Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Interim Operations.
The following should be read in conjunction with the Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2009 10-K.
Liquidity and Capital Resources
The Company’s investment portfolio, equity and results of operations can be significantly impacted by the changes in market values of certain securities, particularly during times of increased volatility in security prices. Changes in the market values of publicly traded available for sale securities are reflected in other comprehensive income (loss) and equity. However, changes in the market prices of investments for which the Company has elected the fair value option, declines in the fair values of equity securities that the Company deems to be other than temporary and declines in the fair values of debt securities related to credit losses are reflected in the consolidated statements of operations and equity.
The Company’s largest publicly traded available for sale equity securities with changes in market values reflected in other comprehensive income (loss) are Fortescue and Inmet. During the nine month period ended September 30, 2010, the market value of the Company’s investment in the common shares of Fortescue increased from $988,400,000 at December 31, 2009 (excluding shares sold in 2010) to $1,249,500,000 at September 30, 2010, and the market value of the Company’s investment in Inmet decreased from $339,100,000 at December 31, 2009 to $311,900,000 at September 30, 2010. The change in the market values of the Company’s investments in ACF and Jefferies, for which the fair value option was elected, was reflected in operations as a component of income related to associated companies. 60;During the nine month period ended September 30, 2010, the Company recognized unrealized gains (losses) related to its investments in ACF and Jefferies of $182,200,000 and $(50,500,000), respectively. For the nine month 2010 period, the Company also recorded impairment losses for declines in value of securities deemed to be other than temporary in its consolidated statement of operations of $1,700,000, reflected as a component of net securities gains (losses).
In addition to cash and cash equivalents, the Company also considers investments classified as current assets and investments classified as non-current assets on the face of its consolidated balance sheet as being generally available to meet its liquidity needs. Securities classified as current and non-current investments are not as liquid as cash and cash equivalents, but they are generally easily convertible into cash within a relatively short period of time. As of September 30, 2010, the sum of these amounts aggregated $3,019,200,000. However, since $664,600,000 of this amount is pledged as collateral pursuant to various agreements, represents investments in non-public securities or is held by subsidiaries that are party to agreements that restrict the Company’s ability to use the funds for o ther purposes, the Company does not consider those amounts to be available to meet the Parent’s liquidity needs. The $2,354,600,000 that is available is comprised of cash and short-term bonds and notes of the U.S. Government and its agencies, U.S. Government-Sponsored Enterprises and other publicly traded debt and equity securities (including the Fortescue common shares of $1,249,500,000 and the Inmet common shares of $311,900,000). This amount does not include the cash received from the sale of ACF common shares on October 1, 2010. The Parent’s available liquidity, and the investment income realized from the Parent’s cash, cash equivalents and marketable securities is used to meet the Parent company’s short-term recurring cash requirements, which are principally the payment of interest on its debt, corporate overhead expenses and maturing repurchase agreements.
In February 2010, the Company sold 30,000,000 common shares of Fortescue for net cash proceeds of $121,500,000, which resulted in the recognition of a net securities gain of $94,900,000 in the first quarter of 2010.
In May 2010, the Company sold its investment in LPH for cash consideration of $85,000,000, which resulted in the recognition of a net securities gain of $66,200,000 in the second quarter of 2010.
During the second quarter of 2010, the Company received and recognized as income from discontinued operations a $9,500,000 distribution from Empire, which has been undergoing a voluntary liquidation since 2001.
In July 2010, the Company received $154,900,000 from FMG (net of $17,200,000 in withholding taxes) in payment of the accrued interest due on the FMG Note through June 30, 2010. The payment includes interest accrued since the inception of mining operations that previously had been deferred due to the restricted payments covenant contained in FMG’s senior secured debt agreements (for periods prior to January 1, 2010), including interest on the deferred interest. FMG was able to make this payment because its consolidated coverage ratio (as defined in FMG’s senior secured debt agreements) exceeded the minimum required for the previous four fiscal quarters ending June 30, 2010. Inasmuch as the senior secured debt has been called for redemption on November 8, 2010, the covenants requiring the defe rral of interest should no longer apply. Future interest payments under the FMG Note will be dependent upon the physical volume of iron ore sold and the selling price; as a result, it is not possible to predict whether interest earned in the most recent quarter will continue at the same level in future quarters.
On August 9, 2010, the Company was advised that Fortescue is asserting that FMG is entitled to issue additional subordinated notes identical to the FMG Note in an unlimited amount. Fortescue further claims that any interest to be paid on additional subordinated notes can dilute, on a pro rata basis, the Company’s entitlement to the above stated interest of 4% of net revenue. The Company does not believe that FMG has the right to issue additional notes which affect the Company’s interest or that the interpretation by Fortescue of the terms of the FMG Note, as currently claimed by Fortescue, reflects the agreement between the parties.
On September 1, 2010, the Company filed a Writ of Summons against Fortescue, FMG and Fortescue’s Chief Executive Officer in the Supreme Court of Western Australia. The Writ of Summons seeks, among other things, an injunction restraining the issuance of any additional notes identical to the FMG Note and damages. If the litigation is ultimately determined adversely to the Company and additional notes are issued, the Company’s future cash flows from the FMG Note and future results of operations would be materially and adversely affected to the extent of the dilution resulting from the issuance of such additional notes.
In August 2010, the Company sold its operating retail shopping center in Long Island, New York for cash consideration of $17,100,000 and recorded a pre-tax and after tax gain on sale of discontinued operations of $4,600,000.
In September 2010, the Company sold ResortQuest for $53,600,000 and recognized a pre-tax and after tax gain on sale of discontinued operations of $35,300,000.
On October 1, 2010, the Company sold all of its ACF common shares to a subsidiary of General Motors in connection with General Motors’ acquisition of all of the outstanding common stock of ACF. The Company received aggregate cash consideration of $830,600,000 for its shares of ACF common stock, which were acquired at a cost of $425,800,000.
In October 2010, the Company sold STi Prepaid for aggregate cash consideration of $20,000,000, which will be paid over a 26 month period.
