Quarterly Report
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 


FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2006

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     .

COMMISSION FILE NUMBER: 000-26489

ENCORE CAPITAL GROUP, INC.

(Exact name of registrant as specified in its charter)

 

Delaware   48-1090909

(State or other jurisdiction of

incorporation or organization)

 

(IRS Employer

Identification No.)

8875 Aero Drive, Suite 200

San Diego, California

  92123
(Address of principal executive offices)   (Zip code)

(877) 445 - 4581

(Registrant’s telephone number, including area code)

(Not Applicable)

(Former name, former address and former fiscal year, if changed since last report)

 


Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the last 90 days.

Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  ¨    Accelerated filer  x    Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).

Yes  ¨    No  x

Indicate the number of shares outstanding of each of the issuer’s classes of stock, as of the latest practicable date.

 

Class

   Outstanding at July 24, 2006

Common Stock, $0.01 par value

   22,776,478 shares

 



Table of Contents

ENCORE CAPITAL GROUP, INC.

INDEX TO FORM 10-Q

 

     Page

PART I – FINANCIAL INFORMATION

  

Item 1 – Consolidated Financial Statements

  

Unaudited Condensed Consolidated Statements of Financial Condition

   2

Unaudited Condensed Consolidated Statements of Operations

   3

Unaudited Condensed Consolidated Statement of Stockholders’ Equity

   4

Unaudited Condensed Consolidated Statements of Cash Flows

   5

Notes to Unaudited Condensed Consolidated Financial Statements

   7

Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations

   24

Supplemental Performance Data

   35

Item 3 – Quantitative and Qualitative Disclosures about Market Risk

   43

Item 4 – Controls and Procedures

   43

PART II – OTHER INFORMATION

   44

Item 1 – Legal Proceedings

   44

Item 1A – Risk Factors

   45

Item 4 – Submission of Matters to a Vote of Security Holders

   48

Item 6 – Exhibits

   49

SIGNATURES

   50

Certification of Principal Executive Officer

  

Certification of Principal Financial Officer

  

Certification of the Principal Executive and Financial Officers pursuant to Section 906 of the SARBANES-OXLEY ACT of 2002

  


Table of Contents

PART I. FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

ENCORE CAPITAL GROUP, INC.

Condensed Consolidated Statements of Financial Condition

(In Thousands, Except Par Value Amounts)

 

     June 30,
2006
(Unaudited)
   December 31,
2005 (A)

Assets

     

Cash and cash equivalents

   $ 10,078    $ 7,026

Restricted cash

     4,027      4,212

Accounts receivable, net

     3,565      5,515

Investment in receivable portfolios, net

     253,437      256,333

Property and equipment, net

     4,775      5,113

Prepaid income tax

     9,331      13,570

Purchased servicing asset

     1,934      3,035

Forward flow asset

     33,690      38,201

Other assets

     17,790      16,065

Goodwill

     14,205      14,148

Identifiable intangible assets, net

     4,427      5,227
             

Total assets

   $ 357,259    $ 368,445
             

Liabilities and stockholders’ equity

     

Liabilities:

     

Accounts payable and accrued liabilities

   $ 19,679    $ 23,101

Accrued profit sharing arrangement

     12,848      16,528

Deferred tax liabilities, net

     9,463      7,241

Deferred revenue

     1,524      3,326

Purchased servicing obligation

     1,080      1,776

Debt

     177,369      198,121
             

Total liabilities

     221,963      250,093
             

Commitments and contingencies

     

Stockholders’ equity:

     

Convertible preferred stock, $.01 par value, 5,000 shares authorized, no shares issued and outstanding

     —        —  

Common stock, $.01 par value, 50,000 shares authorized, 22,777 shares and 22,651 shares issued and outstanding as of June 30, 2006 and December 31, 2005, respectively

     228      227

Additional paid-in capital

     62,652      57,989

Accumulated earnings

     72,098      59,925

Accumulated other comprehensive income

     318      211
             

Total stockholders’ equity

     135,296      118,352
             

Total liabilities and stockholders’ equity

   $ 357,259    $ 368,445
             

(A) Derived from the audited consolidated financial statements as of December 31, 2005.

See accompanying notes to condensed consolidated financial statements.

 

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ENCORE CAPITAL GROUP, INC.

Condensed Consolidated Statements of Operations

(In Thousands, Except Per Share Amounts)

(Unaudited)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2006     2005     2006     2005  

Revenues

        

Revenue from receivable portfolios, net

   $ 59,604     $ 53,519     $ 117,178     $ 103,939  

Servicing fees and other related revenue

     6,329       239       9,235       295  
                                

Total revenues

     65,933       53,758       126,413       104,234  
                                

Operating expenses

        

Salaries and employee benefits

     16,306       12,375       32,585       24,975  

Stock-based compensation expense

     1,464       —         2,845       —    

Cost of legal collections

     12,944       8,631       24,222       16,987  

Other operating expenses

     5,655       4,150       12,101       8,792  

Collection agency commissions

     5,032       3,462       9,645       5,486  

General and administrative expenses

     3,300       2,869       7,033       5,027  

Depreciation and amortization

     968       417       1,928       928  
                                

Total operating expenses

     45,669       31,904       90,359       62,195  
                                

Income before other income (expense) and income taxes

     20,264       21,854       36,054       42,039  
                                

Other income (expense)

        

Interest expense

     (7,337 )     (8,384 )     (15,288 )     (16,471 )

Other income

     284       203       334       608  
                                

Total other expense

     (7,053 )     (8,181 )     (14,954 )     (15,863 )
                                

Income before income taxes

     13,211       13,673       21,100       26,176  

Provision for income taxes

     (5,716 )     (5,576 )     (8,927 )     (10,627 )
                                

Net income

   $ 7,495     $ 8,097     $ 12,173     $ 15,549  
                                

Basic - earnings per share computation:

        

Net income available to common stockholders

   $ 7,495     $ 8,097     $ 12,173     $ 15,549  
                                

Weighted average shares outstanding

     22,776       22,286       22,729       22,257  
                                

Earnings per share – Basic

   $ 0.33     $ 0.36     $ 0.54     $ 0.70  
                                

Diluted - earnings per share computation:

        

Net income available to common stockholders

   $ 7,495     $ 8,097     $ 12,173     $ 15,549  
                                

Weighted average shares outstanding

     22,776       22,286       22,729       22,257  

Incremental shares from assumed conversion of stock options

     615       1,231       663       1,309  
                                

Diluted weighted average shares outstanding

     23,391       23,517       23,392       23,566  
                                

Earnings per share – Diluted

   $ 0.32     $ 0.34     $ 0.52     $ 0.66  
                                

See accompanying notes to condensed consolidated financial statements.

 

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ENCORE CAPITAL GROUP, INC.

Condensed Consolidated Statement of Stockholders’ Equity

(Unaudited, In Thousands)

 

     Common Stock    Additional
Paid-In
Capital
  

Accumulated

Earnings

  

Accumulated

Other

Comprehensive
Income

  

Total

Equity

  

Comprehensive

Income

     Shares    Par               

Balance at December 31, 2005

   22,651    $ 227    $ 57,989    $ 59,925    $ 211    $ 118,352   

Net income

   —        —        —        12,173      —        12,173    $ 12,173

Other comprehensive income:

                    

unrealized gain on non-qualified deferred compensation plan assets

   —        —        —        —        107      107      107

Exercise of stock options

   126      1      143      —        —        144      —  

Stock-based compensation related to stock options

   —        —        2,845      —        —        2,845      —  

Tax benefit related to stock option exercises

   —        —        793      —        —        793      —  

Tax benefit from convertible note interest expense

   —        —        882      —        —        882      —  
                                              

Balance at June 30, 2006

   22,777    $ 228    $ 62,652    $ 72,098    $ 318    $ 135,296    $ 12,280
                                              

See accompanying notes to condensed consolidated financial statements.

 

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ENCORE CAPITAL GROUP, INC.

Condensed Consolidated Statements of Cash Flows

(Unaudited, In Thousands)

 

     Six Months Ended
June 30,
 
     2006     2005  

Operating activities

    

Gross collections

   $ 166,802     $ 136,260  

Less:

    

Amounts collected on behalf of third parties

     (351 )     (597 )

Amounts applied to principal on receivable portfolios

     (49,411 )     (31,724 )

Servicing fees

     99       295  

Operating expenses

     (81,201 )     (61,754 )

Interest payments

     (6,095 )     (2,776 )

Contingent interest payments

     (12,601 )     (16,412 )

Other income

     334       608  

Decrease in restricted cash

     185       502  

Income taxes

     (863 )     (10,702 )

Excess tax benefits from stock-based payment arrangements

     (749 )     —    
                

Net cash provided by operating activities

     16,149       13,700  
                

Investing activities

    

Cash paid for Jefferson Capital acquisition

     —         (142,860 )

Purchases of receivable portfolios

     (43,842 )     (44,862 )

Collections applied to principal of receivable portfolios

     49,411       31,724  

Proceeds from the sale of marketable securities

     —         40,000  

Proceeds from put-backs of receivable portfolios

     1,984       739  

Purchases of property and equipment

     (790 )     (1,051 )
                

Net cash provided by (used in) investing activities

     6,763       (116,310 )
                

Financing activities

    

Proceeds from notes payable and other borrowings

     4,500       167,366  

Repayment of notes payable and other borrowings

     (25,134 )     (54,025 )

Capitalized loan costs

     —         (2,103 )

Proceeds from exercise of common stock options and warrants

     144       685  

Excess tax benefits from stock-based payment arrangements

     749       —    

Repayment of capital lease obligations

     (119 )     (95 )
                

Net cash (used in) provided by financing activities

     (19,860 )     111,828  
                

Net increase in cash

     3,052       9,218  

Cash and cash equivalents, beginning of period

     7,026       9,731  
                

Cash and cash equivalents, end of period

   $ 10,078     $ 18,949  
                

See accompanying notes to condensed consolidated financial statements.

 

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ENCORE CAPITAL GROUP, INC.

Condensed Consolidated Statements of Cash Flows (cont.)

Reconciliation of Net Income to Net Cash Provided by Operating Activities

(Unaudited, In Thousands)

 

     Six Months Ended
June 30,
 
     2006     2005  

Net income

   $ 12,173     $ 15,549  

Adjustments to reconcile net income to net cash provided by operating activities:

    

Depreciation and amortization

     1,928       928  

Amortization of loan costs

     737       142  

Stock-based compensation expense

     2,845       55  

Tax benefit from convertible note interest expense

     882       —    

Tax benefit from stock option exercises

     793       881  

Deferred income tax expense (benefit)

     2,222       (2,109 )

Excess tax benefits from stock-based payment arrangements

     (749 )     —    

Impairment on receivable portfolios, net

     (146 )     —    

Changes in operating assets and liabilities

    

Decrease in restricted cash

     185       502  

Decrease (increase) in other assets

     534       (619 )

Decrease in prepaid income tax

     4,239       1,153  

Decrease in accrued profit sharing arrangement

     (3,680 )     (2,839 )

(Decrease) increase in accounts payable and accrued liabilities

     (5,814 )     57  
                

Net cash provided by operating activities

   $ 16,149     $ 13,700  
                

See accompanying notes to condensed consolidated financial statements.

 

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ENCORE CAPITAL GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1: Ownership and Description of Business

Encore Capital Group, Inc. (“Encore”) together with its subsidiaries (the “Company”) is a systems-driven purchaser and manager of charged-off consumer receivable portfolios and provider of bankruptcy services to the finance industry. The Company acquires its receivable portfolios at deep discounts from their face values using its proprietary valuation process that is based on the consumer attributes of the underlying accounts. Based upon the Company’s ongoing analysis of these accounts, it employs a dynamic mix of collection strategies to maximize its return on investment. The receivable portfolios the Company purchases consist primarily of unsecured, charged-off domestic consumer credit card, auto deficiency, telecom, and healthcare receivables purchased from national financial institutions, major retail credit corporations, telecom companies and resellers of such portfolios. Acquisitions of receivable portfolios are financed by operations and by borrowings from third parties. See Note 6 for further discussion of the Company’s debt.

Encore is a Delaware holding company whose principal assets are its investments in various wholly owned subsidiaries.

Note 2: Summary of Significant Accounting Policies

Significant Accounting Policies

Please refer to the Company’s annual report on Form 10-K as of and for the year ended December 31, 2005 for a summary of the Company’s significant accounting policies.

Basis of Presentation

The accompanying unaudited interim condensed consolidated financial statements of the Company have been prepared in accordance with Rule 10-01 of Regulation S-X promulgated by the Securities and Exchange Commission and, therefore, do not include all information and footnotes necessary for a fair presentation of financial position, results of operations and cash flows in conformity with accounting principles generally accepted in the United States of America (“GAAP”). However, in the Company’s opinion, the accompanying unaudited interim condensed consolidated financial statements contain all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the Company’s consolidated financial position as of June 30, 2006, its consolidated results of operations for the three and six months ended June 30, 2006 and 2005, and its cash flows for the six months ended June 30, 2006 and 2005. The unaudited interim condensed consolidated results of operations of the Company for the three and six months ended June 30, 2006 may not be indicative of future results. These unaudited interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s annual report on Form 10-K as of and for the year ended December 31, 2005, filed with the Securities and Exchange Commission on March 15, 2006.

 

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Effects of New Accounting Pronouncements

On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123R (“SFAS No. 123R”) “Share-Based Payment,” which addresses the accounting for stock-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. SFAS No. 123R is a revision of Statement of Financial Accounting Standards No. 123 (“SFAS No. 123”), “Accounting For Stock-Based Compensation.” In January 2005, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 107, which provides supplemental implementation guidance for SFAS No. 123R. SFAS No. 123R eliminates the ability to account for stock-based compensation transactions using the intrinsic value method under Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees”, and instead generally requires that such transactions be accounted for using a fair-value-based method. SFAS No. 123R requires establishing assumptions and estimates of weighted-average fair value per share of options granted and performance shares issued, as well as using a valuation model to calculate the fair value of stock-based awards. The Company uses the Black-Scholes option-pricing model to determine the fair-value of stock-based awards, which is consistent with that used for pro forma disclosures under SFAS No. 123. The Company has elected the modified prospective transition method as permitted by SFAS No. 123R and accordingly prior periods have not been restated to reflect the impact of SFAS No. 123R. The modified prospective transition method requires that stock-based compensation expense be recorded for all new and unvested stock options, and restricted stock units, that are ultimately expected to vest as the requisite service is rendered beginning on January 1, 2006. Stock-based compensation expense for awards granted prior to January 1, 2006 is based on the grant date fair-value as determined under the pro forma provisions of SFAS No. 123. In accordance with SFAS No. 123R, beginning in the first quarter of 2006, the Company has presented excess tax benefits from the exercise of stock-based compensation awards as a financing activity in the Condensed Consolidated Statement of Cash Flows.

