UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-K/A
AMENDMENT NO. 1
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2005
Commission file number 0-22081
EPIQ SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
Missouri |
| 48-1056429 |
(State or other jurisdiction of |
| (I.R.S. Employer Identification No.) |
incorporation or organization) |
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501 Kansas Avenue, Kansas City, Kansas |
| 66105-1300 |
(Address of principal executive office) |
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Registrant’s telephone number, including area code (913) 621-9500
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common Stock, $.01 par value
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes o No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes o No x
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 past 90 days. Yes x No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
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.
Large Accelerated Filer o |
| Accelerated Filer x |
| Non-Accelerated Filer o |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x
The aggregate market value of voting common stock held by non-affiliates of the registrant (based upon the last reported sale price on the Nasdaq National Market), as of the last business day of the registrant’s most recently completed second fiscal quarter (June 30, 2005) was approximately $293,000,000.
There were 19,264,871 shares of common stock of the registrant outstanding as of February 22, 2006.
Documents incorporated by reference: The information required by Part III of Form 10-K is incorporated herein by reference to the registrant’s definitive Proxy Statement relating to its 2006 Annual Meeting of Shareholders, which will be filed with the Commission within 120 days after the end of the registrant’s fiscal year.
EPIQ SYSTEMS, INC.
ANNUAL REPORT ON FORM 10-K/A
TABLE OF CONTENTS
PART I
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PART II
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| Management’s Discussion and Analysis of Financial Condition And Results of Operation |
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| Changes in and Disagreements with Accountants on Accounting and Financial Disclosure |
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PART III
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| Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters |
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PART IV
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Explanatory Note
Epiq Systems, Inc. is filing this Amendment No. 1 to our Annual Report on Form 10-K (Form 10-K/A) to restate our previously issued financial statements as of December 31, 2005 and 2004, and for each of the three years in the period ended December 31, 2005, included in our Annual Report on Form 10-K for the year ended December 31, 2005, initially filed with the SEC on March 8, 2006 and to restate the quarterly financial information included in that Annual Report on Form 10-K for the fiscal year ended December 31, 2005 initially filed with the SEC on March 8, 2006, as discussed in note 17 of the accompanying notes to the consolidated financial statements.
During fiscal year 2006, and subsequent to the original issuance of our Annual Report on Form 10-K for the fiscal year ended December 31, 2005, management identified an accounting error in its consolidated financial statements related to determination of the appropriate accounting treatment for certain complex aspects of revenue recognition, specifically the evaluation of vendor specific objective evidence of fair value for specified software upgrades provided within a bundled arrangement as required by Statement of Position 97-2 (SOP 97-2), Software Revenue Recognition. On November 14, 2006, our audit committee, in consultation with management, determined that our previously issued financial statements for the fiscal years ended December 31, 2005, 2004 and 2003, included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005, for the quarters ended March 31, 2006 and 2005, included in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2006, and for the quarters ended June 30, 2006 and 2005, included in our Quarterly Report on Form 10-Q for the quarter ended June 30, 2006, should be restated. The restatement is further discussed in note 17 of the accompanying consolidated financial statements.
This Form 10-K/A amends and restates Items 1, 1A, 2 and 5 of Part I, Items 6, 7, 8 and 9A of Part II, and Item 15 of Part IV of the original filing to reflect the effects of this restatement and to incorporate additional comments as a result of our receipt of comment letters from the SEC’s Division of Corporation Finance. The remaining Items contained within this Form 10-K/A consist of all other Items originally contained in Form 10-K for the fiscal year ended December 31, 2005. These remaining Items are not amended by this filing. Except for the forgoing amended information, this Form 10-K/A continues to describe conditions as of the date of the original filing, and we have not updated the disclosures contained herein to reflect events that occurred at a later date. In addition, pursuant to the rules of the SEC, Exhibits 31.1, 31.2, 32.1, and 32.2 of the original filing have been amended to contain currently dated certification from our Chief Executive Officer and Chief Financial Officer. The updated certifications are attached to this Form 10-K/A as Exhibits 31.1, 31.2, 32.1, and 32.2.
CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING STATEMENTS
In this report, in other filings with the SEC and in press releases and other public statements by our officers throughout the year, Epiq Systems, Inc. makes or will make statements that plan for or anticipate the future. These forward-looking statements include statements about our future business plans and strategies, and other statements that are not historical in nature. These forward-looking statements are based on our current expectations. Many of these statements are found in the “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” sections of this report.
Forward-looking statements may be identified by words or phrases such as “believe,” “expect,” “anticipate,” “should,” “planned,” “may,” “estimated,” “potential,” “goal,” and “objective.” Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended, provide a “safe harbor” for forward-looking statements. In order to comply with the terms of the safe harbor, and because forward-looking statements involve future risks and uncertainties, listed in Item 1A, “Risk Factors,” of this report are a variety of factors that could cause actual results and experience to differ materially from the anticipated results or other expectations expressed in our forward-looking statements. We undertake no obligation to update any forward-looking statements contained herein or in future communications to reflect future events or developments.
General
Epiq Systems, Inc. (Epiq) is a provider of technology-based solutions for the legal and fiduciary services industries. Our products and services assist clients with the administration of complex legal proceedings, including electronic discovery, bankruptcy administration and class action administration. Our clients include leading law firms, corporate legal departments, bankruptcy trustees, and other professional advisors who require sophisticated case administration and document management capabilities, extensive subject matter expertise and a high service capacity. We provide clients with an integrated offering of both proprietary technology and value-added services that comprehensively address their extensive business requirements.
We have acquired several companies as part of our strategic business plan. During 2005, we acquired nMatrix, Inc. to enter the market for electronic litigation discovery, Hilsoft, Inc. to enhance our capabilities in legal notification services, and Novare, Inc. to supplement our professional services for corporate restructuring client engagements. During 2004, we acquired Poorman-Douglas Corporation to enter the market for class action and mass tort administrative services. During 2003, we acquired Bankruptcy Services LLC (BSI) to enter the market for corporate restructuring bankruptcy reorganization administrative services.
In November 2003, we determined that our infrastructure software business, which operated in the automated data exchange software market, was no longer aligned with our long-term strategic objectives. On April 30, 2004, we completed the sale of this business.
We were incorporated in the State of Missouri on July 13, 1988, and on July 15, 1988 acquired all of the assets of an unrelated predecessor corporation, including the name, Electronic Processing, Inc. Our shareholders approved an amendment to our Articles of Incorporation on June 7, 2000 to change our name from Electronic Processing, Inc. to Epiq Systems, Inc.
Our principal executive office is located at 501 Kansas Avenue, Kansas City, Kansas 66105. The telephone number at that address is (913) 621-9500, and our website address is www.epiqsystems.com. We make available free of charge through our internet website our annual report on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K and amendments to those reports filed with or furnished to the SEC as soon as reasonably practicable after we electronically file those reports with or furnish them to the SEC. The public may read and copy any materials filed by us with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at http://www.sec.gov. The contents of these websites are not incorporated into this report. Further, our references to the URLs for these websites are intended to be inactive textual references only.
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Both our case management segment and our document management segment provide products and services primarily to the legal and fiduciary services industries. Segment information related to revenues from external customers, a measure of profit or loss, and total assets is contained in note 15 of the notes to consolidated financial statements. Our clients include leading law firms, corporate legal departments, bankruptcy trustees, case administrators and other professional advisors, who use our products and services for the administration of legal proceedings such as electronic litigation discovery, bankruptcy administration and class action administration.
Our case and document management segments provide our clients with a broad range of technology and service offerings to meet the unique needs and requirements of each matter. For example, a particular class action matter may require professional services, call center support and claims processing from our case management segment and a uniquely developed media campaign to provide notice to a class of unknown claimants and document custody services from our document management segment, while another class action matter may only require claims processing services from our case management segment and a simple class mailing notification to a class of known claimants from our document management segment. Not all cases have the same business requirements, and our expanded technology and service offerings allow clients to procure services from our broad range of case management and document management solutions.
Our case management and document management technology and service offerings provide solutions primarily for the bankruptcy, class action and mass tort and electronic discovery markets. These technology and service offerings can cross the various markets and customers we serve. For example, our legal notification expert may develop a document management notice program for either a bankruptcy matter or a class action matter. Our various proprietary technology solutions are used individually or in a unique combination for electronic discovery, class action, or bankruptcy matters. We provide a unique set of case management and document management capabilities for each particular matter.
We view each segment as providing a distinct group of services and solutions to our customers. Both groups of services and solutions are critical to our business as many of our customers will require both case management and document management solutions. By having both groups of services, we are able to provide the customer with an end-to-end solution. Our customers typically have a large amount of discrete information to organize and process. Case management provides a set of services to facilitate the “back-office” administration of cases for the bankruptcy, class action and electronic discovery markets. Document management consists primarily of notification for bankruptcy and class action customers. Our expertise enables us to provide this notification on a timely basis.
Electronic Discovery
The substantial increase of electronic documents in the business community has changed the dynamics of how attorney’s support discovery in complex litigation matters. According to the 2005 Socha-Gelbmann Electronic Discovery Survey, the 2004 domestic commercial electronic discovery revenues were estimated at $832 million, an approximate 94% increase from 2003. According to this same source, the market is expected to continue to grow at a substantial rate from 2005 to 2007, with expected increases of 50% to 60% each year. Due to the increasing complexity of cases, the increasing volume of data that are maintained electronically, and the increasing volume of documents (both paper and electronic) that are produced in all types of litigation, law firms are increasingly reliant on electronic evidence management systems to organize and manage the litigation discovery process.
Bankruptcy
Bankruptcy is an integral part of the United States’ economy, and bankruptcy filings have remained near record levels for the past several years. As reported by the Administrative Office of the U.S. Courts for the
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government fiscal years ended September 30, 2003, 2004, and 2005, there were approximately 1.66 million, 1.62 million, and 1.78 million new bankruptcy filings, respectively.
There are five chapters of the U.S. Bankruptcy Code that serve different purposes and require various types of services and information. Our products and services are designed for cases filed under the following three chapters:
· Chapter 7 is a liquidation bankruptcy for individuals or businesses that, as measured by the number of new cases filed in 2005, accounted for approximately 75% of all bankruptcy filings. In a Chapter 7 case, the debtor’s assets are liquidated and the resulting cash proceeds are used by the Chapter 7 bankruptcy trustee to pay creditors. Chapter 7 cases typically last several years.
· Chapter 11 is a reorganization model of bankruptcy for corporations that, as measured by the number of new cases filed in fiscal 2005, accounted for approximately 1% of all bankruptcy filings. Chapter 11 generally allows a company to continue operating under a plan of reorganization to restructure its business and to modify payment terms of both secured and unsecured obligations. Chapter 11 cases may last several years.
· Chapter 13 is a reorganization model of bankruptcy for individuals that, as measured by the number of new cases filed in 2005, accounted for approximately 24% of all bankruptcy filings. In a Chapter 13 case, debtors make periodic cash payments into a reorganization plan and a Chapter 13 bankruptcy trustee uses these cash payments to make monthly distributions to creditors. Chapter 13 cases typically last between three and five years.
The participants in a bankruptcy proceeding include the debtor, the debtor’s counsel, the creditors, and the bankruptcy judge. Chapter 7 and Chapter 13 cases also have a professional bankruptcy trustee who is responsible for administering the bankruptcy case. For Chapter 7 and 13 bankruptcy products and services, our customers are professional bankruptcy trustees. For Chapter 11 bankruptcy products and services, our customers are the debtor companies that file a plan of reorganization, often referred to as a debtor-in-possession.
Class Action
Class action and mass tort litigation have become a discrete component within the United States’ economy. Class action and mass tort refer to litigation in which class representatives bring a lawsuit against a defendant company or other persons on behalf of a large group of similarly affected persons (the class). Mass action or mass tort refers to class action cases that are particularly large or prominent.
The class action and mass tort marketplace is significant, with estimated annual tort claim costs in excess of $250 billion according to an update study issued in 2004 by Towers Perrin. Administrative costs, which include costs, other than defense costs, incurred by either the insurance company or self-insured entity in the administration of claims, comprise approximately 20% of this total. Key participants in this marketplace include law firms that specialize in representing class action and mass tort plaintiffs and other law firms that specialize in representing defendants. Class action and mass tort litigation is often complicated and the cases, including administration of any settlement, may last several years.
Products and Services
Case Management Segment
Case management support for client engagements may last several years and has a revenue profile that typically includes a recurring component. Our case management segment generates revenue primarily through the following integrated technology-based products and services.
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· An integrated solution of a proprietary technology platform and related professional services that facilitates case administration of bankruptcy, class action, commercial litigation, financial transaction, government settlements, and mass tort client engagements.
· Professional and support services, including case management, claims processing, specialty bankruptcy consulting, claims administration, project management, and customized programming and technology services.
· Data hosting fees, volume-based fees, and professional services fees related to the management of large volumes of electronic data in support of a legal proceeding.
· Proprietary electronic discovery software that sorts, cleanses, organizes and performs searches on large databases in support of a legal proceeding.
· Software installed in bankruptcy trustee offices and provided over the internet that facilitates the administration of Chapter 7 and Chapter 13 bankruptcy cases.
· Database conversions, maintenance and processing, such as creditor and class action claims, and conversion of that data into an organized, searchable, electronic database that we maintain on our servers and use, with our customer, to manage the particular case.
· Call center support to process and respond to telephone inquiries related to creditor and class action claims.
Document Management Segment
Document management revenue is generally non-recurring due to the unpredictable nature of the frequency, timing and magnitude of the clients’ business requirements. Our document management segment generates revenue primarily through the following services.
· Legal noticing services to parties of interest in bankruptcy and class action matters.
· Reimbursement for costs incurred related to postage on mailing services.
· Media campaign and advertising management in which we coordinate notification through various media outlets, such as print, radio and television, to potential parties of interest for a particular client engagement.
· Document custody services in which we maintain custody of key case documents and store those documents for our customer.
Customers
Our clients for both case management and document management segments include law firms, corporate legal departments, bankruptcy trustees and other professional advisors. Frequently, law firms act as referral sources for our products and services, which are ultimately consumed and paid for by a corporate client involved in a bankruptcy proceeding, class action settlement or other complex litigation. While a corporate client may sometimes be involved in only a single engagement with us, our relationship with the law firm is longer and normally spans multiple client engagements. Accordingly, we rely extensively on our network of law firm relationships and expend considerable resources to develop and extend those relationships.
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Electronic Litigation Discovery
For electronic litigation discovery, our customers are typically large corporations that use our products and services cooperatively with their legal counsel or other professional advisors to manage the electronic litigation discovery process.
Bankruptcy
For our Chapter 7 and Chapter 13 bankruptcy trustee products, our end-user customers are professional bankruptcy trustees. The Executive Office for United States Trustees, a division of the U.S. Department of Justice, appoints all bankruptcy trustees. A United States Trustee is appointed in most federal court districts and generally has responsibility for overseeing the integrity of the bankruptcy system. The bankruptcy trustee’s primary responsibilities include liquidating the debtor’s assets (Chapter 7) or collecting funds from the debtor (Chapter 13), distributing the collected funds to creditors pursuant to the orders of the bankruptcy court and preparing regular status reports for the Executive Office for United States Trustees and for the bankruptcy court. Trustees typically manage an entire caseload of bankruptcy cases simultaneously.
The application of Chapter 7 bankruptcy regulations has the practical effect of discouraging trustee customers from incurring direct administrative costs for computer system expenses. As a result, we provide our Chapter 7 products and services to trustee customers at no direct charge, and our trustee customers agree to maintain deposit accounts for bankruptcy cases under their administration at a designated banking institution. We have marketing arrangements with various banks under which we provide Chapter 7 trustee case management software and related services and the bank provides the Chapter 7 bankruptcy trustee with deposit-related banking services. Under these Chapter 7 deposit relationships, we receive revenues based on factors such as the aggregate amount of trustee deposits maintained at the bank, the number of customers using our product, software upgrades, and ancillary professional services. Prior to April 1, 2004, we had an exclusive marketing arrangement with Bank of America for Chapter 7 trustee products and services. Effective April 1, 2004, this relationship became a non-exclusive marketing arrangement. During February 2006, the parties agreed to extend the arrangement indefinitely. Either party may, with appropriate notice, wind down the arrangement over a period, including the notice period, of three years. Since April 1, 2004, we have established new deposit relationships with additional financial institutions. During the year ended December 31, 2005, a substantial majority of our Chapter 7 trustee clients’ deposits were maintained at Bank of America.
Our customers for corporate restructuring bankruptcy solutions are debtor corporations or businesses that file a plan of reorganization. Law firms representing these companies are a key conduit through which both we and our competitors gain access to the debtor companies prior to their filing for bankruptcy. Debtor’s counsel often uses our services and products directly on behalf of their client, and we have developed relationships with the bankruptcy departments at various law firms.
Class Action
Our customers for class action and mass tort solutions are primarily large corporations that are administering the settlement or resolution of class action or mass tort cases. We sell our services directly to those customers; however, our relationships with other interested parties, including plaintiff and defense law firms, often provide access to these customers.
Sales and Marketing
Our sales department markets our case management and document management products and services directly to prospective customers and referral law firms through on-site sales calls. We focus on attracting and retaining customers by providing integrated technology solutions with leading edge features and by providing exceptional customer service. Our account executives, case managers and relationship managers
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are responsible for providing ongoing support services for existing customers. Various relationship managers, case managers and sales representatives attend industry trade shows. We also conduct direct mail campaigns and advertise in trade journals.
Competition
There are a variety of companies competing, primarily on the basis of quality of service, technology innovations, and price, for the finite number of available client engagements that become available each year. Competitors include BMC Group, Inc., Bankruptcy Management Solutions, Inc., Electronic Evidence Discovery, Inc., Fios, Inc., The Garden City Group Inc., Kroll Ontrack, Inc., Rust Consulting Inc., The Trumbull Group, Zantaz, Lexis Nexis Applied Discovery and others. Additionally, certain law firms, accounting firms, management consultant firms, turnaround specialists and crisis management firms offer certain products and services that compete with ours.
Government Regulation
Our products and services are not directly regulated by the government. Our bankruptcy trustee customers and corporate restructuring debtor customers are, however, subject to significant regulation under the United States Bankruptcy Code, the Federal Rules of Bankruptcy Procedure and local rules and procedures established by bankruptcy courts. The Executive Office for United States Trustees, a division of the United States Department of Justice, oversees the bankruptcy industry and establishes administrative rules governing our clients’ activities. Our class action and mass tort cases are subject to various federal and state laws as well as rules and procedures established by the courts.
In February 2005, new federal class action and tort reform legislation was passed and signed by President Bush. The primary impact of the new federal legislation is to require that certain types of class action lawsuits be brought in federal court rather than state courts. We believe the new federal legislation will likely result in fewer class action lawsuits in state courts. The slower processing of class action lawsuits in federal courts could delay the ultimate settlement of those cases, which could adversely affect the timing of services we provide in those cases. Similar to this recent federal legislation, there have been various efforts at the state level to modify and reform the laws and procedures related to class action and mass tort. We cannot predict the effect, if any, that state legislative action would have on the number or size of class action and mass tort lawsuits filed or on the claims administration process.
In April 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 was passed and signed by President Bush. The intent of this legislation, which became effective October 2005, is to move certain individual bankruptcy filings from Chapter 7, which liquidates most of the debtor’s assets and discharges most of the debtor’s liabilities, to Chapter 13 which does not liquidate the debtor’s assets but which requires a debtor to pay disposable income to their creditors. The legislation also affects Chapter 11 bankruptcy filings, in part by placing more strict limits on the period of time in which the debtor has an exclusive right to propose a reorganization plan, accelerating the time frame in which a debtor must determine whether to reject a lease or other executory contract, and potentially increasing certain priority claims. The legislation appears to have had the effect of increasing bankruptcy filings prior to the effective date of the legislation. It is unclear what impact, if any, the legislation will have on bankruptcy filings after the legislation’s October 2005 effective date. As a result, we cannot predict the effect, if any, that this legislation will have on our business.
Employees
As of December 31, 2005, we employed approximately 500 full-time employees, none of whom is covered by a collective bargaining agreement. We believe the relationship with our employees is good.
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This report, other reports to be filed by us with the SEC, press releases made by us and other public statements by our officers, oral and written, contain or will contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended, including those relating to the possible or assumed future results of operations and financial condition. Because those statements are subject to a number of uncertainties and risks, actual results may differ materially from those expressed or implied by the forward-looking statements. Listed below are risks associated with an investment in our securities that could cause actual results to differ from those expressed or implied.
Substantially all of our Chapter 7 revenues are collected through a single financial institution, and the termination of that marketing arrangement could cause uncertainty and adversely affect our future Chapter 7 revenue and earnings.
The application of Chapter 7 bankruptcy regulations discourages Chapter 7 trustees from incurring direct administrative costs for computer system expenses. As a result, we provide our products and services to Chapter 7 trustee customers at no direct charge, and our Chapter 7 trustee customers agree to deposit the cash proceeds from liquidations of debtors’ assets with a designated financial institution with which we have a Chapter 7 marketing arrangement. We have arrangements with several financial institutions under which our Chapter 7 trustees deposit the Chapter 7 liquidated assets at one of those financial institutions. Under these arrangements:
· we license our proprietary software to the trustee and furnish hardware, conversion services, training and customer support, all at no cost to the trustee;
· the financial institution provides certain banking services to the joint trustee customers; and
· we collect from the financial institution monthly revenues based primarily upon a percentage of the total liquidated assets on deposit at that financial institution.
These bankruptcy deposit-based fees are the largest component of our Chapter 7 revenues.
Previously, we promoted our Chapter 7 product exclusively through a marketing arrangement established with Bank of America in November 1993. Substantially all of our Chapter 7 revenues are collected through this relationship. On April 1, 2004, this exclusive marketing arrangement became a non-exclusive arrangement. During February 2006, the parties agreed to extend the non-exclusive arrangement indefinitely. Either party may, with appropriate notice, wind down the arrangement over a period of three years, including the notice period. If either party were to give notice of termination of this arrangement, we could experience uncertainty relating to the transfer of Chapter 7 trustee deposits to other financial institutions, and we could experience a decline in revenues and earnings as those deposits were transferred during the wind-down period.
Chapter 7 revenues from Bank of America comprised 3%, 3% and 44% of our total revenue recognized for the years ended December 31, 2005, 2004, and 2003, respectively. As of December 31, 2005, 2004, and 2003, we had recorded on our consolidated balance sheets $59.7 million, $35.2 million, and $8.2 million, respectively, of deferred revenue related to Bank of America.
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We have established new arrangements with additional financial institutions, and changes in or terminations of those marketing arrangements could cause uncertainty and adversely affect our future Chapter 7 revenue and earnings.
We also have marketing arrangements with several other financial institutions under which our Chapter 7 trustees may deposit the Chapter 7 liquidated assets. Additionally, we may seek to establish additional Chapter 7 depository bank relationships in the future. Changes in the terms of one or more of those marketing arrangements or the termination of any of those marketing arrangements could create uncertainty with current and prospective trustee customers or operational difficulties for trustees, which could adversely affect our relationships with those joint customers and our Chapter 7 revenues and earnings.
Some of our pricing models for Chapter 7 trustee clients have or are scheduled to have a component of pricing tied to prevailing interest rates, and a significant decline in interest rates would adversely affect our revenues and earnings.
Under the Chapter 7 marketing arrangements we have with each depository financial institution, certain fees we earn for deposits placed with those financial institution could have, within certain limits, variability based on fluctuations in short-term interest rates. A significant decline in short-term interest rates would adversely affect our Chapter 7 revenues and earnings.
If a financial institution with which we have a marketing arrangement for Chapter 7 products and services is perceived negatively by current or prospective trustee clients, our case management revenue and earnings could be adversely affected.
The Chapter 7 depository banks, with which we have joint marketing arrangements, provide banking products and services directly to our trustee clients. If the financial institution provides ineffective banking products or services to the joint customers or has errors or omissions in its processing, we could experience collateral damage to our reputation. We cannot control the quality of products and services provided by the Chapter 7 depository banks to the joint customers. Additionally, if a depository bank arrangement is discontinued, it could disrupt the effective delivery of banking services to trustees. If the migration to a successor depository bank is not completed smoothly or if we were unable to move the trustee customer’s deposits to a different banking arrangement prior to the expiration, we could lose trustee customers, which could adversely affect our case management revenues and our results of operations.
Bankruptcy reform legislation could alter the market for our products and services, which could cause a reduction in our revenues and earnings.
In April 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 was passed and signed by President Bush. The intent of this legislation, which became effective October 2005, is to move certain individual bankruptcy filings from Chapter 7, which liquidates most of the debtor’s assets and discharges most of the debtor’s liabilities, to Chapter 13 bankruptcy filings, which do not liquidate the debtor’s assets but which requires a debtor to pay disposable income to their creditors. The legislation also affects corporate restructuring bankruptcy filings, in part by placing more strict limits on the period of time in which the debtor has an exclusive right to propose a reorganization plan, accelerating the time frame in which a debtor must determine whether to reject a lease, and potentially increasing certain priority claims. To date, the legislation appears to have had two effects: (1) a significant increase in the number of bankruptcy filings prior to the effective date of the legislation, and (2) a corresponding decline in bankruptcy filings in the few months after the effective date of the legislation. While neither of these two effects had an immediate material impact on our bankruptcy-related revenues, it is possible that there could be longer-term consequences to the reform legislation that we have not yet identified. As a result, we cannot predict the effect, if any, that this legislation will have on our business.
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Tort reform legislation could reduce the number and scope of class action and mass action cases, thus reducing our business prospects in the class action market.
In February 2005, new federal class action and tort reform legislation was passed and signed by President Bush. The primary impact of the new federal legislation is to require that certain types of class action lawsuits be brought in federal court rather than state courts. We believe the new federal legislation will likely result in fewer class action lawsuits in state courts, which are generally perceived as faster and more plaintiff-friendly than federal courts. The slower processing of class action lawsuits in federal courts could delay the ultimate settlement of those cases, which could adversely affect the timing of services we provide in those cases. Likewise, the new federal legislation could have the effect of lowering the overall number of class action cases, whether filed in federal or state courts. Similar to this recent federal experience, there have been various efforts at the state level to modify and reform the laws and procedures related to class action and mass tort. The goal of certain state tort reform proposals has been to reduce the number and scope of class action and mass action cases. While we cannot predict whether any tort reform legislation will pass at the state levels or the substance of any future changes, any legislative efforts that are successful in reducing the number or scope of class action or mass action cases would likely have an adverse effect on our results of operations.
We have a limited number of bankruptcy trustee clients and a limited number of significant referral sources for corporate restructuring and class action and mass tort engagements. The loss of even a limited number of our trustee customers or referral sources could result in a loss of revenue and earnings.
There is a limited number of Chapter 7 and Chapter 13 bankruptcy trustees to whom we can market our bankruptcy products and services. Additionally, we rely heavily on a limited number of corporate restructuring and class action referral sources to earn new business engagements. Our future financial performance will depend on our ability to maintain existing trustee customer accounts, to attract business from trustees that are currently using a competitor’s software product, to maintain our existing referral relationships, and to develop new referral relationships. The loss of even a limited number of trustee customers or a reduction in referral sources could result in a material loss of revenue and earnings.
We encounter competition for our products and services from other third party providers and we could lose existing customers and fail to attract new business.
The markets for case and document management products and services are competitive, continually evolving and subject to technological change. We believe that the principal competitive factors in the markets we serve include the breadth and quality of system and software solution offerings, the stability of the information systems provider, the features and capabilities of the product and service offerings, and the potential for enhancements. Our success will depend upon our ability to keep pace with technological change and to introduce, on a timely and cost-effective basis, new and enhanced software solutions and services that satisfy changing client requirements and achieve market acceptance.
The fluctuations in quarterly projects for clients have affected and may affect in the future the timing of our quarterly revenues and earnings and are likely to affect our future quarterly results.
The initiation or termination of a large corporate restructuring, class action or mass tort engagement can directly affect our revenues and earnings for a particular quarter, and the levels of services, particularly services related to document management required for an ongoing corporate restructuring or class action engagement can fluctuate quarter to quarter during the time that the debtor is in Chapter 11 corporate restructuring or the class action lawsuit is active.
9
Our quarterly results have fluctuated in the past and may fluctuate in the future. If they do, our operating results may not meet the expectations of securities analysts or investors. This could cause fluctuations in the market price of our common stock.
Our quarterly results have fluctuated during the last year and may fluctuate in the future. As a result, our quarterly revenues and operating results are increasingly difficult to forecast. It is possible that our future quarterly results from operations from time to time will not meet the expectations of securities analysts or investors. This could cause a material drop in the market price of our common stock.
Our business will continue to be affected by a number of factors, any one of which could substantially affect our results of operations for a particular fiscal quarter. Specifically, our quarterly results from operations can vary due to:
· fluctuations in bankruptcy trustees’ deposit balances or caseloads;
· unanticipated expenses related to software maintenance or customer service;
· the timing, size, cancellation or rescheduling of customer orders; and
· the timing and market acceptance of new software versions or support services.
Our stock price may be volatile even if our quarterly results do not fluctuate significantly.
If our quarterly results fluctuate, the market price for our common stock may fluctuate as well and those fluctuations may be significant. Even if we report stable or increased earnings, the market price of our common stock may be volatile. There are a number of factors, beyond earnings fluctuations, that can affect the market price of our common stock, including the following:
· a decrease in market demand for our stock;
· downward revisions in securities analysts’ estimates;
· announcements of technological innovations or new products developed by us or our competitors;
· the degree of customer acceptance of new products or enhancements offered by us;
· general market conditions and other economic factors; and
· actual or perceived improvements in the national economy and the corresponding assumption that our bankruptcy business will decline as the economy improves.
In addition, the stock market has experienced significant price and volume fluctuations that have particularly affected the market prices of stocks of technology companies and that have often been unrelated to the operating performance of particular companies. The market price of our common stock has been volatile and this is likely to continue.
10
If corporate restructuring cases on which we are retained convert to Chapter 7, we may not be paid for the products and services we have provided.