The Board of Directors has authorized the Company, from time to time, to purchase its outstanding debt securities through cash purchases in open market transactions, privately negotiated transactions or otherwise. Such repurchases, if any, depend upon prevailing market conditions, the Company’s liquidity requirements and other factors; such purchases may be commenced or suspended at any time without notice. During the third quarter of 2010, the Company repurchased an aggregate $16,700,000 principal amount of its outstanding debt securities. In October 2010, the Company repurchased an additional aggregate $34,000,000 principal amount of its outstanding debt securities.
Effective October 2010, Berkadia’s secured credit facility with a subsidiary of Berkshire Hathaway was amended to increase the size of the credit facility from $1 billion to $1.5 billion, with the Company agreeing to provide the increased funds under the facility. The additional availability will be used by Berkadia to fund its mortgage originations and servicing activities. Berkadia originates commercial mortgage loans solely for agencies of the U.S. Government using their underwriting guidelines, and loans are sold to the agencies within a specified period of time after origination. The increase in the size of the credit facility will enable Berkadia to hold new loan originations for a longer period prior to sale, generating interest income in excess of the interest due under the facility.
So long as there is no default under the credit facility, principal repayments will first be applied to the Company’s portion of the outstanding loan and then to Berkshire Hathaway’s portion. In addition, the Company has the right to direct Berkadia to expedite its sale of loans under its various programs thereby reducing or eliminating the need for the additional funding. Pursuant to the Company's amended guaranty to Berkshire Hathaway, any losses incurred under the facility will continue to be shared equally by the Company and Berkshire Hathaway.
27
Consolidated Statements of Cash Flows
Net cash of $45,900,000 was provided by operating activities in the nine month 2010 period as compared to $121,500,000 of cash used for operating activities in the nine month 2009 period. The change in operating cash flows reflects proceeds received from FMG ($154,900,000, net of withholding taxes), greater income tax payments, lower interest payments and increased distributions of earnings from associated companies. STi Prepaid's telecommunications operations generated funds from operating activities of $500,000 during the 2010 period and $900,000 during the 2009 period. ResortQuest generated funds from operating activities of $6,300,000 during the 2010 period and used funds of $600,000 during the 2009 period. Keen, which became a consolidated subsidiary in November 2009, generated funds of $1,900,000 during the nine month period ended September 30, 2010; Premier generated funds of $18,100,000 and $15,800,000 during the 2010 and 2009 periods, respectively; and the Company’s manufacturing segments generated funds from operating activities of $21,100,000 and $22,100,000 during the 2010 and 2009 periods, respectively. Funds used by Sangart, a development stage company, increased to $16,000,000 during 2010 from $14,000,000 during the 2009 period. In 2010, distributions from associated companies principally include earnings distributed by Berkadia ($21,000,000) and Jefferies ($10,900,000). In 2009, distributions from associated companies principally include earnings distributed by HFH ShortPLUS Fund L.P. (“Shortplus”) ($14,500,000), Keen ($7,800,000) and Garcadia ($9,000,000).
Net cash of $44,900,000 was used for investing activities in the nine month 2010 period as compared to $132,500,000 of cash provided by investing activities in the nine month 2009 period. Investments in associated companies include CLC ($2,700,000) and ACF ($7,200,000) in 2010 and CLC ($42,000,000), ACF ($8,200,000) and Berkadia ($5,000,000) in 2009. Capital distributions from associated companies include Berkadia ($2,100,000), JHYH ($17,100,000), Wintergreen Partners Fund, L.P. (“Wintergreen”) ($4,400,000), and Garcadia ($6,700,000) in 2010 and Keen ($28,300,000), Wintergreen ($39,000,000), Shortplus ($24,800,000) and Starboard Value Opportunity Partners, LP ($11,500,000) in 2009.
Net cash of $180,100,000 was provided by financing activities in the nine month period ended September 30, 2010 as compared to $15,800,000 of cash used for financing activities in the nine month period ended September 30, 2009. Issuance of debt for 2010 and 2009 primarily reflects the increase in repurchase agreements of $211,800,000 and $45,100,000, respectively, and for 2009, $2,500,000 for MB1’s debt obligation. Reduction of debt for 2010 includes $17,600,000 for the buyback of $6,200,000 principal amount of the 7% Senior Notes, $5,500,000 principal amount of the 7 3/4% Senior Notes, $3,000,000 principal amount of the 8 1/8% Senior Notes and $2,000,000 principal amount of the 8.65% Junior Subordinated Deferrable Interest Debentures, and $10,200,000 for repayment of debt of a subsidiary. Reduc tion of debt for 2009 includes $29,600,000 for the buyback of $35,600,000 principal amount of the 7% Senior Notes.
Critical Accounting Estimates
The Company’s discussion and analysis of its financial condition and results of operations are based upon its consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires the Company to make estimates and assumptions that affect the reported amounts in the financial statements and disclosures of contingent assets and liabilities. On an on-going basis, the Company evaluates all of these estimates and assumptions. The following areas have been identified as critical accounting estimates because they have the potential to have a material impact on the Company's financial statements, and because they are based on assumptions which are used in the accounting records to reflect, at a specific point in time, events whose ult imate outcome won’t be known until a later date. Actual results could differ from these estimates.
Income Taxes - At September 30, 2010, the Company’s valuation allowance for its net deferred tax asset fully reserved for all of the potential future tax savings from federal net operating loss carryforwards (“NOLs”) and for a substantial portion of its state NOLs. In accordance with GAAP, the Company records a valuation allowance to reduce its deferred tax asset to the net amount that is more likely than not to be realized. The amount of any valuation allowance recorded does not in any way adversely affect the Company’s ability to use its NOLs to offset taxable income in the future. If in the future the Company determines that it is more likely than not that the Company will be able to realize its net deferred tax asset in excess of its net recorded amount, an adjustment to increase the net deferred tax asset would increase income in such period. If in the future the Company were to determine that it would not be able to realize all or part of its net recorded deferred tax asset, an adjustment to decrease the net deferred tax asset would be charged to income in such period. The Company is required to consider all available evidence, both positive and negative, and to weight the evidence when determining whether a valuation allowance is required. Generally, greater weight is required to be placed on objectively verifiable evidence when making this assessment, in particular on recent historical operating results.
