Western Life Insurance Company, NWL Services, Inc., Alternative Benefit Management, Inc., and American National Insurance Company effective November 23, 1998 (incorporated by reference to Exhibit 10(p) to the Company's Form 10-K for the year ended December 31, 1998).
Exhibit 10(q) - Bonus Agreement by and between National Western Life Insurance Company and Richard M. Edwards effective August 1, 1999 (filed on page __ of this report).
Exhibit 10(r) - Bonus Agreement by and between National Western Life Insurance Company and Arthur W. Pickering effective August 10, 1999 (filed on page __ of this report).
Exhibit 21 - Subsidiaries of the Registrant (filed on page ___ of this report).
Exhibit 27 - Financial Data Schedule (filed electronically pursuant to Regulation S-K).
(b) Reports on Form 8-K
A report on Form 8-K dated September 30, 1999, was filed by the Company on October 7, 1999, disclosing the execution of a settlement agreement of a pending lawsuit between National Western Life Insurance Company, National Annuity Programs, Inc., Robert L. Myer, and certain affiliates of Myer as described in detail in Item 3, Legal Proceedings.
(c) Exhibits
Exhibits required by Regulation S-K are listed as to location in the Listing of Exhibits in Item 14(a)3 above. Exhibits not referred to have been omitted as inapplicable or not required.
(d) Financial Statement Schedules
The financial statement schedules required by Regulation S-K are listed as to location in Attachment A, Index to Financial Statements and Schedules, on page __ of this report.
ATTACHMENT A
Index to Financial Statements and Schedules
Page
Independent Auditors' Report
Consolidated Balance Sheets, December 31, 1999 and 1998
Consolidated Statements of Earnings for the years ended December 31, 1999, 1998, and 1997
Consolidated Statements of Comprehensive Income for the years ended December 31, 1999, 1998, and 1997
Consolidated Statements of Stockholders' Equity for the years ended December 31, 1999, 1998, and 1997
Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998, and 1997
Notes to Consolidated Financial Statements
Schedule I - Summary of Investments Other Than Investments in Related Parties, December 31, 1999
Schedule V - Valuation and Qualifying Accounts for the years ended December 31, 1999, 1998, and 1997
All other schedules are omitted because they are not applicable, not required, or because the information required by the schedule is included elsewhere in the financial statements or notes.
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders National Western Life Insurance Company Austin, Texas
We have audited the consolidated financial statements of National Western Life Insurance Company and subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of National Western Life Insurance Company and subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1999, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
KPMG LLP
Austin, Texas March 3, 2000
NATIONAL WESTERN LIFE INSURANCE COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 1999 and 1998 (In thousands)
NATIONAL WESTERN LIFE INSURANCE COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 1999 and 1998 (In thousands except share amounts)
NATIONAL WESTERN LIFE INSURANCE COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF EARNINGS For the Years Ended December 31, 1999, 1998, and 1997 (In thousands except per share amounts)
NATIONAL WESTERN LIFE INSURANCE COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME For the Years Ended December 31, 1999, 1998, and 1997 (In thousands)
NATIONAL WESTERN LIFE INSURANCE COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY For the Years Ended December 31, 1999, 1998, and 1997 (In thousands)
NATIONAL WESTERN LIFE INSURANCE COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1999, 1998, and 1997 (In thousands)
NATIONAL WESTERN LIFE INSURANCE COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED For the Years Ended December 31, 1999, 1998, and 1997 (In thousands)
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
NATIONAL WESTERN LIFE INSURANCE COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(A) Principles of Consolidation - The accompanying consolidated financial statements include the accounts of National Western Life Insurance Company and its wholly owned subsidiaries (the Company), The Westcap Corporation, NWL Investments, Inc., NWL Properties, Inc., NWL 806 Main, Inc., NWL Services, Inc., and NWL Financial, Inc. The Westcap Corporation ceased brokerage operations during 1995 and filed for reorganization under Chapter 11 of the U.S. Bankruptcy Code in 1996. As a result, The Westcap Corporation is reflected as discontinued operations in the accompanying financial statements. The bankruptcy reorganization was completed in January, 1999, National Western retained 100% continuing ownership of the reorganized Westcap, and the subsidiary is now operating as a real estate management company. All significant intercorporate transactions and accounts have been eliminated in consolidation.
(B) Basis of Presentation - The accompanying consolidated financial statements have been prepared in conformity with generally accepted accounting principles which require management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities, and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Significant estimates included in the accompanying financial statements include (1) contingent liabilities related to litigation, (2) recoverability of deferred policy acquisition costs, (3) estimated losses related to discontinued operations, and (4) valuation allowances for mortgage loans.
National Western Life Insurance Company also files financial statements with insurance regulatory authorities which are prepared on the basis of statutory accounting practices which are significantly different from financial statements prepared in accordance with generally accepted accounting principles. These differences are described in detail in the statutory information section of this note.
(C) Investments - Investments in debt securities the Company purchases with the intent to hold to maturity are classified as securities held to maturity. The Company has the ability to hold the securities, as it would be unlikely that forced sales of securities would be required prior to maturity to cover payments of liabilities. As a result, securities held to maturity are carried at amortized cost less declines in value that are other than temporary.
Investments in debt and equity securities that are not classified as securities held to maturity are reported as securities available for sale. Securities available for sale are reported in the accompanying financial statements at individual fair value. Any valuation changes resulting from changes in the fair value of the securities are reflected as a component of stockholders' equity in accumulated other comprehensive income. These unrealized gains or losses in stockholders' equity are reported net of taxes and adjustments to deferred policy acquisition costs.
Transfers of securities between categories are recorded at fair value at the date of transfer. The unrealized holding gains or losses for securities transferred from available for sale to held to maturity are included in accumulated other comprehensive income and amortized into earnings over the remaining life of the security as an adjustment to yield in a manner consistent with the amortization or accretion of premium or discount on the associated security.
Premiums and discounts are amortized or accreted over the life of the related security as an adjustment to yield using the effective interest method. Realized gains and losses for securities available for sale and securities held to maturity are included in earnings and are derived using the specific identification method for determining the cost of securities sold. A decline in the fair value below cost that is deemed other than temporary is charged to earnings, resulting in the establishment of a new cost basis for the security.
Mortgage loans and other long-term investments are stated at cost, less unamortized discounts and allowances for possible losses. Policy loans are stated at their aggregate unpaid balances. Real estate is stated at the lower of cost or fair value less estimated costs to sell.
(D) Cash Equivalents - For purposes of the statements of cash flows, the Company considers all short-term investments with a maturity at date of purchase of three months or less to be cash equivalents.
(E) Derivative Financial Instruments - The Company purchases over-the-counter index options, which are derivative financial instruments, to hedge the equity return component of its equity-indexed annuity products. The index options act as hedges to match closely the returns on the S&P 500 Composite Stock Price Index which may be paid to policyholders. As a result, changes to policyholders' liabilities are substantially offset by changes in the value of the options. Cash is exchanged upon purchase of the index options, and no principal or interest payments are made by either party during the option periods. Upon maturity or expiration of the options, cash is paid to the Company based on the S&P 500 performance and terms of the contract.
The index options are reported at fair value in the accompanying financial statements. The changes in the values of the index options and the changes in the policyholder liabilities are both reflected in the statement of earnings. Any gains or losses from the sale or expiration of the options, as well as period-to-period changes in values, are reflected as net investment income in the statement of earnings.
Although there is credit risk in the event of nonperformance by counterparties to the index options, the Company does not expect any counterparties to fail to meet their obligations, given their high credit ratings. In addition, credit support agreements are in place with substantially all counterparties, which further reduces the Company's credit exposure. At December 31, 1999 and 1998, the fair values of index options owned by the Company totaled $32,820,000 and $23,900,000, respectively.
(F) Insurance Revenues and Expenses - Premiums on traditional life insurance products are recognized as revenues as they become due or, for short duration contracts, over the contract periods. Benefits and expenses are matched with premiums in arriving at profits by providing for policy benefits over the lives of the policies and by amortizing acquisition costs over the premium-paying periods of the policies. For universal life and investment annuity contracts, revenues consist of policy charges for the cost of insurance, policy administration, and surrender charges assessed during the period. Expenses for these policies include interest credited to policy account balances and benefit claims incurred in excess of policy account balances. The related deferred policy acquisition costs are amortized in relation to the present value of expected gross profits on the policies.
(G) Federal Income Taxes - Federal income taxes are accounted for under the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance for deferred tax assets is provided if all or some portion of the deferred tax asset may not be realized. An increase or decrease in a valuation allowance that results from a change in circumstances that affects the realizability of the related deferred tax asset is included in income.
(H) Depreciation of Property, Equipment, and Leasehold Improvements - Depreciation is based on the estimated useful lives of the assets and is calculated on the straight-line and accelerated methods. Leasehold improvements are amortized over the lesser of the economic useful life of the improvement or the term of the lease.
(I) Classification - Certain reclassifications have been made to the prior years to conform to the reporting categories used in 1999.
(J) Statutory Information - National Western Life Insurance Company, domiciled in Colorado, prepares its statutory financial statements in accordance with accounting practices prescribed or permitted by the Colorado Division of Insurance. Prescribed statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners (NAIC), as well as state laws, regulations, and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. Such practices may differ from state to state and may even differ from company to company within a state. However, the NAIC has recently completed a comprehensive process of codifying statutory accounting practices and procedures. Other than specific individual state laws, the codification results will be the only source of prescribed statutory accounting practices. The Company's state of domicile, Colorado, is currently in the process of adopting the new codified statutory accounting practices and procedures. Insurance companies must adopt these new statutory accounting practices in 2001, which may result in significant changes to existing practices used in the preparation of statutory financial statements. The Company will perform a review of the entire newly codified statutory accounting practices and procedures during 2000. Based on a preliminary review, National Western does not anticipate a material impact to its capital and surplus position as a result of implementation of the new prescribed statutory accounting procedures.
The following are major differences between generally accepted accounting principles and current prescribed or permitted statutory accounting practices.
1. The Company accounts for universal life and investment annuity contracts based on the provisions of Statement of Financial Accounting Standards (SFAS) No. 97, "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments." The basic effect of the statement with respect to certain long-duration contracts is that deposits for universal life and investment annuity contracts are not reflected as revenues, and surrenders and certain other benefit payments are not reflected as expenses. However, statutory accounting practices do reflect such items as revenues and expenses.
A summary of direct premiums and deposits collected is provided below:
2. Any gains or losses from the sale or expiration of index options, as well as period-to-period changes in values, are reflected as net investment income in the statement of earnings under generally accepted accounting principles. For statutory accounting purposes prior to 1999, period-to-period changes in values of index options were recorded directly to capital and surplus, and gains or losses from sales or expirations were reported in income as realized gains or losses on investments. Effective January 1, 1999, the statutory accounting treatment for index options is the same as generally accepted accounting principles.
3. For statutory accounting purposes, litigation settlements are often recorded as direct reductions of capital and surplus. However, litigation settlements are recorded in the statement of earnings for generally accepted accounting principles.
4. Under generally accepted accounting principles, commissions and certain expenses related to policy issuance and underwriting, all of which generally vary with and are related to the production of new business, are deferred. For traditional products, these costs are amortized over the premium-paying period of the related policies in proportion to the ratio of the premium earned to the total premium revenue anticipated, using the same assumptions as to interest, mortality, and withdrawals as were used in calculating the liability for future policy benefits. For universal life and investment annuity contracts, these costs are amortized in relation to the present value of expected gross profits on these policies. The Company evaluates the recoverability of deferred policy acquisition costs on an annual basis. In this evaluation, the Company considers estimated future gross profits or future premiums, as applicable for the type of contract. The Company also considers expected mortality, interest earned and credited rates, persistency, and expenses. Statutory accounting practices require commissions and related costs to be expensed as incurred.
A summary of information relative to deferred policy acquisition costs is provided in the table below:
5. Under generally accepted accounting principles, the liability for future policy benefits on traditional products has been calculated by the net level method using assumptions as to future mortality (based on the 1965-1970 and 1975-1980 Select and Ultimate mortality tables), interest ranging from 4% to 8%, and withdrawals based on Company experience. For universal life and investment annuity contracts, the liability for future policy benefits represents the account balance. For statutory accounting purposes, liabilities for future policy benefits for life insurance policies are calculated by the net level premium method or the commissioners reserve valuation method. Future policy benefit liabilities for annuities are calculated based on the continuous commissioners annuity reserve valuation method and provisions of Actuarial Guidelines 33 and 35.
6. Deferred Federal income taxes are provided for temporary differences which are recognized in the financial statements in a different period than for Federal income tax purposes. Deferred taxes are not recognized in statutory accounting practices. Also, for statutory accounting purposes, the Company has recorded Federal income tax receivables as permitted by the Colorado Division of Insurance. The Federal income tax receivables related to subsidiary losses have been recorded directly to surplus and were not recorded in results of operations.
7. For statutory accounting purposes, debt securities are recorded at amortized cost, except for securities in or near default, which are reported at market value.
8. Investments in subsidiaries are recorded at admitted asset value for statutory purposes, whereas the financial statements of the subsidiaries have been consolidated with those of the Company under generally accepted accounting principles.
9. The asset valuation reserve and interest maintenance reserve, which are investment valuation reserves prescribed by statutory accounting practices, have been eliminated, as they are not required under generally accepted accounting principles.
10. The recorded value of the life interest in the Libbie Shearn Moody Trust (the Trust) is reported at its initial valuation, net of accumulated amortization, under generally accepted accounting principles. The initial valuation was based on the assumption that the Trust would provide certain income to the Company at an assumed interest rate and is being amortized over 53 years, the life expectancy of Mr. Robert L. Moody at the date he contributed the life interest to the Company. For statutory accounting purposes, the life interest has been valued at $26,400,000, which was computed as the present value of the estimated future income to be received from the Trust. However, this amount was amortized to a valuation of $12,775,000 over a seven-year period ended December 31, 1999, in accordance with Colorado Division of Insurance permitted accounting requirements. Prescribed statutory accounting practices provide no accounting guidance for such asset. The statutory admitted value of this life interest at December 31, 1999, is $12,775,000 in comparison to a carrying value of $4,056,000 in the accompanying consolidated financial statements.
11. Reconciliations of statutory stockholders' equity, as included in the annual statements filed with the Colorado Division of Insurance, to the respective amounts as reported in the accompanying consolidated financial statements prepared under generally accepted accounting principles are as follows:
12. Reconciliations of statutory net earnings, as included in the annual statements filed with the Colorado Division of Insurance, to the respective amounts as reported in the accompanying consolidated financial statements prepared under generally accepted accounting principles are as follows:
(2) DEPOSITS WITH REGULATORY AUTHORITIES
The following assets were on deposit with state and other regulatory authorities as required by law at the end of each year:
(3) INVESTMENTS
(A) Investment Income
The major components of net investment income are as follows:
Investments of the following amounts were not income producing for the preceding twelve months:
The Company had mortgage loans totaling $3,014,000 that were on nonaccrual status as of December 31, 1999. No mortgage loans were on nonaccrual status during 1998 or 1997. Also, the Company had no investments in debt securities that were on nonaccrual status during 1999, 1998, or 1997. Reductions in interest income associated with nonperforming mortgage loans totaled $192,000 in 1999.
(B) Mortgage Loans and Real Estate
Concentrations of credit risk arising from mortgage loans exist in relation to certain groups of customers. A group concentration arises when a number of counterparties have similar economic characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in economic or other conditions. The Company does not have a significant exposure to any individual customer or counterparty. The major concentrations of mortgage loan credit risk for the Company arise by geographic location in the United States and by property type as detailed below.
As of December 31, 1999, mortgage loans with book values totaling approximately $3,014,000 were considered impaired. As of December 31, 1998, no mortgage loans were considered impaired. For the years ended December 31, 1999 and 1997, average investments in impaired mortgage loans were $1,616,000 and $676,000, respectively. There were no investments in impaired mortgage loans for the year ended December 31, 1998. Interest income recognized on impaired loans during the impaired period for the years ended December 31, 1999 and 1997, was not significant. Impaired loans are typically placed on nonaccrual status, and no interest income is recognized. However, if cash is received on the impaired loan, it is applied to principal and interest on past due payments, beginning with the most delinquent payment.
Detailed below are changes in the allowance for mortgage loan losses for 1999, 1998, and 1997:
At December 31, 1999 and 1998, the Company owned investment real estate totaling $11,388,000 and $13,553,000 which is reflected in other long-term investments in the accompanying financial statements. The Company records real estate at the lower of cost or fair value less estimated costs to sell. Real estate values are monitored and evaluated at least annually by the use of independent appraisals or internal valuations. Decreases in market values affecting carrying values are recorded in a valuation allowance which is reflected in realized gains or losses on investments. For the years ended December 31, 1999 and 1998, there were no impairment losses on real estate due to decreases in market value. For the year ended December 31, 1997, impairment losses on real estate due to decreases in market values totaled $46,000.
(C) Investment Gains and Losses
The table below presents realized gains and losses and changes in unrealized gains and losses on investments for 1999, 1998, and 1997:
(D) Debt and Equity Securities
The tables below present amortized cost and fair values of securities held to maturity and securities available for sale at December 31, 1999:
The tables below present amortized cost and fair values of securities held to maturity and securities available for sale at December 31, 1998:
The amortized cost and fair values of investments in debt securities at December 31, 1999, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The Company uses the specific identification method in computing realized gains and losses. Proceeds from sales of securities available for sale during 1999 and 1997 totaled $56,126,000 and $50,706,000, respectively. There were no sales of securities available for sale during 1998. Gross gains and gross losses realized on those sales are detailed below:
The Company did not sell any held to maturity securities during 1999. In 1998, the Company sold one held to maturity security due to significant credit deterioration of the issuing company. Amortized cost of the security totaled $2,981,000, and a realized loss of $3,000 was recognized on the sale. In 1997, the Company sold one held to maturity security, also due to significant credit deterioration of the issuing company. Amortized cost of the security totaled $1,987,000, and a realized gain of $6,000 was recognized on the sale.
The Company held in its investment portfolio below investment grade debt securities totaling $70,900,000, $44,974,000, and $41,149,000 at December 31, 1999, 1998, and 1997, respectively. These amounts represent approximately 2.2% of total invested assets in 1999, and 1.4% in 1998 and 1997. Below investment grade securities generally have greater default risk than higher rated corporate debt. The issuers of these securities are usually more sensitive to adverse industry or economic conditions than are investment grade issuers.
Except for U.S. government agency mortgage-backed securities, the Company had no investments in any entity in excess of 10% of stockholders' equity at December 31, 1999.
(E) Transfers of Securities
At July 31, 1994, the Company transferred debt securities with fair values totaling $805 million from securities available for sale to securities held to maturity. On December 29, 1995, the Company made additional transfers totaling $156 million to the held to maturity category from securities available for sale. Lower holdings of securities available for sale significantly reduce the Company's exposure to equity volatility while still providing securities for liquidity and asset/liability management purposes. The transfers of securities were recorded at fair values in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." This statement requires that the unrealized holding gain or loss at the date of the transfer continue to be reported in a separate component of stockholders' equity but shall be amortized over the remaining life of the security as an adjustment of yield in a manner consistent with the amortization of any premium or discount. The amortization of an unrealized holding gain or loss reported in equity will offset or mitigate the effect on interest income of the amortization of the premium or discount for the held to maturity securities. The transfer of securities from available for sale to held to maturity had no effect on net earnings of the Company. However, stockholders' equity was adjusted as follows:
Net unrealized gains and losses on investment securities included in stockholders' equity at December 31, 1999 and 1998, are as follows:
(F) Change in Accounting Principles
In June, 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities." In June, 1999, SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133," was issued deferring SFAS No. 133, which will now be effective for all fiscal quarters of all fiscal years beginning after June 15, 2000. SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The statement defines several designations of derivatives based on the instrument's intended use and specifies the appropriate accounting treatment for changes in the fair value of the derivative based on its resulting designation.
The Company currently sells equity-indexed annuities that contain an equity return component for policyholders which is an embedded derivative instrument. The Company purchases index options, which are also derivative instruments, to hedge this equity return component. The index options are reported at fair value in the Company's financial statements, which is in accordance with SFAS No. 133 requirements. The Company also uses a fair value approach in recording policy liabilities for the equity-indexed annuities. However, there is currently no specific, authoritative interpretation of SFAS No. 133 with respect to accounting for equity-indexed annuity liabilities. Additional guidance in 2000 regarding this issue may result in a definitive method significantly different from that currently used by the Company. As a result, the ultimate implementation of SFAS No. 133 could have a significant effect on the Company's results of operations. The Company expects to implement the new statement in the first quarter of 2001.
(4) REINSURANCE
(A) Summary of Significant Reinsurance Information
The Company is party to several reinsurance agreements. The Company's general policy is to reinsure that portion of any risk in excess of $200,000 on the life of any one individual. Total life insurance in force was $9.75 billion and $9.40 billion at December 31, 1999 and 1998, respectively. Of these amounts, life insurance in force totaling $1.68 billion and $1.47 billion was ceded to reinsurance companies, primarily on a yearly renewable term basis, at December 31, 1999 and 1998, respectively.
In accordance with the reinsurance contracts, reinsurance receivables including amounts related to claims incurred but not reported and liabilities for future policy benefits totaled $2,473,000 and $4,269,000 at December 31, 1999 and 1998, respectively. Premium revenues were reduced by $7,904,000, $7,245,000, and $5,719,000 for reinsurance premiums incurred during 1999, 1998, and 1997, respectively. Benefit expenses were reduced by $3,350,000, $3,013,000, and $5,396,000 for reinsurance recoveries during 1999, 1998, and 1997, respectively. A liability exists with respect to reinsurance, as the Company remains liable if the reinsurance companies are unable to meet their obligations under the existing agreements.
(B) Change in Accounting Principles
In October, 1998, the American Institute of Certified Public Accountants (AICPA) issued Statement of Position (SOP) 98-7, "Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk." The SOP specifies classifications for insurance and reinsurance contracts for which deposit accounting is appropriate and specifies accounting methods for each. For each insurance and reinsurance contract accounted for under deposit accounting, a deposit asset or liability should be recognized at inception and should be measured based on consideration paid or received, less any premiums or fees to be retained by the insurer or reinsurer, irrespective of the experience of the contract. The Company anticipates that this SOP will not have a significant effect on its financial statements, as the Company's current insurance and reinsurance contracts all transfer insurance risk. SOP 98-7 is effective for all fiscal years beginning after June 15, 1999. The Company currently plans to implement the SOP in the first quarter of 2000.
(5) FEDERAL INCOME TAXES
Total Federal income taxes for 1999, 1998, and 1997 were allocated as follows:
The provisions for Federal income taxes attributable to earnings from continuing operations vary from amounts computed by applying the statutory income tax rate to earnings before Federal income taxes. The reasons for the differences and the corresponding tax effects are as follows:
There were no deferred taxes attributable to enacted tax rate changes for the years ended December 31, 1999, 1998, and 1997.
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1999 and 1998, are presented below:
There was no valuation allowance for deferred tax assets at December 31, 1999 and 1998. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that the Company will realize the benefits of these deductible differences.
Prior to the Tax Reform Act of 1984 (1984 Act), a portion of a life insurance company's income was not subject to tax until it was distributed to stockholders, at which time it was taxed at the regular corporate tax rate. In accordance with the 1984 Act, this income, referred to as policyholders' surplus, would not increase, yet any amounts distributed would be taxable at the regular corporate rate. The balance of this account as of December 31, 1999, is approximately $2,446,000. No provision for income taxes has been made on this untaxed income, as management is of the opinion that no distribution to stockholders will be made from policyholders' surplus in the foreseeable future. Should the balance in the policyholders' surplus account at December 31, 1999, become taxable, the Federal income taxes computed at present rates would be approximately $856,000.
The Company files a consolidated Federal income tax return with its subsidiaries. Allocation of the consolidated tax liability is based on separate return calculations pursuant to the "wait-and-see" method as described in sections 1.1552-1(a)(2) and 1.1502-33(d)(2)(i) of the current Treasury Regulations. Under this method, consolidated group members are not given current credit for net losses until future net taxable income is generated to realize such credits. In accordance with this consolidated tax sharing agreement, tax benefits resulting from discontinued brokerage operation losses totaling $4,944,000 in 1998 and $350,000 in 1997 were included in earnings from continuing operations.
(6) TRANSACTIONS WITH CONTROLLING STOCKHOLDER AND AFFILIATES
(A) Life Interest in Libbie Shearn Moody Trust
The Company's wholly owned subidiary, NWL Services, Inc., is the beneficial owner of a life interest (1/8 share) in the trust estate of Libbie Shearn Moody (the Trust) which was previously owned by Mr. Robert L. Moody, Chairman of the Board of Directors of the Company. The Company has issued term insurance policies on the life of Mr. Robert L. Moody which are reinsured through agreements with unaffiliated insurance companies. NWL Services, Inc., is the beneficiary of these policies for an amount equal to the statutory admitted value of the Trust, which was $12,775,000 at December 31, 1999. The excess of $27,000,000 face amount of the reinsured policies over the statutory admitted value of the Trust has been assigned to Mr. Robert L. Moody. The recorded net asset values in the accompanying consolidated financial statements for the life interest in the Trust are as follows:
Income from the Trust and related expenses reflected in the accompanying consolidated statements of earnings are summarized as follows:
(B) Common Stock
Mr. Robert L. Moody, Chairman of the Board of Directors, owns 198,074 of the total outstanding shares of the Company's Class B common stock and 1,160,896 of the Class A common stock.
Holders of the Company's Class A common stock elect one-third of the Board of Directors of the Company, and holders of the Class B common stock elect the remainder. Any cash or in-kind dividends paid on each share of Class B common stock shall be only one-half of the cash or in-kind dividends paid on each share of Class A common stock. Also, in the event of liquidation of the Company, the Class A stockholders shall first receive the par value of their shares; then the Class B stockholders shall receive the par value of their shares; and the remaining net assets of the Company shall be divided between the stockholders of both Class A and Class B common stock, based on the number of shares held.
(7) PENSION PLANS
(A) Defined Benefit Plans
The Company has a qualified defined benefit pension plan covering substantially all full-time employees. The plan provides benefits based on the participants' years of service and compensation. The Company makes annual contributions to the plan that comply with the minimum funding provisions of the Employee Retirement Income Security Act. During 1998 the Company adopted Statement of Financial Accounting Standards (SFAS) No. 132, "Employers' Disclosures About Pensions and Other Postretirement Benefits." This statement revises employers' disclosures about pension and other postretirement benefit plans, but it does not change the measurement or recognition of those plans. A detail of plan disclosures in accordance with SFAS No. 132 is provided below:
The following summarizes the changes in benefit obligations for the years ended:
The following summarizes the changes in the fair value of plan assets, primarily consisting of equity and fixed income securities, for the years ended:
The following sets forth the plan's funded status and the related amounts recognized in the Company's financial statements as of:
The following are the weighted-average assumptions as of:
Net periodic benefit costs include the following components for the years ended:
The Company also sponsors a nonqualified defined benefit plan primarily for senior officers. The plan provides benefits based on the participants' years of service and compensation. During 1998 the Company transferred the pension obligations and administrative responsibilities of the plan to a pension administration firm. Upon transfer, the Company paid $4,880,000 to cover current and future liabilities and administration of the plan. Pension expense for 1998, up to the time of transfer, was $324,000. The financial effects of the transaction resulted in additional pension expense during 1998 totaling $2,543,000, as the amount paid upon transfer exceeded the pension liabilities recorded for financial statement purposes in accordance with SFAS No. 87 and SFAS No. 132.
The obligations under the plan are now the responsibility of the new pension administration firm, which is a subsidiary of American National Insurance Company (ANICO). ANICO has also guaranteed the payment of pension obligations under the plan. However, National Western has a contingent liability with respect to the pension plan should these entities be unable to meet their obligations under the existing agreements. Also, National Western has a contingent liability with respect to the plan in the event that a plan participant continues employment with National Western beyond age seventy, the aggregate average annual participant salary increases exceed 10% per year, or any additional employees become eligible to participate in the plan. If any of these conditions are met, National Western would be responsible for any additional pension obligations resulting from these items.
(B) Defined Contribution Plans
In addition to the defined benefit plans, the Company has a qualified 401(k) plan for substantially all full-time employees and a nonqualified deferred compensation plan primarily for senior officers. The Company makes annual contributions to the 401(k) plan of two percent of each employee's compensation. Additional Company matching contributions of up to two percent of each employee's compensation are also made each year based on the employee's personal level of salary deferrals to the plan. All Company contributions are subject to a vesting schedule based on the employee's years of service. For the years ended December 31, 1999, 1998, and 1997, Company contributions totaled $272,000, $270,000, and $250,000, respectively.
The nonqualified deferred compensation plan was established to allow eligible employees to defer the payment of a percentage of their compensation and to provide for additional Company contributions. Company contributions are subject to a vesting schedule based on the employee's years of service. For the years ended December 31, 1999, 1998, and 1997, Company contributions totaled $79,000, $60,000, and $36,000, respectively.
(8) SHORT-TERM BORROWINGS
The Company has available a $60 million bank line of credit primarily for cash management purposes relating to investment transactions. The Company is required to maintain a collateral security deposit in trust with the bank equal to 120% of any outstanding liability. The Company had no outstanding liabilities or collateral security deposits with the bank at December 31, 1999 and 1998. The Company had no borrowings on the line of credit during 1998. The weighted average interest rates on borrowings for the years ended December 31, 1999 and 1997 were 5.88%, and 6.42%, respectively. Actual borrowings and interest expense for 1999 and 1997 were minimal.
(9) COMMITMENTS AND CONTINGENCIES
(A) Legal Proceedings
The Westcap Corporation Bankruptcy Proceedings
The Chapter 11 bankruptcy reorganization of the Company's wholly owned subsidiary, The Westcap Corporation (Westcap), was completed in the first quarter of 1999. Pursuant to the reorganization plan, National Western retained 100% continuing ownership of the reorganized Westcap, and the subsidiary is now operating as a real estate management company. No losses were reported for discontinued brokerage operations in 1999, as the entire $14,125,000 settlement payment was accrued and reported as a loss in the third quarter of 1998. Any additional losses will depend on the results of The City Colleges lawsuit filed against National Western on March 28, 1994, for alleged Federal or state securities law "control person" violations relating to Westcap, and which is pending in the United States District Court, Western District of Texas. This suit is described in more detail below.
Westcap Related Litigation
On March 28, 1994, the Community College District No. 508, County of Cook and State of Illinois (The City Colleges) filed a complaint in the United States District Court for the Northern District of Illinois, Eastern Division, against National Western Life Insurance Company (the Company or National Western) and subsidiaries of The Westcap Corporation (Westcap), a wholly owned subsidiary of the Company. The suit sought rescission of securities purchase transactions by The City Colleges from Westcap between September 9, 1993, and November 3, 1993, alleged compensatory damages, punitive damages, injunctive relief, declaratory relief, fees, and costs. National Western was named as a "controlling person" of the Westcap defendants. Westcap filed Chapter 11 bankruptcy, and The City Colleges filed a claim in the bankruptcy court against Westcap. The claim was tried before the bankruptcy court, and in September, 1997, a $56,173,000 judgment was entered against Westcap favorable to The City Colleges. Westcap appealed this decision to the United States District Court for the Southern District of Texas (Houston Division). On July 24, 1998, the United States District Court affirmed the orders of the bankruptcy court with respect to their underlying conclusion that Westcap is liable to The City Colleges under the Texas Securities Act, but the Court vacated the orders and remanded them to the bankruptcy court to determine the correct amount of damages in a manner consistent with the Court's opinion and the Texas Securities Act. The bankruptcy court on November 16, 1998, entered an order allowing a claim of The City Colleges against the Westcap estate of $51,738,868. Westcap has appealed the bankruptcy court's and District Court's judgment to the Fifth Circuit Court of Appeals. Oral argument on the appeal was held on February 29, 2000, and no ruling has yet been rendered.
While Westcap is a wholly owned subsidiary of the Company, the Company is not a party to the bankruptcy or the judgment against Westcap by the bankruptcy court or the United States District Court. The lawsuit against the Company was stayed in September, 1994, pending resolution of The City Colleges' claim against Westcap. Following the judgment against Westcap in the bankruptcy court, on December 2, 1997, the stay was lifted by the United States District Court in Illinois, and The City Colleges filed an amended complaint seeking to hold the Company liable for the claim allowed in the bankruptcy court against Westcap under the "control person" provision of the Texas Securities Act. The suit seeks approximately $56 million plus fees and costs. The maximum sought by City Colleges will be determined by the final amount allowed The City Colleges in the Westcap bankruptcy appeal, discussed above. The Company filed jurisdictional and venue motions to have the case transferred to the United States District Court for the Western District of Texas, which motions were agreed to by the Plaintiff, and the case is now pending in the United States District Court for the Western District of Texas, where the parties have engaged in discovery activities. The case is set for trial in September, 2000. The Company believes it has reasonable and adequate defenses to the suit. Although the alleged damages, if sustained, would be material to the Company's financial statements, a reasonable estimate of any actual losses which may result from the suit cannot be made at this time. Accordingly, no provision for any liability that may result from this suit has been recognized in National Western's financial statements.
On July 5, 1995, San Patricio County, Texas, filed suit in the District Court of San Patricio County, Texas, against National Western Life Insurance Company (the Company) and its chief executive officer, Robert L. Moody. The suit arose from derivative investments purchased by San Patricio County from Westcap Securities, L.P., or Westcap Government Securities, Inc., affiliates of The Westcap Corporation. The suit alleged that the Westcap affiliates were controlled by the Company and Mr. Moody and that they were responsible for the alleged wrongful acts of the Westcap affiliates in selling the securities to the Plaintiff. Plaintiff alleged that the Westcap affiliates violated duties and responsibilities owed to the Plaintiff related to the investment recommendations and decisions made by Plaintiff, and alleged that the Plaintiff was financially damaged by such actions of Westcap. The suit was settled effective March 9, 1998, with a payment of $200,000 by National Western to San Patricio County and with no admission of liability. In exchange for the payment, National Western and Robert L. Moody received a general release of all claims asserted, including all claims that have been asserted against Westcap Securities, L.P., or could have been asserted in another court against Westcap Securities, L.P., and the lawsuit was dismissed. The $200,000 settlement payment was recorded as other operating expenses in 1998.
Class Action Litigation
National Western Life Insurance Company (the Company or National Western) and National Annuity Programs, Inc. (NAP), were sued in the District Court of Travis County, Texas, by a former agent of the Company, eight plaintiffs, and fourteen intervenors, being present and past annuity policyholders of the Company, and on behalf of an asserted class of annuity policyholders of the Company, and alleged that, in the sale of certain Company annuities to the plaintiffs and intervenors, the Company and NAP (i) had violated the Texas Deceptive Trade Practices-Consumer Protection Act, statutes in the Texas Insurance Code, and certain rules and regulations of the Texas Department of Insurance; (ii) committed common law fraud; (iii) were negligent; (iv) had breached a duty of good faith and fair dealing; (v) made negligent misrepresentations; (vi) committed a civil conspiracy to commit fraud; and (vii) breached policy contracts. The plaintiffs sought (i) certification of one or more classes; and (ii) recovery of unspecified actual damages, monies paid by plaintiffs, attorneys' fees, prejudgment and postjudgment interests and costs, increased or treble damages, punitive damages, and general relief as awarded by the Court. NAP was an independent marketing general agency under contract with the Company that hired and supervised the agents marketing the annuity products on behalf of the Company.
On September 8, 1998, National Western, NAP, and the policyholder plaintiffs, intervenors, and class-representatives in this class action litigation filed with the Court a joint motion for preliminary approval of a Settlement Agreement among the parties. The parties requested the Court to review the Settlement Agreement and make a preliminary determination that it was fair, adequate, and reasonable to the members of the proposed classes and that the proposed classes were capable of being certified for settlement purposes, to approve the form of the notices of the settlement to the classes, and to set a class certification and fairness hearing on the settlement.
In exchange for a final order and judgment dismissing with prejudice the claims asserted against National Western and NAP by all members of the settlement classes, National Western agreed to contribute approximately $5 million to the proposed settlement, and NAP agreed to contribute $750,000. Additionally, National Western agreed to pay the costs of notice to the class and administration of the settlement claims process, to guarantee minimum interest rates of 3% and 5% in the future on certain settlement options under specified annuity policies which are the subject matter of the litigation, and to provide additional incidental settlement benefits, all as detailed in the motion and Settlement Agreement.
National Western proceeded with notification of class members and preliminary administration of the claims process during late 1998 and January, 1999. Costs for this process totaling $250,000 were accrued as other operating expenses as of December 31, 1998, in the accompanying financial statements. On January 20, 1999, the Court held a "fairness hearing" and approved the Settlement Agreement. As a result, National Western also accrued the estimated $5,000,000 settlement as other operating expenses as of December 31, 1998. The actual settlement payments totaling $5,000,000 were made during 1999.
Other Litigation
On September 30, 1999, National Western Life Insurance Company (the Company), National Annuity Programs, Inc. (NAP), Robert L. Myer (Myer), and certain affiliates of Myer executed a Definitive Compromise Settlement Agreement (Agreement) of the declaratory judgment lawsuit pending between them in the District Court of Travis County, Texas. The declaratory judgment action was filed by the Company and sought court construction of a general agent manager contract and amendments thereto (Contract) between the Company and NAP entered into in 1983 and amended thereafter, a declaration that the contract was enforceable, but had been breached by NAP, and for damages from NAP. The Company alleged tortious interference by Myer with the Contract, conspiracy, and damages. NAP and Myer had counter-claimed for declaratory judgment, breach of contract, indemnity, fraud, statutory violations, damages, and attorneys' fees from the Company.
By the settlement each party dismissed with prejudice all claims asserted by them in the pending lawsuit. NAP and Myer released the Company from any claim for any funds and other rights arising under the Contract and from all negligence and other claims arising prior to the Agreement. The Company released NAP, Myer, and Myer affiliates from all negligence and other claims, excluding any claims arising under the reinsurance contract between the Company and NAP Life Insurance Company, a Myer affiliate. The Company acquired NAP, and Myer indemnified and held the Company harmless from all claims of any nature asserted against NAP based on its acts or omissions prior to the Agreement, except for claims by policyholders and agents relating to the sale of the Company's products. The Company indemnified Myer for NAP acts or omissions occurring after September 30, 1999. The Company will pay or cause to be paid or released all valid claims for unpaid commissions to sub- agents of NAP who wrote business for the Company under the Contract. The Company completed such payments to these agents in 1999 in the aggregate amount of $820,000.
As a result of the settlement, accrued bonus commissions relating to the NAP contract totaling $8,482,000 were released, as they are no longer considered a liability to NAP and will not be paid. Accordingly, the release of these accrued commissions from liabilities in 1999 resulted in additional income of $8,482,000, before taxes. It is anticipated that any future renewal premiums received by the Company on currently issued and in force annuity policies written by NAP sub-agents under the Contract could generate additional commissions for such sub-agents. The payment of such future commissions is subject to and conditioned upon receipt of such renewal premiums by the Company and compliance by the sub-agents with the terms of the agents' contracts with the Company and NAP.
By separate Commutation Agreement dated September 30, 1999, the Company and NAP Life Insurance Company ("NAP Life"), an affiliate of Robert L. Myer, canceled and terminated the Specific Benefit Reinsurance Agreement between them dated March 1, 1988, whereby the Company had ceded fifty percent (50%) of the premiums, reserves, and liabilities on a portion of its policies of insurance. The effect of the Commutation Agreement did not have a significant impact on the financial statements of the Company, as the cost to National Western to terminate the agreement totaled $182,000.
National Western Life Insurance Company is also currently a defendant in several other lawsuits, substantially all of which are in the normal course of business. In the opinion of management, the liability, if any, which may arise from these lawsuits would not have a material adverse effect on the Company's financial position.
(B) Financial Instruments
In order to meet the financing needs of its customers in the normal course of business, the Company is a party to financial instruments with off-balance sheet risk. These financial instruments are commitments to extend credit which involve elements of credit and interest rate risk in excess of the amounts recognized in the balance sheet.
The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amounts, assuming that the amounts are fully advanced and that collateral or other security is of no value. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. The Company controls the credit risk of these transactions through credit approvals, limits, and monitoring procedures.
The Company had commitments to extend credit relating to mortgage loans totaling $7,575,000 at December 31, 1999. Commitments to extend credit are legally binding agreements to lend to a customer that generally have fixed expiration dates or other termination clauses and may require payment of a fee. Commitments do not necessarily represent future liquidity requirements, as some could expire without being drawn upon. The Company evaluates each customer's creditworthiness on a case-by-case basis.
(C) Guaranty Association Assessments
National Western Life Insurance Company is subject to state guaranty association assessments in all states in which it is licensed to do business. These associations generally guarantee certain levels of benefits payable to resident policyholders of insolvent insurance companies. Many states allow premium tax credits for all or a portion of such assessments, thereby allowing potential recovery of these payments over a period of years. However, several states do not allow such credits.
The Company estimates its liabilities for guaranty association assessments by using the latest information available from the National Organization of Life and Health Insurance Guaranty Associations. The Company monitors and revises its estimates for assessments as additional information becomes available which could result in changes to the estimated liabilities. Guaranty association assessment expenses were significantly lower in 1999 and 1998 than in 1997 and prior years. The reductions are due to changes in estimated liabilities, changes in estimated recoverable capitalized assessments, and assessment refunds received from states during 1999 and 1998. Other operating expenses related to state guaranty association assessments totaled $104,000 and $952,000 for the years ended December 31, 1999 and 1997, respectively. The previously described changes and refunds resulted in a net credit in other operating expenses for guaranty association assessments totaling $365,000 for 1998.
(D) Leases
The Company leases its executive office building and various computer and other office related equipment. Rental expenses for these leases for the years ended December 31, 1999, 1998, and 1997 were $920,000, $745,000, and $743,000, respectively.
Total annual lease obligations as of December 31, 1999, are as follows (in thousands):
(10) STOCKHOLDERS' EQUITY
(A) Changes in Common Stock Shares Outstanding
Details of changes in shares of common stock outstanding are provided below:
(B) Dividend Restrictions
The Company is restricted by state insurance laws as to dividend amounts which may be paid to stockholders without prior approval from the Colorado Division of Insurance. The restrictions are based on statutory earnings and surplus levels of the Company. The maximum dividend payment which may be made without prior approval in 2000 is $49,566,000. The Company has never paid cash dividends on its common stock, as it follows a policy of retaining any earnings in order to finance the development of business and to meet regulatory requirements for capital.
(C) Regulatory Capital Requirements
The Colorado Division of Insurance imposes minimum risk-based capital requirements on insurance companies that were developed by the National Association of Insurance Commissioners (NAIC). The formulas for determining the amount of risk-based capital (RBC) specify various weighting factors that are applied to statutory financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio of the Company's regulatory total adjusted capital to its authorized control level RBC, as defined by the NAIC. Companies below specific trigger points or ratios are classified within certain levels, each of which requires specified corrective action. The Company's current statutory capital and surplus is significantly in excess of the threshold RBC requirements.
(D) Stock and Incentive Plan
The Company has a stock and incentive plan which provides for the grant of any or all of the following types of awards to eligible employees: (1) stock options, including incentive stock options and nonqualified stock options; (2) stock appreciation rights, in tandem with stock options or freestanding; (3) restricted stock; (4) incentive awards; and (5) performance awards. The plan began on April 21, 1995, and will terminate on April 20, 2005, unless terminated earlier by the Board of Directors. The number of shares of Class A, $1.00 par value, common stock which may be issued under the plan, or as to which stock appreciation rights or other awards may be granted, may not exceed 300,000. These shares may be authorized and unissued shares or treasury shares.
All of the employees of the Company and its subsidiaries are eligible to participate in the plan. In addition, directors of the Company, other than Compensation and Stock Option Committee members, are eligible for restricted stock awards, incentive awards, and performance awards. Company directors, including members of the Compensation and Stock Option Committee, are eligible for nondiscretionary stock options.
The Committee approved the issuance of nonqualified stock options to selected officers of the Company during 1998 and 1997 totaling 48,500 and 21,900, respectively. Additionally, during 1998 the Committee granted 10,000 nonqualified, nondiscretionary stock options to Company directors. No nonqualified stock options were issued in 1999. The directors' stock options vest 20% annually following one full year of service to the Company from the date of grant. The officers' stock options vest 20% annually following three full years of service to the Company from the date of grant. The exercise prices of the stock options were set at the fair market values of the common stock on the dates of grant. A summary of shares available for grant and stock option activity is detailed below:
Vested and exercisable options at December 31, 1999, 1998, and 1997 totaled 26,170, 7,910, and 2,400, respectively. The weighted-average exercise price for these options was $49.92 at December 31, 1999 and $38.13 at December 31, 1998 and 1997.
The following table summarizes information about stock options outstanding at December 31, 1999.
In October, 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation." This statement establishes financial accounting and reporting standards for stock-based employee compensation plans. It defines a fair value based method of accounting for employee stock options or similar equity instruments. However, it also allows an entity to continue to measure compensation cost for plans using the intrinsic value based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees."
Under the fair value based method, compensation cost is measured at the grant date based on the fair value of the award and is recognized over the service period, which is usually the vesting period. For stock options, fair value is determined using an option pricing model that takes into account various information and assumptions regarding the Company's stock and options. Under the intrinsic value based method, compensation cost is the excess, if any, of the quoted market price of the stock at grant date or other measurement date over the amount an employee must pay to acquire the stock.
The Company has elected to continue to apply the accounting methods prescribed by APB Opinion No. 25 for its existing stock and incentive plan. No compensation costs have been recorded for the Company's existing plan using the intrinsic value based method. However, if compensation expense for the stock options had been determined using the fair value based method under SFAS No. 123, the Company's net earnings and earnings per share would have been reduced to the pro forma amounts as follows:
The fair value of the options used in estimating the pro forma amounts above were estimated on the date of grant using an option pricing model with the weighted-average assumptions as detailed below:
(11) EARNINGS PER SHARE
In February, 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 128, "Earnings Per Share." This statement changes the computation, presentation, and disclosure requirements for earnings per share (EPS). SFAS No. 128 replaces the presentation of primary and fully diluted EPS with basic and diluted EPS, respectively. Basic EPS excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity.
The Company adopted SFAS No. 128 effective December 31, 1997. In accordance with the statement, prior period earnings per share data was restated. The following table sets forth the computation of basic and diluted earnings per share:
(12) COMPREHENSIVE INCOME
The Company adopted Statement of Financial Accounting Standards (SFAS) No. 130, "Reporting Comprehensive Income," in the first quarter of 1998. SFAS No. 130 establishes standards for reporting and display of comprehensive income and its components (revenues, expenses, gains, and losses) in a full set of general-purpose financial statements. This statement requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. This statement requires that an enterprise (a) classify items of other comprehensive income by their nature in a financial statement and (b) display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position.
SFAS No. 130 affects the Company's reporting presentation of certain items such as foreign currency translation adjustments and unrealized gains and losses on investment securities. These items are now a component of other comprehensive income, as reported in the accompanying financial statements. Prior period financial statements have been reclassified for comparative purposes in accordance with SFAS No. 130. Components of other comprehensive income and related taxes are provided below for 1999, 1998, and 1997.
(13) UNAUDITED QUARTERLY FINANCIAL DATA
Quarterly results of operations for 1999 are summarized as follows:
The fourth quarter net earnings in 1999 reflect the following significant items:
Net earnings were $20,338,000 for the quarter ended December 31, 1999, compared to $10,482,000 for the fourth quarter of 1998. Earnings for the 1999 fourth quarter were affected by the Company's equity-indexed annuity business. These annuities combine features associated with traditional fixed annuities, such as guaranteed minimum interest rates, with the option to have interest rates linked in part to an equity index, the S&P 500 Index. To offset the potential higher returns required to be paid on these products, the Company purchases index options in addition to traditional debt security investments. Index options, which are recorded at market value each reporting period, act as hedges to match closely the returns based on the S&P 500 Index.
The Company's fourth quarter 1999 earnings are largely a result of improvement in stock market conditions from the 1999 third quarter. The increased earnings in the 1999 fourth quarter essentially offset the significantly lower earnings performance of the 1999 third quarter, which coincides with the fluctuations of the S&P 500 Index. Because of the volatility and large declines in the S&P 500 Index during the third quarter of 1999, the Company recorded significant decreases in investment income resulting from unrealized mark-to-market losses on index options. This produced significantly lower earnings in the third quarter of 1999. The S&P 500 Index decline also resulted in lower interest credited to equity-indexed annuity contracts. However, primarily because of policy liability reserving treatments related to minimum guaranteed interest rates, the reduction in annuity contract interest expense was much less than the decline in investment income. For the fourth quarter of 1999, the S&P 500 Index reversed its poor performance of the previous quarter. The S&P 500 Index increased significantly, which increased the Company's investment income from unrealized mark-to-market gains on index options and produced the improved earnings performance for the fourth quarter of 1999.
Quarterly results of operations for 1998 are summarized as follows:
The fourth quarter net earnings in 1998 reflect the following significant items:
Net earnings for the quarter ended December 31, 1998, were $10,482,000 compared to $14,493,000 for the fourth quarter of 1997. Included in results for the quarter are two nonrecurring charges which significantly lowered the Company's earnings. As more fully described in Note 9, Commitments and Contingencies, the Diffie, et al vs. National Western Life Insurance Company and National Annuity Programs, Inc., class action litigation was settled in January, 1999, with the Company agreeing to pay $5,000,000 in the settlement. This amount was accrued in the accompanying financial statements in the fourth quarter of 1998, thereby reducing earnings $3,250,000, after taxes. Also during the fourth quarter of 1998, the Company transferred pension obligations and administrative responsibilities of its nonqualified defined benefit plan to a pension administration firm. The financial effects of the transaction resulted in additional pension expense in the fourth quarter totaling $1,653,000, net of taxes, as described in detail in Note 7, Pension Plans.
(14) SEGMENT AND OTHER OPERATING INFORMATION
(A) Operating Segment Information
In previous years the Company reported two industry segments, life insurance operations and brokerage operations. For the year ended December 31, 1998, the Company implemented Statement of Financial Accounting Standards (SFAS) No. 131, "Disclosures About Segments of an Enterprise and Related Information," and redefined its reportable operating segments as domestic life insurance, international life insurance, and annuities. The Company's segments are organized based on product types and geographic marketing areas.
A summary of segment information, prepared in accordance with SFAS No. 131, is provided below:
Selected Segment Information:
Reconciliations of segment information to the Company's consolidated financial statements are provided below:
(B) Geographic Information
A significant portion of the Company's premiums and contract revenues are from countries other than the United States. Premiums and contract revenues detailed by country are provided below:
Premiums and contract revenues are attributed to countries based on the location of the policyholder. The Company has no significant assets, other than financial instruments, located in countries other than the United States.
(C) Major Agency Relationships
A significant portion of the Company's premiums and deposits were sold through three marketing agencies in recent years. Combined business from these agencies accounted for approximately 29% of total direct premium revenues and universal life and investment annuity contract deposits for 1999. These same three marketing agencies accounted for 26% and 17% of total direct premiums and deposits for 1998 and 1997, respectively.
(15) FAIR VALUES OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:
Investment securities: Fair values for investments in debt and equity securities are based on quoted market prices, where available. For securities not actively traded, fair values are estimated using values obtained from various independent pricing services and the Securities Valuation Office of the National Association of Insurance Commissioners. In the cases where prices are unavailable from these sources, prices are estimated by discounting expected future cash flows using a current market rate applicable to the yield, credit quality, and maturity of the investments.
Cash and short-term investments: The carrying amounts reported in the balance sheet for these instruments approximate their fair values.
Mortgage loans: The fair values of performing mortgage loans are estimated by discounting scheduled cash flows through the scheduled maturities of the loans, using interest rates currently being offered for similar loans to borrowers with similar credit ratings. Fair values for significant nonperforming loans are based on recent internal or external appraisals. If appraisals are not available, estimated cash flows are discounted using a rate commensurate with the risk associated with the estimated cash flows. Assumptions regarding credit risk, cash flows, and discount rates are judgmentally determined using available market information and specific borrower information.
Policy loans: The fair values for policy loans are calculated by discounting estimated cash flows using U.S. Treasury bill rates as of December 31, 1999 and 1998. The estimated cash flows include assumptions as to whether such loans will be repaid by the policyholders or settled upon payment of death or surrender benefits on the underlying insurance contracts. As a result, these assumptions incorporate both Company experience and mortality assumptions associated with such contracts.
Index options: Fair values for index options are based on quoted market prices.
Life interest in Libbie Shearn Moody Trust: The fair value of the life interest is estimated based on assumptions as to future dividends from the Trust over the life expectancy of Mr. Robert L. Moody. These estimated cash flows were discounted at a rate consistent with uncertainties relating to the amount and timing of future cash distributions. However, the Company has limited the fair value to the statutory admitted value of the Trust, as this is the maximum amount to be received by the Company in the event of Mr. Moody's premature death.
Investment annuity and supplemental contracts: Fair values of the Company's liabilities for deferred investment annuity contracts are estimated to be the cash surrender values of each contract. The cash surrender value represents the policyholder's account balance less applicable surrender charges. The fair values of liabilities for immediate investment annuity contracts and supplemental contracts with and without life contingencies are estimated by discounting estimated cash flows using U.S. Treasury bill rates as of December 31, 1999 and 1998.
Fair values for the Company's insurance contracts other than investment contracts are not required to be disclosed. This includes the Company's traditional and universal life products. However, the fair values of liabilities under all insurance contracts are taken into consideration in the Company's overall management of interest rate risk, which minimizes exposure to changing interest rates through the matching of investment maturities with amounts due under insurance and investment contracts.
The carrying amounts and fair values of the Company's financial instruments are as follows:
Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instruments. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular financial instrument. Because no market exists for a portion of the Company's financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
(16) DISCONTINUED BROKERAGE OPERATIONS
Effective July 17, 1995, The Westcap Corporation (Westcap), a wholly owned brokerage subsidiary of National Western Life Insurance Company, discontinued all sales and trading activities in its Houston, Texas, office. In September, 1995, Westcap approved a plan to close its remaining sales office in New Jersey and to cease all brokerage operations. Subsequently, on April 12, 1996, The Westcap Corporation and its wholly owned subsidiary, Westcap Enterprises, Inc., separately filed voluntary petitions for reorganization under Chapter 11 of the U.S. Bankruptcy Code in the United States Bankruptcy Court, Southern District of Texas, Houston Division.
In accordance with generally accepted accounting principles, the assets and liabilities of Westcap have been reclassified in the accompanying consolidated balance sheets to separately identify them as assets and liabilities of discontinued operations. Losses from discontinued brokerage operations have also been reflected separately from continuing operations of the Company. The 1995 losses from discontinued operations resulted in the complete write-off of National Western Life Insurance Company's investment in Westcap on a consolidated basis. However, a $1,000,000 cash infusion was made to Westcap on March 18, 1997, for operational expenses incurred during its bankruptcy. This contribution was reflected as a loss from discontinued operations in 1997.
By order dated August 28, 1998, the United States Bankruptcy Court, Southern District of Texas, Houston Division, confirmed and approved the Third Amended Joint Consensual Plan of Reorganization (the Plan) of The Westcap Corporation and Westcap Enterprises, Inc. Pursuant to the Plan, National Western received credit for the $1,000,000 previously contributed to Westcap in bankruptcy in March, 1997, and paid an additional $14,125,000 to compromise and settle various claims and litigation.
The $14,125,000 was paid by National Western on January 13, 1999. However, the settlement payment was accrued in other liabilities as of December 31, 1998, and reflected as a 1998 loss from discontinued operations in the accompanying financial statements. As part of the bankruptcy reorganization, National Western retained 100% continuing ownership of the reorganized Westcap, and the subsidiary is now operating as a real estate management company.
NATIONAL WESTERN LIFE INSURANCE COMPANY AND SUBSIDIARIES SCHEDULE V VALUATION AND QUALIFYING ACCOUNTS For the Years Ended December 31, 1999, 1998, and 1997 (In thousands)
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
NATIONAL WESTERN LIFE INSURANCE COMPANY
Date: March 29, 2000 /S/ Robert L. Moody
By: Robert L. Moody, Chairman of the Board,Chief Executive Officer, and Director
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signature Title (Capacity) Date
/S/ Robert L. Moody Chairman of the Board, March 29, 2000 Robert L. Moody Chief Executive Officer, and Director (Principal Executive Officer)
/S/ Ross R. Moody President, Chief Operating Officer, March 29, 2000 Ross R. Moody and Director
/S/ Robert L. Busby, III Senior Vice President - March 29, 2000 Robert L. Busby, III Chief Administrative Officer, Chief Financial Officer and Treasurer (Principal Financial Officer)
/S/ Vincent L. Kasch Vice President - Controller and March 29, 2000 Vincent L. Kasch Assistant Treasurer (Principal Accounting Officer)
/S/ Arthur O. Dummer Director March 29, 2000 Arthur O. Dummer
/S/ Harry L. Edwards Director March 29, 2000 Harry L. Edwards
/S/ E. Douglas McLeod Director March 29, 2000 E. Douglas McLeod
/S/ Charles D. Milos Director March 29, 2000 Charles D. Milos
Director March 29, 2000 Frances A. Moody
Director March 29, 2000 Russell S. Moody
/S/ Louis E. Pauls, Jr. Director March 29, 2000 Louis E. Pauls, Jr.
/S/ E.J. Pederson Director March 29, 2000 E.J. Pederson | 32,855 | 220,278 |
32017_1999.txt | 32017_1999 | 1999 | 32017 | Item 1. Business
Elcor Corporation (Registrant), incorporated in 1965 as a Delaware corporation, is a publicly held corporation headquartered in Dallas, Texas. Shares of the Registrant's common stock are traded on the New York Stock Exchange with the ticker symbol - ELK.
Lines of Business
Roofing Products
The Registrant, through Elk Corporation of Dallas and its subsidiaries (Elk), is engaged in the manufacture and sale of premium laminated fiberglass asphalt shingles and accessory roofing products. Elk also manufactures and sells nonwoven fiberglass roofing mats for use in manufacturing asphalt roofing products, and nonwoven mats for use in other industrial applications. Elk's premium laminated fiberglass asphalt shingle manufacturing plants are located in Tuscaloosa, Alabama, Ennis, Texas, and Shafter, California. In August 1999, Elk announced plans to build a fourth major laminated shingle plant in Myerstown, Pennsylvania. Commencement of operations for this new plant is scheduled for the December quarter of calendar year 2000. The Myerstown, Pennsylvania plant is expected to increase Elk's total laminated shingle capacity by approximately 38%.
The major products manufactured at Elk's roofing plants are premium laminated fiberglass asphalt shingles sold under its brand names: Prestique(R) Plus, Prestique I, Prestique II and Capstone(R). In fiscal 1995, Elk introduced Prestique premium laminated fiberglass asphalt shingle product lines with the patented Enhanced High Definition(R) and Raised Profile(TM) look. In addition, Elk also manufactures premium fiberglass asphalt hip and ridge products: Seal-a-Ridge(R) and Z(R) ridge brands. Several other premium asphalt roofing and accessory products are currently under development. Overall, asphalt shingles account for about 90% of the nation's sloped roof market. Premium laminated asphalt shingles account for approximately 37% of the residential sloped asphalt shingle roofing market. About 83% of all asphalt shingles are used in reroofing and remodeling and 17% are used in new construction.
Elk's roofing products are sold by employee sales personnel primarily to roofing wholesale distributors, delivery being made by contract carrier or by customer vehicles from the manufacturing plants or warehouses. Elk's products are distributed nationwide with Texas, California and Florida representing the largest market areas. The Roofing Products segment accounted for approximately 88% of consolidated sales of the Registrant in fiscal 1999. For the past several years, the building materials distribution industry has consolidated at a rapid pace with many smaller independent distributors being acquired by emerging larger national building products distributors. One customer, ABC Supply Co. Inc., the largest roofing wholesale distributor in the United States, accounted for 18% of consolidated sales in fiscal 1999, 16% of consolidated sales in fiscal 1998, and 14% of consolidated sales in fiscal 1997.
Elk operates two nonwoven fiberglass mat lines that run in parallel at its Ennis, Texas facility. Elk's nonwoven fiberglass roofing mat facilities supply all of its internal fiberglass roofing mat needs. In addition, roofing mats are sold by employee sales personnel to other asphalt roofing products manufacturers. Nonwoven mats are also sold to manufacturers of construction and industrial products who use such mats in their products, and to distributors of industrial filtration products. Elk's nonwoven mats are shipped by contract carrier to its other roofing plants and to its customers' locations.
On September 15, 1998, Elk experienced an explosion at its fiberglass roofing mat plant in Ennis, Texas. The explosion significantly damaged a drying oven and caused less extensive damage to the remainder of one mat manufacturing line. There was no damage to the separate mat line that runs in parallel to the damaged line, nor was there any damage to Elk's Ennis, Texas shingle manufacturing plant. There were no injuries from the explosion. The damaged line was restored to partial operation in December 1998. By March 1999, the damaged section had been replaced. In June 1999, the line was operating at line speeds equivalent to line speeds at the time of the explosion. Refer to the "Involuntary Conversion" footnote on page 36 of this Form 10-K for a more detailed discussion of this matter.
During fiscal 1999, Elk made significant progress in developing a family of proprietary Versashield(TM) nonwoven coated products for use in a variety of industrial and consumer applications. A semi-commercial pilot manufacturing line was installed at the Ennis, Texas facility to further development of these products and to initiate market development sales.
Industrial Products
The Registrant, through Chromium Corporation (Chromium), historically has conducted its operations through two business divisions and so operated throughout fiscal 1999. Effective July 1, 1999, Chromium's business divisions were segregated into separate companies. The former Reciprocating Engine Components Division will continue to do business as Chromium Corporation and the former Conductive Coatings Division will be operated as subsidiaries of Cybershield, Inc. (Cybershield).
Cybershield is engaged in electroless shielding of plastic enclosures for digital wireless cellular phones, telecommunications and other electronic equipment. Electroless shielding is designed to control the level of electromagnetic and radio frequency interference (EMI/RFI) emissions generated by microchips and electronic components. Cybershield's product offerings also include dispense conductive gaskets which are formed in place, proprietary plating of die-cast magnesium components, decorative finishes, conductive spray paints and vacuum metalization of plastic components. Sales are generated by employee sales personnel, with delivery made primarily by contract carrier. To keep pace with rapidly growing demand, Cybershield completed a third expansion of its Lufkin, Texas facility during fiscal 1999.
In January 1999, Cybershield acquired YDK America, Inc., located in Canton, Georgia, a leading supplier to the computer industry of electronic plastic enclosures and components having electroless conductive coatings. This acquisition doubled Cybershield's electroless coating capacity and geographically reduced the source concentration risk for its customers. In June 1999, YDK America, Inc. was renamed Cybershield of Georgia, Inc.
Chromium is engaged in the remanufacture of diesel engine cylinder liners, including hard chrome plating of cylinder bores and tin plating of pistons, primarily for the railroad and marine industries; and hard chrome plating of original equipment cylinder liners and tin plating of pistons for major domestic locomotive manufacturers. In the fourth quarter of fiscal 1999, Registrant's management approved a consolidation plan for Chromium's reciprocating engine components business. All operations for this business activity at Lufkin, Texas will be transferred to Chromium's Cleveland, Ohio plant. Relocation and other consolidation items are expected to be completed in the first half of fiscal 2000. Subsequent to the completion of this business consolidation, the Lufkin, Texas facility will be used exclusively for conductive coatings operations.
Another unit of the Registrant, OEL, Ltd., d/b/a Ortloff Engineers, Ltd. (Ortloff) is engaged in providing technology licensing and engineering support services and in providing engineering consulting services to the oil and gas production, gas processing and sulfur recovery industries. Ortloff licenses technology covered by and related to twelve patents owned by the Registrant for use in new or redesigned natural gas and refinery gas processing facilities, and utilizes technology licensed from others and its own expertise in the performance of consulting and engineering assignments. Although one important patent expired in fiscal 1999, Ortloff was awarded three new patents and continues to develop and patent improved processes for natural gas processing. Moreover, Ortloff offers significant expertise and other nonpatented technology associated with its processes that is difficult for customers to obtain on a cost effective basis from others. Ortloff has also been successful in expanding its markets into several parts of Latin America.
Patent license fees are calculated by standard formulas that take into account both specific project criteria and market conditions, adjusted for special conditions that exist in a project. Engineering consulting assignments are performed under consulting services agreements at negotiated rates.
Information as to Industry Segments
For Financial Information by Company Segments, see the table on page 40 of this Annual Report on Form 10-K.
Accounting Change
In fiscal 1999, the Registrant adopted Statement of Position 98-5, "Reporting on the Costs of Start-Up Activities," issued by the Accounting Standards Executive Committee of the America Institute of Certified Public Accountants. The cumulative effect of this change in accounting principle is reported on the Consolidated Statement of Operations.
Competitive Conditions
Roofing Products
Even though the asphalt roofing products manufacturing business is highly competitive, the Registrant believes that Elk is a leading manufacturer of premium laminated fiberglass asphalt shingles. Elk has been able to compete successfully with its competitors, some of which are larger in size and have greater financial resources.
There are a number of major national and regional manufacturers marketing their products in a portion or all of the market areas served by the Registrant's plants. The Registrant competes primarily on the basis of product quality, design and service. Typically, the Registrant is able to sell its roofing products at higher prices than its competitors receive for similar type products.
Industrial Products
The Registrant believes the success of Cybershield in becoming a qualified supplier for and obtaining significant orders from major digital cellular phone manufacturers, together with telecommunications and other electronic equipment manufacturers, has enabled it to become a market leader. The Registrant competes primarily on the basis of product quality, design and service.