In corporate restructuring engagements we provide services directly to the debtor and we are paid directly by the debtor. If a debtor’s corporate restructuring case converts to Chapter 7 liquidation, we might not be paid for products and services previously provided and we would most likely lose all future revenue from the case. We have had corporate restructuring cases convert to Chapter 7 cases in the past. The conversion of a major corporate restructuring case to Chapter 7 could have a material adverse effect on our results of operations.
If the bankruptcy court reduces or eliminates our fees in major corporate restructuringcases, our results of operations could be impaired.
In corporate restructuring cases, the bankruptcy court may reduce or eliminate fees paid for administrative services such as those we provide. If the court reduced or eliminated fees due to us in a major corporate restructuring case, our results of operations could be materially affected.
If we are unable to develop new technologies, we could lose existing customers and fail to attract new business.
We regularly undertake new projects and initiatives in order to meet the changing needs of our customers. In doing so, we invest substantial resources with no assurance of the ultimate success of the project or initiative. We believe our future success will depend, in part, upon our ability to:
· enhance our existing products;
· design and introduce new solutions that address the increasingly sophisticated and varied needs of our current and prospective customers;
· maintain our technology skills; and
· respond to technological advances and emerging industry standards on a timely and cost-effective basis.
We may not be able to incorporate future technological advances into our business, and future advances in technology may not be beneficial to or compatible with our business. In addition, keeping abreast of technological advances in our business may require substantial expenditures and lead-time. We may not be successful in using new technologies, adapting our solutions to emerging industry standards, or developing, introducing and marketing new products or enhancements. Furthermore, we may experience difficulties that could delay or prevent the successful development, introduction or marketing of these products. If we incur increased costs or are unable, for technical or other reasons, to develop and introduce new products or enhancements in a timely manner in response to changing market conditions or customer requirements, we could lose existing customers and fail to attract new business.
New releases of our software products may have undetected errors, which could cause litigation claims against us or damage to our reputation.
We intend to continue to issue new releases of our software products periodically. Complex software products, such as those we offer, can contain undetected errors when first introduced or as new versions are released. Any introduction of new products and future releases has a risk of undetected errors. These undetected errors may be discovered only after a product has been installed and used by our customers. Likewise, the software products we acquire in business acquisitions have a risk of undetected errors.
11
Errors may be found in our software products in the future. Any undetected errors, as well as any difficulties in installing and maintaining our new software and releases or difficulties training customers and their staffs on the utilization of new products and releases, may result in a delay or loss of revenue, diversion of development resources, damage to our reputation, increased service costs, increased expense for litigation and impaired market acceptance of our products.
Security problems with, or product liability claims arising from, our software products and business processes could cause increased expense for litigation, increased service costs and damage to our reputation.
We have included security features in our products that are intended to protect the privacy and integrity of data. Security for our products is critical given the highly confidential nature of the information our software processes. Our software products and the servers on which the products are used may not be impervious to intentional break-ins (“hacking”) or other disruptive problems caused by the internet or by other users. Hacking or other disruptive problems could result in the diversion of development resources, damage to our reputation, increased service costs or impaired market acceptance of our products, any of which could result in higher expenses or lower revenues. Additionally, we could be exposed to potential liability related to hacking or other disruptive problems. Defending these liability claims could result in increased expenses for litigation and a significant diversion of our management’s attention.
Furthermore, we administer claims for third parties. Errors or fraud related to the processing or payment of these claims could result in the diversion of management resources, damage to our reputation, increased service costs or impaired market acceptance of our services, any of which could result in higher expenses and/or lower revenues. Additionally, such errors or fraud related to the processing or payment of claims could result in lawsuits alleging damages. Defending such claims could result in increased expenses for litigation and a significant diversion of our management’s attention.
Interruptions or delays in service from our third-party Web hosting facility could impair the delivery of our service and harm our business.
We provide certain of our services through computer hardware that is currently located in a third-party Web hosting facility operated by a third party vendor. We do not control the operation of this facility, and it is subject to damage or interruption from earthquakes, floods, fires, power loss, terrorist attacks, telecommunications failures and similar events. It is also subject to break-ins, sabotage, intentional acts of vandalism and similar misconduct. The occurrence of a natural disaster, a decision to close the facility without adequate notice or other unanticipated problems at the facility could result in lengthy interruptions in our service. In addition, the failure by our vendor to provide our required data communications capacity could result in interruptions in our service. Any damage to, or failure of, our systems could result in interruptions in our service. Interruptions in our service may reduce our revenue, cause us to issue credits or pay penalties, cause customers to terminate their agreements with us and adversely affect our ability to secure business in the future. Our business will be harmed if our customers and potential customers believe our service is unreliable.
If our security measures are breached and unauthorized access is obtained to a customer’s data, our service may be perceived as not being secure, customers may curtail or stop using our service and we may incur significant liabilities.
Our service involves the storage and transmission of customers’ proprietary information, and security breaches could expose us to a risk of loss of this information, litigation and possible liability. If our security measures are breached as a result of third-party action, employee error, malfeasance or otherwise and, as a result, someone obtains unauthorized access to one of our customers’ data, our reputation will be damaged, our business may suffer and we could incur significant liability. Because techniques used to obtain unauthorized access or to sabotage systems change frequently and generally are not recognized until launched against a target, we may be unable to anticipate these techniques or to implement adequate
12
preventative measures. If an actual or perceived breach of our security occurs, the market perception of the effectiveness of our security measures could be harmed and we could lose sales and customers.
We may be sued by third parties for alleged infringement of their proprietary rights.
The software and internet industries are characterized by the existence of a large number of patents, trademarks, and copyrights and by frequent litigation based on allegations of infringement or other violations of intellectual property rights. We have received in the past, and may receive in the future, communications from third parties claiming that we have infringed on the intellectual property rights of others. Our technologies may not be able to withstand any third-party claims or rights against their use. Any intellectual property claims, with or without merit, could be time-consuming and expensive to resolve, could divert management attention from executing our business plan, and could require us to pay monetary damages or enter into royalty or licensing agreements. In addition, certain customer agreements require us to indemnify our customers for third-party intellectual property infringement claims, which would increase the cost to us of an adverse ruling on such a claim. An adverse determination could also prevent us from offering our service to others.
We rely on third-party hardware and software, which could cause errors or failures of our service.
We rely on hardware purchased or leased and software licensed from third parties in order to offer certain services. Any errors or defects in third-party hardware or software could result in errors or a failure of our service which could harm our business.
Our intellectual property is not protected through patents or formal copyright registration. Therefore, we do not have the full benefit of patent or copyright laws to prevent others from replicating our software.
Our intellectual property rights are not protected through patents or formal copyright registration. We may not be able to protect our trade secrets or prevent others from independently developing substantially equivalent proprietary information and techniques or from otherwise gaining access to our trade secrets. In addition, foreign intellectual property laws may not protect our intellectual property rights. Moreover, litigation may be necessary to enforce our intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others or to defend against claims of infringements. Litigation of this nature could result in substantial expense for us and diversion of management and other resources, which could result in a loss of revenue and profits.
Our failure to develop and maintain products and services that assist our customers in complying with significant government regulation could result in decreased demand for our products and services.
Our products and services are not directly regulated by the government. Our bankruptcy customers are, however, subject to significant regulation, including the United States Bankruptcy Code, the Federal Rules of Bankruptcy Procedure and local rules and procedures established by bankruptcy courts. The Executive Office for United States Trustees, a division of the United States Department of Justice, oversees bankruptcy trustees and establishes administrative rules governing trustees’ activities. Additionally, the process of administering the settlement of class action or mass tort cases is subject to court supervision and review by opposing plaintiffs’ and defendants’ counsel. The success of our business has been, and will continue to be, partly dependent on our ability to develop and maintain products and provide services that allow clients to perform their duties within applicable regulatory and judicial rules and procedures and that allow corporate restructuring debtors to make filings and send required notices on a timely and accurate basis. Future regulation and court practices or procedures may limit or eliminate the ability of clients to utilize the types of products and services that we currently provide. Our failure to adapt our products and services to
13
changes in the Bankruptcy Code and applicable legislative and judicial rules and procedures could cause us to lose existing customers or fail to attract new customers.
The integration of acquired businesses is time consuming, may distract our management from our other operations, and can be expensive, all of which could reduce or eliminate our expected earnings.
In November 2005, we acquired nMatrix for approximately $126 million in cash and stock. In January 2004, we acquired Poorman-Douglas for approximately $116 million in cash. In addition to these acquisitions, during the five years ended December 31, 2005, we acquired five other businesses at a combined cost of approximately $90 million. We may consider additional opportunities to acquire other companies, assets or product lines that complement or expand our business. If we are unsuccessful in integrating these companies or product lines with our existing operations, or if integration is more difficult than anticipated, we may experience disruptions to our operations. A difficult or unsuccessful integration of an acquired business would likely have a material adverse effect on our results of operations.
Some of the risks that may affect our ability to integrate or realize any anticipated benefits from companies we acquire include those associated with:
· unexpected losses of key employees or customers of the acquired company;
· conforming the acquired company’s standards, processes, procedures and controls with our operations;
· increasing the scope, geographic diversity and complexity of our operations;
· difficulties in transferring processes and know-how;
· difficulties in the assimilation of acquired operations, technologies or products;
· diversion of management’s attention from other business concerns;
· adverse effects on existing business relationships with customers; and
· the challenges of operating internationally after the nMatrix acquisition.
In certain circumstances, we may be obligated to pay one of our shareholders the difference between $20.35 per share and the price at which that shareholder sells up to 1,228,501 shares of our common stock, which could adversely affect the market price of our common stock.
We issued to the former owner of nMatrix 1.2 million shares as a part of the purchase price for the nMatrix business. We are required to maintain an effective registration statement for the resale of those shares by that shareholder until November 15, 2007. Our agreement with that shareholder includes a limited price protection provision, which provides that if the shareholder sells any of those shares pursuant to the registration statement at a per share price (before commissions and other transaction expenses) lower than $20.35, then we will pay that selling shareholder an amount in cash equal to the number of shares sold by the shareholder multiplied by the difference between the $20.35 minus the sale price. The limited price protection will terminate permanently upon the earlier of termination of our obligation to maintain effectiveness of the registration statement or, during the period of effectiveness of the registration statement, after any 15 trading days (which need not be consecutive trading days) on which both of the following conditions are satisfied: (1) the shareholder may lawfully sell shares under the registration statement, and (2) the closing price for our common stock has been equal to or greater than $20.35 per share.
14
As a result of the imminent expiration of either the limited price protection, the shareholder may choose to sell all or substantially all the shares of our common stock then held by that shareholder subject to these agreements. Those sales could adversely affect the market price of our common stock at that time.
Our business and results of operations may be adversely affected if we are unable to manage our growth effectively.
Certain businesses we have acquired, including most recently the nMatrix business, have experienced substantial growth immediately prior to the time we acquired the business. The success of those types of acquisitions is dependent upon a number of factors, including the ability to hire, train and retain an adequate number of experienced managers and employees for those rapidly growing businesses, the establishment of policies, procedures and internal controls to allow us to monitor the growth of those businesses, and other factors that are beyond our control. Expansion internationally will increase demands on management and divert their attention, which could have an adverse impact on our business and financial results. The challenges of managing the growth of an acquired business may distract our management from their normal duties associated with our historical core businesses.
We have non-U.S. operations which are subject to certain inherent risks.
As a result of our recent acquisition of nMatrix, we now maintain small offices in the United Kingdom and Australia. We anticipate that we will seek to expand our currently limited global operations and may enter new global markets. Our foreign business is transacted in the local functional currency, but we do not currently have any material exposure to foreign currency transaction gains or losses. All other business transactions are in U.S. dollars. To date, we have not entered into any derivative financial instruments to manage our foreign currency risk. Our current and proposed international activities are subject to certain inherent risks, including specific country economic conditions, exchange rate fluctuation, changes in regulatory requirements, reduced protection of intellectual property rights, potential adverse tax consequences, different or additional product functionality requirements, and cultural differences.
The use of our common stock to fund acquisitions or to refinance debt incurred for acquisitions could dilute existing shares.
We have used our common stock to refinance debt incurred for several prior acquisitions. During June 2004, we issued $50 million of convertible notes, which are convertible into approximately 2.9 million shares of common stock, to refinance a portion of the purchase price for the January 2004 Poorman-Douglas acquisition. During November 2005, we issued approximately 1.2 million shares of common stock and incurred approximately $101 million of bank indebtedness in connection with our nMatrix acquisition. We may consider issuing additional common shares and using the proceeds to pay part or all of this additional indebtedness.
We may consider further opportunities to acquire companies, assets or product lines that complement or expand our business. We expect that future acquisitions, if any, could provide for consideration to be paid in cash, shares of our common stock, or a combination of cash and shares. If the consideration for an acquisition is paid in common stock, existing shareholders’ investments could be diluted. Furthermore, we may decide to issue convertible debt or additional shares of common stock and use part or all of the proceeds to finance or refinance the costs of any past or future acquisitions.
15
We depend upon our key personnel and we may not be able to retain them or to attract, assimilate and retain highly qualified employees in the future.
Our future success will depend in significant part upon the continued service of our senior management and certain of our key technical personnel and our continuing ability to attract, assimilate and retain highly qualified technical, managerial, and sales and marketing personnel. We do not have employment agreements with our Chief Executive Officer, President, or Chief Financial Officer. We do have employment agreements with our Chief Executive Officer — Poorman-Douglas Corporation, our President — Bankruptcy Services LLC., and key executives of nMatrix. We maintain key-man life insurance policies on our Chief Executive Officer and our President. The loss of the services of any of these executives or other key personnel or the inability to hire or retain qualified personnel in the future could have a material adverse impact on our results of operations.
We do not pay cash dividends on our common stock and our common stock may not appreciate in value or even maintain the price at which you purchased your shares.
We presently do not intend to pay any cash dividends on our common stock. Subject to any financial covenants in current or future financing agreements that directly or indirectly restrict the payment of dividends, the payment of dividends is within the discretion of our board of directors and will depend upon our future earnings, if any, our capital requirements, our financial condition and any other factors that the board of directors may consider. In addition, certain terms of our convertible notes and certain provisions in our credit agreement may restrict our ability to pay dividends in the future. We currently intend to retain all earnings to reduce our debt and for use in the operation and expansion of our business. As a result, the success of your investment in our common stock will depend entirely upon its future appreciation. Our common stock may not appreciate in value or even maintain the price at which you purchased your shares.
Our articles of incorporation contain a provision that could be used by us, without shareholder approval, to discourage or prevent a takeover of our company.
Some provisions of our articles of incorporation could make it more difficult for a third party to acquire control of our company, even if the change of control would be beneficial to certain shareholders. For example, our articles of incorporation include “blank check” preferred stock provisions, which permit our board of directors to issue one or more series of preferred stock without shareholder approval. In conjunction with the issuance of a series of preferred stock, the board is authorized to fix the rights of that series, including voting rights, liquidation preferences, conversion rights and redemption privileges. The board could issue a series of preferred stock to a friendly investor and use one or more of these features of the preferred stock to discourage or prevent a takeover of the company. Additionally, our articles of incorporation do not permit cumulative voting in the election of directors. Cumulative voting, if available, would enable minority shareholders to elect one or more representatives to the board in certain circumstances, which could be used by third parties to facilitate a takeover of our company that was opposed by our board or management.
16
Compliance with changing regulation of corporate governance and public disclosure may result in additional expenses.
Compliance with changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations, and Nasdaq National Market rules, are time consuming and expensive. Since 2002, we have spent substantial amounts of management time and have incurred substantial legal and accounting expense in complying with the Sarbanes-Oxley Act and regulatory initiatives resulting from that Act. Complying with these new laws and regulations also creates uncertainty for companies such as ours. These new or changed laws, regulations and standards are subject to varying interpretations in many cases due to their lack of specificity. As a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, our efforts to comply with evolving laws, regulations and standards have resulted in, and are likely to continue to result in, increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities. In particular, our efforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002 and the related regulations regarding our required assessment of our internal controls over financial reporting and our external auditors’ certification of that assessment have required the commitment of significant financial and managerial resources. We expect these efforts to require the continued commitment of significant resources.
SEC rules implementing Section 404 of Sarbanes-Oxley require disclosure of the remediation of significant deficiencies or material weaknesses in internal controls over financial reporting and the existence, at year-end, of material weaknesses related to our internal control over financial reporting. If we are required to make any of these types of disclosures in the future, these disclosures could adversely affect the price of our common stock.
17
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
Our corporate headquarters are located in a 49,000-square-foot facility in Kansas City, Kansas. This owned property serves as collateral under our credit facility. We also have significant corporate offices in New York City and in metropolitan Portland, Oregon, and maintain smaller offices in Chicago, Miami, Washington, D.C., Los Angeles, Philadelphia and London.
We occasionally become involved in litigation arising in the normal course of business. There is no currently pending or, to the knowledge of management, threatened material litigation against us.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted in the fourth quarter of 2005 to a vote of security holders.
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ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock is traded under the symbol “EPIQ” on the Nasdaq National Market. The following table shows the reported high and low sales prices for the common stock for the calendar quarters of 2005 and 2004 as reported by Nasdaq:
|
|
| 2004 |
| |||||||||
|
| High |
| Low |
| High |
| Low |
| ||||
First Quarter |
| $ | 15.00 |
| $ | 12.05 |
| $ | 20.90 |
| 15.50 |
| |
Second Quarter |
| 16.97 |
| 12.90 |
| 17.80 |
| 13.24 |
| ||||
Third Quarter |
| 22.22 |
| 16.13 |
| 16.65 |
| 12.63 |
| ||||
Fourth Quarter |
| 22.44 |
| 17.21 |
| 17.03 |
| 13.81 |
| ||||
As of February 17, 2006, there were approximately 100 owners of record of our common stock and approximately 4,200 beneficial owners of our common stock.
Dividends
At this time, we intend to retain our earnings to reduce our debt and for use in the operation and expansion of our business. Accordingly, we do not expect to declare or pay any cash dividends in the foreseeable future. Under the terms of our subordinated convertible debt agreement, we are restricted from payment of dividends while the subordinated convertible debt is outstanding. Thereafter, the payment of dividends is within the discretion of our board of directors and will depend upon various factors, including future earnings, capital requirements, financial condition, the terms of our credit agreement, the terms of our convertible notes, and other factors deemed relevant by the board of directors. Various financial covenants in our credit agreement and our outstanding convertible notes may have the effect of limiting the ability of our board of directors to declare and pay cash dividends on our common stock. There is no restriction on the ability of our subsidiaries to transfer funds to Epiq in the form of cash dividends, loans or advances.
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Equity Compensation Plan Information
The following table sets forth as of December 31, 2005 (a) the number of securities to be issued upon exercise of outstanding options, warrants and rights, (b) the weighted average exercise price of outstanding options, warrants and rights and (c) the number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a)).
|
| (a) |
| (b) |
| (c) |
| |||
|
|
|
|
|
|
|
| Number of securities |
| |
Equity compensation plans approved by security holders |
| 4,119,000 |
| $ | 13.77 |
| 986,000 |
| ||
Equity compensation plans not approved by security holders |
| 650,000 |
| $ | 19.03 |
| 0 |
| ||
Total |
| 4,769,000 |
| $ | 14.49 |
| 986,000 |
| ||
As of December 31, 2005, equity compensation plans approved by security holders consist of our 1995 Stock Option Plan and our 2004 Equity Incentive Plan. Securities remaining available for future issuance under equity compensation plans approved by security holders consist solely of shares available under the 2004 Equity Incentive Plan. Securities remaining available for future issuance under our 2004 Equity Incentive Plan may be issued, in any combination, as incentive stock options, non-qualified stock options, stock appreciation rights or restricted stock.
As of December 31, 2005, equity compensation plans not approved by security shareholders consist solely of stock options issued in conjunction with our acquisitions of BSI, Poorman-Douglas, and nMatrix. The stock options issued to key employees of BSI, Poorman-Douglas, and nMatrix were inducement stock options issued in conjunction with the execution of employment agreements with each of those key employees to become employees of our newly acquired subsidiaries. In accordance with the Nasdaq corporate governance rules, shareholder approval of these inducement stock option grants was not required.
The stock options granted under equity compensation plans not approved by security holders were granted at an option exercise price equal to fair market value of the common stock on the date of grant, are non-qualified options, are exercisable for up to 10 years from the date of grant, and otherwise have terms substantially identical to the material terms of the 1995 Stock Option Plan and the 2004 Equity Incentive Plan. Stock options granted in conjunction with the acquisition of BSI vested 20% on January 31, 2003, the grant date thereof, and continue to vest 20% per year on each anniversary of the grant date until fully vested on January 31, 2007. Stock options granted in conjunction with the acquisition of Poorman-Douglas vest 20% per year, with the initial vesting having occurred January 31, 2005, over five years. Stock options granted in conjunction with the acquisition of nMatrix vest 25% per year, with the initial vesting to occur November 15, 2007, over five years.
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Recent Sales of Unregistered Securities
On November 15, 2005, we issued 1,228,501 shares of restricted common stock to the sole owner of nMatrix as payment of a portion of the nMatrix purchase price. We issued the common stock in reliance on the exemption from registration in Section 4(2) of the Securities Act of 1933, as amended.
The 1.2 million shares issued in the nMatrix acquisition were issued to the sole owner of nMatrix (Seller), which also received approximately $100 million in cash in that transaction. The stock purchase agreement included customary representations by Seller that, among other things, Seller is an “accredited investor” and is capable of evaluating the merits and risks of acquiring the shares, that Seller has received and reviewed certain material from the company, including our periodic reports under the Exchange Act, that Seller was acquiring the share consideration for investment and not with a view toward, or for sale in connection with, any distribution thereof, or with any present intention of distributing or selling the share consideration, other than pursuant to a valid registration statement. In addition, Seller acknowledged in the stock purchase agreement that the shares had not been registered under the Securities Act or the securities or “blue sky” laws of any state, and agreed that the shares would not be sold, transferred, offered for sale, pledged, hypothecated or otherwise disposed of without registration under the Securities Act, except pursuant to registration of the reoffer and resale of the share consideration pursuant to the Securities Act, or pursuant to an exemption from registration available under the Securities Act.
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
None.
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ITEM 6. SELECTED FINANCIAL DATA
The following table presents selected historical financial data for the years ended December 31, 2005, 2004, 2003, 2002, and 2001. The selected financial data gives effect to the restatement discussed in note 17 to the consolidated financial statements.
|
| (In Thousands, Except Per Share Data) |
| |||||||||||||
|
| Years Ended December 31, |
| |||||||||||||
|
| 2005 |
| 2004 |
| 2003 |
| 2002 |
| 2001 |
| |||||
|
| (As Restated) |
| (As Restated) |
| (As Restated) |
|
|
|
|
| |||||
|
|
|
|
|
|
|
|
|
|
|
| |||||
|
|
|
|
|
|
|
|
|
|
|
| |||||
INCOME STATEMENT DATA: |
|
|
|
|
|
|
|
|
|
|
| |||||
Revenues from continuing operations |
| $ | 106,330 |
| $ | 98,368 |
| $ | 59,780 |
| $ | 36,256 |
| $ | 28,149 |
|
Income (loss) from continuing operations |
| (3,842 | ) | (7,290 | ) | 9,595 |
| 9,766 |
| 6,253 |
| |||||
Income (loss) from discontinued operations |
| — |
| 667 |
| (5,818 | ) | (1,533 | ) | (1,311 | ) | |||||
Net income (loss) |
| (3,842 | ) | (6,623 | ) | 3,777 |
| 8,233 |
| 4,942 |
| |||||
Income (loss) per share — Diluted |
|
|
|
|
|
|
|
|
|
|
| |||||
from continuing operations |
| $ | (0.21 | ) | $ | (0.41 | ) | $ | 0.53 |
| $ | 0.64 |
| $ | 0.44 |
|
from discontinued operations |
| $ | — |
| $ | 0.04 |
| $ | (0.32 | ) | $ | (0.10 | ) | $ | (0.09 | ) |
Net income (loss) per share — Diluted |
| $ | (0.21 | ) | $ | (0.37 | ) | $ | 0.21 |
| $ | 0.54 |
| $ | 0.35 |
|
|
|
|
|
|
|
|
|
|
|
|
| |||||
BALANCE SHEET DATA: |
|
|
|
|
|
|
|
|
|
|
| |||||
Working capital related to continuing operations |
| $ | (25,090 | ) | $ | 22,979 |
| $ | 39,023 |
| $ | 63,503 |
| $ | 27,286 |
|
Total assets |
| 418,471 |
| 244,317 |
| 143,186 |
| 108,037 |
| 70,648 |
| |||||
Long-term debt |
| 145,906 |
| 74,499 |
| 3,066 |
| 289 |
| 594 |
| |||||
Stockholders’ equity |
| 140,468 |
| 118,550 |
| 124,325 |
| 102,375 |
| 65,144 |
|
During June 2001, we completed a follow-on offering of 1,537,500 shares of common stock and received net proceeds of $22.7 million.
During October 2001, we acquired certain assets from ROC Technologies. The acquisition was accounted for using the purchase method of accounting with the operating results of ROC Technologies included in our statements of operations since the date of acquisition.
During July 2002, we acquired the Chapter 7 trustee business of CPT Group, Inc. The acquisition was accounted for using the purchase method of accounting with the operating results of CPT Group included in our statements of operations since the date of acquisition.
During November 2002, we completed a private placement of 2,000,000 shares of common stock and received net proceeds of $28.1 million.
During January 2003, we acquired the member interests of BSI. The acquisition was accounted for using the purchase method of accounting with the operating results of BSI included in our statements of operations since the date of acquisition. See note 13 of the notes to consolidated financial statements.
As explained in note 17 of the notes to consolidated financial statements, in October 2003 we entered into a three-year arrangement related to our Chapter 7 bankruptcy trustee business that included various elements which had previously been provided on a standalone basis. As a result, subsequent to October 1, 2003 we deferred substantially all of our Chapter 7 bankruptcy trustee revenue. The effect of this deferral reduced revenue recognized for the years ended December 31, 2005, 2004 and 2003; substantially decreased our net income for the year ended December 31, 2003 and increased our net loss for the years ended December 31, 2005 and 2004 compared with prior years; and substantially decreased our working capital as of December 31, 2005.
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During November 2003, the decision was made to dispose of our infrastructure software business and the business was sold in April 2004. Accordingly, all revenues, cost of sales, operating expenses, assets and liabilities related to infrastructure software have been reclassified as discontinued operations for all periods presented. See note 14 of the notes to consolidated financial statements.
During January 2004, we acquired the equity of P-D Holding Corp. and its wholly-owned operating subsidiary, Poorman-Douglas Company (Poorman-Douglas). The acquisition was accounted for using the purchase method of accounting with the operating results of Poorman-Douglas included in our statement of operations since the date of acquisition. See note 13 of the notes to consolidated financial statements.
During October 2005, we acquired the equity of Hilsoft, Inc. (Hilsoft). The acquisition was accounted for using the purchase method of accounting with the operating results of Hilsoft included in our statement of operations since the date of acquisition. See note 13 of the notes to consolidated financial statements.
During November 2005, we acquired the equity of nMatrix, Inc. and nMatrix Australia Pty. Ltd. (collectively, nMatrix). The acquisition was accounted for using the purchase method of accounting with the operating results of nMatrix included in our statement of operations since the date of acquisition. See note 13 of the notes to consolidated financial statements.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
This discussion and analysis should be read in conjunction with the consolidated financial statements and the accompanying notes to the consolidated financial statements included in the Form 10-K/A and gives effect to the restatement described in note 17 to the accompanying consolidated financial statements.
Management’s Overview
We are a provider of technology-based solutions for the legal and fiduciary services industries. Our products and services assist clients with the administration of complex legal proceedings, including electronic litigation discovery, bankruptcy administration and class action administration. We have two operating segments: case management and document management.
Our case management segment generates revenue primarily through integrated technology-based products and services that support client engagements for electronic litigation discovery, class action and mass tort, and bankruptcy proceedings that can last several years and has a revenue profile that typically includes a recurring component. Our document management segment generates revenue primarily through legal noticing services, reimbursement for costs incurred related to postage on mailing services, media campaign and advertising management and document custody services. Document management revenue is generally less recurring due to the unpredictable nature of the frequency, timing, and magnitude of the clients’ business requirements.
The number of new bankruptcy filings each year may vary based on the level of consumer and business debt, the general economy, interest rate levels and other factors. For the government fiscal years ended September 30, 2003, 2004, and 2005, the Administrative Office of the U.S. Courts reported approximately 1.66 million, 1.62 million, and 1.78 million new bankruptcy filings, respectively. We believe an important indicator of future bankruptcy filings is the level of consumer and business debt outstanding. The most recent available Federal Reserve Flow of Funds Accounts of the United States, dated December 8, 2005, reported increases in both consumer and business debt outstanding as compared with the same period of the prior year.
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For our Chapter 7 bankruptcy services, our end-user customers are professional bankruptcy trustees. The application of Chapter 7 bankruptcy regulations has the practical effect of discouraging trustee customers from incurring direct administrative costs for computer system expenses. As a result, we provide our Chapter 7 services to trustee customers at no direct charge, and our trustee customers maintain deposit accounts for bankruptcy cases under their administration at a designated banking institution. We have marketing arrangements with various banks under which we provide Chapter 7 bankruptcy trustee case management software and related services and the bank provides the Chapter 7 bankruptcy trustee with deposit-related banking services. Our most significant marketing arrangement is with our primary depository institution, Bank of America. Under this arrangement, we primarily receive revenue based on the aggregate amount of trustee deposits and the number of Chapter 7 trustees which we refer to collectively as volume-based fees. These volume-based fees compensate us for the software license, hardware and postcontract customer support services which we provide to the Chapter 7 bankruptcy trustees.
Prior to October 2003, our primary depository institution engaged us to provide the trustees with software upgrades in the first and second quarter of each year. These software upgrades were documented in arrangements which were separate from our volume-based fee arrangement. Once the upgrade was delivered to the trustees and we had provided satisfactory evidence of the delivery, we would invoice the primary depository institution for the agreed upon amount and recognize revenue related to the software upgrade.