During the second half of 2008 the Company recorded significant unrealized losses on many of its largest investments, recognized other than temporary impairments for a number of other investments and reported reduced profitability from substantially all of its operating businesses. Additionally, the 2008 losses recognized by the Company resulted in a cumulative loss in total comprehensive income (loss) during the three year period ending December 31, 2008. In assessing the realizability of the net deferred tax asset at December 31, 2008, the Company concluded that its recent operating loss and the then current economic conditions worldwide be given more weight than its projections of future taxable income during the period that it has NOLs available (until 2030), and be given more weight than the Company’s l ong track record of generating taxable income. As a result, the Company concluded that a valuation allowance was required against substantially all of the net deferred tax asset.
The Company will continue to evaluate the realizability of its net deferred tax asset in future periods. However, before the Company would reverse any portion of its valuation allowance in excess of taxes recorded on reported income, it will need positive evidence that it has historical positive cumulative taxable income over a period of time which is likely to continue in future periods. At that time, any decrease to the valuation allowance would be based upon the Company’s projections of future taxable income, which are inherently uncertain. Recently, the Company has recognized significant realized and unrealized gains on certain of its large investments, and if that trend continues, the Company may recognize an additional net deferred tax asset in future periods.
The Company also records reserves for contingent tax liabilities based on the Company’s assessment of the probability of successfully sustaining its tax filing positions.
Impairment of Long-Lived Assets – The Company evaluates its long-lived assets for impairment whenever events or changes in circumstances indicate, in management’s judgment, that the carrying value of such assets may not be recoverable. When testing for impairment, the Company groups its long-lived assets with other assets and liabilities at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities (or asset group). The determination of whether an asset group is recoverable is based on management’s estimate of undiscounted future cash flows directly attributable to the asset group as compared to its carrying value. If the carrying amount of the asset group is gre ater than the undiscounted cash flows, an impairment loss would be recognized for the amount by which the carrying amount of the asset group exceeds its estimated fair value.
Current economic conditions have adversely affected most of the Company’s operations and investments. A worsening of current economic conditions or a prolonged recession could cause a decline in estimated future cash flows expected to be generated by the Company’s operations and investments. If future undiscounted cash flows are estimated to be less than the carrying amounts of the asset groups used to generate those cash flows in subsequent reporting periods, particularly for those with large investments in property and equipment (for example, manufacturing, gaming entertainment, land based oil and gas drilling operations, real estate and certain associated company investments), impairment charges would have to be recorded.
As more fully discussed in the 2009 10-K, one of the Company’s real estate subsidiaries, MB1 is the owner and developer of a mixed use real estate project located in Myrtle Beach, South Carolina. The acquisition and construction costs were funded by capital contributed by the Company and nonrecourse indebtedness with a balance of $100,500,000 at September 30, 2010, that is collateralized by the real estate.
During the second quarter of 2009, MB1 was unable to make scheduled payments under its interest rate swap agreement and received several default notices under its bank loan. These events constituted a change in circumstances that caused the Company to evaluate whether the carrying amount of MB1’s real estate asset was recoverable. Based on its evaluation, the Company recorded an impairment charge of $67,800,000 during the second quarter of 2009 (classified as selling, general and other expenses). Although MB1’s bank loan matured in October 2009, it was not repaid since MB1 did not have sufficient funds and the Company is under no obligation and had no intention to provide the funds to MB1 to pay off the loan.
During the second quarter of 2010, MB1 entered into an agreement with its lenders under which, among other things, MB1 agreed not to interfere with or oppose foreclosure proceedings and the lenders agreed to release MB1 and various guarantors of the loan. A receiver has been put in place at the property and the foreclosure proceedings are underway. Upon foreclosure, the Company will record a gain equal to the excess of the loan balance over the then book value of the real estate. At September 30, 2010, the carrying value of MB1’s real estate was $67,100,000; if foreclosure proceedings were completed the gain recognized would have been $33,400,000 at September 30, 2010.
Impairment of Securities – Declines in the fair values of equity securities considered to be other than temporary and declines in the fair values of debt securities related to credit losses are reflected in the consolidated statements of operations. The Company evaluates its investments for impairment on a quarterly basis.
The Company’s determination of whether a security is other than temporarily impaired incorporates both quantitative and qualitative information; GAAP requires the exercise of judgment in making this assessment, rather than the application of fixed mathematical criteria. The various factors that the Company considers in making its determination are specific to each investment. For publicly traded debt and equity securities, the Company considers a number of factors including, but not limited to, the length of time and the extent to which the fair value has been less than cost, the financial condition and near term prospects of the issuer, the reason for the decline in fair value, changes in fair value subsequent to the balance sheet date, the ability and intent to hold investments to maturity, and other fac tors specific to the individual investment. For investments in private equity funds and non-public securities, the Company bases its determination upon financial statements, net asset values and/or other information obtained from fund managers or investee companies.
The Company has a portfolio of non-agency mortgage backed bond securitizations, which were acquired at significant discounts to face amounts and are accounted for as acquisitions of impaired loans. The Company estimates the future cash flows for these securities to determine the accretable yield; increases in estimated cash flows are accounted for as a yield adjustment on a prospective basis but decreases in estimated cash flows below amortized cost due to credit losses are recognized as impairments in the consolidated statements of operations. Contractual cash flows in excess of estimated cash flows are not part of the accretable yield. The market for these securities is highly illiquid and they rarely trade. On a regular basis, the Company re-estimates the future cash flows of these secur ities and records impairment charges if appropriate. The fair values for these securities are primarily determined using an income valuation model to calculate the present value of expected future cash flows, which incorporates assumptions regarding potential future rates of delinquency, prepayments, defaults, collateral losses and interest rates.