The Registrant believes that Chromium is the leading remanufacturer of diesel engine cylinder liners and pistons for the railroad and marine transportation industries and is the primary supplier of hard chrome plated finishes for original equipment diesel engine cylinder liners to all of the major domestic locomotive manufacturers. The Registrant believes it has smaller competitors in the locomotive diesel engine cylinder liner remanufacturing market. Chromium has achieved a leading position in these markets through competition on the basis of product performance, quality, service and price. In addition, technical innovations that enhance quality and performance are also increasing the value-added content per unit produced. However, consolidation in the railroad industry and environmental regulations have fostered a competitive market with more economies of scale and scope. Accordingly, it may be desirable for Chromium to form strategic alliances with customers or others in the supply chain.
The Registrant believes that it holds significant state-of-the-art patents covering some of the most competitive processes for the cryogenic processing of refinery and natural gas streams to remove the higher value components, such as ethane and propane, which are primarily used as petrochemical feedstocks. The Registrant believes that Ortloff has widely recognized expertise in the design and operation of facilities for natural gas and refinery gas processing and sulfur recovery.
Backlog
Backlog was not significant, nor is it material, in the Registrant's operations.
Raw Materials
Roofing Products
In the asphalt roofing products manufacturing business, the significant raw materials are ceramic coated granules, asphalt, glass fibers, resins and mineral filler. All of these materials are presently available from several sources and are in adequate supply. Historically, the Registrant has been able to pass some of the higher raw material and transportation costs through to the customer.
Industrial Products
In the electroless shielding business, copper and nickel are the significant raw materials. These materials are presently available and are in adequate supply. In the Registrant's business of hard chrome plating and remanufacturing diesel engine cylinder liners, chromic acid is a significant raw material which is presently available from a number of domestic suppliers. The Registrant believes these domestic suppliers obtain the ore for manufacturing chromic acid principally from sources outside the United States, some of which may be subject to political uncertainty. The Registrant has been advised by its suppliers that they maintain substantial inventories of chromic acid in order to minimize the potential effects of foreign interruption in ore supply.
No raw materials are utilized in the Registrant's engineering consulting and technology licensing business.
Patents, Licenses, Franchises and Concessions
The Registrant holds certain patents, particularly in its engineering consulting and licensing business, which are significant to its operations. However, the Registrant does not believe that the loss of any one of these patents or of any license, franchise or concession would have a material adverse effect on the Registrant's overall business operations. The Registrant, through its subsidiary, Elk Corporation of Dallas, is involved in patent litigation against GAF Building Materials Corporation and related GAF entities concerning design and utility patents covering certain aspects of Elk's High Definition shingles. Refer to Item 3 "Legal Proceedings" for a more detailed discussion of this matter.
Environmental Matters
The Registrant and its subsidiaries are subject to federal, state and local requirements regulating the discharge of materials into the environment, the handling and disposal of solid and hazardous wastes, and protection of the public health and the environment generally (collectively, Environmental Laws). Certain facilities of the Registrant's subsidiaries ship waste products to various waste management facilities for treatment or disposal. Governmental authorities have the power to require compliance with these Environmental Laws, and violators may be subject to civil or criminal penalties, injunctions or both. Third parties may also have the right to sue for damages and/or to enforce compliance and to require remediation of contamination.
The Registrant and its subsidiaries are also subject to Environmental Laws that impose liability for the costs of cleaning up contamination resulting from past spills, disposal, and other releases of hazardous substances. In particular, an entity may be subject to liability under the Federal Comprehensive Environmental Response, Compensation and Liability Act (CERCLA or Superfund) and similar state laws that impose liability -- without a showing of fault, negligence, or regulatory violations -- for the generation, transportation or disposal of hazardous substances that have caused or may cause, environmental contamination. In addition, an entity could be liable for cleanup of property it owns or operates even if it did not contribute to the contamination of such property. From time to time, the Registrant or its subsidiaries may incur such remediation and related costs at the company owned plants and certain offsite locations.
The Registrant anticipates that its subsidiaries will incur costs to comply with Environmental Laws, including remediating any existing non-compliance with such laws and achieving compliance with anticipated future standards for air emissions and reduction of waste streams. Such subsidiaries expend funds to minimize the discharge of materials into the environment and to comply with governmental regulations relating to the protection of the environment. Neither these expenditures nor other activities initiated to comply with Environmental Laws is expected to have a material impact on the consolidated financial position, net earnings or liquidity of the Registrant.
Persons Employed
At June 30, 1999, the Registrant and its subsidiaries had 1,145 employees. Of this total, 597 were employed in the Roofing Products business segment, 512 were employed in the Industrial Products business segment, and 36 were employed at the corporate office. The Registrant believes that it has good relations with its employees. In the fourth quarter of fiscal 1999, the Registrant's management approved a consolidation plan for Chromium's reciprocating engine components business that will result in the elimination of 64 positions in the first half of fiscal 2000.
Extended Payment Terms
In some years, the Registrant's roofing products business provides extended payment terms to certain customers for some product shipments during the winter and early spring months, with payment generally due during the summer months. As of June 30, 1999, $3,468,000 in receivables relating to such shipments were outstanding, the majority of which are due in the first four months of fiscal 2000. As of August 31, 1999, $1,909,000 of these receivables had been collected.
Seasonal Business
The Registrant's industrial products businesses are substantially nonseasonal. The Registrant's roofing products manufacturing business is seasonal to the extent that cold, wet or icy weather conditions during the late fall and winter months in its marketing areas typically limit the installation of residential roofing products which causes sales to be slower during such periods. Damage to roofs from extreme weather such as severe wind, hurricanes and hail storms can result in higher demand for periods up to eighteen to twenty-four months depending upon the extent of roof damage. Working capital requirements and related borrowings fluctuate during the year because of seasonality. Generally, working capital requirements and borrowings are higher in the spring and summer months, and lower in the fall and winter months.
Item 2.
Item 2. Properties
All significant facilities are owned and unencumbered by liens in favor of nonaffiliates except as discussed herein.
Roofing Products
Asphalt roofing products are manufactured at plants located in Tuscaloosa, Alabama, Ennis, Texas and Shafter, California. A fourth major laminated shingle plant in Myerstown, Pennsylvania is under construction and is scheduled to commence operations in the December quarter of calendar year 2000. Fiberglass roofing mat, nonwoven industrial, reinforcement and filtration products are manufactured on two parallel production lines located in Ennis, Texas.
Corporate headquarters and administrative offices for the asphalt roofing products operations are located in the same leased facility as the Registrant's corporate offices in Dallas, Texas.
Industrial Products
Conductive coatings operating facilities are located in Lufkin, Texas and Canton, Georgia. Plants for the reciprocating engines components business, which primarily are involved in the hard chrome plating of original equipment and remanufactured diesel engine cylinder liners and related equipment, are located in Cleveland, Ohio and Lufkin, Texas. In the first half of fiscal 2000, operations for the reciprocating engine components business will be consolidated and all operations for this business activity will be transferred to Cleveland, Ohio. Subsequent to the completion of this business consolidation, the Lufkin, Texas facility will be used exclusively for Cybershield's conductive coatings operations.
Corporate headquarters and administrative offices for the conductive coatings and reciprocating engines components businesses are located in the same leased facility as the Registrant's corporate offices in Dallas, Texas.
The Ortloff engineering and process licensing group is located in leased offices in Midland, Texas.
Corporate Offices
The Registrant's corporate headquarters is located in leased offices in Dallas, Texas.
In addition, one of the Registrant's subsidiaries owns land and buildings in Waco, Texas, formerly used in the discontinued solid waste handling equipment manufacturing business. This facility is expected to be sold in fiscal 2000.
Item 3.
Item 3. Legal Proceedings
GAF Patent Litigation
On February 8, 1994, a wholly owned subsidiary, Elk Corporation of Dallas (Elk) was granted a design patent covering the ornamental aspects of certain Elk shingles. On December 6, 1994, Elk was granted a utility patent on the functional aspects of certain Elk shingles. Elk has sued GAF Building Materials Corporation and related GAF entities (collectively, GAF) in federal court for infringement of these patents and trade dress. In the design patent case, Elk seeks to recover as damages the total profit that GAF has made from the infringing shingles. In the utility patent case, Elk seeks to recover as damages a reasonable royalty on GAF's sales of infringing shingles and certain lost profits.
GAF seeks a declaratory judgment that the Elk patents are not infringed and are either invalid or unenforceable. GAF has also asserted claims for unfair competition, Lanham Act violations based on alleged false advertising, and common law fraud, generally praying for damages of not less than $25 million including actual and punitive damages, plus interest, costs, and reasonable attorney fees. Elk disputes GAF's claims, and management intends vigorously to defend them and to enforce its intellectual property rights. In April 1998, the District Court for the Northern District of Texas entered a partial final judgment in the design patent case based on an inequitable conduct ruling and certified the case for appeal. On February 11, 1999, the United States Court of Appeals for the Federal Circuit (Court of Appeals) issued a decision upholding the district court's partial final judgment against Elk in its design patent case. The decision held that the district court committed no reversible error in finding Elk's design patent unenforceable. On April 16, 1999, the Court of Appeals denied Elk's petition for a rehearing of the case.
On July 15, 1999, Elk appealed by a petition for certiorari with the United States Supreme Court. GAF filed its opposition in August 1999. Elk expects a Supreme Court decision whether to hear its appeal before the end of fiscal 2000.
While management can give no assurances regarding the ultimate outcome of the litigation, even if the outcome were to be adverse to Elk, it is not expected to have a material effect on the Registrant's consolidated results of operations, financial position or liquidity.
Gibraltar Tort Litigation
In December 1995 through August 1996, Chromium Corporation was sued in four separate tort lawsuits brought by the same attorneys on behalf of numerous plaintiffs who allege unspecified personal injuries and property damages associated with the former operation of a licensed hazardous waste treatment, storage and disposal facility in Smith County, Texas known as the Gibraltar facility. The four suits were brought against or expanded to include the current and former owners and operators of the facility, and more than fifty other defendants, including Chromium and several Fortune 500 companies, as generators of waste sent to the facility (as named in a particular lawsuit, "Generator Defendants").
The plaintiffs non-suited or dismissed the Generator Defendants from two of the cases. In another case, Williams, et al. v. Akzo Nobel Chemicals, Inc., et al., the Smith County (Texas) District Court dismissed Chromium and certain other Generator Defendants, but the ruling dismissing these Generator Defendants was reversed on appeal.
In June 1999, Chromium entered into a settlement agreement involving plaintiffs from the Williams case and Adams v. American Ecology Environmental Services Corporation, a related case pending in the Tarrant County (Texas) District Court since August 1996. Consummation of the settlement is pending. The settlement, which Chromium accrued in the fourth quarter of fiscal 1999, did not have a material adverse effect on the Registrant's consolidated results of operations, financial position, or liquidity. The facility owners and Chromium's insurers have declined or failed to accept Chromium's claims relating to defense and indemnity from the Gibraltar suits, and collection of these claims remains uncertain.
Frontier Chemical Site
In 1993, Chromium entered into an Administrative Order on Consent with the United States Environmental Protection Agency (USEPA) under which Chromium and other Potentially Responsible Parties (PRPs) agreed to perform Phase I response activities at the Frontier Chemical Royal Avenue Site (Site), a former state-permitted waste processing and management facility in New York and to reimburse USEPA for response costs incurred by USEPA at the Site. All of the Phase I work was concluded in 1994. Chromium was assessed a total of $109,250 of the $4 million cost estimate assessed to all Phase I PRPs. Chromium has not been and does not expect to be named as a PRP in any subsequent phases of cleanup.
Chromium's final assessment in this matter net of all recoveries cannot be calculated until its PRP group determines which assessments are uncollectible, and certain proceedings to share in proceeds of a closure bond or to challenge USEPA cost reimbursement calculations are finally resolved. Management of the Registrant believes that future offsets or other adjustments to the original assessment will be relatively nominal, and that the final disposition of this matter will not have a material adverse effect on the Registrant's consolidated results of operations, financial position, or liquidity.
Other
There are various other lawsuits and claims pending against the Registrant and its subsidiaries arising in the ordinary course of their businesses. In the opinion of the Registrant's management based in part on advice of counsel, none of these actions should have a material adverse effect on the Registrant's consolidated results of operations, financial position, or liquidity.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
Inapplicable.
Executive Officers of the Registrant
Certain information concerning the Registrant's executive officers is set forth below:
All of the executive officers except Mr. Sisler have been employed by the Registrant or its subsidiaries in responsible management positions for more than the past five years. In July 1996, Mr. Rosebery and Mr. Work were appointed as Directors of the Registrant. On August 18, 1997, Mr. Work and Mr. Rosebery were each elected as Vice Chairmen. On August 26, 1997, Mr. Work was elected as Chairman of the Board, President and Chief Executive Officer of the Registrant following the death on August 22, 1997 of Mr. Roy E. Campbell, who previously held those positions. In June 1997, Mr. Holguin was elected as Vice President, Information Systems. Previously Mr. Holguin was Assistant Vice President, Information Systems.
On August 14, 1995, Mr. Sisler was appointed by the Board of Directors as Vice President, General Counsel and Secretary of the Registrant. Mr. Sisler was employed by Central and South West Corporation from 1991 to 1995, most recently as a Senior Attorney. Mr. Sisler has practiced law for more than fifteen years and his responsibilities have included corporate, securities and other business legal matters in several industries.
Officers are elected annually by the Board of Directors.
PART II
Item 5.
Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters
The principal market on which the Registrant's common stock is traded is the New York Stock Exchange. Registrant's common stock is also traded on the Boston, Midwest and Philadelphia Stock Exchanges. There were 964 holders of record and approximately 3,438 beneficial shareholders of the Registrant's common stock at September 7, 1999.
The quarterly dividend declared per share and the high and low prices in dollars per share on Registrant's common stock for each quarter during fiscal year 1999 and fiscal year 1998, adjusted for a three-for-two stock split declared in June 1999, are set forth in the following tables:
After the completion of a previous stock repurchase program authorized in 1994, in September 1998, the Registrant's Board of Directors authorized the purchase of up to $10,000,000 of additional common shares from time to time on the open market to be used for general corporate purposes. As of June 30, 1999, 129,992 shares with cumulative cost of $1,771,000 had been repurchased under the new repurchase program. In June 1999, the regular quarterly cash dividend was increased to $.05 per common share (after giving effect to a stock split) and a three-for-two stock split payable in the form of a stock dividend was declared, to be distributed on August 11, 1999 to shareholders of record on July 15, 1999.
The limitations affecting the future payment of dividends by Registrant imposed as a part of the Registrant's revolving credit agreement are discussed under the caption "Notes to Consolidated Financial Statements" under the heading "Long-Term Debt" on page 32 of this Annual Report on Form 10-K.
Item 6.
Item 6. Selected Financial Data
The following selected consolidated financial data for each of the five years in the period ended June 30, 1999 have been derived from the audited consolidated financial statements of the Registrant included herein. The selected consolidated financial data set forth below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the consolidated financial statements and notes thereto included elsewhere in this report.
FIVE-YEAR SUMMARY OF SELECTED FINANCIAL DATA
(1) Adjusted for a three-for-two stock split declared in June 1999.
(2) 1996 results include $1,595 in pretax charges in connection with a provision for the adoption of SFAS No. 121 and a previous reduction in value of certain other assets.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
RESULTS OF OPERATIONS
OPERATING SEGMENTS
In accordance with the requirements of FASB SFAS No. 131, the company is segregated into two segments: Roofing Products and Industrial Products. The Roofing Products Group consists of the various operating subsidiaries of Elk Corporation of Dallas (collectively Elk). These companies manufacture and sell premium laminated fiberglass asphalt residential and accessory roofing products, together with nonwoven mats used in manufacturing asphalt roofing products and various industrial applications. Elk accounted for 88% of consolidated sales in fiscal 1999.
The Industrial Products Group is comprised of three diverse businesses: (1) conductive coatings used in digital wireless cellular phones and in other electronic equipment; (2) remanufactured reciprocating engine components used in the railroad and marine transportation industries; and (3) technology licensing and consulting services for the natural gas processing industry. None of the three Industrial Products businesses individually accounted for 10% of consolidated sales, operating income or assets in fiscal 1999.
Historically, the first two businesses in the Industrial Products Group were operated as separate divisions of Chromium Corporation. Effective July 1, 1999, Chromium's operations were segregated into separate companies. Reciprocating engine components will continue to do business as Chromium Corporation and conductive coatings will be operated as subsidiaries of Cybershield, Inc. The technology licensing and consulting services business will continue to be conducted as Ortloff Engineers, Ltd.
FISCAL 1999 COMPARED TO FISCAL 1998
During the fiscal year ended June 30, 1999, income before the cumulative effect of a change in accounting principle increased 38% to $25,283,000 from $18,324,000 in fiscal 1998. Sales increased 19% compared to the prior fiscal year. The increases in sales and income before the accounting change were primarily the result of increased production, a record level of shipments of premium laminated fiberglass asphalt shingles, and accelerating demand for the company's Compushield(R) products used in digital wireless cellular phones. In the first quarter of fiscal 1999, the company adopted Statement of Position 98-5, "Reporting on the Costs of Start-Up Activities," issued by the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants, which resulted in a $4,340,000 charge, net of tax, for the cumulative effect of this accounting change. This one-time cumulative charge reduced net income for fiscal 1999 to $20,943,000 compared to $18,324,000 in the prior fiscal year.
Sales for the Roofing Products Group increased 22% in fiscal 1999 to $278,918,000 from $229,475,000 in fiscal 1998. Each of the company's three roofing plants recorded increased sales as a result of strong demand in most regions of the United States. Elk's shipments were aided by relatively mild weather during the winter months (which permitted increased roofing activity in Elk's seasonally slower period) together with sharply higher demand throughout the
fiscal year in the residential roofing replacement market. Average selling prices were slightly higher in fiscal 1999 compared to fiscal 1998 and customer discounts were lower.
Operating income for the Roofing Products Group increased 81% in fiscal 1999 to $45,061,000 from $24,885,000 in fiscal 1998. Each of the three roofing plants achieved significantly higher operating income in fiscal 1999 as compared to fiscal 1998 as a result of increased manufacturing output and a record level of shipments of premium laminated fiberglass asphalt shingles. Elk's nonwoven fiberglass roofing mat plant also contributed to improved results for the Roofing Products Group. However, a dryer on one production line was damaged by an explosion on September 15, 1998 and the damaged line was shut down or ran at curtailed line speeds for much of fiscal 1999. Due to the company's property damage and business interruption insurance policies, this explosion did not have a material effect on the company's results of operations, financial position or liquidity. As of June 1999, the plant was again running at line speeds equivalent to line speeds at the time of the explosion.
The company currently anticipates continued strong demand for its premium laminated asphalt shingles and mat products in fiscal 2000. The company expects certain raw material costs, particularly asphalt and fiberglass, and shipping and warehousing costs to increase in fiscal year 2000. However, the company believes that anticipated increases in these costs can be offset by price increases on its products, improved manufacturing efficiencies, better raw material usage, and freight and warehousing strategies to maximize shipments.
Sales for the Industrial Products Group increased 1% in fiscal 1999 to $38,816,000 from $38,586,000 in fiscal 1998. Operating income for this Group decreased to $3,566,000 in fiscal 1999 from $10,780,000 in fiscal 1998. During fiscal 1999, the company continued to benefit from strong demand for Compushield(R) conductive coatings and formed-in-place dispense gaskets used in digital wireless cellular phones and other electronic products. Improved sales and operating results for conductive coatings, however, were offset by lower sales and reduced income at Chromium's Reciprocating Engine Components Division and at Ortloff Engineers. The Reciprocating Engine Components Division experienced lower demand for remanufactured large diesel engine components used in the railroad and marine transportation industries, due primarily to further consolidation of the railroad industry and a reduction in maintenance requirements by some of its customers. Chromium is consolidating its operations to its Cleveland, Ohio facility. Estimated costs to relocate equipment and other consolidation items of $1,145,000 are expected to be incurred and expensed in the first half of fiscal 2000. Severance costs of $375,000 relating to terminating employees at its Lufkin, Texas facility were recorded in fiscal 1999. In the fourth quarter of fiscal 1999, Chromium also recorded a $250,000 pretax charge to settle some long-standing third party tort litigation.
Ortloff's patent licensing and engineering consulting services to the petroleum industry were significantly lower in fiscal 1999 as a result of depressed oil prices during much of the fiscal year, causing many of its customers to temporarily reduce capital spending plans. Prospects for fiscal 2000 are improved due to a recovery of oil prices in the latter half of fiscal 1999.
On January 11, 1999, a subsidiary of the company acquired YDK America, Inc. (renamed Cybershield of Georgia, Inc. in June 1999). Operations of this acquired company were included in fiscal 1999 operations subsequent to its acquisition, but were not material.
Overall selling, general and administrative (SG&A) costs in fiscal 1999 increased 13.5% from fiscal 1998, primarily as a result of increased business activity. As a percentage of sales, SG&A costs in fiscal 1999 declined to 12.5% of sales from 13.0% in fiscal 1998.
Interest expense in fiscal 1999 was $2,059,000 compared to $2,577,000 in fiscal 1998. In fiscal 1999, the company capitalized $595,000 in interest costs in connection with the construction of major projects, compared to $160,000 capitalized in fiscal 1998.
FISCAL 1998 COMPARED TO FISCAL 1997
During the fiscal year ended June 30, 1998, sales increased 16% to $268,178,000 from the $230,756,000 reported in fiscal 1997. Net income in fiscal 1998 increased 49% to $18,324,000 from $12,276,000 in the prior fiscal year. Both the Roofing Products and Industrial Products Groups generated significant increases in sales. The Roofing Products Group reported better operating results in fiscal 1998 as compared to the prior fiscal year. However, the substantial increase in net income was primarily attributable to increased demand and dramatically improved operating results in each of the Industrial Products Group's principal operations.
Sales for the Roofing Products Group increased 11% in fiscal 1998 to $229,475,000 from $207,017,000 in fiscal 1997. The Western United States produced very strong demand for Elk Prestique premium laminated shingles. However, shipments on the West Coast were limited during much of the second half of fiscal 1998 by El Nino's impact, as many roofing contractors could not replace leaking roofs during extended periods of heavy rainfall. Demand was also higher in the Southeast, Midwest and North regions. Only in the Southwestern region was demand lower than in the previous fiscal year. Average selling prices were about the same in fiscal 1998 compared to fiscal 1997.
Elk's roofing mat operations achieved significantly higher sales and operating profit, primarily as a result of growing demand for its high quality roofing mats and specialty industrial products.
Operating income for the Roofing Products Group increased 18% in fiscal 1998 to $24,885,000 from $21,052,000 in fiscal 1997. Each of Elk's three roofing plants and its roofing mat operation were very profitable in fiscal 1998, although the Ennis, Texas roofing plant's operating results were lower in fiscal 1998 as a result of lower demand in the Southwestern region. The impact of high winds and heavy rainfall in much of the nation during the winter months increased the level of demand during the latter months of fiscal 1998.
Sales for the Industrial Products Group increased 64% in fiscal 1998 to $38,586,000 from $23,542,000 in fiscal 1997. Operating income for this Group increased to $10,780,000 in fiscal 1998 from $3,498,000 in fiscal 1997. Each of the three principal operations in this business segment reported significantly higher sales and operating income in fiscal 1998. Cybershield continued to benefit from strong demand for its Compushield conductive coatings and dispense conductive gasketing used in digital wireless cellular phones and in other electronic equipment. Chromium also experienced higher sales and significantly improved margins in plating certain proprietary finishes for large diesel engine components during fiscal 1998. Further, Ortloff Engineers' revenues from its technology licensing and consulting services for the natural gas
processing industry about doubled in fiscal 1998 as compared to fiscal 1997. This resulted in a tripling of operating income for this business activity in fiscal 1998.
SG&A costs in fiscal 1998 increased 12.9% from fiscal 1997 primarily as a result of increased business activity. As a percentage of sales, SG&A costs declined to 13.0% of sales in fiscal 1998 from 13.4% of sales in fiscal 1997.
Interest expense in fiscal 1998 was $2,577,000 compared to $1,136,000 in fiscal 1997. In fiscal 1997, $1,784,000 of interest was capitalized in connection with the company's major facilities expansion program. In fiscal 1998, the company capitalized $160,000 in interest costs in connection with its existing plant expansion program.
LIQUIDITY AND CAPITAL RESOURCES
The company generated cash flows from operating activities of $23,391,000 in fiscal 1999, despite a $12,079,000 increase in working capital. The increase in working capital was primarily the result of higher trade receivables and a receivable from an insurance company relating to an explosion at the company's nonwoven fiberglass roofing mat plant. Trade receivables increased primarily as a result of higher sales activities, especially during the last two months of fiscal 1999 (the period to which most outstanding trade receivables apply), when the company achieved a 28% year to year increase. At June 30, 1999, deferred payment term receivables from promotional programs to certain customers were $3,468,000 compared to $6,299,000 at June 30, 1998. Deferred receivables outstanding at June 30, 1999, are primarily due during the first four months of fiscal 2000. The increase in receivables was partially offset by lower inventories and higher current liabilities. The current ratio was 3.3 to 1 at June 30, 1999 and 3.5 to 1 at June 30, 1998. Historically, working capital requirements and associated borrowings fluctuate during the year because of seasonality in some market areas. Generally, working capital requirements and borrowings are higher in the spring and summer, and lower in the fall and winter.
The company used $29,797,000 for net investing activities in fiscal 1999. The majority of investing expenditures were for additions to property, plant and equipment. Capital expenditures totaling approximately $5,500,000 in fiscal 1999 relate to replacement of equipment at the Ennis, Texas mat plant damaged by an explosion. Most of the expenditures incurred to replace damaged equipment are expected to be covered by the company's property damage insurance policy. The majority of other fiscal 1999 capital expenditures are a continuation of productivity, capacity and cost improvement projects at its existing roofing and conductive coatings facilities, capital costs associated with developing new computer systems and expenditures relating to a fourth major laminated shingle plant. In January 1999 a subsidiary of the company acquired YDK America, Inc. for approximately $5,588,000 to expand capacity for its conductive coatings business. The company expects to invest about $137,000,000 over a three-year period beginning in fiscal 2000 to expand capacity and improve productivity at existing plants, to install production facilities for new products, to build a new roofing plant, and to increase capacity for Cybershield's conductive coatings business.
Cash flows provided by financing activities were $5,352,000 during fiscal 1999, primarily resulting from a $15,000,000 increase in long-term debt, offset by dividend payments and purchases of treasury shares. Long-term debt represented 31% of the $200,251,000 of invested capital (long-term debt plus shareholders' equity) at June 30, 1999. At June 30, 1999,
$34,860,000 was available under the company's $100,000,000 unsecured revolving line of credit. During fiscal 1999, the company purchased 429,900 shares of its common shares on the open market under SEC Rule 10b-18 at a total cost of $6,305,000 and completed the $10,000,000 stock repurchase program authorized by the Board of Directors in September 1994. On September 28, 1998, the Board of Directors authorized an additional $10,000,000 stock repurchase program.
In June 1999, the Board of Directors increased the regular quarterly cash dividend to five cents per common share (after giving effect to a stock split) and declared a three-for-two stock split payable in the form of a stock dividend distributed on August 11, 1999 to shareholders of record on July 15, 1999.
The company is planning to increase its unsecured revolving credit facility from $100,000,000 to $125,000,000 in fiscal 2000 to support its capital expansion program. Management believes that current cash and cash equivalents, cash flows from operations and its unsecured revolving credit facility should be sufficient during fiscal 2000 and beyond to fund its planned capital expenditures, working capital needs, dividends, stock repurchases and other cash requirements.
NEW ACCOUNTING STANDARDS
In June 1997, FASB issued SFAS No. 130, "Reporting Comprehensive Income," which establishes standards of reporting of comprehensive income and its components in the consolidated financial statements. The company adopted SFAS No. 130 in fiscal 1999. The adoption of SFAS No. 130 had no effect on the consolidated financial statements as the company has no items that are required to be included as components of comprehensive income.
Also in June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." SFAS No. 131 requires public companies to disclose, among other things, certain interim and annual financial information about the enterprise using a new management approach. The management approach requires segment information to be reported based on how management evaluates the operating performance of its business units or segments. The company adopted SFAS No. 131 in fiscal 1999, but this adoption did not change the company's reportable segments.
In February 1998, the FASB issued SFAS No. 132, "Employers' Disclosures about Pensions and Other Post Retirement Benefits." The company has no significant pension or post retirement benefit plans affected by this statement.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." At June 30, 1999, the company has entered into no significant derivative instruments or hedging activities, although the company regularly reviews the potential benefits of interest rate swap arrangements and may enter into derivative instruments from time to time in the future.
YEAR 2000 ISSUE
The company is currently developing a new information system for most of its critical financial, distribution and manufacturing applications. The system is scheduled for completion and implementation before December 31, 1999 at an estimated total cost of about $11,000,000. While the primary purpose of this new information system is to modernize and improve the company's operations, it is also expected to resolve the Year 2000 issues in these critical computer systems. Costs to develop this new information system are being capitalized. Other costs relating to Year 2000 readiness are being expensed as incurred. As of June 30, 1999, the company's expenditures for its new information system have been $9,032,000, and its expenditures for its Year 2000 readiness projects have been less than $300,000. At this time, other than the cost of developing and implementing its new information system, the company does not believe that the costs of addressing the Year 2000 issue will be material. The company does not believe that other critical information systems work has been deferred due to its Year 2000 efforts.
Using teams of employees and consultants, the company has completed its review and testing of other computer applications and systems not included in the scope of the new information system, including embedded technology, for Year 2000 readiness. The company expects to have completed any required remediation before January 1, 2000. The company has developed contingency plans for its critical information system which primarily consist of making its existing information system Year 2000 compliant in the event the new system is not completed by its scheduled date. The company has completed and tested its remedial programming for its existing computer system and believes this system to be Year 2000 compliant.
The company has made inquiries of key suppliers and other third parties with whom it has significant business relationships to assess their state of readiness in addressing Year 2000 issues that could adversely impact the company. The company has requested a written response from those third parties that they will be Year 2000 compliant by the end of calendar 1999. The company has no means of ensuring that its business partners will be fully Year 2000 compliant. Contingency plans for what the company determines to be the most reasonably and likely worst case scenario are being developed. Disruptions of financial markets or computer system failure at government agencies, financial institutions, utilities and others on which the company is dependent could adversely affect the company. The effects of a potential disruption at these entities cannot be determined at this time.
The company believes the Year 2000 readiness project is on schedule for timely completion. Based on a current assessment of risks relating to its Year 2000 readiness, the company does not believe that this issue will result in uncertainty that is reasonably likely to materially affect future financial results or operating performance.
FORWARD-LOOKING STATEMENTS
In an effort to give investors a well-rounded view of the company's current condition and future opportunities, management's discussion and analysis of the results of operations and financial condition and other sections of this Form 10-K contain "forward-looking statements" about its prospects for the future. Such statements are subject to certain risks and uncertainties which could cause actual results to differ materially from those projected. Such risks and uncertainties include, but are not limited to the following:
1. The company's roofing products business is substantially non-cyclical, but can be affected by weather and the availability of financing and general economic conditions. In addition, the asphalt roofing products manufacturing business is highly competitive. Actions of competitors, including changes in pricing, or slowing demand for asphalt roofing products due to general or industry economic conditions or the amount of inclement weather could result in decreased demand for the company's products, lower prices received or reduced utilization of plant facilities. Further, changes in building codes and other standards from time to time can cause changes in demand, or increases in costs that may not be passed through to customers.
2. In the asphalt roofing products business, the significant raw materials are ceramic coated granules, asphalt, glass fibers, resins and mineral filler. Increased costs of raw materials can result in reduced margins, as can higher trucking and rail costs. Historically, the company has been able to pass some of the higher raw material and transportation costs through to the customer. Should the company be unable to recover higher raw material and/or transportation costs from price increases of its products, operating results could be lower than projected.
3. During fiscal 1997, the company completed the construction of a plant at the company's Ennis, Texas facility to manufacture nonwoven fiberglass roofing mats and other mats for a variety of industrial uses. The company also expects to make about $137 million in new investments to expand capacity and improve productivity at existing plants and to build new plants over a three year period beginning in fiscal 2000. Progress in achieving anticipated operating efficiencies and financial results is difficult to predict for new plant facilities. If such progress is slower than anticipated, if substantial cost overruns occur in building new plants, or if demand for products produced at new plants does not meet current expectations, operating results could be adversely affected.
4. Certain facilities of the company's industrial products subsidiaries must utilize hazardous materials in their production process. As a result, the company could incur costs for remediation activities at its facilities or off-site, and other related exposures from time to time in excess of established reserves for such activities.
5. The company's litigation, including its patent infringement suits against GAF Building Materials Corporation and certain affiliates, is subject to inherent and case-specific uncertainty. The outcome of such litigation depends on numerous interrelated factors, many of which cannot be predicted.
6. Even with fully developed action and contingency plans for Year 2000 readiness, it is possible that the company will not achieve full internal readiness. Further, the company's business may be adversely affected by external Year 2000 disruption that the company is not in position to control, including but not limited to potential disruptions in power and other energy supplies, telecommunications or other infrastructure, potential disruptions in transportation and the supply of raw materials, and potential disruptions in financial and banking systems. Year 2000 problems therefore could result in unanticipated expenses or liabilities, production or disruption delays or other adverse effects on the company.
7. Although the company currently anticipates that most of its needs for new capital in the near future will be met with internally generated funds and borrowings under its unsecured revolving credit facilities, significant increases in interest rates could substantially affect its borrowing costs under its existing loan facility, or its cost of alternative sources of capital.
8. Each of the company's businesses, especially Cybershield's conductive coatings business, is subject to the risks of technological changes that could affect the demand for or the relative cost of the company's products and services, or the method and profitability of the method of distribution or delivery of such products and services. In addition, the company's businesses each could suffer significant setbacks in revenues and operating income if it lost one or more of its largest customers.
9. Although the company insures itself against physical loss to its manufacturing facilities, including business interruption losses, natural or other disasters and accidents, including but not limited to fire, earthquake, damaging winds and explosions, operating results could be adversely affected if any of its manufacturing facilities became inoperable for an extended period of time due to such events.
10. Each of the company's businesses is actively involved in the development of new products, processes and services which are expected to contribute to the company's long-term growth and earnings. If such development activities are not successful, or the company cannot provide the requisite financial and other resources to successfully commercialize such developments, the growth of future sales and earnings may be adversely affected.
Parties are cautioned not to rely on any such forward-looking beliefs or judgments in making investment decisions.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
The Registrant's exposure to market risk from changes in foreign currency risk is not material. The Registrant's outstanding debt has a variable interest rate. Changes in market rates effect interest paid by the Registrant. The Registrant has not entered into any significant derivative instruments or hedging activities, although the Registrant regularly reviews the potential benefits of interest rate swap arrangements and may enter into derivative instruments from time to time in the future.
Item 8.
Item 8. Financial Statements and Supplemental Data
Index to Financial Statements and Financial Statement Schedule
All other schedules are omitted because they are not required, are not applicable, or the information is included in the financial statements or notes thereto.
INDEPENDENT AUDITORS' REPORT
To the Shareholders and Board of Directors, Elcor Corporation
We have audited the accompanying consolidated balance sheets of Elcor Corporation (a Delaware corporation) and subsidiaries as of June 30, 1999 and 1998, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the three years then ended June 30, 1999. These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Elcor Corporation and subsidiaries as of June 30, 1999 and 1998, and the results of their operations and their cash flows for each of the three years then ended June 30, 1999, in conformity with generally accepted accounting principles.
/s/ Arthur Andersen LLP ----------------------------- Arthur Andersen LLP
Dallas, Texas August 16, 1999
CONSOLIDATED BALANCE SHEET
================================================================================ The Summary of Significant Accounting Policies and Notes to Consolidated Financial Statements are an integral part of this statement.
CONSOLIDATED STATEMENT OF OPERATIONS
================================================================================ The Summary of Significant Accounting Policies and Notes to Consolidated Financial Statements are an integral part of this statement.
CONSOLIDATED STATEMENT OF CASH FLOWS
================================================================================ The Summary of Significant Accounting Policies and Notes to Consolidated Financial Statements are an integral part of this statement.
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
================================================================================ The Summary of Significant Accounting Policies and Notes to Consolidated Financial Statements are an integral part of this statement.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF BUSINESS
Elcor Corporation (the company), through subsidiaries, is engaged in two lines of business: Roofing Products and Industrial Products. The Roofing Products segment, which accounts for 88% of consolidated sales, manufactures and sells premium laminated fiberglass asphalt residential shingles and accessory roofing products, together with nonwoven mats used in manufacturing asphalt roofing products and various industrial applications. The Industrial Products group of companies, none of which individually accounted for 10% of consolidated sales, operating income or assets in fiscal 1999, is engaged in the shielding of plastic enclosures used in digital wireless cellular phones and other electronic products from electromagnetic and radio frequency interference, the plating of proprietary finishes for large diesel engine cylinder liners and pistons, and engineering consulting services and licensing of patented technologies for the cryogenic processing of natural gas and refinery gas and sulfur recovery processes for the petroleum industry.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the company and all subsidiaries after elimination of significant intercompany balances and transactions. Service revenues and related expenses are not disaggregated in the Consolidated Statement of Operations due to immateriality. Appropriate references to number of shares and earnings per share information has been adjusted as a result of a three-for-two stock split declared in June 1999.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles 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 reporting period. Actual results could differ from those estimates.
CONCENTRATION OF CREDIT RISK
The majority of the company's sales are in the Roofing Products segment and its primary customers are building materials distributors. For the past several years, the building materials distribution industry has consolidated at a rapid pace with many smaller independent distributors being acquired by emerging larger national building products distributors. The company performs ongoing credit evaluations and maintains reserves for potential credit losses. One customer accounted for 18%, 16% and 14% of consolidated sales in fiscal years 1999, 1998 and 1997, respectively.
REVENUE RECOGNITION
Revenue is recognized at the time products are shipped to the customer or at the time services are rendered.
INVENTORIES
Inventories are stated at the lower of cost (including direct materials, labor, and applicable overhead) or market, using the first-in, first-out (FIFO) method. Inventories were comprised of:
PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment are stated at cost. Major renewals and improvements are capitalized, while maintenance and repairs are expensed when incurred. Depreciation is computed over the estimated useful lives of depreciable assets using the straight-line method. Useful lives for property and equipment are as follows:
Buildings and improvements 10 - 40 years Machinery and equipment 5 - 20 years Computer equipment 3 - 6 years Office furniture and equipment 5 - 12 years
The cost and accumulated depreciation for property, plant and equipment sold, retired, or otherwise disposed of are relieved from the accounts, and resulting gains or losses are reflected in income. Interest is capitalized in connection with the construction of major projects. The capitalized interest is recorded as part of the asset to which it relates and is amortized over the asset's estimated useful life. In 1999, 1998 and 1997, $595,000, $160,000 and $1,784,000 of interest cost was capitalized, respectively.
OTHER ASSETS
Included in other assets in the Consolidated Balance Sheet is the excess of cost over the fair value of net assets (or goodwill) of an acquired company. Goodwill totaling $892,000 is amortized on a straight-line basis over 20 years.
LONG-LIVED ASSETS
The company assesses long-lived assets for impairment under Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." The carrying amount of long-lived assets, including goodwill, is reviewed if facts and circumstances suggest that it may be impaired. If this review indicates that long-lived assets will not be recoverable, as determined based on the estimated undiscounted cash flows of the long-lived assets over the remaining amortization period, the carrying amount of the long-lived assets is reduced by the estimated shortfall of cash flows.
INCOME TAXES
Deferred income taxes are provided to reflect temporary differences between the financial reporting basis and the tax basis of the company's assets and liabilities using presently enacted tax rates.
SUPPLEMENTAL CASH FLOWS
The company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. Supplemental cash flow amounts were as follows:
ACCOUNTING CHANGE
In April 1998, the Accounting Standards Executive Committee (AcSec) of the American Institute of Certified Public Accountants issued Statement of Position 98-5, "Reporting on the Costs of Start-Up Activities," requiring, among other things, companies to expense on a current basis previously capitalized start-up costs. The company adopted this Statement of Position in fiscal 1999, which resulted in a $4,340,000 charge, net of tax, and is reported as a cumulative effect of change in accounting principle on the Consolidated Statement of Operations.
NEW ACCOUNTING STANDARDS
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income," which establishes standards of reporting of comprehensive income and its components in the consolidated financial statements. The company adopted SFAS No. 130 in fiscal 1999. The adoption of SFAS No. 130 had no effect on the consolidated financial statements as the company has no items that are required to be reported as components of comprehensive income.
Also in June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." SFAS No. 131 requires public companies to disclose, among other things, certain interim and annual financial information about the enterprise using a new management approach. The management approach requires segment information to be reported based on how management evaluates the operating performance of its business units or segments. The company adopted SFAS No. 131 in fiscal 1999, but this adoption did not change the company's reportable segments.
In February 1998, the FASB issued SFAS No. 132, "Employers' Disclosures about Pensions and Other Post Retirement Benefits." The company has no significant pension or post retirement benefit plans affected by this statement.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." At June 30, 1999, the company had entered into no significant derivative instruments or hedging activities, although the company regularly reviews the potential benefits of interest rate swap arrangements and may enter into derivative instruments from time to time in the future.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
EARNINGS PER SHARE
Basic earnings per share were computed by dividing net income by the weighted average number of shares of common stock outstanding during the year, adjusted for a three-for-two stock split declared in June 1999. The reconciliation of basic earnings per share to diluted earnings per share is shown in the following table:
LONG-TERM DEBT
The company maintains an unsecured revolving credit facility (Facility) of $100,000,000 of primary credit, including up to a maximum of $5,000,000 in letters of credit, through December 15, 2002. At June 30, 1999, letters of credit totaling $2,140,000 were outstanding.
Borrowings under the Facility bear interest at (1) the higher of the federal funds rate plus .5% or the lender's prime rate, or (2) at the company's option, LIBOR, in each case plus specified basis points based on the ratio of the company's total indebtedness to total capital. The Facility also provides for a commitment fee on the average unused portion of the line and is also based on the ratio of the company's total indebtedness to total capital. Based on financial ratios at June 30, 1999, the LIBOR borrowing rate was LIBOR plus .5% and the commitment fee was .175% of the average unused portion of the line. The average interest rate paid on indebtedness in fiscal 1999 was 6.1%.
The loan agreement, among other things, limits the sale or pledging of assets of subsidiaries involved in manufacturing asphalt roofing products, and requires maintenance of specified current ratios, capitalization ratios and cash flow levels. Dividend payments and stock repurchases are limited to certain specified levels. At June 30, 1999, total cumulative dividend payments and stock repurchased since July 1, 1993 were subject to a $40,095,000 limitation. Actual expenditures for these items as of June 30, 1999 have been $23,214,000.
SHAREHOLDERS' EQUITY
Authorized common stock, par value $1.00, is 100,000,000 shares, of which 19,988,354 shares were issued at June 30, 1999. The Board of Directors is authorized to issue up to 1,000,000 shares of preferred stock, without par value, in one or more series and to determine the rights, preferences, and restrictions applicable to each series. No preferred stock has been issued.
In June 1999, the Board of Directors declared a three-for-two stock split payable in the form of a stock dividend which was distributed on August 11, 1999 to shareholders of record on July 15, 1999. An amount equal to the par value of the common shares issued in connection with the split was transferred from paid-in capital to the common stock account. Appropriate references to number of shares and to per share information in the Consolidated Financial Statements have been adjusted to reflect the stock split on a retroactive basis.
SHAREHOLDER RIGHTS PLAN
On May 26, 1998, the company's Board of Directors adopted a new Shareholder Rights Plan which took effect when the existing rights plan expired on July 8, 1998. Under the new plan, rights were constructively distributed as a dividend at the rate of one right for each share of common stock of the company held by the shareholders of record as of the close of business on July 8, 1998. Until the occurrence of certain events, the rights are represented by and traded in tandem with common stock. Each right will separate and entitle shareholders to buy stock upon an occurrence of certain takeover or stock accumulation events. Should any person or group (Related Person) acquire beneficial ownership of 15% or more of the company's common stock other than certain bona fide institutional investors to whom a 20% threshold applies, all rights not held by the Related Person become rights to purchase one one-hundredth of a share of preferred stock for $110 or $110 of Elcor common stock at a 50% discount. If after such an
event the company merges, consolidates or engages in a similar transaction in which it does not survive, each holder has a "flip over" right to buy discounted stock in a surviving entity.
Under certain circumstances, the rights are redeemable at a price of $0.01 per right. Further, upon defined stock accumulation events, the Board of Directors has the option to exchange one share of common stock per right. The rights will expire by their terms on July 8, 2008.
EMPLOYEE BENEFIT PLANS
The company's Incentive Stock Option Plan provides for the granting of incentive and non-qualified stock options to directors, officers and key employees of the company for purchase of the company's common stock.
Information relating to options is as follows:
The following table summarizes information about options outstanding at June 30, 1999:
At June 30, 1999, 1998 and 1997, 354,570, 314,720 and 327,347 shares were exercisable, respectively. A total of 1,907,003, 375,096 and 595,907 shares were reserved for future grants at June 30, 1999, 1998 and 1997, respectively.
Beginning in fiscal 1997, the company adopted the disclosure-only provisions of SFAS No. 123, "Accounting for Stock-Based Compensation." Accordingly, no compensation cost has been recognized with respect to the company's stock option plan. Pro forma information regarding net income and income per share set forth below has been determined as if the company had accounted for its stock options under the fair value methodology prescribed by SFAS No. 123. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions for fiscal 1999, 1998 and 1997; dividend yields of 1.1%, 1.1% and 1.5%; risk-free interest rates of 4.6%, 6.2% and 6.5%; expected market price volatility of .416, .413 and .429; and expected lives of options of 8.9, 8.5 and 6.9 years. Based on this model, the weighted average fair value of stock options granted in fiscal 1999, 1998 and 1997 was $8.72, $7.75 and $3.85, respectively.
The pro forma amounts presented above may not be representative of the effects on reported net income for future years.
The company's Employee Stock Ownership Plan (ESOP) became effective January 1, 1981. Under the plan, the company contributes a percentage of each participant's annual compensation into a trust, either as treasury stock contributions or cash, which is then used to purchase Elcor common stock. Employees vest 20% after three years of employment and 20% per year thereafter, with the stock distributed at retirement, death, disability, or as authorized by the Plan Administrative Committee. Effective January 1, 1990, the company established an Employee Savings Plan under Internal Revenue Code section 401(k). Under the 401(k) Plan, the company contributes a percentage of each participant's annual compensation into a Plan to be invested among various defined alternatives at the participants' direction. Vesting of company contributions is in accordance with the same schedule as that of the ESOP. All full-time employees, except those covered by plans established through collective bargaining, are eligible for participation in the above plans after meeting minimum service requirements.
The Board of Directors authorized total contributions of 5.0% including forfeitures in fiscal 1999, 5.0% in fiscal 1998 and 4.6% in fiscal 1997, of each participant's annual compensation, as defined, split equally between the ESOP and 401(k) Plans. In addition, on January 1, 1998, the company began contributing an additional $.50 for every $1.00 of employee contributions into the 401(k) Plan limited to a maximum matching of 2% of an employee's compensation. Total contributions charged to expense for these plans were $2,123,000, $1,722,000 and $1,245,000, in 1999, 1998 and 1997, respectively.
The company has a Stock/Loan Plan which allows certain key employees to borrow an amount, based on a percentage of their salaries and the performance of their operating units, for the purpose of purchasing the company's common stock. Under the Stock/Loan Plan, the loans, which are unsecured, and any accrued interest are forgiven and amortized as compensation over five years of continuing service with the company. If employment is terminated for any reason except death, disability or retirement, the balance of the loan becomes due and payable. Loans outstanding at June 30, 1999 and 1998 totaling $1,436,700 and $1,074,000, respectively, are included in other assets.
COMMITMENTS AND CONTINGENCIES
The company and its subsidiaries lease certain office space, facilities, and equipment under operating leases, expiring on various dates through 2004. Total rental expense was $1,618,000 in 1999, $1,505,000 in 1998 and $1,295,000 in 1997. At June 30, 1999, future minimum rental commitments under noncancellable operating leases, payable over the remaining lives of the leases, are:
The company's subsidiaries provide certain warranties for their products which are generally limited to being free from defect in materials or workmanship affecting performance or meeting specified manufacturing and material specifications. During 1999, 1998 and 1997, the company recorded to expense $2,334,000, $1,681,000 and $1,566,000, respectively, in warranty claim settlements and reserves.
On February 8, 1994, a wholly owned subsidiary, Elk Corporation of Dallas (Elk) was granted a design patent covering the ornamental aspects of its High Definition(R) and Raised Profile(TM) shingles. On December 6, 1994, Elk was granted a utility patent on the functional aspects of the High Definition(R) and Raised Profile(TM) shingles. Elk has sued GAF Building Materials Corporation and related GAF entities (collectively GAF) in federal court for infringement of these patents and trade dress. In the design patent case, Elk seeks to recover as damages the total profit that GAF has made from the infringing shingles. In the utility patent case, Elk seeks to recover as damages a reasonable royalty on GAF's sales of infringing shingles and certain lost profits.
GAF seeks a declaratory judgment that the Elk patents are not infringed and are either invalid or unenforceable. GAF has also asserted claims for unfair competition, Lanham Act violations based on alleged false advertising, and common law fraud, generally praying for damages of not less than $25 million including actual and punitive damages, plus interest, costs, and reasonable attorney fees. Elk disputes GAF's claims, and management intends vigorously to defend them and to enforce its intellectual property rights. In April 1998, the District Court for the Northern District of Texas entered a partial final judgment in the design patent case based on an inequitable conduct ruling and certified the case for appeal. On February 11, 1999, the United States Court of Appeals for the Federal Circuit (Court of Appeals) issued a decision upholding the district court's partial final judgment against Elk in its design patent case. The decision held that the district court committed no reversible error in finding Elk's design patent unenforceable. On April 16, 1999, the Court of Appeals denied Elk's petition for a rehearing of the case.
On July 15, 1999, Elk appealed by a petition for certiorari with the United States Supreme Court. GAF filed its opposition in August 1999. Elk expects a Supreme Court decision whether to hear its appeal before the end of fiscal 2000.
While management can give no assurances regarding the ultimate outcome of the litigation, even if the outcome were to be adverse to Elk, it is not expected to have a material effect on the Registrant's financial position or liquidity.
The company and its subsidiaries are involved in other legal actions and claims, including claims arising in the ordinary course of business. Based on advice from legal counsel, management believes such litigation and claims will be resolved without material adverse effect on the consolidated financial statements.
The company is self-insured for its products and completed operations liability exposure because the cost of insurance for such risks is believed to be excessive for the coverage to be provided. Reserves for estimated potential losses of this type have been established.
The company's operations are subject to extensive federal, state and local laws and regulations relating to environmental matters. Although the company does not believe it will be required to expend amounts which will have a material adverse effect on the company's consolidated financial position or results of operations by reason of environmental laws and regulations, such laws and regulations are frequently changed and could result in significantly increased cost of compliance. Further, certain of the company's industrial products operations utilize hazardous materials in their production processes. As a result, the company incurs costs for remediation activities at its facilities and off-site from time to time. The company establishes and maintains reserves for such remediation activities.
INVOLUNTARY CONVERSION
On September 15, 1998, the company experienced an explosion at its fiberglass roofing mat plant in Ennis, Texas. The explosion significantly damaged a drying oven and caused less extensive damage to the remainder of the mat manufacturing line. At the time of the explosion, the damaged mat line supplied all of the company's internal fiberglass roofing mat needs. In addition, roofing mat from the damaged line was being sold to other asphalt roofing products manufacturers. There was no damage to a separate mat line that runs in parallel to the damaged line, nor was there any damage to the company's Ennis, Texas shingle manufacturing plant.
There were no injuries from the explosion. The damaged line was restored to partial operation in December 1998. By March 1999, the damaged section had been replaced. In June 1999, the line was operating at line speeds equivalent to line speeds at the time of the explosion.
The company carries both property damage and business interruption insurance. The $100,000 deductible portion of the loss was recorded during the quarter ended September 30, 1998. The company has submitted claims totaling $17,492,000. As of June 30, 1999, the company had received insurance advances of $9,687,000. Claimed but unpaid amounts are under review by the insurance company. Operating income from the lost sales portion of the business interruption claim have been accounted for as a contingent receivable, and accordingly have not been recorded to income as of June 30, 1999, pending settlement with the insurance company. Assets with net book value of $3,990,000 were destroyed in the explosion and were insured for replacement value. When the insurance claim is settled, any difference between insurance proceeds received and net book value of destroyed assets, if any, will be recorded as a nonrecurring gain.
ACQUISITION AND CONSOLIDATION
On January 11, 1999, a newly formed wholly owned subsidiary of the company purchased all of the outstanding shares of YDK America, Inc., a leading supplier to the computer industry of electronic plastic enclosures and components having electroless conductive coatings. The total purchase price was $5,588,000, net of cash acquired, which was financed through borrowings under Elcor's revolving credit agreement. The purchase price exceeded the fair value of net tangible assets acquired by $892,000, which was recorded as goodwill. The acquisition was accounted for using the purchase method of accounting, and the operating results have been included in the company's consolidated financial statements since the date of acquisition. The acquisition did not have a material impact on operating results in fiscal 1999.
In the fourth quarter of fiscal 1999, management approved a consolidation plan for Chromium Corporation's reciprocating engine components business. All operations for this business activity at Chromium's Lufkin, Texas facility will be transferred to its Cleveland, Ohio plant. Costs to relocate equipment and other consolidation items with an estimated cost of $1,145,000 are expected to be incurred and recorded to expense in the first half of fiscal 2000. In the fourth quarter of fiscal 1999 the company recorded a pretax charge of $375,000 in severance benefits for 64 employees who will not be transferred.
Subsequent to the completion of this business consolidation, the Lufkin, Texas facility will be used exclusively for conductive coatings operations.
ACCRUED LIABILITIES
Accrued liabilities consist of the following:
INCOME TAXES
The company's effective tax rate was 36.0% in 1999, 35.6% in 1998 and 37.0% in 1997. The difference between the federal statutory tax rate and the effective tax rate is reconciled as follows:
Components of the income tax provisions consist of the following:
The significant components of the company's deferred tax assets and liabilities are summarized below:
FINANCIAL INFORMATION BY COMPANY SEGMENTS
(1) In fiscal 1998, operating profit from the company's technology licensing and consulting services business exceeded 10% of consolidated operating profit. This business has not historically met the 10% reporting test nor is it typically expected to in the future. No separate segment is reflected in fiscal 1998 for this business unit.
INDEPENDENT AUDITORS' REPORT ON SUPPLEMENTAL SCHEDULE
To the Shareholders and Board of Directors of Elcor Corporation:
We have audited in accordance with generally accepted auditing standards, the accompanying consolidated financial statements of Elcor Corporation and have issued our report thereon dated August 16, 1999. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The Supplemental Schedule II is the responsibility of the Company's management and is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth herein in relation to the basic financial statements taken as a whole.
/s/ Arthur Andersen LLP ----------------------------- Arthur Andersen LLP
Dallas, Texas August 16, 1999
SCHEDULE II (In thousands)
ELCOR CORPORATION AND SUBSIDIARIES SCHEDULE II - CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED JUNE 30, 1999, 1998, AND 1997
Item 9.
Item 9. Disagreements on Accounting and Financial Disclosure
The Registrant has retained its independent public accountants for over 30 years. There have been no disagreements with the independent public accountants on accounting or financial disclosure matters.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
Information concerning the Directors of the Registrant required by this item is incorporated herein by reference to the material under the caption "Election of Directors" on pages 4, 5 and 6 of the Registrant's Proxy Statement dated September 17, 1999. Information concerning the Executive Officers of the Registrant is contained in Item 1 of this report under the caption "Executive Officers of the Registrant" on pages 10 and 11 of this Annual Report on Form 10-K.
Item 11.
Item 11. Executive Compensation
The information required by this item is incorporated herein by reference to the information under the caption "Executive Compensation" on pages 7 through 10 of the Registrant's Proxy Statement dated September 17, 1999.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information required by this item is incorporated herein by reference to the information under the caption "Stock Ownership" on pages 2 and 3 of the Registrant's Proxy Statement dated September 17, 1999. The referenced information was provided as of September 7, 1999. Registrant is aware of no material change since such date in the beneficial ownership of any officer, director or beneficial owner of five percent of any class of its voting stock.
Item 13.
Item 13. Certain Relationships and Related Transactions
There are no reportable transactions, business relationships or indebtedness between the Registrant and any covered party.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules and Reports of Form 8-K
(a) Financial Statements
The following financial statements of Elcor Corporation are set forth in Item 8 of this Annual Report on Form 10-K:
Financial Statements:
Independent Auditors' Report Consolidated Balance Sheet at June 30, 1999, and 1998 Consolidated Statement of Operations for the years ended June 30, 1999, 1998 and 1997 Consolidated Statement of Cash Flows for the years ended June 30, 1999, 1998, and 1997 Consolidated Statement of Shareholders' Equity for the years ended June 30, 1999, 1998, and 1997 Notes to Consolidated Financial Statements
Financial Statement Schedule:
Independent Auditors' Report Schedule II - Consolidated Valuation and Qualifying Accounts and Reserves
All other schedules are omitted because they are not required, are not applicable, or the information is included in the financial statements or notes thereto.
(b) Reports on Form 8-K
The Registrant filed Forms 8-K on April 16, 1999 and June 28, 1999 relating to press releases containing "forward-looking statements" about its prospects for the future.
(c) Exhibits
**3.1 The Restated Certificate of Incorporation of the Registrant, filed as Exhibit 3.1 to the Registrant's Annual Report on Form 10-K for the year ended June 30, 1994 (File No. 1-5341).
*3.11 Certificate of Amendment to Certificate of Incorporation dated December 2, 1998.
**3.2 Amended and Restated Bylaws of the Registrant, filed as Exhibit 3 to the Registrant's Annual Report on Form 10-K for the year ended June 30, 1981 and as Exhibit 3.2 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended December 31, 1988 originally filed with the Securities and Exchange Commission on February 11, 1989 (File No. 1-5341).
**4.1 Form of Rights Agreement dated as of July 7, 1998, between the company and ChaseMellon Shareholder Services, L.L.C., as Rights Agent, which includes as Exhibits A and B thereto the Forms of Certificate of Designation, Preferences and Rights of Series A Participating Preferred Stock, Rights Certificate, filed as Exhibit 4.1 to the company's current Report on Form 8-K dated May 26, 1998 (File No. 1-5341).
**4.6 Loan Agreement dated September 19, 1993 among Elcor Corporation, Certain Lenders, NationsBank of Texas, N.A., as Issuer, and NationsBank of Texas, N.A., as Administrative Lender, filed as Exhibit 4.6 in the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (File No. 1-5341).
**4.7 First Amendment dated October 31, 1994 to Loan Agreement dated September 29, 1993 among Elcor Corporation, NationsBank of Texas, N.A., as Issuer, and NationsBank of Texas, N.A. as Administrative Lender, filed as Exhibit 4.7 in the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1994 (File No. 1-5341).
**4.8 Second Amendment dated December 15, 1995 to Loan Agreement dated September 29, 1993 among Elcor Corporation, NationsBank of Texas, N.A., As Issuer, Administrative Lender, and Lender; and Bank of America - Texas, N.A. and Comerica Bank - Texas as Lenders, filed as Exhibit 4.8 in the Registrant's Quarterly Report on Form 10-Q for the quarter ended December 31, 1995 (File No. 1-5341).
**4.9 Third Amendment dated October 31, 1996 to Loan Agreement dated September 29, 1993 among Elcor Corporation, NationsBank of Texas, N.A., As Issuer, Administrative Lender, and Lender; and Bank of America - Texas, N.A. and Comerica Bank - Texas as Lenders, filed as Exhibit 4.9 in the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996 (File No. 1-5341).
**4.10 Fourth Amendment dated December 15, 1997 to Loan Agreement dated September 29, 1993 among Elcor Corporation, NationsBank of Texas, N.A., as Issuer, Administrative Lender, and Lender; and Bank of America - Texas, N.A., Comerica Bank - Texas, and the Bank of Tokyo - Mitsubishi, Ltd. as Lenders, filed as Exhibit 4.10 in the Registrant's Quarterly Report on Form 10-Q for the quarter ended December 31, 1997 (File No. 1-5341).
**10.1 Form of Executive Agreement filed as Exhibit 10.1 in the Registrant's Annual Report on Form 10-K for the year ended June 30, 1998 (File No. 1-5341).
**10.2 Amended and Restated Elcor Corporation Employee Stock/Loan Plan filed as Exhibit 10.2 in the Registrant's Annual Report on Form 10-K for the year ended June 30, 1998 (File No. 1-5341).
**10.3 1998 Amended and Restated Elcor Corporation Incentive Stock Option Plan filed as Appendix B in the Registrant's Proxy Statement dated September 18, 1998 (File No. 1-5341).
*21 Subsidiaries of the Registrant.
*23 Consent of Independent Public Accountants.
*27 Financial Data Schedule (EDGAR submission only).
* Filed herewith.
** Incorporated by reference.
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
ELCOR CORPORATION
Date: September 27, 1999 By /s/ Richard J. Rosebery --------------------------------------- Richard J. Rosebery Vice Chairman, Chief Financial and Administrative Officer, and Treasurer
By /s/ Leonard R. Harral --------------------------------------- Leonard R. Harral Vice President and Chief Accounting Officer
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below in multiple counterparts by the following persons on behalf of the Registrant and in the capacities and on the date indicated.
INDEX TO EXHIBITS | 13,971 | 93,354 |
49728_1999.txt | 49728_1999 | 1999 | 49728 | ITEM 1. BUSINESS - -----------------
IEC Electronics Corp. is an independent contract manufacturer of complex printed circuit board assemblies and electronic products and systems. The Company believes that it is a significant provider of contract electronics manufacturing services based upon its state-of-the-art manufacturing facilities, volume of production and quality of its services. Utilizing computer controlled manufacturing and test machinery and equipment, the Company provides manufacturing services employing surface mount technology ("SMT") and pin-through-hole ("PTH") interconnection technologies. The Company believes that, based upon its volume of production, it is one of the larger independent SMT contract manufacturers in the United States. As a full-service contract manufacturer, the Company offers it customers a wide range of manufacturing and management services, on either a turnkey or consignment basis, including design, material procurement and control, manufacturing and test engineering support, statistical quality assurance, complete resource management and distribution. The Company's strategy is to cultivate strong manufacturing relationships with established and emerging original equipment manufacturers ("OEMs").
IEC Electronics Corp., a Delaware corporation, is the successor by merger in 1990 to IEC Electronics Corp., a New York corporation which was organized in 1966. In June 1992, the Company acquired all of the then outstanding common stock of Calidad Electronics, Inc. ("Calidad"), located in Edinburg, Texas. In September 1997, Calidad's name was changed to IEC Electronics-Edinburg, Texas Inc. In November 1994, the Company acquired all of the then outstanding common stock of Accutek, Inc. ("Accutek"), located in Arab, Alabama. In October 1997, Accutek's name was changed to IEC Arab, Alabama Inc. In August 1998, the Company through its newly created Irish subsidiary, IEC Electronics - Ireland Limited, acquired certain assets of Ohshima Manufacturing Limited located in Longford, Ireland. As used herein, "Company" or "IEC" includes IEC Electronics Corp. and its subsidiaries, unless the context otherwise requires.
The Company announced in September 1999 that it would close its Longford, Ireland facility and record a restructuring charge of approximately $4.0 million in the fourth quarter of fiscal 1999. A number of the facility's customers have since been transferred to the Company's other facilities, the majority of equipment is currently marketed for sale and the Company is trying to sublet the facility.
In October 1998 the Company closed its Arab, Alabama facility and had previously recorded a restructuring charge of $4.7 million in the fourth quarter of fiscal 1998. The majority of the facility's larger customers have since been transferred to the Company's other facilities, the equipment has been moved to the Company's other locations, a certain portion of the Alabama real estate was sold, and the balance of the real estate is currently marketed for sale.
The Company has leased and commenced operations in a newly constructed 50,000 square foot facility in Reynosa, Mexico. This Maquiladora facility is manufacturing printed circuit board assemblies and wire harnesses. The facility's shipments began in April 1999.
The Company has achieved world-class ISO 9002 certification and IEC Electronics is ISO 9001 certified. This certification is an international quality assurance standard that most OEMs consider crucial in qualifying their contract manufacturers.
The Company has received approval from the British Approvals Board for Telecommunication allowing it to provide manufacturing and test services to manufacturers producing telecommunication equipment destined for shipment to the European Common Market.
During 1998 the Company opened a state-of-the-art 8,000 square foot Technology Center at its Newark, New York manufacturing facility uniting the Prototype Lab, Design Engineering Group and Advanced Materials Technology Laboratory.
The Company's executive offices are located at 105 Norton Street, Newark, New York 14513. The telephone number is (315) 331-7742 and its internet address is www.iec-electronics.com.
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Contract Electronics Manufacturing: The Industry
The contract electronics manufacturing industry specializes in providing the program management, technical and administrative support and manufacturing expertise required to take a product from the early design and prototype stages through volume production and distribution. It provides quality product, delivered on time and at the lowest cost, to the OEM. This full range of services gives the OEM an opportunity to avoid large capital investments in plant, equipment and staff and allows the OEM to concentrate instead on the areas of its greatest strengths innovation, design and marketing. Utilizing contract electronics manufacturing services such as those provided by IEC gives the customer an opportunity to improve return on investment with greater flexibility in responding to market demands and exploiting new market opportunities.
In recent years, primarily as a response to rapid technological change and increased competition in the electronics industry, OEMs have recognized that by utilizing domestic contract manufacturers they can improve their competitive position, realize an improved return on investment and concentrate on areas of their greatest expertise such as research, product design and development and marketing. In addition, contract manufacturing allows OEMs to bring new products to market rapidly and adjust more quickly to fluctuations in product demand; avoid additional investment in plant, equipment and personnel; reduce inventory and other overhead costs; and establish known unit costs over the life of a contract. Many OEMs now consider contract manufacturers an integral part of their business and manufacturing strategy. Accordingly, the contract electronics manufacturing industry has experienced significant growth as OEMs have established long-term working arrangements with contract manufacturers such as IEC.