In October 2003, we entered into a new arrangement (the 2003 Arrangement) with the primary depository institution. As a part of the 2003 Arrangement, we agreed to continue to perform each of our first and second quarter software upgrades through the term of the arrangement, and the primary depository institution agreed to compensate us for these upgrades on terms similar to our historical terms when we delivered the upgrades on a standalone basis. As the 2003 Arrangement included volume-based pricing related to our software license, hardware and postcontract customer support services, as well as pricing related to software upgrades and special projects, the 2003 Arrangement was considered a bundled arrangement. As the 2003 Arrangement involved the delivery of software, we accounted for this arrangement pursuant to Statement Of Position 97-2, Software Revenue Recognition (SOP 97-2). For bundled arrangements, SOP 97-2 requires that for separate elements of the arrangement, such as software upgrades, we must be able to establish vendor specific objective evidence (VSOE) of fair value. VSOE is established based on the price charged when the same element is sold on a standalone basis. Although we historically sold software upgrades on a standalone basis, each software upgrade is considered a separate product and, therefore, we determined that the price of prior software upgrades cannot be used to establish the price of future software upgrades. As the primary financial institution was our only payee for software upgrades during the period of the 2003 Arrangement, we were unable to establish VSOE for the software upgrades. Under SOP 97-2, if VSOE cannot be established for software upgrades, then consideration received under the 2003 Arrangement, except for consideration related to the provision of hardware and hardware maintenance, must be deferred until all software upgrades have been delivered. Under the terms of the 2003 Arrangement, the final software upgrade will be delivered in the second quarter of 2006. Although, during the period of the 2003 Arrangement, we continued to invoice, and the primary financial institution continued to pay, our volume-based fees related to software licenses and postcontract customer support as well as our semi-annual software upgrades, we did not recognize these amounts as revenue. Instead, these amounts are recorded as deferred revenue liability. The ongoing costs related to this arrangement were recognized as expense when incurred. Substantially all deferred revenue was recognized during the second quarter of 2006 when the final upgrade was delivered. The remaining amount of deferred revenue was recognized during the third quarter of 2006 when the 2003 Arrangement terminated. Throughout the period of the 2003 Arrangement, we continued to recognize revenue related to the hardware and hardware maintenance we provided to Chapter 7 trustees as this revenue is accounted for pursuant to Statement of Financial Accounting Standards No. 13 (SFAS 13), Accounting for Leases. This revenue is a relatively minor component of the 2003 Arrangement.
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During February 2006, we entered into a new arrangement with our primary financial institution, which became effective October 1, 2006. Specified software upgrades and special projects are not contained in this contract, and we anticipate that this arrangement will not require us to defer recognition of revenue.
During 2003, we determined that our infrastructure software segment was no longer aligned with our long-term strategic objectives and we developed a plan to sell this segment within a year. Accordingly, our infrastructure software results for 2004 and 2003, including our gain on disposition of the infrastructure software business, are included entirely within the discontinued operations section of our income statement.
We have acquired a number of businesses during the past several years. In January 2003, we acquired BSI to expand our offerings to include an integrated solution of a proprietary technology platform and professional services for corporate restructurings. In January 2004, we acquired Poorman-Douglas and expanded our product and service offerings to include class action, mass tort, and other similar legal proceedings. In October 2005, we acquired Hilsoft to enhance our ability to provide specialized media placement services related to class action, mass tort and bankruptcy noticing. In November 2005, we acquired nMatrix to expand our product and service offerings to include electronic litigation discovery.
In conjunction with our acquisition of nMatrix, we had notable changes to our capital structure. As partial purchase price consideration, we issued approximately 1.2 million shares of our common stock. To provide us with increased financial flexibility, we also restructured our credit facility. Our amended credit facility now consists of a $25 million senior term loan, due September 2006, and a $100 million senior revolving loan, due November 2008. During the term of the loan we have the right, subject to compliance with our covenants, to increase the senior revolving loan to $175 million.
Critical Accounting Policies
We consider our accounting policies related to revenue recognition, business combinations, goodwill, and identifiable intangible assets to be critical policies in understanding our historical and future performance.
Revenue recognition. We have agreements with clients pursuant to which we deliver various case management and document management services each month.
Significant sources of revenue include:
· Fees contingent upon the month-to-month delivery of case management services defined by client contracts, such as claims processing, claims reconciliation, professional services, call center support, and conversion of data into an organized, searchable electronic database. The amount we earn varies based primarily on the size and complexity of the engagement;
· Hosting fees based on the amount of data stored;
· Deposit-based fees from financial institutions, primarily based on a percentage of total liquidated assets placed on deposit at that financial institution by our bankruptcy trustee clients, to whom we provide, at no charge, software licenses, limited hardware and hardware maintenance, and postcontract customer support (PCS) services,
· Legal noticing services to parties of interest in bankruptcy and class action matters, including media campaign and advertising management, in which we coordinate notification through various media outlets, such as print, radio and television, to potential parties of interest for a particular client engagement, and
· Reimbursement for costs incurred related to postage on mailing services.
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Non-Software Arrangements
Case and document management services related to electronic discovery, corporate restructuring, and class action revenue, which are billed based on volume, are evaluated pursuant to Emerging Issues Task Force (EITF) 00-21, Revenue Arrangements with Multiple Deliverables. For each of these contractual arrangements, we have identified the following deliverables and/or services:
· Electronic Discovery
· Data processing
· Hosting
· Corporate Restructuring
· Consulting
· Claims management
· Printing and reproduction
· Mailing and noticing
· Document management
· Class Action
· Consulting
· Notice campaigns
· Toll free customer support
· Web site design/hosting
· Claims administration
· Distribution
Based on our evaluation of each element, we have determined that each element delivered has standalone value to our customers because we or other vendors sell such services separately from any other services/deliverables. We have also obtained objective and reliable evidence of the fair value of each element based either on the price we charge when we sell an element on a standalone basis or based on third-party evidence of fair value of such services. Lastly, our arrangements do not include general rights of return. Accordingly, each of the service elements in our multiple element case and document management arrangements qualifies as a separate unit of accounting under EITF 00-21. We allocate revenue to the various units of accounting in our arrangements based on the fair value of each unit of accounting, which is generally consistent with the stated prices in our arrangements. As we have evidence of an arrangement, revenue for each separate unit of accounting is recognized each period in accordance with Staff Accounting Bulletin Topic 13, Revenue Recognition (SAB Topic 13). As the services are rendered, our fee becomes fixed and determinable, and collectibility is reasonably assured. Payments received in advance of satisfaction of the related revenue recognition criteria are recognized as a customer deposit until all revenue recognition criteria have been satisfied.
Software Arrangements
For our Chapter 7 bankruptcy trustee arrangements, we provide our trustee clients with a software license, hardware lease, hardware maintenance, and PCS services, all at no charge to the trustee. The trustees place their liquidated estate deposits with a financial institution with which we have an arrangement. The financial institution pays us a monthly fee contingent on the dollar level of average monthly deposits placed by the trustees with that financial institution.
We have arrangements with various depository financial institutions and, prior to October 1, 2003, we had an open ended arrangement with our primary depository financial institution. We also had open ended arrangements with each Chapter 7 trustee client. Under these arrangements, we provided our Chapter 7 trustee clients with a software license, hardware lease, hardware maintenance, and PCS services, all at no charge to the trustee. The trustees placed their liquidating estate deposits with a financial institution with which we had a joint marketing arrangement, typically our primary depository financial institution. We account for the software license and PCS elements in accordance with Statement of Position 97-2, Software Revenue Recognition (SOP 97-2). Since we have not established vendor specific objective evidence (VSOE) of the fair value of the software license, we do not recognize any revenue on delivery of
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the software. The software element is deferred and included with the remaining undelivered element, which is PCS services. This revenue, when recognized, is included on our consolidated statements of operations as a component of “Case management bundled software license, software upgrade and postcontract customer support services” revenue. Revenue related to PCS is entirely contingent on the placement of liquidated estate deposits by the trustee with the financial institution. Accordingly, we recognize this contingent usage based revenue consistent with the guidance provided by the American Institute of Certified Public Accountants’ Technical Practice Aid (TPA) 5100.76, Fair Value in Multiple-Element Arrangements That Include Contingent Usage-Based Fees and Software Revenue Recognition as the fee becomes fixed or determinable at the time actual usage occurs and collectibility is probable. This occurs monthly as a result of the computation, billing and collection of monthly deposit fees. At that time, we have also satisfied the other revenue recognition criteria contained in SOP 97-2, as we have persuasive evidence that an arrangement exists, services have been rendered, the price is fixed and determinable, and collectibility is reasonably assured.
Prior to October 1, 2003, from time to time we would separately negotiate a contract with our primary financial institution to provide the trustee clients with a software upgrade or a special project. For these single element contracts, in accordance with SAB Topic 13, we recognized revenue when persuasive evidence of an arrangement existed, services had been rendered, the price was fixed and determinable, and collectibility was reasonably assured. This occurred on delivery of the single element.
We also provide our trustee clients with certain hardware, such as desktop computers, monitors, and printers, and hardware maintenance. We retain ownership of all hardware provided and, based on guidance provided in EITF 01-8, Determining Whether an Arrangement Contains a Lease, we account for this hardware as a lease. As the hardware maintenance arrangement is an executory contract similar to an operating lease, we use guidance related to contingent rentals in operating lease arrangements for hardware maintenance as well as for the hardware lease. Since the payments under all of our arrangements are contingent upon the level of trustee deposits and the delivery of upgrades and other services, there remain important uncertainties regarding the amount of unreimbursable costs yet to be incurred by us, we account for the hardware lease as an operating lease in accordance with SFAS 13, Accounting for Leases. Therefore, all lease payments, based on the estimated fair value of hardware provided, were accounted for as contingent rentals under EITF Issue No. 98-9, Accounting for Contingent Rent and SAB Topic 13, which requires that we recognize rental income when the changes in the factor on which the contingent lease payment is based actually occur. This occurs at the end of each period as we achieved our target when deposits are held at the depository financial institution as, at that time, evidence of an arrangement exists, delivery has occurred, the amount has become fixed and determinable, and collection is reasonably assured. This revenue, which is less than ten percent of our total revenue, is included in our consolidated statements of operations as a component of “Case management services” revenue.
Effective October 1, 2003, we entered into a three-year arrangement (the 2003 Arrangement) with our primary financial institution under which we delivered two specified upgrades annually with the last specified upgrade to occur in the second quarter of 2006. This arrangement included specific pricing for each software upgrade and certain special projects in addition to the contingent deposit-based pricing related to the software license, hardware, hardware maintenance, and PCS services provided to each trustee client. Therefore, the software upgrades and special projects are part of a bundled arrangement. Each software upgrade is considered a separate and discrete product and, as we do not sell each software upgrade on a standalone basis, we were unable to establish VSOE of the fair value of the software upgrades. As a result, the licensed software, software upgrade, special projects and PCS are a combined unit of accounting. Under the guidance of SOP 97-2, all revenue related to this combined unit of accounting is deferred until the final upgrade is delivered. The ongoing costs related to this arrangement were recognized as expense when incurred. When the final upgrade is delivered and the only remaining undelivered element is PCS, we will then recognize revenue on a pro-rata basis over the term of the agreement. Payments received in advance of satisfaction of the related revenue recognition criteria are recognized as deferred revenue until all revenue recognition criteria have been satisfied. As of December
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31, 2005 and 2004, we had recorded on our consolidated balance sheets $59.7 million and $35.2 million, respectively, of deferred revenue under the 2003 Arrangement. This deferred revenue was recognized during the second and third quarters of 2006. The 2003 Arrangement did not affect our accounting, as described above, for fees received from other financial institutions or our accounting related to hardware and hardware maintenance.
Reimbursements
Our case and document management businesses both have revenue related to the reimbursement of certain costs, primarily postage. Consistent with guidance provided by EITF No. 01-14, Income Statement Characterization of Reimbursements Received for “Out-of-Pocket” Expenses Incurred, reimbursed postage and other reimbursable direct costs are recorded gross in the consolidated statement of operations as “Operating revenue from reimbursed direct costs” and as “Reimbursed direct costs”.
Business combination accounting. We have acquired a number of businesses during the last several years, and we may acquire additional businesses in the future. Business combination accounting, often referred to as purchase accounting, requires us to determine the fair value of all assets acquired, including identifiable intangible assets, and liabilities assumed. The cost of the acquisition is allocated to the assets acquired and liabilities assumed in amounts equal to the fair value of each asset and liability, and any remaining acquisition cost is classified as goodwill. This allocation process requires extensive use of estimates and assumptions, including estimates of future cash flows to be generated by the acquired assets. Certain identifiable intangible assets, such as customer lists and covenants not to compete, are amortized on a straight-line basis over the intangible asset’s estimated useful life. The estimated useful life of amortizable identifiable intangible assets range from one to fourteen years. Goodwill is not amortized. Accordingly, the acquisition cost allocation has had, and will continue to have, a significant impact on our current operating results.
Goodwill. We assess goodwill, which is not subject to amortization, for impairment as of each July 31 and also at any other date when events or changes in circumstances indicate that the carrying value of these assets may exceed their fair value. This assessment is performed at a reporting unit level. A reporting unit is a component of a segment that constitutes a business, for which discrete financial information is available, and for which the operating results are regularly reviewed by management. We develop an estimate of the fair value of each reporting unit, using both a market approach and an income approach. For each reporting unit, the fair value estimate for our 2005 annual assessment was consistent with the fair value estimate for our 2004 annual assessment.
A change in events or circumstances, including a decision to hold an asset or group of assets for sale, a change in strategic direction, or a change in the competitive environment could adversely affect the fair value of one or more reporting units. During November 2003, we determined that our infrastructure software segment was no longer aligned with our long-term strategic objectives and we developed a plan to sell this segment within a year. As a result, we recognized a pre-tax impairment charge of approximately $3.8 million related to goodwill during the year ended December 31, 2003.
The estimate of fair value is highly subjective and requires significant judgment. If we determine that the fair value of any reporting unit is less than the reporting unit’s carrying value, then we will recognize an impairment charge. If goodwill on our balance sheet becomes impaired during a future period, the resulting impairment charge could have a material impact on our results of operations and financial condition. Our unimpaired, recognized goodwill totaled $249.4 million as of December 31, 2005.
Identifiable intangible assets. Each period we evaluate whether events and circumstances warrant a revision to the remaining estimated useful life of each identifiable intangible asset. If events and circumstances warrant a change to the estimate of an identifiable intangible asset’s remaining useful life, then the remaining carrying amount of the identifiable intangible asset would be amortized prospectively over that revised remaining useful life. Furthermore, information developed during our annual assessment, or other events and circumstances, may indicate that the carrying value of one or more
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identifiable intangible assets is not recoverable and its fair value is less than the identifiable intangible asset’s carrying value and would result in recognition of an impairment charge. During November 2003, we determined that our infrastructure software segment was no longer aligned with our long-term strategic objectives and we developed a plan to sell this segment within a year. As a result, we recognized a pre-tax impairment charge of approximately $0.9 million related to identifiable intangible assets during the year ended December 31, 2003.
A change in the estimate of the remaining life of one or more identifiable intangible assets or the impairment of one or more identifiable intangible assets could have a material impact on our results of operations and financial condition. Our identifiable intangible assets’ carrying value, net of amortization, was $53.4 million as of December 31, 2005.
Results of Operations for the Year Ended December 31, 2005 Compared with the Year Ended December 31, 2004
Revenue
Total revenue from operations of $106.3 million for the year ended December 31, 2005 represents an approximate $7.9 million, or 8%, increase compared with $98.4 million of revenue for the prior year. Total revenue includes operating revenue from reimbursed direct costs, which are presented as a separate line item captioned “Operating revenue from reimbursed direct costs” on our consolidated statement of operations. While operating revenue from reimbursed direct costs may fluctuate significantly from period to period, these fluctuations have a minimal effect on our operating income or loss as we realize little or no margin from this revenue. Operating revenue before reimbursed direct costs, which is also presented as a separate line item on our consolidated statement of operations, increased $4.7 million, or approximately 6%, to $82.7 million for the year ended December 31, 2005 compared with $78.0 million for the same period in the prior year. All revenue is directly related to a segment and changes in revenue by segment are discussed below.
Operating Expenses
Direct cost of services, exclusive of depreciation and amortization, decreased approximately $7.2 million, or 19% to $30.2 million for the year ended December 31, 2005 compared with $37.4 million for the prior year. Excluding our subsidiaries acquired during 2005, direct costs of services decreased $8.1 million, or approximately 22%, compared with the prior year. This decrease is primarily the result of a decrease in cost of advertising. Changes in our segment cost structure are discussed below.
Direct cost of bundled software license, software upgrade and postcontract customer support services, exclusive of depreciation and amortization, increased approximately $1.0 million to $3.8 million for the year ended December 31, 2005 compared with $2.8 million for the prior year primarily as a result of increased compensation costs. Changes in our segment cost structure are discussed below.
Reimbursed direct costs increased approximately 18% to $23.8 million for the year ended December 31, 2005 compared with $20.1 million for the prior year. This increase is directly attributable to the increase in operating revenue from reimbursed direct costs.
General and administrative expenses increased $5.2 million, or approximately 20%, to $31.1 million for the year ended December 31, 2005 compared with $25.9 million for the prior year. Excluding our subsidiaries acquired during 2005, general and administrative expenses increased $4.4 million, or approximately 17%, compared with the prior year. This increase primarily results from the increase in the scope and complexity of our business, and is primarily the result of increases in compensation and related expenses, travel, and professional services. Changes in our segment cost structure are discussed below.
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Depreciation and software amortization expenses increased $0.8 million, or approximately 12%, to $7.3 million for the year ended December 31, 2005 compared with $6.5 million for the prior year. Excluding our subsidiaries acquired during 2005, depreciation and software amortization expenses increased $0.5 million, or approximately 8%, compared with the prior year primarily as a result of increased software amortization. Changes in our segment cost structure are discussed below.
Amortization of identifiable intangible assets decreased $1.0 million to $6.8 million for the year ended December 31, 2005 compared with $7.8 million for the prior year. All expense related to amortization of identifiable intangible assets is directly related to a segment and changes in identifiable intangible amortization expense by segment are discussed below.
Acquisition related expenses of $3.0 million for the year ended December 31, 2005 and $2.2 million for the prior year result from non-capitalized expenses for executive bonuses, legal, accounting and valuation services, and travel incurred in connection with potential and completed transactions.
Interest Expense
Interest expense increased $0.5 million, to $6.8 million for the year ended December 31, 2005 compared with $6.3 million of interest expense for the prior year. This increase related to various components:
· Variable interest expense related to our credit facilities and fixed interest expense related to our convertible debt increased $0.7 million to $4.5 million during the year ended December 31, 2005 compared to $3.8 million for the prior year primarily as a result of an increase in our variable interest rate, partly offset by a decrease in weighted average borrowings outstanding during the year.
· Amortization of loan fees related to our credit facilities and our convertible debt offering decreased $1.0 million to $1.1 million during the year ended December 31, 2005 compared to $2.1 million for the prior year. This decrease is primarily a result of amortization related to a short-term subordinated borrowing under the credit facility used to finance the acquisition of Poorman-Douglas in January 2004. All fees related to this subordinated borrowing were amortized during 2004.
· Our convertible debt facility includes a provision allowing the convertible debt holders to extend the debt maturity from three years to six years. Under SFAS 133, Accounting for Derivative Instruments and Hedging Activities, this provision is accounted for as an embedded option. At inception, the embedded option was valued at $1.2 million and the convertible debt balance was reduced by the same amount. The convertible debt accretes approximately $0.1 million each quarter such that, at the end of three years, the convertible debt balance will total $50.0 million. The embedded option must be revalued at each period end based on the probability weighted discounted cash flows related to the additional 4% interest rate payments which would be made if the convertible debt maturity is extended an additional three years. While the changes in fair value of the embedded option and carrying value of the convertible debt do not affect our current cash flow, the aggregate of these changes in value is accounted for as a current income or expense item and is included on our accompanying consolidated statement of operations as a component of interest expense. During the year ended December 31, 2005, we recognized expense related to the convertible debt accretion and change in value of the embedded option of $1.0 million, compared with $0.3 million of such expense in the prior year. If the embedded option is eventually exercised, the value assigned to the embedded option will be amortized to income as a reduction to our 4% convertible debt interest expense over the periods payments are made. If the option is not exercised by some or all convertible debt holders, any remaining related value assigned to the embedded option will be recognized as a gain during that period.
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Debt Extinguishment
During 2004, we replaced the senior portion of the credit facility used to finance the Poorman-Douglas transaction with our KeyBank credit facility. As a result, during the year ended December 31, 2004, we recognized a $1.0 million charge for the write-off of loan fees related to the terminated credit facility. We did not recognize any debt extinguishment expense during 2005.
Effective Tax Rate
Our effective tax rate to record the tax benefit related to our loss from continuing operations increased from 37.2% for the year ended December 31, 2004 to 38.4% for the year ended December 31, 2005. The change in our 2005 effective tax benefit rate compared to the prior year is primarily the result of discrete events, including characterization of the loss from disposal of our discontinued operations from a business loss to a non-business loss and an increase in our research and expenditure credit. Our tax benefit rate is higher than the statutory federal rate of 34% primarily due to state taxes. Two of our subsidiaries, BSI and the recently acquired nMatrix, operate primarily in New York City and are subject to state and local tax rates which are higher than the tax rates assessed by other jurisdictions where we operate.
Net Loss
Our net loss decreased to a $3.8 million net loss for the year ended December 31, 2005 compared with a $6.6 million net loss for the prior year. This decrease in our net loss was primarily the result of an $8.0 million increase in revenues, primarily resulting from the inclusion of revenue from our electronic discovery business acquired during November 2005, and a $2.6 million decrease in direct costs, primarily resulting from a decrease in media campaign and advertising direct costs. This decrease in our net loss was partly offset by a $5.2 million increase in our general and administrative expenses, a $1.9 million decrease in our tax benefit primarily resulting from the reduced pre-tax loss, and a $0.7 million decrease of income from operations of our discontinued infrastructure segment compared with 2004.
Business Segments
The following management discussion and analysis is presented on a basis consistent with our segment disclosure contained in note 15 of our notes to consolidated financial statements.
Revenue
Case management operating revenue before reimbursed direct costs increased approximately 32% to $54.8 million for the year ended December 31, 2005 compared with $41.5 million for the year ended December 31, 2004. nMatrix, which was acquired on November 15, 2005, accounted for approximately $3.7 million of the increase in operating revenue before reimbursed direct costs. The remainder of the increase is primarily attributable to a $5.7 million increase in class action operating revenues before reimbursed direct costs resulting from the timing of several large cases and a $2.8 million increase resulting from a net increase in corporate restructuring professional services.
During February 2006, we entered into a new pricing arrangement with our primary Chapter 7 depository financial institution. This new pricing arrangement will be effective beginning October 2006. Chapter 7 depository fees are included entirely within our case management segment. Under this arrangement, the fees we earn for deposits placed with this financial institution could have, within certain limits, variability based on fluctuations in short-term interest rates. Based on the terms of the pricing arrangement and the current interest rate environment, we do not anticipate that this new pricing arrangement will have a material impact on our 2006 operating cash flows, but the arrangement will affect the timing of our revenue recognition as we anticipate that we will not defer recognition of revenue under this arrangement.
Document management operating revenue before reimbursed direct costs decreased approximately $8.6 million, or approximately 24%, to $27.9 million for the year ended December 31, 2005 compared with $36.5 million for the prior year. This decrease is primarily attributable to a decline in media campaign and advertising services. Our media campaign and advertising services are primarily connected with
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class action and bankruptcy customers for whom we provide case administration services. Media campaign and advertising services vary significantly depending on the characteristics of the case. Generally, cases in which the specific identity of members of the plaintiff class is unknown will require significantly more media campaign and advertising services than cases in which the specific identity of the members of the plaintiff class is known. During 2004, we had several large cases in which the specific identity of the members of the plaintiff class was unknown and, therefore, required extensive media campaign and advertising services. During 2005, the identities of the members of the plaintiff class on our large cases were known and, therefore, did not require extensive media campaign and advertising services. We anticipate that these media campaign and advertising services will increase in 2006 because Hilsoft provides significant levels of media campaign and advertising services and their financial results will be included in our operating results for the entire calendar year 2006, but are only included for slightly more than two months of 2005 following the October 20, 2005 acquisition of that business. Document management operating revenue from reimbursed direct costs of $20.5 million for the year ended December 31, 2005 increased approximately 15% compared with the same period in the prior year. Operating revenue from reimbursed direct costs has little or no margin and, accordingly, this increase in operating revenue from reimbursed direct costs did not have a material effect on our income from operations. Document management revenues, including revenues related to media campaign and services, can fluctuate materially from period to period based on clients’ business requirements.
Operating Expenses
Case management direct costs, general and administrative expenses, and depreciation and software amortization increased $3.5 million, or approximately 12%, to $32.6 million for the year ended December 31, 2005 compared with $29.1 million for the same period in the prior year. nMatrix, which was acquired on November 15, 2005, accounted for approximately $1.4 million of the increase in direct costs, general and administrative expenses, and depreciation and software amortization. Exclusive of nMatrix, direct and administrative expenses, including depreciation and software amortization, increased by $2.1 million, or approximately 7%. This increase is primarily attributable to an increase in reimbursed expenses and expenses related to the expansion of our bankruptcy service offerings. Our case management cost structure is relatively stable and generally does not fluctuate materially with changes in operating revenues.
Document management direct costs, general and administrative expenses, and depreciation and software amortization decreased $4.0 million, or 10%, to $36.6 million for the year ended December 31, 2005 compared with $40.6 million for the prior year. This decrease primarily results from a decrease in cost of media campaign and advertising, related to the decline in media campaign and advertising service revenue discussed above, partly offset by an increase in reimbursed expenses, the inclusion of Hilsoft operating expenses, and an increase in expenses paid to third parties for production services. Our document management cost structure is more variable than case management and will fluctuate based on document management business requirements delivered.
Both the case management and document management segments have identifiable intangible assets. Amortization of case management’s identifiable intangible assets decreased $0.2 million to $5.0 million for the year ended December 31, 2005 compared with $5.2 million for the prior year. This decrease is primarily attributable to certain intangible assets acquired in the BSI acquisition that became fully amortized during 2005, largely offset by an increase in amortization related to intangible assets acquired in the nMatrix acquisition. Amortization of document management’s identifiable intangible assets decreased $0.8 million to $1.7 million for the year ended December 31, 2005 compared with $2.5 million for the prior year. This decrease is primarily attributable to certain intangible assets acquired in the BSI acquisition that became fully amortized during 2005, partly offset by an increase in amortization related to intangible assets acquired in the Hilsoft acquisition. Note 4 of the notes to the consolidated financial statements provides a summary of the total identified intangible assets, the scheduled amortization expense and the scheduled amortization periods for intangible assets acquired through the nMatrix, Hilsoft, Poorman-Douglas and BSI acquisitions.
32
Results of Operations for the Year Ended December 31, 2004 Compared with the Year Ended December 31, 2003
Revenue
Total revenue of $98.4 million for the year ended December 31, 2004 represents a $38.6 million, or approximately 65% increase compared with $59.8 million of revenue for the same period in the prior year. With our acquisition of Poorman-Douglas in January 2004, operating revenue from reimbursed direct costs, such as postage pertaining to document management services, increased significantly during 2004. We reflect the operating revenue from reimbursed direct costs as a separate line item captioned “Operating revenue from reimbursed direct costs” on our consolidated statement of operations. While operating revenue from reimbursed direct costs may fluctuate significantly from period to period, these fluctuations have a minimal effect on our operating income or loss as we realize little or no margin from this revenue. Operating revenue before reimbursed direct costs, which is also presented as a separate line item on our consolidated statement of operations, increased approximately $23.7 million, or approximately 44%, to $78.0 million for the year ended December 31, 2004 compared with $54.3 million for the same period in the prior year. All revenue is directly related to a segment and changes in revenue by segment are discussed below.
Operating Expenses
Direct cost of services, exclusive of depreciation and amortization, increased approximately $29.0 million to $37.4 million for the year ended December 31, 2004 compared with $8.4 million for the same period in the prior year. This increase primarily results from the inclusion of Poorman-Douglas’ expenses subsequent to the acquisition date. Excluding the effect of our Poorman-Douglas acquisition, direct cost of services decreased $0.8 million, or approximately 9%, primarily as a result of a decline in bankruptcy noticing services. Changes in our segment cost structure are discussed below.
Direct cost of bundled software license, software upgrade and postcontract customer support services, exclusive of depreciation and amortization, increased approximately $0.3 million to $2.8 million for the year ended December 31, 2004 compared with $2.5 million for the prior year primarily as a result of increased compensation costs. Changes in our segment cost structure are discussed below.
Reimbursed direct costs increased approximately $14.5 million to $20.1 million for the year ended December 31, 2004 compared with $5.6 million for the prior year. Exclusive of reimbursed direct costs related to the inclusion of Poorman-Douglas, reimbursed direct costs decreased approximately $1.6 million, or approximately 29%, to approximately $4.0 million for the year ended December 31, 2004, compared with approximately $5.6 million for the prior year. This decrease is directly attributable to the decrease, exclusive of Poorman-Douglas, in operating revenue from reimbursed direct costs.
General and administrative expenses increased $9.0 million, or approximately 53%, to $25.9 million for the year ended December 31, 2004 compared with $16.9 million for the same period in the prior year. This increase primarily results from the inclusion of Poorman-Douglas’ expenses subsequent to the acquisition date. Excluding the effect of our Poorman-Douglas acquisition, general and administrative expenses increased $2.5 million for the year ended December 31, 2004, or approximately 15%, compared with the same period in the prior year primarily due to significant increased expenses related to compliance with regulations and standards imposed by Section 404 of the Sarbanes-Oxley Act of 2002, increased travel expense primarily related to additional locations, and increases in compensation and related benefits and insurance coverage due to business expansion. Changes in our segment cost structure are discussed below.
Depreciation and software amortization expenses increased $1.9 million, or approximately 43%, to $6.5 million for the year ended December 31, 2004 compared with $4.6 million for the same period in the prior year. This increase primarily results from the inclusion of Poorman-Douglas’ expenses subsequent to the
33
acquisition date. Excluding the effect of our Poorman-Douglas acquisition, depreciation and software amortization increased $0.2 million, or approximately 5%, compared with the same period in the prior year primarily as a result of our acquisition of additional operating software licenses. Changes in our segment cost structure are discussed below.