The Company recorded the following impairment charges for securities in the consolidated statement of operations during the three and nine months ended September 30, 2010 and 2009 (in thousands):
| | | For the Three Month | | | For the Nine Month | |
| | | Period Ended | | | Period Ended | |
| | | September 30, | | | September 30, | |
| | | 2010 | | | 2009 | | | 2010 | | | 2009 | |
| | | | | | | | | | | | | |
| Publicly traded securities | | $ | – | | | $ | – | | | $ | – | | | $ | 14,400 | |
| Non-public securities and private equity funds | | | – | | | | 100 | | | | – | | | | 2,200 | |
| Non-agency mortgage-backed bond securitizations | | | 200 | | | | 2,600 | | | | 1,700 | | | | 13,000 | |
| Totals | | $ | 200 | | | $ | 2,700 | | | $ | 1,700 | | | $ | 29,600 | |
Impairment of Equity Method Investments – The Company evaluates equity method investments for impairment when operating losses or other factors may indicate a decrease in value which is other than temporary. For investments in investment partnerships that are accounted for under the equity method, the Company obtains from the investment partnership financial statements, net asset values and other information on a quarterly basis and annual audited financial statements. On a quarterly basis, the Company also makes inquiries and discusses with investment managers whether there were significant procedural, valuation, composition and other changes at the investee. Since these investment partnerships record their underlying investments at fair value, after application of the equity method the carrying value of the Company’s investment is equal to its share of the investees’ underlying net assets at their fair values. Absent any unusual circumstances or restrictions concerning these investments, which would be separately evaluated, it is unlikely that any additional impairment charge would be required.
For equity method investments in operating businesses, the Company considers a variety of factors including economic conditions nationally and in their geographic areas of operation, adverse changes in the industry in which they operate, declines in business prospects, deterioration in earnings, increasing costs of operations and other relevant factors specific to the investee. Whenever the Company believes conditions or events indicate that one of these investments might be materially impaired, the Company will obtain from such investee updated cash flow projections and impairment analyses of the investee assets. The Company will use this information and, together with discussions with the investee’s management, evaluate if the book value of its investment exceeds its fair value, and if so and the situation is deemed other than temporary, record an impairment charge.
As more fully discussed in the 2009 10-K, during the nine months ended September 30, 2009, the Company’s equity in losses of Garcadia included impairment charges for goodwill and other intangible assets aggregating $32,300,000. Garcadia’s automobile dealerships had been adversely impacted by general economic conditions, and the bankruptcy filings by two of the three largest U.S. automobile manufacturers was a change in circumstances that caused Garcadia to evaluate the recoverability of its goodwill and other intangible assets. Garcadia prepared discounted cash flow projections for each of its dealerships and concluded that the carrying amount of its goodwill and other intangible assets was impaired.
Business Combinations – At acquisition, the Company allocates the cost of a business acquisition to the specific tangible and intangible assets acquired and liabilities assumed based upon their fair values. Significant judgments and estimates are often made to determine these values, and may include the use of appraisals, consider market quotes for similar transactions, employ discounted cash flow techniques or consider other information the Company believes relevant. The finalization of the purchase price allocation will typically take a number of months to complete, and if final values are materially different from initially recorded amounts adjustments are recorded. Any excess of the cost of a business acquisition over the fair values o f the net assets and liabilities acquired is recorded as goodwill, which is not amortized to expense. Recorded goodwill of a reporting unit is required to be tested for impairment on an annual basis, and between annual testing dates if events or circumstances change that would more likely than not reduce the fair value of a reporting unit below its net book value. At September 30, 2010, the book value of goodwill was $8,200,000. If the fair values of the net assets and liabilities acquired are greater than the purchase price, the excess is treated as a bargain purchase and recognized in income.
Subsequent to the finalization of the purchase price allocation, any adjustments to the recorded values of acquired assets and liabilities would be reflected in the Company’s consolidated statement of operations. Once final, the Company is not permitted to revise the allocation of the original purchase price, even if subsequent events or circumstances prove the Company’s original judgments and estimates to be incorrect. In addition, long-lived assets recorded in a business combination like property and equipment, amortizable intangibles and goodwill may be deemed to be impaired in the future resulting in the recognition of an impairment loss. The assumptions and judgments made by the Company when recording business combinations will have an impact on reported results of operations for many years into the future.
Use of Fair Value Estimates – Under GAAP, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Further, a fair value hierarchy prioritizes inputs to valuation techniques into three broad levels. The fair value hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1), the next priority to inputs that don’t qualify as Level 1 inputs but are nonetheless observable, either directly or indirectly, for the particular asset or liability (Level 2), and the lowest priority to unobservable inputs (Level 3).
Over 90% of the Company’s investment portfolio is classified as available for sale securities, which are carried at estimated fair value in the Company’s consolidated balance sheet. The estimated fair values are principally based on publicly quoted market prices (Level 1 inputs), which can rise or fall in reaction to a wide variety of factors or events, and as such are subject to market-related risks and uncertainties. The Company has a segregated portfolio of mortgage pass-through certificates issued by U.S. Government agencies (GNMA) and by U.S. Government-Sponsored Enterprises (FHLMC or FNMA) which are carried on the balance sheet at their estimated fair value of $648,700,000 at September 30, 2010. Although the markets that these types of securities trade in are generally active, market prices are not always available for the identical security. The fair value of these investments are based on observable market data including benchmark yields, reported trades, issuer spreads, benchmark securities, bids and offers. These estimates of fair value are considered to be Level 2 inputs, and the amounts realized from the disposition of these investments has not been materially different from their estimated fair values.
The fair values of the Company’s portfolio of non-agency mortgage backed bond securitizations, which are primarily determined using an income valuation model to calculate the present value of expected future cash flows, are considered to be Level 3 inputs.
Contingencies – The Company accrues for contingent losses when the contingent loss is probable and the amount of loss can be reasonably estimated. Estimates of the likelihood that a loss will be incurred and of contingent loss amounts normally require significant judgment by management, can be highly subjective and are subject to material change with the passage of time as more information becomes available. Estimating the ultimate impact of litigation matters is inherently uncertain, in particular because the ultimate outcome will rest on events and decisions of others that may not be within the power of the Company to control. The Company does not believe that any of its current li tigation will have a material adverse effect on its consolidated financial position, results of operations or liquidity; however, if amounts paid at the resolution of litigation are in excess of recorded reserve amounts, the excess could be material to results of operations for that period. As of September 30, 2010, the Company’s accrual for contingent losses was not material.