Changes in Accounting Estimate

During the quarter ended June 30, 2006, the Company revised its Unified Collection Score (“UCS”) methodology by extending the collection forecast from 60 months to 72 months. UCS is a proprietary forecasting tool that generates portfolio level expectations of liquidation for portfolios that the Company has owned and serviced for greater than 6 months. For forecasting portfolios owned and serviced less than six months, the Company uses its proprietary Behavioral Liquidation Score (“BLS”) model. The BLS methodology forecasts portfolio level expectations based on credit characteristics of the portfolio over a 54-month period. The Company has observed that receivable portfolios purchased in 2001 and prior have consistently experienced cash collections beyond 60 months from the date of purchase, in some cases 6 to 8 years from the date of purchase. When the Company first developed its cash forecasting models in 2001, limited historical collection data was available with which to accurately model projected cash flows beyond 60 months. With additional collection data accumulated over the last several years, the forecasting models have been improved and the Company believes it has enough collection history to forecast collections to 72 months. Extending the collection forecast in our UCS model from 60 months to 72 months resulted in an increase in the aggregate total estimated remaining collections for the receivable portfolios by $86.0 million or 13.6% as of June 30, 2006. The extension of the collection forecasts is being treated as a change in estimate and, in accordance with

 

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Statement of Financial Accounting Standard No. 154, “Accounting Changes and Error Corrections – a replacement of APB Opinion No. 20 and FASB Statement No. 3,” (“SFAS No. 154”) is being recognized prospectively in the consolidated financial statements. This prospective treatment resulted in an increase in revenue of $0.9 million and an increase in the accrual for contingent interest of $0.4 million for the quarter ended June 30, 2006. The net impact of the change in estimate was to increase second quarter pretax income by $0.5 million, net income by $0.3 million and fully diluted earnings per share by $0.01.

New Accounting Pronouncement

On July 13, 2006, the Financial Accounting Standards Board issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (“FIN No. 48”), which is effective for fiscal years beginning after December 15, 2006. FIN No. 48 establishes recognition and measurement thresholds that must be met before a tax benefit can be recognized in the financial statements. The Company is currently analyzing the effects of the new standard and its potential impact on its financial statements.

Reclassification

Certain amounts included in the accompanying prior periods’ condensed consolidated financial statements have been reclassified to conform to the current period presentation.

Upon completion of a detailed analysis performed on its net tax assets during the quarter ended March 31, 2006, the Company determined that additional tax portfolio amortization deductions should be reflected as an increase in its prepaid income tax balance with a corresponding decrease in the net deferred tax assets. The amount reclassified on the Company’s consolidated statement of condition as of December 31, 2005 was $9.3 million. This reclassification relates to a temporary difference between GAAP and tax accounting, and accordingly has no impact to the consolidated statements of operations.

Note 3: Stock-Based Compensation

On January 1, 2006, the Company implemented SFAS No. 123R, which is a revision of SFAS No. 123. SFAS No. 123R requires establishing assumptions and estimates of the weighted-average fair value of stock options granted and restricted stock issued (“performance shares”), as well as using a valuation model to calculate the fair value of stock-based awards. The Company uses the Black-Scholes option-pricing model to determine the fair-value of stock-based awards. All options are amortized over the requisite service periods of the awards, which are generally the vesting periods. The below assumptions are used by the Company to determine the fair value of stock-based awards.

Expected Life. The expected life of options granted represents the period of time for which the options are expected to be outstanding. An independent third party performed valuation procedures, which took into account the percentage of option exercises, the percentage of options that expired unexercised, and the percentage of options outstanding. The Company used this valuation as guidance to determine the expected life of the options, which is three years.

Expected Volatility. The expected volatility is based on the historical volatility of the Company’s common stock over the weighted-average vesting term of the options, which is three years.

 

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Risk-Free Interest Rate. The risk-free interest rate is derived from the U.S. Treasury yield curve in effect at the date of grant.

Dividends. The Company does not currently anticipate paying any cash dividends on its common stock. Consequently, the Company uses an expected dividend yield of zero in the Black-Scholes option valuation model.

Forfeitures. SFAS No. 123R requires the Company to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. To determine an expected forfeiture rate, the Company examined the historical employee turnover rate over the last 3 years as a proxy for forfeitures. The forfeitures are based on data specific to each employee class under the assumption that different classes of employees can act differently because of title, rank, number of options granted, and other like characteristics. For the purposes of this analysis, these classes included: (i) officers (as defined under Section 16 of the Securities Exchange Act of 1934) and (ii) all others receiving options. Based on the internal analysis, the expected forfeiture rates were determined to be 0.8% for officers and 6.6% for all others. For purposes of calculating pro forma information under SFAS No. 123 for periods prior to January 1, 2006, the Company accounted for forfeitures as they occurred.

The fair value of options granted was estimated at the date of grant using a Black-Scholes option-pricing model with the following weighted-average assumptions:

 

     Six Months Ended
June 30, 2006
  Six Months Ended
June 30, 2005

Weighted average fair value of options granted

   $5.34   $13.39

Risk free interest rate

   4.95%   3.87%

Dividend yield

   0.0%   0.0%

Volatility factor of the expected market price of the Company’s common stock

   45.84%   124.06%

Weighted-average expected life of options

   3 Years   5 Years

Compensation expense is recognized only for those options expected to vest, with forfeitures estimated at the date of grant based on the Company’s historical experience and future expectations. For the three and six months ended June 30, 2006, $1.5 million and $2.8 million was recognized as stock-based compensation expense under SFAS No. 123R, respectively. Unrecognized compensation cost related to stock options and performance shares as of June 30, 2006 was $12.4 million and the weighted-average life of these outstanding stock options and performance shares is approximately 2.6 years. The fair value of options vested were $2.9 million and $3.2 million during the six months ended June 30, 2006 and 2005, respectively.

Prior to the adoption of SFAS No. 123R, the Company measured stock-based compensation expense for its employee stock-based compensation plans using the intrinsic value method prescribed by APB Opinion No. 25. The Company applied the disclosure provisions of SFAS No. 123 as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure” as if the fair-value-based method had been applied in measuring compensation expense. Under APB Opinion No. 25, when the exercise price of the Company’s employee stock

 

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options was equal to the market price of the underlying stock on the date of the grant, no compensation expense was recognized.

The following table illustrates the effect on net income after taxes and net income per common share as if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based compensation during the following periods (in thousands, except per share amounts):

 

     Three Months Ended
June 30, 2005
    Six Months Ended
June 30, 2005
 

Net income, as reported

   $ 8,097     $ 15,549  

Plus: Stock-based employee compensation expense included in reported net income, net of tax

     16       33  

Less: Total stock-based employee compensation expense determined under fair value based method, net of tax

     (738 )     (1,300 )
                

Pro forma net income

   $ 7,375     $ 14,282  
                

Earnings per share:

    

Basic – as reported

   $ 0.36     $ 0.70  
                

Basic – pro forma

   $ 0.33     $ 0.64  
                

Diluted – as reported

   $ 0.34     $ 0.66  
                

Diluted – pro forma

   $ 0.31     $ 0.61  
                

The 1999 Equity Participation Plan (1999 Plan), as amended, reserved up to 3,300,000 shares for grant to employees, directors and consultants. Pursuant to the 1999 Plan, the Company could grant options at a price not less than 85.0% of the fair market value on the date of the grant and for a term not to exceed ten years. Options generally vested ratably over a three-year period unless otherwise determined by the Compensation Committee of the Board of Directors.

On March 30, 2005, the Board of Directors of the Company adopted a new 2005 Stock Incentive Plan (2005 Plan) for Board members, employees, officers, and executives of, and consultants and advisors to, the Company. The 2005 Plan was effective as of March 30, 2005, and was approved by the Company’s stockholders at the annual meeting on May 3, 2005. The 2005 Plan provides for the granting of incentive stock options, nonqualified stock options, stock appreciation rights, restricted stock, performance shares, and performance-based awards to eligible individuals. Upon adoption, an aggregate of 1,500,000 shares of the Company’s common stock were available for awards under the 2005 Plan, plus ungranted shares of stock that were available for future awards under the 1999 Plan. In addition, shares subject to options granted under either the 1999 Plan or the 2005 Plan that terminate or expire without being exercised are available for grant under the 2005 Plan.

On November 1, 2005, the Company adopted a new long-range incentive program (“Performance Shares”) for officers, executives, and other eligible employees pursuant to the 2005 Plan. The Company issued 62,550 performance share grants that could vest from 2006 to 2010, depending on whether certain performance criteria are achieved. If such performance criteria are not met, 50% of the shares will vest in 2010 and the remaining 50% will be forfeited. The performance share grants issued were valued at $16.19 per share, which is the fair market value at

 

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the date of grant, and in accordance with SFAS No. 123R are being amortized on a straight line basis over the expected vesting period of five years.

Performance Shares activity and related information is as follows for the six months ended June 30, 2006:

 

Performance Shares

  

Non-Vested

Shares

    Weighted-
Average
Grant
Date Fair
Value

Beginning of period December 31, 2005

   62,550     $ 16.19

Awarded

   —         —  

Released

   —         —  

Cancelled/forfeited

   (14,850 )     16.19
            

End of period as of June 30, 2006

   47,700     $ 16.19
            

A summary of the Company’s stock option activity and related information is as follows for the six months ended June 30, 2006:

 

     Number of
Shares
    Option Price
Per Share
   Weighted-
Average
Exercise
Price
  

Aggregate
Intrinsic
Value

(in thousands)

Outstanding at December 31, 2005

   2,664,228     $ 0.35 -$20.30    $ 9.99   

Granted

   127,499       10.60 - 14.59      11.76   

Cancelled/forfeited

   (144,215 )     11.00 -16.19      13.49   

Exercised

   (126,328 )     0.35 -1.30      1.14   
                      

Outstanding at June 30, 2006

   2,521,184     $ 0.35 -$20.30    $ 10.32    $ 18,988
                      

The total intrinsic value of options exercised during the six months ended June 30, 2006 and 2005 was $1.4 million and $2.0 million, respectively.

The following table summarizes outstanding and exercisable options as of June 30, 2006:

 

     Options Outstanding    Options Exercisable
Exercise Prices    Number
Outstanding
   Weighted-
Average
Exercise
Price
   Weighted-
Average
Remaining
Life
   Number
Outstanding
   Weighted-
Average
Exercise
Price
$0.35 - $0.52    618,665    $ 0.50    6.17    549,221    $ 0.50
1.00    200,004      1.00    4.71    200,004      1.00
1.30    78,831      1.30    6.58    78,831      1.30
2.95    37,500      2.95    6.81    37,500      2.95
4.50    833      4.50    6.85    833      4.50
10.60    42,000      10.60    9.93    —        —  
11.00    166,668      11.00    7.33    166,668      11.00
12.01    74,999      12.01    7.33    74,999      12.01
14.59    10,500      14.59    9.83    —        —  
15.42    300,000      15.42    8.84    100,000      15.42
16.17    148,334      16.17    7.77    108,342      16.17
16.19    312,850      16.19    9.34    —        —  
16.93    10,000      16.93    7.85    6,667      16.93
17.83    35,000      17.83    8.95    11,667      17.83
18.02    150,000      18.02    9.09    —        —  
18.63    250,000      18.63    8.22    50,000      18.63
20.09    60,000      20.09    8.59    20,000      20.09
20.30    25,000      20.30    8.67    8,334      20.30
                              
$0.35 - $20.30    2,521,184    $ 10.32    7.58    1,413,066    $ 6.05
                              

 

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Note 4: Investment in Receivable Portfolios, Net

Commencing January 1, 2005, the Company began accounting for its investment in receivable portfolios in accordance with the provisions of AICPA Statement of Position 03-03 (“SOP 03-03”), “Accounting for Certain Debt Securities in a Transfer.” SOP 03-03 addresses accounting for differences between initial estimated cash flows expected to be collected from purchased receivables, or “pools”, and subsequent changes to those estimated cash flows. SOP 03-03 limits the revenue that may be accreted, (also known as accretable yield), to the excess of the Company’s estimate of undiscounted cash flows expected to be collected over the Company’s investment, or cost basis, in the pool.

As permitted by SOP 03-03, static pools are established on a quarterly basis with accounts purchased during the quarter that have common risk characteristics. Discrete receivable portfolio purchases during a quarter are aggregated into pools based on these common risk characteristics. Once a static pool is established, the portfolios are permanently assigned to the pool. The discount (i.e., the difference between the cost of each static pool and the related aggregate contractual receivable balance) is not recorded because the Company expects to collect a relatively small percentage of each static pool’s contractual receivable balance. As a result, receivable portfolios are recorded at cost at the time of acquisition. All portfolios with common risk characteristics purchased prior to the adoption of SOP 03-03 were aggregated by quarter of purchase.

In compliance with SOP 03-03, the Company accounts for its investments in consumer receivable portfolios, using either the interest method or the cost recovery method. The interest method applies an effective interest rate, or internal rate of return (“IRR”) to the cost basis of the pool, which is to remain level, or unchanged throughout the life of the pool unless there is an increase in subsequent expected cash flows. Subsequent increases in cash flows expected to be collected generally are recognized prospectively through an upward adjustment of the pool’s effective interest rate over its remaining life. Subsequent decreases in expected cash flows do not change the effective interest rate, but are recognized as an impairment of the cost basis of the pool, and are reflected in the consolidated statement of operations as a reduction in revenue with a corresponding valuation allowance offsetting the investment in receivable portfolios in the consolidated statement of financial condition.

The Company accounts for each static pool as a unit for the economic life of the pool (similar to one loan) for recognition of revenue from receivable portfolios, for collections applied to the cost basis of receivable portfolios and for provision for loss or impairment. Revenue from receivable portfolios is accrued based on each pool’s effective interest rate applied to each pool’s adjusted cost basis. The cost basis of each pool is increased by revenue earned and decreased by gross collections and impairments.