Two important trends have developed in the contract electronics manufacturing industry. First, OEMs increasingly require contract manufacturers to provide complete turnkey manufacturing and material handling services, rather than working on a consignment basis in which the OEM supplies all materials and the contract manufacturer supplies labor. Turnkey contracts involve design, manufacturing and engineering support, the procurement of all materials, and sophisticated in-circuit and functional testing and distribution. The manufacturing partnership between OEMs and contract manufacturers involves an increased use of "just-in-time" inventory management techniques which minimize the OEM's investment in component inventories, personnel and related facilities, thereby reducing costs.
A second trend in the industry has been the increasing shift from PTH to SMT interconnection technologies. PTH technology involves the attachment of electronic components to printed circuit boards with leads or pins which are inserted into pre-drilled holes in the boards. The pins are then soldered to the electronic circuits. The drive for increasingly greater functional density has resulted in the emergence of SMT, which eliminates the need for holes and allows components to be placed on both sides of a printed circuit, contributing to size reductions of up to 50%. SMT requires expensive, highly automated assembly equipment and significantly more expertise than PTH technology. To achieve high yields, contract manufacturers must have extensive knowledge and experience in solder paste, solder reflow, thermal management, metal fatigue, adhesives, solvents, flux chemistry, surface analysis, intermetallic bonding and testing. The shift to SMT from PTH technology has increased the use of contract manufacturers by OEMs seeking to avoid the significant capital investment required for development and maintenance of SMT expertise.
The Company continually evaluates emerging technology and maintains a technology road map to ensure relevant processes are available to its customers when commercial and design factors so indicate. The next generation of interconnection technologies will include chip scale packaging and ball grid array (BGA) assembly techniques. The Company has placed millions of BGA's since 1994 and this year added chip scale packaging to its repertoire. Future advances will be directed by the Company's Technology Center which combines Design Services, Prototype Services with the capabilities of the Advanced Materials Technology Laboratory.
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The Company's Strategy
The Company's strategy is to cultivate strong manufacturing partnerships with established and emerging OEMs in the electronics industry. These long-term business partnerships involve the joint development of manufacturing and support strategies with OEM customers and promote customer satisfaction. In implementing this strategy, the Company offers its customers a full range of manufacturing solutions through flexibility in production, high quality and fast-turnaround manufacturing services and computer-aided testing.
As part of its strategy, the Company recognizes the need to offer advanced manufacturing technologies to its customers and, as a consequence, has been actively involved with SMT since the early 1980's. During fiscal 1999, the Company invested approximately $2.4 million in capital equipment. The vast majority of this amount was invested to upgrade equipment and process automation projects. The Company believes that it operates one of the largest SMT facilities in the United States. IEC believes that the high cost of SMT assembly equipment and the increased technical capability necessary to achieve an efficient, high yield SMT operation are significant competitive factors in the market for electronic assembly. The Company also believes that OEMs will increasingly contract for manufacturing on a turnkey basis as they seek to reduce their capital and inventory costs, as manufacturing technologies become more complex and as product life cycles shorten. Generally, turnkey contracts result in stable, close and long-term working relationships with customers. Since major OEMs require that contract manufacturers demonstrate the ability to offer SMT assembly services and to manage and support large turnkey contracts, there are significant barriers to entry in the contract manufacturing industry.
Assembly Process
The Company generally enters into formal agreements with its significant customers. These agreements generally provide for fixed prices for one year, absent any customer changes which impact cost of labor or material, and rolling forecasts of customer requirements. After establishing an OEM relationship, the Company offers its consultation services with respect to the manufacturability and testability of the product design. IEC often recommends design changes to reduce manufacturing costs and to improve the quality of the finished assemblies, and in some instances will produce original designs to the customer's specifications.
Upon receipt, a customer's order is entered into the Company's computer system by customer service personnel and is reviewed by all departments. The Production Control Department generates a detailed manufacturing schedule. Bills of material and approved vendor lists are reviewed by the Engineering Department, which creates a detailed process to direct the flow of product through the plant. The Material Control Department utilizes a material requirement planning (MRP) program to generate the requisitions used by the Purchasing Department to procure all material and components from approved vendors in the quantities and at the time required by the production schedule.
All incoming material is inspected to ensure compliance with customer specifications and delivered to the production floor on a "just-in-time" basis. Material and product movement are carefully and continuously computer-monitored throughout the assembly process to meet customer requirements. The placement and insertion of components on circuit board assemblies are accomplished by high-speed, vision and computer-controlled PTH or SMT machines. Any manual operations are performed prior to passage of the assemblies through various soldering processes. Statistical process control ("SPC") is used to provide consistent results in all steps of the manufacturing process.
The manufactured assembly then moves into the test phase. IEC's computer-aided testing ensures delivery of high quality products on a consistent basis. Computer-driven in-circuit tests verify that all components have been properly placed or inserted and that the electrical circuits are complete. Functional tests determine if the board or system assembly is performing to customer specifications.
Page 6 of 46
IEC assigns a program manager to each customer. The program manager maintains regular contact with the customer to assure timely and complete flow of information between the customer and the Company. Many products manufactured by the Company are in the early stages of their product cycle and therefore undergo numerous engineering changes. In addition, production quantities and schedules of certain products must be varied to respond to changes in customers' marketing opportunities. The Company assesses the impact of such changes on the production process and takes the appropriate action, such as restructuring bills of material, expediting procurement of new components and adjusting its manufacturing and testing plans. IEC believes that its ability to provide flexible and rapid response to customer needs is critical to its success.
Products and Services
The Company manufactures a wide range of assemblies which are incorporated into hundreds of different products. The Company provides contract manufacturing services primarily for micro, mini and mainframe computers; computer peripheral equipment; imaging equipment; office equipment; telecommunications equipment; measuring devices; and medical instrumentation. During the fiscal year ended September 30, 1999 the Company provided contract manufacturing services to approximately 75 different customers, including Compaq Computer Corporation ("Compaq"), Symbol Technologies, Inc.("Symbol"), Stratus Corporation ("Stratus"), Lucent Technologies, Inc.("Lucent"), GenRad, Inc.("GenRad") and General Electric Company.("GE") The Company provides its services to multiple divisions and product lines of many of its customers and typically manufactures for a number of each customer's successive product generations.
Materials Management
In fiscal 1999, 1998, and 1997, turnkey contracts, under which the Company provided materials in addition to a value-added labor component, represented 95 percent, 98 percent and 95 percent of sales, respectively. Materials and the associated material handling expense often represent a very substantial portion of the total manufacturing cost of turnkey products. The Company generally procures material only to meet specific contract requirements. In addition, the Company's agreements with its significant customers generally provide for cancellation charges equal to the costs which are incurred by the Company as a result of a customer's cancellation of contracted quantities. The Company's internal systems provide effective controls for all materials, whether purchased by the Company or provided by the customer, through all stages of the manufacturing process, from receiving to final shipment.
Suppliers
Materials and components used in contract manufacturing, whether supplied by the OEM or by the Company, are available generally from a number of suppliers at negotiated prices which are firm for the life of the purchase order. However, at various times in the electronics industry there have been industry-wide shortages of components which have temporarily delayed the Company's manufacture and shipment of products. The Company's business is not dependent upon any one supplier.
In 1997, Master Distribution Programs were put in place with Arrow/Schweber Electronics and Pioneer-Standard Electronics. These alliances have the benefit of reducing lead time on program parts, reducing the quotation process timetable, providing competitive pricing, providing some protection during allocation, providing better payment terms, reducing overhead cost and providing access to global resources.
Marketing and Sales
The Company markets its services through a direct sales force of 5 individuals, 15 program managers and 9 independent manufacturers' representatives, who currently employ approximately 30 sales people. In addition to the sales and marketing staff, the Company's executives are closely involved with marketing efforts. The Company conducts extensive market research to identify industries and to target companies where the opportunity exists to provide contract manufacturing services across a number of product lines and product generations.
Page 7 of 46
The Company's sales effort is supported by advertising in numerous trade media, sales literature, internet website, video presentations, participation in trade shows and direct mail promotions. Inquiries resulting from these advertising and public relations activities are assigned to the manufacturers' representative covering the customer's location. IEC's direct sales force coordinates all such activity and monitors the performance of the manufacturers' representatives. In addition, referrals by existing customers are an important source of new opportunities. The Company's objective is to further diversify the customers and industries which it serves.
Backlog
The Company's backlog as of December 30, 1999 and December 16, 1998 was approximately $125 million and $107 million, respectively. Backlog consists of contracts or purchase orders with delivery dates scheduled within the next 18 months. Substantially all of the current backlog is expected to be shipped within the Company's current fiscal year. Variations in the magnitude and duration of contracts received by the Company and customer delivery requirements may result in substantial fluctuations in backlog from period to period. Because customers may cancel or reschedule deliveries, backlog is not a meaningful indicator of future financial results.
Governmental Regulation
The Company's operations are subject to certain federal, state and local regulatory requirements relating to environmental, waste management, health and safety matters. Management believes that the Company's business is operated in compliance with applicable regulations promulgated by the Occupational Safety and Health Administration and the Environmental Protection Agency and corresponding state agencies which, respectively, pertain to health and safety in the workplace and the use, discharge, and storage of chemicals employed in the manufacturing process. Current costs of compliance are not material to the Company. However, new or modified requirements, not presently anticipated, could be adopted creating additional expense for the Company.
Employees
The Company's employees numbered approximately 1,315 at December 21, 1999, including 111 employees engaged in engineering, 1,092 in manufacturing and 112 in administrative and marketing functions. None of the Company's U.S. employees are covered by a collective bargaining agreement and the Company has not experienced any work stoppages. Management believes that its employee relations are good. The Company has access to a large work force by virtue of its northeast location midway between Rochester and Syracuse, two upstate New York industrial cities, and by virtue of its Texas location in the Rio Grande Valley.
Patents and Trademarks
The Company holds patents unrelated to contract manufacturing and also employs various registered trademarks. The Company does not believe that either patent or trademark protection is material to the operation of its business.
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Safe Harbor for Forward-looking Statements under Securities Litigation Reform act of 1995: Certain Cautionary Statements
From time to time, the Company or its representatives have made or may make forward-looking statements, orally or in writing. Such forward-looking statements may be included in, but not limited to, press releases, oral statements made with the approval of an authorized executive officer or in various filings made by the Company with the Securities and Exchange commission. The words or phrases "will likely result," "are expected to," "will continue," "is anticipated," "estimate," "project," or similar expressions are intended to identify "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995 (the Reform Act). The Company wishes to ensure that such statements are accompanied by meaningful cautionary statements, so as to maximize to the fullest extent possible the protections of the Safe Harbor established in the Reform Act. Accordingly, such statements are qualified in their entirety by reference to and are accompanied by the following discussion of certain important factors that could cause actual results to differ materially from such forward looking statements.
The risks included here are not exhaustive. Furthermore, reference is also made to other sections of this report which include additional factors which could adversely impact the Company's business and financial performance. Moreover, the Company operates in a very competitive and rapidly changing environment. New risk factors emerge from time to time and it is not possible for management to predict all of such risk factors, nor can it assess the impact of all such risk factors on the Company's business or the extent to which any factor, or a combination of factors may cause actual results to differ materially from those contained in any forward-looking statements. Accordingly, forward-looking statements should not be relied upon as a prediction of actual results.
Stockholders should be aware that while the Company does, from time to time, communicate with securities analysts, it is against the Company's policy to disclose to such analysts any material non-public information or other confidential commercial information. Accordingly, stockholders should not assume that the Company agrees with any statement or report issued by any analyst regardless of the content of such statement or report. Accordingly, to the extent that reports issued by a securities analyst contain any projections, forecasts, or opinions, such reports are not the responsibility of the Company.
Customer Concentration; Dependence On the Electronics Industry
A small number of customers are currently responsible for a significant portion of the Company's net sales. During fiscal 1999, the Company's ten largest customers accounted for 75% of consolidated net sales, and in the fiscal years 1998 and 1997, the Company's ten largest customers accounted for 72% and 73%, respectively, of consolidated net sales. During fiscal 1999, GenRad, Lucent and Compaq, accounted for 23%, 18% and 10%, respectively, of consolidated net sales. In fiscal years 1998 and 1997, Compaq accounted for 38% and 29% and Matrox accounted for 15% and 12% of the Company's consolidated net sales, respectively. The Company is dependent upon continued revenues from its top customers. The percentage of the Company's sales to its major customers may fluctuate from period to period. Significant reductions in sales to any of these customers could have a material adverse effect on the Company's results of operations. The Company has no firm long-term volume purchase commitments from its customers, and over the past few years has experienced reduced lead-times in customer orders. In addition, customer contracts can be canceled and volume levels can be changed or delayed. The timely replacement of canceled, delayed or reduced contracts with new business cannot be assured. These risks are increased because a majority of the Company's sales are to customers in the electronics industry, which is subject to rapid technological change and product obsolescence. The factors affecting the electronics industry, in general, or any of the Company's major customers in particular, could have a material adverse effect on the Company's results of operations.
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Revenue Flucuations
The Company's revenue growth has fluctuated over the last seven fiscal years, with net sales increasing from $43.2 million in fiscal 1992 to a high of $260.7 million in fiscal 1997. Net sales were $248.2 million in fiscal 1998 and $157.5 million in fiscal 1999. Although the Company continues to broaden its portfolio of customers there can be no assurance that its revenues will increase. There can also be no assurance that the Company will successfully manage the integration of any business it may acquire in the future. As the Company manages its existing operations and expands its operation in Mexico, it may experience certain inefficiencies as it integrates new operations and manages geographically dispersed operations. In addition, the Company's results of operations could be adversely affected if any of its facilities do not achieve growth sufficient to offset increased expenditures associated with geographic expansion. Should the Company increase its expenditures in anticipation of a future level of sales which does not materialize, its profitability would be adversely affected. On occasion, customers may require rapid increases in production which can place an excessive burden on the Company's resources.
Potential Fluctuations in Operating Results
The Company's margins and operating results are affected by a number of factors, including product mix, additional costs associated with new projects, price erosion within the electronics industry, capacity utilization, price competition, the degree of automation that can be used in the assembly process, the efficiencies that can be achieved by the Company in managing inventories and fixed assets, the timing of orders from major customers, fluctuations in demand for customer products, the timing of expenditures in anticipation of increased sales, customer product delivery requirements, and increased costs and shortages of components or labor. The Company's turnkey manufacturing, which typically results in higher net sales and gross profits but lower gross profit margins than consignment assembly and testing services, represents a substantial percentage of net sales. All of these factors can cause fluctuations in the Company's operating results over time. Because of these factors, there can be no assurance that the Company's margins or results of operations will not fluctuate or decrease in the future.
Competition
The electronics assembly and manufacturing industry is comprised of a large number of domestic and off-shore companies, several of which have achieved substantial market share. The Company also faces competition from current and prospective customers which evaluate its capacities against the merits of manufacturing products internally. The Company competes with different companies depending on the type of service or geographic area. Certain of the Company's competitors have broader geographic breadth. They also may have greater manufacturing, financial, research and development, and marketing resources than the Company. The Company believes that the primary basis of competition in its targeted markets is manufacturing technology, quality, responsiveness, the provision of value-added services, and price. To be competitive, the Company must provide technologically advanced manufacturing services, high product quality levels, flexible delivery schedules, and reliable delivery of finished products on a timely and price-competitive basis. The Company currently may be at a competitive disadvantage as to price when compared to manufacturers with lower cost structures, particularly with respect to manufacturers with facilities established where labor costs are lower.
Availability of Components
A substantial portion of the Company's net sales are derived from turnkey manufacturing in which the Company provides both materials procurement and assembly services. In turnkey manufacturing, the Company potentially bears the risk of component price increases, which could adversely affect the Company's gross profit margins. At various times there have been shortages of components in the electronics industry. If significant shortages of components should occur, the Company may be forced to delay manufacturing and shipments, which could have a material adverse effect on the Company's results of operations.
Availability of customer-consigned parts and unforeseen shortages of components on the world market are beyond the Company's control and could adversely affect revenue levels and operating efficiencies.
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Year 2000
While the Company has developed and implemented a plan to address Year 2000 issues, as discussed in "Management's Discussion of Operations", there may be risk connected with the identification of the Year 2000 issues of the Company and with the ability of the Company's vendors to identify and address successfully their own Year 2000 issues in a timely manner.
Environment Compliance
The Company is subject to a variety of environmental regulations relating to the use, storage, discharge and disposal of hazardous chemicals used during its manufacturing process. Any failure by the Company to comply with present or future regulations could subject it to future liabilities or the suspension of production which could have a material adverse effect on the Company's business. In addition, such regulations could restrict the Company's ability to expand its facilities or could require the Company to acquire costly equipment or to incur other expenses to comply with environmental regulations.
Dependence on Key Personnel and Skilled Employees
The Company's continued success depends to a large extent upon the efforts and abilities of key managerial and technical employees. The loss of services of certain key personnel could have a material adverse effect on the Company. The Company's business also depends upon its ability to continue to attract and retain senior managers and skilled employees. Failure to do so could adversely affect the Company's operations. The Company's President and Chief Executive Officer died suddenly on December 11, 1999. The Company's Chairman of the Board and former Chief Executive Officer is serving as interim Chief Executive Officer, while an executive search is underway.
ITEM 2.
ITEM 2. PROPERTIES - -------------------
The Company's administrative and principal manufacturing facility is located in Newark, New York and contains an aggregate of approximately 250,000 square feet. The IEC Edinburg, Texas manufacturing facility consists of approximately 87,000 square feet. The Reynosa Mexican facility consists of approximately 50,000 square feet, which is leased under an agreement expiring in 2004.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS - --------------------------
During fiscal 1999, the Company received a Notice of Infringement, along with an offer of a license, from the Lemelson Foundation. The Notice alleged that the Company has infringed certain patents of the Lemelson Foundation relating to machine vision and bar-code technolgy. To date, approximately 480 companies, large and small, have signed licenses with the Lemelson Foundation, believing that a known royalty rate which could be built into the cost of the product was preferable to ongoing litigation with uncertain results. The Company is a member of an industry association, which, on behalf of the electronics manufacturing services industry, negotiated a form license agreement which affords its members the ability to obtain rights to all of the relevant Lemelson patents for a one time paid up royalty. The Company is settling the infringement claim for approximately $530,000, payable, without interest, one-half by February 29,2000 and one half by August 31, 2001.
There are no other material legal proceedings pending to which the Company or any of its subsidiaries is a party or to which any of the Company's or subsidiaries' property is subject. To the Company's knowledge, there are no material legal proceedings to which any director, officer or affiliate of the Company, or any beneficial owner of more than 5 percent (5%) of Common Stock, or any associate of any of the foregoing, is a party adverse to the Company or any of its subsidiaries.
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ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------------------------------------------------------------ During the fourth quarter of fiscal 1999, no matters were submitted to a vote of security holders.
EXECUTIVE OFFICERS OF THE REGISTRANT
The Company's executive officers as of September 30, 1999, were as follows:
Name Age Position
Russell E. Stingel 68 Chairman of the Board and Chief Executive Officer
David W. Fradin 53 President and Chief Operating Officer
Richard L. Weiss 55 Director of Finance
Lawrence W. Swol 44 Vice President and General Manager - International Operations
Bruce C. Barton 53 Vice President, Technology and Quality
Stephen B. Pudles 40 Vice President of Business Development
Stephen H. Hotchkiss 48 Vice President, Sales and Marketing
Patricia A. Bird 39 Corporate Controller
Russell E. Stingel has served as Chairman of the Board of Directors since February 1997, and as a director since October 1996. From July 1996 until his retirement on September 30, 1999, he was Chief Executive Officer of the Company. As a result of Dr. Fradin's death, he was named interim Chief Executive Officer on December 12, 1999. Mr. Stingel also served as President of the Company (February 1996 - June 1997)and as Executive Vice President, Secretary and General Manager of the Company (1977 - February 1996). He was previously employed as President of the Ward Hydraulics Division of Figgee International Holdings, Inc. and in various management positions by General Dynamics Corporation.
David W. Fradin became Chief Executive Officer and a director of the Company on October 1, 1999 and had been President since June 1997. From June 1997 until October 1, 1999 he was also Chief Operating Officer of the Company. Dr. Fradin died suddenly on December 11, 1999. Prior to June 1997, he was previously employed as President and Chief Operating Officer of Harvard Custom Manufacturing LLC, an electronics manufacturing services company (July 1996 - June 1997),and President and Chief Executive Officer of EMD Associates, Inc. (Winnona, MN), an electronics contract manufacturer (1993 - July 1996).
Richard L. Weiss became Vice President and Chief Financial Officer of the Company on October 1, 1999, having joined the Company as Director of Finance in August 1999. Prior thereto, he had been Vice President, Finance of Microwave Data Systems, a division of California Microwave, Inc.(1990-1998). From 1974- 1990, Mr. Weiss was employed by the RF Communications Group of Harris Corp. as a Manager of Finance and Operations and in various other managerial positions.
Lawrence W. Swol has served as Vice President and General Manager - International Operations since April 1999. Prior thereto, he was Vice President/ General Manager - Texas (November 1997-April 1999). He was previously employed as General Manager of Ogden Atlantic Design - Mexico Operations, an electronics manufacturing services company (October 1995 - November 1997). and by Miltope Corporation as Vice President, Operations (1992 - 1995).
Bruce C. Barton became Vice President and General Manager of Newark Operations on October 1, 1999. Prior thereto, he was Vice President, Technology and Quality (February 1998 - October 1999), Director of Technology and Quality (January 1997-February 1998), Director Advanced Engineering and Quality (January 1996 - 1997), Director Advanced Engineering (January 1994 - January 1996), and Senior Manager Test and Manufacturing Engineering (January 1991 - January 1994).
Stephen B. Pudles served as Vice President of Business Development from May 1999 until December 1999, when he left the Company. He was previously employed as President, East Coast Division and at other senior management positions at Tanon Manufacturing (1997-1999).
Stephen H. Hotchkiss has served as Vice President, Sales and Marketing since November 1997. Prior thereto he had been Director of Sales and Marketing (November 1996 - November 1997), Sales Manager (March 1996 - November 1996), and Sales Representative (1977 - 1996).
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Patricia A. Bird has served as Corporate Controller since September 1987. She was previously employed by Arthur Andersen LLP (1982 - 1987). Ms. Bird has announced her resignation, which will take effect in the second quarter of fiscal year 2000.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND - -------------------------------------------------- RELATED STOCKHOLDER MATTERS ---------------------------
(a) Market Information.
The Company's Common Stock is traded on the Nasdaq National Market under the symbol IECE.
The following table sets forth, for the period stated, the high and low closing sales prices for the Common Stock as reported on the Nasdaq National Market.
Closing Sales Price Period High Low
October 1, 1997 - December 31, 1997 $21.750 $12.750 January 1, 1998 - March 30, 1998 $13.875 $ 7.438 April 1, 1998 - June 30, 1998 $ 9.188 $ 6.875 July 1, 1998 - September 30, 1998 $ 7.750 $ 4.250 October 1, 1998 - December 31, 1998 $ 6.188 $ 3.500 January 1, 1999 - March 30, 1999 $ 5.000 $ 3.250 April 1, 1999 - June 30, 1999 $ 3.875 $ 3.250 July 1, 1999 - September 30, 1999 $ 5.500 $ 2.625
The closing price of the Company's Common Stock on the Nasdaq National Market on January 3, 2000 was $2.50.
(b) Holders.
As of January 3, 2000, there were approximately 125 holders of record of the Company's Common Stock.
(c) Dividends.
The Company did not pay any dividends on its Common Stock during the fiscal years ended September 30, 1999 and 1998. It is the current policy of the Board of Directors of the Company to retain earnings for use in the business of the Company. Certain financial covenants set forth in the Company's current loan agreement prohibit the Company from paying cash dividends. The Company does not plan to pay cash dividends on its Common Stock in the foreseeable future.
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Item 6.
Item 6. SELECTED CONSOLIDATED FINANCIAL DATA - -----------------------------------------------
SELECTED CONSOLIDATED FINANCIAL DATA (in thousands, except per share data)
Years Ended September 30,
Income Statement Data 1999 1998(1) 1997 1996 1995(2) - ---------------------- ------------------------------------------------
Net Sales $157,488 $248,159 $260,686 $179,707 $127,610 ------------------------------------------------
Gross (Loss) Profit $(5,766) $13,640 $28,094 $15,219 $18,327 ------------------------------------------------
Operating (Loss) Income $(22,051) $(7,554) $12,321 $2,333 $7,603 ------------------------------------------------
Net (Loss) Income $(20,565) $(6,160) $6,958 $2,498 $4,688 ------------------------------------------------
Net (Loss) Income per Common and common equivalent share: Basic $(2.72) $(0.82) $0.93 $0.34 $0.64 Diluted $(2.72) $(0.82) $0.91 $0.33 $0.64 ------------------------------------------------
Common and Common equivalent shares Basic 7,563 7,542 7,442 7,412 7,359 Diluted 7,563 7,542 7,617 7,496 7,389 ----------------------------------------------- Balance Sheet Data: Working Capital $33,424 $31,764 $34,622 $25,959 $23,074 -----------------------------------------------
Total Assets $93,919 $98,665 $152,070 $109,521 $103,014 -----------------------------------------------
Long-term debt, less current maturities $16,547 $7,138 $6,988 $7,409 $6,857 -----------------------------------------------
Shareholders' equity $48,845 $69,568 $75,461 $67,457 $64,899 -----------------------------------------------
(1) The results of operations and financial position as of and for the year ended September 30, 1998, include the operations of IEC Electronics - Ireland Limited, as of the acquisition date, August 31, 1998.
(2) The results of operations and financial position as of and for the year ended September 30, 1995, include the operations of IEC Arab, Alabama Inc. as of the acquisition date, November 21, 1994.
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ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ----------------------------------------------------------- AND RESULTS OF OPERATIONS --------------------------
MANAGEMENT'S DISCUSSION OF OPERATIONS
The information in this Management's Discussion & Analysis should be read in conjunction with the accompanying consolidated financial statements, the related Notes to Financial Statements and the Five-Year Summary of Financial Data. Forward-looking statements in this Management's Discussion and Analysis are qualified by the cautionary statement in Item 1 of this Form 10K.
Overview - --------
IEC had a challenging year in fiscal 1999 as it continued its transition from heavy reliance on customers in the personal computer industry to establishing a more diverse portfolio of customers. The Company took a number of important steps in 1999, including a strong emphasis on new business development for new and existing customers, starting of production at the Mexican facility, and the closure of its Ireland facility, resulting in the recording of a restructuring charge of approximately $4.0 million in the fourth quarter of fiscal 1999.
Analysis of Operations ---------------------- (dollars in millions)
% % For Year Ended September 30, 1999 1998 Change 1997 Change ---- ---- ------ ---- ------
Net Sales $157.5 $248.2 (36.5%) $260.7 (4.8%)
The 36.5% decrease in fiscal 1999 net sales compared to fiscal year 1998 was mainly attributable to the loss of one major customer and the movement of a significant portion of another customer's production, both, to offshore facilities. Additionally, the Company is continuing to experience a shift from long-run, lower complexity customer contracts to shorter-run, higher complexity contracts. The 4.8% decrease in fiscal 1998 sales compared to fiscal year 1997 resulted from shifts in certain customers' demands, and a shift from long-run, lower complexity customer contracts to shorter-run, higher complexity contracts. Demand in the overall electronics manufacturing services industry remains generally strong and is being driven both by growth in the electronics industry and even more importantly, by increased outsourcing from OEMs. The Company's percentage of turnkey sales has remained steady. Such sales represented 95%,98% and 95% of net sales in fiscal 1999, 1998, and 1997, respectively.
Gross Profit and Selling and Administrative Expenses ---------------------------------------------------- (as a % of Net Sales)
For Year Ended September 30, 1999 1998 1997 ---- ---- ----
Gross Profit (3.7%) 5.5% 10.8%
Selling and Administrative Expenses 7.8% 6.2% 6.1%
Gross profit as a percentage of sales decreased more than 9 percentage points in fiscal 1999 compared to fiscal 1998. This decrease was a result of lower overhead absorption due to underutilized capacity, increased depreciation from a revaluation and reduction of the useful lives of production equipment, change of customer mix, greater customer product complexity with requests for design changes, and multiple new customer and product launches. Frequent design changes and customer start-ups caused manufacturing production interruptions, restarts, increase set-up expenses, creating excess production downtime.
The Company's gross profit percentage decreased over 5 percentage points between fiscal 1998 and fiscal 1997. This decrease was a result of lower overhead absorption due to underutilized capacity, a sizeable loss at the Alabama facility, customer mix, greater customer complexity with requests for design changes, and multiple new customer and product launches. Frequent design changes and customer start-ups cause manufacturing production interruptions, restarts, and increase set-up expense, creating excess production downtime.
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Selling and administrative expenses as a percentage of sales increased to 7.8% compared to 6.2% in fiscal 1998 and from 6.1% in fiscal 1997. The primary reason for the fiscal 1999 increase in SG&A expenses as a percentage of sales is the decrease in the sales base. Actual selling and administrative expenditures decreased in fiscal 1999 to $12.4 million from $15.3 million in fiscal 1998, as a result of decreases in commissions expense related to decreased net sales, and other cost-cutting measures. This was offset by increased depreciation due to the revaluation of the useful lives of the Company's equipment. Selling and administrative expenses of $15.3 million in fiscal 1998 were lower than $15.7 million in fiscal 1997. This decrease is primarily due to decreases in salaries, bonuses and related costs and to decreases in commission expense related to decreased net sales.
Other Income and Expense ------------------------ (dollars in millions)
For Year Ended September 30, 1999 1998 1997 ---- ---- ----
Interest Expense $1.1 $1.8 $1.6
Other Income - .3 .5
Interest Expense decreased $644,000 to $1.1 million in fiscal 1999 from $1.8 million in fiscal 1998, due to lower borrowing levels thoughout the year. Interest expense remained nearly constant at $1.8 million and $1.6 million in 1998 and 1997. Other income is composed primarily of investment earnings.
Income Taxes ------------
For Year Ended September 30, 1999 1998 1997 ---- ---- ----
Effective Tax Rate (11.1%) (31.9%) 37.9%
The Company's low effective tax (benefit) rate of (11.1%)in 1999 resulted largely from the federal income tax benefit from operating losses. This benefit was impacted by the valuation allowance on the net operating loss as well as state income tax expense. The Company's low effective tax (benefit) rate of (31.9%) in 1998 resulted largely from the federal income tax benefit from operating losses offset by state income tax expense. The 1997 effective tax rate of 37.9% reflects a more typical rate based on the Company's current mix of federal, state and foreign jurisdictions.
Restructuring Charge - -------------------- (dollars in millions)
For Year Ended September 30, 1999 1998 1997 ---- ---- ----
Restructuring Charge $4.0 $4.7 -
In September 1999, the Company announced its plan to close its underutilized Irish operation (Ireland) and transfer some of the customers served there to its other operations in New York and Texas. Accordingly, a restructuring charge of approximately $4.0 million was recorded in the fourth quarter of fiscal 1999. The components of the charge are as follows: the write-down of assets to be disposed of to their fair market value ($1.1 million), the write-down of goodwill ($670,000), severance and employee benefits ($619,000), accrual of the remaining lease payments and related building maintenance costs ($895,000) and repayment of a grant provided by the Irish Development Agency ($681,000).
The Irish plant was closed in December 1999. Following the transfer of a number of Ireland's customers, a majority of the equipment is currently being marketed for sale and the Company is trying to sublet the facility.
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In October 1998, the Company closed its underutilized Alabama facility and transferred many of the customers to its other operations in New York and Texas. Accordingly, a restructuring charge of $4.7 million was recorded in the fourth quarter of fiscal 1998. The components of the charge are as follows: the write-down of assets to be disposed of to their fair market value ($2.2 million), the write-down of goodwill ($1.3 million), and severance and employee benefits ($1.2 million). The Company recorded charges of $1.4 million and $1.3 million in fiscal 1999 and 1998, repectively. There have been no significant reallocations or reestimates of the restructuring charges to date.
Liquidity and Capital Resources - -------------------------------
As reflected in the Consolidated Statement of Cash Flows for 1999, the $10.4 million of cash provided by financing activities was used to fund $6.5 million used in operating activities and $2.1 million used in net investing activities, thus increasing cash by $1.8 million. The increase in cash used by operating activities for fiscal 1999 was primarly due to increased levels in accounts receivables, inventory, and accounts payable resulting from higher inventories.
Capital additions were $2.4 million in 1999 and $8.1 million in 1998. These expenditures were primarily used to upgrade the manufacturing capabilities of the Company.
During May 1998, the Company refinanced its $33 million of available lines of credit with a three-year $65 million senior credit facility with a bank group. In June 1999, the Company reduced the credit facilty by $15 million to a $50 million senior credit facility as well as changing the rates and terms of borrowings. The credit facility was collateralized by the majority of assets of the Company. The Company was required to maintain certain financial ratios as well as being subject to other restrictions described in "Notes to Consolidated Financial Statements". The Company was not in compliance with all financial covenants as of September 30, 1999, and therefore entered into a forbearance agreement with the participating banks until an asset-based facility was in place. During the forbearance period, the lenders continued to make revolving loans pursuant to the amended Credit Agreement, upon payment of a forbearance fee and the revision to the interest and facility fee rate calculations.
On December 28, 1999, the Company closed on an asset based facility of $30 million, increasing to $35 million in the second year. The credit facility consists of two components, the first being a $20 million revolving credit facility (increasing to $25 million in the second year) based on eligibility criteria for receivables and inventory. Amounts borrowed are limited to 85% of qualified accounts receivable, 20% of raw materials, and 30% of finished goods inventory, repectively. The second component consists of a $10 million three-year term loan with monthly principal installments based on a five-year amortization with principal payments beginning in April 2000.
Interest on this revolving credit facility is determined at the Company's option on a LIBOR or prime rate basis, plus a margin. Additionally, a facility fee is paid on the unused portion of the facility.
The new credit facility contains specific affirmative and negative covenants binding the Company, including, among others, the maintenance of certain financial covenants, as well as limitations on amounts available under the lines of credit relating to the borrowing base, capital expenditures, lease payments and additional debt. The more restrictive of the covenants provide that the Company maintains a minimum net worth, minimum net income after taxes, maximum debt-to-worth ratio, and minimum cash flow coverage. Covenant compliance begins with the quarter ending December 31, 1999.
The balance outstanding at September 30, 1999 was $17.6 million under the Company's senior credit facility with a weighted average interest rate of 8.25 percent.
The Company's President and Chief Executive Officer died suddenly on December 11, 1999. In the second quarter of fiscal 2000, the Company will be receiving non-taxable income from life insurance proceeds of approximately $2 million.
The Company believes its cash balances, funds generated from operations and its credit facilities will be sufficient for the Company to meet its capital expenditures and working capital needs for its operations as presently conducted. As part of its overall business strategy, the Company may from time to time evaluate acquisition opportunities. The funding of these future transactions, if any, may require the Company to obtain additional sources of financing.
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Impact of Inflation - -------------------
The impact of inflation on the Company's operations for the last three years has been minimal due to the fact that it is able to adjust its bids to reflect any inflationary increases in cost.
Year 2000 Conversion - -------------------- The Year 2000 issue is the result of many existing computer programs written to handle two digits, rather than four, to define the applicable year. Accordingly, date-sensitive software or hardware may not be able to distinguish between the year 1900 and year 2000, and programs that perform arithmetic operations, comparisons or sorting of date fields may begin yielding incorrect results. This could potentially cause a system failure or miscalculations that could disrupt operations, including, among other things, an inability to process transactions, send invoices, or engage in normal business activities. These Year 2000 issues affect virtually all companies and organizations.
The Company developed plans to address the potential risks it faces as a result of Year 2000 issues. These risks included, among other things, the possible failure or malfunction of the Company's internal information systems, possible problems with the products and services the Company has provided its customers, and possible problems arising from the failure of the Company's supplier systems.
The Company developed a plan to address its Year 2000 issues by initially identifying and assessing Year 2000 compliance for all of its applications and information technology equipment (including all mainframe, network and desktop software and hardware, custom and packaged applications, and IT embedded systems), as well as its non-information technology embedded systems, (including non-IT equipment and machinery such as security, fire prevention and climate control systems).
During calendar year 1999, the Company completed an inventory, assessment, remediation and testing of all information technology equipment as well as all non-information technology. The Company believed that its testing was comprehensive. The Company's main operating system was tested on three different occasions. All of the Company's network servers have been upgraded to Year 2000 compliant versions. All other systems have been upgraded to Year 2000 compliant versions or replaced. Although no Year 2000 problems have arisen to the date of this filing, there can be no assurance that all Year 2000 compliance issues have been identified.
A key to our ability to successfully manage our operations is our ability to manage our inventory, both consigned and turnkey. The inventory system is controlled by computer systems. While some of these systems are under the Company's control, systems of our vendors, our customers, transportation companies, and other service providers that are outside the Company's control could fail, delaying shipment or receipt of previously ordered components, causing the Company to delay, cancel or modify orders from customers. This could have a material adverse effect on the Company's results of operations, financial position or cash flow. At this point, the Company has not been advised by any significant supplier that it is not Year 2000 compliant or that any problems have arisen to date.
The Company has collected numerous documents and statements regarding the status of software and hardware in use at the Company. This documentation has been provided upon request to the Company's customers to document the Company's Year 2000 compliance.
The Company's incremental out-of-pocket costs of its Year 2000 compliance have not been material. Costs incurred in the remediation of existing computer software and hardware were approximately $500,000. Such costs do not include internal management time, which the Company does not separately track, nor the deferral of other projects, the effects of which are not expected to be material to the Company's results of operations or financial condition.
Recently Issued Accounting Standards - ------------------------------------ In June 1998, SFAS No. 137,"Accounting for Derivative Instruments and Hedging Activies - Deferral of Effective Date of FASB Statement No. 133", was issued. With issuance of SFAS No. 137, the Company is required to adopt SFAS No. 133 on a prospective basis for interim periods and fiscal years beginning March 1, 2001. The Company believes that the effect of adoption of SFAS No. 133 will not be material based on the Company's current risk management strategies.
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ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ----------------------------------------------------
The information required by this item is incorporated herein by reference to pages 23 through 43 of this Form 10-K and is indexed under Item 14(a)(1) and (2).
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON - --------------------------------------------------------- ACCOUNTING AND FINANCIAL DISCLOSURE -----------------------------------
There have been no disagreements on accounting and financial disclosure matters.
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PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - ------------------------------------------------------------
The information required by this item is presented under the caption entitled "Election of Directors - Nominees for Election as Directors" contained in the definitive proxy statement issued in connection with the Annual Meeting of Stockholders to be held February 23, 2000 and is incorporated in this report by reference thereto. The information regarding Executive Officers of the Registrant is found in Part I of this report.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION - --------------------------------
The information required by this item is presented under the caption entitled "Executive Officer Compensation" contained in the definitive proxy statement issued in connection with the Annual Meeting of Stockholders to be held February 23, 2000 and is incorporated in this report by reference thereto, except, however, the sections entitled "Performance Graph" and "Report of the Compensation Committee of the Board of Directors" are not incorporated in this report by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND - ------------------------------------------------------------- MANAGEMENT ----------
The information required by this item is presented under the caption entitled "Security Ownership of Certain Beneficial Owners and Management" contained in the definitive proxy statement issued in connection with the Annual Meeting of Stockholders to be held February 23, 2000 and is incorporated in this report by reference thereto.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - --------------------------------------------------------
The information required by this item is presented under the caption "Executive Officer Compensation - Certain Transactions" contained in the definitive proxy statement issued in connection with the Annual Meeting of Stockholders to be held February 23, 2000 and is incorporated in this report by reference thereto.
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PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON - ---------------------------------------------------------------- FORM 8-K --------
(a) The following documents are filed as part of this report and as response to Item 8: Page (1) and (2) Financial Statements and Supplementary Schedule Report of Independent Public Accountants...................... 25 Consolidated Balance Sheets as of September 30, 1999 and 1998.................................. 26 Consolidated Statements of Operations for the years ended September 30, 1999, 1998 and 1997 .................... 28 Consolidated Statements of Comprehensive Income (Loss) and Shareholders' Equity for the years ended September 30, 1999, 1998 and 1997................................................ 29 Consolidated Statements of Cash Flows for the years ended September 30, 1999, 1998 and 1997...................... 30 Notes to Consolidated Financial Statements.................... 31 Schedule II Valuation and Qualifying Accounts................. 44
All other schedules are either inapplicable or the information is included in the financial statements and, therefore, have been omitted. (3) Exhibits
Exhibit No. Title Page
3.1 Amended and Restated Certificate of Incorporation of DFT Holdings Corp. (Incorporated by reference to Exhibit 3.1 to the Company's Registration Statement on Form S-1, Registration No. 33-56498) 3.2 Amended Bylaws of IEC Electronics Corp. (Incorporated by reference to Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 27, 1998) 3.3 Agreement and Plan of Merger of IEC Electronics into DFT Holdings Corp. (Incorporated by reference to Exhibit 3.3 to the Company's Registration Statement on Form S-1, Registration No. 33-56498) 3.4 Certificate of Merger of IEC Electronics Corp. into DFT Holdings Corp. - New York. (Incorporated by reference to Exhibit 3.4 to the Company's Registration Statement on Form S-1, Registration No. 33-56498) 3.5 Certificate of Ownership and Merger merging IEC Electronics Corp. into DFT Holdings Corp. - Delaware. (Incorporated by reference to Exhibit 3.5 to the Company's Registration Statement on Form S-1, Registration No. 33-56498) 3.6 Certificate of Merger of IEC Acquisition Corp. into IEC Electronics Corp. (Incorporated by reference to Exhibit 3.6 to the Company's Registration Statement on Form S-1, Registration No. 33-56498) 3.7 Certificate of Admendment of Certificate of Incorporation of IEC Electronics Corp. filed with the Secretary of State of the State of Delaware on Feb. 26, 1998 (Incorporated by reference to Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the Quarter ended March 27, 1998) 3.8 Certificate of Designations of the Series A Preferred Stock of IEC Electronics Corp. filed with the Secretary of State of the State of Delaware on June 3, 1998. 3.9 Articles of Incorporation of Calidad Electronics, Inc. (Incorporated by reference to Exhibit 3.7 to the Company's Registration Statement on Form S-1, Registration No. 33-56498) 3.10 Articles of Amendments to the Articles of Incorporation of Calidad Electronics, Inc. (Incorporated by reference to Exhibit 3.8 to the Company's Registration Statement on Form S-1, Registration No. 33-56498) 3.11 Statement of Change of Registered Office or Registered Agent or both by a Profit Corporation. (Incorporated by reference to Exhibit 3.9 to the Company's Registration Statement on Form S-1, Registration No. 33-56498) 3.12 By-laws of Calidad Electronics, Inc. (Incorporated by reference to Exhibit 3.10 to the Company's Registration Statement on Form S-1, Registration No. 33-56498)
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4.1 Specimen of Certificate for Common Stock. (Incorporated by reference to Exhibit 4.1 to the Company's Registration Statement on Form S-1, Registration No. 33-56498) 4.2 Rights Agreement dated as of June 2, 1998 between IEC Electronics Corp. and ChaseMellon Shareholder Services. LLC., as Rights Agents(Incorporated by reference to Exhibit 4.1 to the Company's Curent Report on Form 8-K dated June 2, 1998) 10.1* IEC Electronics Corp. Stock Option Plan, as amended. (Incorporated by reference to Exhibit 10.1 to the Company's Registration Statement on Form S-1, Registration No. 33-56498) 10.2* Form of Amended and Restated Incentive Stock Option Agreement. (Incorporated by reference to Exhibit 10.2 to the Company's Registration Statement on Form S-1, Registration No. 33-56498) 10.3* Form of Non-Qualified Stock Option Agreement. (Incorporated by reference to Exhibit 10.3 to the Company's Registration Statement on Form S-1, Registration No. 33-56498) 10.4 Documents Executed in Connection with the Acquisition of Certain Real Estate: (i) Agreement for Purchase of Shares, for the Purchase of Certain Real Estate, and for Certain Other Matters among IEC Electronics Corp., Rettel Corporation, Rodney J. Graybill, Jacob A. Graybill and Robert M. Tyle, dated as of August 29, 1983. (ii) Bond Purchase Agreement among IEC Electronics Corp., Wayne County Industrial Development Agency, Rodney J. Graybill, Robert M. Tyle and the Estate of Jacob A. Graybill, dated as of December 1, 1983. (iii) Mortgage from the Wayne County Industrial Development Agency to Rodney J. Graybill, Robert M. Tyle and the Estate of Jacob A. Graybill, dated as of December 1, 1983. (iv) Lease Agreement between the Wayne County Industrial Development Agency and IEC Electronics Corp., dated as of December 1, 1983. (v) Amendment to Agreement for Purchase of Shares, for the Purchase of Certain Real Estate, and for Certain Other Matters among IEC Electronics Corp., Rettel Corporation, Rodney J. Graybill, the Estate of Jacob A. Graybill and Robert M. Tyle, dated as of December 28, 1983. (vi) Loan Agreement between IEC Electronics Corp. and The Village of Newark, dated as of December 28, 1983. (vii) Mortgage between Wayne County Industrial Development Agency and IEC Electronics Corp., as mortgagors, and Wayne County Industrial Development Agency, as mortgagee, dated December 28, 1983. (viii) Mortgage between Wayne County Industrial Development Agency and The Village of Newark, dated December 28, 1983. (ix) First Agreement of Amendment to Loan Agreement of December 28, 1983, between IEC Electronics Corp. and The Village of Newark, dated as of December 30, 1983. (x) Loan and Use Agreement among Wayne County Economic Development Corp., Wayne County Industrial Development Agency, IEC Electronics Corp. and New York Job Development Authority, dated December 30, 1983. (Incorporated by reference to Exhibit 10.6 to the Company's Registration Statement on Form S-1, Registration No. 33-56498) 10.5* Form of Indemnity Agreement. (Incorporated by reference to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended July 2, 1993) 10.6 Credit Agreement dated as of May 16, 1998 among IEC Electronics Corp. and Any Designed Borrower(s) as "Borrowers" with the Lenders signatory thereto and The Chase Manhattan Bank as Adminstrative Agent (Incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 26, 1998) 10.7 Consent and Waiver dated as of July 10, 1998 to Credit Agreement dated May 15, 1998. (Incorporated by reference to Exhibit 10.7 to the Company's Annual Report on Form 10-K for the year ended September 30, 1998) 10.8 Amendment No. 1 and Consent dated as of November 6, 1998 to Credit Agreement dated as May 15, 1998. (Incorporated by reference to Exhibit 10.8 to the Company's Annual Report on Form 10-K for the year ended September 30, 1998)
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10.9* IEC Electronics Corp. 1993 Stock Option Plan, as amended (Incorporated by reference to Exhibit 10.9 to the Company's Annual Report on Form 10-K for the year ended September 30, 1998) 10.10* Form of Incentive Stock Option Agreement (Incorporated by reference to Exhibit 4.2 to the Company's Registration Statement on Form S-8, Registration No. 33-79360) 10.11* Form of Non-Statutory Stock Option Agreement (Incorporated by reference to Exhibit 4.3 to the Company's Registration Statement on Form S-8, Registration No. 33-79360) 10.12* Form of Non-Employee Director Stock Option Agreement (Incorporated by reference to Exhbit 4.4 to the Company's Registration Statement on Form S-8, Registration No. 33-79360) 10.13* Employment Agreement between IEC Electronics Corp. and David W. Fradin (Incorporated by reference to Exhibit 10.18 to the Company's Annual Report on Form 10-K for the year ended September 30, 1997) 10.14* Employment Agreement between IEC Electronics Corp. and Diana R. Kurty, dated September 5, 1997 (Incorporated by reference to Exhibit 10.14 to the Company's Annual Report on Form 10-K for the year ended September 30, 1998) 10.15* Consulting Agreement between IEC Electronics and Edward Butka, dated as of March 1, 1998 (Incorporated by reference to Exhibit 10.15 to the Company's Annual Report on Form 10-K for the year ended September 30, 1998) 10.16* Change in Control Agreement between IEC Electronics Corp. and Russell E. Stingel, dated as of May 1, 1998 (Incorporated by reference to Exhibit 10.16 to the Company's Annual Report on Form 10-K for the year ended September 30, 1998) 10.17* Admendment No.1 to Employment Agreement, Restatement of Non Compete Agreement and Change in Control Agreement between IEC Electronics Corp. and David W. Fradin, dated as of May 1, 1998 (Incorporated by reference to Exhibit 10.17 to the Company's Annual Report on Form 10-K for the year ended September 30, 1998) 10.18* Admendment No.1 to Employment Agreement, Restatement of Non Compete Agreement and Change in Control Agreement between IEC Electronics Corp. and Diana R. Kurty, dated as of May 1, 1998 (Incorporated by reference to Exhibit 10.18 to the Company's Annual Report on Form 10-K for the year ended September 30, 1998) 10.19* Form of Change-in-Control Agreement between IEC Electronics Corp and each of its Vice Presidents, dated as of May 1, 1998. (Incorporated by reference to Exhibit 10.19 to the Company's Annual Report on Form 10-K for the year ended September 30, 1998) 10.20* Severance Agreement between IEC Electronics Corp. and Joseph S. Schadeberg, dated as of November 12, 1998. (Incorporated by reference to Exhibit 10.20 to the Company's Annual Report on Form 10-K for the year ended September 30, 1998) 10.21* IEC Electronics Corp. Savings and Security Plan effective June 1, 1997 (Incorporated by reference to Exhibit 10.17 to the Company's Annual Report on Form 10-K for the year ended September 30, 1997.) 10.22* Admendment to IEC Electronics Corp. Savings and Security Plan effective June 1, 1998. (Incorporated by reference to Exhibit 10.22 to the Company's Annual Report on Form 10-K for the year ended September 30, 1998) 10.23* IEC Electronics Corp. Director Compensation Plan (Incorporated by reference to Exhibit 10.23 to the Company's Annual Report on Form 10-K for the year ended September 30, 1998) 10.24* Amendment No. 2 and Consent (Mexico) dated as of November 19, 1998 to Credit Agreement dated as of May 15, 1998. (Incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended December 25, 1998) 10.25* Amendment No. 3 (Ireland) and Waiver dated as of June 11, 1999 to Credit Agreement dated as May 15, 1998. (Incorporated by reference to Exhibit 3.4 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 28, 1999) 11.1 Statement relating to computation of per share earnings. See Note 8 to the Notes to the Company's Consolidated Financial Statements contained herein. 11.2 Statement relating to Valuation and Qualifing Accounts. See Note 8 to the Notes to the Company's Consolidated Financial Statements contained herein. 22.1 Subsidiaries of IEC Electronics Corp. 45 24.1 Consent of Arthur Andersen LLP 46
(b) Reports on Form 8-K:
None
*Management contract or compensatory plan or arrangement
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SIGNATURES
Pursuant to the requirement of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: January 5, 2000.
IEC Electronics Corp..
By:/s/Russell E. Stingel ----------------------- Russell E. Stingel Chairman of the Board and Interim Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature Title Date
/s/Russell E. Stingel Chairman of the Board and - ---------------------- Interim Chief Executive Officer (Russell E. Stingel) (Principal Executive Officer) January 5, 2000
/s/Richard Weiss Vice President and - ----------------- Chief Financial Officer (Richard Weiss) (Principal Financial and Accounting Officer) January 5, 2000
/s/David J. Beaubien Director January 5, 2000 - -------------------- (David J. Beaubien)
/s/Thomas W. Folger Director January 5, 2000 - -------------------- (Thomas W. Folger)
/s/W.Barry Gilbert Director January 5, 2000 - ------------------- (W.Barry Gilbert)
/s/Robert P. B. Kidd Director January 5, 2000 - ------------------- (Robert P. B. Kidd)
/s/Eben S. Mouilon Director January 5, 2000 - ------------------ (Eben S. Moulton)
/s/Justin L. Vigdor Director January 5, 2000 - ------------------- (Justin L. Vigdor)
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REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To IEC Electronics Corp.:
We have audited the accompanying consolidated balance sheets of IEC Electronics Corp. and subsidiaries as of September 30, 1999 and 1998, and the related consolidated statements of operations, comprehensive income(loss) and shareholders' equity, and cash flows for each of the three years in the period ended September 30, 1999. These financial statements and schedule referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as 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 financial position of IEC Electronics Corp. and subsidiaries as of September 30, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 1999, in conformity with generally accepted accounting principles.
Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in Item 14(a)2 is presented for the purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material repects in relation to the basic financial statements taken as a whole.
/s/Arthur Andersen LLP
Rochester, New York, December 28, 1999
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IEC ELECTRONICS CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 1999, 1998 AND 1997
1. BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: - -- --------------------------------------------------------
Business
IEC Electronics Corp. (IEC) is an independent contract manufacturer of complex printed circuit board assemblies and electronic products and systems. IEC offers its customers a wide range of manufacturing and management services, on either a turnkey or consignment basis, including material procurement and control, manufacturing and test engineering support, statistical quality assurance, and complete resource management.
Consolidation
The consolidated financial statements include the accounts of IEC and its wholly-owned subsidiaries, IEC Electronics-Edinburg, Texas Inc.(Edinburg), IEC Arab, Alabama Inc. (Arab)and also includes from August 31, 1998, IEC Electronics - Ireland Ltd. (Longford)(collectively, the Company). All significant intercompany transactions and accounts have been eliminated.
Revenue Recognition
The Company recognizes revenue upon shipment of product for both turnkey and consignment contracts.
Cash and Cash Equivalents
Cash and cash equivalents include highly liquid investments with original maturities of three months or less. The Company's cash and cash equivalents are held and managed by institutions which follow the Company's investment policy. The fair value of the Company's financial instruments approximates carrying amounts due to the relatively short maturities and variable interest rates of the instruments, which approximate current market interest rates.
Inventories
Inventories are stated at the lower of cost (first-in, first-out) or market.
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Property, Plant, and Equipment
Property, plant, and equipment are stated at cost and are depreciated over various estimated useful lives using the straight-line method.
During the fourth quarter of 1999, the Company completed a review of its fixed asset lives and, in turn, shortened the estimated lives of certain categories of equipment, effective July 1, 1999. The change in estimate was based on the following: the downsizing of the business; the loss of certain "large run" customers which have forced the Company to utilize a quick change-over mentality; and changing technology, therefore obsoleting production equipment more quickly. The effect of this change in estimate increased depreciation for the year ended September 30, 1999 by approximately $4.7 million.
Maintenance and repairs are charged to expense as incurred; renewals and improvements are capitalized. At the time of retirement or other disposition of property, plant, and equipment, the cost and accumulated depreciation are removed from the accounts and any gain or loss is reflected in other income.
Long-Lived Assets
The Company reviews its long-lived assets and certain identifiable intangibles to be held and used for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If such events or changes in circumstances are present, a loss is recognized to the extent the carrying value of the asset is in excess of the sum of the undiscounted cash flows expected to result from the use of the asset and its eventual disposition.
During the fourth quarter of 1999, certain fixed assets were no longer in use and indentified as impaired. The equipment has been marketed for sale, and as such, the carrying value of these assets was written down to the estimated recoverable sales value, net of commissions obtained from appraisals and used equipment quotations. The effect of this impairment recoqnition totalled approximately $400,000 and was included with depreciation expense for the year ended September 30, 1999.
Fair Value of Financial Instruments
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practical to estimate that value.
Current Assets and Liabilities - The carrying amount of cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities approximate fair value because of the short maturity of those instruments.
Debt - The fair value of the Company's debt is estimated based upon the quoted market prices for the same or similar issues which approximates carrying amount.
Costs in Excess of Net Assets Acquired
Costs in excess of net assets acquired of $14.1 million is being amortized on a straight-line basis over 40 years. The balance is presented net of accumulated amortization of $3.9 million and $3.5 million at September 30, 1999 and 1998, respectively. Amortization of $400,000, $475,000, and $474,000 was charged against operations for the years ended September 30, 1999, 1998, and 1997, respectively.
The write-off of net goodwill in the amount of $670,000, related to the Longford operations was charged to the restructuring reserve in fiscal 1999. The write-off of net goodwill of approximately $1.3 million during fiscal 1998 related to the Alabama facility and was charged to the restructuring reserve. See Note 2.
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Net Income per Common and Common Equivalent Share
(Loss)Income Shares Per Share Year-Ended (Numerator) (Denominator) Amount - ------------------------ ------------ ------------ --------- September 30, 1999 Basic EPS Loss available to common shareholders $ (20,565) 7,562,727 $ (2.72) =========== ========= ========= September 30, 1998 Basic EPS Loss available to common shareholders $ (6,160) 7,541,541 $ (.82) =========== ========= ========= September 30, 1997 Basic EPS Income available to common shareholders $ 6,958 7,441,881 $ .93 =========
Effect of dilutive options - 175,464 ----------- ---------- Diluted EPS Income available to common shareholders and and assumed conversions $ 6,958 7,617,345 $ .91 ========== ========= ========
Basic EPS was computed by dividing reported earnings available to common shareholders by weighted-average common shares outstanding during the year. No reconcilation is provided for 1999 and 1998 as the effect would be antidilutive. Options to purchase 36,000 common shares at an average price of $20 per share were outstanding for the year ending September 30, 1997 but were not included in the computation of diluted EPS since the options' exercise price was greater than the average market price of common shares.
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Foreign Currency Translation
The assets and liabilities of the Company's foreign subsidiary are translated based on the current exchange rate at the end of the period for the balance sheet and weighted-average rate for the period of the consolidated statement of operations. Translation adjustments are recorded as a separate component of equity. Transaction gains or losses are included in operations.
Comprehensive Income
During 1999, the Company adopted SFAS No. 130, "Reporting Comprehensive Income." This statement establishes rules for the reporting of comprehensive income and its components. Comprehensive income consists of foreign currency translation adjustments and is presented in the statements of comprehensive income (loss) and shareholders' equity. The adoption of SFAS No. 130 had no impact on total shareholders' equity.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates that affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
2. RESTRUCTURING:
In September 1999, the Company announced its plan to close its underutilized Longford operations and transfer some of the customers served there to its other operations in New York and Texas. Accordingly, a restructuring charge of approximately $4.0 million was recorded in the fourth quarter of fiscal 1999. The components of the charge are as follows: the write-down of assets to be disposed of to their fair market value ($1.1 million), the write-down of goodwill ($670,000), severance and employee benefits ($619,000), accrual of the remaining lease payments and related building maintenance costs ($895,000), and repayment of a grant provided by the Irish Development Agency ($681,000). The Company recorded charges against the accrual of approximately $900,000 during fiscal 1999. There were no significant reallocations or reestimates to date.
Orginally, in August 1998, the Company acquired certain assets of Ohshima Electronics Manufacturing Limited (Ohshima) located in Longford, Ireland, for an initial purchase price of approximately $1.2 million. The acquistion was funded through the Company's existing senior credit facility and accounted for as a purchase. The purchase price exceeded the fair market value of net assets by approximately $740,000, which was being amortized on a straight-line basis over 15 years. The accompanying financial results include the results of Longford from the date of acquistion (August 31, 1998).
In August 1998, the Company announced plans to close its Alabama operations (Arab) and to transfer many of the customers served in that facility to the Company's other operations in New York and Texas. The restructuring charge of $4.7 million relates primarily to the write-down of assets to be disposed of, to their fair market value ($2.2 million), the write-down of goodwill ($1.3 million), and severance and employee benefits ($1.2 million). The Company recorded charges against the accrual of $1.4 million and $1.3 million during fiscal 1999 and fiscal 1998, respectively. There were no significant reallocations or reestimates to date.
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3. INVENTORIES:
The major classifications of inventories are as follows at September 30 (in thousands):
1999 1998 -------- --------
Raw materials $23,226 $14,170 Work-in-process 7,502 5,902 -------- -------- $30,728 $20,072 ======== ========
4. PROPERTY, PLANT, AND EQUIPMENT:
The major classifications of property, plant, and equipment are as follows at September 30 (in thousands):
1999 1998 -------- --------
Land and land improvements $ 1,199 $ 1,166 Buildings and improvements 11,271 11,341 Machinery and Equipment 66,873 65,756 Furniture and fixtures 6,266 6,640 -------- -------- 85,609 84,903 Less- Accumulated depreciation and amortization (63,831) (48,582) -------- -------- $ 21,778 $ 36,321 ======== ========
Depreciation and amortization was $15.1 million, $10.0 million, and $9.3 million for the years ended September 30, 1999, 1998 and 1997, respectively.
Included in property, plant and equipment are land and land improvements with a net book value of approximately $100,000, buildings and improvements with a net book value of approximately $1.2 million, and machinery and equipment with a net book value of approximately $1.8 million which are currently available for sale. The principal depreciation and amortization lives used are as follows:
Estimated Description Useful Lives - ---------------------------- ------------
Land improvements 10 years Buildings and improvements 10 to 40 years Machinery and equipment 3 to 5 years Furniture and fixtures 3 to 7 years
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5. LONG-TERM DEBT:
Long-term debt consists of the following at September 30 (in thousands):
1999 1998 -------- ------- Senior debt facility obtained through revolving line of credit. $17,600 $ 7,000 Mortgage note payable - 158 -------- ------- 17,600 7,158 Less- Current portion, based on the terms of the new credit facility 1,053 20 -------- ------- $16,547 $ 7,138 ======== =======
During May 1998, the Company refinanced its $33 million of available lines of credit with a three-year $65 million senior credit facility with a bank group. In June 1999, the Company reduced the credit facility by $15 million to a $50 million senior credit facility as well as changing the rates and terms of the borrowings. Interest on this revolving credit facility was determined at the Company's option on a LIBOR or prime rate basis, plus a margin. Additionally, a facility fee was paid on the unused portion of the facility. Based on the dates of the related borrowings as of September 30, 1999 and 1998, the interest rates related to the revolving credit facility ranged from 7.025 percent to 8.25 percent and 6.08 percent to 6.64 percent in 1999 and 1998, repectively.
The 30-day LIBOR rate was 5.4375% and the prime rate was 8.25% at September 30, 1999.
The credit facility was collaterlized by the majority of assets of the Company. The Company was required to maintain certain financial ratios as well as to comply with certain restrictions including: limits on incurring additional indebtness; creating liens or other encumbrances; making certain payments, investments or loans; guarantees; selling or otherwise disposing of a substantial portion of assets, or merging or consolidating with an unaffiliated entity. The most significant financial covenants included a leverage ratio, an interest coverage ratio, and a ratio of consolidated current assets to consolidated total indebtedness. The Company was not in compliance with all financial covenants as of September 30, 1999 and therefore entered into a forbearance agreement with the participating banks until a new secured debt asset facility was in place. During the forbearance period, the lenders continued to make revolving loans pursuant to the amended credit agreement, upon payment of a forbearance fee, and a revision to the interest and facility fee rate calculations.
On December 28, 1999, the Company refinanced its existing credit facility with a new bank group. The new agreement is a three year secured asset based facility for $30 million, increasing to $35 million in year two. The credit facility consist of two components, the first a $20 million revolving credit facility (increasing to $25 million in year two) based on eligibility critera for receivables and inventory. Amounts borrowed are limited to 85 percent of qualified accounts receivable, 20 percent of raw materials, and 30 percent of finished goods inventory, repectively. The second component consists of a $10 million three-year term loan with monthly principal installments based on a five year amortization beginning in April 2000.
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At closing, the Company had available for borrowing $28.8 million pursuant to the terms of its new facility. A portion of the net proceeds was used to repay its outstanding obligations under its prior credit facility, leaving approximately $9.0 million available for future borrowings.
The interest rate on the revolving credit facility is calulated based on the Company's debt-to-worth ratio as defined in the credit facility agreement. Accordingly, the interest rate will range from a minimum of prime rate or LIBOR plus 185 basis points to a maximum of prime rate plus 3 1/4 percent or LIBOR plus 600 basis points. Based on the Company's debt-to-worth ratio at the date of the bank's closing, the interest rate is either the prime rate or LIBOR plus 200 basis points. Additionally, a facility fee is paid on the unused portion of the facility.
The interest rate on the term note is calculated based on the Company's debt-to-worth ratio as defined in the credit facility agreement. Accordingly, the interest rate will range from a minimum of prime rate plus 1/8 percent or LIBOR plus 200 basis points to a maximum of prime rate plus 3 1/2 percent or LIBOR plus 625 basis points. Based on the Company's debt-to-worth ratio at the date of the bank's closing, the interest rate is either the prime rate plus 1/8 or LIBOR plus 215 basis points.
The Company is required to make an election to select either the prime rate or LIBOR, as the basis for the interest rate calulation, any change in election is subject to the terms of the credit agreement.
The new credit facility contains specific affirmative and negative covenants binding the Company, including, among others, the maintenance of certain financial covenants, as well as limitations on amounts available under the lines of credit relating to the borrowing base, capital expenditures, lease payments and additional debt. The more restrictive of the covenants provide that the company maintain a minimum tangible net worth, minimum net income after taxes, maximum debt-to-worth ratio, and minimum cash flow coverage. Covenant compliance begins with the quarter ending December 31, 1999.
Based on the terms of the new asset based facility, the aggregate annual maturities of long-term debt at September 30, 1999 are as follows (in thousands):
Year Amount ---- ------ 2000 $ 1,053 2001 2,105 2002 2,105 2003 12,337 ------ $ 17,600 ======
Based on borrowing rates currently available to the Company for bank loans with similar terms and average maturities, the fair value of long-term debt approximates its recorded value.