Amortization of identifiable intangible assets increased $4.2 million to $7.8 million for the year ended December 31, 2004 compared with $3.6 million for the same period in the prior year. All identifiable intangible assets are directly related to a segment and changes in amortization of identifiable intangible assets by segment are discussed below.
Acquisition related expenses of $2.2 million for the year ended December 31, 2004 and $1.8 million for the year ended December 31, 2003 result from non-capitalized expenses for executive bonuses, legal, accounting and valuation services, and travel incurred in connection with potential and completed transactions.
Interest Expense
Interest expense totaled $6.3 million during the year ended December 31, 2004 compared with $0.2 million of interest expense during the same period in the prior year. This increase related to various financing components. Variable interest expense related to our credit facilities, fixed interest expense related to our convertible debt, and interest accreted on debt with no stated interest rate totaled $3.8 million during the year ended December 31, 2004. Amortization of loan fees related to our credit facilities and related to our convertible debt offering totaled $2.1 million during the year ended December 31, 2004. Our convertible debt facility includes a provision allowing the convertible debt holders to extend the debt maturity from three years to six years. Under SFAS 133, Accounting for Derivative Instruments and Hedging Activities, this provision is accounted for as an embedded option. At inception, the embedded option was valued at $1.2 million and the convertible debt balance was reduced by the same amount. The convertible debt accretes approximately $0.1 million each quarter such that, at the end of three years, the convertible debt balance will total $50.0 million. The embedded option must be revalued at each period end based on the probability weighted discounted cash flows related to the additional 4% interest rate payments which would be made if the convertible debt maturity is extended an additional three years. While the changes in fair value of the embedded option and carrying value of the convertible debt do not affect our current cash flow, the aggregate of these changes in value, totaling $0.3 million of expense for the year ended December 31, 2004, is accounted for as a current income or expense item and is included on our accompanying consolidated statement of operations as a component of interest expense. If the embedded option is eventually exercised, the value assigned to the embedded option will be amortized to income as a reduction to our 4% convertible debt interest expense over the periods payments are made. If the option is not exercised by some or all convertible debt holders, any remaining related value assigned to the embedded option will be recognized as a gain during that period.
Debt Extinguishment
During 2004, we replaced the senior portion of the credit facility used to finance the Poorman-Douglas transaction with our KeyBank credit facility. As a result, during the year ended December 31, 2004, we recognized a $1.0 million charge for the write-off of loan fees related to the terminated credit facility. We did not recognize any debt extinguishment expense during 2003.
Effective Tax Rate
Our effective tax rate to record the tax benefit related to our loss from continuing operations was 37.2% for the year ended December 31, 2004 compared to a 42% effective tax rate related to our income from continuing operations for the year ended December 31, 2003. Our tax rate is higher than the statutory federal rate of 34% primarily due to state taxes. Our corporate restructuring subsidiary, BSI, operates primarily in New York City and is subject to state and local tax rates, which are higher than the tax rates assessed by other jurisdictions where we operate. Our effective tax benefit rate related to 2004 losses is less than the 2003 effective tax rate primarily due to expenses that are not deductible for tax purposes.
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Discontinued Operations
Our infrastructure software results are included entirely within the discontinued operations section of our income statement. Pre-tax income from discontinued operations of $1.1 million for the year ended December 31, 2004 resulted primarily from our gain on sale of the business, partly offset by operating losses through the date of sale, which was April 30, 2004. Pre-tax loss from discontinued operations of $9.6 million for the year ended December 31, 2003 was primarily the result of a $7.6 million impairment charge to reduce goodwill, other intangible assets, software and other long-lived assets to their estimated fair value.
Net Income (Loss)
During 2004, we had a net loss of $6.6 million compared with net income of $3.8 million during 2003. This change of $10.4 million is primarily the result of the change in revenue recognition related to 2003 Arrangement which was effective October 1, 2003. Subsequent to inception of the 2003 Arrangement, we have deferred substantially all revenue related to our Chapter 7 trustee business. For all trustees with deposits held with the our primary financial institution, we deferred recognition for all volume-based revenue related to software licensing, postcontract customer support and all software upgrade revenue effective with the October 1, 2003 commencement of the 2003 Arrangement as discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operation, Management Overview” above. As a result, during the year ended December 31, 2004, we recognized approximately $23.7 million less in Chapter 7 revenue than during the year ended December 31, 2003. Additionally, net expenses related to financing increased approximately $7.3 million. This revenue decrease and this expense increase were partly offset by the recognition of a $0.7 million gain on sale of our discontinued segment during 2004 compared with a $5.8 million loss from operations of the discontinued segment during 2003 and a change in our provision for income taxes from a $6.9 million tax expense to a $4.3 million tax benefit.
Business Segments
The following management discussion and analysis is presented on a basis consistent with our segment disclosure contained in note 15 of our notes to consolidated financial statements.
Revenue
Case management operating revenue before reimbursed direct costs was approximately $41.5 million for both the year ended December 31, 2004 and the year ended December 31, 2003. Case management operating revenue includes operating revenue before reimbursed direct costs related to the Poorman-Douglas acquisition subsequent to the acquisition date. Exclusive of Poorman-Douglas, operating revenue before reimbursed direct costs declined by $22.5 million due primarily to a $23.7 decrease in bankruptcy volume-based and software upgrade revenue. The primary reason for this decrease is that, for all trustees with deposits held with our primary financial institution, we deferred recognition for all volume-based revenue related to software licensing, postcontract customer support and all software upgrade revenue effective with the October 1, 2003 commencement of the 2003 Arrangement as discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operation, Management Overview” above.
Document management operating revenue before reimbursed direct costs increased $23.8 million, or approximately 187%, to $36.5 million for the year ended December 31, 2004 compared with $12.7 million for the year ended December 31, 2003. The increase in operating revenue before reimbursed direct costs was primarily the result of the acquisition of Poorman-Douglas. Exclusive of Poorman-Douglas, our document management operating revenue before reimbursed direct costs declined $3.4 million due primarily to a decrease in bankruptcy noticing services. Document management operating revenue from reimbursed direct costs of $17.9 million for the year ended December 31, 2004 increased approximately 243% compared with the same period in the prior year. Operating revenue from reimbursed direct costs has little or no margin and, accordingly, this increase did not have a material
35
effect on our income from operations. Document management revenues can fluctuate materially from period to period based on clients’ business requirements.
Operating Expenses
Case management direct costs, general and administrative expenses, and depreciation and software amortization increased $16.0 million, or approximately 122%, to $29.1 million for the year ended December 31, 2004 compared with $13.1 million for the same period in the prior year. This increase primarily results from the inclusion of Poorman-Douglas’ expenses subsequent to the acquisition date. Exclusive of Poorman-Douglas expenses, case management’s direct and administrative expenses, including depreciation and software amortization, increased $0.9 million due primarily to increases in operating software amortization and wage related expense. Our case management cost structure is relatively stable and generally does not fluctuate materially with changes in operating revenues before reimbursed expenses.
Document management direct costs, general and administrative expenses, and depreciation and software amortization increased $30.9 million to $40.6 million for the year ended December 31, 2004 compared with $9.7 million for the prior year. This increase primarily results from the inclusion of Poorman-Douglas’ expenses, including reimbursed expenses, subsequent to the acquisition date. Exclusive of Poorman-Douglas’ expenses, our document management expenses declined $2.4 million due primarily to a decline in postage and print expense related to a decrease in noticing services. Our document management cost structure is more variable than case management and will fluctuate based on document management business requirements delivered.
Both the case management and document management segments have identifiable intangible assets. Amortization of case management’s identifiable intangible assets increased $3.1 million to $5.2 million for the year ended December 31, 2004 compared with $2.1 million for the prior year. Amortization of document management’s identifiable intangible assets increased $1.0 million to $2.5 million for the year ended December 31, 2004 compared with $1.5 million for the prior year. For both segments, this increase is due primarily to the amortization expense related to the acquired intangible assets resulting from the Poorman-Douglas transaction and the February 2004 commencement of amortization related to the BSI trade name.
Liquidity and Capital Resources
Operating Activities
During the year ended December 31, 2005, our operating activities provided net cash of $27.2 million. The primary sources of cash from operating activities were adjustments for non-cash charges and credits of $7.4 million, primarily as a result of depreciation and amortization of software, loan fees, and identifiable intangible assets partly offset by the benefit for deferred income taxes, and changes in operating assets and liabilities, net of effects from business acquisitions, which increased our operating cash flow by $23.7 million primarily as a result of an increase in deferred revenue and accounts payable and other liabilities partly offset by an increase in trade accounts receivable. These sources of cash were partly offset by our net loss of $3.8 million. Trade payables and other liabilities, excluding acquired trade payables and other liabilities, increased by $27.9 million primarily as a result of a $24.7 million increase in deferred revenue. Deferred revenue increased primarily as the result of deferral of substantially all Chapter 7 bankruptcy trustee revenue. Also contributing to the increase in trade payables and other liabilities were increases in trade payables, accrued interest expense, and accrued bonus. The increase in trade payables was the result of the timing of payments. The increase in accrued interest expense was due to an increase in our debt level and the timing of interest payments. The increase in accrued bonus was primarily due to the timing of bonus payments. These increases represent a net source of cash. Trade accounts receivable, excluding acquired trade receivables, increased by $3.1 million. This increase represents a net use of cash. The increase in trade accounts receivable was the result of timing of collections. We anticipate that our trade accounts receivable will continue to fluctuate from period to period depending on the timing of collections.
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Changes in operating assets and liabilities as a direct result of assets acquired or liabilities assumed have been excluded from our consolidated statements of cash flows. However, subsequent to acquisition, cash flows related to these acquired assets and assumed liabilities are reflected in our consolidated statements of cash flows. For example, accounts receivable and accounts payable acquired or assumed as a part of the transaction are not reflected, respectively, as a use or source of cash. However, the subsequent collection or payment, respectively, of accounts receivable and accounts payable acquired or assumed as a part of the transaction are reflected as an operating source or use of cash, respectively.
Investing Activities
Our most significant use of cash for investing activities was to expand our business through acquisitions. Total cash used in 2005 to acquire businesses, net of $0.9 million cash acquired in the acquisitions, was approximately $110.5 million. During the year ended December 31, 2005, we used cash of approximately $4.6 million to purchase property and equipment. Enhancements to our existing software and development of new software is essential to our continued growth and, during the year ended December 31, 2005, we used cash of approximately $2.3 million to fund internal costs related to development of software for which technological feasibility has been established. During November 2005 we acquired nMatrix, which expanded our business into the electronic discovery market. In support of this expansion, we anticipate software development and purchases of hardware and equipment and software spending will increase during 2006 compared with 2005. We anticipate that cash generated from operations will be adequate to fund our anticipated property, equipment and software spending in 2006.
Financing Activities
In conjunction with our acquisition of nMatrix, during November 2005 we amended our credit facility. Based on the terms of our amended credit facility, we increased our senior term loan borrowings from $17.2 million to $25.0 million. The amended credit facility eliminated the requirement for quarterly amortizing payments on the senior term loan, but shortened the maturity of the senior term loan from June 2008 to August 2006. The amended credit facility also increased our senior revolving loan from $75.0 million to $100.0 million. The maturity of the senior revolving loan was extended from June 2008 to November 2008. During the term of the loan, we have the right, subject to compliance with our covenants, to increase the senior revolving loan to $175.0 million.
During November 2005, under the amended credit facility we borrowed an additional $7.8 million under the senior term loan and $93.0 million under the senior revolving loan to finance the cash portion of our acquisition of nMatrix.
As of December 31, 2005, our borrowings consisted of $51.3 million from the contingent convertible subordinated notes (including the fair value of the embedded option), $25.0 million under the credit facility’s senior term loan, $93.0 million under the credit facility’s senior revolving loan, and approximately $4.2 million of obligations related to capitalized leases and deferred acquisition price.
As of December 31, 2005, significant covenants, all as defined within our credit facility agreement, include a leverage ratio not to exceed 3.50 to 1.00, a senior leverage ratio not to exceed 2.50 to 1.00, a fixed charge coverage ratio of not less than 1.25 to 1.00, and a current ratio of not less than 1.50 to 1.00. However, as a result of the restatement (see note 17 of the accompanying notes to consolidated financial statements) that resulted in the deferral through December 31, 2005, of $59.7 million of revenue related to our Chapter 7 trustee business, we determined that we were not in compliance with these financial covenants as of December 31, 2005. Subsequent to year end, during the second quarter of 2006, we recognized approximately $60.1 million of net deferred revenue and were in compliance with all financial covenants as of June 30, 2006. The deferral of revenue and subsequent recognition of revenue was not anticipated by us or the banks at the time we established the current financial covenants in the credit facility. On December 14, 2006, we obtained a waiver regarding this event of noncompliance from our
37
credit facility syndicate. Accordingly, we have classified this debt as current or long-term based on the debt’s original scheduled maturity.
We believe that the funds generated from operations plus amounts available under our credit facility’s senior revolving loan will be sufficient over the next year to finance currently anticipated working capital requirements, software expenditures, property and equipment expenditures, payments for contractual obligations, and interest payments due on our outstanding borrowings. Funds generated from operations may not be adequate to repay the $25.0 million term loan under our credit facility with an original maturity of August 2006. Sources of liquidity include an amendment to our credit facility to extend the maturity of the term loan(during June 2006, the maturity date of the remaining term loan principal of $15.0 million was extended to June 2007) or, an equity offering of our common shares.
We may pursue acquisitions in the future. If the acquisition price exceeds our then available cash and unused borrowing capacity, we may decide to issue equity, restructure our credit facility, partly finance the acquisition with a note payable, or some combination of the preceding. Covenants contained in our credit facility may limit our ability to consummate an acquisition. Pursuant to the terms of our credit facility, we generally cannot incur indebtedness outside the credit facility with the exception of capital leases and additional subordinated debt, with a limit of $100.0 million of aggregate subordinated debt. Furthermore, for any acquisition we must be able to demonstrate that, on a pro forma basis, we would be in compliance with our covenants during the four quarters prior to the acquisition and we must obtain bank permission for any acquisition for which cash consideration exceeds $65.0 million or total consideration exceeds $125.0 million.
Off-balance Sheet Arrangements
Although we generally do not utilize off-balance sheet arrangements in our operations, we enter into operating leases in the normal course of business. Our operating lease obligations are disclosed below under “Contractual Obligations” and also in note 6 of the notes to consolidated financial statements.
Contractual Obligations
The following table sets forth a summary of our contractual obligations and commitments, excluding periodic interest payments, as of December 31, 2005.
|
| Payments Due By Period |
| |||||||||||||||
|
|
|
|
|
| Less than |
|
|
|
|
| More Than |
| |||||
|
| (In Thousands) |
| |||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
| |||||||
Long-term debt and future accretion (1) |
| $ | 172,389 |
| $ | 27,654 |
| $ | 144,735 |
| $ | — |
| $ | — |
| ||
Employment agreements (2) |
| 10,812 |
| 4,943 |
| 4,345 |
| 1,524 |
| — |
| |||||||
Capital lease obligations |
| 972 |
| 950 |
| 22 |
| — |
| — |
| |||||||
Operating leases |
| 19,201 |
| 3,019 |
| 4,941 |
| 3,581 |
| 7,660 |
| |||||||
Total |
| $ | 203,374 |
| $ | 36,566 |
| $ | 154,043 |
| $ | 5,105 |
| $ | 7,660 |
| ||
(1) A portion of the BSI and Hilsoft purchase price were paid in the form of a non-interest bearing notes, which were discounted using an imputed rate of 5% and 8%, respectively, per annum. The discounts are accreted over the life of the note and each period’s accretion is added to the principal of the respective note. The amount in the above contractual obligation table includes both the notes’ principal, as reflected on our December 31, 2005 consolidated balance sheet, and all future accretion. If certain revenue objectives are satisfied, we will make additional payments, not to exceed $3.0 million, over the next five years to the former owners of Hilsoft. Such payments, if any, are not included in the above contractual obligation table. Convertible debt is included at stated value of the principal redemption and excludes adjustments related to the embedded option, which will not be paid
38
in cash. Any conversion to our common stock of part or all of the convertible debt will reduce our cash obligation related to the convertible debt.
(2) In conjunction with acquisitions, we have entered into employment agreements with certain key employees of the acquired companies.
Recent Accounting Pronouncements
In September 2005, the Emerging Issues Task Force (EITF) issued EITF 05-07, Accounting for Modifications to Conversion Options Embedded in Debt Instruments and Related Issues. EITF 05-07 requires that, when a modification of a convertible debt instrument results in a change in the fair value of an embedded conversion option, the change in fair value of the embedded conversion option be included in the analysis of whether there has been a substantial change in the terms of the convertible debt instrument for purposes of determining whether the debt has been extinguishment. EITF 05-07 also requires subsequent recognition of interest expense for any change in the fair value of the embedded conversion option resulting from a modification of a convertible debt instrument. EITF 05-07 is effective beginning in the first interim or annual reporting period beginning after December 15, 2005. We do not anticipate that the adoption of EITF 05-07 will have a material impact on our consolidated financial statements.
In May 2005, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 154, Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3. SFAS No. 154 requires retrospective application for reporting a change in accounting principle unless such application is impracticable or unless transition requirements specific to a newly adopted accounting principle require otherwise. SFAS No. 154 also requires the reporting of a correction of an error by restating previously issued financial statements. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.
In December 2004, the FASB issued SFAS No. 123 (revised 2004) (SFAS No. 123R), Share-Based Payment. SFAS No. 123R establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods and services or incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. SFAS No. 123R requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award and to recognize that cost over the period during which an employee is required to provide service in exchange for the award. SFAS No. 123R is effective for Epiq beginning January 1, 2006. Accordingly, we will adopt SFAS No. 123R, likely using the modified version of prospective application, beginning with our quarter ending March 31, 2006. Under the modified version of prospective application, compensation costs related to share-based compensation will be recognized in our financial statements for all periods beginning after December 31, 2005. For comparative periods ended on or before December 31, 2005, which are presented in our 2006 and subsequent financial statements, share-based compensation costs will continue to be excluded from our consolidated statement of operations, but we will disclose these share-based compensation costs on a pro forma basis in a note to the consolidated financial statements. During February 2005, our compensation committee approved acceleration of the vesting of certain unvested options for employees, including an executive officer, and non-employee directors. The decision to accelerate the vesting of these options and eliminate future compensation expense was based primarily on a review of our long-term incentive programs considering the effect on our financial statements of changes in accounting rules that we must adopt in 2006. This action, which had an immaterial effect on our financial statements for the year ended December 31, 2005, will reduce the impact of adoption of SFAS No. 123R on our future consolidated financial statements. Adoption of SFAS No. 123R will materially increase our recognized compensation expense and will have a material impact on our consolidated statement of operations and our consolidated balance sheet. We are working with independent valuation experts to document and validate key valuation variables, such as
39
forfeiture rate, expected term, segmentation of employee population, expected term suboptimal exercise price, and expected volatility. Until this work is completed, we are unable to estimate the impact of adoption of this statement on our consolidated financial statements. However, if subsequent to December 31, 2005 no new awards were issued and no existing awards were forfeited, we estimate that adoption of SFAS No. 123R would decrease our net income for the year ending December 31, 2006 by approximately $1.4 million. We do not anticipate that adoption of SFAS No. 123R will have a material impact on our consolidated statement of cash flows.
In August 2005, the FASB issued FASB Staff Position (FSP) No. FAS 123(R)-1, Classification and Measurement of Freestanding Financial Instruments Originally Issued in Exchange for Employee Services under FASB Statement No. 123(R), to defer the requirement of SFAS No. 123R that a freestanding financial instrument originally subject to SFAS No. 123R becomes subject to the recognition and measurement requirements of other applicable generally accepted accounting principles when the rights conveyed by the instrument to the holder are no longer dependent on the holder being an employee of the entity. The guidance in this FSP is effective upon initial adoption of SFAS No. 123R. We do not anticipate that adoption of FSP No. FAS 123(R)-1 will have a material impact on our consolidated financial statements.
In October 2005, the FASB issued FSP No. FAS 123(R)-2, Practical Accommodation to the Application of Grant Date as Defined in FASB Statement No. 123(R). This FSP states that, in determining the grant date of an award subject to SFAS No. 123R, a mutual understanding of the key terms and conditions of an award to an individual employee shall be presumed to exist at the date the award is approved in accordance with the relevant corporate governance requirements if both of the following conditions are met: a) the award is a unilateral grant and, therefore, the recipient does not have the ability to negotiate the key terms and conditions of the award with the employer; and b) the key terms and conditions of the award are expected to be communicated to an individual recipient within a relatively short time period from the date of approval. The guidance in this FSP is effective upon initial adoption of SFAS No. 123R. We do not anticipate that adoption of FSP No. FAS 123(R)-2 will have a material impact on our consolidated financial statements.
In November 2005, the FASB issued FSP No. FAS 123(R)-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards. This FSP provides a simplified method for calculating the pool of excess tax benefits available to absorb tax deficiencies recognized subsequent to the adoption of SFAS No. 123R. We have until December 31, 2006, to determine whether to make a one-time election to adopt the transition method described in this FSP. At this time, management is uncertain whether we will make the election to adopt the transition method described in this FSP and we are unable to estimate the impact, if any, on our consolidated financial statements if we elect to use the transition method described in this FSP.
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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk refers to the risk that a change in the level of one or more market prices, interest rates, indices, volatilities, correlations or other market factors, such as liquidity, will result in losses for a certain financial instrument or group of financial instruments. Our convertible debt and credit facility borrowings create market risks for us. We do not actively manage these market risks.
During 2004, we issued $50.0 million of convertible notes with a 4% fixed interest rate. While we do not have cash flow risk related to this instrument, the instrument does contain an embedded option related to the right of security holders to extend the maturity of the convertible notes which creates an earnings risk. A 10% increase in our stock value would result in a $0.2 million increase in the fair value of the embedded option and a corresponding decrease in pre-tax earnings. A 10% decrease in our stock value would result in a $0.2 million decrease in the fair value of the embedded option and a corresponding increase in pre-tax earnings. The estimated changes in fair value were calculated using a pricing model that incorporates assumptions regarding future volatility, interest rates and credit risk.
At December 31, 2005, we have borrowings outstanding under a credit facility. Interest on borrowings under our credit facility is computed at a variable rate based on the LIBOR rate and the prime rate and results in a market risk related to interest rates. A 1% increase or decrease in the LIBOR rate and the prime rate would increase or decrease, respectively, our annual pre-tax interest expense on variable rate borrowings outstanding as of December 31, 2005 by approximately $1.2 million.
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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our consolidated financial statements appear following Item 15 of this Report.
Supplementary Data - Quarterly Financial Information
The following table sets forth quarterly financial data for the quarters of the years ended December 31, 2005 and 2004 (in thousands, except per share data) as reported previous to our restatement.
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| Quarters |
| ||||||||||
|
| 1st |
| 2nd |
| 3rd |
| 4th |
| ||||
|
| (As Previously Reported) |
| ||||||||||
|
|
|
|
|
|
|
|
|
| ||||
Year ended December 31, 2005 |
|
|
|
|
|
|
|
|
| ||||
Revenues from continuing operations |
| $ | 31,461 |
| $ | 31,635 |
| $ | 32,016 |
| $ | 35,684 |
|
Gross profit (3) |
| 16,531 |
| 16,875 |
| 16,071 |
| 18,535 |
| ||||
Net income |
| 3,250 |
| 2,904 |
| 3,087 |
| 1,707 |
| ||||
Net income per share—Basic (1) |
| $ | 0.18 |
| $ | 0.16 |
| $ | 0.17 |
| $ | 0.09 |
|
Net income per share—Diluted (1) |
| $ | 0.17 |
| $ | 0.15 |
| $ | 0.16 |
| $ | 0.09 |
|
|
|
|
|
|
|
|
|
|
| ||||
Year ended December 31, 2004 |
|
|
|
|
|
|
|
|
| ||||
Revenues from continuing operations |
| $ | 26,012 |
| $ | 34,908 |
| $ | 35,694 |
| $ | 28,806 |
|
Gross profit (3) |
| 14,736 |
| 16,114 |
| 15,937 |
| 13,752 |
| ||||
Income from continuing operations |
| 2,001 |
| 2,983 |
| 2,161 |
| 1,918 |
| ||||
Income (loss) from discontinued operations (2) |
| (264 | ) | 1,008 |
| (77 | ) | — |
| ||||
Net income |
| 1,737 |
| 3,991 |
| 2,084 |
| 1,918 |
| ||||
Net income per share—Basic (1) |
| $ | 0.10 |
| $ | 0.22 |
| $ | 0.11 |
| $ | 0.11 |
|
Net income per share—Diluted (1) |
| $ | 0.10 |
| $ | 0.22 |
| $ | 0.11 |
| $ | 0.10 |
|
(1) The sum of the quarters may not equal the total of the respective year’s net income (loss) per share due to changes in the weighted average shares outstanding throughout the year.
(2) Discontinued operations relates entirely to the sale of our infrastructure business. See note 14 of the accompanying notes to consolidated financial statements.
(3) Gross profit, which was not previously reported, as been added to this table. Gross profit is calculated as total revenue less direct costs of services, reimbursed direct costs, and the portion of depreciation and software amortization attributable to direct costs of services.
42
The following table sets forth the restated (see note 17 of the accompanying notes to the consolidated financial statements) quarterly financial data for the quarters of the years ended December 31, 2005 and 2004 (in thousands, except per share data):
|
| Quarters |
| ||||||||||
|
| 1st |
| 2nd |
| 3rd |
| 4th |
| ||||
|
| (As Restated) |
| (As Restated) |
| (As Restated) |
| (As Restated) |
| ||||
Year ended December 31, 2005 |
|
|
|
|
|
|
|
|
| ||||
Revenues from continuing operations |
| $ | 24,644 |
| $ | 25,352 |
| $ | 26,294 |
| $ | 30,040 |
|
Gross profit (3) |
| 9,714 |
| 10,592 |
| 10,349 |
| 12,891 |
| ||||
Net income (loss) |
| (2,128 | ) | 1,836 |
| 495 |
| (4,045 | ) | ||||
Net income (loss) per share—Basic (1) |
| $ | (0.12 | ) | $ | 0.10 |
| $ | 0.03 |
| $ | (0.22 | ) |
Net income (loss) per share—Diluted (1) |
| $ | (0.12 | ) | $ | 0.10 |
| $ | 0.03 |
| $ | (0.22 | ) |
|
|
|
|
|
|
|
|
|
| ||||
Year ended December 31, 2004 |
|
|
|
|
|
|
|
|
| ||||
Revenues from continuing operations |
| $ | 17,651 |
| $ | 28,268 |
| $ | 29,626 |
| $ | 22,823 |
|
Gross profit (3) |
| 6,375 |
| 9,474 |
| 9,869 |
| 7,769 |
| ||||
Loss from continuing operations |
| (2,198 | ) | (1,245 | ) | (2,397 | ) | (1,450 | ) | ||||
Income (loss) from discontinued operations (2) |
| (264 | ) | 1,008 |
| (77 | ) | — |
| ||||
Net loss |
| (2,462 | ) | (237 | ) | (2,474 | ) | (1,450 | ) | ||||
Net loss per share—Basic (1) |
| $ | (0.14 | ) | $ | (0.01 | ) | $ | (0.14 | ) | $ | (0.08 | ) |
Net loss per share—Diluted (1) |
| $ | (0.14 | ) | $ | (0.01 | ) | $ | (0.14 | ) | $ | (0.08 | ) |
(1) The sum of the quarters may not equal the total of the respective year’s net loss per share due to changes in the weighted average shares outstanding throughout the year.
(2) Discontinued operations relates entirely to the sale of our infrastructure business. See note 14 of the accompanying notes to consolidated financial statements.
(3) Gross profit is calculated as total revenue less direct costs of services, reimbursed direct costs, and the portion of depreciation and software amortization attributable to direct costs of services.
43
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934. Based on their evaluation as of December 31, 2005, the end of the period covered by the original Annual Report on 10-K, our principal executive officer and principal financial officer previously concluded that our disclosure controls and procedures were effective at a reasonable assurance level to ensure that the information required to be disclosed in reports filed or submitted under the Securities Exchange Act of 1934, were recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and was accumulated and communicated to management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. Subsequently, we determined that we had a material weakness, as described below, in our internal control over financial reporting. Therefore in connection with filing this amended Annual Report on Form 10-K/A, our principal executive officer and principal financial officer re-evaluated the effectiveness of disclosure controls and procedures and each concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were not effective.
Management’s Report on Internal Control Over Financial Reporting (as revised)
Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:
· Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the company;
· Provide reasonable assurance that the transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and
· Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.
44
In connection with the original filing of our Annual Report on Form 10-K, our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2005. In making this assessment, our management used the criteria set forth by Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control — Integrated Framework (COSO). Based on our assessment using those criteria, management originally concluded that, as of December 31, 2005, our internal control over financial reporting was effective.
During fiscal year 2006, and subsequent to the original issuance of our Annual Report on Form 10-K for the fiscal year ended December 31, 2005, management identified an accounting error in its consolidated financial statements related to determination of the appropriate accounting treatment for certain complex aspects of revenue recognition, specifically the evaluation of vendor specific objective evidence of fair value for specified software upgrades provided within a bundled arrangement as required by the AICPA’s Statement of Position 97-2 (SOP 97-2), Software Revenue Recognition. On November 14, 2006, our audit committee determined that our previously issued financial statements for the fiscal years ended December 31, 2005, 2004 and 2003, included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005, for the quarters ended March 31, 2006 and 2005, included in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2006, and for the quarters ended June 30, 2006 and 2005, included in our Quarterly Report on Form 10-Q for the quarter ended June 30, 2006, should be restated. The restatement is further discussed in note 17 to the accompanying consolidated financial statements. In connection with the restatement management evaluated the control failure that resulted in the error related to revenue recognition. As a result of this evaluation management determined that a material weakness existed in internal control over financial reporting as of December 31, 2005. Specifically, management has concluded that the Company did not have adequate controls including management oversight related to the evaluation of contracts and the related determination of the appropriate application of generally accepted accounting principles related certain complex aspects of revenue recognition, specifically the evaluation of vendor specific objective evidence of fair value for specified software upgrades provided within a bundled arrangement as required by the AICPA’s Statement of Position 97-2, “Software Revenue Recognition.” This weakness was the result of a material weakness in the design of internal control over financial reporting.