If the amount and timing of future cash collections on a pool of receivables are not reasonably estimable, the Company accounts for such portfolios on the cost recovery method (“Cost Recovery Portfolios”). The accounts in these portfolios have different risk characteristics than those included in other portfolios acquired during the same quarter, or the necessary information was not available to estimate future cash flows and, accordingly, they were not

 

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aggregated with other portfolios. Under the cost recovery method of accounting, no income is recognized until the purchase price of a Cost Recovery Portfolio has been fully recovered. At June 30, 2006, one Cost Recovery Portfolio with a book value of $3.0 million was accounted for using the cost recovery method.

During the quarter ended June 30, 2006, the Company revised its UCS methodology by extending the collection forecast from 60 months to 72 months. UCS is a proprietary forecasting tool that generates portfolio level expectations of liquidation for portfolios that the Company has owned and serviced for greater than 6 months. For forecasting portfolios owned and serviced less than six months, the Company uses its proprietary Behavioral Liquidation Score (“BLS”) model. The BLS methodology forecasts portfolio level expectations based on credit characteristics of the portfolio over a 54-month period. The Company has observed that receivable portfolios purchased in 2001 and prior have consistently experienced cash collections beyond 60 months from the date of purchase, in some cases 6 to 8 years from the date of purchase. When the Company first developed its cash forecasting models in 2001, limited historical collection data was available with which to accurately model projected cash flows beyond 60 months. With additional collection data accumulated over the last several years, the forecasting models have been improved and the Company believes that it has enough collection history to forecast collections to 72 months. Extending the collection forecast in our UCS model from 60 months to 72 months resulted in an increase in the aggregate total estimated remaining collections for the receivable portfolios by $86.0 million or 13.6% as of June 30, 2006. The extension of the collection forecasts is being treated as a change in estimate and, in accordance with SFAS No. 154 is being recognized prospectively in the financial statements. This prospective treatment resulted in an increase in revenue of $0.9 million and an increase in the accrual for contingent interest of $0.4 million for the quarter ended June 30, 2006. The net impact of the change in estimate was to increase second quarter pretax income by $0.5 million, net income by $0.3 million and fully diluted earnings per share by $0.01.

Accretable yield represents the amount of revenue the Company expects to generate over the remaining life of its existing investment in receivable portfolios based on estimated future cash flows. Total accretable yield is the difference between future estimated collections and the current cost basis of a portfolio. The following table summarizes the Company’s accretable yield and an estimate of zero basis future cash flows at the beginning and end of the current period (in thousands):

 

     Six Months Ended June 30, 2006  
     Estimate of
Zero Basis
Cash Flows
    Accretable
Yield
    Total  

Beginning balance at December 31, 2005

   $ 57,116     $ 360,961     $ 418,077  

Revenue recognized, net

     (6,507 )     (51,067 )     (57,574 )

(Reductions) additions on existing portfolios

     (6,615 )     7,175       560  

Additions for current purchases

     —         28,708       28,708  
                        

Balance at March 31, 2006

   $ 43,994     $ 345,777     $ 389,771  

Revenue recognized, net

     (6,734 )     (52,870 )     (59,604 )

Additions on existing portfolios

     19,961       7,326       27,287  

Additions for 12 month curve extension

     —         86,020       86,020  

Additions for current purchases

     —         22,950       22,950  
                        

Balance at June 30, 2006

   $ 57,221     $ 409,203     $ 466,424  
                        

 

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     Six Months Ended June 30, 2005  
     Estimate of
Zero Basis
Cash Flows
    Accretable
Yield
    Total  

Beginning balance at December 31, 2004

   $ 72,740     $ 263,139     $ 335,879  

Revenue recognized, net

     (10,360 )     (40,060 )     (50,420 )

Additions on existing portfolios

     11,432       26,162       37,594  

Additions for current purchases

     —         22,450       22,450  
                        

Balance at March 31, 2005

   $ 73,812     $ 271,691     $ 345,503  

Revenue recognized, net

     (9,230 )     (44,289 )     (53,519 )

Additions on existing portfolios

     1,694       10,130       11,824  

Additions for current purchases

     —         141,611       141,611  
                        

Balance at June 30, 2005

   $ 66,276     $ 379,143     $ 445,419  
                        

During the three months ended June 30, 2006, the Company purchased receivable portfolios with a face value of $594.2 million for $21.3 million, or a purchase cost of 3.58% of face value. The estimated collections at acquisition for these portfolios amounted to $44.2 million. During the six months ended June 30, 2006, the Company purchased receivable portfolios with a face value of $1.2 billion for $48.4 million, or a purchase cost of 4.2% of face value. The estimated collections at acquisition for these portfolios amounted to $100.0 million.

All collections realized after the net book value of a portfolio has been fully recovered (“Zero Basis Portfolios”) are recorded as revenue (“Zero Basis Revenue”). During the three months ended June 30, 2006 and 2005, approximately $6.7 million and $9.2 million, respectively, was recognized as revenue on portfolios for which the related cost basis has been fully recovered. During the six months ended June 30, 2006 and 2005, approximately $13.2 million and $19.6 million, respectively, was recognized as revenue on portfolios for which the related cost basis has been fully recovered.

The following table summarizes the changes in the net balance of the investment in receivable portfolios during the six months ended June 30, 2006 (in thousands, except percentages):

 

     For the Six Months Ended June 30, 2006  
     Accrual Basis
Portfolios
    Cost Recovery
Portfolios
    Zero Basis
Portfolios
    Total  

Balance, beginning of period

   $ 255,299     $ 1,034     $ —       $ 256,333  

Purchases of receivable portfolios

     44,730       3,623       —         48,353  

Gross collections1

     (151,540 )     (1,665 )     (12,516 )     (165,721 )

Basis adjustments

     (1,982 )     —         (2 )     (1,984 )

Revenue recognized1

     103,792       —         12,518       116,310  

Impairment reversals, net

     146       —         —         146  
                                

Balance, end of period

   $ 250,445     $ 2,992     $ —       $ 253,437  
                                

Revenue as a percentage of collections

     68.6 %     0.0 %     100.0 %     70.3 %
                                

 

1 Gross collections and revenue related to the retained interest are not included in these tables. Zero basis collections and revenue related to the retained interest (which was fully amortized in the second quarter of 2004) were $0.7 million and $1.0 million for the six months ended June 30, 2006 and 2005, respectively.

 

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The following table summarizes the change in the valuation allowance for investment in receivable portfolios during the six months ended June 30, 2006 (in thousands):

 

     Valuation
Allowance
 

Balance at December 31, 2005

   $ 3,143  

Provision for impairment losses

     378  

Reversal of prior allowance

     (90 )
        

Balance at March 31, 2006

   $ 3,431  

Provision for impairment losses

     52  

Reversal of prior allowance

     (486 )
        

Balance at June 30, 2006

   $ 2,997  
        

The Company utilizes various business channels for the collection of its receivable portfolios. The following table summarizes collections by collection channel (in thousands):

 

     Three Months Ended June 30,    Six Months Ended June 30,
     2006    2005    2006    2005

Collection sites

   $ 33,579    $ 31,764    $ 74,861    $ 66,806

Legal collections

     29,065      22,622      54,836      43,819

Sales

     1,985      7,359      9,094      10,656

Collection agencies

     13,951      8,159      26,915      13,687

Other

     606      503      1,096      1,292
                           

Gross collections for the period

   $ 79,186    $ 70,407    $ 166,802    $ 136,260
                           

Note 5: Other Assets

Other assets consist of the following (in thousands):

 

     June 30,
2006
   December 31,
2005

Debt issuance costs, net

   $ 4,872    $ 5,441

Deferred court costs, net

     6,548      3,811

Deferred compensation assets

     3,830      3,887

Prepaid employment agreement

     1,444      1,778

Other

     1,096      1,148
             
   $ 17,790    $ 16,065
             

Note 6: Debt

The Company is obligated under borrowings as follows (in thousands):

 

     June 30,
2006
   December 31,
2005

Convertible Senior Notes

   $ 100,000    $ 100,000

Revolving Credit Facility

     62,669      77,169

Secured Financing Facility

     14,102      19,809

Secured Notes

     —        441

Capital Lease Obligations

     598      702
             
   $ 177,369    $ 198,121
             

 

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Convertible Senior Notes

In 2005, the Company issued $100.0 million of 3.375% convertible senior notes due September 19, 2010 (the “Convertible Notes”). Interest on the Convertible Notes is payable semi-annually in arrears on March 19 and September 19 of each year, commencing March 19, 2006. The Convertible Notes rank equally with the Company’s existing and future senior indebtedness and are senior to the Company’s potential future subordinated indebtedness. The Convertible Notes are convertible prior to maturity, subject to certain conditions described below, into shares of the Company’s common stock at an initial conversion rate of 44.7678 per $1,000 principal amount of notes, which represents an initial conversion price of approximately $22.34 per share, subject to adjustment.

In October 2005, the Company obtained stockholder approval of a net-share settlement feature that allows the Company to settle conversion of the Convertible Notes through a combination of cash and stock. Based on the provisions of Emerging Issues Task Force No. 90-19, “Convertible Bonds with Issuer Option to Settle for Cash upon Conversion” (“EITF 90-19”) and Emerging Issues Task Force No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled In, a Company’s Own Stock” (“EITF 00-19”), the net-settlement feature is accounted for as convertible debt and is not subject to the provisions of Statement of Financial Accounting Standards No. 133 “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”). As a result of the net-settlement feature, the Company will be able to substantially reduce the number of shares issuable in the event of conversion of the Convertible Notes by repaying principal in cash instead of issuing shares of common stock for that amount. Additionally, the Company will not be required to include the underlying shares of common stock in the calculation of the Company’s diluted weighted average shares outstanding for earnings per share until the Company’s common stock price exceeds $22.34.

The aggregate underwriting commissions and other debt issuance costs incurred with respect to the issuance of the Convertible Notes were $3.4 million, which have been capitalized as debt issuance costs on the Company’s consolidated statement of financial condition and are being amortized on an effective interest rate method over the term of the Convertible Notes.

The Convertible Notes also contain a restricted convertibility feature that does not affect the conversion price of the Convertible Notes but, instead, places restrictions on a holder’s ability to convert their Convertible Notes into shares of the Company’s common stock. A holder may convert the Convertible Notes prior to March 19, 2010 only if one or more of the following conditions are satisfied:

 

    the average of the trading prices of the Convertible Notes for any five consecutive trading day period is less than 103% of the average of the conversion values of the Convertible Notes during that period;

 

    the Company makes certain significant distributions to holders of the Company’s common stock;

 

    the Company enters into specified corporate transactions; or

 

    the Company’s common stock ceases to be approved for listing on the Nasdaq National Market and is not listed for trading on a U.S. national securities exchange or any similar U.S. system of automated securities price dissemination.

Holders may also surrender their Convertible Notes for conversion anytime on or after March 19, 2010 until the close of business on the trading day immediately preceding September 19, 2010, regardless of whether any of the

 

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foregoing conditions have been satisfied. Upon the satisfaction of any of the foregoing conditions as of the last day of a reporting period, or during the twelve months prior to September 19, 2010, the Company would write off to expense all remaining unamortized debt issuance costs in that period.

If the Convertible Notes are converted in connection with certain fundamental changes that occur prior to March 19, 2010, the Company may be obligated to pay an additional make-whole premium with respect to the Convertible Notes converted.

Convertible Notes Hedge Strategy. Concurrent with the sale of the Convertible Notes, the Company purchased call options to purchase from the counterparties an aggregate of 4,476,780 shares of the Company’s common stock at a price of $22.34 per share. The cost of the call options totaled $27.4 million. The Company also sold warrants to the same counterparties to purchase from the Company an aggregate of 3,984,334 shares of the Company’s common stock at a price of $29.04 per share and received net proceeds from the sale of these warrants of $11.6 million. Taken together, the call option and warrant agreements have the effect of increasing the effective conversion price of the Convertible Notes to $29.04 per share. The call options and warrants must be settled in net shares. On the date of settlement, if the market price per share of the Company’s common stock is above $29.04 per share, the Company will be required to deliver shares of its common stock representing the value of the call options and warrants in excess of $29.04 per share.

The warrants have a strike price of $29.04 and are generally exercisable at anytime. The Company issued and sold the warrants in a transaction exempt from the registration requirements of the Securities Act of 1933, as amended, because the offer and sale did not involve a public offering. There were no underwriting commissions or discounts in connection with the sale of the warrants.

In accordance with EITF No. 00-19 and Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” the Company recorded the net call options and warrants as a reduction in additional paid in capital as of December 31, 2005, and will not recognize subsequent changes in fair value of the call options and warrants in its condensed consolidated financial statements.

Revolving Credit Facility

In May 2006, the Company amended the Revolving Credit Facility. This second amendment to the Revolving Credit Facility extended the termination date to May 2010, reduced the maximum LIBOR spread by 75 basis points, increased the expansion feature to $50.0 million from $25.0 million and eliminated and modified certain financial covenants. The amended Revolving Credit Facility bears interest at a floating rate equal to, at the Company’s option, either: (a) reserve adjusted LIBOR plus a spread that ranges from 175 to 225 basis points, depending on the Company’s leverage; or (b) the higher of the federal funds rate then in effect plus a spread of 50 basis points or the prime rate then in effect. The applicable margin will be adjusted quarterly based on a pricing grid that takes into account certain financial covenants related to the Company’s consolidated statement of financial condition and results of operations. The amended Revolving Credit Facility is secured by all assets of the Company, except for the assets of the Company’s wholly-owned subsidiary, MRC Receivables Corporation, in which the Company’s former secured lender has a first priority security interest.

 

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The amended Revolving Credit Facility provides for an aggregate revolving commitment of $200.0 million, subject to borrowing base availability, with $5.0 million sub-limits for swingline loans and letters of credit. The Revolving Credit Facility borrowing base provides for an 85.0% initial advance rate for the purchase of qualified receivable portfolios. The borrowing base reduces for each qualifying portfolio by 3% per month beginning after the third complete month subsequent to purchase. The aggregate borrowing base is equal to the lesser of (a) the sum of all of the borrowing bases of all qualified receivable portfolios under this facility, as defined above, or (b) 95% of the net book value of all receivable portfolios acquired on or after January 1, 2005. The Company may request an increase in the amount of revolving credit commitments, under the expansion feature to $250.0 million upon satisfying certain conditions, including acceptance of such increase by existing or replacement lenders under the facility that agree to increase their commitments. This financing arrangement does not require the Company to share residual collections with the lender and may be pre-paid in part or in full anytime without penalty.