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6. INCOME TAXES:
The (benefit from)provision for income taxes in fiscal 1999, 1998 and 1997 is summarized as follows(in thousands): 1999 1998 1997 ------- ------- -------
Current Federal $ (3,083) $ (747) $ 4,462 State 170 209 357 Deferred 322 (2,341) (570) -------- --------- -------- (Benefit from)provision for income taxes, net $ (2,591) $(2,879) $ 4,249 ======= ========= ========
The components of the deferred tax asset (liability) at September 30 are as follows(in thousands):
1999 1998 ---- ---- Ireland losses $2,040 $ - Net operating loss and AMT credit carryovers 714 - Accelerated depreciation (1,746) (4,323) New York state investment tax credits 3,301 3,036 Compensated absences 349 587 Inventories 1,836 1,781 Receivables 62 671 Restructuring reserve 637 1,020 Other 463 186 ------- ------- 7,656 2,958 Valuation allowance (7,656) (2,636) ------- ------- $ - $ 322 ======= =======
A full valuation allowance has been established against the net deferred tax asset due to recent losses and tax carryback limitations. The Company has a net operating loss carryforward of $1.1 million (expiring in fiscal 2019) and alternative minimum tax carryforwards of $331,000.
The Company has available approximately $5 million in New York State investment tax credits through 2008. A valuation allowance has been recorded at September 30, 1999 and 1998 to offset a majority of the deferred tax assets generated by New York state investment tax credits since the Company anticipates generating additional investment tax credits each year during the carryforward period, which limits the utilization of the tax credit carryforward.
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The differences between the effective tax rates and the statutory federal income tax rates for fiscal years 1999, 1998 and 1997 are summarized as follows:
1999 1998 1997 ----- ----- ----- (Benefit)provision for income taxes at statutory rates (34.0)% (34.0%)% 34.0% Amortization of cost in excess of net assets acquired 0.5 1.3 1.1 Provision for state taxes,net 0.5 1.5 2.1 Other 0.2 (0.7) 0.7 Deferred Current Valuation Allowance 21.7 - - ----- ----- ----- (11.1)% (31.9)% 37.9% ===== ===== =====
7. SHAREHOLDERS' EQUITY:
Stock-Based Compensation Plans
In November 1993, the Company adopted the 1993 Stock Option Plan (SOP) which replaced and superseded the 1989 Stock Option Plan. However, any outstanding options under the 1989 Stock Option Plan remain in effect in accordance with and subject to the terms of the 1989 Stock Option Plan.
Under the SOP, a total of 1,400,000 shares, inclusive of the foregoing, were reserved for key employees, officers, directors and consultants as of September 30, 1999. The option price for incentive options must be at least 100 percent of the fair market value at date of grant, or if the holder owns more than 10 percent of total common stock outstanding at the date of grant, then not less than 110 percent of the fair market value at the date of grant. Stock options issued prior to 1992 terminate 10 years from date of grant, while incentive and nonqualified stock options issued subsequent to 1991 terminate seven and five years from date of grant, respectively.
Incentive stock options granted during the period between July 1995 through September 1999 vest in increments of 25 percent. Nonqualified stock options granted during fiscal year 1999, 1998 and 1997 vest in increments of 33 1/3 percent.
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Changes in the status of options under the SOP at September 30, are summarized as follows:
Weighted Shares Average Under Exercise Available September 30, Option Price for Grant Exercisable ------------- --------- -------- -------- ----------- 1996 504,542 $10.53 306,504 306,542 Options granted 376,500 8.56 Options exercised (137,131) 7.67 Options forfeited (105,000) 11.89 --------- 1997 638,911 9.75 35,004 199,661 Options granted 113,500 11.89 Options exercised (30,875) 4.33 Options forfeited (69,500) 11.96 --------- 1998 652,036 10.23 491,004 338,911 Options granted 123,000 3.75 Options exercised - - Options forfeited (150,539) 12.48 --------- 1999 624,497 8.38 518,543 367,372 ========= The following table summarizes information about stock options outstanding as of September 30, 1999:
Options Outstanding Options Exercisable -------------------------------------- --------------------------
Number Weighted Number Outstanding Average Weighted Exercisable Weighted Range of at Remaining Average at Average Exercise September 30, Contractual Exercise September 30, Exercise Prices 1999 Life Price 1999 Price - -------------- ---------------- ---------- --------- ---------------- ---------
$ 3.25-$3.875 114,500 6.405 $ 3.728 - $ - $ 5.00-$6.25 139,747 3.567 $ 6.040 80,247 $ 5.903 $ 7.625-$9.75 185,000 3.366 $ 8.774 143,000 $ 8.659 $10.825-$13.00 162,750 2.472 $ 12.174 137,750 $ 12.419 $14.375-$16.50 22,500 4.735 $ 15.850 6,375 $ 15.868 ---------------- ----------------- 624,497 367,372 ================ ================
The weighted average fair value of options granted during fiscal 1999, 1998 and 1997 was $3.74, $11.34 and $4.80, respectively. The fair value of options is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions: risk-free interest rate of 5.00 percent, 5.75 percent and 6.43 percent, for fiscal 1999, 1998 and 1997, respectively; volatility of 53 percent for fiscal 1999 and 1998 and 50 percent for fiscal 1997, respectively; and expected option life of 7 years for fiscal 1999 and 1998, and 5.8 years for fiscal 1997, respectively. The dividend yield was 0 percent. Forfeitures are recognized as they occur.
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The Company applies Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and the disclosure only provisions of SFAS No. 123 "Accounting for Stock-Based Compensation." Accordingly, no compensation expense has been recognized for its stock-based compensation plans. Had the Company recognized compensation cost based upon the fair value at the date of grant for awards under its plans consistent with the methodology prescribed by SFAS No. 123, net income(loss) and net income(loss) per common and common equivalent share would have been as follows for years ended September 30 (in thousands, except per share data):
1999 1998 1997 ---------------- --------------- --------------- As Pro As Pro As Pro Reported Forma Reported Forma Reported Forma -------- ------ -------- ------- ------- -------
Net (loss) income $(20,565) $(20,726) $(6,160) $(6,412) $6,958 $6,683 ========= ======== ======= ======== ======= =======
Net (loss)income per common and common equivalent share: Basic $(2.72) $(2.74) $(.82) $(.85) $0.93 $0.90 ======== ========= ======== ======== ======= ======= Diluted $(2.72) $(2.74) $(.82) $(.85) $0.91 $0.88 ======== ======== ======== ======== ======= =======
Because the SFAS No. 123 method of accounting had not been applied to options granted prior to October 1, 1995, the resulting pro forma compensation cost may not be representative of that to be expected in future years.
Treasury Stock
On August 25, 1997, a note receivable from an officer was paid in full, including accrued interest, by the surrender of Company stock held by the officer. Accordingly, the Company reacquired 20,573 shares at the fair market value of $411,000.
8. MAJOR CUSTOMERS AND CREDIT RISK CONCENTRATIONS:
Financial instruments which potentially subject the Company to concentrations of credit risk consist primarily of cash, cash equivalents, and trade accounts receivable. The Company has concentrations of credit risk due to sales to its major customers.
The Company's revenues are derived primarily from sales to North American customers in the industial and telecommunications industries and are concentrated among specific companies. For the fiscal year ended September 30, 1999, three customers accounted for 23 percent, 18 percent and 10 percent, respectively, of the Company's net sales. For the fiscal year ended September 30, 1998, two customers accounted for 38 percent and 15 percent, respectively, of the Company's net sales. For the fiscal year ended September 30, 1997, two customers accounted for 26 perent and 20 percent, respectively, of the Company's net sales.
At September 30, 1999, amounts due from the three customers represented 36 percent, 20 percent and 4 percent, respectively, of trade accounts receivable. At September 30, 1998, amounts due from the two customers represented 29 percent and 12 percent, respectively, of trade accounts receivable. The Company performs ongoing credit evaluation of its customers' financial positions and generally does not require collateral.
Sales to foreign source customers (primarily in Europe) totaled approximately 16 percent, 34 percent, and 32 percent of total net sales in fiscal years 1999, 1998 and 1997, respectively.
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9. COMMITMENTS AND CONTINGENCIES:
Mexico
During 1999, the Company entered into an agreement for the production and distribution of electronic assemblies in Reynosa, Mexico. The term of the agreement is three years and requires the Company to maintain a minimum of 25 employees. Based on current labor rates, the Company's annual commitment is approximately $300,000. In addition, the Company has entered into a five year lease which expires in April 2004 for a 50,000 aquare foot facility located in Reynosa, Mexico.
The lease contains renewal provisions and generally requires the Company to pay utilities, insurance, taxes, and other operating expenses. Beginning in year three, the lease is subject to minimum increases of 1.5 percent which is reflected in the commitment detail below, however the maximum increase is 3 percent.
The minimum annual rental commintment at September 30, 1999 is payable as follows: (in thousands)
Year Amount ---- ------ 2000 $312 2001 314 2002 319 2003 323 2004 190
Lemelson
During fiscal 1999, the Company received a notice of infringement, along with an offer of a licence, from the Lemelson Foundation. The notice alleged that the Company has infinged certain of the Lemelson Foundation patents relating to machine vision and bar-code technology. To date, approximately 480 companies, large and small have signed licenses with the Lemelson Foundation believing that a known royalty rate which could be built into the cost of the product was preferable to ongoing litigation with uncertain results. An industry association, on behalf of the electronics manufacturing services industry, has negotiated a form license agreement which obtained rights to all of the relevant Lemelson patents for a a one-time paid-up royalty. As of September 30, 1999, the Company has calculated the cost of the corresponding royalty to be approxiately $530,000 based on a licensing period from 1991 though 2001 and recorded a liability to reflect the prior and current years' impact against cost of goods sold.
Litigation
The Company is also subject to other legal proceedings and claims which arise in the ordinary course of its business. Although occasional adverse decisions (or settlements) may occur, the Company believes that the final disposition of such matters will not have a material adverse effect on the financial position or results of operations of the Company.
10. RETIREMENT PLAN:
The Company has a retirement savings plan, established pursuant to Sections 401(a) and 401(k) of the Internal Revenue Code. This plan is for the exclusive benefit of its eligible employees and beneficiaries. Eligible employees may elect to contribute a portion of their compensation each year to the plan. Effective June 1, 1998, The Board of Directors approved a change in the employer match from 33 percent of the amount contributed by participant to 100 percent of the first 3 percent of employee contributions, and 50 percent of the next 3 percent of employee contributions. The matching Company contributions were approximately $744,000, $717,000 and $524,000 for the years ended September 30, 1999, 1998 and 1997, respectively. The plan also allows the Company to make an annual discretionary contribution determined by the Board of Directors. There were no discretionary contributions for fiscal 1999, 1998, or 1997.
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11. ACCOUNTING PRONOUNCEMENTS:
In June 1999, the Finanncial Accounting Standards Board issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activies - Deferral of Effective Date of FASB Statement No. 133 for one year". With issuance of SFAS No. 137, the Company is required to adopt SFAS No. 133 on a prospective basis for interim periods and fiscal years beginning March 1, 2001. The Company believes that the effect of adoption of SFAS No. 133 will not be material based on the Company's current risk management strategies.
12. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
First Second Third Fourth Quarter Quarter Quarter Quarter -------- -------- -------- ----------
(in thousands, except share data) YEAR ENDED SEPTEMBER 30,1999: Net sales $36,281 $34,854 $37,522 $48,831 Gross profit (loss) (602) 474 558 (6,196) Net income (loss) (2,305) (1,760) (1,706) (14,794) Net income (loss) per common and common equivalent share: Basic (0.30) (0.23) (0.23) (1.96) Diluted (0.30) (0.23) (0.23) (1.96)
YEAR ENDED SEPTEMBER 30, 1998: Net sales $94,115 $71,045 $43,125 $39,874 Gross profit(loss) 8,688 4,307 1,258 (613) Net income (loss) 2,327 (891) (1,337) (6,259) Net income (loss) per common and common equivalent share: Basic 0.31 (0.12) (0.18) (0.83) Diluted 0.30 (0.12) (0.18) (0.83)
YEAR ENDED SEPTEMBER 30, 1997: Net sales $50,522 $61,103 $62,798 $86,263 Gross profit 4,708 7,088 7,904 8,394 Net income 912 1,873 1,823 2,350 Net income per common and common equivalent share: Basic 0.12 0.25 0.25 0.31 Diluted 0.12 0.25 0.24 0.30
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SCHEDULE II
IEC ELECTRONICS CORP. AND SUBSIDARIES
VALUATION AND QUALIFYING ACCOUNTS
FOR THE YEARS ENDED SEPTEMBER 30, 1999, 1998 AND 1997
(All amounts in thousands)
1999 1998 1997 ------------------------------ Accounts receivable reserve balance, $ 1,975 $ 722 $ 100 at beginning, of year Provision for doubtful accounts - 1,639 672 Write-off of doubtful accounts, net of recoveries 1,799 386 - ------------------------------- Balance, at end of year $ 176 $1,975 $ 772 ===============================
1999 1998 1997 ------------------------------ Restructuring reserve balance, $ 3,396 $ - $ - at beginning, of year Provision for restructuring 3,965 4,745 - Deductions 2,294 1,349 - ------------------------------- Balance, at end of year $ 5,067 $3,396 - ===============================
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EXHIBIT 22.1
Subsidiaries of IEC Electronics Corp.
IEC Electronics-Edinburg, Texas Inc., a Texas corporation, wholly-owned by IEC Electronics Corp.
IEC Arab, Alabama Inc., a Alabama corporation, wholly-owned by IEC Electronics Corp.
IEC Electronics-Ireland Limited., an Irish corporation, wholly-owned by IEC Electronics Corp
IEC Electronics Foreign Sales Corporation, a Barbados corporation, wholly- owned by IEC Electronics Corp.
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Exhibit 24.1
CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS
As independent public accountants, we hereby consent to the incorporation of our report included in this Form 10-K, into the Company's previously filed Registration Statements on Form S-8 File Nos. 33-63816, 33-79360, 333-4634, 333-84471 and 333-84469.
/s/ Arthur Andersen LLP
Rochester, New York, December 28, 1999
Page 46 of 46 | 16,022 | 107,581 |
1077673_1999.txt | 1077673_1999 | 1999 | 1077673 | ITEM 1. BUSINESS
THE COMPANY
TransDigm is a leading supplier of highly engineered aircraft components for use on nearly all commercial and military aircraft. TransDigm sells its products to commercial airlines, aircraft maintenance facilities, aircraft original equipment manufacturers ("OEMs") and various agencies of the United States government. TransDigm generates most of its EBITDA, As Defined, from sales of replacement parts in the aftermarket, including sales to airlines. This is because most of TransDigm's OEM sales are on an exclusive sole source basis; therefore, in most cases, TransDigm is the only certified provider of these parts in the aftermarket. Because aftermarket parts sales are driven by the size of the worldwide aircraft fleet, they are relatively stable and generate recurring revenues over the life of an aircraft that are many times the size of the original OEM purchases. In addition, because TransDigm has over 40 years of experience in most of its product lines, it benefits from a large and growing installed base of aircraft.
TransDigm differentiates itself based on its engineering and manufacturing capabilities, and typically will not bid on non-proprietary "build to print" business. TransDigm has developed strong product brand names within the airline industry and a reputation for high quality, reliability and customer service. TransDigm focuses on developing highly customized products to solve specific problems of aircraft operators and manufacturers. Management estimates that over 80% of the TransDigm's products are of proprietary design. TransDigm provides its products to commercial airlines, such as United Airlines and Continental Airlines, large commercial transport and regional and business aircraft OEMs, such as Boeing, Bombardier and Cessna, and various agencies of the United States government. While aftermarket and OEM sales each typically account for approximately half of TransDigm's revenues, aftermarket sales typically carry a substantially higher gross margin than sales to OEMs.
TransDigm is comprised of four business units: (1) AdelWiggins, (2) AeroControlex, (3) Marathon Power Technologies Company ("Marathon"), and (4) Adams Rite Aerospace, Inc. ("Adams Rite Aerospace"), each of which has a long history in the aircraft components industry. AdelWiggins manufactures an extensive line of fuel and hydraulic system connectors, specialized clamps, heaters and refueling systems. AeroControlex manufactures customized fuel pumps, compressors, valves, couplings and mechanical and electromechanical controls. Adams Rite Aerospace manufactures mechanical hardware, fluid controls, lavatory hardware, electromechanical controls and oxygen systems related products. Marathon manufactures nickel cadmium batteries and static inverters. Marathon and ZMP, Inc. ("ZMP") the corporate parent of Adams Rite Aerospace, were acquired in August 1997 and April 1999, respectively, as strategic complements to the AdelWiggins and AeroControlex businesses.
TransDigm was formed in 1993 through a management-led buyout of IMO Industries. Since its formation, TransDigm has successfully established leadership positions in well-defined, profitable niches of the aircraft components market that it believes offer sustainable growth opportunities.
On December 3, 1998, Phase II Acquisition Corp., an entity formed by affiliates of Odyssey Investment Partners, LP ("Odyssey"), and Holdings consummated a recapitalization (the "Recapitalization") pursuant to an agreement and plan of merger (the "Merger Agreement"). In connection therewith, Phase II Acquisition Corp. was merged with and into Holdings, with Holdings being the surviving corporation (the "Merger"). The Merger was treated as a recapitalization for financial reporting purposes, which had no impact on the historical basis of Holdings' consolidated assets and liabilities.
PRODUCTS
TransDigm's products are found on virtually all types of aircraft, and TransDigm supplies components to all major domestic and international airlines. Management estimates that over 80% of TransDigm's products are of proprietary design and approximately 70% of TransDigm s sales are derived from parts for which it has achieved sole source designation. TransDigm's products are grouped into fifteen major product lines, each of which is profitable and is operated as a semi-autonomous business unit.
Much of TransDigm's recent success has been due to its identification and development of new products for sale in the commercial aftermarket. TransDigm works closely with customers to identify their unmet needs, such as a component that fails to meet performance expectations or that requires excessive maintenance. TransDigm then utilizes its engineering and design capabilities to develop a prototype for a component that increases the value of the product to the customer. After rigorous testing requirements have been fulfilled and TransDigm has obtained necessary regulatory approvals, the product is made available for sale in the aftermarket and to OEMs.
ADELWIGGINS - AdelWiggins manufactures over 8,000 SKUs, representing 36% of TransDigm's sales for fiscal 1999, which constitute five of TransDigm's fifteen major product lines: (A) flexible tube connectors, (B) special connectors, (C) Adel clamps, (D) Wiggins service systems and (E) heaters and hoses. Tube connectors are fluid line connectors that provide leak tight joints and are found in flexible fluid systems on most aircraft platforms including fuel, water, waste and environmental systems. Special connectors are connectors designed to allow breaking and reconnecting of fluid lines under pressure and are found in quick disconnect applications including refueling and other fluid management systems for military, space and rocket launch applications and in frangible connectors for large commercial transports. Adel clamps include cushioned clamps, engineered elastomers, bare metal clamps, clampshells, block clamps and quick release clamps used to support fuel, hydraulic, fluid and electric lines and are found in a broad variety of clamps located throughout the airplane, including in engines to address high temperature and high vibration requirements. Wiggins service systems include proprietary refueling nozzles and systems, vents, receivers and quick disconnects and are found in mine refueling equipment and military applications such as tanks and armored vehicles that require high flow capabilities and universal compatibility. Heaters and hoses consists of specialized hoses and heaters, including blanket and ribbon heaters, heater cuffs, heated nipples and gaskets and heated tanks throughout the aircraft and are designed to prevent freezing of fluids such as potable water and waste and to provide heat for hot water service applications.
AdelWiggins designs its products specifically to meet the engineering requirements of its customers, focusing on aspects such as: reduced-profile or low-profile geometry, broad ranges of high-temperature service, ease of installation and, where possible, utilization of advanced materials to maximize the strength-to-weight ratios of its components. These factors are critical to both OEMs and commercial airlines given their emphasis on reducing both acquisition and operating costs. In addition, TransDigm believes AdelWiggins' products have a reputation for long service lives and extremely high reliability in stressful operating environments.
Approximately 60% of AdelWiggins' products are proprietary products designed to meet specific customer needs. The remaining 40% are industry standard designs. Roughly 55% of AdelWiggins' products are sole sourced, which is advantageous to TransDigm because it creates significant switching costs associated with the development and qualification of alternative engineered solutions. This sole sourced status has contributed to AdelWiggins achieving aftermarket sales of 26% of its net sales in fiscal 1999. See "Business-Customers."
AeroControlex - AeroControlex manufactures over 13,000 SKUs, representing 36% of TransDigm's sales for fiscal 1999, which constitute three of TransDigm's fifteen major product lines: (A) mechanical controls, (B) pumps and (C) valves and quick disconnects. Mechanical controls include electromechanical control systems, sliding and ball bearing control cables and gearboxes which are found in the lavatory drain, throttle control, engine feedback, landing gear release and in ejection seats and fuel and air systems. Pumps primarily include gear pumps, which are found in hydraulic and fuel systems applications. Valves and quick disconnects include fuel and air system valves, compressors and quick disconnects which are found in air conditioning packages and fuel, radar and potable water systems.
AeroControlex designs, manufactures and sells pumps, compressors, valves, couplings and mechanical controls primarily for the commercial and military aircraft markets. AeroControlex has developed a reputation for providing high-quality, reliable products consistently delivered on time. AeroControlex works closely with customers to leverage its engineering expertise to create technical solutions to customer-specific problems. About 95% of AeroControlex products are proprietary and over 90% are sold on a sole-source basis, which is advantageous to TransDigm because its creates significant switching costs associated with the development and qualification of alternative engineered solutions. This sole sourced status has contributed to AeroControlex achieving aftermarket sales of 69% of its net sales in fiscal 1999. See "Business-Customers."
MARATHON - Marathon manufactures over 5,000 SKUs, representing 16% of TransDigm's sales for fiscal 1999, which constitute three of TransDigm's fifteen major product lines: (A) vented cell nickel-cadmium batteries, (B) static inverters and (C) sealed cell nickel-cadmium batteries. Vented cell nickel-cadmium batteries and sealed cell batteries are used for engine starting and emergency power aboard various aircraft while static inverters convert direct current to alternating current for use in applications such as flight instrumentation and communication. Marathon products are used for numerous military applications, such as the,, Blackhawk, Apache and Cobra programs. Approximately 50% of Marathon's products have achieved sole sourcing status with its customers.
Marathon is one of the world's leading manufacturers of vented cell nickel- cadmium batteries, which require frequent maintenance, as individual cells within a battery are replaced throughout the life of the battery. Marathon, which manufactures and sells both entire batteries and individual cells, realizes replacement revenue in the aftermarket throughout the life of the battery as a result of its position as a sole source supplier of products that accounted for over 50% of its sales. Over 95% of Marathon's sales are proprietary, the status of which has contributed to Marathon achieving aftermarket sales of 72% of its net sales in fiscal 1999. Vented cell batteries are marketed under the Marathon(TM) and SuperPower(TM) brand names.
ADAMS RITE AEROSPACE - Adams Rite Aerospace manufactures over 6,000 SKUs, representing 12% of TransDigm's sales for fiscal 1999, which constitute four of TransDigm's fifteen major product lines: (A) mechanical hardware, (B) fluid control products, (C) electromechanical control products and (D) oxygen systems related products. Mechanical hardware include hardware installed inside the aircraft, such as overhead stowage bin latches, lavatory indicator and door latches, seat control cables and decompression latches, and hardware installed outside of the aircraft, such as door bolting systems. Fluid control products include various aircraft water system components, such as spigots, soap dispensers and water shut-off valves as well as entire self-contained water systems. Electromechanical control products include throttle quadrants, control wheels, electric strikes, speed brake controls and a variety of handle grips. Oxygen systems related products include oxygen cylinders, masks, reducers and control panels. Adams Rite Aerospace achieved aftermarket sales subsequent to its acquisition on April 23, 1999 of 50% of its net sales for the period ended September 30, 1999. See "Business-Customers."
SALES AND MARKETING
Consistent with TransDigm's overall strategy, TransDigm's sales and marketing organization is structured to understand and anticipate the needs of customers in order to continually develop a stream of technical solutions that generate significant value. In particular, TransDigm focuses on the high-margin, repeatable aftermarket segment.
TransDigm has structured AdelWiggins', AeroControlex's, Adams Rite Aerospace's, and Marathon's sales efforts along their collective eleven major product lines, assigning a Product Line Manager to each line. The Product Line Managers are expected to grow the sales and profitability of their product line faster than the served market and to achieve the targeted annual level of bookings, sales, new business and profitability for each product. Assisting the Product Line Managers are Account Managers and Sales Engineers who are responsible for covering major OEM and airline accounts. Account Managers and Sales Engineers are expected to be familiar with the personnel, organization and needs of specific customers, for achieving total bookings and new business goals at each account, and, in conjunction with the Product Line Managers, for determining when additional resources are required at customer locations. All of TransDigm's sales personnel are compensated in part on their bookings and sales and ability to identify and convert new business opportunities.
Though the majority are employees, the Account Manager function may be performed by independent representatives depending on the specific customer, product and geographic location. TransDigm also uses a limited number of distributors to provide logistical support as well as primary customer contact with certain smaller accounts. TransDigm's largest distributor is Aviall, which provides logistic services to the commercial airlines.
BACKLOG
Management believes that sales order backlog (i.e. orders for products that have not yet been shipped) is a useful indicator of sales to OEMs. As of September 30, 1999, the Company estimated its sales order backlog at $62.5 million compared to an estimated $63 million as of September 30, 1998 (including $19.8 million relating to Adams Rite Aerospace). The majority of the purchase orders outstanding as of September 30, 1999 are scheduled for delivery within the next twelve months. Purchase orders are generally subject to cancellation by the customer prior to shipment. The level of unfilled purchase orders at any given date during the year will be materially affected by the timing of the Company's receipt of purchase orders and the speed with which those orders are filled. Accordingly, the Company's backlog as of September 30, 1999 may not necessarily represent the actual amount of shipments or sales for any future period.
FOREIGN OPERATIONS
The Company manufactures virtually all of its products in the United States. However, a portion of the Company's current sales is conducted abroad. These sales are subject to numerous additional risks, including the impact of foreign government regulations, currency fluctuations, political uncertainties and differences in business practices. There can be no assurance that foreign governments will not adopt regulations or take other action that would have a direct or indirect adverse impact on the business or market opportunities of the Company within such governments' countries. Furthermore, there can be no assurance that the political, cultural and economic climate outside the United States will be favorable to the Company's operations and growth strategy.
MANUFACTURING AND ENGINEERING
TransDigm maintains four manufacturing facilities. Each facility serves its respective operating group and comprises manufacturing, distribution and engineering as well as corporate functions, including management, sales and finance. The AdelWiggins, AeroControlex, Marathon and Adams Rite Aerospace facilities encompass approximately 105,000, 44,000, 150,000 and 100,000 square feet of manufacturing space in Los Angeles, California, Cleveland, Ohio, Waco, Texas and Fullerton, California, respectively. In the last several years, management has taken a number of steps to improve productivity and reduce costs, including consolidating operations, developing improved control systems that allow for accurate product line profit and loss accounting, investing in equipment and tooling, installing modern information systems and implementing a broad-based employee training program. Management believes that TransDigm's manufacturing systems and equipment are critical competitive factors that permit it to meet the rigorous tolerances and cost sensitive price structure of aircraft customers. TransDigm focuses its manufacturing activities by product line, alternating its equipment among designs as demand requires. TransDigm is in the process of applying its proven manufacturing strategy to the Marathon facility, where its expects to be able to substantially improve Marathon's performance.
Each of TransDigm's operating groups attempts to differentiate itself from its competitors by producing highly engineered products at a low cost. TransDigm's proprietary products are designed by its engineering staff and intended to serve an unmet need in the aircraft component industry, particularly through its new product initiatives. See "Business-Products." These proprietary designs must withstand the extraordinary conditions and stresses that will be endured by products during use and meet the rigorous demands of TransDigm's customers ' tolerance and quality requirements.
TransDigm uses sophisticated equipment and procedures to ensure the quality of its products and to comply with military specifications and Federal Aviation Administration ("FAA") and OEM certification requirements. TransDigm performs a variety of testing procedures, including testing under different temperature, humidity and altitude levels, shock and vibration testing and X-ray fluorescent measurement. These procedures, together with other customer approved techniques for document, process and quality control, are used throughout TransDigm's manufacturing facilities.
CUSTOMERS
TransDigm's customers include: (A) commercial airlines, including national and regional airlines, particularly for aftermarket MRO components, (B) large commercial transport and regional and business aircraft OEMs, (C) various agencies of the United States government, including the United States military, and (D) various other industrial customers. For the year ended September 30, 1999, two customers represented approximately 15% and 14%, respectively, of the Company's net sales. Two customers represented approximately 20% and 14%, respectively, of the Company's net sales during the year ended September 30, 1998, and one customer represented approximately 15% of the Company's net sales for the year ended September 30, 1997.
TransDigm has strong customer relationships with virtually all important large commercial transport, general aviation and military OEMs. The demand for TransDigm's aftermarket parts and services is related to TransDigm's extensive installed base and to revenue passenger miles and, to a lesser extent, to airline profitability and the size and age of the worldwide aircraft fleet. Some of TransDigm's business is executed under long-term agreements with customers, which encompass many products under a common agreement. TransDigm is also a leading supplier of components used on United States' designed military aircraft. TransDigm's products are used on a variety of fighter aircraft and helicopters. Military aircraft using TransDigm's products include the Lockheed and, the E2C (Hawkeye) and Blackhawk and Apache helicopters.
COMPETITION
TransDigm competes with a number of established companies, including divisions of larger companies that have significantly greater financial, technological and marketing resources than TransDigm. The niche markets within the aerospace industry served by TransDigm are relatively fragmented with several competitors for each of the products and services provided by AdelWiggins, AeroControlex and Marathon. Due to the global nature of the commercial aircraft industry, competition in these categories comes from both U.S. and foreign companies. TransDigm knows of no single competitor, however, that provides the same range of products and services as those provided by TransDigm. Competitors in TransDigm's product lines range in size from divisions of large corporations to small privately held entities, with only one or two components in their entire product line. Some of TransDigm's competitors have significantly greater financial, technological and marketing resources than TransDigm. TransDigm believes that its ability to compete depends on high product performance, short lead-time and timely delivery, competitive price, and superior customer service and support. There can be no assurance that TransDigm will be able to compete successfully with respect to these or other factors.
GOVERNMENTAL REGULATION
The commercial aircraft component industry is highly regulated by both the FAA in the United States and by the Joint Aviation Authorities in Europe, while the military aircraft component industry is governed by military quality specifications. TransDigm, and the components it manufacturers, are required to be certified by one or more of these entities, and, in some cases, by individual OEMs in order to engineer and service parts and components used in specific aircraft models. If material authorizations or approvals were revoked or suspended, the operations of TransDigm would be adversely affected. In the future, new and more stringent government regulations may be adopted, or industry oversight may be heightened, which may have an adverse impact on TransDigm.
TransDigm must also satisfy the requirements of its customers, including OEMs and airlines that are subject to FAA regulations, and provide these customers with products and services that comply with the government regulations applicable to commercial flight operations. In addition, the FAA requires that various maintenance routines be performed on aircraft components, and TransDigm currently satisfies or exceeds these maintenance standards in its repair and overhaul services. Several of TransDigm's operating divisions include FAA-approved repair stations.
TransDigm's operations are also subject to a variety of worker and community safety laws. The Occupational Health and Safety Act ("OHSA") mandates general requirements for safe workplaces for all employees. In addition, OHSA provides special procedures and measures for the handling of certain hazardous and toxic substances. TransDigm believes that its operations are in material compliance with OHSA's health and safety requirements.
RAW MATERIALS AND PATENTS
TransDigm requires the use of various raw materials, including titanium, aluminum, nickel powder, nickel screen, stainless steel and cadmium, in its manufacturing processes. The availability and prices of such raw materials may fluctuate and price increases in these supplies may not be able to be recovered. TransDigm also purchases a variety of manufactured component parts from various suppliers. TransDigm is concentrating its orders, however, among fewer suppliers in order to strengthen its supplier relationships. Raw materials and component parts are generally available from multiple suppliers at competitive prices. However, any delay in TransDigm's ability to obtain necessary raw materials and component parts may affect its ability to meet customer production needs.
TransDigm has various trade secrets, proprietary information, trademarks, trade names, patents, copyrights and other intellectual property rights, which TransDigm believes, in the aggregate but not individually, are important to its business.
ENVIRONMENTAL MATTERS
TransDigm's operations and current and/or former facilities are subject to federal, state and local environmental laws and to regulation by government agencies, including the Environmental Protection Agency. Among other matters, these regulatory authorities impose requirements that regulate the emission, discharge, generation, management, transportation and disposal of hazardous materials and pollutants, govern response actions to hazardous materials which may be or have been released to the environment, and require TransDigm to obtain and maintain permits in connection with its operations. The extensive regulatory framework imposes significant compliance burdens and risks on TransDigm. Although management believes that TransDigm's operations and its facilities are in compliance in all material respects with applicable environmental laws, there can be no assurance that future changes in such laws, regulations or interpretations thereof or the nature of TransDigm's operations will not require TransDigm to make significant additional expenditures to ensure compliance in the future. According to some environmental laws, a current or previous owner or operator of real property may be liable for the costs of investigations, removal or remediation of hazardous materials at such property. Those laws typically impose liability whether or not the owner or operator knew of, or was responsible for, the presence of such hazardous materials. Persons who arrange, or are deemed to have arranged, for disposal or treatment of hazardous materials also may be liable for the costs of investigation, removal or remediation of those substances at the disposal or treatment site, regardless of whether the affected site is owned or operated by that person. Because TransDigm owns and/or operates a number of facilities, and because TransDigm arranges for the disposal of hazardous materials at many disposal sites, TransDigm may incur costs for investigation, removal and remediation, as well as capital costs associated with compliance. Although those environmental costs have not been material in the past and are not expected to be material in the future, there can be no assurance that changes in environmental laws or unexpected investigations and clean-up costs will not be material. TransDigm does not currently contemplate material capital expenditures for environmental compliance remediation for fiscal 2000 or fiscal 2001.
The soil and groundwater beneath TransDigm's facility in Waco, Texas have been impacted by releases of hazardous materials. Because the majority of the contaminants identified to date are presently below action levels prescribed by the Texas Natural Resources Conservation Commission, TransDigm does not believe the condition of the soil and groundwater at the Waco facility will require incurrence of material capital expenditures; however, there can be no assurance that additional contamination will not be discovered or that the remediation required by the Texas Natural Resources Conservation Commission will not be material to the financial condition, results of operations or cash flows of TransDigm.
EMPLOYEES
As of September 30, 1999, TransDigm had approximately 750 full-time employees and 37 temporary employees. Approximately 6% of TransDigm employees were represented by the United Steelworkers Union, and approximately 13% were represented by the United Automobile, Aerospace and Agricultural Implement Workers of America. Collective bargaining agreements between TransDigm and these labor unions expire on April 2002 and November 2000, respectively. TransDigm considers its relationship with its employees generally to be satisfactory.
ITEM 2.
ITEM 2. PROPERTIES
TransDigm owns and operates a 130,000 square foot facility in Los Angeles, California, a 63,000 square foot facility in Cleveland, Ohio and a 219,000 square foot facility in Waco, Texas. In addition, TransDigm leases and operates a 100,000 square foot facility in Fullerton, California and approximately 17,000 square feet in Richmond Heights, Ohio, which is also TransDigm's headquarters. TransDigm also leases certain of its other facilities. Management believes that its machinery, plants and offices are in satisfactory operating condition and will have sufficient capacity to meet foreseeable future needs without incurring significant additional capital expenditures.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
During the ordinary course of business, TransDigm is from time to time threatened with, or may become a party to, legal actions and other proceedings. While TransDigm is currently involved in some legal proceedings, management believes the results of these proceedings will not have a material effect on the results of operations of TransDigm, in part due to indemnification arrangements. TransDigm believes that its potential exposure to those legal actions is adequately covered by its aviation product and general liability insurance.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted during the fourth quarter of the fiscal year covered by this report to a vote of our security holders.
PART II
ITEM 5.
ITEM 5. MARKET FOR OUR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION
There is no established public market for the common stock of Holdings.
HOLDERS
As of September 30, 1999, there were 29 record holders of Holdings' common stock. Holdings is the sole shareholder of TransDigm's common stock.
DIVIDENDS
There have been no cash dividends declared on any class of common equity for the two most recent fiscal years. See restrictions on Holdings' ability to pay dividends and TransDigm's ability to transfer funds to Holdings in Note 9 to our consolidated financial statements appearing elsewhere in this Report.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
SELECTED HISTORICAL FINANCIAL AND OTHER DATA OF TRANSDIGM HOLDING COMPANY
The following table sets forth selected historical consolidated financial and other data of Holdings for each of the fiscal years ended September 30,1995 through 1999 which have been derived from Holdings' audited consolidated financial statements for those years. The selected historical consolidated financial and other data for the fiscal year ended September 30, 1995 has been adjusted to give retroactive effect to the change in accounting for put warrants described in Note 17 to the consolidated financial statements of Holdings as of and for the years ended September 30, 1998, 1997 and 1996 included with Amendment No. 3 of the Company's Form S-4 filed with the Commission on April 23, 1999.
The Company acquired Marathon Power Technologies Company on August 8, 1997 and ZMP, Inc. and its wholly-owned subsidiary, Adams Rite Aerospace, on April 23,1999. Both of the acquisitions were accounted for as a purchase. The results of operations of Marathon, ZMP and Adams Rite Aerospace are included in Holdings' consolidated financial statements from the date of each of the acquisitions.
The information presented below should be read together with the "Management's Discussion and Analysis of Financial Condition and Results of Operations" section and the consolidated financial statements and the notes thereto included elsewhere herein.
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(1) Operating income includes the effect of a non-cash charge of $666 in fiscal 1997 and $242 in fiscal 1998 due to a purchase accounting adjustment to inventory associated with the acquisition of Marathon and a non-cash charge of $1,143 in fiscal 1999 due to a purchase accounting adjustment to inventory associated with the acquisition of Adams Rite Aerospace.
(2) All of the interest expense reported for fiscal 1995 through 1998 represents interest expense of TransDigm. Holdings had no interest expense prior to the Recapitalization discussed in Note 1 to the consolidated financial statements of Holdings included elsewhere in this Report. After the Recapitalization, Holdings incurred $2 million of interest expense during fiscal 1999 relating to the Holdings PIK Notes. Holdings has no other interest expense. TransDigm is not an obligor or a guarantor under the Holdings PIK Notes.
(3) EBITDA represents earnings before interest, taxes, depreciation, amortization, warrant put value adjustment and extraordinary items. EBITDA is presented because management believes it is frequently used by securities analysts, investors and other interested parties in the evaluation of companies in Holdings' industry. However, other companies in Holdings' industry may calculate EBITDA differently than Holdings does. EBITDA is not a measurement of financial performance under generally accepted accounting principles and should not be considered as an alternative to cash flow from operating activities, as a measure of liquidity or an alternative to net income as indicators of Holdings' operating performance or any other measures of performance derived in accordance with generally accepted accounting principles. See Holdings' consolidated statements of cash flows included in Holdings' consolidated financial statements included elsewhere in this Report.
(4) EBITDA, As Defined, is calculated as follows:
EBITDA, As Defined, is presented herein to provide additional information with respect to the ability of Holdings to satisfy its debt service, capital expenditure and working capital requirements and because certain types of covenants in TransDigm's and Holdings' borrowing arrangements are tied to similar measures. While EBITDA-based measures are frequently used as measures of operations and the ability to meet debt service requirements, they are not necessarily comparable to other similarly titled captions of other companies due to differences in methods of calculation.
(5) For purposes of computing the ratio of earnings to fixed charges, earnings consist of earnings before income taxes plus fixed charges. Fixed charges consist of interest expense, amortization of debt expense and the portion (approximately 33%) of rental expense that management believes is representative of the interest component of rental expense. Earnings were insufficient to cover fixed charges by $127 and $19,689 for fiscal 1995 and fiscal 1999, respectively.
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ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
The Company is a leading supplier of highly engineered aircraft components for use on nearly all commercial and military aircraft. The Company sells its products to commercial airlines and aircraft maintenance facilities in the aftermarket, to most original equipment manufacturers ("OEMs") of aircraft and to various agencies of the United States government. Sales of the Company's products are made directly to these organizations as well as through U.S. and international distributors who maintain inventories throughout the world of products purchased from the Company and others.
In connection with the Recapitalization discussed in Note 1 to the consolidated financial statements, including the financing and the application of the proceeds thereof, the Company incurred certain nonrecurring costs and charges, consisting primarily of compensation costs for management bonuses and stock options that were canceled in conjunction with the Recapitalization, the cost of terminating a financial advisory services agreement with an affiliate of one of the Company's stockholders, the write-off of deferred financing costs, and professional, advisory and financing fees. A one-time charge of approximately $40 million ($29 million after tax) was recorded during the year ended September 30, 1999. Because the cash costs included in this charge were funded principally through the proceeds of the subordinated notes and borrowings under the new Senior Credit Facility, this cost did not materially impact the Company's liquidity, ongoing operations or market position. For a discussion of the consequences of the incurrence of indebtedness in connection with the Recapitalization, see the heading "Liquidity and Capital Resources" in this section.
On April 23, 1999, the Company acquired ZMP, the corporate parent of Adams Rite Aerospace, under the terms of an agreement and plan of reorganization, dated March 31, 1999. The purchase price for the acquisition of ZMP was $41 million, subject to post-closing purchase price adjustments. The acquisition of ZMP and the related expenses were funded through $36 million of additional borrowings under the Company's Senior Credit Facility and the use of $5 million of the Company's cash balances. Adams Rite Aerospace is a well established supplier of highly engineered aircraft components that will complement the businesses of AdelWiggins, AeroControlex and Marathon. Through the acquisition of ZMP, the Company acquired four additional major product lines of Adams Rite Aerospace consisting of mechanical hardware, fluid control products, electromechanical control products and oxygen system related products. On an historical basis, Adams Rite Aerospace has realized a lower gross profit as a percentage of net sales than that achieved by the Company. Although management has taken steps to increase the profitability of Adams Rite Aerospace's business over the longer term, consolidation of the financial results of Adams Rite Aerospace with those of the Company has resulted in a lower profit margin for the Company as a whole, at least in the near term.
The following is management's discussion and analysis of certain significant factors that have affected the Company's financial position and operating results during the periods included in the accompanying consolidated financial statements. The Company's fiscal year ends on September 30.
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RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, certain operating data of the Company as a percentage of net sales.
CHANGES IN RESULTS OF OPERATIONS
FISCAL YEAR ENDED SEPTEMBER 30, 1999 COMPARED WITH FISCAL YEAR ENDED SEPTEMBER 30, 1998.
- - NET SALES. Net sales increased by $19.9 million, or 17.9%, to $130.8 million for the year ended September 30, 1999 from $110.9 million for the year ended September 30, 1998, principally due to the acquisition of ZMP and growth in new business programs.
- - GROSS PROFIT. Gross profit (net sales less cost of sales) increased by $9.4 million, or 18.3%, to $60.9 million for the year ended September 30, 1999 from $51.5 million for the year ended September 30, 1998. Approximately $4.8 million of this increase is attributable to the acquisition of ZMP and the remaining $4.6 million resulted from improved profitability in the core businesses derived from new business and productivity efforts. The $4.8 million of ZMP gross profits recorded during the year ended September 30, 1999 are net of a $1.1 million charge relating to the write-up of Adams Rite Aerospace's inventory in place at the time of the acquisition. Gross profit as a percentage of net sales was 47% for the year ended September 30, 1999 and 46% for the year ended September 30, 1998.
- - SELLING AND ADMINISTRATIVE. Selling and administrative expenses increased by $3.1 million, or 29.5%, to $13.6 million for the year ended September 30, 1999 from $10.5 million for the year ended September 30, 1998. This increase principally resulted from the acquisition of ZMP discussed previously and additional new business initiatives. Selling and administrative expenses as a percentage of net sales increased slightly from 9% for the year ended September 30, 1998 to 10% for the year ended September 30, 1999.
- - AMORTIZATION OF INTANGIBLES. Amortization of intangibles decreased by $.3 million, or 12.5%, to $2.1 million for the year ended September 30, 1999 from $2.4 million for the year ended September 30, 1998 due to the amortization of intangible assets recognized in connection with the acquisition of ZMP.
- - RESEARCH AND DEVELOPMENT. Research and development expense increased $.4 million, or 24%, to $2.1 million for the year ended September 30, 1999 from $1.7 million for the year ended September 30, 1998. This increase was primarily attributable to continued new product development. Research and development expense, as a percentage of net sales, was 2% for the years ended September 30, 1998 and September 30, 1999.
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- - MERGER EXPENSES. Merger costs totaling $40 million were incurred during fiscal 1999 in connection with the Merger and Recapitalization (see Note 1 to the consolidated financial statements of Holdings included elsewhere in this Report). The nature of the merger-related charges is detailed below:
- - OPERATING INCOME. Operating income decreased from $36.8 million for the year ended September 30, 1998 to $3.0 million for the year ended September 30, 1999. Operating income decreased by $33.8 million, or 92%. This decrease was primarily attributable to the Merger and Recapitalization. As a percentage of net sales, operating income declined from 33% for the year ended September 30, 1998 to 2% for the year ended September 30, 1999.
- - INTEREST EXPENSE. Interest expense increased by $19.5 million to $22.7 million for the year ended September 30, 1999 from $3.2 million for the year ended September 30, 1998 as a result of the increase in the average level of outstanding borrowings in connection with the Recapitalization and acquisition of ZMP.
- - INCOME TAXES. Income tax expense (benefit) as a percentage of income (loss) before income taxes and the non-deductible warrant put value adjustment was (14%) for fiscal 1999 and 38.6% for fiscal 1998. The tax benefit recorded for fiscal 1999 was significantly impacted by the non-deductible expenses incurred in connection with the Recapitalization
- - NET INCOME (LOSS). The Company incurred a net loss of $16.9 million for the year ended September 30, 1999 compared to net income of $14.1 million for the year ended September 30, 1998 primarily as a result of the factors referred to above.
FISCAL YEAR ENDED SEPTEMBER 30, 1998 COMPARED WITH FISCAL YEAR ENDED SEPTEMBER 30, 1997.
- - NET SALES. Net sales increased by $32.8 million, or 42%, to $110.9 million for fiscal 1998 from $78.1 million for fiscal 1997. Approximately $19.5 million of this increase was attributable to the acquisition of Marathon on August 8, 1997. New business initiatives along with continued strength in airline traffic and airline capital spending resulted in a $7.4 million increase in aftermarket sales, principally for large commercial transport aircraft, and a $5.9 million increase in sales to OEMs.
- - GROSS PROFIT. Gross profit (net sales less cost of sales) increased by $22.6 million, or 78.2%, to $51.5 million for fiscal 1998 from $28.9 million for fiscal 1997. Approximately $9.5 million of this increase was attributable to the acquisition of Marathon, including a $0.4 million reduction in the charge to Marathon's cost of sales resulting from the write-up of Marathon's inventory in place at the time of the acquisition. In addition, the higher sales discussed above resulted in $7.8 million of additional gross profit from aftermarket sales, principally for large commercial transport aircraft, and $5.3 million from sales to OEMs. Gross profit increased as a percentage of net sales from 36.9% in the 1997 period to 46.4% in fiscal 1998. Approximately 3.8% of this increase was attributable to the acquisition of Marathon and the remainder was due to the higher sales discussed above.
- - SELLING AND ADMINISTRATIVE. Selling and administrative expenses increased by $2.9 million, or 38.2%, to $10.5 million for fiscal 1998 from $7.6 million for fiscal 1997. This increase was primarily attributable to the Marathon acquisition partially offset by reduction in bad debt and environmental expenses of $0.3 million each. Selling and administrative expenses as a percentage of net sales remained relatively constant at 9.7% in fiscal 1997 and 9.4% in fiscal 1998.
- - AMORTIZATION OF INTANGIBLES. Amortization of intangibles increased by $0.3 million, or 14.3%, to $2.4 million for fiscal 1998 from $2.1 million for fiscal 1997. The increase in the amortization of intangibles resulted from $0.5 million of additional goodwill amortization relating to the acquisition of Marathon offset by a $0.2 million reduction in the amortization of other intangible assets which became fully amortized in fiscal 1997.
- - RESEARCH AND DEVELOPMENT. Research and development expense increased $0.6 million, or 54.5% to $1.7 million for fiscal 1998 from $1.1 million for fiscal 1997. This increase was primarily attributable to the acquisition of Marathon. Research and development expense as a percentage of net sales remained relatively constant at 1.4% in fiscal 1997 and 1.6% in fiscal 1998.
- - OPERATING INCOME. Operating income increased by $18.7 million, or 103.3%, to $36.8 million for fiscal 1998 from $18.1 million for fiscal 1997. Approximately $4.6 million of this increase was attributable to the acquisition of Marathon and the remainder to the other increases in gross profit discussed above. As a percentage of revenues, operating income increased to 33.2% in fiscal 1998 from 23.1% in fiscal 1997.
- - INTEREST EXPENSE. Interest expense for fiscal 1998 approximated the amount for fiscal 1997 at $3.2 million and $3.5 million, respectively. The $2.1 increase in interest expense resulting from the additional borrowings made in connection with the acquisition of Marathon was more than offset by a $2.4 decrease in interest expense caused by the refinancing of TransDigm's subordinated notes and a general decline in interest rates.
- - INCOME TAXES. Income tax expense as a percentage of income before income taxes and the non-deductible warrant put value adjustment increased to 38.6% in fiscal 1998 from 35.5% in fiscal 1997. The increase in the effective rate resulted from higher non-deductible expenses, including the amortization of goodwill recognized in connection with the Marathon acquisition.
- - NET INCOME. Net income increased by $10.9 million, or 340.6%, to $14.1 million for fiscal 1998 from $3.2 million for fiscal 1997 primarily as a result of the factors referred to above and an extraordinary loss in 1997 of $l.5 million partially offset by a $1.7 million increase in the warrant put value adjustment during fiscal 1998.
INFLATION
Many of the Company's raw materials and operating expenses are sensitive to the effects of inflation, which could result in higher operating costs. The effects of inflation on the Company's businesses during the years ended September 30, 1999 and September 30, 1998 were not significant.
LIQUIDITY AND CAPITAL RESOURCES
The Company used approximately $16.2 million of cash in operating activities during the year ended September 30, 1999 compared to approximately $23.5 million generated during the year ended September 30, 1998. Such decrease in operating cash flows is due to the one-time merger expenses of $40 million, partially offset by improved operating results.
Cash used in investing activities was approximately $44.6 million during the year ended September 30, 1999 compared to approximately $4.3 million used during the year ended September 30, 1998. The change in investing cash flows is primarily due to the use of $41.6 million of cash for the acquisition of Adams Rite Aerospace, a $2.0 million decrease in capital expenditures during fiscal 1999 and a post-closing purchase price adjustment of approximately $.8 million received during the first quarter of fiscal 1998 as a result of the acquisition of Marathon.
Cash provided by financing activities during the year ended September 30, 1999 was approximately $44.1 million compared to approximately $5.1 million used during the year ended September 30, 1998. This change in financing cash flows was due to the incurrence and refinancing of substantial indebtedness as a result of the Recapitalization and the acquisition of ZMP.
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The interest rate for the credit facility is, at TransDigm's option, either (A) a floating rate equal to the Base Rate plus the Applicable Margin, as defined in the credit facility, or (B) the Eurodollar Rate for fixed periods of one, two, three, or six months, plus the Applicable Margin. The "Applicable Margin" means the percentage per year equal to (1) in the case of Tranche A Facility and Revolving Credit Facility, (A) bearing an interest rate determined by the Base Rate, plus 2.25%, 2.00%, 1.75% or 1.50% depending on Holdings' ability to achieve the respective debt coverage ratio specified in the credit facility, as amended; and (B) bearing an interest rate determined by the Eurodollar Rate, plus 3.25%, 3.00%, 2.75% or 2.50% depending on Holdings' ability to achieve the respective debt coverage ratio specified in the credit facility, as amended; and (2) in the case of Tranche B Facility, (A) bearing an interest rate determined by the Base Rate, 2.50%; and (B) bearing an interest rate determined by the Eurodollar Rate, 3.50%. The credit facility is subject to mandatory prepayment with a defined percentage of net proceeds from certain asset sales, insurance proceeds or other awards that are payable in connection with the loss, destruction or condemnation of any assets, certain new debt and equity offerings and 50% of excess cash flow (as defined in the credit facility) in excess of a predetermined amount under the credit facility.
The subordinated notes bear interest at 10 3/8% and do not require principal payments prior to maturity. The Revolving Credit Facility and the Tranche A Facility will each mature on the six year anniversary of the initial borrowing date and the Tranche B Facility will mature on the seven and a half year anniversary of the initial borrowing date. The credit facility requires TransDigm to amortize the outstanding indebtedness under each of the Tranche A and the Tranche B Facilities, commencing in 1999, and contains restrictive covenants that will, among other things, limit the incurrence of additional indebtedness, the payment of dividends, transactions with affiliates, asset sales, acquisitions, mergers and consolidations, liens and encumbrances, and prepayments of other indebtedness.
The Company's primary cash needs will consist of capital expenditures and debt service. The Company incurs capital expenditures for the purpose of maintaining and replacing existing equipment and facilities and, from time to time, for facility expansion. Capital expenditures totaled approximately $3 million and $5.1 million during fiscal 1999 and 1998, respectively.
The Company intends to pursue additional acquisitions that present opportunities to realize significant synergies, operating expense economies or overhead cost savings or to increase the Company's market position. The Company regularly engages in discussions with respect to potential acquisitions and investments. However, there are no binding agreements with respect to any material acquisitions at this time, and there can be no assurance that we will be able to reach an agreement with respect to any future acquisition. The Company's acquisition strategy may require substantial capital, and no assurance can be given that the Company will be able to raise any necessary funds on terms acceptable to the Company or at all. If the Company incurs additional debt to finance acquisitions, its total interest expense will increase.
The Company's ability to make scheduled payments of principal of, or to pay the interest on, or to refinance, its indebtedness, including the subordinated notes, or to fund planned capital expenditures and research and development, will depend on its future performance, which, to a certain extent,is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond its control. Based upon the current level of operations and anticipated cost savings and revenue growth, management believes that cash flow from operations and available cash, together with available borrowings under the credit facility, will be adequate to meet the Company's future liquidity needs for at least the next few years. The Company may, however, need to refinance all or a portion of the principal of the subordinated notes at or prior to maturity. There can be no assurance that the Company's business will generate sufficient cash flow from operations and that anticipated revenue growth and operating improvements will be sufficient to enable the Company to service its indebtedness, including the subordinated notes, or to fund its other liquidity needs. In addition, there can be no assurance that the Company will be able to effect any such refinancing on commercially reasonable terms or at all.
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NEW ACCOUNTING STANDARDS
In June 1997, the Financial Accounting Standards Board issued SFAS No. 130, "Reporting Comprehensive Income." The statement requires that an enterprise classify items of other comprehensive income by their nature in a financial statement and display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position. The Company adopted this standard during the first quarter of fiscal 1999.
In June 1997, the Financial Accounting Standards Board issued SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information." This statement establishes standards for the way public business enterprises report financial and descriptive information about their reportable operating segments such as a measure of segment profit or loss, certain specific revenue and expense items, and segment assets. The Company adopted this standard during fiscal 1999. The adoption of this statement did not change the Company's segment reporting. The Company continues to report its operations as one segment.
In February 1998, the Financial Accounting Standards Board issued SFAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits." The statement requires an enterprise to disclose certain information about its pension and postretirement benefits, including a reconciliation of beginning and ending balances of the benefit obligation, the funded status of the plans, and the amount of net periodic benefit cost recognized. The Company adopted this standard for its fiscal 1999 year-end financial statements.
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement establishes accounting and reporting standards for derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as (a) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment, (b) a hedge of the exposure to variable cash flows of a forecasted transaction, or (c) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign-currency-denominated forecasted transaction. The Company will adopt this standard during fiscal 2001. While management has not completed its analysis of this new accounting standard, its adoption is not expected to have a material effect on the Company's financial statements.
IMPACT OF YEAR 2000 ISSUE
The Company has completed a review of its information technology systems and a review of its embedded systems at all operating locations in order to assess its exposure to year 2000 issues. These reviews, including testing and verification, have been completed internally. The Company purchased all of its computer software (including embedded systems) from third party vendors and is relying on those vendors to make their software year 2000 compliant. Except for the vendor of its e-mail system, those vendors have provided the Company with third party certifications that the Company's systems are year 2000 compliant.
The Company has distributed questionnaires to assess the year 2000 compliance of its suppliers and customers, including various agencies of the United States government. The Company has received confirmation from material suppliers and customers that they are year 2000 compliant.
In the event that year 2000 problems arise within the Company or that its suppliers or customers, including various agencies of the United States government, do not successfully and timely achieve year 2000 compliance, the result may be a delay in the receipt of orders and collection of payments, leading to a temporary loss of revenue. The Company has incurred approximately $405,000 in costs associated with year 2000 compliance and does not expect to incur any significant, additional costs in the future.
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The Company has no formal contingency plan in the event year 2000 problems arise with respect to its information technology systems; however, the Company's accounting and business information systems are not complex, and manual procedures could be performed for a period of time to provide the information necessary to continue to operate the business. In the event that year 2000 problems arise within embedded systems, the Company intends to employ its existing subcontractor machinists to manufacture the affected components.
QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
All of the Company's outstanding indebtedness at September 30, 1998 was repaid in connection with the Merger and Recapitalization. At September 30, 1999, the Company is subject to interest rate risk with respect to borrowings under its credit facility as the interest rates on such borrowings vary with market conditions and, thus, the amount of outstanding borrowings approximates the fair value of the indebtedness. On a historical basis, the weighted average interest rate on the $119.6 million of borrowings outstanding under the credit facility at September 30, 1999 was 8.8%. The effect of a hypothetical one percentage point decrease in interest rates would increase the estimated fair value of the borrowings outstanding under the credit facility on September 30, 1999 by approximately $6 million.
Also outstanding at September 30, 1999 was $125 million of Company indebtedness in the form of subordinated notes and $22 million of Holdings PIK Notes. The interest rates on both of these borrowings are fixed at 10 3/8% and 12% per year, respectively. The fair value of the Company's Senior Subordinated Notes approximated $117.5 million at September 30, 1999 based upon quoted market prices. A determination of the fair value of the Holdings PIK Notes is not considered practicable because they are held by a related party and are not publicly traded. The effect of a hypothetical one percentage point decrease in interest rates would increase the estimated fair value of the borrowings by $13.2 million and $2.4 million, respectively.
ADDITIONAL DISCLOSURE REQUIRED BY INDENTURE
Separate financial information of TransDigm is not presented since the Senior Subordinated Notes are guaranteed by Holdings and all direct and indirect subsidiaries of TransDigm and since Holdings has no operations or assets separate from its investment in TransDigm. In addition, Holdings' only liability consists of Holdings PIK Notes of $20 million that bear interest at 12% annually. Interest expense recognized on the Holdings PIK Notes during the year ended September 30, 1999 was $2 million.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The response to this item is submitted in a separate section of this report following the signature page.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
There were no changes in or disagreements with accountants on accounting and financial disclosure.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS
The following table sets forth certain information concerning the directors and executive officers of Holdings and the directors and executive officers of the Company as of September 30, 1999:
NAME AGE POSITION
Douglas W. Peacock 60 Chairman of the Board of Directors and Chief Executive Officer W. Nicholas Howley 47 President, Chief Operating Officer and Director Robert S. Henderson 43 President, AdelWiggins Group Raymond F. Laubenthal 38 President, AeroControlex Group John F. Leary 52 President, Adams Rite Aerospace, Inc. Albert J. Rodriguez 39 President, Marathon Power Technologies Company Peter B. Radekevich 47 Chief Financial Officer Stephen Berger 60 Director Muzzafar Mirza 41 Director William Hopkins 36 Director Thomas R. Wall, IV 41 Director John W. Paxton 63 Director
Mr. Peacock has been Chairman of the Board of Directors and Chief Executive Officer of TransDigm since its inception in September 1993. He is also a director of Microporous Products, L.P. Prior to joining TransDigm, Mr. Peacock spent six years with IMO Industries Inc. as Executive Vice President of IMO's Instruments and Aerocomponents Group from 1991-1993, Executive Vice President of Power Systems from 1989-1991, and managed IMO's turbomachinery business from 1987-1989. Prior to joining IMO, Mr. Peacock spent 15 years in various managerial positions at Westinghouse Electric Corp. Mr. Peacock received a B.S. degree in chemical engineering from Washington State University and a Ph.D. in physical chemistry from the University of Illinois. Mr. Peacock holds an Airline Transport Pilot Rating and routinely commands flights in TransDigm's corporate aircraft.
Mr. Howley has been a Director of Holdings and President, Chief Operating Officer and Director of TransDigm since the consummation of the Recapitalization. Mr. Howley is also a Director of Nomad Logistic, Inc. Mr. Howley served as Executive Vice President of TransDigm and President of the AeroControlex Group from TransDigm's inception in September 1993 to the date of the consummation of the Recapitalization. Prior to joining TransDigm, Mr. Howley served as General Manager of IMO Industries Inc. Aeroproducts Division, and Director of Finance for the 15 divisions of IMO's Turbomachinery, Aerospace, and Power Transmission groups. Prior to joining IMO, he held various executive positions at Lansdowne Steel/Lansco Corp., a manufacturer of defense and oil drilling products, and the Engineering and Construction Group of Raytheon Co. Mr. Howley received his B.S. in engineering from Drexel University and an MBA from the Harvard University Graduate School of Business.
Mr. Henderson became President of the AdelWiggins Group in September 1999. He previously had served as President of Marathon Power Technologies Company since April 1997. From November 1994 until April 1997, be served as Manager of Operations for the AdelWiggins Group. Prom 1991 until 1994, Mr. Henderson served as Operations Manager at RainBird Sprinkler. Mr. Henderson received his B.A. in mathematics from Brown University and attended the Harvard University Graduate School of Business.
Mr. Laubenthal has been President of AeroControlex Group since November 1998. From December 1996 until November 1998, Mr. Laubenthal served as Director of Manufacturing and Engineering for the AeroControlex Group and had prior extensive experience in manufacturing and engineering at Parker Hannifin Corporation and Textron. From October 1993 to December 1996, Mr. Laubenthal served as Director of Manufacturing for the AeroControlex Group. Mr. Laubenthal received a B.S. degree in mechanical engineering from Case Western Reserve University and an MBA from Northern Illinois University.
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Mr. Leary has been President of Adams Rite Aerospace, Inc. since June 1999. From 1995 to June 1999, Mr. Leary was a General Operations Manager with Furon Company. Prom 1991 to 1995, Mr. Leary was the Plant Manager of Emerson Electric, Chromalox Division. Mr. Leary received his BS in Mechanical Engineering from the New Jersey Institute of Technology.
Mr. Rodriguez has been President of Marathon Power Technologies Company since September 1999. From January 1998 until September 1999, Mr. Rodriguez served as Director of Commercial Operations for the AeroControlex Group. From 1993 to 1997, Mr. Rodriguez served as Director of Sales and Marketing for the AeroControlex Group. Mr. Rodriguez has prior experience with IMO Industries, Esterline, as well as Kaiser Electro Precision. Mr. Rodriguez received his Bachelor of Engineering with a concentration in Chemical Engineering from Stevens Institute of Technology.
Mr. Radekevich has been Chief Financial Officer of TransDigm since TransDigm's inception in September 1993. He served as Vice Chairman and Chief Financial Officer of RDK Capital from 1990 to 1993. Prior to joining RDK Capital, Mr. Radekevich spent 16 years with General Electric in various executive and managerial positions in the field of operations, distribution and finance. Mr. Radekevich holds a Bachelor of Administration degree from Case Western Reserve University.
Mr. Berger has served as a Director of Holdings and TransDigm since the consummation of the Recapitalization. He is also currently serving as Chairman of Odyssey Investment Partners, LLC. Prior to joining Odyssey Investment Partners, LLC, Mr. Berger was a general partner of Odyssey Partners, LP. From 1990 to 1993, Mr. Berger served as Chairman and CEO of FGIC, a wholly-owned subsidiary of GE Capital Corp., and subsequently became Executive Vice President of GE Capital Corp. Prom 1985 to 1990, Mr. Berger was Executive Director of the Port Authority of New York and New Jersey. Mr. Berger presently serves as a member of the Board of Trustees of Brandeis University.
Mr. Mirza has served as a Director of Holdings and TransDigm since the consummation of the Recapitalization. Mr. Mirza is also currently a member of Odyssey Investment Partners, LLC and has been a principal in the private equity investing group of Odyssey Partners, LP since 1993. From 1988 to 1993, Mr. Mirza was employed by the merchant banking group of GE Capital Corp.
Mr. Hopkins has served as a Director of Holdings and TransDigm since the consummation of the Recapitalization. Mr. Hopkins is also currently a member of Odyssey Investment Partners, LLC and has been a principal in the private equity investing group of Odyssey Partners, LP since 1994. Prior to joining Odyssey, Mr. Hopkins was a member of the merchant banking group of GE Capital Corp.
Mr. Wall has served as a Director of Holdings and TransDigm since their inception in 1993. Mr. Wall joined Kelso & Company in 1983 and has served as a Managing Director of Kelso & Company since 1990. Mr. Wall presently serves as a member of the Board of Directors of AMF Bowling, Inc., Citation Corporation, Consolidated Vision Group, Inc., Cygnus Publishing, Inc., iXL Enterprises, Inc., Mitchell Supreme Fuel Company Mosler Inc., Peebles, Inc., and 21st Century Newspapers, Inc.