As a result of the material weakness, management of the Company, under the direction of its CEO and CFO, has revised their assessment of the effectiveness of internal control over financial reporting as of December 31, 2005. This revised assessment was based on the COSO criteria. As a result of the revised assessment the Company’s management, including its CEO and CFO, concluded that its internal control over financial reporting was not effective as of December 31, 2005.
Management has excluded Hilsoft, Inc., nMatrix, Inc., nMatrix Australia Pty. Ltd., and nMatrix Ltd. from the assessment of internal control over financial reporting as of December 31, 2005 because we completed the acquisition of these entities during 2005. Hilsoft, Inc., nMatrix, Inc., nMatrix Australia Pty. Ltd., and nMatrix Ltd. are wholly-owned subsidiaries all of which were acquired during the fourth quarter of the year ended December 31, 2005 and whose financial statements, exclusive of goodwill, certain identifiable intangible assets, consisting of customer relationships, covenants not to compete, and trade names, and intercompany amounts (all of which are subject to corporate level controls), constitute 12% and 6% of net and total assets, respectively, 4% of revenues and (22)% of net loss of the consolidated financial statement amounts as of and for the year ended December 31, 2005. Our conclusion in this Annual Report on Form 10-K/A regarding the effectiveness of our internal control over financial reporting as of December 31, 2005 does not include the internal control over financial reporting of Hilsoft, Inc., nMatrix, Inc., nMatrix Australia Pty. Ltd., and nMatrix Ltd.
Our management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2005 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report which appears beginning on page 47.
45
Remediation Activities
After identifying the material weakness subsequent to the original issuance of our Annual Report on Form 10-K for the fiscal year ended December 31, 2005, management initiated changes to remediate the material weakness described above. We believe that, prior to December 31, 2006, we completed our remediation of the aforementioned material weakness in our internal control over financial reporting. The completed remediation measures included the implementation of appropriate controls related to contracts or other arrangements that are within the scope of SOP 97-2 to provide a written analysis of the appropriate accounting for these contracts or other arrangement and the review of our conclusions with qualified internal accounting personnel or third party accounting experts. In addition, we have provided our accounting staff with additional training related to generally accepted accounting principles and financial statement reporting matters.
Changes in Internal Control Over Financial Reporting
There have been no changes in our internal control over financial reporting during the quarter ended December 31, 2005 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
46
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders
Epiq Systems, Inc.
Kansas City, Kansas
We have audited management’s revised assessment, included in Management’s Report on Internal Control Over Financial Reporting (as revised) appearing under Item 9A of this Annual Report on Form 10-K/A, that Epiq Systems, Inc. and subsidiaries (the “Company”) did not maintain effective internal control over financial reporting as of December 31, 2005, because of the effect of the material weakness identified in management’s assessment based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). As described in Management’s Report on Internal Control Over Financial Reporting (as revised), management excluded from its assessment the internal control over financial reporting at Hilsoft, Inc., nMatrix, Inc., nMatrix Australia Pty. Ltd., and nMatrix Ltd., all of which were acquired during the fourth quarter of the year ended December 31, 2005, and whose financial statements, exclusive of goodwill, certain identifiable assets, consisting of customer relationships, covenants not to compete, and trade names, and intercompany, constitute 12% and 6% of net and total assets, respectively, 4% of revenues and (22)% of net income of the consolidated financial statement amounts as of and for the year ended December 31, 2005. Accordingly, our audit did not include the internal control over financial reporting at Hilsoft, Inc., nMatrix, Inc., nMatrix Australia Pty. Ltd., and nMatrix Ltd. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
47
In our report dated March 7, 2006, we expressed an unqualified opinion on management’s assessment that the Company maintained effective internal control over financial reporting and an unqualified opinion on the effectiveness of internal control over financial reporting. As described in the following paragraph, the Company subsequently identified material misstatements in its financial statements for the years ended December 31, 2005, 2004, and 2003, which caused such financial statements to be restated. Management subsequently revised its assessment due to the identification of a material weakness, described in the following paragraph, which resulted in the errors and related financial statement restatement. Accordingly, our opinion on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005 expressed herein is different from that expressed in our previous report.
A material weakness is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weakness has been identified and included in management’s assessment:
Inadequate internal controls related to revenue recognition: The Company did not have adequate controls including management oversight related to the evaluation of contracts and the related determination of the appropriate application of generally accepted accounting principles related to certain complex aspects of revenue recognition, specifically the evaluation of vendor specific objective evidence of fair value for specified software upgrades provided within a bundled arrangement as required by the AICPA’s Statement of Position 97-2, “Software Revenue Recognition.” This weakness constitutes a material weakness in the design of internal control over financial reporting, and resulted in material adjustments to the consolidated financial statements as of December 31, 2005 and 2004 and for the fiscal years ended December 31, 2005, 2004, and 2003 as discussed in note 17 to the consolidated financial statements.
This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the consolidated financial statements and consolidated financial statement schedule as of and for the year ended December 31, 2005 (as restated) of the Company and this report does not affect our report on such financial statements and financial statement schedule.
In our opinion, management’s revised assessment that the Company did not maintain effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the COSO. Also in our opinion, because of the effects of the material weakness described above on the achievement of the objectives of the control criteria, the Company has not maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the COSO.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and consolidated financial statement schedule as of and for the year ended December 31, 2005 of the Company and our report dated March 7, 2006 (February 3, 2007 as to note 5 and the effect of the restatement discussed in note 17) expressed an unqualified opinion on those consolidated financial statements and the consolidated financial statement schedule.
DELOITTE & TOUCHE LLP
Kansas City, Missouri
March 7, 2006 (February 3, 2007 as to the effects of the material weakness discussed in Management’s
Report on Internal Control Over Financial Reporting (as revised))
48
None.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Incorporated by reference to our Proxy Statement for our 2006 Annual Meeting of Shareholders filed with the Securities and Exchange Commission on April 28, 2006.
ITEM 11. EXECUTIVE COMPENSATION
Incorporated by reference to our Proxy Statement for our 2006 Annual Meeting of Shareholders filed with the Securities and Exchange Commission on April 28, 2006.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER MATTERS
Incorporated by reference to our Proxy Statement for our 2006 Annual Meeting of Shareholders filed with the Securities and Exchange Commission on April 28, 2006.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Incorporated by reference to our Proxy Statement for our 2006 Annual Meeting of Shareholders filed with the Securities and Exchange Commission on April 28, 2006.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Incorporated by reference to our Proxy Statement for our 2006 Annual Meeting of Shareholders filed with the Securities and Exchange Commission on April 28, 2006.
49
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) The following documents are filed as a part of this report:
(1) Financial Statements. The following consolidated financial statements, contained on pages F-1 through F-39 of this report, are filed as part of this report under Item 8 “Financial Statements and Supplementary Data.”
Report of Independent Registered Public Accounting Firm |
|
|
|
Consolidated Balance Sheets (Restated) — December 31, 2005 and 2004 |
|
|
|
Consolidated Statements of Operations (Restated) — Years Ended December 31, 2005, 2004 and 2003 |
|
|
|
Consolidated Statements of Changes in Stockholders’ Equity (Restated) — Years Ended December 31, 2005, 2004 and 2003 |
|
|
|
Consolidated Statements of Cash Flows (Restated) — Years Ended December 31, 2005, 2004 and 2003 |
|
|
|
Notes to Consolidated Financial Statements |
|
|
|
(2) Financial Statement Schedules. Epiq Systems, Inc. and subsidiaries for each of the years in the three-year period ended December 31, 2005.
Schedule II — Valuation and qualifying accounts
(3) Exhibits. Exhibits are listed on the Exhibit Index at the end of this report.
50
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: February 8, 2007 | EPIQ SYSTEMS, INC. | |
| By: | /s/ Tom W. Olofson |
|
| Tom W. Olofson |
|
| Chairman of the Board, Chief Executive |
|
| Officer and Director |
In accordance with the Exchange Act this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on the dates indicated.
Signature |
| Name and Title |
| Date |
|
|
|
|
|
/s/ Tom W. Olofson |
| Tom W. Olofson |
| February 8, 2007 |
|
| Chairman of the Board, Chief Executive Officer and Director (Principal Executive Officer) |
|
|
|
|
|
|
|
/s/ Christopher E. Olofson |
| Christopher E. Olofson |
| February 8, 2007 |
|
| President, Chief Operating Officer and Director |
|
|
|
|
|
|
|
/s/ Elizabeth M. Braham |
| Elizabeth M. Braham |
| February 8, 2007 |
|
| Executive Vice President, Chief Financial Officer (Principal Financial Officer) |
|
|
|
|
|
|
|
/s/ Douglas W. Fleming |
| Douglas W. Fleming |
| February 8, 2007 |
|
| Director of Finance, Chief Accounting Officer (Principal Accounting Officer) |
|
|
|
|
|
|
|
/s/ W. Bryan Satterlee |
| W. Bryan Satterlee |
| February 8, 2007 |
|
| Director |
|
|
|
|
|
|
|
/s/ Edward M. Connolly, Jr. |
| Edward M. Connolly, Jr. |
| February 8, 2007 |
|
| Director |
|
|
|
|
|
|
|
/s/ James A. Byrnes |
| James A. Byrnes |
| February 8, 2007 |
|
| Director |
|
|
|
|
|
|
|
/s/ Joel Pelofsky |
| Joel Pelofsky |
| February 8, 2007 |
|
| Director |
|
|
51
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
Epiq Systems, Inc.
Kansas City, Kansas
We have audited the accompanying consolidated balance sheets of Epiq Systems, Inc. and subsidiaries (the “Company”) as of December 31, 2005 and 2004, and the related consolidated statements of operations, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005. Our audits also included the financial statement schedule listed in the Index at Item 15(a)(2). These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Epiq Systems, Inc. and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
As discussed in note 17, the accompanying consolidated balance sheets as of December 31, 2005 and 2004 and the related consolidated statements of operations, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005 have been restated.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 7, 2006 (February 3, 2007 as to the effects of the material weakness discussed in Management’s Report on Internal Control Over Financial Reporting, as revised) expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an adverse opinion on the effectiveness of the Company’s internal control over financial reporting because of a material weakness.
/s/ DELOITTE & TOUCHE LLP
Kansas City, Missouri
March 7, 2006 (February 3, 2007 as to note 5 and the effects of the restatement discussed in note 17)
F-1
EPIQ SYSTEMS, INC.
(In Thousands, Except Share and Per Share Data)
|
| As of December 31, |
| ||||
|
| 2005 |
| 2004 |
| ||
|
| (As Restated, |
| (As Restated, |
| ||
ASSETS |
|
|
|
|
| ||
CURRENT ASSETS: |
|
|
|
|
| ||
Cash and cash equivalents |
| $ | 13,563 |
| $ | 13,330 |
|
Trade accounts receivable, less allowance for doubtful accounts of $3,481 and $1,069, respectively |
| 33,504 |
| 18,690 |
| ||
Prepaid expenses |
| 2,818 |
| 2,052 |
| ||
Income taxes refundable |
| 4,643 |
| 3,477 |
| ||
Deferred income taxes |
| 25,579 |
| 754 |
| ||
Other current assets |
| 85 |
| 736 |
| ||
Total Current Assets |
| 80,192 |
| 39,039 |
| ||
|
|
|
|
|
| ||
LONG-TERM ASSETS: |
|
|
|
|
| ||
Property, equipment and leasehold improvements, net |
| 23,751 |
| 20,431 |
| ||
Software development costs, net |
| 8,848 |
| 5,838 |
| ||
Goodwill |
| 249,427 |
| 147,728 |
| ||
Other intangibles, net of accumulated amortization of $13,758 and $11,707, respectively |
| 53,399 |
| 24,057 |
| ||
Deferred income taxes |
| — |
| 4,229 |
| ||
Other |
| 2,854 |
| 2,995 |
| ||
Total Long-term Assets, net |
| 338,279 |
| 205,278 |
| ||
Total Assets |
| $ | 418,471 |
| $ | 244,317 |
|
|
|
|
|
|
| ||
LIABILITIES AND STOCKHOLDERS’ EQUITY |
|
|
|
|
| ||
CURRENT LIABILITIES: |
|
|
|
|
| ||
Accounts payable |
| $ | 7,954 |
| $ | 4,263 |
|
Customer deposits |
| 2,196 |
| 2,375 |
| ||
Accrued compensation |
| 3,944 |
| 873 |
| ||
Other accrued expenses |
| 3,322 |
| 841 |
| ||
Deferred revenue |
| 60,224 |
| 58 |
| ||
Current maturities of long-term obligations |
| 27,642 |
| 7,650 |
| ||
Total Current Liabilities |
| 105,282 |
| 16,060 |
| ||
|
|
|
|
|
| ||
LONG-TERM LIABILITIES: |
|
|
|
|
| ||
Deferred income taxes |
| 26,815 |
| — |
| ||
Deferred revenue |
| — |
| 35,208 |
| ||
Long-term obligations (excluding current maturities) |
| 145,906 |
| 74,499 |
| ||
Total Long-term Liabilities |
| 172,721 |
| 109,707 |
| ||
|
|
|
|
|
| ||
STOCKHOLDERS’ EQUITY: |
|
|
|
|
| ||
Preferred stock — $1 par value; 2,000,000 shares authorized; none issued and outstanding |
| — |
| — |
| ||
Common stock — $0.01 par value; 50,000,000 shares authorized; issued and outstanding — 19,253,466 and 17,883,917 shares at 2005 and 2004, respectively |
| 193 |
| 179 |
| ||
Additional paid-in capital |
| 128,484 |
| 102,738 |
| ||
Retained earnings |
| 11,791 |
| 15,633 |
| ||
Total Stockholders’ Equity |
| 140,468 |
| 118,550 |
| ||
Total Liabilities and Stockholders’ Equity |
| $ | 418,471 |
| $ | 244,317 |
|
See accompanying notes to consolidated financial statements.
F-2
EPIQ SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In Thousands, Except Per Share Data)
|
| Years Ended December 31, |
| |||||||
|
| 2005 |
| 2004 |
| 2003 |
| |||
|
| (As Restated, |
| (As Restated, |
| (As Restated, |
| |||
|
|
|
|
|
|
|
| |||
REVENUE: |
|
|
|
|
|
|
| |||
Case management services |
| $ | 53,042 |
| $ | 41,275 |
| $ | 23,063 |
|
Case management bundled software license, software upgrade and postcontract customer support services |
| 1,771 |
| 199 |
| 18,469 |
| |||
Document management services |
| 27,874 |
| 36,549 |
| 12,730 |
| |||
Operating revenue before reimbursed direct costs |
| 82,687 |
| 78,023 |
| 54,262 |
| |||
Operating revenue from reimbursed direct costs |
| 23,643 |
| 20,345 |
| 5,518 |
| |||
Total Revenue |
| 106,330 |
| 98,368 |
| 59,780 |
| |||
|
|
|
|
|
|
|
| |||
OPERATING EXPENSES: |
|
|
|
|
|
|
| |||
Direct cost of services (exclusive of depreciation and amortization shown separately below) |
| 30,225 |
| 37,411 |
| 8,380 |
| |||
Direct cost of bundled software license, software upgrade and postcontract customer support services (exclusive of depreciation and amortization shown separately below) |
| 3,809 |
| 2,849 |
| 2,491 |
| |||
Reimbursed direct costs |
| 23,756 |
| 20,124 |
| 5,619 |
| |||
General and administrative |
| 31,072 |
| 25,886 |
| 16,868 |
| |||
Depreciation and software amortization |
| 7,288 |
| 6,527 |
| 4,568 |
| |||
Amortization of intangibles |
| 6,751 |
| 7,767 |
| 3,610 |
| |||
Acquisition related |
| 2,984 |
| 2,197 |
| 1,793 |
| |||
Total Operating Expenses |
| 105,885 |
| 102,761 |
| 43,329 |
| |||
|
|
|
|
|
|
|
| |||
INCOME (LOSS) FROM OPERATIONS |
| 445 |
| (4,393 | ) | 16,451 |
| |||
|
|
|
|
|
|
|
| |||
EXPENSES (INCOME) RELATED TO FINANCING: |
|
|
|
|
|
|
| |||
Interest expense |
| 6,809 |
| 6,343 |
| 201 |
| |||
Interest income |
| (122 | ) | (128 | ) | (284 | ) | |||
Debt extinguishment |
| — |
| 995 |
| — |
| |||
Net Expenses (Income) Related to Financing |
| 6,687 |
| 7,210 |
| (83 | ) | |||
|
|
|
|
|
|
|
| |||
INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE INCOME TAXES |
| (6,242 | ) | (11,603 | ) | 16,534 |
| |||
|
|
|
|
|
|
|
| |||
PROVISION (BENEFIT) FOR INCOME TAXES |
| (2,400 | ) | (4,313 | ) | 6,939 |
| |||
|
|
|
|
|
|
|
| |||
INCOME (LOSS) FROM CONTINUING OPERATIONS |
| (3,842 | ) | (7,290 | ) | 9,595 |
| |||
|
|
|
|
|
|
|
| |||
DISCONTINUED OPERATIONS: |
|
|
|
|
|
|
| |||
Income (loss) from operations of discontinued infrastructure segment (including gain on disposal of $1,616 during the year ended December 31, 2004) |
| — |
| 1,104 |
| (9,562 | ) | |||
Income tax (expense) benefit from operations of discontinued infrastructure segment |
| — |
| (437 | ) | 3,744 |
| |||
TOTAL DISCONTINUED OPERATIONS |
| — |
| 667 |
| (5,818 | ) | |||
|
|
|
|
|
|
|
| |||
NET INCOME (LOSS) |
| $ | (3,842 | ) | $ | (6,623 | ) | $ | 3,777 |
|
F-3
EPIQ SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Continued)
(In Thousands, Except Per Share Data)
|
| Years Ended December 31, |
| |||||||
|
| 2005 |
| 2004 |
| 2003 |
| |||
|
| (As Restated, |
| (As Restated, |
| (As Restated, |
| |||
NET INCOME (LOSS) PER SHARE INFORMATION: |
|
|
|
|
|
|
| |||
Income (loss) per share — Basic |
|
|
|
|
|
|
| |||
Income (loss) from continuing operations |
| $ | (0.21 | ) | $ | (0.41 | ) | $ | 0.54 |
|
Income (loss) from discontinued operations |
| — |
| 0.04 |
| (0.33 | ) | |||
Net income (loss) per share — Basic |
| $ | (0.21 | ) | $ | (0.37 | ) | $ | 0.21 |
|
|
|
|
|
|
|
|
| |||
Income (loss) per share — Diluted |
|
|
|
|
|
|
| |||
Income (loss) from continuing operations |
| $ | (0.21 | ) | $ | (0.41 | ) | $ | 0.53 |
|
Income (loss) from discontinued operations |
| — |
| 0.04 |
| (0.32 | ) | |||
Net income (loss) per share — Diluted |
| $ | (0.21 | ) | $ | (0.37 | ) | $ | 0.21 |
|
|
|
|
|
|
|
|
| |||
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING: |
|
|
|
|
|
|
| |||
Basic |
| 18,092 |
| 17,848 |
| 17,619 |
| |||
Diluted |
| 18,092 |
| 17,848 |
| 18,104 |
|
See accompanying notes to consolidated financial statements.
F-4
EPIQ SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
(In Thousands)
|
| As of December 31, |
| |||||||
|
| 2005 |
| 2004 |
| 2003 |
| |||
|
| (As Restated, |
| (As Restated, |
| (As Restated, |
| |||
PREFERRED SHARES (2,000 authorized) |
| — |
| — |
| — |
| |||
|
|
|
|
|
|
|
| |||
COMMON SHARES (50,000 authorized): |
|
|
|
|
|
|
| |||
Shares, beginning of year |
| 17,884 |
| 17,781 |
| 16,538 |
| |||
Shares issued upon exercise of options |
| 140 |
| 103 |
| 189 |
| |||
Shares issued in acquisition of business |
| 1,229 |
| — |
| 1,054 |
| |||
Shares, end of year |
| 19,253 |
| 17,884 |
| 17,781 |
| |||
|
|
|
|
|
|
|
| |||
COMMON STOCK — PAR VALUE $0.01 PERSHARE: |
|
|
|
|
|
|
| |||
Balance, beginning of year |
| $ | 179 |
| $ | 178 |
| $ | 165 |
|
Proceeds from exercise of options |
| 2 |
| 1 |
| 2 |
| |||
Shares issued in acquisition of business |
| 12 |
| — |
| 11 |
| |||
Balance, end of year |
| 193 |
| 179 |
| 178 |
| |||
|
|
|
|
|
|
|
| |||
ADDITIONAL PAID-IN CAPITAL: |
|
|
|
|
|
|
| |||
Balance, beginning of year |
| 102,738 |
| 101,891 |
| 83,731 |
| |||
Proceeds from exercise of options |
| 1,029 |
| 595 |
| 1,039 |
| |||
Tax benefit from exercise of options |
| 496 |
| 252 |
| 746 |
| |||
Net proceeds from (expenses for) private placement of stock |
| — |
| — |
| (114 | ) | |||
Shares issued in acquisition of business |
| 24,221 |
| — |
| 16,489 |
| |||
Balance, end of year |
| 128,484 |
| 102,738 |
| 101,891 |
| |||
|
|
|
|
|
|
|
| |||
RETAINED EARNINGS: |
|
|
|
|
|
|
| |||
Balance, beginning of year |
| 15,633 |
| 22,256 |
| 18,479 |
| |||
Net income (loss) |
| (3,842 | ) | (6,623 | ) | 3,777 |
| |||
Balance, end of year |
| 11,791 |
| 15,633 |
| 22,256 |
| |||
|
|
|
|
|
|
|
| |||
TOTAL STOCKHOLDERS’ EQUITY |
| $ | 140,468 |
| $ | 118,550 |
| $ | 124,325 |
|
See accompanying notes to consolidated financial statements.
F-5
EPIQ SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands)
|
| Years Ended December 31, |
| |||||||
|
| 2005 |
| 2004 |
| 2003 |
| |||
|
| (As Restated, |
| (As Restated, |
| (As Restated, |
| |||
CASH FLOWS FROM OPERATING ACTIVITIES: |
|
|
|
|
|
|
| |||
Net income (loss) |
| $ | (3,842 | ) | $ | (6,623 | ) | $ | 3,777 |
|
Adjustments to reconcile net income (loss) to net cash from operating activities: |
|
|
|
|
|
|
| |||
Benefit for deferred income taxes |
| (9,864 | ) | (2,491 | ) | (5,081 | ) | |||
Depreciation and software amortization |
| 7,288 |
| 6,527 |
| 5,796 |
| |||
Loan fee amortization and debt extinguishment |
| 1,147 |
| 3,115 |
| — |
| |||
Change in valuation of embedded option and convertible debt |
| 1,034 |
| 292 |
| — |
| |||
Amortization of intangible assets |
| 6,751 |
| 7,767 |
| 3,745 |
| |||
Asset impairment charges |
| — |
| — |
| 7,615 |
| |||
Gain on sale of discontinued operation |
| — |
| (1,616 | ) | — |
| |||
Other, net |
| 1,015 |
| 370 |
| 234 |
| |||
Changes in operating assets and liabilities, net of effects from business acquisitions: |
|
|
|
|
|
|
| |||
Trade accounts receivable |
| (3,141 | ) | 7,951 |
| (5,948 | ) | |||
Prepaid expenses and other assets |
| (330 | ) | 1,187 |
| (981 | ) | |||
Accounts payable and other liabilities |
| 3,126 |
| (10,779 | ) | 2,618 |
| |||
Deferred revenue |
| 24,742 |
| 27,069 |
| 8,145 |
| |||
Income taxes, including tax benefit from exercise of stock options |
| (688 | ) | (1,180 | ) | 731 |
| |||
Net cash provided by operating activities |
| 27,238 |
| 31,589 |
| 20,651 |
| |||
|
|
|
|
|
|
|
| |||
CASH FLOWS FROM INVESTING ACTIVITIES: |
|
|
|
|
|
|
| |||
Purchase of property and equipment |
| (4,555 | ) | (5,424 | ) | (3,772 | ) | |||
Software development costs |
| (2,269 | ) | (1,670 | ) | (2,753 | ) | |||
Cash paid for acquisition of businesses, net of cash acquired |
| (110,533 | ) | (113,111 | ) | (43,263 | ) | |||
Proceeds from sale of infrastructure business |
| 489 |
| 1,111 |
| — |
| |||
Purchase of short-term investments |
| 6,000 |
| — |
| — |
| |||
Sale of short-term investments |
| (6,000 | ) | — |
| — |
| |||
Other investing activities, net |
| 38 |
| 65 |
| (209 | ) | |||
Net cash used in investing activities |
| (116,830 | ) | (119,029 | ) | (49,997 | ) | |||
|
|
|
|
|
|
|
| |||
CASH FLOWS FROM FINANCING ACTIVITIES: |
|
|
|
|
|
|
| |||
Proceeds from long-term debt borrowings |
| 106,841 |
| 193,500 |
| — |
| |||
Debt issuance costs |
| (938 | ) | (5,931 | ) | — |
| |||
Payments under long-term debt and capital lease obligations |
| (17,109 | ) | (118,455 | ) | (347 | ) | |||
Expenses for stock issuance |
| — |
| — |
| (114 | ) | |||
Proceeds from exercise of stock options |
| 1,031 |
| 595 |
| 1,041 |
| |||
Net cash provided by financing activities |
| 89,825 |
| 69,709 |
| 580 |
| |||
|
|
|
|
|
|
|
| |||
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS |
| 233 |
| (17,731 | ) | (28,766 | ) | |||
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR |
| 13,330 |
| 30,347 |
| 59,827 |
| |||
(Increase) decrease in cash classified as held for sale |
| — |
| 714 |
| (714 | ) | |||
CASH AND CASH EQUIVALENTS, END OF YEAR |
| $ | 13,563 |
| $ | 13,330 |
| $ | 30,347 |
|
See accompanying notes to consolidated financial statements.
F-6
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004 AND 2003
NOTE 1: NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of Epiq Systems, Inc. (“Epiq”) and its wholly-owned subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation.
Nature of Operations
Epiq is a national provider of technology-based solutions for the legal and fiduciary services industries. Our products and services assist clients with the administration of complex legal proceedings, including electronic litigation discovery, bankruptcy administration and class action administration. Our clients include leading law firms, corporate legal departments, bankruptcy trustees, and other professional advisors who require sophisticated case administration and document management capabilities, extensive subject matter expertise and a high service capacity. We provide clients with an integrated offering of both proprietary technology and value-added services that comprehensively address their extensive business requirements.
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and in banks and all liquid investments with original maturities of three months or less at the time of purchase.
Software Development Costs
Certain internal software development costs incurred in the creation of computer software products are capitalized once technological feasibility has been established. Capitalized costs are amortized based on the ratio of current revenue to current and estimated future revenue for each product with minimum annual amortization equal to the straight-line amortization over the remaining estimated economic life of the product.
Goodwill and Identifiable Intangible Assets
Goodwill is not amortized but is assigned to a reporting unit and tested for impairment at least annually and between annual tests if events or changes in circumstances have indicated that the assets might be impaired. Our annual impairment test, performed in July 2005 and using a discounted cash flow analysis to determine the fair value of each reporting unit, indicated that there were no impairments.
Identifiable intangible assets, resulting from various business acquisitions, consist primarily of customer relationships, trade names and agreements not to compete. Customer relationships, trade names and agreements not to compete are being amortized on a straight-line basis over their estimated economic benefit period, generally from one to 14 years. Identifiable intangibles assets are reviewed for impairment whenever events or changes in circumstances have indicated that the carrying amount of these assets might not be recoverable.
Impairment of Long-lived Assets
Long-lived assets are reviewed for impairment, using our best estimates of operating cash flows based on reasonable and supportable assumptions and projections, whenever events or changes in circumstances indicate that the carrying amount of the assets might not be recoverable.
Deferred Loan Fees
Incremental, third party costs related to establishing credit facilities and issuing convertible debt are capitalized and amortized based on the amortization schedule of the related debt. The unamortized costs are included as a component of other long-term assets on our consolidated balance sheets. Amortization costs are included as a component of interest expense on our consolidated statements of operations. Unamortized costs related to debt extinguished prior to maturity due to refinancing were expensed and comprise debt extinguishment on our consolidated statements of operations.
F-7
Stock-Based Compensation
Stock compensation awards are accounted for under the intrinsic method of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. Opinion No. 25 requires compensation cost to be recognized based on the excess, if any, between the quoted market price at the date of grant and the amount an employee must pay to acquire stock. Stock options awarded by us are granted with an exercise price equal to the fair market value on the date of the grant. As required by Statement of Financial Accounting Standard (“SFAS”) No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure, an amendment of FASB Statement No. 123, following is a reconciliation of reported net income and net income per share to pro forma net income and pro forma net income per share had the compensation cost been determined based on the fair value at the grant dates using SFAS No. 123, Accounting for Stock-Based Compensation, for the years ended December 31, 2005, 2004 and 2003 (in thousands, except per share data):
|
|
|
| Years Ended December 31, |
| |||||||
|
|
|
| 2005 |
| 2004 |
| 2003 |
| |||
|
|
|
|
|
|
|
|
|
| |||
Net income (loss), as reported |
|
|
| $ | (3,842 | ) | $ | (6,623 | ) | $ | 3,777 |
|
Add: stock-based employee compensation included in reported net earnings, net of tax |
|
|
| — |
| — |
| — |
| |||
Deduct: Total stock-based employee compensation expense determined under fair value based method for all options, net of tax |
|
|
| (6,605 | ) | (2,975 | ) | (2,195 | ) | |||
Net income (loss), pro forma |
|
|
| $ | (10,447 | ) | $ | (9,598 | ) | $ | 1,582 |
|
|
|
|
|
|
|
|
|
|
| |||
Net income (loss) per share — Basic |
| As reported |
| $ | (0.21 | ) | $ | (0.37 | ) | $ | 0.21 |
|
|
| Pro forma |
| $ | (0.58 | ) | $ | (0.54 | ) | $ | 0.09 |
|
|
|
|
|
|
|
|
|
|
| |||
Net income (loss) per share — Diluted |
| As reported |
| $ | (0.21 | ) | $ | (0.37 | ) | $ | 0.21 |
|
|
| Pro forma |
| $ | (0.58 | ) | $ | (0.54 | ) | $ | 0.09 |
|
Pro forma amounts presented above are based on actual earnings and consider only the effects of estimated fair values of stock options. For the year ended December 31, 2005, we did not assume conversion of the convertible notes as the effect was antidilutive. The convertible notes, if converted, would result in issuance of 2,857,000 shares of our common stock.