The terms of the amended Revolving Credit Facility include restrictions and covenants, which limit, among other things, the payment of dividends and the incurrence of additional indebtedness and liens. The terms also require compliance with financial covenants that establish a minimum net worth threshold and require maintenance of specified ratios for debt to adjusted EBITDA and EBIT to interest expense. Subject to certain exceptions, the dividend restriction referred to above generally provides that the Company will not, during any fiscal year, make distributions with respect to common stock or other equity interests in an aggregate amount in excess of 20% of consolidated net income for such period.

The credit agreement specifies a number of events of default (some of which are subject to applicable cure periods), including, among others, the failure to make payments when due, noncompliance with covenants, and defaults under other agreements or instruments of indebtedness. Upon the occurrence of an event of default, the lenders may terminate the amended Revolving Credit Facility and declare all amounts outstanding to be immediately due and payable.

At June 30, 2006, of the $200.0 million commitment, our outstanding balance was $62.7 million, which bore a weighted average interest rate of 7.7%. Our aggregate borrowing base was $153.7 million, of which $91.1 million was available for future borrowings.

Secured Financing Facility

On December 20, 2000 MRC Receivables Corporation, a wholly owned bankruptcy-remote, special-purpose entity entered into a $75.0 million secured financing facility (the “Secured Financing Facility”) to finance the purchase of receivable portfolios. On December 31, 2004, this facility expired. Amounts outstanding under the Secured Financing Facility accrue interest at the prime rate plus 3.0% per annum, which was 11.25% at June 30, 2006. Principal payments, as defined in the agreement and accrued interest are payable weekly. Notes issued under the facility are collateralized by the charged-off receivables that were purchased with the proceeds from this financing arrangement. Unless amended, each note has a maturity date not to exceed 27 months after the borrowing date. Once an individual note is repaid (and the Company has recovered its investment in the receivable portfolio), the Company and the lender share the residual collections, net of servicing fees paid to the Company. The residual collections paid to the lender are classified as contingent interest. The sharing in residual cash flows continues for

 

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the entire economic life of the receivable portfolios financed using this facility, and will extend substantially beyond the expiration date of the Secured Financing Facility. Estimates of the residual cash flows to be paid to the lender are used to determine an effective interest rate and are accrued each period as contingent interest.

The following table summarizes interest expense associated with the Secured Financing Facility for the periods presented (in thousands):

 

     Three Months Ended June 30,    Six Months Ended June 30,
     2006    2005    2006    2005

Stated interest

   $ 420    $ 876    $ 897    $ 1,900

Contingent interest

     4,235      6,689      8,921      13,572
                           

Total interest expense

   $ 4,655    $ 7,565    $ 9,818    $ 15,472
                           

The Secured Financing Facility had a balance of $14.1 million as of June 30, 2006 and was collateralized by certain charged-off receivable portfolios with an aggregate carrying amount of $40.8 million at that time. The assets pledged under this financing facility, together with their associated cash flows, would not be available to satisfy claims of general creditors of the Company.

Capital Lease Obligations

The Company has capital lease obligations for certain computer equipment. These lease obligations require monthly payments aggregating approximately $21,372 through November 2008 and have implicit interest rates ranging from 2.9% to 3.1%. Capital lease obligations outstanding as of June 30, 2006 were $0.6 million.

Note 7: Income Taxes

The Company recorded an income tax provision of $5.7 million, reflecting an effective rate of 43.3% of pretax income during the three months ended June 30, 2006. The effective tax rate for the three months ended June 30, 2006, consists primarily of a provision for Federal income taxes of 31.9% (which is net of a benefit for state taxes of 3.1%), a provision for state taxes of 8.8%, the effect of permanent book versus tax differences of 0.1% and the effect of an anticipated adjustment related to an Internal Revenue Service tax audit of the Company’s 2003 income tax return of 2.5%, which the Company concluded in the three months ended June 30, 2006, was probable. For the three months ended June 30, 2005 the Company recorded an income tax provision of $5.6 million, reflecting an effective rate of 40.8% of pretax income. The effective tax rate for the three months ended June 30, 2005, consists primarily of a provision for Federal income taxes of 31.9% (which is net of a benefit for state taxes of 3.1%), a provision for state taxes of 8.8%, and the effect of permanent book versus tax differences of 0.1%.

The Company recorded an income tax provision of $8.9 million, reflecting an effective rate of 42.3% of pretax income during the six months ended June 30, 2006. The effective tax rate for the six months ended June 30, 2006, consists primarily of a provision for Federal income taxes of 31.9% (which is net of a benefit for state taxes of 3.1%), a provision for state taxes of 8.8%, the effect of permanent book versus tax differences of 0.1% and the effect of an anticipated adjustment related to an Internal Revenue Service tax audit of the Company’s 2003 income tax return of 1.5%, which the Company concluded in the three months ended June 30, 2006, was probable. For the six months ended June 30, 2005, the Company recorded an income tax provision of $10.6 million, reflecting an effective rate of 40.6% of pretax income. The effective tax rate for the six months ended June 30, 2005, consists

 

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primarily of a provision for Federal income taxes of 31.9% (which is net of a benefit for state taxes of 3.1%), a provision for state taxes of 8.8%, less the effect of permanent book versus tax differences of 0.1%.

Upon completion of a detailed analysis of its net tax assets, performed during the three months ended March 31, 2006, the Company determined that additional tax portfolio amortization deductions should be reflected as an increase in its prepaid income tax balance with a corresponding decrease in the net deferred tax assets. The amount reclassified on the Company’s consolidated statement of condition as of December 31, 2005 was $9.3 million. This reclassification relates to a temporary difference between GAAP and tax accounting, and accordingly has no impact to the consolidated statements of operations.

Note 8: Purchase Concentrations

The following table summarizes the concentration of our purchases by seller sorted by total aggregate costs, for the six months ended June 30, 2006 and 2005, adjusted for put-backs, account recalls and replacements (in thousands, except percentages):

 

    

Concentration of Initial

Purchase Cost by Seller

 
     For The Six Months Ended  
     June 30, 2006     June 30, 2005  
     Cost     %     Cost     %  

Seller 1

   $ 21,009     43.4 %   $ 95,708     68.1 %

Seller 2

     10,331     21.4 %     —       —    

Seller 3

     6,256     12.9 %     —       —    

Seller 4

     4,543     9.4 %     2,370     1.7 %

Seller 5

     3,622     7.5 %     31,211     22.2 %

Seller 6

     1,286     2.7 %     9,347     6.6 %

Seller 7

     743     1.5 %     —       —    

Seller 8

     563     1.2 %     —       —    

Seller 9

     —       —         1,084     0.8 %

Seller 10

     —       —         850     0.6 %
                            
   $ 48,353     100.0 %   $ 140,570     100.0 %

Adjustments1

     (139 )       (200 )  
                    

Purchase, net

   $ 48,214       $ 140,370    
                    

 

1 Adjusted for put-backs, account recalls and replacements.

Note 9: Commitments and Contingencies

Litigation

On October 18, 2004, Timothy W. Moser, a former officer of the Company, filed an action in the United States District Court for the Southern District of California against the Company, and certain individuals, including several of the Company’s officers and directors. On February 14, 2005 the Company was served with an amended complaint in this action alleging defamation, intentional interference with contractual relations, breach of contract, breach of the covenant of good faith and fair dealing, intentional and negligent infliction of emotional distress and civil conspiracy arising out of certain statements in the Company’s Registration Statement on Form S-1 originally filed in September 2003 and alleged to be included in the Company’s Registration Statement on Form S-3 originally

 

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filed in May 2004. The amended complaint seeks injunctive relief, economic and punitive damages in an unspecified amount plus an award of profits allegedly earned by the defendants and alleged co-conspirators as a result of the alleged conduct, in addition to attorney’s fees and costs. On May 2, 2006, the court denied our special motion to strike pursuant to California’s anti-SLAPP statute, denied in part and granted in part our motion to dismiss, denied a variety of ex parte motions and applications filed by the plaintiff and denied the plaintiff’s motion for leave to conduct discovery or file supplemental briefing. The court granted the plaintiff 30 days in which to further amend his complaint, and on June 1, 2006, the plaintiff filed a second amended complaint in which he amended his claim for negligent infliction of emotional distress. On May 25, 2006, we filed a notice of appeal of the court’s order denying the anti-SLAPP motion and on June 16, 2006, we filed a motion to stay the case. The hearing on this motion is scheduled for August 14, 2006. The Company believes the claims are without merit and will vigorously defend the action. Although the outcome of this matter cannot be predicted with certainty, management does not currently believe that this matter will have a material adverse effect on the Company’s consolidated financial position or results of operations.

On September 7, 2005, Mr. Moser filed a related action in the United States District Court for the Southern District of California against Triarc Companies, Inc. (Triarc), a significant stockholder of the Company, alleging intentional interference with contractual relations and intentional infliction of emotional distress. The case arises out of the same statements made or alleged to have been made in the Company’s Registration Statements mentioned above. On January 7, 2006, Triarc was served with an amended complaint seeking injunctive relief, an order directing Triarc to issue a statement of retraction or correction of the allegedly false statements, economic and punitive damages in an unspecified amount and attorney’s fees and costs. Triarc tendered the defense of this action to the Company, and the Company accepted the defense and will indemnify Triarc, pursuant to the indemnification provisions of the Registration Rights Agreements dated as of October 31, 2000 and February 21, 2002, and the Underwriting Agreements dated September 25, 2004 and January 20, 2005 to which Triarc is a party. Although the outcome of this matter cannot be predicted with certainty, management does not currently believe that this matter will have a material adverse effect on the Company’s consolidated financial position or results of operations.

The Fair Debt Collection Practices Act (“FDCPA”) and comparable state statutes may result in class action lawsuits, which can be material to the Company due to the remedies available under these statutes, including punitive damages. Management is aware of a number of cases styled as class actions that have been filed against the Company. To date, a class has been certified in one of these cases. The Company believes that these cases are without merit and intends to vigorously defend them. However, several of these cases present novel issues on which there is no legal precedent. As a result, the Company is unable to predict the range of possible outcomes.

There are a number of other lawsuits or claims pending or threatened against the Company. In general, these lawsuits or claims have arisen in the ordinary course of business and involve claims for actual damages arising from alleged misconduct or improper reporting of credit information by the Company or its employees. Although litigation is inherently uncertain, based on past experience, the information currently available and the possible availability of insurance and/or indemnification from originating institutions in some cases, management of the Company does not believe that the currently pending and threatened litigation or claims will have a material adverse effect on the Company’s consolidated financial position or results of operations. However, future events or

 

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circumstances, currently unknown to management, will determine whether the resolution of pending or threatened litigation or claims will ultimately have a material effect on the Company’s consolidated financial position, liquidity or results of operations in any future reporting periods.

Purchase Commitments

In connection with the Company’s acquisition of Jefferson Capital Group in June 2005, the Company entered into a forward flow agreement to purchase a minimum of $3.0 billion in face value of credit card charge-offs over a five-year period at a fixed price. Future minimum purchase commitments at a fixed price under this agreement are as follows as of June 30, 2006 (amounts in thousands):

 

2006    2007    2008    2009    2010    Total
$18,439    $ 36,876    $ 36,876    $ 36,876    $ 18,438    $ 147,505

The purchase commitment above assumes that the remaining commitment as of June 30, 2006 will be incurred ratably over the remaining term of the agreement.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

“Management’s Discussion and Analysis of Financial Condition and Results of Operations” should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K as of and for the year ended December 31, 2005, filed with the Securities and Exchange Commission. The Form 10-K contains a general description of our industry and a discussion of recent trends affecting the industry. Certain statements herein may constitute “forward-looking statements” under the Private Securities Litigation Reform Act of 1995 (the “Reform Act”), for which we claim the protection of the safe harbor of the Reform Act. See Part II - Item 1A. Risk Factors for more discussion on our forward-looking statements.

Introduction

We are a systems-driven purchaser and manager of charged-off consumer receivable portfolios and a provider of bankruptcy services to the finance industry. We acquire receivable portfolios at deep discounts from their face values using our proprietary valuation process that is based on the consumer attributes of the underlying accounts. Based upon the ongoing analysis of these accounts, we employ a dynamic mix of collection strategies to maximize our return on investment.

Special Committee to Consider Strategic Alternatives

On June 5, 2006, we announced the formation of a special committee of the board of directors (the “Special Committee”) to consider strategic alternatives. The Special Committee is comprised of independent members of our board of directors. The Special Committee has retained J.P. Morgan Securities Inc. and Deutsche Bank Securities Inc. as its financial advisors. The board of directors formed the Special Committee to identify and evaluate various strategic alternatives to enhance stockholder value, including the potential sale of the company. We cannot assure you that this strategic alternatives review process will result in any strategic transaction or sale of the company. We do not intend to disclose developments or provide updates on the progress or status of the strategic alternatives review process or of any strategic alternatives under consideration, unless and until the board of directors has approved a specific transaction.