Mr. Paxton has served as a Director of Holdings and TransDigm since the consummation of the Recapitalization. Mr. Paxton is also currently chairman of Odyssey Industrial Technologies, LLC, which is a joint venture with Odyssey Investment Partners, LLC, and Chairman of the Board, President and Chief Executive Officer of Telxon Corporation. Prior to joining TransDigm as a Director, Mr. Paxton was a member of the Board of Directors of Paxar Corporation ("Paxar") and President of Paxar's Printing Solution Group from October 1997 to the calendar year end 1998. Mr. Paxton served as President and Chief Executive Officer of Monarch Marking Systems from October 1995 to October 1997. Prior to joining Monarch Marking Systems, Mr. Paxton joined Litton Industries ("Litton") as a Corporate Vice President in 1991 when Litton acquired Intermec Corporation. During his years at Litton, Mr. Paxton had responsibility for the Industrial Automation Group. He became Corporate Executive Vice President and Chief Operating Officer of the Industrial Automation Systems Group of Western Atlas, Inc. when Western Atlas, Inc. was spun off by Litton in March 1994. Mr. Paxton presently serves as a member of the Board of Directors of AIM, National Association of Manufacturers, World Economic Forum and Telxon Corporation.
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BOARD COMMITTEES
Holdings' Board of Directors has a Compensation Committee and an Audit Committee. The Compensation Committee, which is comprised of Messrs. Berger, Mirza and Hopkins, establishes salaries, incentives and other forms of compensation for executive officers and administers incentive compensation and benefit plans provided for employees. The Audit Committee, which is comprised of Messrs. Wall, Mirza and Hopkins, reviews Holdings' and TransDigm's audit policies and oversees the engagement of Holdings' and TransDigm's independent auditors.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The following table sets forth the aggregate compensation paid or accrued by TransDigm for services rendered during fiscal 1999, 1998 and 1997 to the Chief Executive Officer of TransDigm and each of the four other most highly paid executive officers of TransDigm (collectively the "Named Executive Officers"):
SUMMARY COMPENSATION TABLE
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(1) Bonus for fiscal year 1998 includes a one-time bonus paid by TransDigm in connection with the Recapitalization.
(2) Does not include perquisites and other personal benefits because the value of these items did not exceed the lesser of $50,000 or 10% of reported salary and bonus of any of the listed executives.
(3) Includes $9,600 in contributions by TransDigm, as projected to calendar year end 1999, to a plan established under Section 401(k) of the Internal Revenue Code (the "401(k) plan") and $10,059 of Company-paid life insurance.
(4) Includes $9,600 in contributions by TransDigm, as projected to calendar year end 1999, to the 401(k) plan and $1,296 in Company-paid life insurance.
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(5) Includes $7,200 in contributions by TransDigm, as projected to calendar year end 1999, to the 401(k) plan and $351 in Company-paid life insurance.
(6) Includes $9,300 in contributions by TransDigm, as projected to calendar year end 1999, to the 401(k) plan and $444 in Company-paid life insurance.
(7) Includes $8,000 in contributions by TransDigm, as projected to calendar year end 1999, to the 401(k) plan and $558 in Company-paid life insurance.
AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION/SAR VALUES
MANAGEMENT STOCKHOLDERS AGREEMENT
Together with the consummation of the Recapitalization, Holdings, Odyssey and the employee stockholders of Holdings, including the Named Executive Officers (the "Management Stockholders") entered into a Management Stockholders' Agreement (the "Management Stockholders' Agreement") which governs the shares of common stock of Holdings (the "Common Stock") and options to purchase Common Stock, in each case, retained by such persons after the Recapitalization and any new options and shares acquired thereafter, including the exercise of options. See "Executive Compensation-Stock Option Plan."
The Management Stockholders' Agreement provides that, except for certain transfers to family members and family trusts, no Management Stockholder may transfer Common Stock until the fifth anniversary of the Recapitalization, and thereafter, any proposed transfer will be subject to Holdings' right of first refusal.
The Management Stockholders' Agreement also provides that upon termination of the employment of a Management Stockholder, that Management Stockholder will have certain put rights and Holdings will have certain call rights regarding any Common Stock or any options to purchase Common Stock, in each case, owned by him at that time.
Upon Mr. Peacock's cessation of active service as Chief Executive Officer on or after the third anniversary of the Recapitalization, if TransDigm has achieved specified financial targets, he may require Holdings to repurchase up to 80% of his Common Stock during the period, if any, for which he is serving as non-executive Chairman of the Board. See "Executive Compensation-Employment Agreements." Mr. Peacock may thereafter require repurchase of the remaining 20% of his Common Stock on or after the fifth anniversary of the Recapitalization or his later termination of services to Holdings. Holdings will be permitted to honor its obligation to Mr. Peacock by issuing notes under certain circumstances.
If the provisions of any law, the terms of credit and financing arrangements or Holdings' financial circumstances would prevent Holdings from making a repurchase of shares pursuant to the Management Stockholders' Agreement, Holdings will not make such purchase until all such prohibitions lapse, and will then also pay the Management Stockholder a specified rate of interest on the repurchase price.
The Management Stockholders' Agreement further provides that, in the event of certain types of transfers of Common Stock by Odyssey, the Management Stockholders may participate in those transfers and/or Odyssey may require the Management Stockholders to transfer their shares in those transactions, in each case, on a pro rata basis.
Pursuant to the Management Stockholders' Agreement, the Management Stockholders are entitled to participate on a pro rata basis with, and on the same terms as, Odyssey in any future offering of Common Stock. Those participation rights will lapse following a public offering of Common Stock if the Common Stock so offered is then listed on a national exchange or if the public offering includes 50% or more of the outstanding Common Stock that will have been issued following the offering.
EMPLOYMENT AGREEMENTS
In connection with the Recapitalization, Holdings entered into an employment agreement with each of Messrs. Peacock and Howley. Pursuant to the agreement with Mr. Peacock, Mr. Peacock will continue to serve as Chairman of the Board and Chief Executive Officer for a period of at least five years, provided that after three years, Mr. Peacock may elect to continue his service either as Chief Executive Officer or as a non-executive Chairman. It is intended that Mr. Howley will be Mr. Peacock's successor. Pursuant to the agreement with Mr. Howley, Mr. Howley will continue to serve as President and Chief Operating Officer of Holdings for a period of at least five years. Those employment agreements also will provide specified severance benefits in the event of termination of employment under certain circumstances.
Each of those employment agreements provide that in the event the respective executive's employment terminates by reason of death, disability, termination without "cause" or resignation with "good reason" (all as defined in those employment agreements), Holdings will continue payment of base salary, bonus and other perquisites and benefits, in the case of Mr. Howley, for 15 months thereafter and, in the case of Mr. Peacock, for 18 months thereafter or, if terminated prior to the third anniversary of the Recapitalization, until such third anniversary, whichever is longer.
Pursuant to those employment agreements, Messrs. Peacock and Howley will receive annual base salaries no less than $330,000 and $225,000, respectively, in each case, subject to annual increases as determined by the Compensation Committee, and annual cash bonuses based on achievement of performance criteria established by the Board of Directors.
STOCK OPTION PLAN
During fiscal 1999, Holdings adopted the 1998 Stock Option Plan (the "Option Plan"), pursuant to which stock options may be granted to Independent Directors (as defined in the Option Plan), employees and consultants of Holdings, TransDigm and any subsidiary of Holdings or TransDigm (the "Plan Participants"). In addition, the Option Plan governs those options retained pursuant to the Rollover Investment (the "Rollover Options"). A total of 18,990 shares of Common Stock of Holdings were reserved for issuance under the Option Plan and 15,115 of the options were issued during fiscal 1999. The Chief Executive Officer has discretion to select the Plan Participants and to specify the terms of such options, including the number of shares, the exercise price and the vesting and expiration of options, subject to approval by the Compensation Committee.
The Compensation Committee has discretion under the Option Plan to adjust options to reflect certain specified events such as stock dividends, stock splits, recapitalizations, mergers or reorganizations of, or by, Holdings. In addition, the Board of Directors has the right to amend, suspend or terminate the Option Plan, subject to stockholder approval for certain amendments.
The Rollover Options are fully vested and nonforfeitable. In connection with the Recapitalization, Holdings granted options to certain employees of TransDigm including the Named Executive Officers for the purchase of shares of Common Stock of Holdings (the "New Options"). Such New Options are intended to qualify as "incentive stock options" to the extent permitted under the Internal Revenue Code, and have an exercise price equal to the price per share paid by Odyssey in connection with the Recapitalization. Twenty percent of each of Messrs. Peacock's and Howley's New Options was vested as of the date of grant. Subject to the executive's continued employment with and, in the case of Mr. Peacock, continued service as non-executive Chairman of the Board of the Company, the remaining 80% of his New Options will become exercisable upon the earlier of(1) the Company's achievement of specified financial targets or (2) certain specified dates in the Option Agreement. Furthermore, in the event of a "change of control" (as defined in the Option Agreement), a specified percentage of the New Options may become exercisable based upon the terms of such transaction. The New Options generally will expire 10 years after grant and may expire earlier in the event of the executive's earlier termination of employment.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth certain information regarding the beneficial ownership of the Common Stock of Holdings with respect to each beneficial owner of more than 5.0% of the outstanding Common Stock of Holdings and beneficial ownership of the Common Stock of Holdings by each director and named executive officer and all directors and executive officers as a group:
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(*) Less than 1.0%
(1) Consists of 100,240 shares of common stock owned by Odyssey Investment Partners, LP (the "Fund"), Odyssey Coinvestors, LLC ("Coinvestment"), TD Coinvestment I, LLC ("TD I"), and TD Coinvestment II, LLC ("TD II" and together with the Fund, Coinvestment and TD I, "Odyssey"). Odyssey Capital Partners, LLC is the general partner of the Fund. Odyssey Investment Partners, LLC is the manager of the Fund and the managing member of each of Coinvestment, TD I and TD II. The principal business address for Odyssey is 280 Park Avenue, West Tower, 38th Floor, New York, N.Y. 10017. Stephen Berger, Muzzafar Mirza, William Hopkins (directors of Holdings) and Brian Kwait and Paul Barnett are managing members of Odyssey Capital Partners, LLC and Odyssey Investment Partners, LLC and, therefore, may each be deemed to share voting and investment power with respect to such shares deemed to be owned by Odyssey. Each of them disclaims beneficial ownership of such shares.
(2) KIA IV-TD, LLC ("KIA IV-TD") and Kelso Equity Partners II, L.P. ("KEP II") have beneficial ownership of 17,473 and 949 shares, respectively. Due to their common control, KIA IV-TD, Kelso Partners IV, L.P., the managing member of KIA IV-TD ("KP IV" and, together with KIA IV-TD and KEP II, "Kelso"), and KEP II could be deemed to beneficially own each other's shares, but each disclaims such beneficial ownership. In addition, Mr. Wall, Joseph S. Schuchert, Frank T. Nickell, George E. Matelich, Michael B. Goldberg, David I. Wahrhaftig, Frank K. Bynum, Jr. and Philip E. Berney may be deemed to share beneficial ownership of shares beneficially owned by KIA IV-TD, KP IV and KEP II by virtue of their status as general partners of KP IV, which is the managing member of KIA IV-TD, and as general partners of KEP II, but each disclaims such beneficial ownership. The address of each of KIA IV-TD, KP IV, KEP II and Messrs. Wall, Schuchert, Nickell, Matelich, Goldberg, Wahrhaftig, Bynum and Berney is c/o Kelso & Company, 320 Park Avenue, 24th Floor, New York, New York 10022.
(3) Includes 100,240 shares and votes deemed to be beneficially owned by Odyssey (as defined). Mr. Berger is a senior managing member of Odyssey Capital Partners, LLC and Odyssey Investment Partners, LLC. As a result, Mr. Berger may be deemed to share voting and investment power with respect to such shares. Mr. Berger disclaims beneficial ownership of such shares.
(4) Includes 772 shares purchasable within 60 days upon the exercise of options held by Mr. Henderson.
(5) Includes 100,240 shares and votes deemed to be beneficially owned by Odyssey. Mr. Hopkins is a managing member of Odyssey Capital Partners, LLC and Odyssey Investment Partners, LLC. As a result, Mr. Hopkins may be deemed to share voting and investment power with respect to such shares. Mr. Hopkins disclaims beneficial ownership of such shares.
(6) Includes 6,690 shares purchasable within 60 days upon the exercise of options held by Mr. Howley.
(7) Includes 780 shares purchasable within 60 days upon the exercise of options held by Mr. Laubenthal.
(8) Includes 100,240 shares and votes deemed to be beneficially owned by Odyssey. Mr. Mirza is a managing member of Odyssey Capital Partners, LLC and Odyssey Investment Partners, LLC. As a result, Mr. Mirza may be deemed to share voting and investment power with respect to such shares. Mr. Mirza disclaims beneficial ownership of such shares.
(9) Includes 6,989 shares purchasable within 60 days upon the exercise of options held by Mr. Peacock and 811 shares and votes owned by TD Equity LLC, of which Mr. Peacock is the managing member. Mr. Peacock disclaims ownership of the 811 shares and votes owned by TD Equity LLC.
(10) Includes 568 shares purchasable within 60 days upon the exercise of options held by Mr. Radekevich.
(11) As described in footnotes (1), (3), (5) and (8), Messrs. Berger, Hopkins and Mirza may each be deemed to share investment and voting power with respect to 100,240 shares deemed to be beneficially owned by the General Partner of Odyssey, Mr. Wall may be deemed to share investment and voting power with respect to 18,422 shares owned by Kelso and Mr. Peacock may be deemed to share investment and voting power with respect to 811 shares owned by TD Equity LLC. Each of Messrs. Berger, Hopkins, Mirza, Wall and Peacock disclaims ownership of such shares. Excluding such shares, all officers and directors as a group beneficially own 16,382 shares, or 13.5%, which are purchasable within 60 days upon the exercise of options.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
TAX ALLOCATION AGREEMENT
TransDigm and Holdings are parties to a Tax Allocation Agreement. Under the terms of the Tax Allocation Agreement, TransDigm is obligated to make payments to Holdings equal to the amount of income taxes that TransDigm would have owed in respect of federal and state income taxes on behalf of TransDigm and its subsidiaries if TransDigm and its subsidiaries were, for tax purposes, a separate consolidated group.
ONE-TIME MANAGEMENT BONUSES
Following the consummation of the Recapitalization, TransDigm paid certain members of senior management an aggregate of $5.9 million as a one-time bonus in connection with the Recapitalization. See "Executive Compensation."
TERMINATION OF FINANCIAL ADVISORY SERVICES AGREEMENT
TransDigm paid $6.0 million to Kelso & Company, an affiliate of Kelso, in consideration for the termination of a Financial Advisory Services Agreement. This payment was made upon consummation of the Recapitalization.
Kelso may be deemed, collectively, to beneficially own 15.2% of the Common Stock of Holdings. In addition, Mr. Wall, a director of Holdings and TransDigm, is a general partner of each of the Kelso entities.
KELSO STOCKHOLDERS AGREEMENT
Pursuant to the Merger Agreement, Holdings, Odyssey, KIA IV-TD and KEP II entered into a stockholders agreement (the "Stockholders Agreement") concurrently with consummation of the Recapitalization. The Stockholders Agreement provides for customary transfer restrictions, tag-along and drag-along rights, registration rights and an agreement among the parties to vote their shares of Common Stock, including the agreement of Odyssey to designate a representative of Kelso to the Board of Directors of Holdings. See also "Directors and Executive Officers" for a description of certain agreements that have been entered into with certain members of management in connection with the Recapitalization. See "Certain Relationships and Related Transactions- Termination of Financial Advisory Services Agreement."
ODYSSEY FINANCIAL SERVICES
As part of the Recapitalization, TransDigm paid Odyssey a fee of approximately $3.5 million. Odyssey is the majority stockholder of Holdings. In addition, Messrs. Berger, Hopkins and Mirza, each a director of Holdings and TransDigm, are managing members of the General Partner of Odyssey.
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) FINANCIAL STATEMENTS
The following consolidated financial statements of the Company are included in a separate section of this Report following the signature pages:
Consolidated Balance Sheets - September 30, 1999 and September 30, 1998
Consolidated Statements of Operations - Years Ended September 30, 1999, September 30, 1998 and September 30, 1997
Consolidated Statements of Changes in Shareholders' Equity (Deficiency) - Years Ended September 30, 1999, September 30, 1998 and September 30, 1997
Consolidated Statements of Cash Flows - Years Ended September 30, 1999, September 30, 1998 and September 30, 1997
Notes to Consolidated Financial Statements
Report of Independent Auditors
(a)(2) FINANCIAL STATEMENT SCHEDULES
The following financial statement schedule is included in a separate section of this Report following the signature pages - Valuation and Qualifying Accounts - Years Ended September 30, 1999, September 30, 1998 and September 30, 1997.
(a)(3) EXHIBITS
EXHIBIT DESCRIPTION OF EXHIBIT NO.
*2.1 Agreement and Plan of Merger, dated August 3, 1998, between Phase II Acquisition Corp. and TransDigm Holding Company.
*2.2 Amendment One, dated November 9,1998, to the Agreement and Plan of Merger between Phase II Acquisition Corp. and TransDigm Holding Company.
*2.3 Agreement and Plan of Reorganization, dated as of March 31, 1999, by and among TransDigm Inc., ARA Acquisition Corporation, ZMP, Inc. and TCW Special Placements Fund II.
*3.1 Restated Certificate of Incorporation, filed on September 28, 1993, of TransDigm Holding Company.
*3.2 Certificate of Amendment, filed on December 21,1993, of the Restated Certificate of Incorporation of TransDigm Holding Company.
*3.3 Certificate of Ownership and Merger, filed on December 3,1998, merging Phase II Acquisition Corp. with and into TransDigm Holding Company.
*3.4 Certificate of Incorporation, filed on July 2,1993, of NovaDigm Acquisition, Inc. (TransDigm Inc.).
*3.5 Certificate of Amendment, filed on July 22, 1993, of the Certificate of Incorporation of NovaDigm Acquisition, Inc. (TransDigm Inc.).
*3.6 Certificate of Ownership and Merger, filed on September 13, 1993, merging IMO Aerospace Company with and into TransDigm Inc.
*3.7 Certificate of Incorporation, filed on March 28, 1994, of MPT Acquisition Corp. (Marathon Power Technologies Company).
*3.8 Certificate of Amendment, filed on May 18,1994, of the Certificate of Incorporation of MPT Acquisition Corp. (Marathon Power Technologies Company).
*3.9 Certificate of Amendment, filed on May 24, 1994, of the Certificate of Incorporation of MPT Acquisition Corp. (Marathon Power Technologies Company).
EXHIBIT DESCRIPTION OF EXHIBIT NO.
*3.10 Amended and Restated Articles of Incorporation, filed on April 23, 1999, of ZMP, Inc.
*3.11 Certificate of Ownership and Merger, filed on April 23, 1999, merging ARA Acquisition Corporation with and into ZMP, Inc.
*3.12 Articles of Incorporation, filed on July 30, 1986, of ARP Acquisition Corporation (Adams Rite Aerospace, Inc.).
*3.13 Certificate of Amendment, filed on September 12, 1986, of the Articles of Incorporation of ARP Acquisition Corporation (Adams Rite Aerospace, Inc.).
*3.14 Certificate of Amendment, filed on January 27, 1992, of the Articles of Incorporation of Adams Rite Aerospace Products, Inc. (Adams Rite Aerospace, Inc.).
*3.15 Certificate of Amendment, filed on December 31, 1992, of the Articles of Incorporation of Adams Rite Aerospace Products, Inc. (Adams Rite Aerospace, Inc.).
*3.16 Certificate of Amendment, filed on August 11,1997, of the Articles of Incorporation of Adams Rite Aerospace Sabre International, Inc. (Adams Rite Aerospace, Inc.).
*3.17 Bylaws of TransDigm Holding Company.
*3.18 Bylaws of NovaDigm Acquisition, Inc. (TransDigm Inc.).
*3.19 Bylaws of MPT Acquisition Corp. (Marathon Power Technologies Company).
*3.20 Amended and Restated Bylaws of ZMP, Inc.
*3.21 Amended and Restated Bylaws of Adams Rite Aerospace, Inc.
*4.1 Indenture, dated December 3, 1998, among TransDigm Inc., TransDigm Holding Company and Marathon Power Technologies Company and State Street Bank and Trust Company, as trustee, relating to $125,000,000 aggregate principal amount of 10 3/8% Senior Subordinated Notes due 2008 and the registered 10 3/8% Senior Subordinated Notes due 2008.
*4.2 Supplemental Indenture, dated April 23, 1999, among ZMP, Inc. and Adams Rite Aerospace, Inc. and State Street Bank and Trust Company, as trustee.
*4.3 Specimen Certificate of 10 3/8% Senior Subordinated Notes due 2008 (the "Old Notes") (included in Exhibit 4.1 hereto).
*4.4 Specimen Certificate of the registered 10 3/8% Senior Subordinated Notes due 2008 (the "New Notes") (included in Exhibit 4.1 hereto).
*4.5 Registration Rights Agreement, dated December 3, 1998, among TransDigm Inc., TransDigm Holding Company and Marathon Power Technologies Company and BT Alex.Brown Incorporated and Credit Suisse First Boston Corporation.
*4.6 Indenture, dated December 3, 1998, between TransDigm Holding Company and State Street Bank and Trust Company, as trustee, relating to $20,000,000 aggregate principal amount of 12% Pay-in-Kind Senior Notes due 2009.
*4.7 Specimen Certificate of 12% Pay-in-Kind Senior Notes due 2009 (included in Exhibit 4.6 hereto).
*4.8 Registration Rights Agreement, dated December 3, 1998, among TransDigm Holding Company and Kelso Investment Associates IV, L.P. and Kelso Equity Partners II, L.P.
*4.9 Credit Agreement, dated December 3, 1998, among TransDigm Inc. and TransDigm Holding Company and Bankers Trust Company, as the administrative agent, and the various financial institutions parties thereto.
*4.10 First Amendment to the Credit Agreement, dated December 10, 1998, among TransDigm Inc. and TransDigm Holding Company and Bankers Trust Company, as the administrative agent, and the various financial institutions parties thereto.
*4.11 Second Amendment to the Credit Agreement, dated April 23, 1999, among TransDigm Inc., TransDigm Holding Company and Marathon Power Technologies Company and Bankers Trust Company, as the administrative agent, and the various financial institutions parties thereto.
*4.12 Third Amendment to the Credit Agreement, dated April 23, 1999, among TransDigm Inc. and TransDigm Holding Company and Bankers Trust Company, as the administrative agent, and the various financial institutions parties thereto.
*4.13 Specimen Revolving Note evidencing the revolving borrowings under the Credit Agreement (included in Exhibit 4.9 hereto).
EXHIBIT DESCRIPTION OF EXHIBIT NO.
*4.14 Specimen Term A Note evidencing the Term A credit advances under the Credit Agreement (included in Exhibit 4.9 hereto).
*4.15 Specimen Term B Note evidencing the Term B credit advances under the Credit Agreement (included in Exhibit 4.9 hereto).
*4.16 Security Agreement, dated December 3, 1998, among TransDigm Inc., TransDigm Holding Company and Marathon Power Technologies Company and Bankers Trust Company, as the administrative agent under the Credit Agreement.
*4.17 Pledge Agreement, dated December 3, 1998, among TransDigm Inc., TransDigm Holding Company and Marathon Power Technologies Company and Bankers Trust Company, as the administrative agent under the Credit Agreement.
*4.18 Form of Assignment of Security Interest in United States Copyrights by TransDigm Inc., TransDigm Holding Company and Marathon Power Technologies Company for the benefit of Bankers Trust Company, as the administrative agent under the Credit Agreement (included in Exhibit 4.16 hereto).
*4.19 Form of Assignment of Security Interest in United States Trademarks and Patents by TransDigm Inc., TransDigm Holding Company and Marathon Power Technologies Company for the benefit of Bankers Trust Company, as the administrative agent under the Credit Agreement (included in Exhibit 4.16 hereto).
*5.1 Opinion of Latham & Watkins regarding the validity of the New Notes.
*10.1 Stockholders' Agreement, dated December 3, 1998, by and among TransDigm Holding Company, Odyssey Investment Partners Fund, LP, Odyssey Coinvestors, LLC, TD-Equity LLC, KIA IV-TD, LLC and Kelso Equity Partners II, L.P.
*10.2 Stockholders' Agreement, dated December 3, 1998, by and among TransDigm Holding Company, Odyssey Investment Partners Fund and certain employee stockholders of TransDigm Holding Company.
*10.3 Tax Allocation Agreement, dated December 3, 1998, between TransDigm Holding Company and TransDigm Inc.
10.4 Employment Agreement dated May 19, 1999, between TransDigm Holding Company and Douglas W. Peacock.
10.5 Employment Agreement dated May 19, 1999, between TransDigm Holding Company and W. Nicholas Howley.
*10.6 TransDigm Inc. Senior Executive Benefits Plan.
*10.7 Summary of Annual Incentive Compensation Plan for Key Management Employees of TransDigm Inc.
12.1 Computation of Ratio of Earnings to Fixed Charges.
12.2 Computation of Ratio of EBITDA, As Defined, to Interest Expense.
12.3 Computation of Ratio of Total Debt to EBITDA, As Defined.
*21.1 Subsidiaries of TransDigm Holding Company.
24.1 Power of Attorney - TransDigm Holding Company
24.2 Power of Attorney - TransDigm Inc.
24.3 Power of Attorney - Marathon Power Technologies Company
24.4 Power of Attorney - ZMP, Inc.
24.5 Power of Attorney - Adams Rite Aerospace, Inc.
*25.1 Statement of Eligibility and Qualification (form T-1) under the Trust Indenture Act of 1939 of State Street Bank and Trust Company.
27.1 Financial Data Schedule.
*99.1 Form of Letter of Transmittal and related documents to be used in conjunction with the exchange offer.
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(*) (Incorporated by reference to same titled exhibit to the Co-Registrants' Registration Statement on Form S-4 dated January 29, 1999 File No.333-71397, as amended.)
(b) REPORTS ON FORM 8-K
We did not file any reports on Form 8-K during the fourth quarter of fiscal 1999.
(c) EXHIBITS
The exhibits which are listed under Item 14(a)(3) are filed or incorporated by reference herein.
(d) SEPARATE FINANCIAL STATEMENTS AND SCHEDULES
The following financial statement schedule is included in a separate section of this Report following the signature pages - Valuation and Qualifying Accounts - Years Ended September 30,1999, September 30, 1998 and September 30, 1997.
SIGNATURES
Pursuant to the requirements of Section 13 of the Securities Act of 1934, as amended, each of the Co-Registrants has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Richmond Heights, State of Ohio, on December 23, 1999.
TRANSDIGM HOLDING COMPANY
By: /s/ Peter B. Radekevich ----------------------------------------- Peter B. Radekevich Chief Financial Officer
TRANSDIGM INC.
By: /s/ Peter B. Radekevich ----------------------------------------- Peter B. Radekevich Chief Financial Officer
MARATHON POWER TECHNOLOGIES COMPANY
By: /s/ Peter B. Radekevich ----------------------------------------- Peter B. Radekevich Chief Financial Officer
ZMP, INC.
By: /s/ Peter B. Radekevich ----------------------------------------- Peter B. Radekevich Chief Financial Officer
ADAMS RITE AEROSPACE, INC.
By: /s/ Peter B. Radekevich ----------------------------------------- Peter B. Radekevich Chief Financial Officer
TRANSDIGM HOLDING COMPANY
Pursuant to the requirements of the Securities Act of 1934, this Report has been signed below by the following persons on behalf of the Co-Registrant and in the capacities and as of the dates indicated.
TRANSDIGM INC.
Pursuant to the requirements of the Securities Act of 1934, this Report has been signed below by the following persons on behalf of the Co-Registrant and in the capacities and as of the dates indicated.
MARATHON POWER TECHNOLOGIES COMPANY
Pursuant to the requirements of the Securities Act of 1934, this Report has been signed below by the following persons on behalf of the Co-Registrant and in the capacities and as of the dates indicated.
ZMP, INC.
Pursuant to the requirements of the Securities Act of 1934, this Report has been signed below by the following persons on behalf of the Co-Registrant and in the capacities and as of the dates indicated.
ADAMS RITE AEROSPACE, INC.
Pursuant to the requirements of the Securities Act of 1934, this Report has been signed below by the following persons on behalf of the Co-Registrant and in the capacities and as of the dates indicated.
* The undersigned, by signing his name hereto, does sign and execute this Annual Report on Form 10-K pursuant to the Power of Attorney executed by the above-named officers and Directors of the Co-Registrants and filed with the Securities and Exchange Commission on behalf of such officers and Directors.
By: /s/ Peter B. Radekevich ------------------------------------ Peter B. Radekevich, ATTORNEY-IN-FACT
TRANSDIGM HOLDING COMPANY AND SUBSIDIARIES
ANNUAL REPORT ON FORM 10-K: FISCAL YEAR ENDED SEPTEMBER 30,1999
ITEM 8 AND ITEM 14(a) (1)
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX
PAGE FINANCIAL STATEMENTS:
Independent Auditors' Report
Consolidated Balance Sheets at September 30, 1999 and September 30,1998
Consolidated Statements of Operations for the Years Ended September 30, 1999, September 30,1998 and September 30, 1997
Consolidated Statements of Changes in Shareholders' Equity (Deficiency) for the Years Ended September 30, 1999, September 30, 1998 and September 30, 1997
Consolidated Statements of Cash Flows for the Years Ended September 30, 1999, September 30, 1998 and September 30, 1997
Notes to Consolidated Financial Statements --
SUPPLEMENTARY DATA:
Independent Auditors' Report
Valuation and Qualifying Accounts for the Years Ended September 30, 1999, September 30, 1998 and September 30, 1997
INDEPENDENT AUDITORS' REPORT
To the Shareholders and Board of Directors of TransDigm Holding Company
We have audited the accompanying consolidated balance sheets of TransDigm Holding Company and its subsidiaries (the "Company") as of September 30,1999 and 1998, and the related consolidated statements of operations, changes in stockholders' equity (deficiency) and of cash flows for each of the three years in the period ended September 30, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of TransDigm Holding Company and its subsidiaries as of September 30, 1999 and 1998 and the results of their operations and their cash flows for each of the three years in the period ended September 30, 1999 in conformity with generally accepted accounting principles.
DELOITTE & TOUCHE LLP
Cleveland, Ohio November 1, 1999
TRANSDIGM HOLDING COMPANY
CONSOLIDATED BALANCE SHEETS SEPTEMBER 30, 1999 AND 1998 (In Thousands of Dollars) - --------------------------------------------------------------------------------
See notes to consolidated financial statements.
TRANSDIGM HOLDING COMPANY
CONSOLIDATED STATEMENTS OF OPERATIONS (In Thousands of Dollars) - --------------------------------------------------------------------------------
See notes to consolidated financial statements.
TRANSDIGM HOLDING COMPANY
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIENCY) (In Thousands of Dollars)
See notes to consolidated financial statements.
TRANSDIGM HOLDING COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS (In Thousands of Dollars) - --------------------------------------------------------------------------------
TRANSDIGM HOLDING COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS (In Thousands of Dollars) - --------------------------------------------------------------------------------
See notes to consolidated financial statements.
TRANSDIGM HOLDING COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENT$ YEARS ENDED SEPTEMBER 30, 1999, 1998 AND 1997 - --------------------------------------------------------------------------------
1. DESCRIPTION OF THE BUSINESS AND MERGER
TransDigm Holding Company ("Holdings"), through its wholly-owned operating subsidiary, TransDigm Inc. ("TransDigm"), is a premier supplier of proprietary mechanical components servicing predominantly the aircraft industry. TransDigm, along with its wholly-owned subsidiaries, Marathon Power Technologies Company ("Marathon"), ZMP, Inc. ("ZMP") and Adams Rite Aerospace, Inc., ("Adams Rite Aerospace") (collectively, the "Company"), offers a broad line of component products including tube connectors, valves, batteries, static inverters, pumps, quick disconnects, clamps, ball bearing and sliding controls, mechanical hardware, fluid controls, lavatory hardware, electromechanical controls, and oxygen systems related products.
On December 3, 1998, Phase II Acquisition Corp. ("Acquiror"), an entity formed by affiliates of Odyssey Investment Partners, LP ("Odyssey"), and Holdings consummated a definitive agreement and plan of merger (the "Merger Agreement" or the "Merger"). Pursuant to the terms of the Merger, Acquiror was merged with and into Holdings, with Holdings being the surviving corporation in the Merger (the "Surviving Corporation"). In the Merger, owners of Holdings' outstanding common stock received, in exchange for each outstanding share of common stock (except for shares held directly or indirectly by Holdings or the Rolled Shares, as defined below), the "Per Share Merger Consideration," as defined in the Merger Agreement. The aggregate consideration payable pursuant to the Merger, including amounts payable to holders of options and warrants, was approximately $299.7 million.
In connection with the Merger, Kelso Investment Associates IV, LP and Kelso Equity Partners II, LP (collectively, "Kelso") retained approximately 15.4% of the Surviving Corporation's outstanding common stock (the "Rolled Shares"). In addition, certain members of management of Holdings agreed, in connection with and as a condition to entering into the Merger Agreement, to rollover stock options with an estimated gross and net value of approximately $17.2 million and $13.7 million, respectively. The Merger was treated as a recapitalization (the "Recapitalization") for financial reporting purposes, which had no impact on the historical basis of Holdings' consolidated assets and liabilities.
Simultaneously with the Merger, Holdings and TransDigm refinanced all of their existing debt. The Merger, the refinancing, and payment of fees and expenses were funded by (i) existing cash balances, (ii) investments by Odyssey of $100.2 million, (iii) funds from a new $120 million Senior Credit Facility, (iv) funds from $125 million Senior Subordinated Notes and (v) Holdings PIK Notes of $20 million issued to certain stockholders. The Senior Credit Facility was subsequently increased to $154 million in connection with the acquisition of ZMP and Adams Rite Aerospace (see Note 2).
In connection with the Merger, the Company incurred a one-time charge of approximately $40 million during the year consisting primarily of compensation costs recognized as a result of the cancellation of certain stock options, the costs of terminating a financial advisory services agreement, the write-off of deferred financing costs and professional advisory fees.
Separate financial statements of TransDigm are not presented since the Senior Subordinated Notes are guaranteed by Holdings and all direct and indirect subsidiaries of TransDigm and since Holdings has no operations or assets separate from its investment in TransDigm.
2. ACQUISITIONS
MARATHON POWER TECHNOLOGIES COMPANY - On August 8, 1997, TransDigm acquired all of the outstanding common stock of Marathon for approximately $41.6 million in cash (including acquisition expenses), $4 million of which was placed into two $2 million escrow accounts (an environmental escrow and an indemnity escrow) to indemnify TransDigm in the event certain defined environmental and other costs were incurred by Marathon or TransDigm subsequent to the acquisition. A post-closing purchase price adjustment of approximately $.8 million was received from the seller during November 1997 from the indemnity escrow. The remainder of the indemnity escrow was released to the seller during the year ended September 30, 1998. The environmental escrow account expires after the occurrence of certain defined events in the Stock Purchase Agreement. During September 1998, the seller filed a lawsuit against the Company to release the environmental escrow alleging that the Company had violated the requirements of the Stock Purchase Agreement relating to the investigation of the presence of certain contaminants at the Marathon facility in Texas (Note 15). The Company has filed counter claims against the seller and the ultimate outcome of this matter cannot presently be determined.
The acquisition was financed with available cash of approximately $10.9 million and the proceeds of senior term debt of approximately $30 million. The excess of the aggregate purchase price over the fair market value of net assets acquired of approximately $28.9 million was recognized as goodwill and is being amortized on a straight-line basis over 40 years. The senior term debt was subsequently refinanced in conjunction with the Merger (see Note 1).
The acquisition has been accounted for as a purchase and Marathon's operations have been included in Holdings financial statements since the date of the acquisition.
ZMP, INC. AND ADAMS RITE AEROSPACE, INC. - On April 23, 1999, TransDigm acquired all of the outstanding common stock of ZMP, the corporate parent of Adams Rite Aerospace, through a merger. Adams Rite Aerospace manufactures mechanical hardware, fluid controls, lavatory hardware, electromechanical controls and oxygen systems related products. The purchase price for the acquisition was $41 million, subject to adjustment for changes in working capital and other matters as defined in the merger agreement. The acquisition was funded through $36 million of additional borrowings under the Company's credit facility and the use of approximately $5 million of the Company's cash balances. As a result of the acquisition, ZMP and Adams Rite Aerospace became wholly-owned subsidiaries of TransDigm.
The Company accounted for the acquisition as a purchase and included the results of operations of the acquired companies in the accompanying fiscal 1999 consolidated financial statements from the effective date of the acquisition. The purchase price was allocated based on a preliminary determination of estimated fair values at the date of the acquisition as follows (in thousands):
Current assets $ 18,218 Property and equipment 4,739 Goodwill 25,457 Other assets 382 Current liabilities (6,494) Other liabilities (451) --------- Net $ 41,851 =========
Goodwill is being amortized on a straight-line basis over forty years.
PRO-FORMA INFORMATION - The following table summarizes the unaudited, consolidated pro-forma results of operations, as if the acquisitions had occurred at the beginning of the following periods ended September 30 (in thousands):
1999 1998
Net sales $ 151,624 $ 146,920
Income from operations 1,913 40,069
Net income (loss) (18,646) 13,867
The consolidated pro-forma operating loss for the year ended September 30, 1999 includes the following charges recognized by Adams Rite Aerospace prior to the acquisition: (1) $1.4 million ($.84 million after tax) for compensation expense recognized in connection with a common stock warrant granted to its former chief executive officer and (2) $.8 million ($.8 million after tax) for costs directly related to the acquisition.
This pro-forma information is not necessarily indicative of the results that actually would have been obtained if the operations had been combined as of the beginning of the periods presented and is not intended to be a projection of future results.
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
CONSOLIDATION - The accompanying consolidated financial statements include the accounts of TransDigm Holding Company and subsidiaries. All significant intercompany balances and transactions have been eliminated.
REVENUE RECOGNITION - Revenue is recognized when products are shipped to the customer. Any anticipated losses on contracts are charged to earnings when identified.
CASH EQUIVALENTS - The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents.
ALLOWANCE FOR UNCOLLECTIBLE ACCOUNTS - The Company reserves for amounts determined to be uncollectible based on specific identification and historical experience.
INVENTORIES - Inventories are stated at the lower of cost or market. Cost of inventories is determined by the average cost and the first-in, first-out (FIFO) methods. Provision for potentially obsolete or slow-moving inventory is made based on management's analysis of inventory levels and future sales forecasts. In accordance with industry practice, all inventories are classified as current assets even though a portion of the inventories is not expected to be realized within one year.
PROPERTY, PLANT AND EQUIPMENT - Property, plant and equipment are stated at cost. Depreciation is computed using the straight-line method at rates based on the estimated useful lives of the assets.
DEBT ISSUE COSTS AND DISCOUNTS - The cost of obtaining financing as well as debt discounts are amortized using the interest method over the respective terms of the related debt issues.
INTANGIBLE ASSETS - Intangible assets are amortized on a straight-line basis over their respective estimated useful lives ranging from 5 to 40 years. The Company assesses the recoverability of intangibles by determining whether the amortization over the remaining life can be recovered through projected, undiscounted, future operations.
INCOME TAXES - The Company accounts for income taxes using an asset and liability approach. Deferred taxes are recorded for the difference between the book and tax basis of various assets and liabilities.
PRODUCT WARRANTY COSTS - The Company generally provides a one year warranty on certain products beginning on the date the product is installed on an aircraft. A provision for estimated sales returns and the cost of repairs is recorded at the time of sale and periodically adjusted to reflect actual experience.
PUT WARRANTS - Prior to their redemption in connection with the Merger (see Note 1), the Company recorded a liability for the estimated put value of its outstanding warrants to purchase common stock and recognized in earnings any changes in the estimated put value.
ESTIMATES - The preparation of financial statements in conformity with generally accepted accounting principles 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 reporting period. Actual results could differ from those estimates.
COMPREHENSIVE INCOME - The Company adopted the provisions of Statement No. 130 of the Financial Accounting Standards Board (the "FASB"), Reporting Comprehensive Income, during the first quarter of fiscal 1999. Accordingly, the Company's accumulated other comprehensive income, consisting solely of its minimum pension liability adjustment, is reported separately in the accompanying consolidated balance sheets and statements of changes in stockholders' equity (deficiency), net of taxes of $390,000 and $521,000 at September 30, 1999 and 1998, respectively.
SEGMENT REPORTING - The Company adopted Statement No.131 of the FASB, Disclosures About Segments of an Enterprise and Related Information, during the current fiscal year. This statement establishes standards for the way public business enterprises report financial and descriptive information about their reportable operating segments such as a measure of segment profit or loss, certain specific revenue and expense items, and segment assets. The adoption of this statement did not change the Company's segment reporting. The Company continues to report its operations as one segment. In addition, substantially all of the Company's operations are located within the United States.
4. SALES AND ACCOUNTS RECEIVABLE
SALES - The Company's sales and receivables are concentrated in the aircraft industry. The Company's customers consist primarily of original equipment manufacturers of aircraft and aircraft subassemblies, commercial airlines, distributors, and various agencies of the United States government, including the U.S. military.
Information concerning the Company's net sales by its principal product categories is as follows for the years ended September 30, 1999 and 1998 (in thousands):
Sales by product information prior to 1998 is not considered material and is therefore not presented.
For the year ended September 30, 1999, two customers represented approximately 15% and 14%, respectively, of the Company's net sales. Two customers represented approximately 20% and 14%, respectively, of the Company's net sales during the year ended September 30, 1998 and one customer represented approximately 15% of the Company's net sales for the year ended September 30, 1997.
Export sales to customers, primarily in Western Europe, were $30.7 million in 1999, $17.8 million in 1998, and $15.5 million in 1997.
ACCOUNTS RECEIVABLE - Accounts receivable consist of the following at September 30 (in thousands):
Approximately 9% of the Company's receivables at September 30, 1999 were due from one customer and approximately 27% of the receivables were due from entities, which principally operate outside of the United States. Credit is extended based on an evaluation of each customer's financial condition and collateral is generally not required.
5. INVENTORIES
Inventories consist of the following at September 30 (in thousands):
6. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consist of the following at September 30 (in thousands):
7. INTANGIBLE ASSETS
Intangible assets, net of accumulated amortization, consist of the following at September 30 (in thousands):
Accumulated amortization of intangibles was $18.5 million at September 30, 1999 and $16.5 million at September 30, 1998.
8. ACCRUED LIABILITIES
Accrued liabilities consist of the following at September 30 (in thousands): 1999 1998
Compensation and related benefits $ 5,260 $ 3,993 Interest 4,593 135 Estimated losses on uncompleted contracts 2,809 3,012 Sales returns and repairs 1,841 1,391 Environmental costs 157 280 Income taxes 380 Other 1,059 1,048 --------- -------- Total $ 15,719 $ 10,239 ======== ========
9. DEBT
SUMMARY - The Company's long-term debt consists of the following at September 30 (in thousands): 1999 1998
Term loans $119,557 $ 45,000 Senior Subordinated Notes 125,000 Holdings PIK Notes 22,000 -------- -------- Total debt 266,557 45,000 Current maturities (7,595) (5,000) -------- -------- Long-term portion $258,962 $ 40,000 ======== ========
REVOLVING CREDIT SWING LINE, AND TERM LOANS - In connection with the Merger (see Note 1) and the acquisition of ZMP and Adams Rite Aerospace (see Note 2), TransDigm repaid its existing term loans and obtained a new $154 million Senior Credit Facility with a group of financial institutions, which consists of (1) a $30 million revolving credit line (including $3 million of available swing line loans) maturing in 2004 and (2) a term loan facility in the aggregate of $124 million, consisting of a $62 million Tranche A Facility maturing in 2004 and a $62 million Tranche B Facility maturing in 2006. At September 30, 1999, the Company had $30 million of borrowings (the entire revolving credit line) available under the credit facility.
The interest rate for the credit facility is, at TransDigm's option, either (A) a floating rate equal to the Base Rate plus the Applicable Margin, as defined in the credit facility; or (B) the Eurodollar Rate for fixed periods of one, two, three, or six months, plus the Applicable Margin. The credit facility is subject to mandatory prepayment with a defined percentage of net proceeds from certain asset sales, insurance proceeds or other awards that are payable in connection with the loss, destruction or condemnation of any assets, certain new debt and equity offerings and 50% of excess cash flow (as defined in the credit facility) in excess of a predetermined amount under the credit facility. The interest rate on outstanding borrowings at September 30, 1999 ranged from 8.625% to 8.875%.
All obligations under the Senior Credit Facility are guaranteed by Holdings and each of the subsidiaries, direct and indirect, of TransDigm. The indebtedness outstanding under the Senior Credit Facility is secured by a pledge of the stock of TransDigm and all of its domestic subsidiaries and a perfected lien and security interest in assets other than real estate (tangible and intangible) of TransDigm, its direct and indirect subsidiaries and Holdings. The agreement also contains a number of restrictive covenants that, among other things, restrict Holdings, TransDigm and their subsidiaries from various actions, including mergers and sales of assets, use of proceeds, granting of liens, incurrence of indebtedness, voluntary prepayment of indebtedness, capital expenditures, paying dividends, business activities, investments and acquisitions, and transactions with affiliates. The agreement also requires the Company to comply with certain financial covenants pertaining to earnings, interest coverage and leverage. The Company is in compliance with all financial covenants of the Senior Credit Facility as of September 30, 1999. The maturities of the Company's term loans by fiscal year are as follows: $7.6 million in 2000, $11 million in both 2001 and 2002, $14.4 million in 2003, $13.8 million in 2004 and $61.8 million thereafter.
SENIOR SUBORDINATED NOTES - TransDigm's Senior Subordinated Notes (the "Notes") bear interest at an annual rate of 10 3/8%, maturing on December 1, 2008 and are unsecured obligations of TransDigm ranking subordinate to the Company's senior debt, as defined in the note agreement. Up to 35% of the Notes are redeemable by TransDigm prior to December 1, 2001 with the proceeds of an equity offering. The Notes are also redeemable after December 1, 2003, in whole or in part, at specified redemption prices, which decline over the remaining term of the Notes. If a change in control of the Company occurs, the holders of the Notes will have the right to demand that the Company redeem the Notes at a purchase price equal to 101% of the principal amount of the Notes plus accrued interest. The Notes contain many of the same restrictive covenants included in the Senior Credit Facility. The Company is in compliance with all financial covenants of the Notes as of September 30, 1999.
HOLDINGS PIK NOTES - In connection with the Merger (see Note 1), Holdings issued $20 million of pay-in-kind notes due 2009 ("Holdings PIK Notes" or "PIK Notes"). The PIK Notes are unsecured obligations of Holdings, which has no significant assets or operations. Interest on the PIK Notes is accrued at an annual fixed rate of 12% and is payable semi-annually in the form of additional PIK Notes through December 2003. Thereafter, cash interest is payable semi-annually commencing in the year 2004. The PIK Notes are redeemable by Holdings prior to their maturity under certain circumstances and contain many of the same restrictive covenants included in the Notes and Senior Credit Facility. The Company is in compliance with all financial covenants of the PIK Notes as of September 30, 1999.
EXTRAORDINARY LOSS - During the year ended September 30, 1997, the Company redeemed, in advance of their scheduled maturity, outstanding subordinated notes which had a carrying value at the time of the redemption of approximately $19.3 million ($20 million principal balance net of an unamortized discount of approximately $0.7 million). As a result of the redemption, the Company recognized an extraordinary loss of approximately $1.5 million (net of a current income tax benefit of approximately $1 million) on the early extinguishment of debt which included prepayment costs of approximately $0.8 million and the write-off of the remaining unamortized debt issue costs of approximately $1 million. The subordinated notes bore interest at an annual rate of 13%, payable semi-annually.
10. RETIREMENT PLANS
The Company has two non-contributory defined benefit pension plans which together cover all of its union employees. The plans provide benefits of stated amounts for each year of service. The Company's funding policy is to contribute actuarially determined amounts allowable under Internal Revenue Service regulations. The plans' assets consist primarily of guaranteed investment contracts with an insurance company.
The following information for the defined benefit plans is provided pursuant to Statement No.132 of the FASB, Employers' Disclosures About Pensions and Other Postretirement Benefits, which became effective during the year ended September 30,1999. This statement modified the financial statement footnote disclosures regarding the plans but did not change the manner in which retirement plan obligations or expenses are measured or recognized in the financial statements.
The Company also sponsors a defined contribution employee savings plan that covers substantially all of the Company's non-union employees. Under the plan, the Company contributes a percentage of employee compensation and matches a portion of employee contributions to the plan. The cost recognized for such contributions under this plan for the year ended September 30, 1999 was approximately $.7 million and, for the years ended September 30, 1998 and 1997, was approximately $.6 million in each year.
11. INCOME TAXES
The provision (benefit) for income taxes consists of the following for the years ended September 30 (in thousands):
The difference between the provision (benefit) for income taxes at the federal statutory income tax rate and the tax shown in the consolidated statements of operations for the years ended September 30 are as follows (in thousands):
The components of the deferred tax assets at September 30 consist of the following (in thousands):
12. COMMON STOCK AND OPTIONS
COMMON STOCK - Authorized capital stock of the Company consists of 900,000 shares of common stock (voting), par value $.01 per share and 100,000 shares of Class A (non-voting) common stock. At September 30, 1999, common stock issued to management personnel is subject to the Management Shareholders' Agreement which provides management shareholders the right (a "put") to require the Company to repurchase their shares of common stock under certain conditions at fair market value. Accordingly, the estimated put value of the 1,270 outstanding shares of voting common stock held by management for which it is probable that the put rights will be exercised has been classified as redeemable common stock in the accompanying September 30, 1999 consolidated balance sheet.
During the years ended September 30, 1999, 1998 and 1997, the Company issued common stock (voting and non-voting Class A) principally to Odyssey in connection with the Merger in 1999 (see Note 1) and to employees and members of its board of directors in prior years, as follows (in thousands):
During the years ended September 30, 1999, 1998 and 1997, the Company also repurchased common stock (voting and non-voting Class A), principally as a result of the Merger in 1999 (see Note 1) and from terminated employees in prior years, as follows (in thousands):
* - Excluding put warrants and redeemable common stock.
STOCK OPTIONS - The Company has certain stock option plans for its employees. The options generally vest upon the earlier of: (1) the occurrence of certain events such as the achievement of certain earnings targets or a change in the control of the Company or (2) certain specified dates in the option agreements. The options are not exercisable more than ten years after the date the options are granted. A summary of the status of the Company's stock option plans as of September 30, 1999, 1998 and 1997 and changes during the years then ended is presented below:
The following table summarizes information about stock options outstanding at September 30, 1999:
At September 30, 1999, 3,875 remaining options were available for award under the Company's stock option plans.
The Company applies Accounting Principles Board Opinion No. 25 and related interpretations in accounting for its stock option plans. No compensation cost has been recognized for its stock option plans. Had compensation cost for the Company's stock option plans been determined based on the fair value at the grant dates for awards under those plans consistent with the method specified in Statement No. 123 of the FASB, the Company's net loss for the year ended September 30, 1999 would have increased by approximately $634,000 and the Company's net income for the preceding two years would have been reduced by approximately $115,000 in each year.
The weighted average fair value of options granted during the years ended September 30, 1999 and 1997 was $383.89 and $125.65, respectively. The fair value of the options granted was estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions: risk-free interest rates ranging from 5.99% to 6.85%, expected life of approximately seven years, expected volatility and dividend yield of 0%.
13. LEASES
The Company leases office space for its corporate headquarters and one of its divisions. The Company also leases the manufacturing facility utilized by Adams Rite Aerospace. The office space lease requires rental payments of approximately $200,000 per year through 2004. TransDigm may also be required to share in the operating costs of the facility under certain conditions. The Adams Rite Aerospace facility lease requires rental payments ranging from $540,000 to $780,000 through December 2012. TransDigm also has commitments under operating leases for vehicles and equipment. Rental expense was $688,000 in 1999, $599,000 in 1998, and $540,000 in 1997. Future, minimum rental commitments at September 30, 1999 under operating leases having initial or remaining non-cancelable lease terms exceeding one year are $974,000 in 2000, $927,000 in 2001, $862,000 in 2002, $786,000 in 2003, $725,000 in 2004, and $4,365,000 thereafter.
14. FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company has various financial instruments, including cash and cash equivalents, accounts receivable and payable, accrued liabilities and long-term debt. The carrying value of the Company's cash and cash equivalents, accounts receivable and payable, and accrued liabilities approximates their fair value due to the short-term maturities of these assets and liabilities. The Company also believes that the aggregate fair value of its term loans approximates its carrying amount because the interest rates on the debt are reset on a frequent basis to reflect current market rates. The fair value of the Company's Senior Subordinated Notes approximated $117,500,000 at September 30, 1999 based upon quoted market prices. A determination of the fair value of the Holdings PIK Notes is not considered practicable because they are held by a related party (see Note 1) and are not publicly traded.
15. CONTINGENCIES
ENVIRONMENTAL - The soil and groundwater beneath the Company's facility in Waco, Texas have been impacted by releases of hazardous materials. The resulting contaminants of concern have been delineated and characterized. Because the majority of these contaminants are presently below action levels prescribed by the Texas Natural Resources Conservation Commission ("TNRCC"), and because an escrow (Note 2) was previously funded to cover the cost of remediation that TNRCC might require for those contaminants currently in excess of action limits, the Company does not believe the condition of the soil and groundwater at the Waco facility will require incurrence of material expenditures; however, there can be no assurance that additional contamination will not be discovered or that the remediation required by the TNRCC will not be material to the financial condition, results of operations, or cash flows of the Company.
OTHER - While the Company is currently involved in certain legal proceedings, management believes the results of these proceedings will not have a material effect on the financial condition, results of operations or cash flows of the Company. During the ordinary course of business, the Company is from time to time threatened with, or may become a party to, legal actions and other proceedings. The Company believes that its potential exposure to such legal actions is adequately covered by its aviation product and general liability insurance.
16. NEW ACCOUNTING STANDARD
In June 1998, the Financial Accounting Standards Board issued Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. This statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives), and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as (a) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment, (b) a hedge of the exposure to variable cash flows of a forecasted transaction, or (c) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign-currency-denominated forecasted transaction. The Company will adopt this standard during fiscal 2001.
While management has not completed its analysis of this new accounting standard, its adoption is not expected to have a material effect on the Company's financial statements.
* * * * * *
INDEPENDENT AUDITORS' REPORT
To the Shareholders and Board of Directors of TransDigm Holding Company
We have audited the consolidated balance sheets of TransDigm Holding Company and its subsidiaries (the "Company") as of September 30, 1999 and 1998, and the related consolidated statements of operations, changes in stockholders' equity (deficiency) and of cash flows for each of the three years in the period ended September 30, 1999 and have issued our report thereon dated November 1, 1999; such consolidated financial statements and report are included on pages through of this Form 10-K. Our audits also included the consolidated financial statement schedule of the Company, shown on page. This consolidated financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such consolidated financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
DELOITTE & TOUCHE LLP
Cleveland, Ohio November 1, 1999
TRANSDIGM HOLDING COMPANY
VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED SEPTEMBER 30, 1999, 1998 AND 1997 (In thousands)
(1) For the allowance for doubtful accounts and reserve for excess and obsolete inventory, the amounts in this column represent charge-offs net of recoveries. For the sales returns and repairs and environmental accrued liabilities, the amounts primarily represent expenditures charged against liabilities.
EXHIBIT INDEX TO FORM 10K FOR THE YEAR ENDED SEPTEMBER 30, 1999 | 20,084 | 134,637 |
67472_1999.txt | 67472_1999 | 1999 | 67472 | Item 1 - Business
General Development of the Business
Molex Incorporated originated from an enterprise established in 1938. It was incorporated in 1972 in the state of Delaware. As used herein the term "Molex" or "Company" includes Molex Incorporated and its United States and international subsidiaries.
General Description of the Business
Molex is a leading manufacturer of electronic, electrical and fiber optic interconnection products and systems; switches; value-added assemblies; and application tooling. The Company operates 50 plants in 21 countries and employs 14,700 people worldwide. In fiscal 1999, products manufactured and sold outside the U.S. generated 66% of sales.
Molex serves original equipment manufacturers in industries that include automotive, computer, computer peripheral, business equipment, telecommunications, consumer products and premise wiring. The Company offers more than 100,000 products to customers primarily through direct sales people and authorized distributors. The worldwide market for electronic connectors, cable assemblies and backplanes was estimated at $27.1 billion. With a 6.3% market share, Molex is the second-largest connector manufacturer in the world in what is a fragmented but highly competitive industry.
Molex conducts business in one industry segment: the manufacture and sale of electrical components. The Company designs, manufactures, and distributes electrical and electronic devices such as terminals, connectors, planer cables, cable assemblies, interconnection systems, fiber optic interconnection systems, backplanes and mechanical and electronic switches. Crimping machines and terminal inserting equipment (known as "application tooling") are offered on a lease or purchase basis to the Company's customers for the purpose of applying the Company's components to the customers' products. Net revenue from application tooling constitutes approximately 1% of the Company's net revenues. Molex products are designed for use in a broad range of electrical and electronic applications as set forth below:
Percentage of Fiscal 1999 Market Net Revenue Products
Computer/business equipment/ 56% Computers, peripheral telecommunications equipment, calculators, copiers, pagers and dictation equipment
Consumer Products 19% Televisions, stereo high fidelity systems, compact disc players, video tape recorders, camcorders, electronic games, microwave ovens, refrigerators, freezers, dishwashers, disposals and air conditioners
Automotive 15% Automobiles, trucks, recreational vehicles and farm equipment
Other 10% Electronic medical equipment, vending machines, security equipment and modular office furniture and premise wiring
The Company sells its products primarily to original equipment manufacturers and their subcontractors and suppliers. The Company's customers include various multinational companies, including Apple, AT&T, Canon, Compaq, Delco, Ford, Hewlett Packard, IBM, JVC, Matsushita, Motorola, Philips, Sony, Thomson, Toshiba, and Xerox, many of which Molex serves on a global basis. Net revenues contributed by different industry groups fluctuate due to various factors including model changes, new technology, introduction of new products and composition of customers. No customer accounted for 10% or more of net revenues in fiscal years 1999, 1998 or 1997. While its customers generally make purchasing decisions on a decentralized basis, Molex believes that, due to its financial strength and product development capabilities, it has and will continue to benefit from the trend of many of its customers toward the use of fewer vendors. In the United States and Canada, the Company sells its products primarily through direct sales engineers and industrial distributors. Internationally, Molex sells primarily through its own sales organizations in Japan, Hong Kong, Singapore, Taiwan, Republic of Korea, Malaysia, Thailand, China, Australia, England, Italy, Ireland, France, Spain, Germany, the Netherlands, Switzerland, Poland, Sweden, Norway, Denmark, South Africa, India, Canada, Mexico and Brazil.
Outside of the United States and Canada, Molex also sells its products through manufacturers' representative organizations, some of which act as distributors, purchasing from the Company for resale. The manufacturers' representative organizations are granted exclusive territories and are compensated on a commission basis. These relationships are terminable by either party on short notice. All sales orders received are subject to approval by the Company.
The Company promotes its products through leading trade magazines, direct mailings, catalogs and other promotional literature. Molex is a frequent participant in trade shows and also conducts educational seminars for its customers and its manufacturers' representative organizations.
There was no significant change in the Company's suppliers, products, markets or methods of distribution during the last fiscal year.
Molex generally seeks to locate manufacturing facilities to serve local customers and currently has 50 manufacturing facilities in 21 countries on six continents.
The principal raw materials and component parts Molex purchases for the manufacture of its products include brass, copper, aluminum, steel, tin, nickel, gold, silver, nylon and other molding materials, and nuts, bolts, screws and rivets. Virtually all materials and components used in the Company's products are available from several sources. Although the availability of such materials has generally been adequate, no assurance can be given that additional cost increases or material shortages or allocations imposed by its suppliers in the future will not have a materially adverse effect on the operations of the Company.
Competition
The business in which the Company is engaged is highly competitive. Most of the Company's competitors offer products in some but not all of the industries served by the Company. Molex believes that the ability to meet customer delivery requirements and maintenance of product quality and reliability are competitive factors that are as important as product pricing. Some of the Company's competitors have been established longer and have substantially larger manufacturing, sales, research and financial resources.
Patents/Trademarks
As of June 30, 1999, the Company owned 702 United States patents and had 273 patent applications on file with the United States Patent Office. The Company also has 2,184 corresponding patents issued and 3,225 applied for in other countries as of June 30, 1999. No assurance can be given that any patents will be issued on pending or future applications. As the Company develops products for new markets and uses, it normally seeks available patent protection. The Company believes that its patents are of importance but does not consider itself materially dependent upon any single patent or group of related patents.
Backlog
The backlog of unfilled orders at June 30, 1999 was approximately $243.4 million; this compares to $231.0 million at June 30, 1998. Substantially all of these orders are scheduled for delivery within twelve months. The Company's experience is that orders are normally delivered within ninety days from acceptance.
Research and Development
Molex incurred total research and development costs of $105.9 million in 1999, $93.9 million in 1998, and $89.5 million in 1997. The Company incurred costs relating to obtaining patents of $5.2 million in 1999, $5.4 million in 1998, and $5.6 million in 1997 which are included in total research and development costs. The Company's policy is to charge these costs to operations as incurred.
The Company introduced many new products during the year; however, in the aggregate, these products did not require a material investment of assets.
Compliance
The Company believes it is in full compliance with federal, state and local regulations pertaining to environmental protection. The Company does not anticipate that the costs of compliance with such regulations will have a material effect on its capital expenditures, earnings or competitive position.
Employees
As of June 30, 1999, the Company employed 14,700 people worldwide. The Company believes its relations with its employees are favorable.
International Operations
The Company is engaged in material operations in foreign countries. Net revenue derived from international operations for the fiscal year ended June 30, 1999 was approximately 66% of consolidated net revenue.
The Company believes the international net revenue and earnings will continue to be significant. The analysis of the Company's operations by geographical area appears in footnote 9 on page 49 of the 1999 Annual Report to Shareholders and is incorporated herein by reference.
Item 2
Item 2 - Properties Molex owns and leases manufacturing, warehousing and office space in several locations around the world. The total square footage of these facilities is presented below:
Owned Leased Total 3,303,151 1,912,428 5,215,579
The leases are of varying terms with expirations ranging from fiscal 1999 through fiscal 2025. The leases in aggregate are not considered material to the financial position of the Company.
The Company's buildings, machinery and equipment have been well maintained and are adequate for its current needs.
A listing of principal manufacturing facilities is presented below:
Australia Ireland Republic of Korea Melton, Victoria Millstreet Town Ansan City (2) Shannon Brazil Singapore Manaus Italy Jurong Town Sao Paulo Padova South Africa Canada Japan Midrand Scarborough, Ontario Kagoshima Okayama Taiwan China (P.R.C.) Shioya Taipei Dongguan Shizuoka Shanghai Yamato Thailand Bangkok England Malaysia Southhampton Perai, Penang United States Auburn Hills, Michigan (2) Mexico Maumelle, Arkansas (2) France Guadalajara Manchester, New Hampshire Chateau Gontier Magdalena Orange, California Nogales (2) Pinellas Park, Florida Germany St. Petersburg, Florida Biberach Poland Downers Grove, Illinois Ettlingen Starogard Lisle, Illinois Naperville, Illinois (2) India Puerto Rico Mooresville, Indiana Bangalore Ponce Lincoln, Nebraska (3) Gandhinagar
Item 3
Item 3 - Legal Proceedings
None deemed material to the Company's financial position or consolidated results of operations.
Item 4
Item 4 - Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5
Item 5 - Market for the Registrant's Common Equity and Related Stockholder Matters
Molex is traded on the National Market System of the NASDAQ in the United States and on the London Stock Exchange. The information set forth under the caption "Fiscal 1999, 1998, and 1997 by Quarter (Unaudited)" on page 50 of the 1999 Annual Report to Shareholders is incorporated herein by reference.
The following table presents quarterly dividends per common share for the last two fiscal years. The fiscal 1998 dividends per share have been restated for the 25% stock dividend issued in November, 1997.
Class A Common Stock Common Stock
Fiscal 1999 Fiscal 1998 Fiscal 1999 Fiscal 1998 Quarter Ended - September 30, 0.0150 0.0120 0.0150 0.0120 December 31, 0.0150 0.0150 0.0150 0.0150 March 31, 0.0150 0.0150 0.0150 0.0150 June 30, 0.0150 0.0150 0.0150 0.0150 Total 0.0600 0.0570 0.0600 0.0570
Cash dividends on Common Shares have been paid every year since 1977.
A description of the Company's Common Stock appears in footnote 3 on page 44 of the 1999 Annual Report to Shareholders and is incorporated herein by reference.
On June 16, 1999, The Company acquired Cardell Corporation, an automotive terminal and connector manufacturer. In connection with this acquisition, the former shareholders of Cardell received 2.3 million shares of Molex Common Stock (MOLX), approximate market value $69.4 million, which were exempt from registration under Section 4(2) of the Securities Act of 1933.
Item 6
Item 6 - Selected Financial Data
The information set forth under the caption "Ten Year Financial Highlight Summary" (only the five years in the period ended June 30, 1999) on page 31 of the 1999 Annual Report to Shareholders is incorporated herein by reference.
Item 7
Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations
The information set forth under the caption "Management's Discussion of Financial Condition and Results of Operations" on pages 32 through 36 of the 1999 Annual Report to Shareholders is incorporated herein by reference.
Item 7A
Item 7A - Quantitative and Qualitative Disclosures About Market Risk
The information set forth under the caption "Quantitative and Qualitative Disclosures About Market Risk" on page 36 of the 1999 Annual Report to Shareholders is incorporated herein by reference.