Results of Operations
The 2010 Periods Compared to the 2009 Periods
General
Substantially all of the Company’s operating businesses sell products or services that are impacted by general economic conditions in the U.S. and to a lesser extent internationally. Poor general economic conditions have reduced the demand for products or services sold by the Company’s operating subsidiaries and/or resulted in reduced pricing for products or services. Troubled industry sectors, like the residential real estate market, have had an adverse impact on some of the Company’s operating segments, including real estate, manufacturing and gaming entertainment. The discussions below and in the 2009 10-K concerning revenue and profitability by segment consider current economic conditions and the impact such conditions have had and may continue to have on each segment; however, s hould general economic conditions worsen and/or if the country experiences a prolonged recession, the Company believes that all of its businesses would be adversely impacted.
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A summary of results of operations for the Company for the three and nine month periods ended September 30, 2010 and 2009 is as follows (in thousands):
| | | For the Three Month | | | For the Nine Month | |
| | | Period Ended September 30, | | | Period Ended September 30, | |
| | | 2010 | | | 2009 | | | 2010 | | | 2009 | |
| Income (loss) from continuing operations | | | | | | | | | | | | |
| before income taxes and income | | | | | | | | | | | | |
| related to associated companies: | | | | | | | | | | | | |
Manufacturing: | | | | | | | | | | | | |
Idaho Timber | | $ | (559 | ) | | $ | (2,714 | ) | | $ | 1,282 | | | $ | (8,035 | ) |
Conwed Plastics | | | 2,043 | | | | 3,067 | | | | 7,776 | | | | 10,217 | |
Oil and Gas Drilling Services | | | (5,374 | ) | | | – | | | | (16,147 | ) | | | – | |
Gaming Entertainment | | | (7,474 | ) | | | 1,163 | | | | (4,308 | ) | | | 3,693 | |
Domestic Real Estate | | | (179 | ) | | | (1,676 | ) | | | (3,823 | ) | | | (78,258 | ) |
| Medical Product Development | | | (9,742 | ) | | | (4,983 | ) | | | (22,902 | ) | | | (13,680 | ) |
Other Operations | | | (10,373 | ) | | | (2,453 | ) | | | (11,446 | ) | | | (19,215 | ) |
Corporate | | | (27,027 | ) | | | (29,406 | ) | | | 119,018 | | | | (139,261 | ) |
Total consolidated income (loss) from continuing | | | | | | | | | | | | | | | | |
operations before income taxes and income | | | | | | | | | | | | | | | | |
related to associated companies | | | (58,685 | ) | | | (37,002 | ) | | | 69,450 | | | | (244,539 | ) |
| | | | | | | | | | | | | | | | | |
| Income related to associated companies | | | | | | | | | | | | | | | | |
| before income taxes | | | 321,330 | | | | 392,458 | | | | 145,905 | | | | 892,881 | |
Total consolidated income from | | | | | | | | | | | | | | | | |
continuing operations before income taxes | | | 262,645 | | | | 355,456 | | | | 215,355 | | | | 648,342 | |
| | | | | | | | | | | | | | | | | |
| Income taxes: | | | | | | | | | | | | | | | | |
Income (loss) from continuing operations before | | | | | | | | | | | | | | | | |
income related to associated companies | | | 3,540 | | | | 1,341 | | | | 10,936 | | | | 5,810 | |
Associated companies | | | (3,382 | ) | | | 12,941 | | | | (8,079 | ) | | | 25,678 | |
Total income taxes | | | 158 | | | | 14,282 | | | | 2,857 | | | | 31,488 | |
| | | | | | | | | | | | | | | | | |
Income from continuing operations | | $ | 262,487 | | | $ | 341,174 | | | $ | 212,498 | | | $ | 616,854 | |
Manufacturing – Idaho Timber
A summary of results of operations for Idaho Timber for the three and nine month periods ended September 30, 2010 and 2009 is as follows (in thousands):
| | | For the Three Month | | | For the Nine Month | |
| | | Period Ended | | | Period Ended | |
| | | September 30, | | | September 30, | |
| | | 2010 | | | 2009 | | | 2010 | | | 2009 | |
| | | | | | | | | | | | | |
| Revenues and other income | | $ | 37,789 | | | $ | 40,136 | | | $ | 134,621 | | | $ | 107,782 | |
| | | | | | | | | | | | | | | | | |
| Expenses: | | | | | | | | | | | | | | | | |
Cost of sales | | | 35,416 | | | | 39,741 | | | | 124,020 | | | | 105,103 | |
Salaries and incentive compensation | | | 1,300 | | | | 1,407 | | | | 4,309 | | | | 4,285 | |
Depreciation and amortization | | | 1,034 | | | | 1,076 | | | | 3,105 | | | | 3,242 | |
Selling, general and other expenses | | | 598 | | | | 626 | | | | 1,905 | | | | 3,187 | |
| | | | 38,348 | | | | 42,850 | | | | 133,339 | | | | 115,817 | |
| | | | | | | | | | | | | | | | | |
Income (loss) before income taxes | | $ | (559 | ) | | $ | (2,714 | ) | | $ | 1,282 | | | $ | (8,035 | ) |
Revenues for the three month 2010 period decreased as compared to the same period in 2009 reflecting a 13% reduction in shipment volume; average selling prices increased approximately 7%. Revenues for the nine month 2010 period increased as compared to the same period in 2009; shipment volume and average selling prices increased approximately 5% and 20%, respectively. Idaho Timber believes that the abundance of existing homes available for sale in the market and the recent downturn in housing starts due, in part, to the expiration of the federal government’s home buyers’ tax credits program have negatively impacted Idaho Timber’s revenues during the third quarter and will continue to do so during the remainder of 2010. Idaho Timber believes that the increase in revenues for the nine month 2010 period as compared to the same period in 2009 primarily reflects customers replenishing dimension lumber inventory levels during the first half of the year that had been reduced during the recession, an increase in housing starts, a more balanced supply of lumber in the marketplace relative to demand and an increase in demand for certain of Idaho Timber’s products.
Raw material costs, the largest component of cost of sales (approximately 81% of cost of sales), reflect the changes in shipment volume and increased costs for the 2010 periods as compared to the same periods in 2009. Raw material cost per thousand board feet increased approximately 4% and 18%, respectively, in the three and nine month 2010 periods as compared to the same periods in 2009, which was caused by reduced supply due to increased lumber exports and greater demand. The difference between Idaho Timber’s selling price and raw material cost per thousand board feet (spread) increased by 23% and 25%, respectively, for the three and nine month 2010 periods as compared to the same periods in 2009. Cost of sales for the three and nine month 2009 periods also include charges of $1,400,000 to red uce the carrying value of certain timber deed contracts.