Overview

Results for the three months ended June 30, 2006 as compared to the three months ended June 30, 2005 are as follows:

 

    Gross collections on receivable portfolios increased $8.8 million, or 12.5%, to $79.2 million

 

    Revenue, excluding Ascension’s bankruptcy servicing fees of $6.2 million, increased $5.9 million, or 11.0%, to $59.7 million. Total revenue increased $12.1 million, or 22.6%, to $65.9 million

 

    Net income decreased $0.6 million, or 7.4%, to $7.5 million

 

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Results for the six months ended June 30, 2006 as compared to the six months ended June 30, 2005 are as follows:

 

    Gross collections on receivable portfolios increased $30.5 million, or 22.4%, to $166.8 million

 

    Revenue, excluding Ascension’s bankruptcy servicing fees of $9.1 million, increased $13.1 million, or 12.5%, to $117.3 million. Total revenue increased $22.2 million, or 21.3%, to $126.4 million

 

    Net income decreased $3.4 million, or 21.7%, to $12.2 million

Although gross collections and revenue were higher for the three and six months ended June 30, 2006 compared to the three and six months ended June 30, 2005, net income was lower. The lower net income for the three months ended June 30, 2006 was primarily the result of the expensing of stock options associated with our adoption of Statement of Financial Accounting Standards No. 123R (“SFAS No. 123R”) “Share-Based Payment,” in the amount of $0.9 million on an after-tax basis, higher operating expenses associated with our higher volume of gross collections, and increased costs associated with new operating initiatives focused on increasing portfolio liquidation and lower effective accretion rates on collections from portfolios purchased in 2004, 2005, and 2006 compared to portfolios purchased in prior years due to a more competitive pricing environment in recent years, offset by after-tax net income of $0.8 million in our subsidiary, Ascension Capital Group, LP, (“Ascension”), increased accretion revenue associated with revising our Unified Collection Score (“UCS”) model by extending our collection forecast from 60 months to 72 months, and increased accretion revenue related to new operating initiatives. The lower net income for the six months ended June 30, 2006 was primarily the result of several factors including the expensing of stock options associated with our adoption of SFAS No. 123R in the amount of $1.7 million on an after-tax basis, the after-tax net loss of $0.5 million in Ascension, higher operating expenses associated with our higher volume of gross collections, and increased costs associated with new operating initiatives focused on increasing portfolio liquidation and lower effective accretion rates on collections from portfolios purchased in 2004, 2005, and 2006 compared to portfolios purchased in prior years due to a more competitive pricing environment in recent years, offset by increased accretion revenue associated with revising our UCS forecasts by extending our collection forecast from 60 months to 72 months, and increased accretion revenue during the quarter ended June 30, 2006 related to new operating initiatives implemented by the Company. The market for the purchase of unsecured charged-off consumer debt has remained competitive and we have continued to be disciplined in our approach to purchasing. During the three and six months ended June 30, 2006, we purchased $21.3 million and $48.4 million, respectively in receivable portfolios and amortized $19.8 million and $49.4 million, respectively in cost basis on our receivable portfolios. Our ability to grow revenue will be based on our ability to increase liquidation on our receivable portfolios, which would increase our internal rates of return applied to the cost basis of the portfolio, and to purchase additional receivable portfolios.

During the three and six months ended June 30, 2006, there was a significant reduction in placements of accounts at Ascension, our bankruptcy servicing business. We believe that this was the result of the large volume of bankruptcy filings in October 2005, just prior to the effective date of the new Bankruptcy Reform Act (the “Act”). We expect placement levels to return to historical levels by early 2007. Also, consistent with our revenue recognition policy, the revenue associated with the significant number of Chapter 7 account placements in October 2005 were recognized during the three months ended June 30, 2006.

 

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Results of Operations

Results of operations in dollars and as a percentage of revenue were as follows (in thousands, except percentages):

 

     Three Months Ended June 30,  
     2006     2005  

Revenue

        

Revenue from receivable portfolios, net

   $ 59,604     90.4 %   $ 53,519     99.6 %

Servicing fees and other related revenue

     6,329     9.6 %     239     0.4 %
                            

Total revenue

     65,933     100.0 %     53,758     100.0 %
                            

Operating expenses

        

Salaries and employee benefits

     16,306     24.7 %     12,375     23.0 %

Stock-based compensation expense

     1,464     2.2 %     —       —    

Cost of legal collections

     12,944     19.6 %     8,631     16.1 %

Other operating expenses

     5,655     8.6 %     4,150     7.7 %

Collection agency commissions

     5,032     7.6 %     3,462     6.4 %

General and administrative expenses

     3,300     5.0 %     2,869     5.3 %

Depreciation and amortization

     968     1.5 %     417     0.8 %
                            

Total operating expenses

     45,669     69.2 %     31,904     59.3 %
                            

Income before other income (expense) and income taxes

     20,264     30.8 %     21,854     40.7 %
                            

Other income (expense)

        

Interest expense

     (7,337 )   (11.1 %)     (8,384 )   (15.6 %)

Other income

     284     0.4 %     203     0.4 %
                            

Total other expense

     (7,053 )   (10.7 %)     (8,181 )   (15.2 %)
                            

Income before income taxes

     13,211     20.1 %     13,673     25.5 %

Provision for income taxes

     (5,716 )   (8.7 %)     (5,576 )   (10.4 %)
                            

Net income

   $ 7,495     11.4 %   $ 8,097     15.1 %
                            
     Six Months Ended June 30,  
     2006     2005  

Revenue

        

Revenue from receivable portfolios, net

   $ 117,178     92.7 %   $ 103,939     99.7 %

Servicing fees and other related revenue

     9,235     7.3 %     295     0.3 %
                            

Total revenue

     126,413     100.0 %     104,234     100.0 %
                            

Operating expenses

        

Salaries and employee benefits

     32,585     25.8 %     24,975     24.0 %

Stock-based compensation expense

     2,845     2.2 %     —       —    

Cost of legal collections

     24,222     19.2 %     16,987     16.3 %

Other operating expenses

     12,101     9.6 %     8,792     8.4 %

Collection agency commissions

     9,645     7.6 %     5,486     5.3 %

General and administrative expenses

     7,033     5.6 %     5,027     4.8 %

Depreciation and amortization

     1,928     1.5 %     928     0.9 %
                            

Total operating expenses

     90,359     71.5 %     62,195     59.7 %
                            

Income before other income (expense) and income taxes

     36,054     28.5 %     42,039     40.3 %
                            

Other income (expense)

        

Interest expense

     (15,288 )   (12.1 %)     (16,471 )   (15.8 %)

Other income

     334     0.3 %     608     0.6 %
                            

Total other expense

     (14,954 )   (11.8 %)     (15,863 )   (15.2 %)
                            

Income before income taxes

     21,100     16.7 %     26,176     25.1 %

Provision for income taxes

     (8,927 )   (7.1 %)     (10,627 )   (10.2 %)
                            

Net income

   $ 12,173     9.6 %   $ 15,549     14.9 %
                            

 

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Comparison of Results of Operations

Revenue

Our revenue is comprised primarily of accretion revenue, zero basis revenue, and servicing fee revenue. Accretion revenue represents revenue derived from pools (quarterly groupings of purchased receivable portfolios) with a cost basis that has not been fully amortized. Revenue from pools with a remaining unamortized cost basis is accrued based on each pool’s effective interest rate applied to each pool’s remaining unamortized cost basis. The cost basis of each pool is increased by revenue earned and decreased by gross collections and impairments. The effective interest rate is the internal rate of return derived from the timing and amounts of actual cash received and anticipated future cash flow projections for each pool. We account for our investment in receivable portfolios utilizing the interest method in accordance with the provisions of the AICPA’s Statement of Position 03-03, “Accounting for Certain Debt Securities Acquired in a Transfer” (“SOP 03-03”).

During the quarter ended June 30, 2006, we revised our UCS methodology by extending the collection forecast from 60 months to 72 months. UCS is a proprietary forecasting tool that generates portfolio level expectations of liquidation for portfolios that we have owned and serviced for greater than 6 months. For forecasting portfolios owned and serviced less than six months, we use our proprietary Behavioral Liquidation Score (“BLS”) model. The BLS methodology forecasts portfolio level expectations based on credit characteristics of the portfolio over a 54-month period. We have observed that receivable portfolios purchased in 2001 and prior have consistently experienced cash collections beyond 60 months from the date of purchase, in some cases 6 to 8 years from the date of purchase. When we first developed our cash forecasting models in 2001, we had limited historical collection data with which to accurately model projected cash flows beyond 60 months. With additional collection data accumulated over the last several years, we have improved the forecasting models and we believe that we have enough collection history to forecast collections to 72 months. Extending the collection forecast in our UCS model from 60 months to 72 months resulted in an increase in the aggregate total estimated remaining collections for the receivable portfolios by $86.0 million, or 13.6% as of June 30, 2006. The extension of the collection forecasts is being treated as a change in estimate and, in accordance with Statement of Financial Accounting Standard No. 154, (“Accounting Changes and Error Corrections – a replacement of APB Opinion No. 20 and FASB Statement No. 3,”) is being recognized prospectively in the financial statements. This prospective treatment resulted in an increase in revenue of $0.9 million and an increase in the accrual for contingent interest of $0.4 million for the quarter ended June 30, 2006. The net impact of the change in estimate was to increase second quarter pretax income by $0.5 million, net income by $0.3 million and fully diluted earnings per share by $0.01. Also during the second quarter, we increased our total estimated remaining collections by $33.1 million, or 4.8% as of June 30, 2006, to reflect the additional collections we expect to receive from new operating initiatives we implemented. This resulted in an increase in revenue of $2.1

 

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million for the quarter, which was offset by $1.3 million in operating expenses incurred in connection with these initiatives.

Total revenue was $65.9 million for the three months ended June 30, 2006, an increase of $12.1 million, or 22.6%, compared to total revenue of $53.8 million for the three months ended June 30, 2005. The increase in revenue was primarily the result of revenue accreted on portfolios acquired in connection with our Jefferson Capital acquisition and other recent portfolio purchases. As discussed above, the increase was also related to the increase in the effective interest rate on certain pools of receivable portfolios in connection with our implementation of new operating initiatives, and the extension of our collection forecasts from 60 to 72 months. The increases in revenue were mitigated in part by a greater portion of our collections coming from 2004, 2005 and 2006 purchases that have lower effective accretion rates than purchases made in prior years due to a more competitive pricing environment in 2004, 2005 and 2006. Of the increase in revenue, $6.3 million related to bankruptcy servicing revenue associated with our acquisition of Ascension in August 2005. Gross collections increased $8.8 million, or 12.5%, to $79.2 million during the three months ended June 30, 2006, from $70.4 million during the three months ended June 30, 2005.

Total revenue was $126.4 million for the six months ended June 30, 2006, an increase of $22.2 million, or 21.3%, compared to total revenue of $104.2 million for the six months ended June 30, 2005. The increase in revenue was primarily the result of revenue accreted on portfolios acquired in connection with our Jefferson Capital acquisition and other recent portfolio purchases. As discussed above, the increase was also related to the increase in the effective interest rate on certain pools of receivable portfolios in connection with our implementation of new operating initiatives and the extension of our collection forecasts from 60 to 72 months. The increases in revenue were mitigated in part by a greater portion of our collections coming from 2004, 2005, and 2006 purchases that have lower effective accretion rates than purchases made in prior years due to a more competitive pricing environment in 2004, 2005 and 2006. Of the increase in revenue, $9.1 million related to bankruptcy servicing revenue associated with our acquisition of Ascension in August 2005. Gross collections increased $30.5 million, or 22.4%, to $166.8 million during the six months ended June 30, 2006, from $136.3 million during the six months ended June 30, 2005.

The following table summarizes our portfolio revenue by revenue-to-collections percentage. The accrual basis portfolios from 1999 to 2003 represent pool groups with high internal rates of return and high revenue to collection percentages (in thousands, except percentages):

 

     For the Three Months Ended
June 30, 2006
   

For the Three Months Ended

June 30, 2005

 
     Revenue to
Collections
Percentage
    Revenue    Percentage
of Total
Revenue
    Revenue to
Collections
Percentage
    Revenue    Percentage
of Total
Revenue
 

Zero Basis Portfolios

   100.0 %   $ 6,734    11.3 %   100.0 %   $ 9,230    17.2 %

1999 – 2003 Accrual Basis Portfolios

   88.6 %     16,134    27.1 %   76.3 %     25,231    47.2 %

2004 – 2005 Accrual Basis Portfolios

   70.0 %     32,065    53.8 %   68.5 %     19,058    35.6 %

2006 Accrual Basis Portfolios

   56.4 %     4,671    7.8 %   —         —      —    
                                      

Total

   75.4 %   $ 59,604    100.0 %   76.4 %   $ 53,519    100.0 %
                                      

 

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For the Six Months Ended

June 30, 2006

   

For the Six Months Ended

June 30, 2005

 
     Revenue to
Collections
Percentage
    Revenue    Percentage
of Total
Revenue
    Revenue to
Collections
Percentage
    Revenue    Percentage
of Total
Revenue
 

Zero Basis Portfolios

   100.0 %   $ 13,241    11.3 %   100.0 %   $ 19,590    18.8 %

1999 – 2003 Accrual Basis Portfolios

   80.3 %     35,080    29.9 %   78.2 %   $ 51,392    49.5 %

2004 – 2005 Accrual Basis Portfolios

   63.3 %     63,371    54.1 %   65.5 %   $ 32,957    31.7 %

2006 Accrual Basis Portfolios

   58.0 %     5,486    4.7 %   —         —      —    
                                      

Total

   70.4 %   $ 117,178    100.0 %   76.6 %   $ 103,939    100.0 %
                                      

During the twelve months ended June 30, 2006, we invested $102.4 million for portfolios with face values aggregating $2.9 billion for an average purchase price of 3.6% of face value. This is a $106.2 million decrease, or 50.7%, in the amount invested compared with the $208.6 million invested during the twelve months ended June 30, 2005 to acquire portfolios with a face value aggregating $6.1 billion for an average purchase price of 3.4% of face value. The decrease is primarily a result of the $96.6 million allocated to the $2.8 billion of face value portfolio purchased as part of the Jefferson Capital Group acquisition in June 2005.

For revenue recognition purposes, portfolios are divided into two groups: Accrual Basis Portfolios - those that still have a remaining unamortized basis, and Zero Basis Portfolios - those portfolios for which the cost basis has been completely amortized. Zero basis revenue represents revenue derived from receivable portfolios whose cost basis has been fully amortized. When there is no remaining cost basis to amortize, each dollar collected is recognized entirely as revenue. During the three months ended June 30, 2006, $6.4 million (exclusive of $0.4 million of zero basis revenue on the retained interest) was recognized as zero basis revenue, a $2.4 million decrease from the $8.8 million (exclusive of $0.5 million of zero basis revenue on the retained interest) recognized during the three months ended June 30, 2005. During the six months ended June 30, 2006, $12.5 million (exclusive of $0.7 million of zero basis revenue on the retained interest) was recognized as zero basis revenue, a $6.1 million decrease from the $18.6 million (exclusive of $1.0 million of zero basis revenue on the retained interest) recognized during the six months ended June 30, 2005. We expect the revenue from these portfolios to decline in future quarters as collections from these portfolios diminish. For additional information on revenue see the Supplemental Performance Data below.

Operating Expenses

Total operating expenses were $45.7 million for the three months ended June 30, 2006, an increase of $13.8 million, or 43.1%, compared to total operating expenses of $31.9 million for the three months ended June 30, 2005.

Total operating expenses were $90.4 million for the six months ended June 30, 2006, an increase of $28.2 million, or 45.3%, compared to total operating expenses of $62.2 million for the six months ended June 30, 2005.