Item 8
Item 8 - Financial Statements and Supplementary Data
The following consolidated financial statements of the Company set forth on pages 38 through 49 of the 1999 Annual Report to Shareholders and the independent auditors' report set forth on page 37 of the 1999 Annual Report to Shareholders are incorporated herein by reference:
Independent Auditors' Report
Consolidated Balance Sheets - June 30, 1999 and 1998
Consolidated Statements of Income for the years ended June 30, 1999, 1998 and 1997
Consolidated Statements of Shareholders' Equity for the years ended June 30, 1999, 1998 and 1997
Consolidated Statements of Cash Flows for the years ended June 30, 1999, 1998 and 1997
Notes to Consolidated Financial Statements
The supplementary data regarding quarterly results of operations, set forth under the caption "Fiscal 1999, 1998, and 1997 by Quarter (Unaudited)" on page 50 of the 1999 Annual Report to Shareholders, is incorporated herein by reference.
The statement of changes in shares outstanding appears on Page 19 of this Form 10-K.
Item 9
Item 9 - Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
PART III
Item 10
Item 10 - Directors and Executive Officers of the Registrant
The information under the caption "Election of Directors" in the Company's Proxy Statement for the annual meeting of Stockholders to be held on October 22, 1999 (the "Company's 1999 Proxy Statement") is incorporated herein by reference. The information called for by Item 401 of Regulation S-K relating to the Executive Officers is furnished below.
Executive Officers of the Registrant
The following information relates to the executive officers of the Registrant who serve at the discretion of the Board of Directors and are customarily elected for one-year terms at the Regular Meeting of the Board of Directors held immediately following the Annual Stockholders' Meeting. All of the executive officers named hold positions as officers and/or directors of one or more subsidiaries of the Registrant. For purposes of this disclosure, only the principal positions are set forth. Year Employed Positions Held with Registrant by Name During the Last Five Years (a) Age Registrant Frederick A. Krehbiel(b) Co-Chairman and Co-Chief 58 1965(c) Executive Officer (1999-); Chairman (1993-1999) and Chief Executive Officer (1988-1999).
John H. Krehbiel, Jr.(b) Co-Chairman and Co-Chief 62 1959(c) Executive Officer (1999-); President (1975-1999) and Chief Operating Officer (1996-1999).
J. Joseph King President and Chief Operating 55 1975 Officer (1999-); Executive Vice President (1996-1999); Group Vice President-International Operations (1988-1996).
Martin P. Slark Executive Vice President (1999-); 44 1976 Corporate Vice President (1990-1999) and President, Americas (1996-1999); President, U.S. (1994-1996).
Raymond C. Wieser Senior Vice President (1999-); 60 1965(c) Senior Vice President, Americas (1996-1999); Corporate Vice President and President, Commercial Division-U.S. Operations (1994-1996).
Year Employed Positions Held with Registrant by Name During the Last Five Years (a) Age Registrant
Robert B. Mahoney Corporate Vice President, 46 1995 Treasurer and Chief Financial Officer (1996-); Vice President (1994-1995) and Corporate Controller (1990-1995) of National Semiconductor Corporation.
Ronald L. Schubel Corporate Vice President (1982-) 56 1981 and President, Americas (1999-); President, Far East South (1994-1998); President, Commercial Division-U.S. Operations (1982-1994).
Werner W. Fichtner Corporate Vice President 56 1981 (1987-) and President, Europe (1981-).
Goro Tokuyama Corporate Vice President 65 1985 (1990-)and President, Far East North (1988-), and President of Molex Japan Co., Ltd. (1985-).
James E. Fleischhacker Corporate Vice President 55 1984 (1994-) and President, Far East South (1998-); President, DataComm Division-Americas (1989-1998).
Kathi M. Regas Corporate Vice President (1994-); 43 1985 Director, Human Resources U.S. Operations (1989-1995).
Louis A. Hecht Corporate Secretary (1977-) and 55 1974 General Counsel (1975-). __________________________________________________________________________ (a) All positions are with Registrant unless otherwise stated. (b) John H. Krehbiel, Jr. and Frederick A. Krehbiel (the "Krehbiel Family") are brothers. The members of the Krehbiel Family may be considered to be "control persons" of the Registrant. The other officers listed above have no relationship, family or otherwise, to the Krehbiel family, Registrant or each other. (c) Includes period employed by Registrant's predecessor.
Item 11
Item 11 - Executive Compensation
The information under the caption "Executive Compensation" in the Company's 1999 Proxy Statement is incorporated herein by reference.
Item 12
Item 12 - Security Ownership of Certain Beneficial Owners and Management
The information under the caption "Security Ownership of Management and of Certain Beneficial Owners" in the Company's 1999 Proxy Statement is incorporated herein by reference.
Item 13
Item 13 - Certain Relationships and Related Transactions
The information under the captions "Election of Directors," "Indebtedness of Management" and "Security Ownership of Management and of Certain Beneficial Owners" in the Company's 1999 Proxy Statement is herein incorporated by reference.
PART IV
Item 14
Item 14 - Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a) 1. Financial Statements
The following consolidated financial statements contained in the Company's 1999 Annual Report to Shareholders have been incorporated by reference in Item 8.
Page(s) in Annual Report Item to Shareholders
Independent Auditors' Report 37
Consolidated Balance Sheets - June 30, 1999 and 1998 38-39
Consolidated Statements of Income - for the years ended June 30, 1999, 1998 and 1997 40
Consolidated Statements of Shareholders' Equity - for the years ended June 30, 1999, 1998 and 1997 41
Consolidated Statements of Cash Flows - for the years ended June 30, 1999, 1998 and 1997 42
Notes to Consolidated Financial Statements 43-49
Fiscal 1999, 1998 and 1997 by Quarter (Unaudited) 50
(a) 2. Financial Statement Schedule Page in the Form 10-K
Independent Auditors' Report 16
Statement of Changes in Shares Outstanding for the years ended June 30, 1999, 1998 and 1997 17
Schedule II - Valuation and Qualifying Accounts 18
All other schedules are omitted because they are inapplicable, not required under the instructions, or the information is included in the consolidated financial statements or notes thereto.
Separate financial statements for the Company's unconsolidated affiliated companies, accounted for by the equity method, have been omitted because they do not constitute significant subsidiaries.
(a) 3. Exhibits
The exhibits listed on the accompanying Index to Exhibits are filed or incorporated herein as part of this Report.
(b) Reports on Form 8-K
Molex filed no reports on Form 8-K with the Securities and Exchange Commission during the last quarter of the fiscal year ended June 30, 1999.
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders of Molex Incorporated Lisle, Illinois
We have audited the consolidated financial statements of Molex Incorporated and its subsidiaries as of June 30, 1999 and 1998, and for each of the three years in the period ended June 30, 1999, and have issued our report thereon dated July 28, 1999; such financial statements and report are included in your 1999 Annual Report to Shareholders and are incorporated herein by reference. Our audits also included the statements of changes in shares outstanding and the financial statement schedule of Molex Incorporated and its subsdidiaries, listed in Item 14(a)2. These statements of changes in shares outstanding and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such statements of changes in shares outstanding and financial statement schedule, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
/S/DELOITTE & TOUCHE LLP
Chicago, Illinois July 28, 1999
MOLEX INCORPORATED EXHIBIT INDEX Exhibit Number Exhibit 3 3.1 Certificate of Incorporation (as amended)(incorporated by reference to 1998 Form 10-K, Exhibit 3.1)
3.2 By-Laws (as amended)
4 Instruments defining rights of security holders including indentures. See Exhibit 3.1
10 Material Contracts 10.1 The Molex Deferred Compensation Plan (incorporated by reference to 1984 Form 10-K, Exhibit 10.6)
10.2 The 1990 Molex Incorporated Executive Stock Bonus Plan (as amended)(incorporated by reference to 1998 Form 10-K, Exhibit 10.2)
10.3 The 1990 Molex Incorporated Stock Option Plan (as amended) (incorporated by reference to 1998 Form 10-K, Exhibit 10.3)
10.4 The 1991 Molex Incorporated Incentive Stock Option Plan (as amended)
10.5 The 1998 Molex Incorporated Stock Option Plan
13 Molex Incorporated Annual report to Shareholders for the year ended June 30, 1999. (Such Report, except to the extent incorporated herein by reference, is being furnished for the information of the Securities and Exchange Commission only and is not to be deemed filed as a part of this annual report on Form 10-K)
Exhibit Number Exhibit
22 Subsidiaries of registrant
24 Independent Auditors' Consent
27 Financial Data Schedule
(All other exhibits are either inapplicable or not required)
S I G N A T U R E S
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Company has duly caused this Annual Report to be signed on its behalf by the undersigned, there unto duly authorized.
MOLEX INCORPORATED ------------------------- (Company)
September 22, 1999 /S/ ROBERT B. MAHONEY By: Robert B. Mahoney Corporate Vice President, Treasurer and Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
September 22, 1999 /S/ F. A. KREHBIEL F. A. Krehbiel Co-Chairman of the Board and Co-Chief Executive Officer
September 22, 1999 /S/ J. H. KREHBIEL, JR. J. H. Krehbiel, Jr. Co-Chairman of the Board and Co-Chief Executive Officer
September 22, 1999 /S/ J. JOSEPH KING J. Joseph King President and Chief Operating Officer Director
September 22, 1999 /S/ ROBERT B. MAHONEY Robert B. Mahoney Corporate Vice President, Treasurer and Chief Financial Officer
September 22, 1999 /S/ F. L. KREHBIEL F. L. Krehbiel Director
September 22, 1999 /S/ MICHAEL J. BIRCK Michael J. Birck Director
September 22, 1999 /S/ DOUGLAS K. CARNAHAN Douglas K. Carnahan Director
September 22, 1999 /S/ EDGAR D. JANNOTTA Edgar D. Jannotta Director
September 22, 1999 /S/ DONALD G. LUBIN Donald G. Lubin Director
September 22, 1999 /S/ MASAHISA NAITOH Masahisa Naitoh Director
September 22, 1999 /S/ DR. ROBERT J. POTTER Dr. Robert J. Potter Director | 3,517 | 23,880 |
1055455_1999.txt | 1055455_1999 | 1999 | 1055455 | ITEM 3. LEGAL PROCEEDINGS.
The Company has been named as a defendant in a lawsuit filed by the previous stockholders of two of the Company's subsidiaries. The lawsuit also names U.S. Office Products and certain former and present executive officers of U.S. Office Products as defendants. The lawsuit was instituted on January 19, 1999, in the Circuit Court for the County of Kent, State of Michigan. The defendants removed the suit to the Southern Division of the United States District Court for the Western District of Michigan. The case was subsequently transferred to the United States District Court for the District of Columbia, to be consolidated with other pending actions against U. S. Office Products.
The plaintiffs allege that U.S. Office Products and the named U.S. Office Products executive officers made fraudulent misrepresentations and omissions about among other things, U.S. Office Products' plans to engage in a restructuring which would include a spin-off of its travel business to its existing shareholders (the "Travel Distribution"). The plaintiffs contend that such alleged misrepresentations and omissions induced the plaintiffs to sell their businesses to U.S. Office Products. The Company has been named in the lawsuit as a successor to U.S. Office Products' travel businesses. The plaintiffs contend that they may seek rescission of the purchases of these two subsidiaries or damages for the value of the assets of the two subsidiaries from the Company and have requested that the Company be required to hold such assets in a constructive trust for the plaintiffs. As of December 26, 1999, the approximate book value of these two subsidiaries was $12.6 million. The Company intends to vigorously defend against this lawsuit.
Individuals purporting to represent various classes composed of stockholders who purchased shares of U.S. Office Products common stock between June 5, 1997 and November 2, 1998 filed six actions in the United States District Court for the Southern District of New York and four actions in the United States District Court of the District of Columbia in late 1998 and early 1999. Each of the actions named Jonathan Ledecky (a former director of Navigant), U.S. Office Products, and, in some cases, Sands Brothers & Co. Ltd. as defendants. Navigant has not been named as a defendant in these actions. The actions claim that the defendants made misstatements, failed to disclose material information, and otherwise violated Sections 10(b) and/or 14 of the Securities Exchange Act of 1934 and Rules 10b-5 and 14a-9 thereunder in connection with U.S. Office Products' Strategic Restructuring. Two of the actions alleged a violation of Sections 11, 12 and/or 15 of the Securities Act of 1933 and/or breach of contract under California law relating to U.S. Office Products' acquisition of Mail Boxes Etcetera. The actions seek declaratory relief, unspecified money damages and attorney's fees. All of these actions have been consolidated and transferred to the United States District Court for the District of Columbia. A consolidated amended complaint was filed on July 29, 1999, naming U.S. Office Products and Mr. Ledecky as defendants.
Sellers of two businesses that U.S. Office Products acquired in the fall of 1997 and that were spun off in connection with U.S. Office Products' Strategic Restructuring (which included the Travel Distribution) also have filed complaints in the United States District Court for the District of Delaware, and the United States District Court for the District of Connecticut. These lawsuits were filed on February 10, 1999 and March 3, 1999, respectively, and name, among others, U.S. Office Products as a defendant. Both of these cases have been transferred and consolidated for pretrial purposes with the purported class-action pending in the United States District Court for the District of Columbia.
Sellers of two other businesses acquired in October 1997 and December 1997 that were not spun off by U.S. Office Products have also filed complaints in state court in Kentucky and state court in Indiana in which U.S. Office Products is named as defendant. Those complaints were filed on or about September 2, 1999, and September 30, 1999. These cases have been removed to federal district court, and U.S. Office Products has sought to have both cases transferred and consolidated with the cases pending in the United States District Court for the District of Columbia. Each of these disputes generally relates to events surrounding the Strategic Restructuring, and the complaints that have been filed assert claims of violation of federal and/or state securities and other laws, fraud, misrepresentation, conspiracy, breach of contract, negligence, and/or breach of fiduciary duty.
In October 1999, the United States District Court for the District of Columbia ordered that the parties in all of the cases before it engage in mediation, and "administratively closed" the cases that had been consolidated until completion of the mediation process. Mediation sessions were held in December 1999 and January 2000. If the cases are not settled by mediation, the cases will be reopened with the court.
On April 14, 1998, a stockholder purporting to represent a class composed of all U.S. Office Products' stockholders filed an action in the Delaware Chancery Court. The action names U.S. Office Products and its directors, including Mr. Ledecky, as defendants, and claims that the directors breached their fiduciary duty to stockholders of U.S. Office Products by changing the terms of the self tender offer for U.S. Office Products' common stock that was a part of the Strategic Restructuring Plan to include employee stock options. The complaint seeks injunctive relief, damages and attorneys' fees. The directors filed an answer denying the claims against them, and U.S. Office Products has moved to dismiss all claims against it.
In connection with the Travel Distribution, the Company agreed to indemnify U.S. Office Products for certain liabilities, which could include claims such as those made against U.S. Office Products in these lawsuits. If U.S. Office Products were entitled to indemnification under this agreement, the Company's indemnification obligation, however, likely would be limited to 5.2% of U.S. Office Products' indemnifiable loss, up to a maximum of $1.75 million.
Navigant is also involved in various other legal actions arising in the ordinary course of its business. Navigant believes that none of these actions will have a material adverse effect on its business, financial condition and results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matter was submitted to a vote of the Company's stockholders, through the solicitation of proxies or otherwise, during the fourth quarter of fiscal year 1999.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
Market Information
The Company's Common Stock ("Common Stock") is quoted on the Nasdaq Stock Market National Market under the symbol "FLYR." The following table sets forth, for the period indicated, the range of high and low sales prices per share of Common Stock, as reported on the Nasdaq Stock Market National Market:
(1) Prior to June 9, 1998, Navigant was a division of U.S. Office Products.
Holders
At March 13, 2000, the last reported sales price of the Common Stock was $9.44 per share, and the number of holders of record of the Common Stock was approximately 3,283.
Dividends
The Company has not declared or paid dividends on its Common Stock since its formation, and the Company does not anticipate paying dividends in the foreseeable future. The decision whether to apply legally available funds to the payment of dividends on Navigant Common Stock will be made by the Board of Directors from time to time in the exercise of its business judgment, taking into account, among other things, Navigant's results of operations and financial condition, any then existing or proposed commitments by Navigant for the use of available funds, and Navigant's obligations with respect to the holders of any then outstanding indebtedness or preferred stock. Furthermore, Navigant's ability to pay dividends may be restricted from time to time by financial covenants in its credit agreements.
Sales of Unregistered Securities
During the fiscal year ended December 26, 1999, there were no sales by the Company of unregistered securities.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA.
The historical financial data presented below should be read in conjunction with the consolidated financial statements, including the notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" that appear elsewhere in this Annual Report.
- -------- (1) The historical financial information of the businesses that were acquired in business combinations accounted for under the pooling-of-interests method during the period from January through April 1997 have been combined on a historical basis in accordance with generally accepted accounting principles ("GAAP") to present this financial data as if these pooled businesses had always been members of the same operating group. The financial information of the businesses acquired in business combinations accounted for under the purchase method is included from the dates of their respective acquisitions. (2) For a discussion of non-recurring charges, see "Management's Discussion and Analysis of Financial Condition and Results of Operations--Introduction." (3) "EBITDA" is defined as income from operations, plus depreciation and amortization. EBITDA is not intended to represent cash flow from operations in accordance with GAAP and should not be used as an alternative to net income as an indicator of operating performance or to cash flow as a measure of liquidity. EBITDA is included in this Annual Report because it is a basis upon which Navigant assesses its financial performance. While EBITDA is frequently used as a measure of operations and the ability to meet debt service requirements, it is not necessarily comparable to other similarly titled captions of other companies due to potential inconsistencies in the method of calculation.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Introduction
The Company provides corporate travel management services and, to a more limited extent, other travel services, throughout the United States, in Canada and in the United Kingdom.
The Company's consolidated financial statements give retroactive effect to the four business combinations accounted for under the pooling-of-interests method during the period from January through April 1997 (the "Pooled Companies") and includes the results of operations for the seven companies acquired in business combinations in 1997 accounted for under the purchase method (the "1997 Purchased Companies"), the eight companies acquired in business combinations in 1998 accounted for under the purchase method (the "1998 Purchased Companies") and the ten companies acquired in business combinations in 1999 accounted for under the purchase method (the "1999 Purchased Companies") from their respective dates of acquisition.
Sources of Revenue
Historically, arrangements between corporate travel management companies and their clients generally did not provide for any direct compensation from clients for travel bookings and services completed on their behalf. Consequently, corporate travel management companies were largely dependent for their revenues on the point of sale percentage commissions paid by the airlines for each ticket issued and to a lesser extent on hotel and car rental commissions. In 1995, the airlines instituted a commission cap of $50 on round- trip domestic tickets and $25 on one-way domestic tickets. In October 1997, the airlines cut the base commission on domestic and international tickets from 10% to 8% of the ticket price. The Company and other travel management companies were significantly affected by these commission reductions, particularly the October 1997 reduction, which resulted in a decrease in gross revenue per transaction. In October 1998, the airlines instituted a commission cap of $100 on round-trip international tickets and $50 on one-way international tickets. Most recently, in October 1999, the airlines further cut the base commission on domestic and international tickets from 8% to 5% of the ticket price. The previous commission caps of $50 on round-trip domestic tickets and $25 on one- way domestic tickets and $100 on round-trip international tickets and $50 on one-way international tickets remained in effect.
In response to the reduction in airline commissions and consistent with growing industry practice, the Company has entered into management contracts and service fee arrangements with a significant number of its clients. Although the terms of the Company's management contracts vary depending on the type of services
provided and by client, the Company typically deducts a pre-negotiated management fee, its direct operating expenses and its indirect overhead costs from commissions collected for travel arrangements made on behalf of the client. If the commissions do not exceed the amounts deducted, the client pays the difference to the Company. If the commissions exceed the amounts deducted, the Company typically pays the excess to the client. In addition, the Company typically charges a service fee for each ticket and other transactions to clients who do not have a management contract with the Company. The Company charges between $10 and $35 for each air travel ticket issued to such clients and retains all of the related commissions collected from the airlines.
The Company believes that its management contracts and service fee arrangements should minimize the financial impact of the above noted commission caps, as well as any future changes in the airline commission rates. The Company believes that at least 95% of its total transactions are currently generated from clients under management contracts and service fee arrangements and expects this percentage to increase to 98% to 100% during the early part of 2000 as contracts are renegotiated.
The Company has entered into agreements with major airlines for the payment of "incentive override" commissions in addition to the base commissions described above. Under these agreements, the airlines generally pay additional commissions on domestic and international air travel if the volume of the Company's ticket sales surpasses specified thresholds, which typically are based on the airlines' share of the relevant markets. Additionally, the Company has negotiated favorable contracts with selected computer reservation systems vendors, hotel commission clearinghouses, and rental car companies. Some of these contracts provide payments to the Company of up-front fees or annual payments or cost savings to Navigant.
Expenses
The Company's direct operating expenses include principally labor (which comprised approximately 76.3% and 70.7% of total direct operating expenses in 1999 and 1998, respectively), net commission payments to clients under management contracts, communication costs and other costs associated with the selling and processing of travel reservations.
The Company's general and administrative expenses include principally labor (which comprised approximately 50.4% and 52.1% of total general and administrative expenses in 1999 and 1998, respectively), occupancy and other costs.
1997 Non-Recurring Charges
The Company incurred non-recurring acquisition costs of $1.16 million during 1997 in connection with the acquisition of the Pooled Companies. These non- recurring charges included accounting, legal and investment banking fees, real estate and environmental assessments and appraisals and various regulatory fees.
1998 Non-Recurring Charges
During 1998, the Company incurred the following non-recurring charges:
On March 13, 1998, the Company received 90 days' notice of termination of a business relationship that contributed approximately $600,000 to net operating income during 1997. In March 1998, the Company wrote off $613,000 in intangible assets relating to the original acquisition of this contract. In addition to this charge, the Company took a charge in April 1998 of approximately $698,000 in connection with the disposition of certain equipment, severance charges and other costs associated with a change in operational strategy to a centralized management structure at one of its locations. This switch to a centralized management structure from a regional structure at this location is consistent with the existing structure at the other regional travel management companies acquired.
The Company incurred strategic restructuring costs of $3.75 million in connection with the Travel Distribution as an allocation from U.S. Office Products. Of this amount, $1.0 million was an allocation to the Company for a portion of the strategic restructuring charge incurred by U.S. Office Products and the remaining $2.75 million was as a result of U.S. Office Products Company's purchase of a pro rata portion of the Company's stock options pursuant to a tender offer made in connection with the Travel Distribution. Of the $2.75 million, $2.68 million was recorded as a non-cash compensation charge while the $73,000 relates to the Company's portion of payroll taxes on the compensation.
As part of the Company's increased focus on operational matters subsequent to the Travel Distribution, it undertook a formal plan approved by its Board of Directors for cost reduction measures including the elimination of duplicative facilities, the consolidation of certain operating functions and the deployment of common information systems. The implementation of the cost reduction measures commenced in November 1998 and resulted in the Company recording a restructuring charge of $3.18 million in November and December 1998. The 1998 charge included the closure of 20 facilities, the sale of one building and the severance associated with the termination of 127 employees. Through December 1999, 18 facilities have been closed or consolidated and 142 employees have been terminated. The following table summarizes non-recurring charges associated with the 1998 cost reduction plan and sets forth their usage for the periods indicated:
2000 Non-Recurring Charges
In February 2000, the Company undertook a formal plan approved by the Board of Directors for further cost reduction measures including the consolidation of certain operating functions on a regional basis and the elimination of duplicative facilities. The implementation of the cost reduction measures commenced in March 2000 and resulted in the Company recording a restructuring charge of approximately $1.9 million in March 2000. Management anticipates that these measures will be completed throughout 2000. The 2000 charge includes the severance associated with the termination of approximately 130 positions and the merger of several facilities.
The following discussion should be read in conjunction with Navigant's consolidated financial statements and related notes thereto appearing elsewhere in the Annual Report.
Results of Operations
The following table sets forth various items as a percentage of revenues for 1999, 1998 and 1997:
Consolidated Results of Operations
Fiscal Year Ended December 26, 1999 Compared to Fiscal Year Ended December 27,
Consolidated revenues increased 33.7%, from $171.4 million for 1998 to $229.2 million for 1999. This increase was primarily due to the inclusion of the revenues from the 1998 and 1999 Purchased Companies from their respective dates of acquisition, which added approximately $52.5 million in consolidated revenues. Additionally, the Company has increased revenues in 1999 through improved national contracts with certain of its vendors and internal growth.
Operating expenses increased 29.3%, from $99.7 million, or 58.2% of revenues, for 1998 to $129.0 million, or 56.3% of revenues, for 1999. The decrease in operating expense as a percentage of revenues was due primarily to the spreading of certain fixed operating expenses over a larger revenue base and an increase in revenue from certain vendors, due to the Company's negotiation of improved national contracts with these vendors.
General and administrative expenses increased 27.8%, from $48.0 million, or 28.0% of revenues, for 1998 to $61.3 million, or 26.8% of revenues, for 1999. The decrease in general and administrative expenses as a percentage of revenues was due primarily to the 1998 and 1999 Purchased Companies having lower general and administrative expenses as a percentage of revenues than the Company and as a result of spreading certain fixed general and administrative expenses over a larger revenue base. Additionally, the Company has begun implementing integration efforts to reduce redundant facilities and functions, resulting in a decrease in general and administrative expenses during 1999.
Depreciation and amortization expense increased 36.1%, from $7.2 million, or 4.2% of revenues, for 1998 to $9.8 million, or 4.2% of revenues, for 1999. This increase was due to the increase in the number of purchase acquisitions and the resultant higher goodwill amortization included in the results for 1999 compared to 1998.
The Company did not incur any non-recurring charges in 1999 compared to $8.2 million during 1998. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Introduction--1998 Non-Recurring Charges."
Interest expense, net, increased from $1.8 million or 1.1% of revenues, for 1998 to $5.7 million, or 2.5% of revenues, for 1999. The increase was attributable to financing the acquisition of the 1998 and 1999 Purchased Companies with borrowings under the Company's credit facility as the average debt balance for 1999 increased to $75.5 million compared to $31.7 million for 1998 resulting in approximately $2.9 million in interest expense. Additionally, the increase in interest rates associated with the Federal Reserve rate increases resulted in $1.0 million additional interest expense as the Company's average interest rate increased from 6.5% in 1998 to 7.8% in 1999.
Provision for income taxes increased from $4.0 million for 1998 to $10.2 million for 1999, reflecting effective income tax rates of 62.0% and 43.7%, respectively. The high effective income tax rate compared to the federal statutory rate of 35% was primarily due to an increase in non-deductible goodwill amortization resulting from acquisition activity. The effective rate in 1999 was lower than the effective rate in 1998 due to a lower ratio of non- deductible goodwill amortization to pre-tax income in the later periods. Additionally, the 1998 effective rate is adversely affected by the large non- recurring charges, which increased the ratio of non-deductible goodwill amortization to pre-tax income in 1998 from 16.1% to 36.8%.
Fiscal Year Ended December 27, 1998 Compared to Fiscal Year Ended December 28,
Consolidated revenues increased 88.5%, from $90.9 million for 1997 to $171.4 million for 1998. This increase was primarily due to the inclusion of the revenues from the 1997 and 1998 Purchased Companies from their respective dates of acquisition, which added approximately $79.0 million in consolidated revenues. Additionally, the Company also increased the number of clients under management contracts and service fee arrangements. This revenue offset the approximate 20% reduction in commission revenue, due to the commission cuts imposed by the airlines on all travel in October 1997. Additionally, the Company increased revenues in 1998 due to the internal growth of approximately 1.5%.
Operating expenses increased 89.9%, from $52.5 million, or 57.8% of revenues, for 1997 to $99.7 million, or 58.2% of revenues, for 1998. The increase in operating expense as a percentage of revenues was due primarily to normal inflationary pressures on salaries and other operating expense in 1998 while overall revenues remained flat when excluding revenues from acquisitions as discussed above.
General and administrative expenses increased 75.3%, from $27.4 million, or 30.1% of revenues, for 1997 to $48.0 million, or 28.0% of revenues, for 1998. The decrease in general and administrative expenses as a percentage of revenues was due primarily to the 1998 Purchased Companies having lower general and administrative expenses as a percentage of revenues than the Company and as a result of spreading certain fixed general and administrative expenses over a larger revenue base.
Depreciation and amortization expense increased from $3.1 million, or 3.4% of revenues, for 1997 to $7.2 million, or 4.2% of revenues, for 1998. This increase was due to the increase in the number of purchase acquisitions and the resultant higher goodwill amortization included in the results for 1998 compared to 1997.
The Company incurred non-recurring charges of $8.2 million during 1998 compared to $1.2 million during 1997. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Introduction--1998 Non- Recurring Charges."
Interest expense, net, increased from $285,000 or 0.3% of revenues, for 1997 to $1.8 million, or 1.1% of revenues, for 1998. The increase was attributable to financing the acquisition of the 1998 Purchased Companies with borrowings under the Company's credit facility as the average debt balance for 1998 increased to $31.7 million compared to $10.0 million for 1997.
Provision for income taxes increased from $3.0 million for 1997 to $4.0 million for 1998, reflecting effective income tax rates of 45.6% and 62.0%, respectively. The high effective income tax rate compared to the federal statutory rate of 35% was primarily due to an increase in non-deductible goodwill amortization
resulting from acquisition activity. The effective rate in 1998 was higher than the effective rate in 1997 due to a higher ratio of non-deductible goodwill amortization to pre-tax income in 1998, which was attributable to the larger non-recurring charge in 1998. This increased the ratio of non-deductible goodwill amortization to pre-tax income in 1998 from 16.1% to 36.8%. Additionally, the Pooled Companies were not subject to federal income taxes on a corporate level prior to being acquired by Navigant as they had elected to be treated as subchapter S corporations ("Subchapter S Companies"), resulting in minimal income tax expense during the period from January through April 1997.
Liquidity and Capital Resources
At December 26, 1999, the Company had cash of $2.0 million, excluding restricted cash in NavigantVacations.com, working capital of $20.1 million ($5.1 excluding restricted cash in NavigantVacations.com), borrowings of $90.0 million under the Amended and Restated Credit Agreement from NationsBank, N.A. as Administrative Agent (the "Credit Facility"), $17.2 million of other indebtedness, including capital lease obligations, and available capacity under the Credit Facility of $35.0 million. The Company's capitalization, defined as the sum of long-term debt and stockholders' equity at December 26, 1999 was approximately $232.2 million.
The Company has financed its operational growth and acquisitions primarily from internally generated cash flow from operations and borrowings under the Credit Facility. These borrowings are secured by the accounts receivable and other assets of the Company.
The Company anticipates that its cash flow from operations and borrowings under the Credit Facility will provide sufficient cash to enable the Company to meet its working capital needs, debt service requirements and planned capital expenditures for property and equipment through at least fiscal 2002 based on current budgets.
During 1999, net cash provided by operating activities was $10.0 million. Net cash used in investing activities was $47.2 million, including $5.2 million for additions to property and equipment, such as computer equipment and office furniture, and $28.0 million for the acquisition of the 1999 Purchased Companies, and $15.0 million for the purchase of cash equivalents with the restricted cash in NavigantVacations.com offset by the proceeds from the sale of a building for $1.0 million. Net cash provided by financing activities was $39.0 million, consisting of $8.1 million for repayments by the Company of long-term indebtedness, $2.2 million for payment of debt issuance costs attributable to the Company's new revolving credit facility and $3.2 million for the repurchase of common stock offset by net increases of $36.7 million in the Company's Credit Facility, $15 million from the proceeds of the issuance of a minority interest in NavigantVacations.com, and $800,000 for the proceeds from the exercise of stock options.
During 1998, net cash provided by operating activities was $10.1 million. Net cash used in investing activities was $65.4 million, including $4.3 million for additions to property and equipment, such as computer equipment and office furniture, and $59.5 million for the acquisition of the 1998 Purchased Companies. Net cash provided by financing activities was $49.3 million, consisting of $53.3 million in proceeds from the Company's Credit Facility and $15.0 million from the Stock Offering, partially offset by repayment to U.S. Office Products of the $8.8 million of indebtedness allocated to the Company in the Travel Distribution (net of advances from U.S. Office Products in 1998) and by $6.9 million of dividends to U.S. Office Products.
During 1997, net cash provided by operating activities was $6.5 million. Net cash used in investing activities was $2.6 million, including $1.4 million for additions to property and equipment, such as computer equipment and office furniture, and $1.2 million to pay for non-recurring acquisition costs. Net cash used in financing activities was $7.7 million, including $12.2 million for repayment of indebtedness and $3.0 million for the payment of dividends, partially offset by advances to Navigant of $7.3 million from U.S. Office Products.
In August 1999, the Company obtained the Credit Facility, a secured $125.0 million revolving credit facility to replace the Company's previous $60.0 million revolving credit facility and a $15.0 million short term
bridge loan agreement. The Credit Facility is available for working capital, capital expenditures, and acquisitions, subject to compliance with the applicable covenants. The Credit Facility is scheduled to expire in August 2004. Interest on borrowings under the Credit Facility accrues at a rate of, at the Company's option, either (i) LIBOR plus a margin of between 1.25% and 2.75%, depending on the Company's funded debt to EBITDA ratio, or (ii) the Alternative Base Rate (defined as the higher of (x) the NationsBank, N.A. prime rate and (y) the Federal Funds rate plus .50%) plus a margin of between .25% and 1.75%, depending on the Company's funded debt to EBITDA ratio. Indebtedness under the Credit Facility is secured by substantially all of the assets of the Company. The Credit Facility is subject to terms and conditions typical of facilities of such size and includes certain financial covenants.
The Company intends to continue to pursue acquisition opportunities and may be in various stages of negotiation, due diligence and documentation of potential acquisitions at any time. The timing, size or success of any acquisition effort and the associated potential capital commitments cannot be predicted. The Company expects to fund future acquisitions primarily with cash flow from operations and borrowings, including borrowings under the Credit Facility, as well as issuance of additional equity or debt. To the extent the Company funds a significant portion of the consideration for future acquisitions with cash, it may have to increase the amount available for borrowing under the Credit Facility or obtain other sources of financing through the public or private sale of debt or equity securities. There can be no assurance that the Company will be able to secure such financing if and when it is needed or on terms the Company deems acceptable. If the Company is unable to secure acceptable financing, its acquisition program could be negatively affected. Capital expenditures for equipment and expansion of facilities are expected to be funded from cash flow from operations and supplemented as necessary by borrowings under the Credit Facility.
Fluctuations in Quarterly Results of Operations
The business travel industry is seasonal and the Company's results have fluctuated because of these seasonal variations. Net revenues and net income for the Company are generally higher in the second and third calendar quarters. The Company expects this seasonality to continue in the future. The Company's quarterly results of operations may also be subject to fluctuations as a result of changes in relationships with certain travel suppliers, changes in the mix of services offered by the Company, extreme weather conditions or other factors affecting travel. Unexpected variations in quarterly results could also adversely affect the price of the Company's common stock, which in turn could limit the ability of the Company to make acquisitions.
As the Company continues to complete acquisitions, it may become subject to additional seasonal influences. Quarterly results also may be materially affected by the timing of acquisitions, the timing and magnitude of costs related to such acquisitions, variations in the prices paid by the Company for the products it sells, the mix of products sold and general economic conditions. Moreover, the operating margins of companies acquired may differ substantially from those of the Company, which could contribute to the further fluctuation in its quarterly operating results. Therefore, results for any quarter are not necessarily indicative of the results that the Company may achieve for any subsequent fiscal quarter or for a full fiscal year.
Inflation
The Company does not believe that inflation has had a material impact on its results of operations.
New Accounting Pronouncements
On June 15, 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities ("FAS 133"). FAS 133, as subsequently amended, is effective for all fiscal quarters of all fiscal years beginning after June 15, 2000 (January 1, 2001 for the Company). FAS 133 requires that all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value of derivatives are to be recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge
transaction and, if it is, the type of hedge transaction. The Company believes that, due to its limited use of derivative instruments, the adoption of FAS 133 will not have a significant effect on the Company's results of operations or its financial position.
Risk Factors
Significant Indebtedness and Interest Payment Obligations
Navigant is significantly leveraged. At December 26, 1999, Navigant had $107.2 million of consolidated outstanding debt and its total consolidated debt, as a percentage of capitalization, was 46.2%. Navigant may also need to incur additional debt in the future to complete acquisitions or capital projects or for working capital even though its Credit Facility imposes some limits on its ability to do so. Navigant's high level of indebtedness could have important consequences to its stockholders, which include the following:
. its ability to obtain additional financing to fund its business strategy, debt service requirements, capital expenditures, working capital or other purposes may be impaired;
. its ability to use operating cash flow in other areas of its business will be limited because Navigant must dedicate a substantial portion of these funds to pay interest and principal on its debt;
. certain of its borrowings bear interest at variable rates, which could result in higher interest expense in the event of increases in interest rates;
. it may not be able to compete with others who are not as highly leveraged; and
. its significant leverage may limit its flexibility to adjust to changing market conditions, changes in its industry and economic downturns.
Navigant's ability to pay interest on its debt obligations will depend upon its future operating performance and its ability to obtain additional debt or equity financing. Prevailing economic conditions and financial, business and other factors, many of which are beyond Navigant's control, will affect its ability to make these payments. If in the future Navigant cannot generate sufficient cash from operations to meet its obligations, Navigant will need to refinance, obtain additional financing or sell assets. Navigant cannot assure its stockholders that its business will generate cash flow, or that it will be able to obtain funding, sufficient to satisfy its debt service requirements.
Restrictions Imposed by Terms of Indebtedness
The covenants in Navigant's existing debt agreements, including the Credit Facility and any future financing agreements may adversely affect its ability to finance future operations or capital needs or to engage in other business activities. These covenants limit or restrict Navigant's ability to:
. incur additional debt or prepay or modify any additional debt that may be incurred;
. make certain acquisitions or investments;
. pay dividends and make distributions;
. repurchase its securities;
. create liens;
. transfer or sell assets;
. enter into transactions with affiliates;
. issue or sell stock of subsidiaries;
. merge or consolidate; or
. materially change the nature of its business.
In addition, Navigant's Credit Facility also requires it to comply with certain financial ratios. Navigant's ability to comply with these ratios may be affected by events beyond its control. If Navigant breaches any of these covenants in its Credit Facility, or if Navigant is unable to comply with the required financial ratios, it may be in default under its Credit Facility. A significant portion of Navigant's indebtedness then may become immediately due and payable. Navigant is not certain whether it would have, or be able to obtain, sufficient funds to make these accelerated payments. Compliance with the covenants is also a condition to revolver borrowings under the Credit Facility on which Navigant relies to fund its liquidity.
Holding Company Structure
Navigant is a holding company. Navigant's subsidiaries conduct substantially all of its consolidated operations and own substantially all of its consolidated assets. Consequently, Navigant's cash flow and its ability to meet its debt service obligations depends upon the cash flow of its subsidiaries, the payment of funds by its subsidiaries to Navigant in the form of loans, dividends or otherwise. Navigant's subsidiaries are not obligated to make funds available to Navigant for payment on debt or otherwise. In addition, their ability to make any payments will depend on their earnings, the terms of their indebtedness, business and tax considerations and legal restrictions.
Risks Related to Revenue
Historically, corporate travel management companies were largely dependent for their air travel ticketing revenues on the point of sale percentage commissions paid by airlines for each ticket issued. Since 1995, most airlines have substantially reduced the amount of commissions paid to travel agents for booking domestic and international flights. The airlines have both capped the total commissions paid per ticket and reduced the commission rates per ticket payable to travel agents and may further reduce commissions in the future. Further reductions in commissions may reduce Navigant's revenue. See "Management's Discussion and Analysis of Financial Condition and Results of Operations of Navigant--Introduction--Sources of Revenue" in Item 7. There can be no assurance that the airlines will not further reduce commissions.
Navigant has responded to the reductions in the commissions paid by airlines by entering into management contracts and service fee arrangements with many of its corporate clients. Although the terms of its management contracts vary depending on the type of services provided and by client, Navigant typically deducts a pre-negotiated management fee, its direct operating expenses and its indirect overhead costs from commissions collected for travel arrangements made on behalf of the client. If the commissions do not exceed the amounts deducted, the client pays the difference to Navigant. If the commissions exceed the amounts deducted, Navigant typically pays the excess to the client. In addition, Navigant typically charges a service fee for each ticket and other transactions to clients who do not have a management contract with Navigant. In the future Navigant may not be able to maintain or continue to negotiate management contracts or continue to receive current levels of fees from those contracts, and also may not be able to charge service fees or maintain the level of such service fees.
Navigant also derives part of its revenues from incentive override commissions paid by the major airlines. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Introduction-- Sources of Revenue" in Item 7. If, during any period, Navigant fails to meet incentive levels, revenues could decrease. In addition, the airlines may reduce or terminate incentive override commissions and Navigant may not be able to extend its current incentive override commission arrangements or enter into new arrangements that are as favorable as its current arrangements.
Substantial Competition and Industry Consolidation; New Methods of Distribution
The corporate travel management industry is extremely competitive. Navigant competes primarily with other corporate travel management companies. Some of Navigant's competitors are larger and have greater brand-name recognition and financial resources than Navigant. Competition within the corporate travel
management industry is increasing as the industry undergoes a period of consolidation. Certain of Navigant's competitors are expanding their size and financial resources through consolidation. Some travel management companies may have relationships with certain travel suppliers which give them access to favorable availability of products (including airplane seats and hotel rooms) or more competitive pricing than that offered by Navigant. Furthermore, some corporate travel management companies have a strong presence in particular geographic areas which may make it difficult for Navigant to attract customers in those areas. As a result of competitive pressures, Navigant may suffer a loss of clients, and its revenues or margins may decline.
Navigant also competes with travel suppliers, including airlines, hotels and rental car companies. Innovations in technology, such as the Internet and computer on-line services, have increased the ability of travel suppliers to distribute their travel products and services directly to consumers. Although corporate travel management companies and travel agencies remain the primary channel for travel distribution, businesses and consumers can now use the Internet to access information about travel products and services and to purchase such products and services directly from the suppliers, thereby bypassing corporate travel management companies and travel agents. Navigant believes that no single Internet-based service presently provides access to the full range of information available to Navigant and its agents. An Internet- based travel service may, however, provide such access in the future. In addition, although Navigant believes the service, knowledge and skills of its employees and its incorporation of new, alternative distribution channels, position it to compete effectively in the changing industry, there can be no assurance that Navigant will compete successfully or that the failure to compete successfully will not have a material adverse effect on Navigant's financial condition and results of operations.
Dependence on Travel Suppliers
Navigant is dependent upon travel suppliers for access to their products and services (including airplane seats and hotel rooms). Certain travel suppliers offer Navigant pricing that is preferential to published fares, enabling Navigant to offer prices lower than would be generally available to travelers and other corporation travel management companies or travel agents. Travel suppliers can generally cancel or modify their agreements with Navigant upon relatively short notice, leaving Navigant subject to the loss of contracts, changes in its pricing agreements, commission schedules and incentive override commission arrangements, and more restricted access to travel suppliers' products and services, which could have a material adverse effect on Navigant's business, financial condition and results of operations.
Dependence Upon Technology
Navigant's business is dependent upon a number of different information and telecommunications technologies. In addition, Navigant's ability to quote air travel ticket prices, make reservations and sell tickets is dependent upon its contractual right to use, and the performance of, computer reservation systems operated by SABRE, Galileo/Apollo, Worldspan and Amadeus. Navigant's business, financial condition and results of operations may be materially adversely affected if these technologies or systems fail, or if Navigant's access to these systems is restricted.
Risks Associated with the Corporate Travel Management Industry; General Economic Conditions
Navigant's operating results generally depend upon factors affecting the corporate travel management industry. Navigant's revenues and earnings are especially sensitive to events that affect business air travel, and the level of car rentals and hotel reservations. A number of factors, including recession or slower economic growth, rising travel costs, extreme weather conditions and concerns about passenger safety, could result in a temporary or longer-term overall decline in demand for business travel. Advances in technology and communications, such as videoconferencing and Internet-based teleconferencing, may also adversely impact travel patterns and travel demand. Navigant believes that price-based competition will continue in the airline industry for the foreseeable future. The continuation of such competition and the occurrence of any of the events described above could have a material adverse effect on Navigant's business, financial condition and results of operations.
Risks Related to Integration of Operations and Acquisitions
One of Navigant's strategies is to increase operating margins by consolidating and integrating certain administrative functions common to all of its subsidiaries. This integration will require substantial attention from senior management and may require future substantial capital expenditures. The integration process may disrupt Navigant's operations as well as those of its subsidiaries as its management's attention is diverted from other tasks, and as technological, practical or personnel issues arise. There can be no assurance that the integration and consolidation will be completed, or that, if completed, Navigant will recognize economic benefit.
Currently, Navigant and some of its subsidiaries operate on separate computer systems and Navigant and most of its subsidiaries operate on separate telephone systems, several of which use different technologies. Although Navigant has made substantial progress in consolidating its back-room accounting, several other systems have not been consolidated. Navigant expects that it will eventually integrate these other systems, but it has not yet established a definitive timetable for integration of all of such systems or its definitive capital needs for the integration. The contemplated integration of its systems may cause disruption to Navigant's business and may not result in the intended cost efficiencies. In addition, rapid changes in technologies may require capital expenditures to improve or upgrade client service.
Risks Related to Navigant's Acquisition Strategy
General. One of Navigant's strategies is to increase its revenues and the markets it serves through the acquisition of additional corporate travel companies. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Risk Factors--Risk of Rapid Growth; Limited History as a Stand-Alone Company" in Item 7. Navigant may not be able to make acquisitions at the pace it desires or on favorable terms, if at all. In addition, the consolidation of the travel management industry has reduced the number of companies available for sale, which could lead to higher prices being paid for the acquisition of the remaining travel management companies.
The companies Navigant has acquired, or which Navigant may acquire in the future, may not achieve sales and profitability that would justify Navigant's investment in them. Navigant's acquisitions of companies outside the United States may subject it to certain risks inherent in conducting business internationally. These risks include fluctuations in currency exchange rates, new and different legal and regulatory requirements and difficulties in staffing and managing foreign operations.
Integration. Integration of operations of the companies Navigant acquired or may acquire in the future may also involve a number of special risks, which may have adverse short-term effects on Navigant's operating results. These may be caused by:
. severance payments to employees of acquired companies;
. restructuring charges associated with the acquisitions; and
. other expenses associated with a change in control.
Integration of acquire companies may also result in:
. diversion of management's attention;
. difficulties with retention;
. the need to hire and train key employees;
. risks associated with unanticipated problems or legal liabilities; and
. amortization of acquired intangible assets, including goodwill.
Navigant conducts due diligence and generally requires representations, warranties and indemnifications from the former owners of acquired companies. Navigant cannot be certain, however, that such owners will
have accurately represented the financial and operating conditions of their companies. If an acquired company's financial or operating results were misrepresented, the acquisition could have a material adverse effect on Navigant's results of operations and financial condition.
Financing. Navigant currently intends to finance its future acquisitions by using cash, borrowed funds, shares of its Common Stock or a combination thereof. If Navigant's Common Stock does not maintain a sufficient market value, if its price is highly volatile, or if, for other reasons, potential acquisition candidates are unwilling to accept Navigant's Common Stock as part of the consideration for the sale of their businesses, Navigant may then be required to use more of its cash resources or more borrowed funds in order to maintain its acquisition program. Navigant's ability to use shares of its Common Stock to make acquisitions may also be limited by Section 355(e) of the Internal Revenue Code. That section provides that a company that distributes shares of a subsidiary in a spin-off that is otherwise tax-free will incur U.S. federal income tax liability if 50% or more, by vote or value, of the capital stock of either the company making the distribution or the spin-off subsidiary is acquired pursuant to a plan or series of related transactions that includes the spin-off. Acquisitions made by Navigant within two years before or after the distribution by U.S. Office Products of Navigant's Common Stock in June 1998 may be deemed part of such a plan or series of related transactions. If Navigant is unable to use Common Stock for acquisitions and Navigant does not have sufficient cash resources, its growth could be limited unless Navigant is able to obtain additional capital through debt or other financing. Navigant may not be able to obtain additional capital if and when needed on terms Navigant deems acceptable. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Risk Factors--Restrictions Imposed by Terms of Indebtedness" in Item 7.
Accounting. Generally accepted accounting principles require that an entity be autonomous for a period of two years before it is eligible to complete business combinations under the pooling-of-interests method. Navigant has been and will be unable to satisfy this criterion for a period of two years following the distribution of its common stock by U.S. Office Products (until approximately June 2000). Therefore, any business combination completed by Navigant during such period will be accounted for under the purchase method, resulting in the recording of goodwill. The amortization of the goodwill has and will reduce Navigant's reported net income below that which would have been reported if it had used the pooling-of-interests method. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Risk Factors--Material Amount of Goodwill" in Item 7. Existing stockholders may suffer dilution if Navigant uses Navigant Common Stock as consideration for future acquisitions. Moreover, the issuance of additional shares of Navigant Common Stock may negatively impact earnings per share and the market price of Navigant Common Stock.
Additionally, the Financial Accounting Standards Board is currently considering proposed guidance that could eliminate the pooling-of-interest method and could shorten the amortization period for goodwill from the current maximum of 40 years to 20 years. This proposed guidance, if adopted, may negatively impact earnings per share and the market price of Navigant Common Stock.
Reliance on Key Personnel
Navigant's operations depend on the continued efforts of Edward S. Adams, its Chairman and Chief Executive Officer, C. Thomas Nulty, its President and Chief Operating Officer, Robert C. Griffith, its Chief Financial Officer and Treasurer, its other executive officers and the senior management of its subsidiaries. Furthermore, Navigant's operations will likely depend on the senior management of the companies that may be acquired in the future. If any of these people become unable to continue in his or her present role, or if Navigant is unable to attract and retain other skilled employees, its business could be adversely affected.
Material Amount of Goodwill
As of December 26, 1999, approximately $193.4 million, or 67.3%, of Navigant's total assets and 154.8% of Navigant's stockholders' equity represent intangible assets, the significant majority of which is goodwill.
Goodwill represents the excess of cost over the fair market value of net assets acquired in business combinations accounted for under the purchase method. Navigant amortizes goodwill on a straight-line method over a period of 35 years with the amount amortized in a particular period constituting a non-cash expense that reduces its net income. Amortization of goodwill resulting from certain past acquisitions, and additional goodwill recorded in certain future acquisitions may not be deductible for tax purposes. In addition, Navigant will be required to periodically evaluate the recoverability of goodwill by reviewing the anticipated undiscounted future cash flows from the operations of the acquired companies and comparing such cash flows to the carrying value of the associated goodwill. If Navigant determines that goodwill has become impaired in later years, earnings in such years will be significantly adversely affected.
A reduction in net income resulting from the amortization or write down of goodwill would currently affect financial results and could have a material and adverse impact upon the market price of Navigant Common Stock. Navigant believes that anticipated cash flows associated with intangible assets recognized in the 1997 Purchased Companies, the 1998 Purchased Companies and the 1999 Purchased Companies will continue over the period during which the associated goodwill will be amortized, and there presently is no persuasive evidence that any material portion will dissipate during such period.
Additionally, the Financial Accounting Standards Board is currently considering proposed guidance that could shorten the amortization period for goodwill from the current maximum of 40 years to 20 years. This proposed guidance, if adopted, may negatively impact earnings per share and the market price of Navigant Common Stock.
Seasonality and Quarterly Fluctuations
The domestic and international travel service industry is extremely seasonal. Navigant's past results have fluctuated because of seasonal variations in the travel services industry. Navigant's net revenues and net income are generally higher in the second and third calendar quarters and lowest in the fourth calendar quarter. Navigant expects this seasonality to continue in the future. Navigant's quarterly results of operations may also be subject to fluctuations as a result of the timing and cost of acquisitions, changes in relationships with certain travel suppliers, changes in the mix of services offered by Navigant, the timing of the payment of incentive override commissions by travel suppliers, extreme weather conditions or other factors affecting travel.
Risk of Rapid Growth; Limited History as a Stand-Alone Company
Navigant was formed through the acquisition of twelve corporate travel management companies from January 1997 through May 1998, and Navigant has made seventeen additional acquisitions since that time. Navigant expects to continue to grow in part through acquisitions. The rapid pace of acquisitions has, and will continue to, put pressure on Navigant's executive management, personnel and corporate support systems. Any inadequacy of Navigant's systems to manage the increased size and scope of operations resulting from growth could adversely affect Navigant's operations, business and financial results and condition.
Navigant has been an independent company since its initial public offering in June 1998. Navigant's future performance will depend on its ability to function as a stand-alone entity, to finance and manage expanding operations and to adapt its information systems to changes in its business. Furthermore, the financial information included herein may not necessarily reflect what the results of operations and financial condition would have been had Navigant been a separate, stand-alone entity during the periods presented. The financial information also may not be indicative of Navigant's future results of operations and financial condition.
Potential Liabilities Related to Distributions
In connection with the distributions of the shares of four U.S. Office Products' businesses (including Navigant) in June 1998, Navigant and three other companies whose shares were distributed by U.S. Office Products entered into a series of agreements providing the allocation of certain liabilities. Navigant and the
other companies agreed in a Tax Allocation Agreement to jointly and severally indemnify U.S. Office Products for tax losses relating to the distribution that are attributable to acts or omissions of Navigant and the other companies. A Tax Indemnification Agreement among Navigant and the other spun-off companies requires each company responsible for tax losses to indemnify the other companies for those losses and their liabilities to U.S. Office Products under the Tax Allocation Agreement. If the tax losses are not attributable to either U.S. Office Products or any of the other companies, each of the companies and U.S. Office Products is liable for its pro rata portion of the losses based on the value of each company's common stock after the distributions.
Navigant also entered into a Distribution Agreement with U.S. Office Products under which Navigant is responsible for liabilities related to its business; certain employee benefits liabilities; securities laws liabilities arising from the distribution of Navigant shares, its initial public offering and information related to its business supplied to U.S. Office Products; and U.S. Office Products' liabilities for earn-outs from acquisitions of its subsidiaries made prior to the distribution. Navigant and the other companies that were spun off have also agreed to bear a pro rata portion of certain United States securities law and general corporate liabilities of U.S. Office Products incurred prior to the distribution (including a pro rata portion of any liability of another spun off company to U.S. Office Products that is not paid) up to a maximum of $1.75 million for each company.
Jonathan J. Ledecky, a previous member of Navigant's Board of Directors, and U.S. Office Products have been named as defendants in at least 10 lawsuits alleging that Mr. Ledecky and U.S. Office Products violated various United States securities laws. The plaintiffs in those lawsuits generally claim that Mr. Ledecky, on behalf of U.S. Office Products, made a series of materially false and misleading statements in connection with the distributions of the shares of Navigant and the other companies and the related tender offer and restructuring. Although neither Navigant nor its executive officers have been named as defendants in these lawsuits, Navigant could be required pursuant to the Distribution Agreement to indemnify U.S. Office Products for a portion of its liability in connection with these lawsuits.
Potential Volatility of Stock Price
The trading price of the Navigant Common Stock could be subject to wide fluctuations in response to variations in Navigant's quarterly operating results, changes in earnings estimates by analysts, conditions in Navigant's businesses, general market or economic conditions or other factors. In addition, in recent years the stock market has experienced extreme price and volume fluctuations. These fluctuations have had a substantial effect on the market prices for many companies, often unrelated to the operating performance of the specific companies. Such market fluctuations could have a material adverse effect on the market price of Navigant Common Stock.
Dependence on ARC Agreements
Navigant depends on the ability to sell airline tickets for a substantial portion of its revenue. To sell airline tickets, Navigant must enter into, and maintain, an Agent Reporting Agreement for each operating subsidiary with the Airlines Reporting Company ("ARC"). Agent Reporting Agreements impose numerous financial, operational, and administrative obligations on Navigant. These agreements allow ARC to cancel an Agent Reporting Agreement for failure to meet any of these obligations. If Navigant's Agent Reporting Agreements are cancelled by ARC, Navigant would be unable to sell airline tickets and its results of operations would be materially adversely affected.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.
Market risks related to the Company's operations result primarily from changes in interest rates. The Company's interest rate exposure relates primarily to long-term debt obligations. A significant portion of the Company's interest expense is based upon variable interest rates of its bank's prime rate or the Eurodollar rate, as discussed in Footnote 9 of the Notes to Consolidated Financial Statements included elsewhere herein. Based upon the Company's 1999 average borrowings under the Credit Facility, a 50 basis point movement in the base rate or LIBOR rate would approximate $378,000 annual increase or decrease in interest expense.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The following financial information is included on the pages indicated:
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders of Navigant International, Inc.
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Navigant International, Inc. and its subsidiaries (the "Company") at December 26, 1999 and December 27, 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 26, 1999, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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 the opinion expressed above.
PricewaterhouseCoopers LLP
Denver, Colorado February 28, 2000
NAVIGANT INTERNATIONAL, INC.
CONSOLIDATED BALANCE SHEETS (In Thousands, Except Share Data)
See accompanying notes to consolidated financial statements.
NAVIGANT INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF INCOME (In Thousands, Except per Share Amounts)
See accompanying notes to consolidated financial statements.
NAVIGANT INTERNATIONAL, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (In Thousands)
See accompanying notes to consolidated financial statements.
NAVIGANT INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (In Thousands)
See accompanying notes to consolidated financial statements.
NAVIGANT INTERNATIONAL, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS--(Continued) (In Thousands)
The Company issued U.S. Office Products (see Note 1) common stock, notes payable and cash in connection with certain business combinations accounted for under the purchase method in the years ended December 26, 1999, December 27, 1998 and December 28, 1997. The fair values of the assets and liabilities of the acquired companies at the dates of the acquisitions are presented as follows:
- -------- . During the year ended December 28, 1997, the Company used U.S. Office Products common stock to repay $1,772 of indebtedness.
. During the year ended December 27, 1998, U.S. Office Products contributed $1,495 of capital to the Company.
. During the year ended December 27, 1998, the Company acquired $1,590 in fixed assets by capital lease transactions.
See accompanying notes to consolidated financial statement
NAVIGANT INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Unless Otherwise Noted)
NOTE 1--BACKGROUND
Navigant International, Inc. (the "Company"), a Delaware corporation, is one of the five largest corporate travel management companies in the United States. The Company manages all aspects of its client's travel processes, focusing on reducing their travel expenses.
Prior to June 9, 1998, the Company was a wholly-owned subsidiary of U.S. Office Products Company ("U.S. Office Products"). On June 9, 1998, as part of its comprehensive restructuring plan, U.S. Office Products spun off its Corporate Travel Services division as an independent publicly owned company. This transaction was effected through the distribution of shares of the Company to U.S. Office Products shareholders (the "Travel Distribution"). U.S. Office Products and the Company also entered into a number of agreements to facilitate the Travel Distribution and the transition of the Company to an independent business enterprise. At the date of the Travel Distribution, U.S. Office Products allocated to the Company $15,000 in debt plus an additional $1,400 in debt incurred by U.S. Office Products for a business travel acquisition prior to the Travel Distribution to the Company. The Company was allocated $1,000 in strategic restructuring costs which represents the Company's portion of the costs incurred by U.S. Office Products as a result of the Travel Distribution. These costs were paid upon the completion of the Travel Distribution. Additionally, in connection with the Travel Distribution, the Company sold 2.0 million shares of the Company's common stock in an initial public offering (the "Stock Offering"). The gross proceeds to the Company in the Stock Offering were $18,000 and the expenses incurred were as follows: (i) $1,260 for the underwriters discount and non-accountable expense allowance; and (ii) approximately $1,748 for other expenses, including legal, accounting and printing fees. The Company used the net proceeds in the Stock Offering of $14,992 to repay a portion of the outstanding indebtedness the Company borrowed under its line of credit facility (See Note 9) to repay the indebtedness allocated to it in the Travel Distribution.
The Corporate Travel Services division was created by U.S. Office Products in January 1997 and completed four business combinations accounted for under the pooling-of-interests method during the period from January 1997 to April 1997 (the "Pooled Companies"). As a result, the operations of the Company prior to the completion of such business combinations represent the combined results of the Pooled Companies operating as separate autonomous entities.
The Company's operations are primarily concentrated in one market segment - airline travel- and the customers are geographically diverse with no single customer base concentrated in a single industry. Management considers a downturn in this market segment to be unlikely. The Company's operations are seasonal, with the November and December periods having the lowest airline bookings. The majority of the leisure travel services the Company provides are directed to the Company's corporate customers and the related financial information is not separately stated in the Company's internal reports.
NOTE 2--BASIS OF PRESENTATION
Subsequent to the Travel Distribution, the consolidated financial statements of the Company include the accounts of Navigant International, Inc. and its subsidiaries after elimination of intercompany accounts and transactions.
Prior to the Travel Distribution, the consolidated financial statements reflect the assets, liabilities, divisional equity, revenues and expenses that were directly related to the Company as it was operated within U.S. Office Products. In cases involving assets and liabilities not specifically identifiable to any particular business of U.S. Office Products, only those assets and liabilities expected to be transferred to the Company
NAVIGANT INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in Thousands, Unless Otherwise Noted)
prior to the Travel Distribution were included in the Company's separate consolidated balance sheet. The Company's statement of income includes all of the related costs of doing business including an allocation of certain general corporate expenses of U.S. Office Products which were not directly related to these businesses including certain corporate executives' salaries, accounting and legal fees, departmental costs for accounting, finance, legal, purchasing, marketing and human resources as well as other general overhead costs. These allocations were based on a variety of factors, dependent upon the nature of the costs being allocated, including revenues, number and size of acquisitions and number of employees. Management believes these allocations were made on a reasonable basis.
U.S. Office Products used a centralized approach to cash management and the financing of its operations. As a result, minimal amounts of cash and cash equivalents were allocated to the Company at the time of the Travel Distribution. The consolidated statement of income includes an allocation of interest expense on all debt allocated to the Company. See Note 9 for further discussion of interest expense.
NOTE 3--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and footnotes thereto. Actual results could differ from those estimates.
Fiscal Year
The Company reports its financial results on a 52- or 53-week fiscal year ending on the Sunday closest to December 31. Each fiscal quarter consists of a 13-week period with one 14-week period in a 53-week year. All fiscal years presented were 52-week periods.
Reclassifications
Certain reclassifications have been made in the 1998 and 1997 financial statements to conform to the 1999 presentation.
Cash and Cash Equivalents
The Company considers temporary cash investments with original maturities of three months or less from the date of purchase to be cash equivalents.
Restricted Cash in NavigantVacations.com
The Company's received a $15 million investment from an unrelated venture capital fund for an ownership interest in NavigantVacations.com LLC which was previously wholly owned (see additional discussion in Note 12). The proceeds of this investment are restricted and can only be used to fund the operations of NavigantVacations.com LLC.
Concentration of Credit Risk
Financial instruments which potentially subject the Company to concentrations of credit risk consist primarily of trade accounts receivable. Receivables arising from sales to customers are not collateralized and, as a result, management continually monitors the financial condition of its customers to reduce the risk of loss.
NAVIGANT INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in Thousands, Unless Otherwise Noted)
Property and Equipment
Property and equipment are stated at cost. Additions and improvements are capitalized. Maintenance and repairs are expensed as incurred. Depreciation of property and equipment is calculated using the straight-line method over the estimated useful lives of the respective assets. The estimated useful lives range from 25 to 40 years for buildings and their components and 3 to 10 years for furniture, fixtures and equipment. Property and equipment leased under capital leases is being amortized over the lesser of its useful life or its lease terms.
Intangible Assets
Intangible assets consist of goodwill, which represents the excess of cost over the fair value of assets acquired in business combinations accounted for under the purchase method. Substantially all goodwill is amortized on a straight line basis over an estimated useful life of 35 years. Management periodically evaluates the recoverability of the carrying value of goodwill using a methodology prescribed in Statement of Financial Accounting Standards ("SFAS") No. 121. The Company also reviews long-lived assets and the related intangible assets for impairment whenever events or changes in circumstances indicate the carrying amounts of such assets may not be recoverable. Recoverability of these assets is evaluated by comparing the forecasted undiscounted future cash flows of the operation to which the assets relate to their net book value, including associated intangible assets, of such operation. If the operation is determined to be unable to recover the carrying amount of its assets, then intangible assets are written down first, followed by the other long-lived assets of the operation, to fair value. Fair value is determined based on discounted cash flows or appraised values, depending upon the nature of the assets.
Translation of Foreign Currencies
Balance sheet accounts of foreign subsidiaries are translated using the year-end exchange rate, and statement of income accounts are translated using the average exchange rate for the year. Translation adjustments are recorded in stockholders' equity as a component of comprehensive income.
Fair Value of Financial Instruments
The carrying amounts of the Company's financial instruments including cash and cash equivalents, accounts receivable, accounts payable, accrued liabilities and indebtedness approximate fair value.
Income Taxes
Subsequent to the Travel Distribution, the Company began recognizing and paying taxes as a separate legal entity. The provision for income taxes is based on income before taxes as reported in the accompanying consolidated statements of income. Deferred tax assets and liabilities are determined based on the differences between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Prior to the Travel Distribution and as a division of U.S. Office Products, the Company did not file separate federal income tax returns but rather was included in the federal income tax returns filed by U.S. Office Products and its subsidiaries from the respective dates that the entities within the Company were acquired by U.S. Office Products and through the date of the Travel Distribution. Prior to the Travel Distribution, for purposes of the consolidated financial statements, the Company's allocated share of U.S. Office Products' income tax provision was based on the "separate return" method. Certain companies acquired in pooling-of-interests transactions elected to be taxed as Subchapter S corporations, and accordingly, no federal income taxes were recorded by those companies for periods prior to their acquisition by U.S. Office Products.
NAVIGANT INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in Thousands, Unless Otherwise Noted)
Revenue Recognition
Revenues consist of commissions on travel services and year-end volume bonuses from travel service providers. The Company records revenues from air reservations, hotel and car reservations and management and service fee arrangements when earned, which is at the time a reservation is booked and ticketed. The Company provides a reserve for cancellations and reservation changes, and provisions for such amounts are reflected in net revenues. The reserves that have been netted against net revenues are not material in the periods reflected. The Company's estimate for cancellations and reservation changes could vary significantly from actual results based upon changes in economic and political conditions that impact corporate travel patterns. Cruise revenues are recorded when the customer is no longer entitled to a full refund of the cost of the cruise. The Company records incentive override commissions on an accrual basis in the month they are earned based upon the Company's estimated ticket sales in excess of required thresholds. Incentive payments from vendors for signing extended contracts are deferred and recognized as income over the life of the contract.