The fair value of stock options is estimated using the Black-Scholes option-pricing model with the following key assumptions:
|
| 2005 |
| 2004 |
| 2003 |
|
Expected life (years) |
| 5.0 - 5.3 |
| 5.3 - 5.4 |
| 5.5 - 6.2 |
|
Expected volatility |
| 40% |
| 30% - 48% |
| 50% - 55% |
|
Risk-free interest rate |
| 4.0% - 4.3% |
| 2.9% - 3.9% |
| 2.2% - 3.1% |
|
Dividend yield |
| 0% |
| 0% |
| 0% |
|
Income Taxes
A liability or asset is recognized for the deferred tax consequences of temporary differences between the tax basis of assets or liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. A valuation allowance is provided when, in the opinion of management, it is more likely than not that some portion or all of a deferred tax asset will not be realized.
F-8
Revenue Recognition
We have agreements with clients pursuant to which we deliver various case management and document management services each month.
Significant sources of revenue include:
· Fees contingent upon the month-to-month delivery of case management services defined by client contracts, such as claims processing, claims reconciliation, professional services, call center support, and conversion of data into an organized, searchable electronic database. The amount we earn varies based primarily on the size and complexity of the engagement;
· Hosting fees based on the amount of data stored;
· Deposit-based fees from financial institutions, primarily based on a percentage of total liquidated assets placed on deposit at that financial institution by our bankruptcy trustee clients, to whom we provide, at no charge, software licenses, limited hardware and hardware maintenance, and postcontract customer support (PCS) services,
· Legal noticing services to parties of interest in bankruptcy and class action matters, including media campaign and advertising management, in which we coordinate notification through various media outlets, such as print, radio and television, to potential parties of interest for a particular client engagement, and
· Reimbursement for costs incurred, primarily related to postage on mailing services.
Non-Software Arrangements
Case and document management services related to electronic discovery, corporate restructuring, and class action revenue, which are billed based on volume, are evaluated pursuant to Emerging Issues Task Force (EITF) 00-21, Revenue Arrangements with Multiple Deliverables. For each of these contractual arrangements, we have identified the following deliverables and/or services:
· Electronic Discovery
· Data processing
· Hosting
· Corporate Restructuring
· Consulting
· Claims management
· Printing and reproduction
· Mailing and noticing
· Document management
· Class Action
· Consulting
· Notice campaigns
· Toll free customer support
· Web site design/hosting
· Claims administration
· Distribution
Based on our evaluation of each element, we have determined that each element delivered has standalone value to our customers because we or other vendors sell such services separately from any other services/deliverables. We have also obtained objective and reliable evidence of the fair value of each element based either on the price we charge when we sell an element on a standalone basis or based on third-party evidence of fair value of such services. Lastly, our arrangements do not include general rights of return. Accordingly, each of the service elements in our multiple element case and document management arrangements qualifies as a separate unit of accounting under EITF 00-21. We allocate revenue to the various units of accounting in our arrangements based on the fair value of each unit of accounting, which is generally consistent with the stated prices in our arrangements. As we have evidence of an arrangement, revenue for each separate unit of accounting is recognized each period in accordance with Staff Accounting Bulletin Topic 13, Revenue Recognition (SAB Topic 13). As the services are rendered, our fee becomes fixed and determinable, and collectibility is reasonably assured. Payments
F-9
received in advance of satisfaction of the related revenue recognition criteria are recognized as a customer deposit until all revenue recognition criteria have been satisfied.
Software Arrangements
For our Chapter 7 bankruptcy trustee arrangements, we provide our trustee clients with a software license, hardware lease, hardware maintenance, and PCS services, all at no charge to the trustee. The trustees place their liquidated estate deposits with a financial institution with which we have an arrangement. The financial institution pays us a monthly fee contingent on the dollar level of average monthly deposits placed by the trustees with that financial institution.
We have arrangements with various depository financial institutions and, prior to October 1, 2003, we had an open ended arrangement with our primary depository financial institution. We also had open ended arrangements with each Chapter 7 trustee client. Under these arrangements, we provided our Chapter 7 trustee clients with a software license, hardware lease, hardware maintenance, and PCS services, all at no charge to the trustee. The trustees placed their liquidating estate deposits with a financial institution with which we had a joint marketing arrangement, typically our primary depository financial institution. We account for the software license and PCS elements in accordance with Statement of Position 97-2, Software Revenue Recognition (SOP 97-2). Since we have not established vendor specific objective evidence (VSOE) of the fair value of the software license, we do not recognize any revenue on delivery of the software. The software element is deferred and included with the remaining undelivered element, which is PCS services. This revenue, when recognized, is included on our consolidated statements of operations as a component of “Case management bundled software license, software upgrade and postcontract customer support services” revenue. Revenue related to PCS is entirely contingent on the placement of liquidated estate deposits by the trustee with the financial institution. Accordingly, we recognize this contingent usage based revenue consistent with the guidance provided by the American Institute of Certified Public Accountants’ Technical Practice Aid (TPA) 5100.76, Fair Value in Multiple-Element Arrangements That Include Contingent Usage-Based Fees and Software Revenue Recognition as the fee becomes fixed or determinable at the time actual usage occurs and collectibility is probable. This occurs monthly as a result of the computation, billing and collection of monthly deposit fees contractually agreed to. At that time, we have also satisfied the other revenue recognition criteria contained in SOP 97-2, as we have persuasive evidence that an arrangement exists, services have been rendered, the price is fixed and determinable, and collectibility is reasonably assured.
Prior to October 1, 2003, from time to time we would separately negotiate a contract with our primary financial institution to provide the trustee clients with a software upgrade or a special project. For these single element contracts, in accordance with SAB Topic 13, we recognized revenue when persuasive evidence of an arrangement existed, services had been rendered, the price was fixed and determinable, and collectibility was reasonably assured. This occurred on delivery of the single element.
We also provide our trustees with certain hardware, such as desktop computers, monitors, and printers, and hardware maintenance. We retain ownership of all hardware provided and, based on guidance provided in EITF 01-8, Determining Whether an Arrangement Contains a Lease, we account for this hardware as a lease. As the hardware maintenance arrangement is an executory contract similar to an operating lease, we use guidance related to contingent rentals in operating lease arrangements for hardware maintenance as well as for the hardware lease. Since all of the payments under all of our arrangements are contingent upon the level of trustee deposits and the delivery of upgrades and other services, and there remain important uncertainties regarding the amount of unreimbursable costs yet to be incurred by us, we account for the hardware lease as an operating lease in accordance with SFAS 13, Accounting for Leases. Therefore, all lease payments, based on the estimated fair value of hardware provided, were accounted for as contingent rentals under EITF Issue No. 98-9, Accounting for Contingent Rent and SAB Topic 13, which requires that we recognize rental income when the changes in the factor on which the contingent lease payment is based actually occur. This occurred at the end of each period as we achieve our target when deposits are held at the depository financial institution as, at that time, evidence of an arrangement exists, delivery has occurred, the amount has become fixed and determinable, and collection is reasonably assured. This revenue, which is less than ten percent of our total revenue, is included in our consolidated statements of operations as a component of “Case management services” revenue.
Effective October 1, 2003, we entered into a three-year arrangement (the 2003 Arrangement) with our primary financial institution under which we delivered two specified upgrades annually with the last specified upgrade to occur in the second quarter of 2006. This arrangement included specific pricing for each software upgrade and certain special projects in addition to the contingent deposit-based pricing related to the software license, hardware, hardware maintenance, and PCS services provided to each trustee client. Therefore, the software upgrades and special projects are part of a bundled arrangement. Each software upgrade is considered a separate and discrete product and, as we do not sell each software upgrade on a
F-10
standalone basis, we were unable to establish VSOE of the fair value of the software upgrades. As a result, the licensed software, software upgrade, special projects and PCS are a combined unit of accounting. Under the guidance of SOP 97-2, all revenue related to this combined unit of accounting is deferred until the final upgrade is delivered. The ongoing costs related to this arrangement were recognized as expense when incurred. When the final upgrade is delivered and the only remaining undelivered element is PCS, we will then recognize revenue on a pro-rata basis over the term of the agreement. Payments received in advance of satisfaction of the related revenue recognition criteria are recognized as deferred revenue until all revenue recognition criteria have been satisfied. As of December 31, 2005 and 2004, we had recorded on our consolidated balance sheets $59.7 million and $35.2 million, respectively, of deferred revenue under the 2003 Arrangement. This deferred revenue was recognized during the second and third quarters of 2006. The 2003 Arrangement did not affect our accounting, as described above, for fees received from other financial institutions or our accounting related to hardware and hardware maintenance.
Reimbursements
Our case and document management businesses both have revenue related to the reimbursement of certain costs, primarily postage. Consistent with guidance provided by EITF No. 01-14, Income Statement Characterization of Reimbursements Received for “Out-of-Pocket” Expenses Incurred, reimbursed postage and other reimbursable direct costs are recorded gross in the consolidated statement of operations as “Operating revenue from reimbursed direct costs” and as “Reimbursed direct costs”.
Costs related to contract acquisition, origination, and set-up
SAB Topic 13 provides guidance that contract acquisition, origination, and set-up costs may be expensed as incurred or capitalized and amortized in accordance with FASB Technical Bulletin No. 90-1, “Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts” or Statement of Financial Accounting Standards No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct costs of Leases.” We have elected to expense these costs as incurred.
Derivative Financial Instrument
The holders of our contingently convertible subordinated notes have the right to extend the maturity of these notes for a period not to exceed three years. Under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, the right to extend the maturity of the notes represents an embedded option and is accounted for as a derivative financial instrument. The fair value of our obligation related to the embedded option has been included as a component of our long-term obligations on our accompanying consolidated balance sheets. Changes in the fair value of the embedded option are recorded each period as a component of interest expense on our accompanying consolidated statements of operations. Changes in the fair value of the embedded option do not affect our cash flows and, accordingly, are reflected as an adjustment to reconcile net income to net cash from operating activities on our accompanying consolidated statements of cash flows.
Comprehensive Income (Loss)
We do not have any components of other comprehensive income; therefore comprehensive income (loss) equals net income (loss) for each of the three years ended December 31, 2005, 2004 and 2003.
Income (Loss) Per Share
Basic net income (loss) per share is computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted net income (loss) per share is computed by dividing net income available to common shareholders, increased by the amount of interest expense, net of tax, related to outstanding convertible debt by the weighted average number of outstanding common shares and shares that may be issued in future periods relating to outstanding stock options and convertible debt, if dilutive.
Segment Information
In determining our reportable segments, we consider how we organize our business internally for making operating decisions and assessing business performance. Substantially all our revenues are derived from sources within the United States of America and substantially all of our long-lived assets are located in the United States of America.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. Estimates also affect the reported amounts of revenues and expenses during the periods reported. Actual results could differ from those estimates.
F-11
Recent Accounting Pronouncements
In September 2005, the EITF issued EITF 05-07, Accounting for Modifications to Conversion Options Embedded in Debt Instruments and Related Issues. EITF 05-07 requires that, when a modification of a convertible debt instrument results in a change in the fair value of an embedded conversion option, the change in fair value of the embedded conversion option be included in the analysis of whether there has been a substantial change in the terms of the convertible debt instrument for purposes of determining whether the debt has been extinguished. EITF 05-07 also requires subsequent recognition of interest expense for any change in the fair value of the embedded conversion option resulting from a modification of a convertible debt instrument. EITF 05-07 is effective beginning in the first interim or annual reporting period beginning after December 15, 2005. We do not anticipate that the adoption of EITF 05-07 will have a material impact on our consolidated financial statements.
In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3. SFAS No. 154 requires retrospective application for reporting a change in accounting principle unless such application is impracticable or unless transition requirements specific to a newly adopted accounting principle require otherwise. SFAS No. 154 also requires the reporting of a correction of an error by restating previously issued financial statements. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.
In December 2004, the FASB issued SFAS No. 123 (revised 2004) (SFAS No. 123R), Share-Based Payment. SFAS No. 123R establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods and services or incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. SFAS No. 123R requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award and to recognize that cost over the period during which an employee is required to provide service in exchange for the award. SFAS No. 123R is effective for Epiq beginning January 1, 2006. Accordingly, we will adopt SFAS No. 123R, likely using the modified version of prospective application, beginning with our quarter ending March 31, 2006. Under the modified version of prospective application, compensation costs related to share-based compensation will be recognized in our financial statements for all periods beginning after December 31, 2005. For comparative periods ended on or before December 31, 2005, which are presented in our 2006 and subsequent financial statements, share-based compensation costs will continue to be excluded from our consolidated statements of operations, but we will disclose these share-based compensation costs on a pro forma basis in a note to the consolidated financial statements. During February 2005, our compensation committee approved acceleration of the vesting of certain unvested options for employees, including an executive officer, and non-employee directors. The decision to accelerate the vesting of these options and eliminate future compensation expense was based primarily on a review of our long-term incentive programs considering the effect on our financial statements of changes in accounting rules that we must adopt in 2006. This action, which had an immaterial effect on our financial statements for the year ended December 31, 2005, will reduce the impact of adoption of SFAS No. 123R on our future consolidated financial statements. Adoption of SFAS No. 123R will materially increase our recognized compensation expense and will have a material impact on our consolidated income statement and balance sheet. We are working with independent valuation experts to document and validate key valuation variables, such as forfeiture rate, expected term, segmentation of employee population, expected term suboptimal exercise price, and expected volatility. Until this work is completed, we are unable to estimate the impact of adoption of this statement on our consolidated financial statements. However, if subsequent to December 31, 2005 no new awards were issued and no existing awards were forfeited, we estimate that adoption of SFAS No. 123R would decrease our net income for the year ending December 31, 2006 by approximately $1.4 million. We do not anticipate that adoption of SFAS No. 123R will have a material impact on our consolidated statement of cash flows.
In August 2005, the FASB issued FASB Staff Position (FSP) No. FAS 123(R)-1, Classification and Measurement of Freestanding Financial Instruments Originally Issued in Exchange for Employee Services under FASB Statement No. 123(R), to defer the requirement of SFAS No. 123R that a freestanding financial instrument originally subject to SFAS No. 123R becomes subject to the recognition and measurement requirements of other applicable generally accepted accounting principles when the rights conveyed by the instrument to the holder are no longer dependent on the holder being an employee of the entity. The guidance in this FSP is effective upon initial adoption of SFAS No. 123R. We do not anticipate that adoption of FSP No. FAS 123(R)-1 will have a material impact on our consolidated financial statements.
In October 2005, the FASB issued FSP No. FAS 123(R)-2, Practical Accommodation to the Application of Grant Date as Defined in FASB Statement No. 123(R). This FSP states that, in determining the grant date of an award subject to SFAS No.
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123R, a mutual understanding of the key terms and conditions of an award to an individual employee shall be presumed to exist at the date the award is approved in accordance with the relevant corporate governance requirements if both of the following conditions are met: a) the award is a unilateral grant and, therefore, the recipient does not have the ability to negotiate the key terms and conditions of the award with the employer; and b) the key terms and conditions of the award are expected to be communicated to an individual recipient within a relatively short time period from the date of approval. The guidance in this FSP is effective upon initial adoption of SFAS No. 123R. We do not anticipate that adoption of FSP No. FAS 123(R)-2 will have a material impact on our consolidated financial statements.
In November 2005, the FASB issued FSP No. FAS 123(R)-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards. This FSP provides a simplified method for calculating the pool of excess tax benefits available to absorb tax deficiencies recognized subsequent to the adoption of SFAS No. 123R. We have until December 31, 2006, to determine whether to make a one-time election to adopt the transition method described in this FSP. At this time, management is uncertain whether we will make the election to adopt the transition method described in this FSP and we are unable to estimate the impact, if any, on our consolidated financial statements if we elect to use the transition method described in this FSP.
F-13
NOTE 2: PROPERTY AND EQUIPMENT
Property, equipment and leasehold improvements are stated at cost and depreciated or amortized on a straight-line basis over the estimated useful life of each asset. The classification of property, equipment and leasehold improvements and their estimated useful lives is as follows (in thousands):
| December 31, |
| Estimated |
| |||||
|
| 2005 |
| 2004 |
| Useful Life |
| ||
|
|
|
|
|
|
|
| ||
Land |
| $ | 192 |
| $ | 192 |
|
|
|
Building and building and leasehold improvements |
| 8,947 |
| 8,912 |
| 5 - 30 years |
| ||
Furniture and fixtures |
| 2,061 |
| 2,035 |
| 5 - 10 years |
| ||
Computer and office equipment |
| 23,044 |
| 17,379 |
| 2 - 5 years |
| ||
Mailroom equipment |
| 858 |
| 832 |
| 3 - 5 years |
| ||
Transportation equipment |
| 6,396 |
| 4,855 |
| 3 - 5 years |
| ||
|
| 41,498 |
| 34,205 |
|
|
| ||
Less accumulated depreciationand amortization |
| (17,747 | ) | (13,774 | ) |
|
| ||
Property, equipment and leasehold improvements, net |
| $ | 23,751 |
| $ | 20,431 |
|
|
|
Computer and office equipment includes property acquired under capital leases. As of December 31, 2005 and 2004, assets acquired under capital lease had a historical cost basis of $2.9 million and $2.7 million, respectively, and accumulated amortization of $1.4 million and $0.5 million, respectively. Amortization expense related to these assets has been included as a component of “Depreciation and software amortization” in the accompanying consolidated statements of operations. “Depreciation and software amortization” includes approximately $5.0 million, $4.5 million, and $3.3 million of expenses related to direct costs of services and direct costs of bundled software license, software upgrade and postcontract customer support services for the years ended December 31, 2005, 2004 and 2003, respectively.
NOTE 3: SOFTWARE DEVELOPMENT COSTS
The following is a summary of software development costs capitalized (in thousands):
| Year Ended December 31, |
| |||||
|
| 2005 |
| 2004 |
| ||
|
|
|
|
|
| ||
Amounts capitalized, beginning of year |
| $ | 11,838 |
| $ | 7,212 |
|
Development costs capitalized |
| 2,269 |
| 1,670 |
| ||
Acquisitions |
| 2,869 |
| 2,956 |
| ||
Amounts capitalized, end of year |
| 16,976 |
| 11,838 |
| ||
|
|
|
|
|
| ||
Accumulated amortization, end of year |
| (8,128 | ) | (6,000 | ) | ||
Software development costs, net |
| $ | 8,848 |
| $ | 5,838 |
|
Included in the above are capitalized software development costs for unreleased products of $1.0 million and $1.3 million at December 31, 2005 and 2004, respectively. During the years ended December 31, 2005, 2004 and 2003, we recognized amortization expense related to capitalized software development costs of $2.1 million, $1.8 million, and $1.9 million, respectively.
F-14
NOTE 4: GOODWILL AND INTANGIBLE ASSETS
Changes in the carrying amounts of goodwill by segment are as follows (in thousands):
|
| Year Ended December 31, 2005 |
| Year Ended December 31, 2004 |
| ||||||||||||||
|
| Case |
| Document |
|
|
| Case |
| Document |
|
|
| ||||||
Balance, beginning of period |
| $ | 106,371 |
| $ | 41,357 |
| $ | 147,728 |
| $ | 43,716 |
| $ | 20,472 |
| $ | 64,188 |
|
Goodwill acquired during the period |
| 94,565 |
| 7,134 |
| 101,699 |
| 62,655 |
| 20,885 |
| 83,540 |
| ||||||
Balance, end of period |
| $ | 200,936 |
| $ | 48,491 |
| $ | 249,427 |
| $ | 106,371 |
| $ | 41,357 |
| $ | 147,728 |
|
Other intangible assets as of December 31, 2005 and 2004 consisted of the following (in thousands):
| December 31, |
| Estimated |
| |||||
|
| 2005 |
| 2004 |
| Useful Life |
| ||
|
|
|
|
|
|
|
| ||
Amortized Identifiable Intangible Assets: |
|
|
|
|
|
|
| ||
|
|
|
|
|
|
|
| ||
Customer relationships |
| $ | 37,313 |
| $ | 16,560 |
| 2 - 14 years |
|
Accumulated amortization |
| (6,170 | ) | (7,656 | ) |
|
| ||
Customer relationships, net |
| 31,143 |
| 8,904 |
|
|
| ||
|
|
|
|
|
|
|
| ||
Trade names |
| 2,319 |
| 1,574 |
| 1 - 2 years |
| ||
Accumulated amortization |
| (1,578 | ) | (721 | ) |
|
| ||
Trade names, net |
| 741 |
| 853 |
|
|
| ||
|
|
|
|
|
|
|
| ||
Non-compete agreements |
| 27,525 |
| 17,630 |
| 5 - 10 years |
| ||
Accumulated amortization |
| (6,010 | ) | (3,330 | ) |
|
| ||
Non-compete agreements, net |
| 21,515 |
| 14,300 |
|
|
| ||
|
|
|
|
|
|
|
| ||
Total amortized intangible assets, net |
| $ | 53,399 |
| $ | 24,057 |
|
|
|
The weighted average life for identifiable intangibles acquired during 2005 are as follows:
Customer relationships |
| 7.9 years |
|
Trade names |
| 1.4 years |
|
Non-compete agreements |
| 5.0 years |
|
All identifiable intangibles |
| 7.0 years |
|
F-15
Amortization expense for each year in the three year period ended December 31, 2005 and estimated amortization expense for each of the next five years is as follows (in thousands):
| For the Year Ending |
| ||
Aggregate amortization expense included in continuing operations: |
|
|
| |
2003 |
| $ | 3,610 |
|
2004 |
| 7,767 |
| |
2005 |
| 6,751 |
| |
|
|
|
| |
Estimated amortization expense: |
|
|
| |
2006 |
| 10,853 |
| |
2007 |
| 8,384 |
| |
2008 |
| 7,964 |
| |
2009 |
| 6,882 |
| |
2010 |
| 6,492 |
| |
During November 2003 (the “Measurement Date”), a decision was made to dispose of our infrastructure software business. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, long-lived assets classified as held for sale were measured at the lower of their carrying amounts or fair value less cost to sell. Accordingly, as of the Measurement Date, we performed an impairment analysis based on estimated proceeds from the sale less selling costs. Based on this analysis, the carrying amount of goodwill and identified intangible assets related to the infrastructure software segment, with an aggregate balance of $4.8 million as of January 1, 2003, was entirely impaired. The related impairment charge is included as a component of discontinued operations on our consolidated statements of operations for the year ended December 31, 2003.
The following is a summary of indebtedness outstanding (in thousands):
| Year Ended December 31, |
| |||||
|
| 2005 |
| 2004 |
| ||
|
|
|
|
|
| ||
Senior term loan |
| $ | 25,000 |
| $ | 21,875 |
|
Senior revolving loan |
| 93,028 |
| 5,000 |
| ||
Convertible subordinated debt, including embedded option |
| 51,326 |
| 50,292 |
| ||
Capital leases |
| 972 |
| 1,773 |
| ||
Deferred acquisition price |
| 3,222 |
| 3,209 |
| ||
Total indebtedness |
| $ | 173,548 |
| $ | 82,149 |
|
Credit Facilities
As of December 31, 2004, we had a credit facility, with KeyBank National Association as administrative agent, which consisted of a $25.0 million senior term loan, with amortizing quarterly principal payments of $1.6 million, and a $50.0 million senior revolving loan.
In conjunction with our acquisition of the nMatrix companies, during November 2005 we amended our credit facility. Based on the terms of our amended credit facility, we increased our senior term loan borrowings from $17.2 million to $25.0 million. The amended credit facility eliminated the requirement for quarterly amortizing payments on the senior term loan, but also shortened the maturity of the senior term loan from June 2008 to August 2006. The amended credit facility also increased our senior revolving loan from $75.0 million to $100.0 million. The maturity of the senior revolving loan was extended from June 2008 to November 2008.
F-16
During November 2005, under the amended credit facility we borrowed an additional $7.8 million under the senior term loan and $93.0 million under the senior revolving loan to finance the cash portion of our acquisition of nMatrix.
The credit facility is secured by liens on our real property and a significant portion of our personal property and contains financial covenants related to earnings before interest, provision for income taxes, depreciation and amortization (“EBITDA”), total debt, senior debt, fixed charges and working capital. As of December 31, 2005, our borrowings under the new credit facility totaled $118.0 million, consisting of $25.0 million borrowed under the senior term loan and $93.0 million borrowed under the senior revolving loan. Interest on the credit facility is generally based on a spread, which as of December 31, 2005 was 300 basis points, over the LIBOR rate. As of December 31, 2005, the interest rate charged on outstanding borrowings under the credit facility ranged from 7.4% to 7.6%.
Convertible Subordinated Debt
During June 2004, we issued $50.0 million of contingent convertible subordinated notes. Net proceeds of $47.4 million were used to repay and terminate an outstanding subordinated term loan and to pay in full our then outstanding revolving loan balance. The contingency has been satisfied and the notes may, at the option of the holders, be converted into shares of our common stock at any time. These convertible subordinated notes:
· bear interest at a fixed rate of 4%, payable quarterly;
· are convertible into shares of our common stock at a price of $17.50 per share; and
· mature on June 15, 2007, subject to extension of maturity to June 15, 2010 at the option of the note holders.
If all shares were converted, the notes would convert into approximately 2.9 million shares of our common stock. If we change our capital structure (for example, through a stock dividend or stock split) while the notes are outstanding, the conversion price will be adjusted on a consistent basis and, accordingly, the number of shares of common stock we would issue on conversion would be adjusted.
The holders of the notes have the right to extend the maturity of the notes for a period not to exceed three years. Under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, the right to extend the maturity of the notes represents an embedded option subject to bifurcation. The embedded option was initially valued at $1.2 million and the convertible debt balance was reduced by the same amount. The convertible debt is accreted approximately $0.1 million each quarter such that, at the end of three years, the convertible debt balance will total $50.0 million. On our accompanying consolidated statements of operations, this accretion is a component of interest expense. The embedded option must be revalued at each period end based on the probability weighted discounted cash flows related to the additional 4% interest rate payments that will be made if the convertible debt maturity is extended an additional three years. Under this methodology, the embedded option has a current value of approximately $1.9 million. On our accompanying consolidated balance sheets, our obligation related to the embedded option has been included as a component of the convertible note payable. During the year ended December 31, 2005, the value of the embedded option increased by approximately $0.6 million and this increase is included as a component of interest expense on our accompanying consolidated statements of operations for the year ended December 31, 2005. The changes in carrying value of the convertible debt and fair value of the embedded option do not affect our cash flow and, if the embedded option is exercised, the value assigned to the embedded option will be amortized as a reduction to our 4% convertible debt interest expense over the periods payments are made. If the option is not exercised by some or all convertible debt holders, any remaining related value assigned to the embedded option will be recognized as a gain during that period.
Covenant Compliance
Our credit facility contains financial covenants related to earnings before interest, provision for income taxes, depreciation, amortization and other adjustments as defined in the agreements (EBITDA) and total debt. In addition, our credit facility also contains financial covenants related to senior debt, fixed charges, and working capital. As a result of the restatement, which resulted in the deferral of a substantial portion of revenue related to the 2003 Arrangement as described in note 17, we were not in compliance with these financial covenants as of December 31, 2005. Subsequent to year end, as a result of recognition of the deferred revenue during the second and third quarters of 2006; we were in compliance with all financial covenants as of June 30, 2006 and September 30, 2006. The deferral of revenue through March 31, 2006, and the recognition of the deferred revenue during the second and third quarter of 2006, was not anticipated by us or the banks at the time we established the financial covenants in the credit facility. On December 14, 2006, we obtained a waiver regarding this event of noncompliance from our credit facility syndicate. Accordingly, we have classified this debt as current or long-term based on the debt’s original scheduled maturity.
F-17
Capital Lease
At December 31, 2005, our debt obligation related to capital leases, classified as a current liability, was approximately $1.0 million.
Deferred Acquisition Price
On January 31, 2003, we acquired 100% of the membership interests of Bankruptcy Services LLC (“BSI”), a provider of technology-based case management, consulting and administrative services for corporate restructurings,. A portion of the purchase price, $4.0 million, was deferred. This deferred purchase price, which is payable in five annual installments through January 2008, was discounted using an imputed interest rate of 5% per annum. At December 31, 2005, the discounted value of the remaining note payments was approximately $2.8 million of which approximately $1.7 million was classified as a current liability.
On October 20, 2005, we acquired 100% of the equity of Hilsoft, Inc. (“Hilsoft”), a specialty provider of legal notification services, primarily for class action engagements. A portion of the purchase price, $0.5 million, was deferred. This deferred payment, which is non-interest bearing and is payable on October 20, 2007, was discounted using an imputed interest rate of 8% per annum. At December 31, 2005, the discounted value of this deferred payment was approximately $0.4 million and is classified entirely as a noncurrent liability.
Scheduled Principal Payments
Our long-term obligations, including credit facility debt outstanding as of December 31, 2005, convertible debt (including embedded option), deferred acquisition costs, and capitalized leases, mature as follows for years ending December 31 (in thousands):
2006 |
| $ | 27,642 |
|
2007 |
| 52,342 |
| |
2008 |
| 93,564 |
| |
Total |
| $ | 173,548 |
|
F-18
NOTE 6: OPERATING LEASES
We have non-cancelable operating leases for office space at various locations expiring at various times through 2015. Each of the leases requires us to pay all executory costs (property taxes, maintenance and insurance). Additionally, we have non-cancelable operating leases for office equipment and automobiles expiring through 2009.