Salaries and employee benefits

Total salaries and employee benefits increased by $3.9 million, or 31.8%, to $16.3 million during the three months ended June 30, 2006 from $12.4 million during the three months ended June 30, 2005. The increase was primarily the result of a $3.0 million or 35.2% increase in salaries, wages and payroll taxes associated with additional headcount. Of this headcount increase, approximately 100 employees representing $1.0 million in salaries, wages

 

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and payroll taxes related to our collection site in St. Cloud, Minnesota acquired from Jefferson Capital in June 2005 and approximately 200 employees representing $2.6 million in salaries, wages and payroll taxes related to Ascension which we acquired in August 2005.

Total salaries and employee benefits increased by $7.6 million, or 30.5%, to $32.6 million during the six months ended June 30, 2006 from $25.0 million during the six months ended June 30, 2005. The increase was primarily the result of a $6.0 million or 35.6% increase in salaries, wages and payroll taxes associated with additional headcount. Of this headcount increase, approximately 100 employees representing $2.0 million in salaries, wages and payroll taxes related to our collection site in St. Cloud, Minnesota acquired from Jefferson Capital in June 2005 and approximately 200 employees representing $5.3 million in salaries, wages and payroll taxes related to Ascension which we acquired in August 2005.

Stock-based compensation expenses

Stock-based compensation amounted to $1.5 million and $2.8 million for the three and six months ended June 30, 2006, respectively. These amounts are the result of implementing Statement of Financial Accounting Standards No. 123R, “Share-Based Payments” (“SFAS No. 123R”), effective January 1, 2006. SFAS No. 123R requires us to expense stock options, restricted stock, and any other share-based payments beginning January 1, 2006 but does not require us to expense these amounts in any prior periods. See Note 3 to the unaudited interim condensed consolidated financial statements for a further discussion of stock-based compensation.

Cost of legal collections

The cost of legal collections increased $4.3 million, or 50.0% to $12.9 million during the three months ended June 30, 2006 as compared to $8.6 million during the three months ended June 30, 2005. These costs represent contingent fees paid to our nationwide network of attorneys and costs of litigation. The increase in the cost of legal collections was primarily the result of an increase of $6.5 million, or 28.5% in gross collections through our legal channel. Gross legal collections amounted to $29.1 million during the three months ended June 30, 2006 from $22.6 million collected during the three months ended June 30, 2005. Cost of legal collections increased as a percent of gross collections through this channel to 44.5% during the three months ended June 30, 2006, from 38.2% during the three months ended June 30, 2005, primarily as a result of upfront costs associated with new operating initiatives focused on increasing portfolio liquidation.

The cost of legal collections increased $7.2 million, or 42.6% to $24.2 million during the six months ended June 30, 2006 as compared to $17.0 million during the six months ended June 30, 2005. These costs represent contingent fees paid to our nationwide network of attorneys and costs of litigation. The increase in the cost of legal collections was primarily the result of an increase of $11.0 million, or 25.1% in gross collections through our legal channel. Gross legal collections amounted to $54.8 million during the six months ended June 30, 2006 from $43.8 million collected during the six months ended June 30, 2005. Cost of legal collections increased as a percent of gross collections through this channel to 44.2% during the six months ended June 30, 2006, from 38.8% during the six months ended June 30, 2005, primarily as a result of upfront costs associated with new operating initiatives focused on increasing portfolio liquidation.

 

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Other operating expenses

Other operating expenses increased $1.5 million, or 36.3%, to $5.7 million during the three months ended June 30, 2006 from $4.2 million during the three months ended June 30, 2005. The increase was primarily attributed to Ascension (acquired in August 2005), which contributed $1.8 million of other operating expenses relating to its bankruptcy services business, including $0.5 million of amortization expense relating to the purchased servicing asset. This increase was offset by a reduction in the cost of direct mail campaigns, which decreased $0.2 million, or 12.1%, to $1.5 million during the three months ended June 30, 2006 compared to $1.7 million during the three months ended June 30, 2005.

Other operating expenses increased $3.3 million, or 37.6%, to $12.1 million during the six months ended June 30, 2006 from $8.8 million during the six months ended June 30, 2005. This increase is the result of increases in the number of direct mail campaigns and operating costs associated with Ascension, which we acquired in August 2005. The cost of direct mail campaigns increased $0.3 million, or 6.7%, to $4.2 million during the six months ended June 30, 2006 compared to $3.9 million during the six months ended June 30, 2005. Ascension contributed $3.2 million to the overall increase, including $1.1 million of amortization expense relating to the purchased servicing asset.

Collection agency commissions

During the three months ended June 30, 2006, we paid $5.0 million in commissions to third party collection agencies, or 36.1% of the related gross collections of $14.0 million compared to $3.5 million in commissions, or 42.4% of the related gross collections of $8.2 million during the three months ended June 30, 2005. The increase in commissions is consistent with the increase in collections through this channel. The decrease in the commission rate as a percentage of the related gross collections is primarily due to the mix of accounts placed with the agencies. Commissions as a percentage of collections in this channel vary from period to period depending on, among other things, the time from charge-off of the accounts placed with an agency (freshly charged-off accounts have a lower commission rate).

During the six months ended June 30, 2006, we paid $9.6 million in commissions to third party collection agencies, or 35.8% of the related gross collections of $26.9 million compared to $5.5 million in commissions, or 40.1% of the related gross collections of $13.7 million during the six months ended June 30, 2005. The increase in commissions is consistent with the increase in collections through this channel. The decrease in the commission rate as a percentage of the related gross collections is primarily due to the mix of accounts placed with the agencies. Commissions as a percentage of collections in this channel vary from period to period depending on, among other things, the time from charge-off of the accounts placed with an agency (freshly charged-off accounts have a lower commission rate).

General and administrative expenses

General and administrative expenses increased $0.4 million, or 15.0%, to $3.3 million during the three months ended June 30, 2006, from $2.9 million during the three months ended June 30, 2005. The increase was primarily the result of a $0.6 million increase in general corporate matters and $0.5 million in increased expenses related to the

 

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addition of the St. Cloud site and the acquisition of Ascension in August 2005. These increases were offset by lower legal costs of $0.7 million relating to litigation defense.

General and administrative expenses increased $2.0 million, or 40.0%, to $7.0 million during the six months ended June 30, 2006, from $5.0 million during the six months ended June 30, 2005. The increase was primarily the result of a $1.2 million increase in general corporate matters and $1.1 million in increased expenses related to the addition of the St. Cloud site and the acquisition of Ascension in August 2005. These increases were offset by lower legal costs of $0.3 million relating to litigation defense.

Depreciation and amortization

Depreciation and amortization expense increased $0.6 million, or 132.1%, to $1.0 million during the three months ended June 30, 2006, from $0.4 million during the three months ended June 30, 2005. Amortization expense for the three months ended June 30, 2006 relating to intangible assets purchased from Ascension in the third quarter 2005 was $0.4 million. There were no amortizable intangible assets for the three months ended June 30, 2005. Depreciation expense remained relatively consistent at $0.6 million and $0.4 million during the three months ended June 30, 2006 and 2005, respectively.

Depreciation and amortization expense increased $1.0 million, or 107.8%, to $1.9 million during the six months ended June 30, 2006, from $0.9 million during the six months ended June 30, 2005. Amortization expense for the six months ended June 30, 2006 relating to intangible assets purchased from Ascension in the third quarter 2005 was $0.8 million. There were no amortizable intangible assets for the six months ended June 30, 2005. Depreciation expense remained relatively consistent at $1.1 million and $0.9 million during the six months ended June 30, 2006 and 2005, respectively.

Interest expense

Interest expense decreased $1.1 million, or 12.5% to $7.3 million during the three months ended June 30, 2006 from $8.4 million during the three months ended June 30, 2005.

Interest expense decreased $1.2 million, or 7.2% to $15.3 million during the six months ended June 30, 2006 from $16.5 million during the six months ended June 30, 2005.

The following table summarizes our interest expense (in thousands, except percentages):

 

     For the Three Months Ended June 30,  
     2006    2005    $ Change     % Change  

Stated interest on debt obligations

   $ 2,626    $ 1,527    $ 1,099     72.0 %

Amortization of loan fees and other loan costs

     476      168      308     183.3 %

Contingent interest

     4,235      6,689      (2,454 )   (36.7 %)
                        

Total interest expense

   $ 7,337    $ 8,384    $ (1,047 )   (12.5 %)
                        

 

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     For the Six Months Ended June 30,  
     2006    2005    $ Change     % Change  

Stated interest on debt obligations

   $ 5,330    $ 2,610    $ 2,720     104.2 %

Amortization of loan fees and other loan costs

     1,037      289      748     258.8 %

Contingent interest

     8,921      13,572      (4,651 )   (34.3 %)
                        

Total interest expense

   $ 15,288    $ 16,471    $ (1,183 )   (7.2 %)
                        

The decrease in interest expense is due to a decrease in contingent interest recorded under the terms of our Secured Financing Facility. Under the terms of our Secured Financing Facility, once we repay the lender for the notes associated with each purchased portfolio and collect sufficient amounts to recoup our initial cash investment in each purchased portfolio, we then share the residual collections “Contingent Interest” from the receivable portfolios, net of our servicing fees, with the lender. We make estimates with respect to the timing and amount of collections of future cash flows from these receivable portfolios. Based on these estimates, we record a portion of the estimated future profit sharing obligation as Contingent Interest Expense.

We have financed portfolio purchases subsequent to December 31, 2004 using our Revolving Credit Facility, which does not require the sharing of residual collections with the lender. See Note 6 to the unaudited interim condensed consolidated financial statements for a further discussion on our Revolving Credit Facility.

Other income and expense

During the three months ended June 30, 2006, total other income was $0.3 million, compared to $0.2 million for the three months ended June 30, 2005. During the six months ended June 30, 2006, total other income was $0.3 million, compared to $0.6 million for the six months ended June 30, 2005. For the six month ended June 30, 2006, the decrease in other income and expense was primarily the result of lower interest income due to lower balances of invested cash.

Provision for income taxes

During the three months ending June 30, 2006, we recorded an income tax provision of $5.7 million, reflecting an effective rate of 43.3% of pretax income. Our effective tax rate for the three months ended June 30, 2006 differed from the federal statutory rate primarily due to the net effect of state taxes and the effect of an anticipated adjustment related to an Internal Revenue Service tax audit of our 2003 income tax return. For the three months ended June 30, 2005, we recorded an income tax provision of $5.6 million, reflecting an effective rate of 40.8% of pretax income. Our effective tax rate for the three months ended June 30, 2005 differed from the federal statutory rate primarily due to the net effect of state taxes. The increase in our effective tax rate was the result of the changing mix of permanent book versus tax differences relative to higher taxable income and the increase in tax expense related to the tax audit issue noted above.

During the six months ending June 30, 2006, we recorded an income tax provision of $8.9 million, reflecting an effective rate of 42.3% of pretax income. Our effective tax rate for the six months ended June 30, 2006 differed from the federal statutory rate primarily due to the net effect of state taxes and the effect of an anticipated adjustment related to an Internal Revenue Service tax audit of our 2003 income tax return. For the six months ended June 30, 2005, we

 

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recorded an income tax provision of $10.6 million, reflecting an effective rate of 40.6% of pretax income. Our effective tax rate for the six months ended June 30, 2005 differed from the federal statutory rate primarily due to the net effect of state taxes. The increase in our effective tax rate was the result of the changing mix of permanent book versus tax differences relative to higher taxable income and the increase in tax expense related to the tax audit issue noted above. See Note 7 to the unaudited interim condensed consolidated financial statements for a further discussion of income taxes.

Upon completion of a detailed analysis performed in the first quarter of 2006 on its net tax assets, we determined that additional tax portfolio amortization deductions should be reflected as an increase in our prepaid income tax balance with a corresponding decrease in the net deferred tax assets. The amount reclassified on our consolidated statement of condition as of December 31, 2005 was $9.3 million. This reclassification relates to a temporary difference between GAAP and tax accounting, and accordingly has no impact to the consolidated statements of operations.

 

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Supplemental Performance Data

Cumulative Collections to Purchase Price Multiple

The following table summarizes our purchases and related resulting gross collections per year of purchase (in thousands, except multiples):

 

     Cumulative Collections through June 30, 2006
    

Purchase

Price1

  <20004    2000    2001    2002    2003    2004    2005    2006    Total2    CCM3
<1999    $ 41,1174   $ 61,703    $ 26,926    $ 22,545    $ 15,007    $ 7,546    $ 4,202    $ 2,042    $ 861    $ 140,832    3.4
1999      48,712     7,864      21,299      19,174      16,259      11,508      8,654      5,157      2,239      92,154    1.9
2000      6,153     —        5,489      7,172      4,542      4,377      2,293      1,323      523      25,719    4.2
2001      38,188     —        —        21,197      54,184      33,072      28,551      20,622      7,575      165,201    4.3
2002      61,500     —        —        —        48,322      70,227      62,282      45,699      17,360      243,890    4.0
2003      88,543     —        —        —        —        59,038      86,958      69,932      28,098      244,026    2.8
2004      101,376     —        —        —        —        —        39,400      79,845      28,025      147,270    1.5
2005      193,427     —        —        —        —        —        —        66,491      72,306      138,797    0.7
2006      48,214     —        —        —        —        —        —        —        9,464      9,464    0.2
                                                                         
Total    $ 627,230   $ 69,567    $ 53,714    $ 70,088    $ 138,314    $ 185,768    $ 232,340    $ 291,111    $ 166,451    $ 1,207,353    1.9
                                                                         

 

1 Adjusted for put-backs, account recalls, purchase price rescissions, and the impact of an acquisition in 2000.
2 Cumulative collections from inception through June 30, 2006.
3 Cumulative Collections Multiple (“CCM”) - collections to date as a multiple of purchase price.
4 From inception to December 31, 1998.

Total Estimated Collections to Purchase Price Multiple

The following table summarizes our purchases, resulting historical gross collections, and estimated remaining gross collections by year of purchase (in thousands, except multiples):

 

    

Purchase

Price1

 

Historical

Gross

Collections2

  

Estimated
Remaining
Gross

Collections

  

Total
Estimated
Gross

Collections

  

Total Estimated Gross

Collections to
Purchase Price

<1999    $ 41,1173   $ 140,832    $ 1,253    $ 142,085    3.5
1999      48,712     92,154      4,674      96,828    2.0
2000      6,153     25,719      1,204      26,923    4.4
2001      38,188     165,201      27,092      192,293    5.0
2002      61,500     243,890      50,877      294,767    4.8
2003      88,543     244,026      85,916      329,942    3.7
2004      101,376     147,270      116,694      263,964    2.6
2005      193,427     138,797      341,243      480,040    2.5
20064      48,214     9,464      90,908      100,372    2.1
                               
Total    $ 627,230   $ 1,207,353    $ 719,861    $ 1,927,214    3.1
                               

 

1 Adjusted for put-backs, account recalls, purchase price rescissions, and the impact of an acquisition in 2000.

 

2 Cumulative collections from inception through June 30, 2006.

 

3 From inception to December 31, 1998.

 

4 2006 purchases have collections forecasted using a 54 month collection forecast until the portfolios are greater than six months from the date of purchase, at which time a 72 month forecast will be used.