Operating Expenses
Operating expenses include travel agent salaries, communications, revenue sharing expense and other costs associated with the selling and processing of travel reservations.
Advertising Costs
The Company expenses advertising costs when the advertisement occurs. Advertising costs are included in the consolidated statement of income as a component of general and administrative expenses.
Net Income Per Share
Net income per share is calculated in accordance with SFAS No. 128, "Earnings Per Share." Basic earnings per share amounts are based upon the weighted average number of common shares outstanding during the year. Diluted earnings per share amounts are based upon the weighted average number of common and common equivalent shares outstanding during the year. The difference between basic and diluted earnings per share, for the Company, is solely attributable to stock options. Common equivalent shares are excluded from the computation in periods in which they have an anti-dilutive effect. For the years ended December 26, 1999, December 27, 1998 and December 28, 1997, options for 3.4 million; 3.1 million; and 340,000 shares, respectively, were excluded from diluted earnings per share.
Distribution Ratio
On May 14, 1998, the U.S. Office Products Board of Directors approved the distribution ratio for the Company in connection with the Travel Distribution. At the date of the Travel Distribution, the Company issued to U.S. Office Products shareholders one share of its common stock for every ten shares of U.S. Office Products common stock held by each respective shareholder. The share data reflected in the accompanying financial statements represents the historical share data for U.S. Office Products for the period, or as of the date indicated, and retroactively adjusted to give effect to the one for ten distribution ratio.
New Accounting Pronouncements
On June 15, 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities ("FAS 133").
NAVIGANT INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in Thousands, Unless Otherwise Noted)
FAS 133, as subsequently amended, is effective for all fiscal quarters of all fiscal years beginning after June 15, 2000 (January 1, 2001 for the Company). FAS 133 requires that all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction. Management of the Company anticipates that, due to its limited use of derivative instruments, the adoption of FAS 133 will not have a significant effect on the Company's results of operations or its financial position.
NOTE 4--BUSINESS COMBINATIONS
Pooling-of-Interests Method
In 1997, the Company issued 3,731,152 shares of U.S. Office Products common stock to acquire the Pooled Companies. The Pooled Companies and the number of shares issued in each business combination are as follows:
The Company's consolidated financial statements give retroactive effect to the acquisitions of the Pooled Companies for all periods presented.
The following presents the separate results, in each of the periods presented, of the Company (excluding the results of the Pooled Companies prior to the dates on which they were acquired), and the Pooled Companies up to the dates on which they were acquired:
Purchase Method
In 1999, the Company made ten acquisitions accounted for under the purchase method. The aggregate purchase price for these acquisitions was $39,601 consisting of cash, net of cash acquired, of $28,001 and notes payable of $11,600. None of these acquisitions was significant on an individual basis. The total assets acquired in these ten acquisitions were $59,324, including intangible assets of $45,043. The results of these acquisitions have been included in the Company's results from their respective dates of acquisition. Some of these acquisitions have earn-out provisions that could result in additional purchase consideration payable in 2000 depending upon the earnings of these acquisitions. No accrual has been recorded on the balance sheet for these potential payments.
NAVIGANT INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in Thousands, Unless Otherwise Noted)
In 1998, the Company made eight acquisitions accounted for under the purchase method for an aggregate purchase price of $63,061 consisting of cash, net of cash acquired, of $59,505 and notes payable of $3,556. The total assets acquired in these eight acquisitions were $71,106, including intangible assets of $61,926. Included in this aggregate purchase price is the acquisition of Arrington Travel Center, Inc. for $17.1 million, Atlas Travel Services Ltd. (Houston) for $17.6 million, and World Express Travel, Inc. for $8.2 million. The other six acquisition were not significant on an individual basis. The results of these acquisitions have been included in the Company's results from their respective dates of acquisition. Several of these acquisitions have earn- out provisions that could result in additional purchase consideration payable in 1999 and 2000 dependent upon the earnings of these acquisitions. During 1999, there were no additional payments related to these earn-out provisions. No accrual has been recorded on the balance sheet for any additional potential payments.
In 1997, the Company made seven acquisitions accounted for under the purchase method for an aggregate purchase price of $84,120, consisting of 3,802,367 shares of U.S. Office Products' common stock with a market value of $83,780 and cash, net of cash acquired, of $340. Included in this aggregate purchase price is the acquisition of Associated Travel Services, LLC for $19.6 million, McGregor Travel Management, Inc. for $31.3 million. Travel Consultants, Inc. for $11.7 million, and Omni Travel Service, Inc. for $10.9 million. The other three acquisitions were not significant on an individual basis. The total assets related to these seven acquisitions were $107,830, including intangible assets of $84,345. The results of these acquisitions have been included in the Company's results from their respective dates of acquisition. One of these acquisitions had an earn-out provision that resulted in additional purchase consideration payable in 1998 which was dependent upon earnings of this acquisition. In 1998, $1,563 was paid related to this earn- out.
The following presents the unaudited pro forma results of operations of the Company for the years ended December 26, 1999 and December 27, 1998 and includes the Company's consolidated financial statements, which give retroactive effect to the results of the companies acquired in purchase acquisitions as if all such purchase acquisitions had been made at the beginning of each period presented. The results presented below include certain pro forma adjustments of $(850) and $(91) for the years ended December 26, 1999 and December 27, 1998, respectively, to reflect the amortization of intangible assets, adjustments in executive compensation, the interest expense associated with the debt incurred to finance the 1999 and 1998 acquisitions, and the inclusion of a federal income tax provision on all earnings:
The unaudited pro forma results of operations are prepared for comparative purposes only and do not necessarily reflect the results that would have occurred had the acquisitions occurred at the beginning of each period or the results which may occur in the future.
NAVIGANT INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in Thousands, Unless Otherwise Noted)
Acquisitions for 1999, 1998 and 1997 accounted for under the purchase method and their related date of acquisition are as follows:
NAVIGANT INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in Thousands, Unless Otherwise Noted)
NOTE 5--NON-RECURRING CHARGES
During 1998, the Company incurred the following non-recurring charges:
On March 13, 1998, the Company received 90 days' notice of termination of a business relationship that contributed approximately $600 to net operating income during 1997. The Company had provided travel administration services to this client under a five-year agreement based on a fee per transaction basis, with all commissions being remitted back to this client. During March 1998, the Company wrote off $613 in intangible assets relating to the original acquisition of this contract. In addition to this charge, the Company took a charge in April 1998 of approximately $698 in connection with the disposition of certain equipment, severance charges and other costs associated with a change in operational strategy to a centralized management structure at one of its locations. This switch to a centralized management structure from a regional structure at this location is consistent with the existing structure at the other regional travel management companies acquired.
The Company incurred a strategic restructuring costs of $3,750 in connection with the Travel Distribution as an allocation from U.S. Office Products. Of this amount, $1,000 was an allocation to the Company for a portion of the strategic restructuring charge incurred by U.S. Office Products and the remaining $2,750 was as a result of U.S. Office Products Company's purchase of a pro rata portion of the Company's stock options pursuant to a tender offer made in connection with the Travel Distribution. Of the $2,750, $2,677 was recorded as a non-cash compensation charge while the $73 relates to the Company's portion of payroll taxes on the compensation.
NAVIGANT INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in Thousands, Unless Otherwise Noted)
As part of the Company's increased focus on operational matters subsequent to the Travel Distribution, it undertook a formal plan approved by its Board of Directors for cost reduction measures including the elimination of duplicative facilities, the consolidation of certain operating functions and the deployment of common information systems. The implementation of the cost reduction measures commenced in November 1998 and resulted in the Company recording a restructuring charge of $3,175 in November and December 1998. The 1998 charge included the closure of 20 facilities, the sale of one building and the severance associated with the termination of 127 employees. Through December 1999, 18 facilities have been closed or consolidated and 142 employees have been terminated. The following table summarizes non-recurring charges associated with the 1998 cost reduction plan and sets forth their usage for the periods indicated
During 1997, the Company incurred non-recurring acquisition costs of $1,156, in connection with the acqusition of the Pooled Companies. Non-recurring acquisition costs represent costs incurred by the Company in business combinations accounted for under the pooling-of-interests method. These costs include accounting, legal, and investment banking fees, real estate and environmental assessments and appraisals, various regulatory fees and recognition of transaction related obligations. Generally accepted accounting principles require the Company to expense all acquisition costs (both those paid by the Company and those paid by the sellers of the acquired companies) related to business combinations accounted for under the pooling-of-interests method. These costs were recorded and paid in 1997.
NOTE 6--PROPERTY AND EQUIPMENT
Property and equipment consists of the following:
NAVIGANT INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in Thousands, Unless Otherwise Noted)
Depreciation expense for the years ended December 26, 1999, December 27, 1998 and December 28, 1997 was $4,592, $3,467 and $1,722, respectively. Amortization expense for assets under capital leases for the years ended December 26, 1999 and December 27, 1998 was $95 and $124, respectively.
NOTE 7--INTANGIBLE ASSETS
Intangible assets consist of the following:
Amortization expense for the years ended December 26, 1999, December 27, 1998 and December 28, 1997 was $5,065, $3,576 and $1,368, respectively.
NOTE 8--OTHER ACCRUED LIABILITIES
Other accrued liabilities consist of the following:
NAVIGANT INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in Thousands, Unless Otherwise Noted)
NOTE 9--CREDIT FACILITIES
Long-Term Debt
Long-term debt consists of:
On the date of the Travel Distribution, the Company executed a credit agreement with NationsBank, N.A., as administrative agent. Effective August 6, 1999, this credit agreement was expanded to $125 million and the new facility matures on August 2004. The facility is secured by substantially all of the Company's assets and the credit is subject to terms and conditions typical of facilities of such size, including certain financial covenants. At December 26, 1999, the Company was in compliance with these debt covenants. Interest rate options available to the Company vary depending upon the satisfaction of certain specified financial ratios.
The Company withholds between 20% and 30% of the purchase price for acquisitions and executes an unsecured note payable with the former owners with an interest rate ranging from 5.5% to 6.5%. Maturities are typically one to two years and are subject to the acquired company meeting certain revenue thresholds for the period immediately following the acquisition. Additionally, repayment of the note payable is subject satisfaction of certain representations and warranties.
Maturities of Long-Term Debt
Maturities of long-term debt are as follows:
NAVIGANT INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in Thousands, Unless Otherwise Noted)
Payable to U.S. Office Products
The short-term payable to U.S. Office Products was incurred by the Company primarily as a result of U.S. Office Products repaying short-term debt outstanding at the businesses acquired by U.S. Office Products at or soon after their respective dates of acquisition and through the centralized cash management system, which involves daily advances or sweeps of cash to keep the cash balance at or near zero on a daily basis. U.S. Office Products has charged the Company interest on the short-term payable at U.S. Office Products' weighted average interest rate during the applicable periods.
The average outstanding long-term payable to U.S. Office Products during the years ended December 27, 1998 and December 28, 1997 was $4,709 and $5,440, respectively. Interest has been allocated to the Company based upon the Company's average outstanding payable balance with U.S. Office Products at U.S. Office Products' weighted average interest rate during such period.
The Company's financial statements include allocations of interest expense from U.S. Office Products totaling $376 and $352 during the years ended December 27, 1998 and December 28, 1997, respectively.
In conjunction with the Travel Distribution, U.S. Office Products allocated a specified amount of debt outstanding under its credit facilities to the Company and required the Company, on or prior to the Travel Distribution, to obtain a credit facility, to borrow funds under such facility and to use the proceeds of such borrowings to pay off the U.S. Office Products debt so allocated plus any additional debt incurred by U.S. Office Products after January 12, 1998 (the date of the approval by the board of directors of U.S. Office Products to spin-off the Company) in connection with the acquisition of an entity that has become or will become a subsidiary of the Company. As part of the Travel Distribution, $15,000 of U.S. Office Products' debt was allocated to the Company, and since January 12, 1998, U.S. Office Products incurred an additional $1,400 of debt in connection with such an acquisition. The Company borrowed $16,400 under its credit facility with NationsBank, N.A. on the date of Travel Distribution to pay off the debt of U.S. Office Products.
NOTE 10--INCOME TAXES
Income before income taxes consist of the following:
NAVIGANT INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in Thousands, Unless Otherwise Noted)
The provision for income taxes consists of:
Deferred taxes are comprised of the following:
NAVIGANT INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in Thousands, Unless Otherwise Noted)
The Company's effective income tax rate varied from the U.S. federal statutory tax rate as follows:
Certain Pooled Companies were organized as Subchapter S corporations prior to the closing of their acquisitions by the Company and, as a result, the federal tax on their income was the responsibility of their individual stockholders. Accordingly, the specific Pooled Companies provided no federal income tax expense prior to their acquisitions.
Taxes are not provided on undistributed earnings of non-U.S. subsidiaries because such earnings are either permanently reinvested or do not exceed available foreign tax credits.
NOTE 11--LEASE COMMITMENTS
The Company leases various types of office facilities, equipment and furniture and fixtures under noncancelable lease agreements, which expire at various dates. Future minimum lease payments under noncancelable capital and operating leases are as follows:
Rent expense for all operating leases for the years ended December 26, 1999, December 27, 1998 and December 28, 1997 was $6,936, $5,632, and $3,583, respectively.
NOTE 12--MINORITY INTEREST IN NAVIGANTVACATIONS.COM LLC
On October 13, 1999, the Company sold a minority interest in its NavigantVacations.com LLC subsidiary to third party venture capital firms for $15 million. This minority interest can ultimately be converted to an approximately 22.5% stake in the subsidiary. Of the $15 million investment, $2.5 million was for 125,000
NAVIGANT INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in Thousands, Unless Otherwise Noted)
common units and the remaining $12.5 million was for 12,500 convertible preferred units with a 6% guaranteed dividend rate. Repayment of the $12.5 million is redeemable by NavigantVacations.com upon certain conditions including: if an initial public offering of the subsidiary does not occur within two years, if the Company defaults under its Credit Facility, or if the Company undergoes a change of control as defined in the Credit Facility. Should the subsidiary not redeem the units, the holders of the preferred units have the right to have the Company redeem them. The Preferred Stock is convertible into common units at a ratio of ten to one, plus an additional amount equal to the accrued but unpaid dividends any time prior to an initial public offering or if NavigantVacations.com is sold. Additionally, NavigantVacations.com issued a warrant to these third party venture capital firms for an additional 50,000 common units, at an exercise price of $60 that is exercisable anytime through October 13, 2009.
NOTE 13--COMMITMENTS AND CONTINGENCIES
Litigation
The Company and its subsidiaries are involved in various legal actions in the ordinary course of their business. The Company believes that none of these actions will have a material adverse effect on its business, financial condition and results of operations.
The Company has been named as a defendant in a lawsuit filed by the previous stockholders of two of the Company's subsidiaries. The lawsuit also names U.S. Office Products and certain former and present executive officers of U.S. Office Products as defendants. The lawsuit was instituted on January 19, 1999, in the Circuit Court for the County of Kent, State of Michigan. The defendants removed the suit to the Southern Division of the United States District Court for the Western District of Michigan. The case was subsequently transferred to the United States District Court for the District of Columbia, to be consolidated with other pending actions against U. S. Office Products.
The plaintiffs allege that U.S. Office Products and the named U.S. Office Products executive officers made fraudulent misrepresentations and omissions about among other things, U.S. Office Products' plans to engage in a restructuring which would include a spin-off of its travel business to its existing shareholders (the "Travel Distribution"). The plaintiffs contend that such alleged misrepresentations and omissions induced the plaintiffs to sell their businesses to U.S. Office Products. The Company has been named in the lawsuit as a successor to U.S. Office Products' travel businesses. The plaintiffs contend that they may seek rescission of the purchases of these two subsidiaries or damages for the value of the assets of the two subsidiaries from the Company and have requested that the Company be required to hold such assets in a constructive trust for the plaintiffs. As of December 26, 1999, the approximate book value of these two subsidiaries was $12.6 million. The Company intends to vigorously defend against this lawsuit.
Individuals purporting to represent various classes composed of stockholders who purchased shares of U.S. Office Products common stock between June 5, 1997 and November 2, 1998 filed six actions in the United States District Court for the Southern District of New York and four actions in the United States District Court of the District of Columbia in late 1998 and early 1999. Each of the actions named Jonathan Ledecky (a former director of the Company), U.S. Office Products, and, in some cases, Sands Brothers & Co. Ltd. as defendants. The Company has not been named as a defendant in these actions. The actions claim that the defendants made misstatements, failed to disclose material information, and otherwise violated Sections 10(b) and/or 14 of the Securities Exchange Act of 1934 and Rules 10b-5 and 14a-9 thereunder in connection with U.S. Office Products' Strategic Restructuring. Two of the actions alleged a violation of Sections 11, 12 and/or 15 of the Securities Act of 1933 and/or breach of contract under California law relating to U.S. Office
NAVIGANT INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in Thousands, Unless Otherwise Noted)
Products' acquisition of Mail Boxes Etcetera. The actions seek declaratory relief, unspecified money damages and attorney's fees. All of these actions have been consolidated and transferred to the United States District Court for the District of Columbia. A consolidated amended complaint was filed on July 29, 1999, naming U.S. Office Products and Mr. Ledecky as defendants.
Sellers of two businesses that U.S. Office Products acquired in the fall of 1997 and that were spun off in connection with U.S. Office Products' Strategic Restructuring (which included the Travel Distribution) also have filed complaints in the United States District Court for the District of Delaware, and the United States District Court for the District of Connecticut. These lawsuits were filed on February 10, 1999 and March 3, 1999, respectively, and name, among others, U.S. Office Products as a defendant. Both of these cases have been transferred and consolidated for pretrial purposes with the purported class-action pending in the United States District Court for the District of Columbia.
Sellers of two other businesses acquired in October 1997 and December 1997 that were not spun off by U.S. Office Products have also filed complaints in state court in Kentucky and state court in Indiana in which U.S. Office Products is named as defendant. Those complaints were filed on or about September 2, 1999, and September 30, 1999. These cases have been removed to federal district court, and U.S. Office Products has sought to have both cases transferred and consolidated with the cases pending in the United States District Court for the District of Columbia. Each of these disputes generally relates to events surrounding the Strategic Restructuring, and the complaints that have been filed assert claims of violation of federal and/or state securities and other laws, fraud, misrepresentation, conspiracy, breach of contract, negligence, and/or breach of fiduciary duty.
In October 1999, the United States District Court for the District of Columbia ordered that the parties in all of the cases before it engage in mediation, and "administratively closed" the cases that had been consolidated until completion of the mediation process. Mediation sessions were held in December 1999 and January 2000. If the cases are not settled by mediation, the cases will be reopened with the court.
On April 14, 1998, a stockholder purporting to represent a class composed of all U.S. Office Products' stockholders filed an action in the Delaware Chancery Court. The action names U.S. Office Products and its directors, including Mr. Ledecky, as defendants, and claims that the directors breached their fiduciary duty to stockholders of U.S. Office Products by changing the terms of the self tender offer for U.S. Office Products' common stock that was a part of the Strategic Restructuring Plan to include employee stock options. The complaint seeks injunctive relief, damages and attorneys' fees. The directors filed an answer denying the claims against them, and U.S. Office Products has moved to dismiss all claims against it.
In connection with the Travel Distribution, the Company agreed to indemnify U.S. Office Products for certain liabilities, which could include claims such as those made against U.S. Office Products in these lawsuits. If U.S. Office Products were entitled to indemnification under this agreement, the Company's indemnification obligation, however, likely would be limited to 5.2% of U.S. Office Products' indemnifiable loss, up to a maximum of $1.75 million.
Post Employment Benefits
The Company has entered into employment agreements with several employees that would result in payments to these employees upon a change of control or certain other events. No amounts have been accrued at December 26, 1999 and December 27, 1998 related to these agreements, as no change of control has occurred.
NAVIGANT INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in Thousands, Unless Otherwise Noted)
Travel Distribution
At the date of the Travel Distribution, the Company, U.S. Office Products and the other Spin-Off Companies entered into the Distribution Agreement, the Tax Allocation Agreement and the Employee Benefits Agreement, and the Spin-Off Companies entered into the Tax Indemnification Agreement and may enter into other agreements, including agreements related to referral of customers to one another. These agreements provided, among other things, for U.S. Office Products and the Company to indemnify each other from tax and other liabilities relating to their respective businesses prior to and following the Travel Distribution. Certain of the obligations of the Company and the other Spin-Off Companies to indemnify U.S. Office Products are joint and several. Therefore, if one of the other Spin-Off Companies fails to indemnify U.S. Office Products when such a loss occurs, the Company may be required to reimburse U.S. Office Products for all or a portion of the losses that otherwise would have been allocated to other Spin-Off Companies. In addition, the agreements allocate liabilities, including general corporate and securities liabilities of U.S. Office Products not specifically related to the business travel agency business, between U.S. Office Products and each Spin-Off Company.
NOTE 14--EMPLOYEE BENEFIT PLANS
Effective September 1, 1996, the Company implemented the U.S. Office Products 401(k) Retirement Plan which allows employee contributions in accordance with Section 401(k) of the Internal Revenue Code. Subsequent to the Travel Distribution, the assets of the Company's employees were rolled over into a separate 401(k) Retirement Plan (the "401(k) Plan") implemented by the Company. The Company matches a portion of employee contributions and all full- time employees are eligible to participate in the 401(k) Plan after six months of service.
Certain subsidiaries of the Company have, or had prior to implementation of the 401(k) Plan, qualified defined contribution benefit plans, which allow for voluntary pre-tax contributions by the employees. Within one year following their acquisition by the Company, the assets of these plans are rolled into the Company's 401(k) Plan.
For the years ended December 26, 1999, December 27, 1998 and December 28, 1997, the Company incurred expenses totaling $736, $678 and $277, respectively, related to this plan.
NOTE 15--STOCKHOLDERS' EQUITY
Capital Contribution by U.S. Office Products
During the year ended December 27, 1998, U.S. Office Products contributed $1,495 of capital to the Company. The contribution reflects the forgiveness of inter-company debt by U.S. Office Products, as it was agreed that the Company would be allocated only $15,000 of debt plus the amount of any additional debt incurred after January 12, 1998 in connection with the acquisition of entities that will become subsidiaries of the Company.
Employee Stock Plans
Prior to the Travel Distribution, certain employees of the Company participated in the U.S. Office Products 1994 Long-Term Incentive Plan ("the USOP Plan") covering employees of U.S. Office Products. In June 1998, the Company adopted the 1998 Stock Incentive Plan (the "Plan"), which allows the Company to issue options under the plan up to 30% of the outstanding common stock. All employees of the Company and its subsidiaries, as well as non- employee directors of the Company, are eligible for awards under the Plan
NAVIGANT INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in Thousands, Unless Otherwise Noted)
. Incentive stock options and non-qualified stock options granted to employees are generally exercisable beginning one year from the date of grant in cumulative yearly amounts of 25% of the shares under option and generally expire ten years from the date of grant. Generally, options are issued at exercise prices equal to the market price at the date of grant. At December 26, 1999, the Company had 622,032 shares available for future option grants.
The Company replaced the options to purchase shares of common stock of U.S. Office Products held by employees with options to purchase shares of common stock of the Company. In order to keep the optionholders in the same economic position immediately before and after the Travel Distribution, the number of U.S. Office Products' options held by Company employees was multiplied by 1.556 and the exercise price of those options was divided by 1.556 for purposes of the replacement options. All option data reflected below has been retroactively restated to reflect the effects of the Travel Distribution.
The Company accounts for options issued in accordance with APB Opinion No. 25. Accordingly, because the exercise prices of the options have equaled the market price on the date of grant, no compensation expense has been recognized for the options granted. Had compensation cost for the Company's stock options been recognized based upon the fair value of the stock options on the grant date under the methodology prescribed by SFAS No. 123, "Accounting for Stock- Based Compensation," the Company's net income and net income per share would have been impacted as indicated in the following table:
The fair value of the options granted (which is amortized over the option vesting period in determining the pro forma impact) is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:
The weighted-average fair value of options granted was $5.17, $8.36 and $11.10 for the years ended December 26, 1999, December 27, 1998 and December 28, 1997, respectively.
NAVIGANT INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in Thousands, Unless Otherwise Noted)
A summary of option transactions follows:
As part of the Travel Distribution, U.S. Office Products allowed optionholders the opportunity to tender up to 23.2% of their outstanding options for a price of $17.36 per share (the pre-Travel Distribution price was $27.00 per share). All of the options exercised in 1998 were tendered in connection with the Travel Distribution.
The following table summarizes information about stock options outstanding and exercisable at December 26, 1999:
Under a service agreement entered into with Jonathan J. Ledecky, the Board of Directors of U.S. Office Products agreed that Mr. Ledecky would receive from the Company a stock option for the Company's common stock as of the date of the Travel Distribution. The Board intended the option to be compensation for Mr. Ledecky's services as a director of the Company, and certain services as an employee of the Company. The option was to cover 7.5% of the outstanding Company common stock determined as of the date of the Travel Distribution, with no anti-dilution provisions in the event of issuance of additional shares of common stock (other than with respect to stock splits or reverse stock splits). The total number of options issued to Mr. Ledecky in connection with this grant was 823,000 shares with an exercise price equal to the IPO price of $9.00 per share. These options vested immediately but could not be exercised by Mr. Ledecky for one year.
NAVIGANT INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in Thousands, Unless Otherwise Noted)
Immediately following the effective date of the registration statement filed in connection with the IPO and the Distribution, the Company's Board of Directors granted 823,000 options covering 7.5% of the outstanding shares of the Company's common stock, to certain executive management personnel and non- employee directors. The options were granted under the Plan and had a per share exercise price equal to the IPO price of $9.00 per share, and although these options vested immediately, they could not be exercised for one year.
During 1999, 111,000 options for NavigantVacations.com, LLC units were granted at an exercise price of $10. The options vest immediately, are exercisable immediately and expire ten years from the date of grant. Had compensation cost for these stock options been recognized based upon the fair value of the stock options on the grant date under the methodology prescribed by SFAS No. 123, "Accounting for Stock-Based Compensation," the expense would have been $286,317 for 1999, which would have been allocated 100% to the minority shareholder. The fair value of the options granted is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions: expected life of option of seven years, risk free interest rate of 5.94%, 66.87% expected volatility of stock and zero dividends. The weighted-average fair value of options granted was $3.32 for the year ended December 26, 1999.
NOTE 16--QUARTERLY FINANCIAL DATA (UNAUDITED)
The following presents certain unaudited quarterly financial data for the years ended December 26, 1999 and December 27, 1998:
NOTE 17--SUBSEQUENT EVENT
In February 2000, the Company undertook a formal plan approved by the Board of Directors for cost reduction measures including the consolidation of certain operating functions on a regional basis and the elimination of duplicative facilities. The implementation of the cost reduction measures commenced in March 2000 and resulted in the Company recording a restructuring charge of approximately $1,900 in March 2000. Management anticipates that these measures will be completed throughout 2000. The 2000 charge includes the severance associated with the termination of approximately 130 positions and the closure of several facilities.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
This information is incorporated by reference from the Company's Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Company's annual meeting of stockholders.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
This information is incorporated by reference from the Company's Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Company's annual meeting of stockholders.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
This information is incorporated by reference from the Company's Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Company's annual meeting of stockholders.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
This information is incorporated by reference from the Company's Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Company's annual meeting of stockholders.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) Financial Statement Schedules:
All schedules called for by Form 10-K are omitted because they are inapplicable or the required information is shown in the financial statements, or notes thereto, included herein.
(b) Reports on Form 8-K:
Navigant filed a report on Form 8-K dated October 27, 1999 covering the Limited Liability Company Agreement with OZ Domestic Partners, L.P. and OZ SPCI, Ltd., forming NavigantVacations.com LLC.
Navigant filed a report on Form 8-K/A dated October 27, 1999 covering the acquisition of Arrington Travel Center, Inc. on July 28, 1998.
(c) Exhibits:
Exhibit Index
- -------- + Incorporated by reference from Navigant's Report on Form 8-K filed with the Securities and Exchange Commission on August 11, 1998, as amended by Form 8-K/A filed with the Securities and Exchange Commission on October 9, 1998. ++ Incorporated by reference herein from Navigant's Report on Form 10-Q for the quarterly period ended July 25, 1998, filed with the Securities and Exchange Commission on September 8, 1999. +++ Incorporated by reference herein from Navigant's Report on Form 8-K filed with the Securities and Exchange Commission on October 1, 1998, as amended by Form 8-K/A filed with the Securities and Exchange Commission on November 30, 1998. ++++ Incorporated by reference herein from Navigant's Registration Statement on Form S-1 initially filed with the Securities and Exchange Commission on February 19, 1998 (File No. 333-46539). * Incorporated by reference to Exhibit 10.1 of Navigant's Current Report on Form 8-K filed with the Securities and Exchange Commission on October 27, 1999 (file No. 0-24387) ** Incorporated by reference to Exhibit 10.1 of Navigant's Quarterly Report on Form 10-Q for the quarterly period ended September 26, 1999, filed with the Securities and Exchange Commission on November 10, 1999 (File No. 0- 24387)
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: March 24, 2000
Navigant International, Inc. a Delaware corporation
/s/ Edward S. Adams By: _________________________________ Edward S. Adams Chairman of the Board, Chief Executive Officer, and Director (Principal Executive Officer)
KNOW ALL MEN BY THESE PRESENTS that each person whose signature appears below constitutes and appoints Edward S. Adams his true and lawful attorney-in- fact and agent, with full power of substitution and resubstitution, for him or in his name, place and stead, in any and all capacities to sign to this report, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorney-in-fact and agent or his substitutes, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant in the capacities indicated as of March 24, 2000.
/s/ Robert C. Griffith By: _________________________________ Robert C. Griffith Chief Financial Officer and Treasurer (Principal Financial and Accounting Officer)
/s/ C. Thomas Nulty By: _________________________________ C. Thomas Nulty President and Chief Operating Officer
/s/ Eugene A. Over, Jr. By: _________________________________ Eugene A. Over, Jr. Vice President, General Counsel and Secretary
/s/ Paul Blackney By: _________________________________ Paul Blackney Director
/s/ Vassilios Sirpolaidis By: _________________________________ Vassilios Sirpolaidis Director
/s/ Ned A. Minor By: _________________________________ Ned A. Minor Director
/s/ D. Craig Young By: _________________________________ D. Craig Young Director | 18,144 | 121,259 |
78003_1999.txt | 78003_1999 | 1999 | 78003 | ITEM 1. BUSINESS
GENERAL
Pfizer Inc. (the COMPANY, which may be referred to as WE, US, or OUR) is a research-based, global pharmaceutical company. We discover, develop, manufacture and market innovative medicines for humans and animals.
Our home page on the Internet is at www.pfizer.com. You can learn about us by visiting that site.
NOTE THAT THROUGHOUT THIS 1999 10-K REPORT, WE "INCORPORATE BY REFERENCE" CERTAIN INFORMATION IN PARTS OF OTHER DOCUMENTS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION (SEC). THE SEC ALLOWS US TO DISCLOSE IMPORTANT INFORMATION BY REFERRING TO IT IN THAT MANNER. PLEASE REFER TO SUCH INFORMATION.
RECENT DEVELOPMENT
On February 7, 2000, we announced an agreement to merge with Warner-Lambert Company (Warner-Lambert). Under the terms of the merger agreement, which has been approved by the Board of Directors of both Pfizer and Warner-Lambert, we will exchange 2.75 shares of Pfizer voting common stock for each outstanding share of Warner-Lambert voting common stock in a tax-free transaction valued at $98.31 per Warner-Lambert share, or an equity value of $90 billion based on the closing price of our stock on February 4, 2000 of $35.75 per share. Customary and usual provisions will be made for outstanding options and warrants.
The combined company, which will be called Pfizer Inc., is expected to have (excluding any impact of anticipated restructuring charges and transaction fees of $1.7 billion to $2.2 billion):
o compounded annual revenue growth of 13% and earnings growth of 25% through
o $4.7 billion in annual research and development expenses in 2000
o anticipated annual cost savings and efficiencies totaling $1.6 billion by 2002 ($200 million of these savings are expected to be achieved in 2000, $1 billion in 2001 and $1.6 billion in 2002)
o diluted earnings per share of $.98 on a pro forma basis in 2000, $1.27 for 2001 and $1.56 for 2002 (these numbers include the $1.6 billion of cost savings phased in over this time period, but do not include any increased sales from collaborative activities and the $1.8 billion termination fee paid by Warner-Lambert to American Home Products Corporation).
This transaction is subject to customary conditions, including the use of pooling-of-interests accounting, qualifying as a tax-free reorganization, shareholder approval at both companies and usual regulatory approvals. The transaction is expected to close in mid-2000.
BUSINESS SEGMENTS
We operate in two business segments:
o PHARMACEUTICAL, which includes prescription pharmaceuticals for treating cardiovascular diseases, infectious diseases, central nervous system disorders, diabetes, erectile dysfunction, allergies, arthritis and other disorders, as well as non-prescription self-medications, and;
o ANIMAL HEALTH, which includes antiparasitic, anti-infective and anti-inflammatory medicines, and vaccines for livestock, poultry and companion animals.
These businesses derive synergies in certain research and regulatory matters, but each requires different marketing and distribution strategies and sales organizations. Comparative segment revenues, profits and related financial information for 1999, 1998 and 1997 are given in the table entitled SEGMENT INFORMATION on page 60 of our 1999 Annual report. A table captioned PERCENTAGE CHANGE IN TOTAL REVENUES
and a graph captioned TOTAL REVENUES BY BUSINESS SEGMENT on page 29 of our 1999 Annual Report give segment information over the past three years. The information from those sections of our Annual Report is considered to be incorporated in this 1999 10-K report.
Our businesses are heavily regulated in most of the countries where we operate. in the U.S., the main regulatory authority we deal with is the Food and Drug Administration (FDA). The FDA regulates the safety and efficacy of the products we offer, our research quality, our manufacturing processes and our promotion and advertising. Similar Government authorities act in most other countries, and in many cases also regulate our prices. See GOVERNMENT REGULATION AND PRICE CONSTRAINTS, below.
PHARMACEUTICAL SEGMENT
Our Pharmaceutical segment is comprised of the Pfizer Pharmaceuticals Group and the Consumer Health Care Group.
PFIZER PHARMACEUTICALS GROUP
Most of our pharmaceutical sales come from products in three major therapeutic classes: cardiovascular diseases, infectious diseases and central nervous system disorders. We also have products for treatment of diabetes, erectile dysfunction and allergies, as well as a co-promoted product for arthritis. In 1999, prescription pharmaceuticals contributed 88% of our revenues, as compared to 86% in 1998 and 83% in 1997. In 1999, we had seven products, including alliance products, with sales to third parties in excess of $1 billion each. Sales of our major in-line pharmaceutical products - NORVASC, CARDURA, ZITHROMAX, DIFLUCAN, ZOLOFT, VIAGRA AND ZYRTEC - comprised 60% of our revenues. A table captioned NET SALES - MAJOR PHARMACEUTICAL PRODUCTS on page 29 of our 1999 Annual Report is incorporated by reference.
Cardiovascular disease products that treat problems affecting the heart and the blood circulatory system are our largest therapeutic product line. NORVASC, our largest-selling product, is a once-a-day medication for hypertension (high blood pressure) and angina (heart pain). It is the largest-selling high blood pressure medicine in the world. Our other cardiovascular products include PROCARDIA XL, also a once-a-day product for hypertension and angina, and CARDURA, which is used to treat hypertension and benign prostatic hyperplasia (enlarged prostate gland). Sales of PROCARDIA XL continued to decrease during 1999, due, at least in part, to the medical community's increasing emphasis on NORVASC.
Also included in our cardiovascular disease product line is our alliance product, LIPITOR, for treatment of high LIPIDS (cholesterol and, triglycerides) in the bloodstream. We participated in the 1997 launch of LIPITOR under co-promotion and licensing arrangements with the Parke-Davis Division of Warner-Lambert Company, which discovered and developed the drug. Pfizer and Warner-Lambert are continuing a broad clinical program for LIPITOR, as well as planning the development of a single product that contains the cholesterol and high blood pressure lowering medications in LIPITOR and NORVASC, respectively.
We will add to our cardiovascular product line with the first-quarter 2000 launch of Tikosyn. This product is used for the treatment of atrial fibrillation (rapid and irregular heartbeats in the atria or upper chambers of the heart).
In the infectious disease medicine category, our major products are ZITHROMAX and DIFLUCAN. ZITHROMAX is an oral or injectable antibiotic. During 1999, ZITHROMAX continued to be the most prescribed brand-name oral antibiotic in the U.S. sales of ZITHROMAX increased in 1999 due to the increasing recognition by physicians of the product's effectiveness in treating a broad array of infections. DIFLUCAN is used to treat various fungal infections, including vaginal infections and certain infections that afflict AIDS and cancer patients with weakened immune systems.
In June 1999, the European Union's Committee for Proprietary Medicinal Products suspended the European Union ("EU") licenses of the oral and intravenous formulations of our
antibiotic TROVAN for 12 months. In the rest of the world, including the U.S., the use of TROVAN is limited to serious infections in institutionalized patients (see Item 3, LEGAL PROCEEDINGS, below).
For treatment of central nervous system disorders, we offer ZOLOFT and co-promote ARICEPT. ZOLOFT is used for treatment of depression, obsessive-compulsive disorder, panic disorder and posttraumatic stress disorder. In 1999, Zoloft became the second Pfizer-developed product to achieve $2 billion in annual sales. We participated in the 1997 launch of ARICEPT for treatment of mild-to-moderate Alzheimer's disease. ARICEPT substantially expanded the prior market for pharmaceutical treatment of that disease. The drug was discovered and developed by Eisai Co., Ltd. which contracted with us to license and co-promote the product in the U.S. and several other countries.
In October 1999, we received an approvable letter from the FDA for RELPAX, for the treatment of migraine. Regulatory review is continuing in Europe.
In 1998, we introduced VIAGRA, our oral medication for the treatment of erectile dysfunction. Since launch, doctors have written over 17 million prescriptions for Viagra tablets for more than 6 million patients in the U.S. alone. More than 150 million tablets have been dispensed worldwide.
Our other major pharmaceutical products include GLUCOTROL XL, for the treatment of diabetes, and ZYRTEC, which is used for the treatment of allergies and related problems. ZYRTEC is licensed to us by the Belgian company UCB S.A. for sales in the U.S. and Canada. We co-promote ZYRTEC in the U.S. with a subsidiary of UCB S.A.
In February 1999, we participated in the launch of CELEBREX with G.D. Searle & Co. (Searle), a division of Monsanto Company, the discoverer and developer of CELEBREX. CELEBREX is used for the relief of symptoms of adult rheumatoid arthritis and osteoarthritis. We co-promote CELEBREX with Searle in all world markets except Japan.
CONSUMER HEALTH CARE GROUP
Our Consumer Health Care Group products include non-prescription over-the-counter (OTC) medications, therapeutic skin care products and personal care products. Among our better-known brands in the U.S. are:
o VISINE eye care
o BENGAY topical analgesics
o CORTIZONE hydrocortisone skin cream
o RID anti-lice products
o UNISOM sleep aids
o DESITIN ointments for treatment of diaper rash
o PLAX pre-brushing dental rinse
o BARBASOL shave creams and gels
Several product-line extensions building on these brands have been introduced in recent years. Other products are sold only in selected international markets. Sales of the Consumer Health Care Group accounted for about 4% of our total revenues in 1999 and 1998 and 5% in 1997.
Our Consumer Health Care Group can extend the life of some of our prescription medications by converting them to OTC medications. For example, an OTC formulation of DIFLUCAN, known as DIFLUCAN ONE, is sold in the U.K. as a treatment for vaginal candidiasis. Similarly, ZYRTEC is sold as an OTC product in Canada under the brand name REACTINE. As market conditions permit, and when we have necessary approval from drug regulatory authorities, we plan to pursue similar launches for other products.
ANIMAL HEALTH SEGMENT
Pfizer's Animal Health Group discovers, develops, manufactures and sells products for the prevention and treatment of diseases in livestock, poultry and companion animals. Among the products we produce are antibiotics, antiparasitics, anti-inflammatories, vaccines and related products for livestock and companion animals. Our Animal Health Group
revenues grew 2% to $1.3 billion in 1999, in part due to the successful launch of the new antiparasitic for dogs and cats, REVOLUTION (marketed as STRONGHOLD in Europe), and continued growth from the canine anti-arthritic Rimadyl. These benefits were offset by continuing weakness in the livestock market in the U.S. and Europe. Animal Health sales accounted for approximately 8% of our total revenues in 1999, 10% of our total revenues in 1998 and 12% of our total revenues in 1997.
The $1.3 billion worldwide pet antiparasitic market consists of medicines for external parasites such as fleas and ticks, treatments for gastrointestinal worms, and heartworm preventatives. Our product REVOLUTION is the first product to treat all three problems. This once-a-month, simple-to-administer, topical liquid protects against internal and external parasites, including heartworm, fleas, and ear mites in both dogs and cats; American dog ticks and sarcoptic mange in dogs; and hookworm and roundworm in cats. The U. S. launch of REVOLUTION was one of the most successful in the history of animal health.
Since its introduction in 1997, nearly five million arthritic dogs worldwide have been treated with RIMADYL to relieve acute and chronic pain associated with osteoarthritis, a condition that afflicts about 15% of all dogs. The new chewable form provides the pet owner with greater convenience of administration.
Other important Pfizer companion animal products include VANGUARD vaccines for canine enteric disease, LEUKOCELL vaccines for feline leukemia, CLAVAMOX/SYNULOX anti-infectives, and ANIPRYL for Cushing's disease and Cognitive Dysfunction Syndrome in dogs.
Our Animal Health Group produces leading antiparasitic products, vaccines and anti-infectives for cattle, swine and poultry. Among these are DECTOMAX to protect cattle, swine and sheep from internal and external parasites, and RESPISURE/STELLAMUNE vaccines to prevent a type of pneumonia and the related problems of slow weight gains, decreased feed efficiency, and lack of uniformity in size in swine.
Other products for livestock include TERRAMYCIN LA-200, an injectable version of the TERRAMYCIN broad-spectrum antibiotic used for various animal diseases; VALBAZEN and PARATECT products to treat internal parasites and BOVISHIELD vaccine for cattle respiratory disease.
The council of European Agricultural Ministers voted to ban the use of our antibiotic feed additive STAFAC (virginiamycin) throughout the European Union after June 1999. We do not expect the ban on sales of STAFAC to have a material effect on the Company's future results of operations.
RESEARCH AND PRODUCT DEVELOPMENT
Innovation by our research and development operations is very important to the success of our businesses. Our goal is to discover, develop and bring to market innovative products that address major unmet medical needs. This goal has been supported by our substantial research and development investments. We spent approximately $2.8 billion in 1999, $2.3 billion in 1998 and $1.8 billion in 1997 on research and development.
We are planning for future growth of our research operations. Current construction at our three major research centers will add approximately two million square feet of laboratory space. Other research facilities are also being added or expanded.
We conduct research internally, and also through contracts with third parties, through collaborations with universities and biotechnology companies and in cooperation with other pharmaceutical firms. We also seek out innovative technologies developed by third parties to acquire or incorporate into our product lines through licensing or other arrangements.
Drug development is time consuming, expensive and unpredictable. On average, only one out of many thousands of chemical compounds discovered by researchers proves to be both medically effective and safe enough to become an approved medicine. The process from discovery to regulatory approval can take more than ten years. Candidates can fail at any
stage of the process, and even late-stage product candidates could fail to receive regulatory approval.
In view of the limited period of patent protection, and to gain the marketing advantage of being first to market in a particular therapeutic category, we try to be efficient as well as careful in our new product development. We strive to minimize delays in handling new product candidates and look for opportunities such as contracting studies to outside researchers, to move development forward effectively and efficiently.
We feel that our investments in research have been rewarded by the number of pharmaceutical compounds and new therapies we have in all stages of development. In recent years, our discovery scientists have delivered dozens of new chemical compounds to early development. While each new candidate is far from regulatory approval, new drug candidates are the foundation for future products. A table and discussion of supplemental filings for existing products and drug candidates in development are set out under the heading PRODUCT DEVELOPMENTS beginning on page 30 of our 1999 Annual Report. That discussion is incorporated by reference.
Our research operations add value to our existing products by improving their effectiveness and by discovering new uses for them. In 1999, for example, the FDA approved the additional use of ZOLOFT for the treatment of posttraumatic stress disorder.
Our competitors also devote substantial sums and resources to research and development. In addition, the consolidation that has occurred in our industry has created companies with substantial research and development resources. The competition fostered by the fruits of this research could result in erosion of sales and unanticipated product obsolescence.
INTERNATIONAL OPERATIONS
We have significant operations outside the United States. They are conducted both through our subsidiaries and through distributors, and involve the same business segments - pharmaceutical and animal health - as our U.S. operations.
Japan is our second-largest single national market, with 8% of our total revenues in 1999, 7% in 1998 and 9% in 1997. No single country outside the U.S. had revenues of 10% of our total revenues.
For a geographic breakdown of revenues, see the table GEOGRAPHIC DATA on page 60 of our 1999 Annual Report. That information is incorporated by reference.
Our international businesses are subject, in varying degrees, to a number of risks inherent in carrying on business in other countries. These include:
o currency fluctuations
o capital and exchange control regulations
o expropriation and nationalization
o other restrictive government actions
Our international businesses are also subject to government-imposed constraints, including laws on pricing or reimbursement for use of products. See the section under the heading GOVERNMENT REGULATION AND PRICE CONSTRAINTS for discussion of those matters.
Revenue growth in 1999 was not significantly impacted by foreign exchange. In 1998, currency movements relative to the U.S. dollar reduced our reported revenues in many countries. Depending on the direction of change relative to the U.S. dollar, foreign currency values can either improve or reduce the reported dollar value of our net assets and results of operations. We cannot predict with certainty future changes in foreign exchange rates or the effect they will have on us. We attempt to anticipate such changes, however, and try to mitigate their effects. See Note 4-D to our financial statements, DERIVATIVE FINANCIAL INSTRUMENTS, on pages 46 and 47 in our 1999 Annual Report. That discussion is incorporated
by reference. Related information about valuation and risks associated with such financial instruments in parts E and F of that same Note is also incorporated by reference.
MARKETING
In our global pharmaceuticals business, we promote our products to health care providers such as doctors, nurse practitioners and hospitals, Pharmacy Benefit Managers and Managed Care Organizations (MCOs). We also market directly to consumers in the United States through direct-to-consumer print and television advertising. In addition, we sponsor general advertising to educate the public about our innovative medical research.
Our operations include several pharmaceutical sales organizations. Each sales organization markets a distinct group of products. We increased our sales force over the past several years so that our recently introduced products and late-stage candidates will reach their full potential. Our U.S. pharmaceutical sales representatives total approximately 5,400. This number reflects the creation of a new primary-care sales force and a specialty sales force dedicated largely to rheumatology, as well as the expansion of other specialty sales forces in the U.S. Overseas operations employ about 11,300 sales representatives.
Our prescription pharmaceutical products are sold principally to wholesalers, but we also sell directly to retailers, including hospitals, clinics, government agencies and pharmacies.
Through our marketing organizations, we explain the approved uses and advantages of our products to medical professionals. We work to gain access to MCO formularies (lists of recommended or approved medicines and other products compiled by pharmacists and physicians) by demonstrating the qualities and treatment benefits of our products. We also work with MCOs to assist them with disease management, patient education and other tools that help their medical treatment routines.
Marketing of prescription pharmaceuticals depends to a degree on complex decisions about the scope of clinical trials made years before product approval. All drugs must complete clinical trials required by regulatory authorities to show they are safe and effective for treating one or more particular medical problems. A manufacturer may choose, however, to undertake additional studies to demonstrate additional advantages of a compound, including comparative clinical trials with competitive products.
Those studies can be costly, can take years to complete and the results are uncertain. Balancing these considerations makes it difficult to decide whether and when to undertake such additional studies. But, when they are successful, such studies can have a major impact on approved marketing claims and strategies.
Our Consumer Health Care Group uses its own representatives to promote its products. We use print and television consumer advertising for our consumer health care products. Those products are sold through various retailers.
Separate sales organizations also are used by our Animal Health business to promote its products. Its advertising and promotion are generally targeted to health professionals, directly and through medical journals. Animal health and nutrition products are sold through veterinarians, drug wholesalers, distributors, retail outlets and directly to users. Where appropriate, these products are also marketed through print and television advertising.
During 1999, pharmaceutical sales to our three largest pharmaceutical and consumer health care products wholesalers were:
o McKesson HBOC, Inc. - 14% of our total revenues;
o Cardinal Health, Inc. - 12% of our total revenues; and
o Bindley Western Industries, Inc. - 7% of our total revenues.
Those sales were concentrated in the Pharmaceutical segment. Apart from these
instances, none of our business segments is dependent on any one or group of related customers.
PATENTS AND INTELLECTUAL PROPERTY RIGHTS
Our products are sold around the world under brand-name trademarks we consider in the aggregate to be of material importance. Trademark protection continues in some countries as long as the mark is used; in other countries, as long as it is registered. Registrations generally are for fixed, but renewable, terms.
We own or license a number of U.S. and foreign patents. These patents cover:
o pharmaceutical products and their uses
o pharmaceutical formulations
o product manufacturing processes
o intermediate chemical compounds used in manufacturing
Patents for individual products extend for varying periods according to the date of patent filing or grant and the legal term of patents in the various countries where patent protection is obtained. The actual protection afforded by a patent, which can vary from country to country, depends upon the type of patent, the scope of its coverage and the availability of legal remedies in the country.
In the aggregate, our patent and related rights are of material importance to our businesses in the United States and most other countries. Based on current product sales, and considering the vigorous competition with products sold by others, the patent rights we consider significant in relation to our business as a whole are those for NORVASC, CARDURA, ZYRTEC, ZITHROMAX, ZOLOFT, DIFLUCAN, GLUCOTROL XL and VIAGRA. Our basic U.S. patents relating to NORVASC, ZOLOFT, DIFLUCAN, GLUCOTROL XL and VIAGRA expire between 2004 and 2011. The U.S. patent on CARDURA expires in 2000.
PROCARDIA XL employs a novel sustained-release drug-delivery system developed and patented by Alza Corporation. We hold an exclusive license to use this delivery system with the active ingredient in PROCARDIA XL. The patents on the system run until 2003. Other companies also offer sustained-release forms of that ingredient or have filed applications with the FDA seeking approval of such products. One such product that has been approved has not been rated by the FDA to be appropriate for substitution in place of PROCARDIA XL. Another product was approved by the FDA in December, 1999, and rated therapeutically equivalent. Additional products were filed for FDA approval in 1998 which appear to infringe our patents (see the discussion of all of these matters in Item 3, LEGAL PROCEEDINGS, below. Also see the discussion below about PROCARDIA XL sales in the section CAUTIONARY FACTORS THAT MAY AFFECT FUTURE RESULTS). It is not possible to predict the timing and impact on sales of PROCARDIA XL of competition from other products.
ZITHROMAX is patented by Pliva, a Croatian pharmaceutical company. The drug is licensed exclusively to us by Pliva for sales and marketing in major countries, and we purchase the compound in bulk crude form from Pliva. Pliva's U.S. patent on ZITHROMAX expires in 2005.
ZYRTEC is patented by the Belgian company, UCB S.A. The drug is licensed exclusively to us for sales in the U.S. and semi-exclusively with UCB S.A. For sales in Canada. The U.S. patent on ZYRTEC held by UCB S.A. expires in 2007.
We have other patent rights covering additional products that have smaller sales revenues.
We expect that the patents on some of our newest products and late-stage product candidates could become significant to our business as a whole in the future.
The expiration of a product patent normally results in significant competition from generic products against the covered product and, particularly in the U.S., can result in a dramatic
reduction in sales of the pioneering product. In some cases, however, we can continue to obtain commercial benefits from:
o product manufacturing trade secrets
o patents on uses for products
o patents on processes and intermediates for the economical manufacture of the active ingredients
o patents for special formulations of the product or delivery mechanisms
o conversion of the active ingredient to over-the-counter products
The effect of product patent expiration also depends upon:
o the nature of the market and the position of the product in it
o the growth of the market
o the complexities and economics of manufacture of the product
o the requirements of generic drug laws
One of the main limitations on our operations in some countries outside the U.S. is the lack of effective intellectual property protection of our products. Under international agreements in recent years, global protection of intellectual property rights is improving. The General Agreement on Tariffs and Trade requires participant countries to amend their intellectual property laws to provide patent protection for pharmaceutical products by the end of a ten-year transition period. A number of countries are doing this. We have experienced significant growth in our businesses in some of those nations and our continued business expansion in those countries depends to a large degree on further patent protection improvement.
COMPETITION
Competition is intense in all of our businesses, and includes many large and small competitors. The principal means of competition varies among product categories and business groups. Technological innovations affecting:
o efficacy
o safety
o patients' ease of use
o cost effectiveness
are important to success in all of our businesses. Our businesses also focus on unmet medical needs and therapeutic improvements. Our emphasis on innovation has led to our multi-billion-dollar research and development investments over the past decade.
Our pharmaceutical business competes with worldwide research-based drug companies, many smaller research companies with more limited therapeutic focus and generic drug manufacturers. Our pharmaceutical operations are among the largest in the world.
In recent years, a comparison of the total cost of medical treatments using pharmaceuticals versus alternative treatments for the same condition has become an important basis of competition. Managed Care Organizations and Pharmacy Benefit Managers look to cost advantages as well as medical benefits in making their drug formulary decisions.
Our pharmaceutical sales and marketing organization is a valuable competitive asset. Our salespeople's ability to reach medical professionals with information about our products helps us respond to competitive efforts and launch new products.
Many other companies, large and small, manufacture and sell one or more products that are similar to our consumer health care products. Sources of competitive advantage in the OTC market include:
o product quality and efficacy
o brand identity
o advertising and promotion
o product innovation
o broad distribution capabilities
o customer satisfaction
o price
Significant expenditures for advertising, promotion and marketing are generally required to achieve consumer acceptance of consumer health care products.
We have a significant presence in the animal health marketplace, but many other companies offer competitive products. Altogether, there are hundreds of producers of animal health products throughout the world. The principal methods of competition vary somewhat depending on the particular product. They include:
o product innovation
o service
o price
o quality
o effective promotion to veterinary professionals and consumers
We promote our products directly through our sales representatives as well as through advertising.
In the current environment of competitive pressures on profit margins, we continue efforts to control the growth of our expenses. Although research and development budgets have grown significantly, we have kept our costs down in other areas such as manufacturing, distribution and sales administration by restructuring and consolidating facilities. These measures have brought us new efficiencies and reduced or contained our operating expenses.
MANAGED CARE ORGANIZATIONS
The growth of Managed Care Organizations in the U.S. has been a major factor in the competitive make-up of the health care marketplace. Over half the U.S. population now participates in some version of managed care. Because of the size of the patient population covered by MCOs, marketing of prescription drugs to them and the Pharmacy Benefit Managers (PBMs) that serve many of those organizations has become important to our business.
MCOs can include medical insurance companies, medical plan administrators, health-maintenance organizations, alliances of hospitals and physicians and other physician organizations. The purchasing power of MCOs has been increasing in recent years due to their growing numbers of enrolled patients. At the same time, those organizations have been consolidating into fewer, even larger entities. This enhances their purchasing strength and importance to us.
A major objective of MCOs is to contain and, where possible, reduce health care expenditures. They typically use formularies, volume purchases and long-term contracts to negotiate discounts from pharmaceutical providers. They use their purchasing power to bargain for lower supplier prices. They also emphasize primary and preventive care, out-patient treatment, and procedures performed at doctors' offices and clinics. Hospitalization and surgery, typically the most expensive forms of treatment, are carefully managed.
As discussed above in MARKETING, MCOs and PBMs typically develop formularies to reduce their cost for medications. Formularies can be based on the prices and therapeutic benefits of the available products. Due to their lower cost, generic medicines are often favored. The breadth of the products covered by formularies can vary considerably from one MCO to another, and many formularies include alternative and competitive products for treatment of particular medical problems. MCOs use a variety of means to encourage patients' use of products listed on their formularies.
Exclusion of a product from a formulary can lead to its sharply reduced usage in the MCO patient population. Consequently, pharmaceutical companies compete aggressively to have their products included. Where possible,
companies compete for inclusion based upon unique features of their products, such as greater efficacy, better patient ease of use or fewer side effects. A lower overall cost of therapy is also an important factor. Products that demonstrate fewer therapeutic advantages must compete for inclusion based primarily on price.
The growth of MCOs also appears to have led to greater usage of some drugs. The use of certain drugs can prevent the need for more costly treatments such as hospitalization, professional therapy or even surgery. Because of these advantages, such drugs can become favored first-line treatments. In addition, the current trend of some patients to opt for managed care alternatives to Medicare may increase overall pharmaceutical usage among that elderly population. Medicare generally does not pay for medicines, so patients who do not have another source of prescription drug coverage must bear that cost. MCOs, however, often offer drug benefits for their participants.
These developments have not only created pressure on prices, but also have increased sales of products on formularies. We have been generally, although not universally, successful in having our major products included on MCO formularies.
Another way we address the interests of MCOs is by developing disease management programs. These programs can be attractive to MCOs by improving patient communications and compliance with dosage directions, which are important for effective disease treatment. They can help MCOs address various aspects of disease management, such as prevention, diagnosis and treatment of certain diseases, including use of pharmaceutical products. This comprehensive approach can improve the quality of care and lower costly complications of chronic diseases.
GENERIC PRODUCTS
One of the biggest competitive challenges we face in the U.S. is from generic pharmaceutical manufacturers. Upon the expiration of U.S. patent protection on an important product, we can lose the major portion of U.S. sales of the product within a year. Generic competitors operate without our large research and development expenses and our costs of conveying medical information about the product to the medical community. In addition, the FDA approval process exempts generics from costly and time-consuming clinical trials to demonstrate their safety and efficacy, and allows generic manufacturers to rely on the safety and efficacy of the pioneer product. Generic products need only demonstrate a level of availability in the blood stream equivalent to that of the pioneer product. This means that after we have borne the expenses of discovering, developing and testing a medicine for safety and efficacy, obtaining regulatory approval and informing the medical community about its therapeutic benefits, generic competitors can charge much less for a competing version of our product and still be profitable.
As noted above, MCOs that focus primarily on the immediate cost of drugs may favor generics over brand-name drugs. Many governments also encourage the use of generics as alternatives to brand-name drugs in their health care programs, including Medicaid in the U.S. Laws in the U.S. generally allow, and in some cases require, pharmacists to substitute generic drugs that have been rated under government procedures to be therapeutically equivalent to a brand-name drug. The substitution must be made unless the prescribing physician expressly forbids it.
RAW MATERIALS
Raw materials essential to our businesses are purchased worldwide in the ordinary course of business from numerous suppliers. In general, these materials are available from multiple sources. No serious shortages or delays were encountered in 1999, and none are expected in 2000.
GOVERNMENT REGULATION AND PRICE CONSTRAINTS
Pharmaceutical companies are subject to heavy regulation by a number of national, state and local agencies. Of particular importance is the FDA in the United States. It has jurisdiction over all our businesses and administers requirements covering the testing, safety, effectiveness, approval, manufacturing, labeling and marketing of our pharmaceutical products. In some cases, FDA requirements and/or reviews have increased the amount of time and money necessary to develop new products and bring them to market.
The FDA also regulates our consumer health care products and, along with the U.S. Department of Agriculture and the Environmental Protection Agency, our animal health products. Some regulatory actions pertaining to our products are discussed in Item 3, LEGAL PROCEEDINGS, below.
Since the beginning of 1998, the approval of new drugs across the EU is possible only using the European Medicines Evaluation Agency's (EMEA) mutual recognition or central approval processes. The use of either of these procedures should provide a more rapid and consistent approval across all fifteen member states than was the case when the approval processes were operating independently within each member state. Further, on January 1, 2000, Norway and Iceland became full participants in the EU central approval processes. In addition, the agreement between the EU and ten Eastern European states to base their approvals on the centralized EU approval will significantly speed the regulatory process in those countries. The EMEA does not have jurisdiction over patient reimbursement or pricing matters in EU member countries, however. We will continue to deal with individual countries on such issues.
In recent years, various legislative proposals have been offered in Congress and in some state legislatures that would bring about major changes in the affected health care systems. Some states have passed such legislation, and further federal and state proposals are possible. These could include price or patient reimbursement constraints on medicines and restrictions on access to certain products. Similar issues exist in many foreign countries where we do business. We cannot predict the outcome of such initiatives, but we will work to maintain patient access to our products and to oppose price constraints.
Also in the U.S., proposals have called for substantial changes in the Medicare and Medicaid programs. If such changes are enacted, they may require significant reductions from currently projected government expenditures for these programs. Driven by budget concerns, Medicaid managed care systems have been implemented in several states. If the Medicare and Medicaid programs implement changes that restrict the access of a significant population of patients to our innovative medicines, our business could be materially affected. On the other hand, relatively little pharmaceutical use is currently covered by Medicare. As noted above, if changes to these programs shift patients to MCOs that cover pharmaceuticals, or drug coverage for Medicare beneficiaries is expanded, usage of pharmaceuticals could increase.
Legislation in the U.S. requires us to give rebates to state Medicaid agencies based on each state's reimbursement of pharmaceutical products under the Medicaid program. We also must give discounts or rebates on purchases or reimbursements of pharmaceutical products by certain other federal and state agencies and programs. See the discussion regarding rebates on page 30 of our 1999 Annual Report for details on the cost to us of such discounts and rebates, which is incorporated by reference.
We encounter similar regulatory and legislative issues in most other countries. For example, in 1997, Japan announced a price reduction on drugs. In Europe and some other international markets, the government provides health care at low direct cost to consumers and regulates pharmaceutical prices or patient
reimbursement levels to control costs for the government-sponsored health care system.
This international patchwork of price regulation has led to inconsistent prices and some third-party trade in our products from markets with low prices. Such trade exploiting price differences between countries can undermine our sales in markets with higher prices.
We are also subject to the jurisdiction of various other regulatory and enforcement departments and agencies, such as the Department of Health and Human Services, the Federal Trade Commission and the Department of Justice in the U.S., and are, therefore, subject to possible administrative and legal proceedings and actions by those organizations (see Item 3, LEGAL PROCEEDINGS, below). Such actions may include product recalls, seizures and other civil and criminal sanctions. In some cases, we have initiated product recalls voluntarily.
It is difficult to predict the future impact of the broad and expanding legislative and regulatory requirements affecting us.
ENVIRONMENTAL LAW COMPLIANCE
Most of our manufacturing and certain research operations are affected by federal, state and local environmental laws. We have made, and intend to continue to make, necessary expenditures for compliance with applicable laws. We are also cleaning up environmental contamination from past industrial activity at certain sites (see Item 3, LEGAL PROCEEDINGS, below). As a result, we incurred capital and operational expenditures in 1999 for environmental protection and clean-up of certain past industrial activity as follows:
o environmental-related capital expenditures -- $66 million
o other environmental-related expenses -- $88 million
While we cannot predict with certainty the future costs of such clean-up activities, capital expenditures, or operating costs for environmental compliance, we do not believe they will have a material effect on our capital expenditures, earnings or competitive position.
YEAR 2000
We have not experienced any operational problems as a result of Year 2000 issues, and Year 2000 had no material effect on our revenues. Although the transition from 1999 to 2000 did not adversely impact our Company, there can be no assurances that we will not experience any negative effects or disruptions in our businesses in the future as a result of Year 2000 issues.
The total cost of our Year 2000 Program was $130 million, of which we incurred $94 million in 1999, $31 million in 1998 and $5 million in 1997. These costs were expensed as incurred, except for capitalizable hardware of approximately $8 million in 1999, $4 million in 1998 and $1 million in 1997, and were funded through operating cash flows. Such costs did not include normal system upgrades and replacements.
CORPORATE/FINANCIAL SUBSIDIARIES
We conduct international banking operations through a subsidiary, Pfizer International Bank Europe (PIBE), based in Dublin, Ireland. PIBE, incorporated under the laws of Ireland, operates under a banking license from the Central Bank of Ireland. It makes loans and accepts deposits in several currencies in international markets. PIBE is an active Euromarket lender to high quality corporations and governments through its portfolio of loans and money market instruments. Loans are made primarily on a short and medium term basis, typically with floating interest rates.
We also own an insurance operation, The Kodiak Company Limited, which reinsures certain assets, inland transport and marine cargo of our international operations. Financial data for these subsidiaries are set out in Note 3 to our financial statements, FINANCIAL SUBSIDIARIES, on pages 44 and 45 in our 1999 Annual Report, which is incorporated by reference.
TAX MATTERS
The discussion of tax-related matters (including certain proceedings involving proposed tax adjustments relating to prior years) in Note 9 to our financial statements, TAXES ON INCOME, on pages 49 and 50 in our 1999 Annual Report is incorporated by reference.