Future minimum lease payments during the years ending December 31 are as follows (in thousands):
2006 |
| $ | 3,019 |
|
2007 |
| 2,670 |
| |
2008 |
| 2,271 |
| |
2009 |
| 1,995 |
| |
2010 |
| 1,586 |
| |
Thereafter |
| 7,660 |
| |
Total minimum lease payments |
| $ | 19,201 |
|
Expense related to operating leases was approximately $2.9 million, $2.5 million, and $1.0 million for the years ended December 31, 2005, 2004 and 2003, respectively.
Subsequent to year-end, we entered into a lease for new office space for our electronic litigation discovery operations. This lease extends through 2015 and has total minimum lease of approximately $17.9 million.
NOTE 7: STOCKHOLDERS’ EQUITY
On November 15, 2005, we issued approximately 1.2 million shares of restricted common stock, valued at approximately $24.2 million, as a part of the transaction to purchase nMatrix. Under the terms of a registration rights agreement executed concurrent with the acquisition agreement, we have agreed to prepare and file with the SEC a registration statement, and to use our best efforts to cause the registration statement to become effective as soon as reasonably practicable thereafter, to enable the resale of these shares on a delayed or continuous basis under Rule 415 of the Securities Act of 1933, as amended.
On January 31, 2003, we issued approximately 1.1 million shares of restricted common stock, valued at approximately $16.5 million, as a part of the transaction to purchase the membership interests of BSI. Half of the restricted shares could not be sold, transferred or encumbered for a period of one year from the date of issue, and the other half of the restricted shares could not be sold, transferred or encumbered for a period of two years from the date of issue. All shares of our common stock issued in connection with the BSI acquisition are now unrestricted.
At this time we intend to retain our earnings to reduce our debt and for use in the operation and expansion of our business and, accordingly, do not expect to declare or pay any cash dividends during the foreseeable future. Under the terms of our subordinated convertible debt agreement, we are restricted from payment of dividends while the subordinated convertible debt is outstanding. Thereafter, the payment of dividends is within the discretion of our board of directors and will depend upon various factors, including future earnings, capital requirements, financial condition, the terms of our credit agreement, the terms of our convertible notes, and other factors deemed relevant by the board of directors. There is no restriction on the ability of our subsidiaries to transfer funds to Epiq in the form of cash dividends, loans or advances.
F-19
NOTE 8: EMPLOYEE BENEFIT PLANS
Stock Purchase Plan
We have an employee stock purchase plan that provides an opportunity for employees to purchase shares of our common stock through payroll deduction. The purchase prices for all employee participants are based on the closing bid price on the last business day of the month.
Defined Contribution Plan
We have defined contribution 401(k) plans covering substantially all employees. For Epiq and BSI employees, we match 60% of the first 10% of employee contributions and also have the option of making discretionary contributions. For Poorman-Douglas employees, the percent match is based on years of service. After three years of service, we match 100% of the first 6% of employee contributions. Our contributions under both plans were approximately $0.8 million, $0.8 million, and $0.4 million for the years ended December 31, 2005, 2004, and 2003, respectively.
NOTE 9: FINANCIAL INSTRUMENTS AND CONCENTRATIONS
Fair Value of Financial Instruments
Estimates of fair values are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could affect the estimates.
As of December 31, 2005, the carrying value of cash, cash equivalents, and trade receivables approximate fair value. Borrowings under our credit facility are repriced frequently at market rates and approximate fair value. Our notes related to the BSI and Hilsoft deferred acquisition price are discounted at an imputed interest rate of 5% and 8%, respectively, and their combined carrying value of $3.2 million approximates fair value as of December 31, 2005. As of December 31, 2005, our convertible notes, which have a fixed interest rate of 4%, have a carrying value of $51.3 million and a fair value of $50.3 million. The fair value was calculated using a pricing model that incorporates assumptions regarding future volatility, interest rates and credit risk.
Significant Customer and Concentration of Credit Risk
On April 1, 2004, our exclusive national marketing arrangement with Bank of America became a non-exclusive arrangement with pricing established through September 30, 2006. During February 2006, the parties agreed to extend the arrangement indefinitely. Either party may, with appropriate notice, wind down the agreement over a period, including the notice period, of three years. We currently promote our Chapter 7 TCMSâ software related products and services through marketing arrangements with various financial institutions. Bank of America has been, and continues to be, a significant partner for these marketing arrangements. Revenues recognized by us from Bank of America, all related to our case management segment, were approximately 3%, 3% and 44% of our total revenues for the years ended December 31, 2005, 2004 and 2003, respectively. Additionally, Bank of America represented approximately 13% and 12% of our accounts receivable balance as of December 31, 2005 and 2004, respectively. In addition, a customer related to our newly acquired electronic litigation discovery business represented approximately 13% of our accounts receivable balance as of December 31, 2005.
F-20
The following table presents the income from operations before income taxes and the provision for (benefit from) income taxes (in thousands):
|
| Years Ended December 31, |
| |||||||
|
| 2005 |
| 2004 |
| 2003 |
| |||
|
|
|
|
|
|
|
| |||
Income (loss) from continuing operations before income taxes |
| $ | (6,242 | ) | $ | (11,603 | ) | $ | 16,534 |
|
|
|
|
|
|
|
|
| |||
Provision (benefit) for income taxes from continuing operations: |
|
|
|
|
|
|
| |||
Currently payable (receivable) income taxes |
|
|
|
|
|
|
| |||
Federal |
| $ | 6,996 |
| $ | (16 | ) | $ | 7 ,245 |
|
State |
| 468 |
| 83 |
| 2,886 |
| |||
Total |
| 7,464 |
| 67 |
| 10,131 |
| |||
|
|
|
|
|
|
|
| |||
Deferred income taxes |
|
|
|
|
|
|
| |||
Federal |
| (8,560 | ) | (2,962 | ) | (2,627 | ) | |||
State |
| (1,304 | ) | (1,418 | ) | (565 | ) | |||
Total |
| (9,864 | ) | (4,380 | ) | (3,192 | ) | |||
|
|
|
|
|
|
|
| |||
Provision (benefit) for income taxes from continuing operations |
| (2,400 | ) | (4,313 | ) | 6,939 |
| |||
|
|
|
|
|
|
|
| |||
Provision (benefit) for income taxes from discontinued operations: |
|
|
|
|
|
|
| |||
Current income taxes |
| — |
| (1,452 | ) | (1,855 | ) | |||
Deferred income taxes |
| — |
| 1,889 |
| (1,889 | ) | |||
Provisions (benefit) for income taxes from discontinued operations |
| — |
| 437 |
| (3,744 | ) | |||
|
|
|
|
|
|
|
| |||
Cons olidated income tax provision (benefit) |
| $ | (2,400 | ) | $ | (3,876 | ) | $ | 3,195 |
|
F-21
A reconciliation of the provision (benefit) for income taxes from continuing operations at the statutory rate of 34% for the years ended December 31, 2005 and 2004 and 35% for the year ended December 31, 2003 to the provision (benefit) for income taxes from continuing operations at our effective rate is shown below (in thousands):
|
| Years En ded December 31, |
| ||||
|
| 2005 |
| 2004 |
| 2003 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Computed at the statutory rate |
| $(2,122 | ) | $(3,945 | ) | $5,787 |
|
Change in taxes resulting from: |
|
|
|
|
|
|
|
State income taxes, net of federal tax effect |
| (274 | ) | (514 | ) | 1,000 |
|
Research and development credits |
| (196 | ) | (99 | ) | (92 | ) |
Permanent differences |
| 299 |
| 239 |
| 83 |
|
Other |
| (107 | ) | 6 |
| 161 |
|
Provision (benefit) for income taxes from continuing operations |
| $(2,400 | ) | $(4,313 | ) | $6,939 |
|
Tax benefits related to acquisitions of $0.3 million and $0.5 million were recorded as a reduction to goodwill for the years ended December 31, 2005 and 2004, respectively.
The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities on the accompanying consolidated balance sheets are as follows (in thousands):
|
| December 31, |
| ||
|
| 2005 |
| 2004 |
|
|
|
|
|
|
|
|
|
|
|
| |
Deferred tax assets: |
|
|
|
|
|
Deferred revenue |
| $23,601 |
| $13,925 |
|
Allowance for doubtful accounts |
| 1,567 |
| 467 |
|
Convertible debt |
| 567 |
| 115 |
|
Intangible assets |
| 532 |
| 127 |
|
Accrued liabilities |
| 906 |
| — |
|
State net operating loss carryforwards |
| 572 |
| 781 |
|
Total deferred tax assets |
| 27,745 |
| 15,415 |
|
|
|
|
|
|
|
Deferred tax liabilities: |
|
|
|
|
|
Prepaid expenses |
| 868 |
| 494 |
|
Intangible assets |
| 22,958 |
| 6,396 |
|
Property and equipment and software development costs |
| 4,873 |
| 3,542 |
|
Other |
| 282 |
| — |
|
Total deferred tax liabilities |
| 28,981 |
| 10,432 |
|
|
|
|
|
|
|
Net deferred tax asset (liability) |
| $(1,236 | ) | $4,983 |
|
As of December 31, 2005, we have aggregate state operating loss carryforwards, primarily related to our acquisitions of Poorman-Douglas and nMatrix, of $9.9 million. These carryforwards expire as follows: $7.5 million in 2019 and $2.4 million in 2025. Management believes that it is more likely than not that we will be able to utilize these carryforwards and, therefore, no valuation allowance is necessary.
F-22
The above net deferred tax asset (liability) is presented on the consolidated balance sheets as follows (in thousands):
|
| December 31, |
| ||
|
| 2005 |
| 2004 |
|
|
|
|
|
|
|
|
|
|
|
|
|
Current deferred income tax asset |
| $25,579 |
| $754 | &nbs p; |
Long-term deferred income tax asset (liability) |
| (26,815 | ) | 4,229 |
|
|
| $(1,236 | ) | $4,983 |
|
NOTE 11: NET INCOME (LOSS) PER SHARE
Basic net income (loss) per share is computed by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted net income (loss) per share is computed by dividing net income (loss) available to common shareholders, increased by the amount of interest expense, net of tax, related to outstanding convertible debt, by the weighted average number of outstanding common shares and incremental shares that may be issued in future periods relating to outstanding stock options and convertible debt, if dilutive. When calculating incremental shares related to outstanding stock options, we apply the treasury stock method. The treasury stock method assumes that proceeds, consisting of the amount the employee must pay on exercise, compensation cost attributed to future services and not yet recognized, and excess tax benefits that would be credited to additional paid-in capital on exercise of the options, are used to repurchase outstanding shares at the average market price for the period. The treasury stock method is applied only to share grants for which the effect is dilutive (in thousands, except per share data).
|
| Year Ended December 31, |
| ||||||||||||||||||||||
|
| 2005 |
| 2004 |
| 2003 |
| ||||||||||||||||||
|
| Net Loss |
| Weighted |
|
|
| Net Loss |
| Weighted |
|
|
|
|
| Weighted |
|
|
| ||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||||
Basic income (loss) per share from continuing operations |
| $ | (3,842 | ) | 18,092 |
| $ | (0.21 | ) | $ | (7,290 | ) | 17,848 |
| $ | (0.41 | ) | $ | 9,595 |
| 17,619 |
| $ | 0.54 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||||
Effect of dilutive securities: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||||
Stock options |
|
|
| — |
|
|
|
|
| — |
|
|
|
|
| 485 |
|
|
| ||||||
Convertible debt |
|
|
| — |
|
|
|
|
| — |
|
|
|
|
| — |
|
|
| ||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||||
Diluted income (loss) per share from continuing operations |
| $ | (3,842 | ) | 18,092 |
| $ | (0.21 | ) | $ | (7,290 | ) | 17,848 |
| $ | (0.41 | ) | $ | 9,595 |
| 18,104 |
| $ | 0.53 |
|
For the years ended December 31, 2005 and 2004, we did not assume conversion of the convertible debt or exercise of any share-based options as the effect would be anti-dilutive. For the year ended December 31, 2003, weighted-average outstanding stock options totaling approximately 0.1 million shares of common stock were antidilutive and, therefore, not included in the computation of diluted earnings per share. For the convertible notes, issued in June 2004, we did not assume conversion for the years ended December 31, 2005 and 2004 as the effect would be anti-dilutive.
F-23
NOTE 12: STOCK OPTIONS
During June 2004, our 2004 Equity Incentive Plan (the “2004 Plan”) was approved by our shareholders and replaced our 1995 Stock Option Plan, as amended (the “1995 Plan”). The 2004 Plan limits the combined grant of options to acquire shares of common stock, stock appreciation rights, and restricted stock to 3,000,000 shares. Any grant under the 2004 Plan that expires or terminates unexercised, becomes unexercisable or is forfeited will be available for further grants unless, in the case of options granted, related stock appreciation rights are exercised. At December 31, 2005, there were approximately 986,000 options available for future grants under the 2004 Plan. Under the 2004 Plan, the option price may not be less than 100% of the fair market value of the common stock on the date of grant for a non-qualified stock option or an incentive stock option (“ISO”). In the case of an ISO granted to an employee owning more than 10% of the voting stock of Epiq, the option price may not be less than 110% of the fair market value of the common stock on the date of grant.
The Compensation Committee of the Board of Directors administers the 2004 Plan and has discretion to determine the term of an option, which may not be exercised more than 10 years after the date of grant. In the case of an ISO granted to an employee owning more than 10% of the voting stock of Epiq, the term may not exceed five years from the date of grant. Options may not be transferred by an optionee except by will or the laws of descent and distribution or to a family member by gift or qualified domestic relations order and are exercisable during the lifetime of an optionee only by the optionee or the optionee’s guardian or legal representatives. Assuming the option is otherwise still exercisable, options must be exercised within one year after termination of employment due to death or disability and within three months of any other termination of employment.
The Board of Directors may require in its discretion that any option granted becomes exercisable only in installments or after some minimum period of time, or both. The vesting schedule for outstanding options ranges from immediate to five years.
During November 2005, as part of the nMatrix acquisition, inducement stock options were granted, outside the 2004 Plan, to key employees to acquire up to 370,000 shares of common stock. The options were granted at an option exercise price equal to fair market value of the common stock on the date of grant, were non-qualified options, were exercisable for up to 10 years from the date of grant and vested 25% on the second anniversary of the grant date and continue to vest 25% per year on each anniversary of the grant date until fully vested.
During February 2005, our compensation committee approved acceleration of the vesting of certain unvested options for employees, including an executive officer, and non-employee directors. The decision to accelerate the vesting of these options and eliminate future compensation expense was based primarily on a review of our long-term incentive programs considering the effect on our financial statements of changes in accounting rules that we must adopt in 2006. This action, which had an immaterial effect on our financial statements for the year ended December 31, 2005, will reduce the impact of adoption of SFAS No. 123R on our future consolidated financial statements.
During the year ended December 31, 2004, as part of the Poorman-Douglas acquisition, inducement stock options were granted, outside the 1995 Plan and 2004 Plan, to key executives to acquire up to 300,000 shares of common stock. The options were granted at an option exercise price equal to fair market value of the common stock on the date of grant, were non-qualified options, were exercisable for up to 10 years from the date of grant and vested 20% on the first anniversary of the grant date and continue to vest 20% per year on each anniversary of the grant date until fully vested. During the year, one of the executives transitioned from full-time employee status to a consulting role and his option to purchase 100,000 shares of common stock was terminated.
During the year ended December 31, 2003, as part of the BSI acquisition, inducement stock options were granted, outside the 1995 Plan and 2004 Plan, to a key executive to acquire up to 100,000 shares of common stock. The option was granted at an option exercise price equal to fair market value of the common stock on the date of grant, were non-qualified options, were exercisable for up to ten years from the date of grant and vested 20% on the grant date and continues to vest 20% per year on each anniversary of the grant date until fully vested. During the year ended December 31, 2003, the vested portion of the option was exercised to purchase 20,000 shares of common stock.
F-24
Following is a summary of our stock options outstanding as of each year ended December 31 (in thousands, except price data):
|
| 2005 |
| 2004 |
| 2003 |
| ||||||||||||
|
|
|
| Weighted- |
|
|
| Weighted- |
|
|
| Weighted- |
| ||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||||
Outstanding, beginning of year |
| 3,230 |
| $ | 13.65 |
| 2,192 |
| $ | 12.38 |
| 1,744 |
| $ | 6.87 |
| |||
Granted |
| 1,750 |
| 15.43 |
| 1,370 |
| 15.48 |
| 727 |
| 16.42 |
| ||||||
Forfeited |
| (70 | ) | 14.08 |
| (232 | ) | 15.83 |
| (87 | ) | 10.08 |
| ||||||
Exercised |
| (141 | ) | 7.25 |
| (100 | ) | 5.75 |
| (192 | ) | 5.36 |
| ||||||
Outstanding, end of year |
| 4,769 |
| 14.49 |
| 3,230 |
| 13.65 |
| 2,192 |
| 12.38 |
| ||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||||
Options exercisable, end of year |
| 3,323 |
|
|
| 1,783 |
|
|
| 1,225 |
|
|
| ||||||
Weighted-average fair value of options granted during the year |
| $ | 6.46 |
|
|
| $ | 7.04 |
|
|
| $ | 8.34 |
|
|
| |||
The following table summarizes information about stock options outstanding as of December 31, 2005 (in thousands, except life and price data):
|
| Options Outstanding |
| Options Exercisable |
| ||||||||
|
|
|
|
|
|
|
|
|
|
|
| ||
|
|
|
|
|
|
|
|
|
|
|
| ||
$1.56 to $11.99 |
| 597 |
| 4.18 years |
| $ | 6.48 |
| 597 |
| $ | 6.48 |
|
$12.00 to $13.99 |
| 1,221 |
| 8.77 years |
| 12.45 |
| 1,009 |
| 12.37 |
| ||
$14.00 to $15.99 |
| 1,141 |
| 8.32 years |
| 15.18 |
| 836 |
| 15.34 |
| ||
$16.00 to $17.99 |
| 761 |
| 7.33 years |
| 16.61 |
| 566 |
| 16.62 |
| ||
$18.00 and over |
| 1,049 |
| 9.19 years |
| 19.11 |
| 315 |
| 18.66 |
| ||
|
| 4,769 |
| 7.95 years |
| 14.49 |
| 3,323 |
| 13.38 |
| ||
F-25
NOTE 13: BUSINESS ACQUISITIONS
nMatrix
On November 15, 2005, Epiq, acting through a wholly-owned subsidiary, acquired all the issued and outstanding shares of capital stock of nMatrix, Inc., nMatrix Australia Ptd. Ltd., and nMatrix Ltd. (collectively, “nMatrix”) for approximately $126.2 million, including capitalized acquisition costs. We believe this acquisition provides complementary diversification to our existing legal services business as nMatrix provides electronic litigation discovery services to law firms and in-house counsel. The purchase price consisted of cash of $100.0 million and approximately 1.2 million shares of our common stock. The fair value of our common stock issued, calculated based upon the five-day average of the closing price of the common stock two days before and two days after the acquisition was agreed to and publicly announced, was approximately $24.2 million. nMatrix, which will be included within our case management segment, will be operated from its current locations in New York, the United Kingdom, and Australia. Based on our preliminary valuation, the purchase price has been allocated as follows (in thousands):
Accounts receivable |
| $ | 11,844 |
|
Other current assets |
| 2,926 |
| |
Property and software |
| 7,323 |
| |
Trade names |
| 474 |
| |
Customer relationships |
| 25,040 |
| |
Non-compete agreements |
| 6,675 |
| |
Current liabilities |
| (6,426 | ) | |
Deferred tax liability |
| (16,301 | ) | |
Goodwill |
| 94,602 |
| |
|
|
|
| |
Total purchase price |
| $ | 126,157 |
|
Trade names, customer relationships, and the non-compete agreements are amortized using the straight-line method over one year, eight years, and five years, respectively. The excess purchase price of $94.6 million was allocated to goodwill and is not amortized but will be reviewed for impairment annually and between annual tests if events or changes in circumstances indicate that the asset might be impaired. The purchase price in excess of the tax basis of the assets, primarily allocated to identifiable intangible assets and goodwill, is not expected to be deductible for tax purposes. Of our common shares issued as consideration, approximately 246,000 are held in escrow. On submission of properly approved indemnification claims, the escrow trustee will liquidate sufficient shares to pay the indemnification claim. As of December 31, 2005, we have not submitted any claims related to this escrow. The escrow arrangement terminates May 14, 2007, at which time any of our common shares that have not been liquidated to pay claims will be distributed to the seller. Also, $4.0 million of the cash consideration is held in escrow pending collection of certain pre-acquisition receivables. Each month, a portion of the escrow is released to the seller based on the prior month’s collection of these pre-acquisition receivables. As of December 31, 2005, $2.6 million remained in this escrow account. This escrow arrangement terminates following the payment for collections made during September 2006 of these pre-acquisition receivables, at which time any amount that remains in escrow will be distributed to us.
The acquisition was accounted for using the purchase method of accounting with the operating results included in the accompanying consolidated financial statements from the date of acquisition.
F-26
Hilsoft, Inc.
On October 20, 2005, we acquired for cash all the issued and outstanding shares of capital stock of Hilsoft Inc. We believe this acquisition provides complementary diversification to our existing class action business as Hilsoft is a specialty provider of legal notification services, primarily for class action engagements. The total value of the transaction, including capitalized transaction costs, was $9.3 million. If certain revenue objectives are satisfied, we may be required to make additional payments of up to $3.0 million to the former owners of Hilsoft. Hilsoft, which will be included entirely within our document management segment, will be operated from its current location in Pennsylvania. Based on our preliminary valuation, the purchase price has been allocated as follows (in thousands):
Tangible assets |
| $ | 418 |
|
Trade name |
| 271 |
| |
Customer backlog |
| 323 |
| |
Non-compete agreements |
| 2,680 |
| |
Current liabilities |
| (291 | ) | |
Deferred taxes, net |
| (1,341 | ) | |
Goodwill |
| 7,233 |
| |
|
|
|
| |
Total purchase price |
| $ | 9,293 |
|
Customer backlog and the trade name are amortized using the straight-line method over two years. The non-compete agreements are amortized using the straight-line method over five years. The excess purchase price of $7.2 million was allocated to goodwill and is not amortized but will be reviewed for impairment annually and between annual tests if events or changes in circumstances indicate that the asset might be impaired. The purchase price in excess of the tax basis of the assets, primarily allocated to identifiable intangible assets and goodwill, is not expected to be deductible for tax purposes.
The acquisition was accounted for using the purchase method of accounting with the operating results included in the accompanying consolidated financial statements from the date of acquisition.
F-27
P-D Holding Corp.
On January 30, 2004, we acquired for cash 100% of the equity of P-D Holding Corp. and its wholly-owned subsidiary, Poorman-Douglas Corporation (collectively, “Poorman-Douglas”). We believe this acquisition provides complementary diversification to our existing legal services business as Poorman-Douglas is a provider of technology-based products and services for class action, mass tort and bankruptcy case administration. The total value of the transaction, including capitalized acquisition costs, was approximately $115.7 million. Based on our valuation, the purchase price has been allocated as follows (in thousands):
|
|
|
| |
Current assets |
| $ | 21,986 |
|
Deferred tax assets |
| 6,044 |
| |
Property and software |
| 8,391 |
| |
Trade names |
| 1,100 |
| |
Customer backlog |
| 6,200 |
| |
Customer relationships |
| 2,300 |
| |
Non-compete agreements |
| 5,900 |
| |
Goodwill |
| 83,141 |
| |
Current liabilities |
| (12,920 | ) | |
Deferred tax liabilities |
| (6,476 | ) | |
|
|
|
| |
Total purchase price |
| $ | 115,666 |
|
All acquired identifiable intangible assets are amortized on a straight-line basis as follows: the trade names over two years, the customer backlog over three years, the customer relationships over twelve years, and the non-compete agreements over five years. The excess purchase price of $83.1 million was allocated to goodwill and is not amortized but will be reviewed for impairment annually and between annual tests if events or changes in circumstances indicate that the asset might be impaired. The purchase price in excess of the tax basis of the assets, primarily allocated to identifiable intangible assets and goodwill, is not expected to be deductible for tax purposes.
The acquisition was accounted for using the purchase method of accounting with the operating results included in the accompanying consolidated financial statements from the date of acquisition.
F-28
Bankruptcy Services LLC
On January 31, 2003, we acquired 100% of the membership interests of Bankruptcy Services LLC (“BSI”), a provider of technology-based case management, consulting and administrative services for corporate restructuring cases. The total value of the transaction, including capitalized transaction costs, was $67.0 million of which $45.5 million was paid in cash, $16.5 million (approximately 1.1 million shares) was paid in our common stock, $3.4 million was deferred in the form of a non-interest bearing note with a face value of $4.0 million discounted using an imputed interest rate of 5% per annum, $1.3 million of liabilities were assumed, and $0.3 million was paid in acquisition costs. The purchase price was allocated as follows (in thousands):
Current assets |
| $ | 2,616 |
|
Property and software |
| 755 |
| |
Trade names |
| 474 |
| |
Customer backlog |
| 4,700 |
| |
Non-compete agreements |
| 11,730 |
| |
Goodwill |
| 46,739 |
| |
|
|
|
| |
Total purchase price |
| $ | 67,014 |
|
Customer backlog and the non-compete agreements are amortized using the straight-line method over, respectively, two years and ten years. Initially, the trade name was not amortized as it had an indefinite life. In conjunction with our acquisition of Poorman-Douglas we reassessed our use of all trade names. Accordingly, in February 2004 we commenced amortizing the BSI trade name on a straight-line basis over two years. The excess purchase price of $46.7 million was allocated to goodwill and is not amortized but will be reviewed for impairment annually and between annual tests if events or changes in circumstances indicate that the asset might be impaired. The purchase price in excess of the tax basis of the assets, primarily allocated to identifiable intangible assets and goodwill, has been determined to be deductible for tax purposes.
The acquisition was accounted for using the purchase method of accounting with the operating results included in the accompanying consolidated financial statements from the date of acquisition.
F-29
Pro Forma Information
Unaudited pro forma operations, assuming each purchase acquisition was made at the beginning of the year preceding the acquisition, are shown below (in thousands, except per share data):
|
| For the Years Ended December 31, |
| |||||||
|
| 2005 |
| 2004 |
| 2003 |
| |||
|
|
|
|
|
|
|
| |||
Total revenues |
| $ | 133,618 |
| $ | 119,875 |
| $ | 125,376 |
|
|
|
|
|
|
|
|
| |||
Income (loss) from continuing operations |
| $ | (4,122 | ) | $ | (12,424 | ) | $ | 10,508 |
|
Discontinued operations |
| — |
| 667 |
| (5,818 | ) | |||
Net loss |
| $ | (4,122 | ) | $ | (11,757 | ) | $ | 4,690 |
|
|
|
|
|
|
|
|
| |||
Net income (loss) per share: |
|
|
|
|
|
|
| |||
Net income (loss) per share — Basic |
|
|
|
|
|
|
| |||
Income (loss) from continuing operations |
| $ | (0.23 | ) | $ | (0.70 | ) | $ | 0.60 |
|
Income (loss) from discontinued operations |
| — |
| 0.04 |
| (0.33 | ) | |||
Net income per share — Basic |
| $ | (0.23 | ) | $ | (0.66 | ) | $ | 0.27 |
|
|
|
|
|
|
|
|
| |||
Income (loss) per share — Diluted |
|
|
|
|
|
|
| |||
Income (loss) from continuing operations |
| $ | (0.23 | ) | $ | (0.70 | ) | $ | 0.58 |
|
Income (loss) from discontinued operations |
| — |
| 0.04 |
| (0.32 | ) | |||
Net income (loss) per share — Diluted |
| $ | (0.23 | ) | $ | (0.66 | ) | $ | 0.26 |
|
Pro forma data reflects the difference in amortization expense between Epiq and the acquired companies as well as other adjustments, including income taxes and management compensation. The pro forma information is not necessarily indicative of what would have occurred if the acquisition had been completed on that date nor is it necessarily indicative of future operating results.
F-30
NOTE 14: DISCONTINUED OPERATIONS
During November 2003, we determined that the infrastructure software business was no longer aligned with our long-term strategic objectives. Accordingly, we developed a plan to sell, within one year, our infrastructure software business. At the time, we determined that this business should be classified as a discontinued operation and that the related long-lived assets should be measured at the lower of their carrying amounts or fair value less cost to sell. Our estimated proceeds from the sale of our infrastructure software business, net of estimated selling costs, was less than the carrying amount of this business. As a result, for the year ended December 31, 2003, we reduced the carrying value of these assets, consisting of property and equipment, goodwill and other intangible assets, and recorded a pre-tax impairment charge, included in discontinued operations in the consolidated statements of operations, of approximately $7.6 million. The tax benefit related to this impairment charge, also included in discontinued operations in the consolidated statements of operations, was approximately $3.0 million.
On April 30, 2004, we sold our infrastructure software business to a private company with expertise in file transfer technology for consideration consisting of cash and a note receivable. As of December 31, 2005, we had collected all amounts due related to the note receivable. During the year ended December 31, 2004, we recognized a gain related to this sale, included in discontinued operations in the consolidated statements of operations, of approximately $1.0 million, net of tax.
As of December 31, 2004 and 2005, we did not hold any assets or liabilities related to this discontinued business. Revenues, cost of sales, and operating expenses related to this discontinued business have been included in discontinued operations” in the accompanying consolidated statements of operations for all periods presented. Following is summary financial information for discontinued operations (in thousands):
Net revenue and pre-tax income (loss) from discontinued operations:
|
| Years Ended December 31, |
| |||||||
|
| 2005 |
| 2004 |
| 2003 |
| |||
|
|
|
|
|
|
|
| |||
Net revenue from discontinued operations |
| $ | — |
| $ | 661 |
| $ | 1,988 |
|
|
|
|
|
|
|
|
| |||
Pre-tax income (loss) from discontinued operations |
| $ | — |
| $ | 1,104 |
| $ | (9,562 | ) |
F-31
During the quarter ended March 31, 2004, we changed the structure of our operating segments as a result of changes in our business operations. These changes included our decision, during November 2003, to hold for sale our infrastructure business and our acquisition, in January 2004, of Poorman-Douglas, a provider of technology-based products and services for class action, mass tort and bankruptcy case administration.