 

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Unamortized Balances of Portfolios

The following table summarizes the remaining unamortized balances of our purchased receivable portfolios by year of purchase as of June 30, 2006 (in thousands, except percentages):

 

    

Unamortized

Balance as of

June 30, 2006

  

Purchase

Price1

  

Unamortized

Balance as a

Percentage of

Purchase Price2

   

Unamortized

Balance as a

Percentage of Total

 
2001    $ 142    $ 38,188    0.4 %   0.1 %
2002      7,430      61,500    12.1 %   2.9 %
2003      15,178      88,543    17.1 %   6.0 %
2004      41,541      101,376    41.0 %   16.4 %
2005      144,910      193,427    74.9 %   57.2 %
20063      44,236      48,214    91.7 %   17.4 %
                          
Totals    $ 253,437    $ 531,248    47.7 %   100.0 %
                          

 

1 Purchase price refers to the cash paid to a seller to acquire a portfolio less the purchase price refunded by a seller due to the return of non-compliant accounts (also defined as put-backs) less the purchase price for accounts that were sold at the time of purchase to another debt purchaser.

 

2 For purposes of this table, cash collections include selected cash sales, which were entered into subsequent to purchase. Cash sales, however, exclude the sales of accounts that occurred at the time of purchase.

 

3 Includes only six months of activity through June 30, 2006.

Portfolio Gross Collections by Channel

During the three and six months ended June 30, 2006 and 2005, we utilized several business channels for the collection of charged-off credit card receivables and other charged-off receivables. The following tables summarize gross collections by collection channel (in thousands):

 

     Three Months Ended
June 30,
   Six Months Ended
June 30,
     2006    2005    2006    2005

Collection sites

   $ 33,579    $ 31,764    $ 74,861    $ 66,806

Legal collections

     29,065      22,622      54,836      43,819

Sales

     1,985      7,359      9,094      10,656

Collection agencies

     13,951      8,159      26,915      13,687

Other

     606      503      1,096      1,292
                           

Gross collections for the period

   $ 79,186    $ 70,407    $ 166,802    $ 136,260
                           

Changes in Investment in Receivable Portfolios

Revenue related to our investment in receivable portfolios is comprised of two components. First, revenue from those portfolios that have a remaining book value and are accounted for on the accrual basis (“Accrual Basis Portfolios”), and second, revenue from those portfolios that have fully recovered their cost basis for which every dollar of gross collections is recorded entirely as Zero Basis Revenue (“Zero Basis Portfolios”).

The following tables summarize the changes in the balance of the investment in receivable portfolios and the proportion of revenue recognized as a percentage of collections (in thousands, except percentages):

 

     For the Three Months Ended June 30, 2006  
     Accrual Basis
Portfolios
    Cost Recovery
Portfolios
    Zero Basis
Portfolios
    Total  

Balance, beginning of period

   $ 248,529     $ 3,880     $ —       $ 252,409  

Purchases of receivable portfolios

     21,262       —         —         21,262  

Gross collections1

     (71,382 )     (888 )     (6,368 )     (78,638 )

Basis adjustments

     (835 )     —         (1 )     (836 )

Revenue recognized1

     52,437       —         6,369       58,806  

Impairment reversals, net

     434       —           434  
                                

Balance, end of period

   $ 250,445     $ 2,992     $ —       $ 253,437  
                                

Revenue as a percentage of collections

     74.1 %     0.0 %     100.0 %     75.3 %
                                

 

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     For the Three Months Ended June 30, 2005  
     Accrual Basis
Portfolios
    Cost Recovery
Portfolios
    Zero Basis
Portfolios
    Total  

Balance, beginning of period

   $ 142,069     $ —       $ —       $ 142,069  

Purchases of receivable portfolios

     118,501       2,546       —         121,047  

Gross collections1

     (60,848 )     (7 )     (8,766 )     (69,621 )

Basis adjustments

     (480 )     —         (1 )     (481 )

Revenue recognized1

     44,289       —         8,767       53,056  
                                

Balance, end of period

   $ 243,531     $ 2,539     $ —       $ 246,070  
                                

Revenue as a percentage of collections

     72.8 %     0.0 %     100.0 %     76.2 %
                                

 

     For the Six Months Ended June 30, 2006  
     Accrual Basis
Portfolios
    Cost Recovery
Portfolios
    Zero Basis
Portfolios
    Total  

Balance, beginning of period

   $ 255,299     $ 1,034     $ —       $ 256,333  

Purchases of receivable portfolios

     44,730       3,623       —         48,353  

Gross collections1

     (151,540 )     (1,665 )     (12,516 )     (165,721 )

Basis adjustments

     (1,982 )     —         (2 )     (1,984 )

Revenue recognized1

     103,792       —         12,518       116,310  

Impairment reversals, net

     146       —         —         146  
                                

Balance, end of period

   $ 250,445     $ 2,992     $ —       $ 253,437  
                                

Revenue as a percentage of collections

     68.6 %     0.0 %     100.0 %     70.3 %
                                

 

     For the Six Months Ended June 30, 2005  
     Accrual Basis
Portfolios
    Cost Recovery
Portfolios
    Zero Basis
Portfolios
    Total  

Balance, beginning of period

   $ 137,553     $ 410     $ —       $ 137,963  

Purchases of receivable portfolios

     138,024       2,546       —         140,570  

Transfers of portfolios

     404       (404 )     —         —    

Gross collections1

     (116,061 )     (13 )     (18,619 )     (134,693 )

Basis adjustments

     (738 )     —         (1 )     (739 )

Revenue recognized1

     84,349       —         18,620       102,969  
                                

Balance, end of period

   $ 243,531     $ 2,539     $ —       $ 246,070  
                                

Revenue as a percentage of collections

     72.7 %     0.0 %     100.0 %     76.4 %
                                

 

1 Gross collections and revenue related to the retained interest are not included in these tables. Zero basis collections and revenue related to the retained interest (which was fully amortized in the second quarter of 2004) was $0.4 million and $0.7 million during the three and six months ended June 30, 2006, respectively. During the three and six months ended June 30, 2005, gross collections and revenue related to the retained interest were $0.5 million and $1.0 million, respectively.

 

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Analysis of Changes in Revenue

The following tables analyze the components of the increase in revenue from our receivable portfolios for the three and six months ended June 30, 2006 compared to the three and six months ended June 30, 2005 (in thousands, except percentages):

 

     For The Three Months Ended June 30,  

Variance Component

   2006     2005     Change     Revenue
Variance
 

Average portfolio balance

   $ 249,868     $ 186,379     $ 63,489     $ 15,087  

Weighted average effective interest rate1

     84.6 %     95.1 %     (10.5 %)     (6,505 )

Zero basis revenue

   $ 6,369     $ 8,767         (2,398 )

Retained interest revenue

   $ 364     $ 463         (99 )
              

Total variance

         $ 6,085  
              

 

     For The Six Months Ended June 30,  

Variance Component

   2006     2005     Change     Revenue
Variance
 

Average portfolio balance

   $ 250,300     $ 166,138     $ 84,162     $ 42,728  

Weighted average effective interest rate1

     83.1 %     101.5 %     (18.4 %)     (23,139 )

Zero basis revenue

   $ 12,518     $ 18,620         (6,102 )

Retained interest revenue

   $ 722     $ 970         (248 )
              

Total variance

         $ 13,239  
              

 

1 For accrual basis portfolios, the weighted average annualized effective interest rate is the accrual rate utilized in recognizing revenue on our accrual basis portfolios. This rate represents the monthly internal rate of return, which has been annualized utilizing the simple interest method. The monthly internal rate of return is determined based on the timing and amounts of actual cash received to date and the anticipated future cash flow projections for each pool.

Purchases by Quarter

The following table summarizes the purchases we made by quarter, and the respective purchase prices (in thousands, except percentages):

 

Quarter    # of
Accounts
   Face Value    Purchase
Price
Q1 2004    400    $ 786,398    $ 17,248
Q2 2004    296      758,877      19,031
Q3 2004    365      721,237      20,967
Q4 2004    530      1,195,090      46,128
Q1 2005    513      530,047      19,523
Q2 20051    2,773      3,675,277      121,939
Q3 20052    434      381,508      14,151
Q4 20052    1,568      1,326,216      39,941
Q1 20062    673      558,574      27,091
Q2 20062    837      594,190      21,262

 

1 Purchase price for Q2 2005 includes a $0.9 million cost adjustment associated with the finalization of the Jefferson Capital purchase price allocation.

 

2 Purchase price includes a $2.3 million, $2.0 million, $2.4 million, and $2.1 million allocation of the forward flow asset for Q3 and Q4 2005 and Q1 and Q2 2006, respectively.

 

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Purchases by Paper Type

The following tables summarize the types of charged-off consumer receivable portfolios we purchased for the three and six months ended June 30, 2006 and 2005 (in thousands):

 

    

Three Months Ended

June 30,

  

Six Months Ended

June 30,

     2006    2005    2006    2005

Credit card

   $ 10,207    $ 117,593    $ 25,918    $ 137,116

Other

     11,055      3,454      22,435      3,454
                           
   $ 21,262    $ 121,047    $ 48,353    $ 140,570
                           

 

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Liquidity and Capital Resources

Overview

Historically, we have met our cash requirements by utilizing our cash flows from operations, bank borrowings, and equity offerings. Our primary cash requirements have included the purchase of receivable portfolios, operational expenses, the payment of interest and the repayment of principal on bank borrowings, and tax payments. Our strong operating performance has resulted in an increase in stockholders’ equity to $135.3 million as of June 30, 2006 from $118.3 million as of December 31, 2005. In addition, we had an unrestricted cash balance of $10.1 million at June 30, 2006, after borrowing $4.5 million and repaying $25.1 million in principal on our debt facilities and purchasing $43.8 in receivable portfolios.

The following table summarizes our cash flows by category for the periods presented (in thousands):

 

     Six Months Ended
June 30,
 
     2006     2005  

Net cash provided by operating activities

   $ 16,149     $ 13,700  

Net cash provided by (used in) investing activities

     6,763       (116,310 )

Net cash (used in) provided by financing activities

     (19,860 )     111,828  

On December 31, 2004 our Secured Financing Facility expired. However, Contingent Interest payments related to our residual collections sharing arrangement with the lender will extend into the future. All of our portfolio purchases are now funded with cash or financed under our $200.0 million Revolving Credit Facility. Unlike our Secured Financing Facility, the Revolving Credit Facility does not require us to share with the lender the residual collections on the portfolios financed. See Note 6 to the unaudited condensed consolidated financial statements for more discussion on our Revolving Credit Facility, Secured Financing Facility and Contingent Interest.

Operating Cash Flows

Net cash provided by operating activities was $16.1 million for the six months ended June 30, 2006, and $13.7 million for the six months ended June 30, 2005. We have been able to generate consistent operating cash flow by maintaining our gross collections performance. Gross collections for the six months ended June 30, 2006 grew $30.5 million, or 22.4%, to $166.8 million from $136.3 million for the six months ended June 30, 2005.

Total cash basis operating expenses were $81.2 million for the six months ended June 30, 2006, compared to $61.8 million for the six months ended June 30, 2005. The increase was primarily volume-related, driven by our collection growth and new operational initiatives, as well as increases in rent expense, and the cost of corporate compliance, offsets by lower litigation defense costs. Interest payments were $18.7 million for the six months ended June 30, 2006, and $19.2 million for the six months ended June 30, 2005. The decrease in interest payments was primarily the result of lower contingent interest payments related to our residual collections sharing arrangement for portfolios financed by our Secured Financing Facility and lower borrowings under the Revolving Credit Facility. See Management’s Discussion and Analysis for a detailed discussion of operating and interest expenses.

 

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Investing Cash Flows

Net cash provided by (used in) investing activities was $6.8 million for the six months ended June 30, 2006, and ($116.3) million for the six months ended June 30, 2005.

The cash flows provided by investing activities for the six months ended June 30, 2006 are primarily related to receivable portfolio purchases of $43.8 million offset by gross collection proceeds applied to the principal of our receivable portfolios in the amount of $49.4 million. The cash flows used in investing activities for the six months ended June 30, 2005 are primarily related to our acquisition of certain assets of Jefferson Capital for $142.9 million and receivable portfolio purchases of $44.9 million, offset by gross collection proceeds applied to the principal of our receivable portfolios in the amount of $31.7 million.

Capital expenditures for fixed assets acquired with internal cash flow were $0.8 million and $1.1 million for the six months ended June 30, 2006 and 2005, respectively.

Financing Cash Flows

Net cash (used in) provided by financing activities was ($19.9) million and $111.8 million for the six months ended June 30, 2006 and 2005, respectively.

The cash used in financing activities during the six months ended June 30, 2006, reflects $25.1 million in repayments of notes payable, amounts outstanding under our line of credit and other borrowings, offset by $4.5 million in borrowings under our line of credit agreement. Cash provided by financing activities for the six months ended June 30, 2005, reflects $167.4 million in borrowings under our line of credit agreement of which $142.9 million was used to fund the Jefferson Capital acquisition, offset by $54.0 million in repayments of notes payable, amounts outstanding under our line of credit and other borrowings.