Selling, general and other expenses for the nine month 2009 period reflect impairment losses on long-lived assets related to one of Idaho Timber’s plants of $1,000,000.
Manufacturing – Conwed Plastics
A summary of results of operations for Conwed Plastics for the three and nine month periods ended September 30, 2010 and 2009 is as follows (in thousands):
| | | For the Three Month | | | For the Nine Month | |
| | | Period Ended | | | Period Ended | |
| | | September 30, | | | September 30, | |
| | | 2010 | | | 2009 | | | 2010 | | | 2009 | |
| | | | | | | | | | | | | |
| Revenues and other income | | $ | 23,476 | | | $ | 21,127 | | | $ | 68,707 | | | $ | 62,478 | |
| | | | | | | | | | | | | | | | | |
| Expenses: | | | | | | | | | | | | | | | | |
Cost of sales | | | 17,767 | | | | 14,683 | | | | 50,114 | | | | 41,876 | |
Salaries and incentive compensation | | | 1,824 | | | | 1,711 | | | | 5,182 | | | | 5,174 | |
Depreciation and amortization | | | 68 | | | | 74 | | | | 243 | | | | 219 | |
Selling, general and other expenses | | | 1,774 | | | | 1,592 | | | | 5,392 | | | | 4,992 | |
| | | | 21,433 | | | | 18,060 | | | | 60,931 | | | | 52,261 | |
| | | | | | | | | | | | | | | | | |
Income before income taxes | | $ | 2,043 | | | $ | 3,067 | | | $ | 7,776 | | | $ | 10,217 | |
Revenues increased in the three and nine month 2010 periods as compared to the same periods in 2009 in many of Conwed Plastics’ markets, including certain markets related to the housing industry. While Conwed Plastics has seen some signs of improved economic conditions and benefited from certain new product launches and new uses of its products, its results continue to be negatively impacted by competitive pressures and customers closely managing their inventory.
The primary raw material in Conwed Plastics’ products is a polypropylene resin, which is a byproduct of the oil refining process, whose price tends to fluctuate with the price of oil. Prices for polypropylene resin increased substantially in the three and nine month 2010 periods as compared to the same periods in 2009, which adversely affected gross margin. The volatility of oil and natural gas prices along with current general economic conditions worldwide make it difficult to predict future raw material costs. Gross margin for the 2010 periods also reflects greater amortization expense for intangible assets.
Oil and Gas Drilling Services
A summary of results of operations for Keen for the three and nine month periods ended September 30, 2010 is as follows (in thousands). As discussed in the 2009 10-K, prior to the date of acquisition (November 2009) Keen was accounted for under the equity method of accounting.
| | | For the Three | | | For the Nine | |
| | | Month Period Ended | | | Month Period Ended | |
| | | September 30, | | | September 30, | |
| | | 2010 | | | 2010 | |
| | | | | | | |
| Revenues and other income | | $ | 31,850 | | | $ | 81,899 | |
| | | | | | | | | |
| Expenses: | | | | | | | | |
Direct operating expenses | | | 27,240 | | | | 69,525 | |
Interest | | | 299 | | | | 970 | |
Salaries and incentive compensation | | | 1,273 | | | | 2,576 | |
Depreciation and amortization | | | 6,460 | | | | 19,220 | |
Selling, general and other expenses | | | 1,952 | | | | 5,755 | |
| | | | 37,224 | | | | 98,046 | |
| | | | | | | | | |
Loss before income taxes | | $ | (5,374 | ) | | $ | (16,147 | ) |
Since Keen’s drilling rigs are principally used to drill for natural gas, its revenue volume and profitability have historically been significantly affected by the actual and anticipated price of natural gas and levels of natural gas in storage. The natural gas exploration and production industry is cyclical and the level of exploration and production activity has been very volatile. During periods of lower levels of drilling activity, price competition for drilling services tends to increase which may result in reduced revenues and profitability; conversely, during periods of increased drilling activity drilling rigs are in demand often resulting in higher prices and contractual commitments from customers to obtain exclusive use of a particular rig for a longer term. Although Keen’s rig uti lization and dayrates modestly increased during the third quarter of 2010 as compared to the first and second quarters of this year, its revenues and profitability continued to be adversely impacted by low natural gas prices and high levels of natural gas in storage. Keen believes that the negative impact of lower natural gas prices has been partially offset by an increasing proportion of its customers using its rigs to drill for oil rather than natural gas as the decline in oil prices has not been as severe as the decline in natural gas prices. Keen’s results for the three and nine month 2010 periods also reflect higher costs related to operating and maintaining additional rigs, including increased headcount, wage increases and costs incurred to maintain, repair and make certain of its rigs operational following periods when they were not in use.
While Keen’s profitability may improve if the price of oil increases, creating additional demand for its rigs, it will not significantly improve without increased natural gas demand that will drive substantially higher and sustained natural gas prices. Increased industrial demand for natural gas, which is tied to achieving economic recovery, is required to significantly improve demand.
Gaming Entertainment
A summary of results of operations for Premier for the three and nine month periods ended September 30, 2010 and 2009 is as follows (in thousands):
| | | For the Three Month | | | For the Nine Month | |
| | | Period Ended | | | Period Ended | |
| | | September 30, | | | September 30, | |
| | | 2010 | | | 2009 | | | 2010 | | | 2009 | |
| | | | | | | | | | | | | |
| Revenues and other income | | $ | 31,080 | | | $ | 26,971 | | | $ | 86,246 | | | $ | 79,745 | |
| | | | | | | | | | | | | | | | | |
| Expenses: | | | | | | | | | | | | | | | | |
Direct operating expenses | | | 22,153 | | | | 20,571 | | | | 62,781 | | | | 59,822 | |
Interest | | | 42 | | | | 114 | | | | 244 | | | | 384 | |
Salaries and incentive compensation | | | 504 | | | | 502 | | | | 1,479 | | | | 1,510 | |
Depreciation and amortization | | | 4,147 | | | | 4,073 | | | | 12,568 | | | | 12,363 | |
Selling, general and other expenses | | | 11,708 | | | | 548 | | | | 13,482 | | | | 1,973 | |
| | | | 38,554 | | | | 25,808 | | | | 90,554 | | | | 76,052 | |
| | | | | | | | | | | | | | | | | |
Income (loss) before income taxes | | $ | (7,474 | ) | | $ | 1,163 | | | $ | (4,308 | ) | | $ | 3,693 | |
Premier’s gaming revenues for the three and nine month 2010 periods increased approximately 18% and 9%, respectively, as compared to the same periods in 2009, while the local gaming market was largely unchanged for the same periods. During the third quarter of 2010, Premier implemented new and enhanced customer loyalty programs, which it believes was the major cause of the growth in its gaming revenues. Premier also believes that claim payments related to the Gulf Coast oil spill and Gulf Coast promotional initiatives funded by third parties may have positively impacted the local gaming market in the third quarter.