With these changes, performance is now assessed for our case management and document management operating segments. Case management solutions provide clients with integrated technology-based products and services for the automation of various administrative tasks. Document management solutions include proprietary technology and production services to ensure timely, accurate and complete execution of the many documents associated with multi-faceted legal cases and communications applications.
Each segment’s performance is assessed based on segment revenues less costs directly attributable to that segment. In management’s evaluation of performance certain costs, such as shared services, administrative staff, and executive management, are not allocated by segment and, accordingly, the following operating segment results do not include those unallocated costs. Assets reported within a segment are those assets used by the segment in its operations and consist of property and equipment, software, identifiable intangible assets and goodwill. All other assets are classified as unallocated.
Information concerning operations of our reportable segments is as follows (in thousands):
|
| Year Ended December 31, 2005 |
| ||||||||||
|
| Case |
| Document |
|
|
|
|
| ||||
|
| Management |
| Management |
| Unallocated |
| Consolidated |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Revenue: |
|
|
|
|
|
|
|
|
| ||||
Operating revenue before reimbursed direct costs |
| $ | 54,813 |
| $ | 27,874 |
| $ | — |
| $ | 82,687 |
|
Operating revenue from reimbursed direct costs |
| 3,138 |
| 20,505 |
| — |
| 23,643 |
| ||||
Total revenue |
| 57,951 |
| 48,379 |
| — |
| 106,330 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Costs and expenses: |
|
|
|
|
|
|
|
|
| ||||
Direct costs, general and administrative costs and depreciation and software amortization |
| 32,580 |
| 36,581 |
| 26,989 |
| 96,150 |
| ||||
Amortization of identifiable intangible assets |
| 5,027 |
| 1,724 |
| — |
| 6,751 |
| ||||
Acquisition related |
| — |
| — |
| 2,984 |
| 2,984 |
| ||||
Total operating expenses |
| 37,607 |
| 38,305 |
| 29,973 |
| 105,885 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Operating income |
| $ | 20,344 |
| $ | 10,074 |
| $ | (29,973 | ) | 445 |
| |
Net expenses related to financing |
|
|
|
|
|
|
| (6,687 | ) | ||||
|
|
|
|
|
|
|
|
|
| ||||
Loss from continuing operations before income taxes |
|
|
|
|
|
|
| (6,242 | ) | ||||
|
|
|
|
|
|
|
|
|
| ||||
Provision for income tax benefit |
|
|
|
|
|
|
| (2,400 | ) | ||||
|
|
|
|
|
|
|
|
|
| ||||
Net loss from continuing operations |
|
|
|
|
|
|
| $ | (3,842 | ) | |||
|
|
|
|
|
|
|
|
|
| ||||
Total assets |
| $ | 260,831 |
| $ | 59,581 |
| $ | 98,059 |
| $ | 418,471 |
|
Provisions for depreciation and amortization |
| $ | 9,681 |
| $ | 2,155 |
| $ | 2,203 |
| $ | 14,039 |
|
Capital expenditures |
| $ | 4,961 |
| $ | 38 |
| $ | 1,825 |
| $ | 6,824 |
|
F-32
|
| Year Ended December 31, 2004 |
| ||||||||||
|
| Case |
| Document |
|
|
|
|
| ||||
|
| Management |
| Management |
| Unallocated |
| Consolidated |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Revenue: |
|
|
|
|
|
|
|
|
| ||||
Operating revenue before reimbursed direct costs |
| $ | 41,474 |
| $ | 36,549 |
| $ | — |
| $ | 78,023 |
|
Operating revenue from reimbursed direct costs |
| 2,465 |
| 17,880 |
| — |
| 20,345 |
| ||||
Total revenue |
| 43,939 |
| 54,429 |
| — |
| 98,368 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Costs and expenses: |
|
|
|
|
|
|
|
|
| ||||
Direct costs, general and administrative costs and depreciation and software amortization |
| 29,107 |
| 40,604 |
| 23,086 |
| 92,797 |
| ||||
Amortization of identifiable intangible assets |
| 5,243 |
| 2,524 |
| — |
| 7,767 |
| ||||
Acquisition related |
| — |
| — |
| 2,197 |
| 2,197 |
| ||||
Total operating expenses |
| 34,350 |
| 43,128 |
| 25,283 |
| 102,761 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Operating loss |
| $ | 9,589 |
| $ | 11,301 |
| $ | (25,283 | ) | (4,393 | ) | |
Net expenses related to financing |
|
|
|
|
|
|
| (7,210 | ) | ||||
|
|
|
|
|
|
|
|
|
| ||||
Loss from continuing operations before income taxes |
|
|
|
|
|
|
| (11,603 | ) | ||||
|
|
|
|
|
|
|
|
|
| ||||
Provision for income tax benefit |
|
|
|
|
|
|
| (4,313 | ) | ||||
|
|
|
|
|
|
|
|
|
| ||||
Net loss from continuing operations |
|
|
|
|
|
|
| $ | (7,290 | ) | |||
|
|
|
|
|
|
|
|
|
| ||||
Total assets |
| $ | 131,233 |
| $ | 51,264 |
| $ | 61,820 |
| $ | 244,317 |
|
Provisions for depreciation and amortization |
| $ | 9,505 |
| $ | 2,998 |
| $ | 1,791 |
| $ | 14,294 |
|
Capital expenditures, including capital leases |
| $ | 5,326 |
| $ | 36 |
| $ | 4,464 |
| $ | 9,826 |
|
F-33
|
| Year Ended December 31, 2003 |
| ||||||||||
|
| Case |
| Document |
|
|
|
|
| ||||
|
| Management |
| Management |
| Unallocated |
| Consolidated |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Revenue: |
|
|
|
|
|
|
|
|
| ||||
Operating revenue before reimbursed direct costs |
| $ | 41,532 |
| $ | 12,730 |
| $ | — |
| $ | 54,262 |
|
Operating revenue from reimbursed direct costs |
| 311 |
| 5,207 |
| — |
| 5,518 |
| ||||
Total revenue |
| 41,843 |
| 17,937 |
| — |
| 59,780 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Costs and expenses: |
|
|
|
|
|
|
|
|
| ||||
Direct costs, general and administrative costs and depreciation and software amortization |
| 13,118 |
| 9,658 |
| 15,150 |
| 37,926 |
| ||||
Amortization of identifiable intangible assets |
| 2,102 |
| 1,508 |
| — |
| 3,610 |
| ||||
Acquisition related |
| — |
| — |
| 1,793 |
| 1,793 |
| ||||
Total operating expenses |
| 15,220 |
| 11,166 |
| 16,943 |
| 43,329 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Operating income |
| $ | 26,623 |
| $ | 6,771 |
| $ | (16,943 | ) | 16,451 |
| |
Net income related to financing |
|
|
|
|
|
|
| 83 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Income from continuing operations before income taxes |
|
|
|
|
|
|
| 16,534 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Provision for income tax expense |
|
|
|
|
|
|
| 6,939 |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Net income from continuing operations |
|
|
|
|
|
|
| $ | 9,595 |
| |||
|
|
|
|
|
|
|
|
|
| ||||
Total assets |
| $ | 59,518 |
| $ | 26,806 |
| $ | 56,862 |
| $ | 143,186 |
|
Provisions for depreciation and amortization |
| $ | 5,881 |
| $ | 1,516 |
| $ | 781 |
| $ | 8,178 |
|
Capital expenditures |
| $ | 3,609 |
| $ | — |
| $ | 2,916 |
| $ | 6,525 |
|
F-34
NOTE 16: SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental cash flow information is as follows (in thousands):
|
| Year Ended December 31, |
| |||||||
|
| 2005 |
| 2004 |
| 2003 |
| |||
|
|
|
|
|
|
|
| |||
Cash paid (received) for: |
|
|
|
|
|
|
| |||
Interest |
| $ | 3,376 |
| $ | 3,877 |
| $ | 53 |
|
Income taxes |
| 8,499 |
| (207 | ) | 7,518 |
| |||
Non-cash investing and financing transactions: |
|
|
|
|
|
|
| |||
Capitalized lease obligations incurred |
| — |
| 2,733 |
| — |
| |||
Issuance of common shares in purchase transactions |
| 24,233 |
| — |
| 16,500 |
| |||
Obligation incurred in purchase transactions |
| 463 |
| — |
| 3,445 |
| |||
NOTE 17: RESTATEMENT OF PREVIOUSLY ISSUED FINANCIAL STATEMENTS
Subsequent to the issuance of our consolidated financial statements for the year ended December 31, 2005, management identified an accounting error in its historical consolidated financial statements related to the appropriate accounting treatment for certain complex aspects of revenue recognition, specifically the evaluation of vendor specific objective evidence (VSOE) of fair value for specified software upgrades provided within a bundled arrangement as required by Statement of Position 97-2, Software Revenue Recognition (SOP 97-2). As a result, we have restated our financial statements as of December 31, 2005 and 2004, and for each of the three years in the period ended December 31, 2005, included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005, initially filed with the SEC on March 8, 2006, for the quarterly information included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005 initially filed with the SEC on March 8, 2006, for the three months ended March 31, 2006 and 2005, included in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2006, initially filed with the SEC on May 9, 2006, for the three and six months ended June 30, 2006 and 2005, included in our Quarterly Report on Form 10-Q for the quarter ended June 30, 2006, initially filed with the SEC on August 8, 2006, and for the three and nine months ended September 20, 2005, included in our Quarterly Report on Form 10-Q for the quarter ended September 30, 2006, filed with the SEC on November 14, 2006.
As background, our Chapter 7 bankruptcy services end-user customers are professional bankruptcy trustees. The application of Chapter 7 bankruptcy regulations has the practical effect of discouraging trustee customers from incurring direct administrative costs for computer systems. As a result, we provide our Chapter 7 services to trustee customers at no direct charge, and our trustee customers maintain deposit accounts for bankruptcy cases under their administration at a designated banking institution. We have marketing arrangements with various banks under which we provide Chapter 7 trustee case management software and related services and the bank provides the Chapter 7 bankruptcy trustee with deposit-related banking services. Under our primary depository financial arrangement, we primarily receive cash based on the aggregate amount of trustee deposits maintained at the bank and the number of Chapter 7 trustees with deposits placed with the bank, which we refer to collectively as volume-based fees. These volume-based fees compensate us for the software license, hardware and postcontract customer support (PCS) services that we provide to the Chapter 7 trustees.
Prior to October 1, 2003, our primary financial institution engaged us to provide the trustees with software upgrades in the first and second quarter of each year. These software upgrades were documented in arrangements that were separate from our volume-based fee arrangement. Once the upgrade was delivered to the trustees and we had provided the bank with satisfactory evidence of the delivery, we would invoice the bank for the agreed upon amount and recognize revenue related to the software upgrade.
In October 2003, we entered into a three year arrangement (the 2003 Arrangement) with our primary financial institution. As a part of the 2003 Arrangement, we continued to perform each of our first and second quarter specified software upgrades
F-35
through the term of the arrangement (September 30, 2006), and the bank agreed to compensate us for these upgrades on terms similar to our historical terms when we delivered the upgrades on a standalone basis. As a result, in our previously reported financial statements, we concluded that we had established VSOE for the software upgrades and we recognized revenue for the software upgrades on delivery. Revenue related to hardware and hardware maintenance was recognized as explained in the “Revenue Recognition” accounting policy contained in note 1. As we did not have VSOE for the software license, we combined the software license with the remaining undelivered element, PCS, as a single unit of accounting. Revenue related to PCS was entirely contingent on the placement of deposits by the trustee with the financial institution. Accordingly, we recognized this contingent usage based revenue consistent with the guidance provided by American Institute of Certified Public Accountants’ Technical Practice Aid (TPA) 5100.76, Fair Value in Multiple-Element Arrangements That Include Contingent Usage-Based Fees and Software Revenue Recognition as the fee became fixed or determinable at the time actual usage occurred and collectibility was probable. This occurred monthly as a result of the computation, billing and collection of monthly deposit fees contractually agreed to with the bankruptcy trustee client. At that time, we had also satisfied the revenue recognition criteria contained in SAB Topic 13, since we had persuasive evidence that an arrangement existed, services had been rendered, the price was fixed and determinable, and collectibility was reasonably assured.
Subsequent to the issuance of the financial statements referenced above, we concluded that, although we historically sold software upgrades on a standalone basis, each specified software upgrade should be considered a separate product and, therefore, the price of prior software upgrades cannot be used to establish the price of future software upgrades. As our primary financial institution was the only payee for software upgrades during the period of the 2003 Arrangement, we were unable to establish VSOE for the software upgrades. Under SOP 97-2, if VSOE cannot be established for software upgrades, then consideration received under the 2003 Arrangement, except for consideration related to the provision of hardware and hardware maintenance, must be deferred until all software upgrades have been delivered. Although we continued to invoice, and the bank continued to pay, our volume-based fees related to software licenses and postcontract customer support as well as our semi-annual software upgrades, these amounts cannot be recognized as revenue when we provide the services. Instead, these amounts are recorded as a deferred revenue liability on our consolidated balance sheet. From inception of the arrangement through December 31, 2005 and March 31, 2006, we recorded as deferred revenue $59.7 million and $66.1 million, respectively, of amounts invoiced under the 2003 Arrangement. On delivery of the final upgrade during the second quarter of 2006, the only remaining undelivered element was PCS services. In accordance with SOP 97-2, on delivery of the final software upgrade we recognized revenue previously deferred on a proportionate basis over the three year term of the contract. As the contract commenced October 1, 2003 and terminated September 30, 2006, we recognized approximately $60.1 million of net deferred revenue related to this arrangement during the second quarter of 2006 and we recognized approximately $6.0 million of deferred revenue related to this arrangement during the third quarter of 2006.
With this restatement, we have also included the presentation of revenue related to software arrangements which include both product (software license and upgrades) with services (PCS) on a separate line item, “Case management bundled software license, software upgrade and postcontract customer support services,” within the revenue section of our consolidated statements of operations. We have also disaggregated direct costs related to operating revenue into three line items, “Direct costs of services,” “Reimbursed direct costs,” and “Direct costs of bundled software license, software upgrade and postcontract customer support services,” within the costs and expenses section of our consolidated statements of operations.
Prior to our restatement, our aggregate deferred revenue was immaterial and was classified as a component of other accrued expenses. With our restatement, deferred revenue is material and is reflected as a separate line item on our condensed consolidated balance sheet. Therefore, we have reclassified deferred revenue previously included as a component of other accrued expenses to the line item deferred revenue.
The restatement also affects taxable income, which resulted in a change to our provision for income taxes. As a result of the deferral of revenue, which had been included in our taxable income, we have restated our deferred tax assets and liabilities.
F-36
A summary of the significant effects of the restatement is as follows: (in thousands, except per share data)
|
| As of December 31, |
| ||||||||||
|
| 2005 |
| 2004 |
| ||||||||
|
| As |
| As |
| As |
| As |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Consolidated Balance Sheet |
|
|
|
|
|
|
|
|
| ||||
Deferred income taxes |
| $ | 1,978 |
| $ | 25,579 |
|
|
|
|
| ||
Total Current Assets |
| 56,591 |
| 80,192 |
|
|
|
|
| ||||
Deferred income taxes |
| — |
| — |
| $ | — |
| $ | 4,229 |
| ||
Total Long-term Assets |
| — |
| — |
| 201,049 |
| 205,278 |
| ||||
Total Assets |
| 394,870 |
| 418,471 |
| 240,088 |
| 244,317 |
| ||||
Other accrued expenses |
| 3,872 |
| 3,322 |
| 899 |
| 841 |
| ||||
Deferred revenue |
| — |
| 60,224 |
| — |
| 58 |
| ||||
Total Current Liabilities |
| 45,608 |
| 105,282 |
| 16,060 |
| 16,060 |
| ||||
Deferred income taxes |
|
|
|
|
| 9,696 |
| — |
| ||||
Deferred revenue |
|
|
|
|
| — |
| 35,208 |
| ||||
Total Long-term Liabilities |
|
|
|
|
| 84,195 |
| 109,707 |
| ||||
Retained earnings |
| 47,864 |
| 11,791 |
| 36,916 |
| 15,633 |
| ||||
Total Stockholders’ Equity |
| 176,541 |
| 140,468 |
| 139,833 |
| 118,550 |
| ||||
Total Liabilities and Stockholders’ Equity. |
| 394,870 |
| 418,471 |
| 240,088 |
| 244,317 |
| ||||
F-37
|
| Years Ended December 31, |
| ||||||||||||||||
|
| 2005 |
| 2004 |
| 2003 |
| ||||||||||||
|
| As |
| As |
| As |
| As |
| As |
| As |
| ||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||||
Consolidated Statements of Operations |
|
|
|
|
|
|
|
|
|
|
|
|
| ||||||
Case management services |
| $ | 79,279 |
| $ | 53,042 |
| $ | 68,526 |
| $ | 41,275 |
| $ | 49,688 |
| $ | 23,063 |
|
Case management bundled software license, software upgrade and postcontract customer support services |
| — |
| 1,771 |
| — |
| 199 |
| — |
| 18,469 |
| ||||||
Total Revenue |
| 130,796 |
| 106,330 |
| 125,420 |
| 98,368 |
| 67,936 |
| 59,780 |
| ||||||
Direct costs of services (exclusive of depreciation and amortization) |
| 57,790 |
| 30,225 |
| 60,384 |
| 37,411 |
| 16,490 |
| 8,380 |
| ||||||
Direct costs of bundled software license, software upgrade and postcontract customer support services (exclusive of depreciation and amortization) |
| — |
| 3,809 |
| — |
| 2,849 |
| — |
| 2,491 |
| ||||||
Reimbursed direct costs |
| — |
| 23,756 |
| — |
| 20,124 |
| — |
| 5,619 |
| ||||||
Income (Loss) from Operations |
| 24,911 |
| 445 |
| 22,659 |
| (4,393 | ) | 24,607 |
| 16,451 |
| ||||||
Income (Loss) from Continuing Operations Before Income Taxes |
| 18,224 |
| (6,242 | ) | 15,449 |
| (11,603 | ) | 24,690 |
| 16,534 |
| ||||||
Provision (Benefit) for Income Taxes |
| 7,276 |
| (2,400 | ) | 6,386 |
| (4,313 | ) | 10,165 |
| 6,939 |
| ||||||
Income (loss) from Continuing Operations |
| 10,948 |
| (3,842 | ) | 9,063 |
| (7,290 | ) | 14,525 |
| 9,595 |
| ||||||
Net Income (Loss) |
| 10,948 |
| (3,842 | ) | 9,730 |
| (6,623 | ) | 8,707 |
| 3,777 |
| ||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||||
Net Income (Loss) per Share |
|
|
|
|
|
|
|
|
|
|
|
|
| ||||||
Basic — income (loss) from continuing operations |
| $ | 0.61 |
| $ | (0.21 | ) | $ | 0.51 |
| $ | (0.41 | ) | $ | 0.82 |
| $ | 0.54 |
|
Basic — net income (loss) per share |
| 0.61 |
| (0.21 | ) | 0.55 |
| (0.37 | ) | 0.49 |
| 0.21 |
| ||||||
Diluted — income (loss) from continuing operations |
| 0.56 |
| (0.21 | ) | 0.49 |
| (0.41 | ) | 0.80 |
| 0.53 |
| ||||||
Diluted — income (loss) from discontinued operations |
|
|
|
|
| 0.03 |
| 0.04 |
|
|
|
|
| ||||||
Diluted — net income (loss) per share |
| 0.56 |
| (0.21 | ) | 0.52 |
| (0.37 | ) | 0.48 |
| 0.21 |
| ||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||||
Weighted Average Common Shares Outstanding — Diluted |
| 21,551 |
| 18,092 |
| 19,828 |
| 17,848 |
|
|
|
|
|
F-38
|
| Years Ended December 31, |
| ||||||||||||||||
|
| 2005 |
| 2004 |
| 2003 |
| ||||||||||||
|
| As |
| As |
| As |
| As |
| As |
| As |
| ||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||||
Consolidated Statements of Cash Flow |
|
|
|
|
|
|
|
|
|
|
|
|
| ||||||
Cash Flows from Operating Activities |
|
|
|
|
|
|
|
|
|
|
|
|
| ||||||
Net income (loss) |
| $ | 10,948 |
| $ | (3,842 | ) | $ | 9,730 |
| $ | (6,623 | ) | $ | 8,707 |
| $ | 3,777 |
|
Provision (benefit) for deferred income taxes |
| (188 | ) | (9,864 | ) | 8,208 |
| (2,491 | ) | (1,855 | ) | (5,081 | ) | ||||||
Accounts payable and other liabilities |
| 3,402 |
| 3,126 |
| (10,762 | ) | (10,779 | ) | 2,607 |
| 2,618 |
| ||||||
Deferred revenue |
| — |
| 24,742 |
| — |
| 27,069 |
| — |
| 8,145 |
| ||||||
Net Cash Provided by Operating Activities |
| 27,238 |
| 27,238 |
| 31,589 |
| 31,589 |
| 20,651 |
| 20,651 |
| ||||||
* * *
F-39
EPIQ SYSTEMS, INC.
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
(in thousands)
|
|
|
| Additions |
|
|
|
|
| |||||||
Description |
| Balance at |
| Charged to |
| Charged to |
| Deductions |
| Balance at |
| |||||
Allowance for doubtful receivables from continuing operations |
|
|
|
|
|
|
|
|
|
|
| |||||
|
|
|
|
|
|
|
|
|
|
|
| |||||
For the year ended December 31, 2005 |
| $ | 1,069 |
| $ | 1,119 |
| $ | 2,008 | (1) | $ | (715 | ) | $ | 3,481 |
|
|
|
|
|
|
|
|
|
|
|
|
| |||||
For the year ended December 31, 2004 |
| 340 |
| 1,099 |
| — |
| (370 | ) | 1,069 |
| |||||
|
|
|
|
|
|
|
|
|
|
|
| |||||
For the year ended December 31, 2003 |
| 5 |
| 347 |
| — |
| (12 | ) | 340 |
| |||||
(1) Consists primarily of allowance related to acquired receivables.
EXHIBIT INDEX
The following exhibits are filed with this Form 10-K/A or are incorporated herein by reference:
Exhibit Number |
| Description |
| ||
| 3.1 |
|
| Articles of Incorporation, as amended through June 2, 2004. Previously filed as an exhibit to the annual report on Form 10-K for the year ended December 31, 2005, filed with the Securities and Exchange Commission on March 8, 2006. |
|
| 3.2 |
|
| Bylaws, as amended and restated. Incorporated by reference and previously filed as an exhibit to the quarterly report on Form 10-Q for the quarter ended March 31, 2001, filed with the Securities and Exchange Commission on May 11, 2001. |
|
| 4.1 |
|
| Reference is made to exhibits 3.1 and 3.2. |
|
| 4.2 |
|
| Securities Purchase Agreement dated as of June 10, 2004, among Epiq Systems, Inc. and the Buyers listed on Exhibit A thereto. Incorporated by reference and previously filed as an exhibit to the current report on Form 8-K filed with the Securities and Exchange Commission on June 14, 2004. |
|
| 4.3 |
|
| Amendment No. 1 to Securities Purchase Agreement among Epiq Systems, Inc. and the Holders, dated as of December 15, 2005. Incorporated by reference and previously filed as an exhibit to the current report on Form 8-K filed with the Securities and Exchange Commission on December 21, 2005. |
|
| 4.4 |
|
| Registration Rights Agreement dated as of June 10, 2004, among Epiq Systems, Inc. and the Buyers listed on the Schedule of Buyers attached thereto. Incorporated by reference and previously filed as an exhibit to the current report on Form 8-K filed with the Securities and Exchange Commission on June 14, 2004. |
|
| 4.5 |
|
| Form of Contingent Convertible Subordinated Note, as amended. Previously filed as an exhibit to the annual report on Form 10-K for the year ended December 31, 2005, filed with the Securities and Exchange Commission on March 8, 2006. |
|
| 10.1 |
|
| 1995 Stock Option Plan, as amended. Incorporated by reference and previously filed as an exhibit to the registration statement on Form SB-2 filed with the Securities and Exchange Commission (File No. 333 -51525) on May 1, 1998. |
|
| 10.2 |
|
| 2004 Equity Incentive Plan. Incorporated by reference and previously filed as an exhibit to the Definitive Proxy Statement filed with the Securities and Exchange Commission on April 28, 2004. |
|
| 10.3 |
|
| Securities Purchase Agreement dated as of November 7, 2002, among Epiq Systems, Inc. and the Purchasers named therein. Incorporated by reference and previously filed as an exhibit to the current report on Form 8-K filed with the Securities and Exchange Commission on November 15, 2002. |
|
| 10.4 |
|
| Membership Interest Purchase Agreement dated as of January 31, 2003, among Jay D. Chazanoff, Stephen R. Simms, Ron L. Jacobs, Kathleen Gerber, Bankruptcy Services LLC, Epiq Systems Acquisition, Inc. and Epiq Systems, Inc. Incorporated by reference and previously filed as an exhibit to the current report on Form 8-K filed with the Securities and Exchange Commission on February 10, 2003. |
|
| 10.5 |
|
| Employment Agreement dated as of January 31, 2003, among Bankruptcy Services LLC, EpiqSystems, Inc and Ron Jacobs. Incorporated by reference and previously filed as an exhibit to the current report on Form 8-K filed with the Securities and Exchange Commission on February 10, 2003. |
|
| 10.6 |
|
| Employment Agreement dated as of January 31, 2003, among Bankruptcy Services LLC, Epiq Systems, Inc. and Kathleen Gerber. Incorporated by reference and previously filed as an exhibit to the current report on Form 8-K filed with the Securities and Exchange Commission on February 10, 2003. |
|
| 10.7 |
|
| Stock Option Agreement among Epiq Systems, Inc., Bankruptcy Services LLC and Ron Jacobs dated as of January 31, 2003. Incorporated by reference and previously filed as an exhibit to the current report on Form 8-K filed with the Securities and Exchange Commission on February 10, 2003. |
|
10.8 |
|
| Agreement and Plan of Merger among P-D Holding Corp., Epiq Systems, Inc., PD Merger Corp., and Endeavour Capital Fund III, L.P., in its capacity as Shareholders’ Representative, dated as of January 30, 2004. Incorporated by reference and previously filed as an exhibit to the current report on Form 8-K filed with the Securities and Exchange Commission on February 13, 2004. |
| |
| 10.9 |
|
| Agreement Related to Merger Agreement among Epiq Systems, Inc., P-D Holding Corp., certain shareholders of P-D Holding Corp. and Endeavour Capital Fund III, L.P., in its capacity as Shareholders’ Representative, dated as of January 30, 2004. Incorporated by reference and previously filed as an exhibit to the current report on Form 8-K filed with the Securities and Exchange Commission on February 13, 2004. |
|
| 10.10 |
|
| Employment and Non-Competition Agreement between Poorman-Douglas Corporation and Jeffrey B. Baker dated as of January 30, 2004. Incorporated by reference and previously filed as an exhibit to the current report on Form 8-K filed with the Securities and Exchange Commission on February 13, 2004. |
|
| 10.11 |
|
| Stock Option Agreement between Epiq Systems, Inc. and Jeffrey B. Baker dated as of January 30, 2004. Incorporated by reference and previously filed as an exhibit to the current report on Form 8-K filed with the Securities and Exchange Commission on February 13, 2004. |
|
| 10.12 |
|
| Stock Purchase Agreement between Epiq Systems Acquisition, Inc. and Ajuta International Pty. Ltd., as trustee of Hypatia Trust, dated as of November 15, 2005. Incorporated by reference and previously filed as an exhibit to the current report on Form 8-K filed with the Securities and Exchange Commission on November 21, 2005. |
|
| 10.13 |
|
| Amended and Restated Credit and Security Agreement dated November 15, 2005, among Epiq Systems, Inc., the Lenders named therein, and KeyBank, National Association, as Lead Arranger, Sole Book Runner, and Administrative Agent. Incorporated by reference and previously filed as an exhibit to the current report on Form 8-K filed with the Securities and Exchange Commission on November 21, 2005. |
|
| 10.14 |
|
| Registration Rights Agreement between Epiq Systems, Inc. and Ajuta International Pty. Ltd., as trustee of Hypatia Trust, dated as of November 15, 2005. Incorporated by reference and previously filed as an exhibit to the current report on Form 8-K filed with the Securities and Exchange Commission on November 21, 2005. |
|
| 10.15 |
|
| Form of Nonqualified Stock Option Agreement under 2004 Equity Incentive Plan. Previously filed as an exhibit to the annual report on Form 10-K for the year ended December 31, 2005, filed with the Securities and Exchange Commission on March 8, 2006. |
|
| 10.16 |
|
| Escrow Agreement among Epiq Systems, Inc., Ajuta International Pty. Ltd., as trustee of Hypatia Trust, and Wells Fargo Bank, N.A. dated as of November 15, 2005. Incorporated by reference and previously filed as an exhibit to the Registration Statement No. 333-133296 on Form S-3/A filed with the Securities and Exchange Commission on June 14, 2006. |
|
| 10.17 |
|
| Letter Agreement dated February 7, 2006, between Epiq Systems, Inc. and Bank of America, N.A. (redacted — request for confidential treatment pending).*+ |
|
| 12.1 |
|
| Statement regarding computation of earnings to fixed charges. * |
|
| 21.1 |
|
| List of Subsidiaries. Previously filed as an exhibit to the annual report on Form 10-K for the year ended December 31, 2005, filed with the Securities and Exchange Commission on March 8, 2006. |
|
| 23.1 |
|
| Consent of Deloitte & Touche LLP, Independent Registered Public Accounting Firm.* |
|
| 31.1 |
|
| Certifications of Chief Executive Officer of the Company under Rule 13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |
|
| 31.2 |
|
| Certifications of Chief Financial Officer of the Company under Rule 13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |
|
| 32.1 |
|
| Certifications of CEO and CFO pursuant to 18 U.S.C. Section 1350.* |
|
* Filed herewith.
+ Certain confidential portions of this exhibit have been redacted. A complete version of this exhibit has been filed with the Secretary of the Securities and Exchange Commission pursuant to an application requesting confidential treatment under Rule 24b-2 of the Securities Exchange Act of 1934.