Future Contractual Cash Obligations

The following table summarizes our future contractual cash obligations as of June 30, 2006 (in thousands):

 

     Payments Due by Period
     Total   

Less Than

1 Year

  

1 – 3

Years

  

3 – 5

Years

  

More
Than

5 Years

Capital lease obligations

   $ 598    $ 258    $ 340    $ —      $ —  

Operating leases

     11,672      1,877      3,261      2,436      4,098

Employment agreements

     770      385      385      —        —  

Secured Financing Facility

     14,102      14,102      —        —        —  

Revolving Credit Facility

     62,669      —        —        62,669      —  

3.375% Convertible Senior Notes

     100,000      —        —        100,000      —  

Contractual interest on 3.375% Convertible Senior Notes

     15,188      3,375      6,750      5,063      —  

Portfolio forward flow agreement

     147,505      36,876      73,752      36,877      —  

Other

     551      551      —        —        —  
                                  

Total contractual cash obligations

   $ 353,055    $ 57,424    $ 84,488    $ 207,045    $ 4,098
                                  

 

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Repayments under our Secured Financing Facility are predicated on our cash collections from the underlying secured receivable portfolios. However, repayment of the original principal amount must be made no later than 27 months following the date of the original advance, unless amended, with respect to each advance under the Secured Financing Facility. The table reflects the repayment of the loans under the Secured Financing Facility based upon our expected cash collections, which reflects repayments earlier than the required due dates. This table does not include future interest or future contingent interest payments. Our amended Revolving Credit Facility has a remaining term of four years and to the extent that a balance is outstanding on our line of credit, it would be due in May 2010. Interest on the Revolving Credit Facility is variable and is not included in this table. The outstanding balance on our line of credit as of June 30, 2006 was $62.7 million. The portfolio forward flow agreement represents estimated payments under our five-year portfolio purchase forward flow agreement entered into on June 7, 2005. For additional information on our debt, see Note 6 to our unaudited interim condensed consolidated financial statements. For additional information on purchase commitments see Note 9 to our unaudited interim condensed consolidated financial statements.

We are in compliance with all covenants under our financing arrangements, and we have achieved eighteen consecutive quarters of positive net income. We believe that we have sufficient liquidity to fund our operations for at least the next twelve months, given our expectation of continued positive cash flows from operations, our cash and cash equivalents of $10.1 million as of June 30, 2006, and $137.3 million in borrowing capacity and borrowing base availability of $91.1 million under our Revolving Credit Facility as of June 30, 2006.

Off Balance Sheet Arrangements

We do not have any off balance sheet arrangements as defined by regulation S-K 303(a)(4).

 

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

For quantitative and qualitative disclosures about market risk affecting Encore, see Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2005, which is incorporated herein by reference. Our exposure to market risk has not changed materially since December 31, 2005.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our periodic reports filed with the Securities and Exchange Commission (“SEC”) is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and that such information is accumulated and communicated to our management as appropriate to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives and management accordingly is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Based on their most recent evaluation, which was completed as of June 30, 2006, the end of the period covered by this Quarterly Report on Form 10-Q as of and for the three months ended June 30, 2006, our Chief Executive Officer and Chief Financial Officer have concluded our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (“Exchange Act”), as amended, are effective.

Changes in Internal Control over Financial Reporting

There was no change in our internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect our internal control over financial reporting. In August 2005, the Company completed the acquisition of Ascension Capital Group, Ltd. As part of the integration process with respect to this acquisition, we are in the process of implementing our controls and procedures into the recently acquired Ascension operations and are conducting control reviews and remediation efforts pursuant to the Sarbanes-Oxley Act of 2002.

 

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PART II - OTHER INFORMATION

Item 1. Legal Proceedings

On October 18, 2004, Timothy W. Moser, a former officer of the Company, filed an action in the United States District Court for the Southern District of California against the Company, and certain individuals, including several of the Company’s officers and directors. On February 14, 2005 the Company was served with an amended complaint in this action alleging defamation, intentional interference with contractual relations, breach of contract, breach of the covenant of good faith and fair dealing, intentional and negligent infliction of emotional distress and civil conspiracy arising out of certain statements in the Company’s Registration Statement on Form S-1 originally filed in September 2003 and alleged to be included in the Company’s Registration Statement on Form S-3 originally filed in May 2004. The amended complaint seeks injunctive relief, economic and punitive damages in an unspecified amount plus an award of profits allegedly earned by the defendants and alleged co-conspirators as a result of the alleged conduct, in addition to attorney’s fees and costs. On May 2, 2006 the court denied our special motion to strike pursuant to California’s anti-SLAPP statute, denied in part and granted in part our motion to dismiss, denied a variety of ex parte motions and applications filed by the plaintiff and denied the plaintiff’s motion for leave to conduct discovery or file supplemental briefing. The court granted the plaintiff 30 days in which to further amend his complaint, and on June 1, 2006, the plaintiff filed a second amended complaint in which he amended his claim for negligent infliction of emotional distress. On May 25, 2006, we filed a notice of appeal from the court’s order denying the anti-SLAPP motion and on June 16, 2006 we filed a motion to stay the case. The hearing on this motion is scheduled for August 14, 2006. The Company believes the claims are without merit and will vigorously defend the action. Although the outcome of this matter cannot be predicted with certainty, management does not currently believe that this matter will have a material adverse effect on the Company’s consolidated financial position or results of operations.

On September 7, 2005, Mr. Moser filed a related action in the United States District Court for the Southern District of California against Triarc Companies, Inc. (Triarc), a significant stockholder of the Company, alleging intentional interference with contractual relations and intentional infliction of emotional distress. The case arises out of the same statements made or alleged to have been made in the Company’s Registration Statements mentioned above. On January 7, 2006, Triarc was served with an amended complaint seeking injunctive relief, an order directing Triarc to issue a statement of retraction or correction of the allegedly false statements, economic and punitive damages in an unspecified amount and attorney’s fees and costs. Triarc tendered the defense of this action to the Company, and the Company accepted the defense and will indemnify Triarc, pursuant to the indemnification provisions of the Registration Rights Agreements dated as of October 31, 2000 and February 21, 2002, and the Underwriting Agreements dated September 25, 2004 and January 20, 2005 to which Triarc is a party. Although the outcome of this matter cannot be predicted with certainty, management does not currently believe that this matter will have a material adverse effect on the Company’s consolidated financial position or results of operations.

The Fair Debt Collection Practices Act (“FDCPA”) and comparable state statutes may result in class action lawsuits, which can be material to the Company due to the remedies available under these statutes, including punitive damages. Management is aware of a number of cases styled as class actions that have been filed against the

 

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Company. To date, a class has been certified in one of these cases. The Company believes that these cases are without merit and intends to vigorously defend them. However, several of these cases present novel issues on which there is no legal precedent. As a result, the Company is unable to predict the range of possible outcomes.

There are a number of other lawsuits or claims pending or threatened against the Company. In general, these lawsuits or claims have arisen in the ordinary course of business and involve claims for actual damages arising from alleged misconduct or improper reporting of credit information by the Company or its employees. Although litigation is inherently uncertain, based on past experience, the information currently available and the possible availability of insurance and/or indemnification from originating institutions in some cases, management of the Company does not believe that the currently pending and threatened litigation or claims will have a material adverse effect on the Company’s consolidated financial position or results of operations. However, future events or circumstances, currently unknown to management, will determine whether the resolution of pending or threatened litigation or claims will ultimately have a material effect on the Company’s consolidated financial position, liquidity or results of operations in any future reporting periods.

Item 1A. Risk Factors

You should carefully consider the factors discussed in Part I, “Item IA. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2005 (the “Form 10-K”), which could materially affect our business, financial condition or future results and are incorporated herein by reference. The following risk factor is a material update to the risk factors contained in the Form 10-K:

The formation of a Special Committee by our board of directors and its consideration of the sale of our company may distract management and employees or otherwise disrupt operations, which could adversely affect our results of operations.

As discussed above, on June 5, 2006, we announced the formation of a Special Committee of our board of directors to consider strategic alternatives. While the Special Committee will look to strategic alternatives it feels may enhance stockholder value, including the potential sale of the company, the uncertainty inherent in such process could undermine company morale and may at times divert management’s attention from routine matters. For instance, the Special Committee has no exact timeline for this process and we do not intend to disclose developments or provide updates on the progress or status of the strategic alternatives review process or of any strategic alternatives under consideration until the board of directors has approved such transaction. In addition, we cannot assure you that this strategic alternatives review process ultimately will result in any strategic transaction or sale of the company, so the stockholders may never realize the potential enhancement in value that the Special Committee is seeking. Ultimately, the unpredictability associated with this process could adversely affect our results of operations in any of the ways described above or in various other ways that are unforeseen at this time.

 

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This report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the “Reform Act”). The words “believe,” “expect,” “anticipate,” “estimate,” “project,” or the negation thereof or similar expressions constitute forward-looking statements within the meaning of the Reform Act. These statements may include, but are not limited to, projections of revenues, income or loss, estimates of capital expenditures, plans for future operations, products or services, and financing needs or plans, as well as assumptions relating to these matters. These statements include, among others, statements found under “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” For all forward-looking statements, we claim the protection of the safe-harbor for forward-looking statements contained in the Reform Act.

Our actual results could differ materially from those contained in the forward-looking statements due to a number of factors, some of which are beyond our control. Factors that could affect our results of operations or financial condition and cause them to differ from those contained in the forward-looking statements include:

 

    Our quarterly operating results may fluctuate and cause the prices of our common stock and convertible notes to decrease;

 

    We may not be able to purchase receivables at sufficiently favorable prices or terms, or at all;

 

    We may not be successful in acquiring and collecting on portfolios consisting of new types of receivables;

 

    We may not be able to collect sufficient amounts on our receivable portfolios to recover our costs and fund our operations;

 

    We may purchase portfolios that contain unprofitable accounts;

 

    The statistical model we use to project remaining cash flows from our receivable portfolios may prove to be inaccurate, which could result in reduced revenues or the recording of an impairment charge if we do not achieve the collections forecasted by our model;

 

    Our industry is highly competitive, and we may be unable to continue to compete successfully with businesses that have greater resources than we have;

 

    Our failure to purchase sufficient quantities of receivable portfolios may necessitate workforce reductions, which may harm our business;

 

    A significant portion of our portfolio purchases during any period may be concentrated with a small number of sellers;

 

    We may be unable to meet our future liquidity requirements;

 

    We may not be able to continue to satisfy the restrictive covenants in our debt agreements;

 

    We use estimates in our revenue recognition, and our earnings will be reduced if actual results are less than estimated;

 

    We may incur impairment charges based on our receivable portfolios, intangible assets or other long lived assets;

 

    Government regulation may limit our ability to recover and enforce the collection of receivables;

 

    We are subject to ongoing risks of litigation, including individual and class actions under consumer credit, collections, employment, securities and other laws;

 

    We may make acquisitions that prove unsuccessful or strain or divert our resources;

 

    We may not be able to hire and retain enough sufficiently trained employees to support our operations, and/or we may experience high rates of personnel turnover;

 

    We may not be able to manage our growth effectively;

 

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    The failure of our technology and telecommunications systems could have an adverse effect on our operations;

 

    We may not be able to successfully anticipate, invest in or adopt technological advances within our industry;

 

    We may not be able to adequately protect the intellectual property rights upon which we rely;

 

    Our results of operations may be materially adversely affected if bankruptcy filings increase; and

 

    We have engaged in transactions with members of our board of directors, significant stockholders, and entities affiliated with them; future transactions with related parties could pose conflicts of interest.

 

    The formation of a special committee by our board of directors and its consideration of strategic alternatives, including the potential sale of our company, may disrupt operations and distract management and employees, which could harm operations. Additionally, the process of exploring strategic alternatives may be more time consuming and expensive than we currently anticipate, may not result in benefits to the company or our stockholders and the uncertainty as to the future direction of the company may harm the company.

Forward-looking statements speak only as of the date the statement was made. They inherently are subject to risks and uncertainties, some of which we cannot predict or quantify. Future events and actual results could differ materially from the forward-looking statements. When considering each forward-looking statement, you should keep in mind the risk factors and cautionary statements found throughout our annual report on Form 10-K as of and for the year ended December 31, 2005 filed with the Securities and Exchange Commission. We do not undertake and specifically decline any obligation to publicly release the result of any revisions to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events, whether as a result of new information, future events, or for any other reason.

In addition, it is our policy generally not to make any specific projections as to future earnings and we do not endorse projections regarding future performance that may be made by third parties.

 

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Item 4. Submission of Matters to a Vote of Security Holders

On June 5, 2006, we held our annual meeting of stockholders. At the annual meeting, Barry R. Barkley, J. Brandon Black, Raymond Fleming, Carl C. Gregory, III, Eric D. Kogan, Alexander Lemond, Richard A. Mandell and Peter W. May were elected to serve as directors. The votes for the election of directors are set forth below:

 

Name of Nominee

   Votes For    Votes Withheld

Barry R. Barkley

   16,858,817    5,486,586

J. Brandon Black

   20,676,259    1,669,144

Raymond Fleming

   20,533,365    1,812,038

Carl C. Gregory, III

   20,682,933    1,662,470

Eric D. Kogan

   20,703,884    1,641,519

Alexander Lemond

   20,532,144    1,813,259

Richard A. Mandell

   20,726,478    1,618,925

Peter W. May

   20,510,550    1,834,853

At the annual meeting, the stockholders also approved Proposal 2, ratifying the appointment of BDO Seidman, LLP as our independent register public accounting firm for fiscal year 2006. The votes for Proposal 2 were as follows:

 

Votes For    Votes Against    Abstentions    Nonvotes
21,825,645    516,537    3,221    0

 

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Item 6. Exhibits

 

10.1    Amendment One dated as of June 5, 2006 to Employment Agreement between the Company and J. Brandon Black (incorporated by reference to Exhibit 10.1 of the registrant’s Current Report on Form 8-K filed on June 9, 2006).
10.2    Amendment One dated as of June 5, 2006 to Severance Agreement between Midland Credit Management, Inc. and Paul Grinberg (incorporated by reference to Exhibit 10.2 of the registrant’s Current Report on Form 8-K filed on June 9, 2006).
10.3    Form of Change of Control Severance and Retention Agreement between the Company and certain executives (incorporated by reference to Exhibit 10.3 of the registrant’s Current Report on Form 8-K filed on June 9, 2006).
31.1    Certification of the Principal Executive Officer pursuant to rule 13-14(a) under the Securities Exchange Act of 1934 (filed herewith)
31.2    Certification of the Principal Financial Officer pursuant to rule 13-14(a) under the Securities Exchange Act of 1934 (filed herewith)
32.1    Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley act of 2002 (furnished herewith)

 

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ENCORE CAPITAL GROUP, INC.

SIGNATURES

Pursuant to the requirements 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.

 

ENCORE CAPITAL GROUP, INC.
By:   /s/ Paul Grinberg
 

Paul Grinberg

Executive Vice-President,

Chief Financial Officer and Treasurer

(Principal Financial and Accounting Officer)

Date: August 3, 2006

 

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