The increase in direct operating expenses in the 2010 periods primarily reflects greater gaming taxes and marketing and promotional costs. As more fully discussed in the 2009 10-K, the former holders of certain of the Premier notes argued that they were entitled to liquidated damages under the indenture governing these notes, and as such were entitled to more than the principal amount of the notes plus accrued interest that was paid to them at Premier’s emergence from bankruptcy. The Company had funded an escrow account to cover the Premier noteholders’ claim for additional damages in the amount of $13,700,000. On September 3, 2010, the Bankruptcy Court for the Southern District of Mississippi awarded the Premier noteholders $9,600,000, plus interest at the federal judgment rate in effect on August 10, 2007 from that date until the date of payment, but in no event would the Premier noteholders be entitled to damages in an amount exceeding the amount held in the escrow account. Any funds remaining in the escrow account after payment of the award are to be returned to the Company. The Company has filed a notice of appeal of the Bankruptcy Court’s decision; no amounts are expected to be paid from the escrow account while the appeal is pending. As a result of the Bankruptcy Court’s decision, the Company recorded an expense in selling, general and other expenses during the third quarter of 2010 of $11,100,000, representing the award plus estimated interest.
Domestic Real Estate
A summary of results of operations for the domestic real estate segment for the three and nine month periods ended September 30, 2010 and 2009 is as follows (in thousands):
| | | For the Three Month | | | For the Nine Month | |
| | | Period Ended | | | Period Ended | |
| | | September 30, | | | September 30, | |
| | | 2010 | | | 2009 | | | 2010 | | | 2009 | |
| | | | | | | | | | | | | |
| Revenues and other income | | $ | 4,933 | | | $ | 5,071 | | | $ | 13,120 | | | $ | 13,647 | |
| | | | | | | | | | | | | | | | | |
| Expenses: | | | | | | | | | | | | | | | | |
Interest | | | 509 | | | | 510 | | | | 1,526 | | | | 1,802 | |
Depreciation and amortization | | | 1,518 | | | | 2,358 | | | | 4,749 | | | | 7,094 | |
Other operating expenses | | | 3,085 | | | | 3,879 | | | | 10,668 | | | | 83,009 | |
| | | | 5,112 | | | | 6,747 | | | | 16,943 | | | | 91,905 | |
| | | | | | | | | | | | | | | | | |
Loss before income taxes | | $ | (179 | ) | | $ | (1,676 | ) | | $ | (3,823 | ) | | $ | (78,258 | ) |
Pre-tax results for the domestic real estate segment are largely dependent upon the performance of the segment’s operating properties, the current status of the Company’s real estate development projects and non-recurring gains or losses recognized when real estate assets are sold. As a result, pre-tax results for this segment for any particular period are not predictable and do not follow any consistent pattern.
As discussed above, during the second quarter of 2009, the Company determined that the carrying amount of the Company’s mixed use real estate project located in Myrtle Beach, South Carolina was not fully recoverable and recorded an impairment charge of $67,800,000, which is included in other operating expenses for the nine month 2009 period. Real estate revenues and other income for the three and nine month 2010 periods include a $1,200,000 gain for an insurance settlement, and for the nine month 2009 period $1,000,000 of income related to the accounting for the mark-to-market value of an interest rate derivative (which was terminated during the second quarter of 2009) relating to the Myrtle Beach project’s debt obligation. Other operating expenses for the nine month 2009 period also includes $1,400, 000 representing the net book value of land and buildings that was contributed to a local municipality and $1,800,000 for the periodic net settlement amount for the interest rate derivative.
Residential property sales volume, prices and new building starts have declined significantly in many U.S. markets, including markets in which the Company has real estate operations in various stages of development. The slowdown in residential sales has been exacerbated by the turmoil in the mortgage lending and credit markets during the past few years, which has resulted in stricter lending standards and reduced liquidity for prospective home buyers. The Company has deferred its development plans for certain of its real estate development projects, and is not actively soliciting bids for its fully developed projects. The Company intends to wait for market conditions to improve before marketing certain of its projects for sale.
Medical Product Development
A summary of results of operations for Sangart for the three and nine month periods ended September 30, 2010 and 2009 is as follows (in thousands):
| | | For the Three Month | | | For the Nine Month | |
| | | Period Ended | | | Period Ended | |
| | | September 30, | | | September 30, | |
| | | 2010 | | | 2009 | | | 2010 | | | 2009 | |
| | | | | | | | | | | | | |
| Revenues and other income | | $ | 6 | | | $ | 53 | | | $ | 11 | | | $ | 5,125 | |
| | | | | | | | | | | | | | | | | |
| Expenses: | | | | | | | | | | | | | | | | |
Salaries and incentive compensation | | | 2,515 | | | | 1,907 | | | | 6,691 | | | | 6,922 | |
Depreciation and amortization | | | 221 | | | | 223 | | | | 653 | | | | 613 | |
Selling, general and other expenses | | | 7,012 | | | | 2,906 | | | | 15,569 | | | | 11,270 | |
| | | | 9,748 | | | | 5,036 | | | | 22,913 | | | | 18,805 | |
| | | | | | | | | | | | | | | | | |
Loss before income taxes | | $ | (9,742 | ) | | $ | (4,983 | ) | | $ | (22,902 | ) | | $ | (13,680 | ) |
Revenues and other income for the nine month 2009 period includes $5,000,000 for insurance proceeds received upon the death of Sangart’s former chief executive officer. Selling, general and other expenses for the three and nine month 2010 periods reflects $3,200,000 and $4,600,000, respectively, of charges related to share-based awards previously granted to a former officer. Sangart’s losses also reflect research and development costs (which are included in selling, general and other expenses) of $1,500,000 and $1,300,000 for the three month periods ended September 30, 2010 and 2009, respectively, and $4,400,000 and $3,400,000 for the nine month periods ended September 30, 2010 and 2009, respectively. Research and development costs increased in 2010 primarily due to the completion of the P hase II proof of concept clinical trial and preparation for a larger Phase II clinical study of MP4OX in trauma patients. Selling, general and other expenses for the nine month 2010 period also reflect $900,000 of lower professional fees and $700,000 of decreased costs for severance, and for the three and nine month 2010 periods $200,000 and $500,000, respectively, of greater royalty expense. Salaries and incentive compensation expense increased in the third quarter of 2010 principally due to higher headcount and greater estimated incentive bonus expense.