EMPLOYEES
In our innovation-intensive business, our employees are vital to our success. We believe we have good relationships with our employees. As of December 31, 1999, we employed approximately 50,900 people in our operations throughout the world. Geographically, this total breaks down as follows:
o United States, 19,300
o Europe, 14,400
o Asia, 6,600
o Canada/Latin America, 5,900
o Africa/Middle East, 4,700
CAUTIONARY FACTORS THAT MAY AFFECT FUTURE RESULTS
(CAUTIONARY STATEMENTS UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995)
OUR DISCLOSURE AND ANALYSIS IN THIS REPORT AND IN OUR 1999 ANNUAL REPORT TO SHAREHOLDERS CONTAIN SOME FORWARD-LOOKING STATEMENTS. FORWARD-LOOKING STATEMENTS GIVE OUR CURRENT EXPECTATIONS OR FORECASTS OF FUTURE EVENTS. YOU CAN IDENTIFY THESE STATEMENTS BY THE FACT THAT THEY DO NOT RELATE STRICTLY TO HISTORICAL OR CURRENT FACTS. THEY USE WORDS SUCH AS "ANTICIPATE," "ESTIMATE," "EXPECT," "PROJECT," "INTEND," "PLAN," "BELIEVE," AND OTHER WORDS AND TERMS OF SIMILAR MEANING IN CONNECTION WITH ANY DISCUSSION OF FUTURE OPERATING OR FINANCIAL PERFORMANCE. IN PARTICULAR, THESE INCLUDE STATEMENTS RELATING TO FUTURE ACTIONS, PROSPECTIVE PRODUCTS OR PRODUCT APPROVALS, FUTURE PERFORMANCE OR RESULTS OF CURRENT AND ANTICIPATED PRODUCTS, SALES EFFORTS, EXPENSES, THE OUTCOME OF CONTINGENCIES SUCH AS LEGAL PROCEEDINGS, ANTICIPATED EFFECTS OF THE MERGER WITH WARNER-LAMBERT DISCUSSED UNDER THE HEADING RECENT DEVELOPMENTS AND FINANCIAL RESULTS. FROM TIME TO TIME, WE ALSO MAY PROVIDE ORAL OR WRITTEN FORWARD-LOOKING STATEMENTS IN OTHER MATERIALS WE RELEASE TO THE PUBLIC.
ANY OR ALL OF OUR FORWARD-LOOKING STATEMENTS IN THIS REPORT, IN THE 1999 ANNUAL REPORT AND IN ANY OTHER PUBLIC STATEMENTS WE MAKE MAY TURN OUT TO BE WRONG. THEY CAN BE AFFECTED BY INACCURATE ASSUMPTIONS WE MIGHT MAKE OR BY KNOWN OR UNKNOWN RISKS AND UNCERTAINTIES. MANY FACTORS MENTIONED IN THE DISCUSSION ABOVE - FOR EXAMPLE, GOVERNMENT REGULATIONS AROUND THE WORLD, YEAR 2000 SYSTEMS COMPLIANCE, GENERIC PRODUCT COMPETITION AND THE COMPETITIVE ENVIRONMENT - WILL BE IMPORTANT IN DETERMINING FUTURE RESULTS. CONSEQUENTLY, NO FORWARD-LOOKING STATEMENT CAN BE GUARANTEED. ACTUAL FUTURE RESULTS MAY VARY MATERIALLY.
WE UNDERTAKE NO OBLIGATION TO PUBLICLY UPDATE FORWARD-LOOKING STATEMENTS, WHETHER AS A RESULT OF NEW INFORMATION, FUTURE EVENTS OR OTHERWISE. YOU ARE ADVISED, HOWEVER, TO CONSULT ANY FURTHER DISCLOSURES WE MAKE ON RELATED SUBJECTS IN OUR 10-Q AND 8-K REPORTS TO THE SEC. ALSO NOTE THAT WE PROVIDE THE FOLLOWING CAUTIONARY DISCUSSION OF RISKS, UNCERTAINTIES AND POSSIBLY INACCURATE ASSUMPTIONS RELEVANT TO OUR BUSINESSES. THESE ARE FACTORS THAT WE THINK COULD CAUSE OUR ACTUAL RESULTS TO DIFFER MATERIALLY FROM EXPECTED AND HISTORICAL RESULTS. OTHER FACTORS BESIDES THOSE LISTED HERE COULD ALSO ADVERSELY AFFECT THE COMPANY. THIS DISCUSSION IS PROVIDED AS PERMITTED BY THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995.
^ Balancing current growth and investment for the future remains a major challenge. Our ongoing investments in new product introductions and research and development for future products could exceed corresponding sales growth. This could produce higher costs without a proportional increase in revenues.
^ In the U.S., many of our pharmaceutical products are subject to increasing pricing pressures, which could be significantly impacted
by the outcome of the current national debate over Medicare reform. If the Medicare program provided outpatient pharmaceutical coverage for its beneficiaries, the federal government, through its enormous purchasing power under the program, could demand discounts from pharmaceutical companies that may implicitly create price controls on prescription drugs. On the other hand, a Medicare drug reimbursement provision may increase the volume of pharmaceutical drug purchases, offsetting, at least in part, these potential price discounts. In addition, managed care organizations, institutions and other government agencies continue to seek price discounts. Government efforts to reduce Medicare and Medicaid expenses are expected to increase the use of managed care organizations. This may result in managed care influencing prescription decisions for a larger segment of the population. International operations are also subject to price and market regulations. As a result, it is expected that pressures on pricing and operating results will continue.
^ Thirty-nine percent of our 1999 revenues arose from international operations, and we expect revenue and net income growth in 2000 to be impacted by changes in foreign exchange rates. Revenues from Asia comprised approximately 11% of total revenues in 1999, including 8% from Japan.
These international-based revenues as well as our substantial international assets result in our exposure to currency exchange rate changes. In addition, our interest-bearing investments, loans and borrowings are subject to interest rate change risk. The risks of such changes and the measures we have taken to help contain those risks are discussed in the section entitled FINANCIAL RISK MANAGEMENT on page 36 in our 1999 Annual Report. For additional details, see Note 4-D to our financial statements, DERIVATIVE FINANCIAL INSTRUMENTS, on pages 46 and 47 in our 1999 Annual Report. Those sections of the Annual Report are incorporated by reference.
Notwithstanding our efforts to foresee and mitigate the effects of changes in fiscal circumstances, we cannot predict with certainty all changes in currency and interest rates, inflation or other related factors affecting our businesses. These factors could affect future results.
^ A new European currency (euro) was introduced in January 1999 to replace the separate currencies of eleven individual countries. The major changes during its first year of existence have occurred in the banking and financial sectors. The impact at the commercial and retail level has been limited but is expected to increase during the next two years through December 31, 2001, when the separate currencies will cease to exist. We are modifying systems and commercial arrangements to deal with the new currency, including the availability of dual currency processes to permit transactions to be denominated in the separate currencies, as well as the euro. The cost of this effort is not expected to have a material effect on our businesses or results of operations. We continue to evaluate the economic and operational impact of the euro, including its impact on competition, pricing and foreign currency exchange risks. There is no guarantee, however, that all problems have been foreseen and corrected, or that no material disruption will occur in our businesses.
^ International operations could be affected by changes in intellectual property legal protections and remedies, trade regulations and procedures and actions affecting approval, production, pricing, reimbursement and marketing of products, as well as by unstable governments and legal systems, intergovernmental disputes and possible nationalization.
^ Cost-containment measures employed by governments that have the effect of limiting patient access to medicines and related issues described above in GOVERNMENT REGULATION AND PRICE CONSTRAINTS affect the growth and profitability of our operations in some countries. Those factors could affect future results.
^ Business combinations among our competitors could affect our competitive position in the pharmaceutical, consumer health care and animal health businesses. Similarly,
combinations among our major customers could increase their purchasing power in dealing with us. In addition, our proposed merger with Warner-Lambert could affect our business, finances and capital structure. While we anticipate earnings and revenues growth, as well as substantial cost savings and operating efficiencies to be achieved in connection with the merger with Warner-Lambert, we cannot give any assurance that these results will be realized in the combined company within the time periods contemplated or even if they will be realized at all.
^ Generic competition is a major challenge in the U.S. Loss of patent protection typically leads to dramatic loss of sales in the U.S. market and could affect future results.
^ Risks and uncertainties particularly apply with respect to product-related forward-looking statements. The outcome of the lengthy and complex process of identifying new compounds and developing new products is inherently uncertain. Prospective products can fail to receive regulatory approval. There are also many considerations that can affect marketing of pharmaceutical products around the world. Regulatory delays, the inability to successfully complete clinical trials, claims and concerns about safety and efficacy, new discoveries, patents and products by competitors and related patent disputes and claims about adverse side effects are a few of the factors that could adversely affect the realization of research and development and product-related forward-looking statements.
^ As discussed above in MARKETING, decisions about research studies made early in the development process of a drug candidate can have a substantial impact on the marketing strategy once the drug receives approval. More detailed studies may demonstrate additional benefits that can help in the marketing, but they consume time and resources and can delay submitting the drug candidate for initial approval. We try to plan clinical trials prudently, but there is no guarantee that a proper balance of speed and testing will be made in each case. The quality of our decisions in this area can affect our future results.
^ Difficulties or delays in product manufacturing or marketing, including, but not limited to, the inability to build up production capacity commensurate with demand, or the failure to predict market demand for or to gain market acceptance of approved products could affect future results.
^ We currently have seven products with annual sales to third parties exceeding one billion dollars. In this group are five medicines discovered by PFIZER - NORVASC, ZITHROMAX, ZOLOFT, VIAGRA and DIFLUCAN - and our alliance products LIPITOR and CELEBREX. Those products accounted for more than half of our 1999 revenues. If these or any of our other major products were to become subject to a problem such as loss of patent protection, unexpected side effects, regulatory proceedings, publicity affecting doctor or patient confidence or pressure from competitive products, or if a new, more effective treatment should be introduced, the impact on our revenues could be significant.
^ We cannot always predict with accuracy the timing or impact of possible future competition on sales of our products. for example, PROCARDIA XL, our patented form of sustained-release nifedipine, has been an important product for us, but its sales have been declining, and we expect that to continue. Sales of PROCARDIA XL were $822 million in 1997, $714 million in 1998 and $521 million in 1999. This decline has been due, at least in part, to the medical community's increased emphasis on our more advanced product, NORVASC. It is also partly attributable to the fact that there has been another form of sustained-release nifedipine available on the market since 1993, although it is not approved for treatment of all the same indications as PROCARDIA XL. Additional potentially competitive products have been filed for FDA approval, one of which was approved by the FDA in December, 1999 (see the discussion in Item 3, LEGAL PROCEEDINGS, below). This indicates that the number of medicines that compete with PROCARDIA XL may increase, and
the sales of competing products may affect our expected results.
^ During 1995, the authors of some non-clinical studies questioned the safety of calcium channel blockers (CCBs). Although the clinical evidence supported the safety of this class of medications, the FDA convened an advisory panel to review their safety. In 1996, that advisory panel found no data to support challenges to the safety of newer sustained-release and intrinsically long-acting CCBs (such as NORVASC and PROCARDIA XL - products for treatment of hypertension and angina).
Questions about this class of products continued throughout 1997, however, and included scientific publications and presentations asserting that these products were associated with various serious medical conditions.
During 1997, data from newly conducted studies and reviews and decisions by two national regulatory authorities, plus newly published National Institutes of Health guidelines, were all supportive of the safety of long-acting CCBs like NORVASC AND PROCARDIA XL and of their appropriateness as first-line medications in the treatment of hypertension.
We continue to believe that the safety and effectiveness of NORVASC and PROCARDIA XL are supported by a large body of data from numerous studies and the daily clinical experiences of physicians around the world. It is not possible, however, to predict the impact on our future sales, if any, of existing or future studies, regulatory agency actions or a continuing debate regarding CCBs.
^ Growth in costs and expenses, changes in product mix and the impact of divestitures, restructuring and other unusual items that could result from evolving business strategies, evaluation of asset realization and organizational restructuring could affect future results. For example, we may be unable to maintain or further enhance those margin improvements achieved in recent years, which would affect future results.
^ In June 1999, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 137, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES - DEFERRAL OF THE EFFECTIVE DATE OF FASB STATEMENT NO. 133. This pronouncement requires us to adopt SFAS No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES, on January 1, 2001. SFAS No. 133 requires a company to recognize all derivative instruments as assets or liabilities in its balance sheet and measure them at fair value.
Such new or revised accounting standards and rules are issued from time to time. Although the standard mentioned above is not expected to have a material impact on our reported financial results, future standards and rules could have such an effect.
^ As described above in the section YEAR 2000, we have not experienced any operational problems as a result of Year 2000 issues, and Year 2000 had no material effect on our revenues. Although the transition from 1999 to 2000 did not adversely impact our Company, there can be no assurances that we will not experience any negative effects or disruptions in our businesses in the future as a result of Year 2000 issues.
^ Changes in the U.S. Tax Code and the tax laws of other countries can affect our net earnings. For example, pursuant to the Small Jobs Protection Act of 1996 (the ACT), Section 936 of the Internal Revenue Code was repealed for tax years beginning after December 31, 1995. Section 936 had created the U.S. possessions corporation income tax credit, which gave us tax benefits for certain operations in Puerto Rico. The Act provided that as an existing credit claimant, we are eligible to continue using the credit against the tax arising from our manufacturing income earned in Puerto Rico for an additional ten-year period. The amount of manufacturing income eligible for the credit during this additional period is subject to a cap based on income earned prior to 1996 in Puerto Rico. This ten-year extension does not apply to investment income earned in Puerto Rico, the credit on which expired as of
July 1, 1996. The Act did not affect the amendments made to Section 936 by the Omnibus Budget Reconciliation Act of 1993, which provided for a five-year phase-down of the U.S. possession tax credit from 100% to 40%. In addition, the Act permitted the extension of the R&D tax credit through June 30, 1998. In 1998, this credit was again extended to June 30, 1999, and in 1999, it was further extended to June 30, 2004.
^ Claims have been brought against us and our subsidiaries for various legal, environmental and tax matters, and additional claims arise from time to time. In addition, our operations are subject to international, federal, state and local environmental laws and regulations. It is possible that our cash flows and results of operations could be affected by the one-time impact of the resolution of these contingencies. We believe that the ultimate disposition of current matters to the extent not previously provided for will not have a material impact on our financial condition or cash flows and results of operations, except where specifically commented upon in the discussion of such matters in LEGAL PROCEEDINGS in Item 3 in this report, in TAX MATTERS above and in Note 9 to our financial statements, TAXES ON INCOME, on pages 49 and 50 in our 1999 Annual Report, which is incorporated by reference.
ITEM 2.
ITEM 2. PROPERTIES
Our world headquarters is located in several buildings in New York City. We own two of these buildings, including our main 33-story office tower, and rent space in others nearby. The 33-story office tower is located on a site we have leased under a long-term ground lease. Altogether, our headquarters operations occupy over 1.6 million square feet of owned and leased office space in New York City.
Our pharmaceutical business owns and leases space for sales and marketing, administrative support and customer service functions around the world.
Our major research and development facilities are located in manufacturing/R&D complexes that we own containing multiple buildings in Groton, Connecticut; Sandwich, England and Nagoya, Japan. The buildings at our Groton facility currently contain approximately 3.5 million square feet of floor space. Approximately 1 million square feet is used for manufacturing, and the rest is used for research and development. The Company also began construction in 1998 on an additional 750,000 square-foot facility on a 24-acre site in nearby New London, Connecticut, to initially house 1,300 employees from the Company's research operations.
Buildings on our 334-acre Sandwich, England campus house research, our U.K. pharmaceutical sales office and a production plant. These facilities contain almost 2 million square feet of floor space, approximately half of which is used for research and development. An additional 900,000 square feet of new research space is under construction.
At our facility in Nagoya, Japan, the buildings contain 790,000 square feet of floor space, of which 300,000 square feet is used for research.
We own other important research facilities in Amboise, France and Terre Haute, Indiana. A number of smaller research and development operations around the world focus principally on their local markets. As discussed above, we have been expanding our research and development facilities in recent years to meet the challenges of handling growing research activities. In 1999, over 2.3 million square feet of research facilities was under construction at our sites in Groton, Sandwich and Nagoya.
Our Global Manufacturing Division operates 32 plants that produce products for our pharmaceutical, consumer and animal health businesses around the world. Twenty of these are major facilities. These plants handle one or more of three basic types of production processes:
o fermentation
o organic synthesis
o product production
We have four major fermentation plants:
o Rixensart, Belgium
o Sao Paulo, Brazil
o Nagoya, Japan
o Sandwich, England, U.K.
Our major organic synthesis facilities are in four locations:
o Barceloneta, Puerto Rico, U.S.
o Groton, Connecticut, U.S.
o Ringaskiddy, Ireland
o Sandwich, England, U.K.
We have major product production plants at seventeen sites in eleven countries:
o Amboise, France
o Barceloneta, Puerto Rico, U.S.
o Brooklyn, New York, U.S.
o Dalian, China
o Illertissen, Germany
o Latina, Italy
o Lee's Summit, Missouri, U.S.
o Lincoln, Nebraska, U.S.
o Louvain-la-Neuve, Belgium
o Nagoya, Japan
o Parsippany, New Jersey, U.S.
o Sandwich, England, U.K.
o San Jose Iturbide, Mexico
o Sao Paulo, Brazil
o Terre Haute, Indiana, U.S.
o Toluca, Mexico
o Valencia, Venezuela
Our Consumer Health Care and Animal Health Groups have their principal executive offices in leased facilities one block away from the Company's world headquarters.
Consumer Health Care has its principal research operations in Parsippany, New Jersey. Consumer Health Care's sales and marketing offices are generally leased and shared with local pharmaceutical sales offices, except in Mexico and the U.K., where Consumer Health has separate offices.
Animal Health owns its North American headquarters in Exton, Pennsylvania, and leases some additional space in a nearby office building. It also owns office space in Zaventem, Belgium, for support of its international operations.
Most of Animal Health's research facilities are shared with our pharmaceutical business.
Our distribution operations in the U.S. include our large, state-of-the-art distribution and order fulfillment operation in a 450,000 square-foot building on a 20-acre site in Memphis, Tennessee, a new 190,000 square-foot distribution center at our plant site in Parsippany, New Jersey, and a facility in Irvine, California. A new West Coast distribution facility is under construction in Reno, Nevada. The Animal Health Group also operates its own distribution facilities. We also operate distribution facilities in major markets around the world.
In general, our properties are well maintained, adequate and suitable to their purposes. The growth of our businesses has created space pressures for certain operations, however. We have responded to such challenges with plans to provide appropriate facilities as needs are demonstrated. Note 7 to our financial statements, PROPERTY, PLANT AND EQUIPMENT on page 48 in our 1999 Annual Report, which discloses amounts invested in land, buildings and equipment, and the discussion of investing activities under the heading SUMMARY OF CASH FLOWS on page 34 of our Annual Report, which describes our capital expenditures, are incorporated by reference. See also the discussion under Note 11 entitled LEASE COMMITMENTS on page 52 of our Annual Report, which is also incorporated by reference.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is involved in a number of claims and litigations, including product liability claims and litigations considered normal in the nature of its businesses. These include suits involving various pharmaceutical and
hospital products that allege either reaction to or injury from use of the product. In addition, from time to time the Company is involved in, or is the subject of, various governmental or agency inquiries or investigations relating to its businesses.
FORMER FOOD SCIENCE DIVISION
In 1999, the Company pleaded guilty to one count of price fixing of sodium erythorbate from July 1992 until December 1994, and one count of market allocation of maltols from December 1989 until December 1995, and paid a total fine of $20 million. The activities at issue involved the Company's former Food Science Group, a division that manufactured food additives and that the Company divested in 1996. The Department of Justice has stated that no further antitrust charges will be brought against the Company relating to the former Food Science Group, that no antitrust charges will be brought against any current director, officer or employee of the Company for conduct related to the products of the former Food Science Group, and that none of the Company's current directors, officers or employees was aware of any aspect of the activity that gave rise to the violations. Five purported class action suits involving these products have been filed against the Company; two in California State Court, and three in New York Federal Court. The Company does not believe that this plea and settlement, or civil litigation involving these products, will have a material effect on its business or results of operations.
NIFEDIPINE PATENTS
On June 9, 1997, the Company received notice of the filing of an Abbreviated New Drug Application (ANDA) by Mylan pharmaceuticals for a sustained-release nifedipine product asserted to be bioequivalent to PROCARDIA XL. Mylan's notice asserted that the proposed formulation does not infringe relevant licensed Alza and Bayer patents and thus that approval of their ANDA should be granted before patent expiration. On July 18, 1997, the Company, together with Bayer AG and Bayer Corporation, filed a patent-infringement suit against Mylan Pharmaceuticals Inc. and Mylan Laboratories Inc. in the United States District Court for the Western District of Pennsylvania with respect to Mylan's ANDA. Suit was filed under Bayer AG's U.S. Patent No. 5,264,446, licensed to the Company, relating to nifedipine of a specified particle size range. On March 16, 1999, the United States District Court granted Mylan's motion to file an amended answer and antitrust counterclaims. On December 17, 1999, Mylan received final approval from the FDA for its 30 mg. extended-release nifedipine tablet. On February 28, 2000, a settlement agreement was entered into between Mylan and the Company under which the litigation was terminated and Mylan will market a generic sustained-release nifedipine product manufactured by the Company under its own trademark.
On or about February 23, 1998, Bayer AG received notice that Biovail Laboratories Incorporated had filed an ANDA for a sustained-release nifedipine product asserted to be bioequivalent to one dosage strength (60 mg.) of PROCARDIA XL. The notice was subsequently received by the Company as well. The notice asserts that the Biovail product does not infringe Bayer's U.S. Patent No. 5,264,446. On March 26, 1998, the Company received notice of the filing of an ANDA by Biovail Laboratories of a 30 mg. dosage formulation of nifedipine alleged to be bioequivalent to PROCARDIA XL. On April 2, 1998, Bayer and Pfizer filed a patent-infringement action against Biovail, relating to their 60 mg. nifedipine product, in the United States District Court for the District of Puerto Rico. On May 6, 1998, Bayer and Pfizer filed a second patent infringement action in Puerto Rico against Biovail under the same patent with respect to Biovail's 30 mg. nifedipine product. These actions have been consolidated for discovery and trial. On April 24, 1998, Biovail Laboratories Inc. brought suit in the United States District Court for the Western District of Pennsylvania against the Company and Bayer seeking a declaratory judgment of invalidity of and/or non-infringement of the 5,264,446 nifedipine patent as well as a finding of violation of the antitrust laws. Biovail has also moved to
transfer the patent infringement actions from Puerto Rico to the Western District of Pennsylvania. Pfizer has opposed this motion to transfer and on June 19, 1998, moved to dismiss Biovail's declaratory judgment action and antitrust action in the Western District of Pennsylvania, or in the alternative, to stay the action pending the outcome of the infringement actions in Puerto Rico. On January 4, 1999, the District Court in Pennsylvania granted Pfizer's motion for a stay of the antitrust action pending the outcome of the infringement actions in Puerto Rico. On January 29, 1999, the District Court in Puerto Rico denied Biovail's motion to transfer the patent infringement actions from Puerto Rico to the Western District of Pennsylvania. On April 12, 1999, Biovail filed a motion for summary judgment also based in part on the summary judgment motion granted to Elan in the Bayer v. Elan litigation in the Northern District of Georgia. Pfizer and Bayer's response was filed on April 26, 1999. On September 20, 1999, the United States District Court in Puerto Rico denied Biovail's motion for summary judgment without prejudice to their refiling after completion of discovery in the PROCARDIA XL patent-infringement litigation. The court set an expedited discovery schedule with a deadline of December 30, 1999, to complete discovery of parties and fact witnesses and February 29, 2000, to complete discovery of expert witnesses. On December 20, 1999, the court extended the date to complete fact discovery to January 28, 2000, and that of expert discovery to March 15, 2000. A status conference with the court scheduled for March 17, 2000, has been postponed and a new date is awaited.
On April 2, 1998, the Company received notice from Lek U.S.A. Inc. of its filing of an ANDA for a 60 mg. formulation of nifedipine alleged to be bioequivalent to PROCARDIA XL. On May 14, 1998, Bayer and Pfizer commenced suit against Lek for infringement of Bayer's U.S. Patent No. 5,264,446, as well as for infringement of a second Bayer patent, No. 4,412,986 relating to combinations of nifedipine with certain polymeric materials. On September 14, 1998, Lek was served with the summons and complaint. Plaintiffs amended the complaint on November 10, 1998, limiting the action to infringement of U.S. Patent 4,412,986. On January 19, 1999, Lek filed a motion to dismiss the complaint alleging infringement of U.S. Patent 4,412,986. Pfizer responded to this motion and oral argument has been held in abeyance pending a settlement conference. In September 1999, a settlement agreement was entered into among the parties staying this litigation until the expiration of U.S. Patent No. 4,412,986 on November 2, 2000.
On February 10, 1999, the Company received a notice from Lek U.S.A. of its filing of an ANDA for a 90 mg. formulation of nifedipine alleged to be bioequivalent to PROCARDIA XL. On March 25, 1999, Bayer and Pfizer commenced suit against Lek for infringement of the same two Bayer patents originally asserted against Lek's 60 mg. formulation. This case was also the subject of a settlement conference. In September, 1999, a settlement agreement was entered into among the parties staying this litigation until the expiration of U.S. Patent No. 4,412,986 on November 2, 2000.
On November 9, 1998, Pfizer received an ANDA notice letter from Martec Pharmaceutical, Inc. for generic versions (30 MG., 60 MG., 90 MG.) OF PROCARDIA XL. On or about December 18, 1998, Pfizer received a new ANDA certification letter stating that the ANDA had actually been filed in the name of Martec Scientific, Inc. On December 23, 1998, Pfizer brought an action against Martec Pharmaceutical, Inc. and Martec Scientific, Inc. in the Western District of Missouri for infringement of Bayer's patent relating to nifedipine of a specific particle size. On January 26, 1999, a second complaint was filed against Martec Scientific in the Western District of Missouri based on Martec's new ANDA certification letter. Martec filed its response to this complaint on February 26, 1999. A hearing to determine claim scope is scheduled for June 1, 2000.
Pfizer filed suit on July 8, 1997, against the FDA in the United States District Court for the District of Columbia, seeking a declaratory judgment and injunctive relief enjoining the FDA from processing Mylan's ANDA or any other ANDA submission referencing PROCARDIA XL that uses a different extended-release mechanism. Pfizer's suit alleges that extended-release mechanisms that are not identical to the osmotic pump mechanism of PROCARDIA XL constitute different dosage forms requiring the filing and approval of suitability petitions under the Food Drug and Cosmetics Act before the FDA can accept an ANDA for filing. Mylan intervened in Pfizer's suit. On March 31, 1998, the U.S. District Judge granted the government's motion for summary judgment against the Company. On July 16, 1999, the D.C. Court of Appeals dismissed the appeal on the ground that since the FDA had not approved any ANDA referencing PROCARDIA XL that uses a different extended-release mechanism than the osmotic pump mechanism of PROCARDIA XL, it was premature to maintain this action, stating that Pfizer has the right to bring such an action if, and when, the FDA approves such an ANDA. Subsequent to FDA's final approval of Mylan's ANDA, on December 18, 1999 Pfizer filed suit against FDA in the United States District Court for the District of Delaware. The suit alleges that FDA unlawfully approved Mylan's 30 mg. extended release product because FDA had not granted an ANDA suitability petition reflecting a difference in dosage form from PROCARDIA XL. As a result of the settlement agreement with Mylan, Pfizer and the FDA have agreed to dismiss this suit without prejudice.
DOXAZOSIN PATENT
On March 31, 1999, the Company received notice from TorPharm of its filing, through its U.S. agent Apotex Corp., of an ANDA for 1 mg., 2 mg., 4 mg. and 8 mg. tablets alleged to be bioequivalent to CARDURA (doxazosin mesylate). The notice letter alleges that Pfizer's patent on doxazosin is invalid in view of certain prior art references. Following a review of these allegations, suit was filed in the United States District Court for the Northern District of Illinois against TorPharm and Apotex Corp. on May 14, 1999. The defendants requested a 90-day period in which to file their answer. The request was granted and TorPharm/Apotex's answer was filed by August 19, 1999. Discovery is in progress. On June 2, 1999, FDA was notified that given the patent litigation and pursuant to provisions of the Federal Food Drug and Cosmetic Act, the FDA may not approve the TorPharm application for thirty months from filing or resolution of the litigation.
DRUG SCREENING PATENTS
On May 5, 1999, the Company filed an action against Sibia Neurosciences, Inc. in the United States District Court for the District of Delaware seeking a declaratory judgment that two Sibia patents claiming reporter gene drug screening assays are invalid, not infringed by the Company, and unenforceable due to Sibia's misuse of its patent rights in seeking certain license terms. On May 27, 1999, Sibia Neurosciences, Inc. filed an answer to the Company's declaratory judgment action in which Sibia denies that a prior case or controversy existed, but admits that a case or controversy does now exist regarding at least one patent in suit, denies the invalidity, unenforceability and non-infringement of the patents in suit, and asserts various jurisdictional and equitable defenses, affirmative defenses, and lack of standing by the Company to assert patent misuse. Sibia Neurosciences also filed a counterclaim alleging willful infringement by the Company of one of the patents in suit. A reply to that counterclaim denying Sibia's allegation has been filed. The parties submitted a joint status report to the court on December 14, 1999, in which the parties agreed to complete fact discovery by August 21, 2000, and commence trial on January 8, 2001.
TROVAFLOXACIN PATENT
On May 19, 1999, Abbott Laboratories filed an action against the Company in the United States District Court of the Northern District of Illinois alleging that the Company's use, sale or manufacture of trovafloxacin infringes Abbott's United States Patent No.
4,616,019 claiming naphthyriding antibiotics and seeking a permanent injunction and damages. An answer denying these allegations was filed on June 9, 1999. Discovery is in progress.
ZOLOFT PATENTS
On December 17, 1999, the Company received notice of the filing of an ANDA by Zenith Goldline Pharmaceuticals for 50 mg. and 100 mg. tablets of sertraline hydrochloride alleged to be bioequivalent to ZOLOFT. Zenith has certified to the FDA that it will not engage in the manufacture, use or sale of sertraline hydrochloride until the expiration of Pfizer's U.S. Patent 4,536,518, which covers sertraline per se and expires December 30, 2005. Zenith has also alleged in its certification to the FDA that the manufacture, use and sale of Zenith's product will not infringe Pfizer's U.S. Patent 4,962,128, which covers methods of treating an anxiety-related disorder or Pfizer's U.S. Patent 5,248,699, which covers a crystalline polymorph of sertraline hydrochloride. These patents expire in November 2009 and August 2012, respectively. On January 28, 2000 the Company filed a patent infringement action against Zenith Goldline and its parent Ivax Corporation in the United States District Court for the District of New Jersey for infringement of the `128 and `699 patents.
FLUCONAZOLE PATENT
On February 1, 2000 the Company received notice of the filing of an ANDA by Novopharm Limited for 50 mg, 100 mg, 150 mg and 200 mg tablets of fluconazole alleged to be bioequivalent to DIFLUCAN. Novopharm has certified to the FDA its position that the Company's U.S. Patent 4,404,216, which covers fluconazole, is invalid. This patent expires in January 2004. On March 10, 2000, the Company filed a patent infringement action under the '216 patent against Novopharm in the United States District Court for the Northern District of Illinois.
HYBRID CORN SEED LITIGATION
In pre-existing litigation between Pioneer Hi-Bred International, Inc. and DeKalb Genetics Corporation in the United States District Court for the Southern District of Iowa, the court granted on October 8, 1999 Pioneer's motion to add additional parties, including Pfizer Inc. and Monsanto Co. (the present owner of DeKalb Genetics Corporation), as codefendant parties. The amended complaint, which claims violations of the federal Lanham Act and Iowa state law stemming from the codefendants' alleged use of Pioneer's corn seed germplasm in the development of competitive corn seed products, was served on the Company on October 19. The Company filed its answer on December 15, 1999.
TROVAN TRADEMARK
On September 22, 1999, the jury in a trademark-infringement litigation brought against the Company by Trovan Ltd. and Electronic Identification Devices, Ltd. relating to use of the TROVAN mark for trovafloxacin issued a verdict in favor of the plaintiffs with respect to liability, holding that the Company had infringed Trovan Ltd.'s mark and had acted in bad faith. Following a further damage trial, on October 12, 1999, the jury awarded Trovan Ltd. a total of $143 million in damages, comprised of $5 million actual damages, $3 million as a reasonable royalty and $135 million in punitive damages. The court held a hearing on December 27, 1999, on whether to award the plaintiffs profits based on the company's sales of TROVAN and, if so, the amount of same. On February 24, 2000, the court entered judgment on the jury verdict and enjoined the company's use of the TROVAN mark effective October 16, 2000. The plaintiff's request to be awarded the company's profits from TROVAN sales and for treble damages was denied. The Company's motion for mistrial remains outstanding and will be considered with additional post-trial motions to overturn the jury verdicts and the damage award.
SHILEY INCORPORATED
As previously disclosed, a number of lawsuits and claims have been brought against the Company and Shiley Incorporated, a wholly owned subsidiary, alleging either personal injury from fracture of 60 degree or 70 degree Shiley Convexo Concave ("C/C") heart valves, or anxiety that properly functioning implanted valves might fracture in the future, or personal injury from a prophylactic replacement of a functioning valve.
In an attempt to resolve all claims alleging anxiety that properly functioning valves might fracture in the future, the Company entered into a settlement agreement in January 1992 in Bowling v. Shiley, et al., a case brought in the United States District Court for the Southern District of Ohio, that established a worldwide settlement class of people with C/C heart valves and their spouses, except those who elected to exclude themselves. The settlement provided for a Consultation Fund of $90 million, which was fixed by the number of claims filed, from which valve recipients received payments that are intended to cover their cost of consultation with cardiologists or other health care providers with respect to their valves. The settlement agreement established a second fund of at least $75 million to support C/C valve-related research, including the development of techniques to identify valve recipients who may have significant risk of fracture, and to cover the unreimbursed medical expenses that valve recipients may incur for certain procedures related to the valves. The Company's obligation as to coverage of these unreimbursed medical expenses is not subject to any dollar limitation. Following a hearing on the fairness of the settlement, it was approved by the court on August 19, 1992, and all appeals have been exhausted.
Generally, the plaintiffs in all of the pending heart valve litigations seek money damages. Based on the experience of the Company in defending these claims to date, including insurance proceeds and reserves, the Company is of the opinion that these actions should not have a material adverse effect on the financial position or the results of operations of the Company. Litigation involving insurance coverage for the Company's heart valve liabilities has been resolved.
ENVIRONMENTAL MATTERS
The Company's operations are subject to federal, state, local and foreign environmental laws and regulations. Under the Comprehensive Environmental Response Compensation and Liability Act of 1980, as amended ("CERCLA" or "Superfund"), the Company has been designated as a potentially responsible party by the United States Environmental Protection Agency with respect to certain waste sites with which the Company may have had direct or indirect involvement. Similar designations have been made by some state environmental agencies under applicable state Superfund laws. Such designations are made regardless of the extent of the Company's involvement. There are also claims that the Company may be a responsible party or participant with respect to several waste site matters in foreign jurisdictions. Such claims have been made by the filing of a complaint, the issuance of an administrative directive or order, or the issuance of a notice or demand letter. These claims are in various stages of administrative or judicial proceedings. They include demands for recovery of past governmental costs and for future investigative or remedial actions. In many cases, the dollar amount of the claim is not specified. In most cases, claims have been asserted against a number of other entities for the same recovery or other relief as was asserted against the Company. The Company is currently participating in remedial action at a number of sites under federal, state, local and foreign laws.
To the extent possible with the limited amount of information available at this time, the Company has evaluated its responsibility for costs and related liability with respect to the above sites and is of the opinion that the Company's liability with respect to these sites should not have a material adverse effect on the financial position or the results of operations of
the Company. In arriving at this conclusion, the Company has considered, among other things, the payments that have been made with respect to the sites in the past; the factors, such as volume and relative toxicity, ordinarily applied to allocate defense and remedial costs at such sites; the probable costs to be paid by the other potentially responsible parties; total projected remedial costs for a site, if known; existing technology; and the currently enacted laws and regulations. The Company anticipates that a portion of these costs and related liability will be covered by available insurance.
ASBESTOS MATTERS
Through the early 1970s, Pfizer Inc. (Minerals Division) and Quigley Company, Inc. ("Quigley"), a wholly owned subsidiary, sold a minimal amount of one construction product and several refractory products containing some asbestos. These sales were discontinued thereafter. Although these sales represented a minor market share, the Company has been named as one of a number of defendants in numerous lawsuits. These actions, and actions related to the Company's sale of talc products in the past, claim personal injury resulting from exposure to asbestos-containing products, and nearly all seek general and punitive damages. In these actions, the Company or Quigley is typically one of a number of defendants, and both are members of the Center for Claims Resolution (the "CCR"), a joint defense organization of sixteen defendants that is defending these claims. The Company and Quigley are responsible for varying percentages of defense and liability payments for all members of the CCR. A number of cases alleging property damage from asbestos-containing products installed in buildings have also been brought against the Company, but most have been resolved.
As of January 29, 2000, there were 57,328 personal injury claims pending against Quigley and 26,890 such claims against the Company (excluding those that are inactive or have been settled in principle), and 68 talc cases against the Company.
The Company believes that its costs incurred in defending and ultimately disposing of the asbestos personal injury claims, as well as the property damage and talc claims, will be largely covered by insurance policies issued by several primary insurance carriers and a number of excess carriers that have agreed to provide coverage, subject to deductibles, exclusions, retentions and policy limits. Litigation against excess insurance carriers seeking damages and/or declaratory relief to secure their coverage obligations has now been largely resolved, although claims against several of such insureds do remain pending. Based on the Company's experience in defending the claims to date and the amount of insurance coverage available, the Company is of the opinion that the actions should not ultimately have a material adverse effect on the financial position or the results of operations of the Company.
BRAND-NAME PRESCRIPTION DRUGS ANTITRUST LITIGATION
In 1993, the Company was named, together with numerous other manufacturers of brand-name prescription drugs and certain companies that distribute brand-name prescription drugs, in suits in federal and state courts brought by various groups of retail pharmacy companies, alleging that the manufacturers violated the Sherman Act by agreeing not to give retailers certain discounts and that the failure to give such discounts violated the Robinson Patman Act. A class action was brought on the Sherman Act claim, as well as additional actions by approximately 3,500 individual retail pharmacies and a group of chain and supermarket pharmacies (the "individual actions") on both the Sherman Act and Robinson Patman Act claims. A retailer class was certified in 1994 (the "Federal Class Action"). In 1996, fifteen manufacturer defendants, including the Company, settled the Federal Class Action. The Company's share was $31.25 million, payable in four annual installments without interest. Trial began in September 1998 for the class case against the non-settlers, and the District Court also permitted the opt-out plaintiffs to add the
wholesalers as named defendants in their cases. The District Court dismissed the case at the close of the plaintiffs' evidence. The plaintiffs appealed and, on July 13, 1999, the Court of Appeals upheld most of the dismissal but remanded on one issue, while expressing doubts that the plaintiffs could prove any damages. The District Court has since opined that the plaintiffs cannot prove such damages.
Retail pharmacy cases also have been filed in state courts in five states, and consumer class actions were filed in state courts in fourteen states and the District of Columbia alleging injury to consumers from the failure to give discounts to retail pharmacy companies.
In addition to its settlement of the retailer Federal Class Action (see above), the Company has also settled several major opt-out retail cases, and along with other manufacturers: (1) has entered into an agreement to settle all outstanding consumer class actions (except Alabama, California, New Mexico, North Dakota, South Dakota and West Virginia), which settlement is going through the approval process in the various courts in which the actions are pending; and (2) has entered into an agreement to settle the California consumer case, which has been approved by the Court there.
The Company believes that these brand-name prescription drug antitrust cases, which generally seek damages and certain injunctive relief, are without merit.
The Federal Trade Commission opened an investigation focusing on the pricing practices at issue in the above pharmacy antitrust litigation. In July 1996, the Commission issued a subpoena for documents to the Company, among others, to which the Company responded. A second subpoena was issued to the Company for documents in May 1997 and the Company again responded. We are not aware of any further activity.
PLAX
FDA administrative proceedings relating to PLAX are pending, principally an industry-wide call for data on all anti-plaque products by the FDA. The call-for-data notice specified that products that have been marketed for a material time and to a material extent may remain on the market pending FDA review of the data, provided the manufacturer has a good faith belief that the product is generally recognized as safe and effective and is not misbranded. The Company believes that PLAX satisfied these requirements and prepared a response to the FDA's request, which was filed on June 17, 1991. This filing, as well as the filings of other manufacturers, is still under review and is currently being considered by an FDA Advisory Committee. The Committee has issued a draft report recommending that plaque removal claims should not be permitted in the absence of data establishing efficacy against gingivitis. The process of incorporating the Advisory Committee recommendations into a final monograph is expected to take several years. If the draft recommendation is ultimately accepted in the final monograph, although it would have a negative impact on sales of PLAX, it will not have a material adverse effect on the sales, financial position or operations of the Company.
On January 15, 1997, an action was filed in Circuit Court, Chambers County, Alabama, purportedly on behalf of a class of consumers, variously defined by the laws or types of laws governing their rights and encompassing residents of up to 47 states. The complaint alleges that the Company's claims for PLAX were untrue, entitling them to a refund of their purchase price for purchases since 1988. A hearing on Plaintiffs' motion to certify the class was held on June 2, 1998. We are awaiting the Court's decision. The Company believes the complaint is without merit.
RID
Since December 1998, four actions have been filed, in state courts in Houston, San Francisco, Chicago and New Orleans, purportedly on behalf of statewide (California) or nationwide (Houston, Chicago and New Orleans) classes of consumers who allege that
the Company's and other manufacturers' advertising and promotional claims for RID and other pediculicides were untrue, entitling them to refunds, other damages and/or injunctive relief. The Houston case has been voluntarily dismissed and proceedings in the San Francisco, Chicago and New Orleans cases are still in early stages of the proceedings. The Company believes the complaints are without merit.
DESITIN
In December, 1999 and January, 2000, two suits were filed in California state courts against the Company and other manufacturers of zinc oxide-containing powders. The first suit was filed by the Center for Environmental Health and the second was filed by an individual plaintiff on behalf of a purported class of purchasers of baby powder products. The suits generally allege that the label of DESITIN powder violates California's "Proposition 65" by failing to warn of the presence of lead, which is alleged to be a carcinogen. In January, 2000, the Company received a notice from a California environmental group alleging that the labeling of DESITIN ointment and powder violates Proposition 65 by failing to warn of the presence of cadmium, which is alleged to be a carcinogen. Several other manufacturers of zinc oxide-containing topical baby products have received similar notices. The Company believes that the labeling for DESITIN complies with applicable legal requirements.
FDA REQUIRED POST-MARKETING REPORTS
In April 1996, the Company received a Warning Letter from the FDA relating to the timeliness and completeness of required post-marketing reports for pharmaceutical products. The letter did not raise any safety issue about Pfizer drugs. The Company has been implementing remedial actions designed to remedy the issues raised in the letter. During 1997, the Company met with the FDA to apprise them of the scope and status of these activities. A review of the Company's new procedures was undertaken by FDA in 1999. The Company and Agency met to review the findings of this review and agreed that commitments and remedial measures undertaken by the Company related to the Warning Letter have been accomplished. The Company agreed to keep the Agency informed of its activities as it continues to modify its processes and procedures.
TROVAN
During May and June, 1999, the FDA and the European Union's Committee for Proprietary Medicinal Products (CPMP) reconsidered the approvals to market Trovan, a broad-spectrum antibiotic, following post-market reports of severe adverse liver reactions to the drug. On June 9, the company announced that, regarding the marketing of TROVAN in the United States, it had agreed to restrict the indications, limit product distribution, make certain other labeling changes and to communicate revised warnings to health care professionals in the United States. On July 1, Pfizer received the opinion of the CPMP recommending a one-year suspension of the licenses to market TROVAN in the European Union. The CPMP opinion has been finalized in a Final Decision by the European Commission. Since June, 1999, three suits and several claims have been received by the Company alleging liver injuries due to the ingestion of TROVAN. The majority of these claims have been resolved without litigation. In June and July, 1999, two of the lawsuits were filed in the Circuit Court, Hampton County, South Carolina on behalf of a purported class of all persons who received TROVAN, seeking compensatory and punitive damages and injunctive relief. One of the suits, seeking injunctive relief, has been dismissed. No substantive proceedings have yet occurred in the other suit and the Company believes that it is not properly maintainable as a class action, and will defend against it accordingly.
RIMADYL
In October 1999 the Company was sued in an action seeking unspecified damages, costs and attorney's fees on behalf of a purported class of people whose dogs had suffered injury or death after ingesting RIMADYL, an antiarthritic medication for older dogs. The suit, which was filed in state court in South Carolina, is in the
early pretrial stages. The Company believes it is without merit.
MEDICAL TECHNOLOGY GROUP
During 1998, the Company completed the sale of all of the businesses and companies that were part of the Medical Technology Group. As part of the sale provisions, the Company has retained responsibility for certain items, including matters related to the sale of MTG products sold by the Company before the sale of the MTG businesses. A number of cases have been brought against Howmedica Inc. (some of which also name the Company) alleging that P.C.A. one-piece acetabular hip prostheses sold from 1983 through 1990 were defectively designed and manufactured and pose undisclosed risks to implantees. These cases have now been resolved. Between 1994 and 1996, seven class actions alleging various injuries arising from implantable penile prostheses manufactured by American Medical Systems were filed and ultimately dismissed or discontinued. Thereafter, between late 1996 and early 1998, approximately 700 former members of one or more of the purported classes, represented by some of the same lawyers who filed the class actions, filed individual suits in Circuit Court in Minneapolis alleging damages from their use of implantable penile prostheses. Most of these claims, along with a number of filed and unfiled claims from other jurisdictions, have now been resolved. The Company believes that most if not all of these cases are without merit.
DIABINESE (BRAZIL)
In June, the Ministry of Justice of the State of Sao Paulo, Brazil, commenced a civil public action against the Company's Brazilian subsidiary, Laboratorios Pfizer Ltda. ("Pfizer Brazil") asserting that during a period in 1991 Pfizer Brazil withheld sale of the pharmaceutical product DIABINESE in violation of antitrust and consumer protection laws. The action sought the award of moral, economic and personal damages to individuals and the payment to a public reserve fund. In February 1996, the trial court issued a decision holding Pfizer Brazil liable. The trial court's opinion also established the amount of moral damages for individuals who might make claims later in the proceeding and set out a formula for calculating the payment into the public reserve fund which could have resulted in a sum of approximately $88 million. Pfizer Brazil appealed this decision. In September 1999, the appeals court issued a ruling upholding the trial court's decision as to liability. However, the appeals court decision overturned the trial court's decision concerning damages, ruling that criteria to apply in the calculation of damages, both as to individuals and as to payment of any amounts to the reserve fund, should be established only in a later stage of the proceeding. The Company believes that this action should not have a material adverse effect on the financial position or the results of operations of the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
EXECUTIVE OFFICERS OF THE COMPANY
As of March 10, 2000, the following executive officers of the Company hold the offices indicated until their successors are chosen and qualified after the next annual meeting of shareholders.
NAME AGE POSITION
Brian W. Barrett........ 60 Vice President; President - Animal Health Group M. Kenneth Bowler....... 57 Vice President - Federal Government Relations Loretta V. Cangialosi... 41 Vice President; Corporate Controller C. L. Clemente.......... 62 Executive Vice President, Corporate Affairs; Secretary and Corporate Counsel; Member of the Corporate Management Committee Gary N. Jortner......... 54 Vice President; Senior Vice President, Product Development- Pfizer Pharmaceuticals Group Karen L. Katen.......... 51 Senior Vice President; Executive Vice President - Pfizer Pharmaceuticals Group and President - U.S. Pharmaceuticals; Member of the Corporate Management Committee J. Patrick Kelly........ 42 Vice President; Senior Vice President - Worldwide Marketing - Pfizer Pharmaceuticals Group Alan G. Levin........... 37 Vice President; Treasurer Henry A. McKinnell...... 57 President and Chief Operating Officer; President - Pfizer Pharmaceuticals Group; Member of the Corporate Management Committee Paul S. Miller.......... 60 Executive Vice President; General Counsel; Member of the Corporate Management Committee George M. Milne, Jr..... 56 Senior Vice President; President - Central Research; Member of the Corporate Management Committee John F. Niblack......... 61 Vice Chairman; Member of the Corporate Management Committee William J. Robison...... 64 Executive Vice President - Corporate Employee Resources; Member of the Corporate Management Committee Craig Saxton............ 57 Vice President; Executive Vice President - Central Research David L. Shedlarz....... 51 Executive Vice President and Chief Financial Officer; Member of the Corporate Management Committee Mohand Sidi Said........ 61 Vice President; Senior Vice President - Pfizer Pharmaceuticals Group and Area President - Asia/Africa/Middle East William C. Steere, Jr... 63 Chairman of the Board and Chief Executive Officer; Chair of the Corporate Management Committee Frederick W. Telling.... 48 Vice President, Corporate Strategic Planning and Policy
Information concerning Messrs. Steere, Clemente and Miller and Drs. McKinnell and Niblack is incorporated by reference from the discussion under the captions NOMINEES FOR DIRECTORS WHOSE TERMS EXPIRE IN 2003, DIRECTORS WHOSE TERMS EXPIRE IN 2001 AND NAMED EXECUTIVE OFFICERS WHO ARE NOT DIRECTORS in Chapter Five of our joint proxy statement/prospectus for the 2000 Annual Meeting of Shareholders.
BRIAN W. BARRETT
Mr. Barrett joined us in 1966 and has held various financial positions, including Chief Financial Officer of Pfizer Canada. In 1971, he was appointed Assistant Controller of Pfizer International in New York; in 1973, Director of International Planning and in 1976, Director of Planning. In 1980, Mr. Barrett was appointed Vice President - Corporate Strategic Planning; in 1983, he became Vice President - Finance for Pfizer International; in 1985, President - -Africa/Middle East; and in 1991, President - Asia/Canada. In 1992, Mr. Barrett was elected one of our Vice Presidents and in 1993, became President, Northern Asia, Australasia and Canada - International Pharmaceuticals Group. Mr. Barrett was named Executive Vice President, International Pharmaceuticals Group, in 1995 and President - Animal Health Group in April 1996.
M. KENNETH BOWLER
Dr. Bowler joined us in 1989 and was elected Vice President - Federal Government Relations in 1990. He formerly served as Staff Director for the House Ways and Means Committee. Dr. Bowler also was on the faculty of the University of Maryland as an Assistant Professor in the Political Science Department.
LORETTA V. CANGIALOSI
Ms. Cangialosi joined us in 1993 as Assistant Manager, Corporate Ledger in the Controllers Division. In 1995 she was named Manager, External Financial Reporting and in 1997 became Director, Accounting Advisory Services. Ms. Cangialosi was named Senior Director, Corporate Accounting in January 1999, and in September 1999 was elected our Vice President; Corporate Controller.
GARY N. JORTNER
Mr. Jortner joined us in 1973 as a Systems Analyst for Pfizer Pharmaceuticals. In 1974, he transferred to product management and progressed through a series of promotions that resulted in his being named Group Product Manager for Pfizer Labs in 1978. In 1981, he became Vice President of Marketing for Pfizer Labs. In 1986, he was promoted to Vice President of Operations for Pfizer Labs. In 1991, he was named Vice President and General Manager, Pfizer Labs Division. In 1992, Mr. Jortner was elected one of our Vice Presidents. In 1994, he was named Vice President; Group Vice President, Disease Management - U.S. Pharmaceuticals Group. In 1997, he became Vice President, Product Development -Pfizer Pharmaceuticals Group, and in 1998, he was promoted to Senior Vice President, Product Development - Pfizer Pharmaceuticals Group.
KAREN L. KATEN
Ms. Katen joined us in 1974 as a Marketing Associate for Pfizer Pharmaceuticals. Beginning in 1975, she progressed through a number of positions of increasing responsibility in the Roerig product management group which resulted in her being named Group Product Manager in 1978. In 1980, she transferred to Pfizer Labs as a Group Product Manager and later became Director, Product Management. In 1983, she returned to Roerig as Vice President-Marketing. In 1986, she was named Vice President and General Manager-Roerig Division. In 1992, she was elected one of our Vice Presidents, and in 1993, became Executive Vice President of the U.S. Pharmaceuticals Group. In 1995 Ms. Katen was named President of the U.S. Pharmaceuticals Group, and in 1997 became Executive Vice President - Pfizer Pharmaceuticals Group. In May 1999 Ms. Katen was elected a Senior Vice President of the Company.
Ms. Katen is a Director of General Motors Corporation and Harris Corporation and serves
on the International Council of J.P. Morgan & Co.
J. PATRICK KELLY
Mr. Kelly joined us in 1981 as a Marketing Research Associate in the Pharmaceuticals Division. He became Product Analyst in 1982 and, in 1983, was made Marketing Associate in the Roerig Division. He progressed through a series of positions of increasing responsibility and became Group Product Manager for Roerig in 1989. In 1992, he was named Vice President-Marketing, Roerig in the U.S. Pharmaceuticals Group and, in 1994, became its Group Vice President, Disease Management. In 1996, he was elected one of our Vice Presidents and, in 1997, was named Senior Vice President, Disease Management U.S. Pharmaceuticals, and later that year became Vice President - Pfizer Pharmaceuticals Group and Senior Vice President - U.S. Pharmaceuticals. In 1998, Mr. Kelly was named Senior Vice President-Worldwide Marketing - Pfizer Pharmaceuticals Group.
ALAN G. LEVIN
Mr. Levin joined us in 1987 as Senior Operations Auditor for the Controller's Division. In 1988, he joined the Treasurer's Division as Controller of the Pfizer International Bank in San Juan, Puerto Rico. He returned to New York in 1991 as Director-Finance, Asia, and in 1993 was named Senior Director-Finance, Asia. In 1995, Mr. Levin was elected our Treasurer. In 1997, he was elected Vice President; Treasurer.
GEORGE M. MILNE, JR.
Dr. Milne joined us in 1970 as a Research Scientist and was promoted to Senior Research Scientist and then Project Manager in 1973 and 1974, respectively. In 1978, Dr. Milne became a Discovery Manager with responsibility for research programs targeting inflammation, pain and mental disease. Following additional postdoctoral training and research in pharmacology, he was promoted to Director and then Executive Director of the Department of Immunology and Infectious Diseases. In 1985, Dr. Milne was appointed the Vice President of global Research and Development Operations before becoming the Senior Vice President of Research and Development in 1988. In 1993, Dr. Milne was elected one of our Vice Presidents and, since that same year, has been President of our Central Research Division. In May 1999 Dr. Milne was elected a Senior Vice President of the Company. Dr. Milne is a Director of Mettler-Toledo Corporation, Inc.
WILLIAM J. ROBISON
Mr. Robison joined us in 1961 as a Sales Representative for Pfizer Labs. After serving in a number of positions of increasing responsibility in the Labs division, he was appointed Vice President of Sales in 1980, and Senior Vice President - Pfizer Labs in 1986. In 1990, he was appointed Vice President and General Manager of Pratt Pharmaceuticals. In 1992, he was named President of the Consumer Health Care Group, and was elected one of our Vice Presidents. In 1996, Mr. Robison was elected Senior Vice President - Corporate Employee Resources, and in May 1999 was elected an Executive Vice President of the Company.
CRAIG SAXTON
Dr. Saxton joined us in 1976 as Clinical Projects Director for the Central Research Division of Pfizer Limited in Sandwich, England. In 1981, he was named Senior Associate Medical Director for the International Division of Pfizer Inc and, in 1982, became the Division's Vice President, Medical Director. Dr. Saxton became Senior Vice President, Clinical Research and Development for the Central Research Division in 1988. In 1993, he was named Executive Vice President - Central Research and was elected one of our Vice Presidents.
DAVID L. SHEDLARZ
Mr. Shedlarz joined us in 1976 as Senior Financial Analyst in the Pharmaceuticals Division. Following a series of positions of increasing responsibility, including service as financial manager and controller of the Marketing/Sales/Production, Diagnostics
Division, he was promoted to Production Controller of the U.S. Pharmaceuticals Division in 1979. He was appointed Assistant Group Controller - U.S. Pharmaceuticals Division in 1981. In 1984, Mr. Shedlarz assumed responsibilities as Group Controller and was promoted to Vice President of Finance of the U.S. Pharmaceuticals Group in 1989. He was elected our Vice President - Finance in 1992, and was named our Chief Financial Officer in 1995. Mr. Shedlarz became our Senior Vice President in 1997, and in May 1999 was elected an Executive Vice President of the Company.
MOHAND SIDI SAID
Mr. Sidi Said joined us in 1965 as a professional sales representative. During his career, he has held a variety of management assignments in Algeria, Morocco, Kenya, Egypt, France, Belgium and the United States. In 1996, he was elected one of our Vice Presidents and was also named Senior Vice President - Pfizer Pharmaceuticals Group and Area President -Asia/Africa/Middle East.
FREDERICK W. TELLING
Dr. Telling joined Pfizer Pharmaceuticals and Diagnostic Products Group in 1977 and progressed through a number of positions of increasing responsibility before being named Director of Planning for the Pharmaceuticals Division in 1981. In 1987, he was named Vice President of Planning and Policy and, in 1994, Senior Vice President of Planning and Policy for the U.S. Pharmaceuticals Group. In October 1994, Dr. Telling was elected our Vice President, Corporate Strategic Planning and Policy.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The principal market for our Common Stock is the New York Stock Exchange. It is also listed on the London, Paris, Brussels and Swiss Stock Exchanges and is traded on various United States regional stock exchanges. Additional information required by this item is incorporated by reference from the table QUARTERLY CONSOLIDATED FINANCIAL DATA on page 61 of our 1999 Annual Report.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
Historical financial information is incorporated by reference from the FINANCIAL SUMMARY on page 62 of our 1999 Annual Report.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Information required by this item is incorporated by reference from the FINANCIAL REVIEW on pages 28 through 37 of our 1999 Annual Report.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Information required by this item is incorporated by reference from the discussion under the heading FINANCIAL RISK MANAGEMENT on page 36 of our 1999 Annual Report.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Information required by this item is incorporated by reference from the INDEPENDENT AUDITORS' REPORT found on page 38 and from the consolidated financial statements, related notes and supplementary data on pages 39 through 61 of our 1999 Annual Report.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY
Information about our Directors is incorporated by reference from the discussion under Item 3 in Chapter Five of our joint proxy statement/prospectus for the 2000 Annual Meeting of Shareholders. The balance of the response to this item is contained in the discussion entitled EXECUTIVE OFFICERS OF THE COMPANY in Part I of this report.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information about executive compensation is incorporated by reference from the discussion under the heading EXECUTIVE COMPENSATION OF PFIZER in Chapter Five of our joint proxy statement/prospectus for the 2000 Annual Meeting of Shareholders.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information about security ownership of certain beneficial owners and management is incorporated by reference from the discussion under the heading SECURITY OWNERSHIP OF PFIZER'S OFFICERS AND DIRECTORS in Chapter Five of our joint proxy statement/prospectus for the 2000 Annual Meeting of Shareholders.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information about certain relationships and transactions with related parties is incorporated by reference from the discussion under the heading RELATED TRANSACTIONS in Chapter Five of our joint proxy statement/prospectus for the 2000 Annual Meeting of Shareholders.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
14 (a)(1) FINANCIAL STATEMENTS The following consolidated financial statements, related notes and independent auditors' report from the 1999 Annual Report to Shareholders are incorporated by reference into Item 8 of Part II of this report:
PAGE(S) IN OUR 1999 ANNUAL REPORT
Independent Auditors' Report..................................... 38 Segment Information.............................................. 60 Geographic Data.................................................. 60 Consolidated Statement of Income................................. 39 Consolidated Balance Sheet....................................... 40 Consolidated Statement of Shareholders' Equity................... 41 Consolidated Statement of Cash Flows............................. 42 Notes to Consolidated Financial Statements....................... 43-60 Quarterly Consolidated Financial Data (unaudited)................ 61
14(a)(2) FINANCIAL STATEMENT SCHEDULES Schedules are omitted because they are not required or the information is given elsewhere in the financial statements. The financial statements of unconsolidated subsidiaries are omitted because, considered in the aggregate, they would not constitute a significant subsidiary.
14(a)(3) EXHIBITS THESE EXHIBITS ARE AVAILABLE UPON REQUEST. REQUESTS SHOULD BE DIRECTED TO C.L. CLEMENTE, SECRETARY, PFIZER INC., 235 EAST 42ND STREET, NEW YORK, NY 10017-5755.
3(i) - Our Restated Certificate of Incorporation as of April 22, 1999, is incorporated by reference from our 10-Q report for the period ended April 4, 1999.
3(ii) - Our By-laws as amended June 24, 1999, are incorporated by reference from Exhibit 3(ii) of our 10-Q report for the period ended July 4, 1999.
4(i) - Our Rights Agreement dated as of October 6, 1997, with ChaseMellon Shareholders Services, L.L.C. is incorporated by reference from our report on Form 8-K dated October 6, 1997.
10(i) - Stock and Incentive Plan as amended through July 1, 1999.
10(ii) - Pfizer Retirement Annuity Plan as amended through November 6, 1997 is incorporated by reference from our 1997 10-K report.
10(iii) - The form of severance agreement with the Named Executive Officers identified in our Proxy Statement for the 2000 Annual Meeting of Shareholders is incorporated by reference from
our 1994 10-K report.
10(iv) - Nonfunded Deferred Compensation and Supplemental Savings Plan is incorporated by reference from our 1996 10-K report.
10(v) - Executive Annual Incentive Plan is incorporated by reference from the exhibit to our Proxy Statement for the 1997 Annual Meeting of Shareholders.
10(vi) - Performance-Contingent Share Award Program is incorporated by reference from Exhibit 10.3 to our 10-Q report for the period ended September 29, 1996.
10(vii) - Nonfunded Supplemental Retirement Plan is incorporated by reference from our 1996 10-K report.
10(viii) - The form of Indemnification Agreement with Directors is incorporated by reference from our 1996 10-K report.
10(ix) - The form of Indemnification Agreement with Named Executive Officers is incorporated by reference from our 1997 10-K report.
10(x) - Non-Employee Directors' Retirement Plan (frozen as of October 1996) is incorporated by reference from our 1996 10-K report.
10(xi) - Annual Retainer Unit Award Plan (for Non-Employee Directors) is incorporated by reference from Exhibit 10.1 to our 10-Q report for the period ended September 29, 1996.
10(xii) - Nonfunded Deferred Compensation and Unit Award Plan for Non-Employee Directors is incorporated by reference from Exhibit 10.2 to our 10-Q report for the period ended September 29, 1996.
10(xiii) - Restricted Stock Plan for Non-Employee Directors is incorporated by reference from our 1996 10-K report.
10(xiv) - Deferred Compensation Plan is incorporated by reference from our 1997 10-K report.
10(xv) - Summary of Annual Incentive Plan.
12 - Computation of Ratio of Earnings to Fixed Charges.
13(a) - The 1999 Annual Report to Shareholders, which, except for those portions incorporated by reference, is furnished solely for the information of the Commission and is not to be deemed "filed."
21 - Subsidiaries of the Company.
23 - Consent of KPMG LLP, independent certified public accountants.
27.1 - Financial Data Schedule for Period Ended December 31, 1999.
27.2 - Financial Data Schedule for Period Ended December 31, 1998.
27.3 - Financial Data Schedule for Period Ended December 31, 1997.
14(b) REPORTS ON FORM 8-K
The Company filed reports on Form 8-K during the last quarter of 1999 dated November 8, 1999; November 12, 1999; November 16, 1999; December 1, 1999; December 8, 1999; December 14, 1999 and December 15, 1999. All reports include information reportable under Item 5 of Form 8-K that related to our proposed merger with Warner-Lambert.
SIGNATURES
Under the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, this report was signed on behalf of the Registrant by the authorized person named below.
Pfizer Inc.
BY: /S/ C.L. CLEMENTE Dated: March ___, 2000 ------------------------------------- C.L. Clemente, Executive Vice President, Secretary and Corporate Counsel
Under the requirements of the Securities Exchange Act of 1934, this report was signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
SIGNATURES TITLE DATE ---------- ----- ----
/S/ WILLIAM C. STEERE, JR. Chairman of the Board, Director March 24, 2000 - -------------------------- (William C. Steere, Jr.) (Principal Executive Officer)
/S/ DAVID L. SHEDLARZ Executive Vice President March 24, 2000 - -------------------------- and Chief Financial Officer (David L. Shedlarz) (Principal Financial Officer)
/S/ LORETTA V. CANGIALOSI Vice President - Controller March 24, 2000 - -------------------------- (Principal Accounting Officer) (Loretta V. Cangialosi)
/S/ MICHAEL S. BROWN Director March 24, 2000 - -------------------------- (Michael S. Brown)
Director March 24, 2000 - -------------------------- (M. Anthony Burns)
/S/ W. DON CORNWELL Director March 24, 2000 - -------------------------- (W. Don Cornwell)
SIGNATURES TITLE DATE ---------- ----- ----
Director March 24, 2000 - -------------------------- (George B. Harvey)
/S/ CONSTANCE J. HORNER Director March 24, 2000 - -------------------------- (Constance J. Horner)
/S/ STANLEY O. IKENBERRY Director March 24, 2000 - -------------------------- (Stanley O. Ikenberry)
/S/ HARRY P. KAMEN Director March 24, 2000 - -------------------------- (Harry P. Kamen)
/S/ THOMAS G. LABRECQUE Director March 24, 2000 - -------------------------- (Thomas G. Labrecque)
/S/ DANA G. MEAD Director March 24, 2000 - -------------------------- (Dana G. Mead)
/S/ HENRY A. MCKINNELL President, Chief Operating March 24, 2000 - -------------------------- Officer and Director (Henry A. McKinnell)
/S/ JOHN F. NIBLACK Vice Chairman and Director March 24, 2000 - -------------------------- (John F. Niblack)
/S/ FRANKLIN D. RAINES Director March 24, 2000 - -------------------------- (Franklin D. Raines)
SIGNATURES TITLE DATE ---------- ----- ----
/S/ RUTH J. SIMMONS Director March 24, 2000 - -------------------------- (Ruth J. Simmons)
/S/ JEAN PAUL VALLES Director March 24, 2000 - -------------------------- (Jean-Paul Valles) | 18,914 | 124,072 |