Sangart is a development stage company that does not have any revenues from product sales. In June 2010, Sangart completed patient enrollment in a Phase II proof of concept clinical trial of MP4OX in trauma patients. During the third quarter, the study results were completed and found that the Phase II proof of concept study was successful. Sangart plans to conduct a larger Phase II clinical study and then a Phase III clinical study in trauma patients. Such studies will take several years to complete at substantial cost, and until they are successfully completed, if ever, Sangart will not be able to request marketing approval and generate revenues from sales in the trauma market. Also as more fully discussed in the 2009 10-K, Sangart is exploring the application of the MP4 techno logy in additional therapeutic areas. The Company is unable to predict when, if ever, it will report operating profits for this segment. The source of Sangart’s funding needs for the next few years has not been determined, and the Company has not made a commitment to provide funds after 2010.
Other Operations
A summary of results of operations for other operations for the three and nine month periods ended September 30, 2010 and 2009 is as follows (in thousands):
| | | For the Three Month | | | For the Nine Month | |
| | | Period Ended | | | Period Ended | |
| | | September 30, | | | September 30, | |
| | | 2010 | | | 2009 | | | 2010 | | | 2009 | |
| | | | | | | | | | | | | |
| Revenues and other income | | $ | 14,262 | | | $ | 13,233 | | | $ | 52,171 | | | $ | 38,889 | |
| | | | | | | | | | | | | | | | | |
| Expenses: | | | | | | | | | | | | | | | | |
Interest | | | 2 | | | | 7 | | | | 11 | | | | 25 | |
Salaries and incentive compensation | | | 2,228 | | | | 2,076 | | | | 6,401 | | | | 6,452 | |
Depreciation and amortization | | | 1,100 | | | | 1,213 | | | | 2,893 | | | | 3,830 | |
Selling, general and other expenses | | | 21,305 | | | | 12,390 | | | | 54,312 | | | | 47,797 | |
| | | | 24,635 | | | | 15,686 | | | | 63,617 | | | | 58,104 | |
| | | | | | | | | | | | | | | | | |
Loss before income taxes | | $ | (10,373 | ) | | $ | (2,453 | ) | | $ | (11,446 | ) | | $ | (19,215 | ) |
Other income for the three and nine month 2010 periods includes $300,000 and $9,500,000, respectively, with respect to government grants to reimburse the Company for certain of its prior expenditures related to energy projects, which were fully expensed as incurred. The change in revenues and other income for the three and nine month 2010 periods also reflects $400,000 and $2,500,000, respectively, of increased revenues at the winery operations. Selling, general and other expenses include $4,900,000 and $4,000,000 for the three month periods ended September 30, 2010 and 2009, respectively, and $18,400,000 and $16,100,000 for the nine month periods ended September 30, 2010 and 2009, respectively, related to the investigation and evaluation of energy projects (principally professional fees and other costs). & #160;Selling, general and other expenses for the 2010 periods also reflect $4,300,000 for other operations’ portion of a settlement charge in connection with the termination and settlement of the Company’s frozen defined benefit pension plan, and a $3,000,000 charge for a settlement with certain insurance companies. Selling, general and other expenses also include charges of $1,600,000 and $4,700,000 for the nine months ended September 30, 2010 and 2009, respectively, at the winery operations to reduce the carrying amount of wine inventory. The change in selling, general and other expenses for the nine month 2010 period as compared to the same period in 2009 also reflects $1,600,000 of greater costs at the winery operations and $1,300,000 of lower costs related to purchased delinquent credit card receivables.
Corporate
A summary of results of operations for corporate for the three and nine month periods ended September 30, 2010 and 2009 is as follows (in thousands):
| | | For the Three Month | | | For the Nine Month | |
| | | Period Ended | | | Period Ended | |
| | | September 30, | | | September 30, | |
| | | 2010 | | | 2009 | | | 2010 | | | 2009 | |
| | | | | | | | | | | | | |
| Revenues and other income (including net | | | | | | | | | | | | |
securities gains (losses)) | | $ | 42,469 | | | $ | 36,840 | | | $ | 297,585 | | | $ | 74,744 | |
| | | | | | | | | | | | | | | | | |
| Expenses: | | | | | | | | | | | | | | | | |
Interest | | | 30,501 | | | | 30,808 | | | | 91,583 | | | | 94,984 | |
Salaries and incentive compensation | | | 11,727 | | | | 17,812 | | | | 22,922 | | | | 39,920 | |
Depreciation and amortization | | | 5,267 | | | | 5,195 | | | | 15,713 | | | | 13,394 | |
Selling, general and other expenses | | | 22,001 | | | | 12,431 | | | | 48,349 | | | | 65,707 | |
| | | | 69,496 | | | | 66,246 | | | | 178,567 | | | | 214,005 | |
| | | | | | | | | | | | | | | | | |
Income (loss) before income taxes | | $ | (27,027 | ) | | $ | (29,406 | ) | | $ | 119,018 | | | $ | (139,261 | ) |
Net securities gains (losses) for Corporate aggregated $9,600,000 for the three month 2009 period and were not material for the three month 2010 period, and $170,400,000 and $(20,300,000) for the nine month 2010 and 2009 periods, respectively. Net securities gains (losses) for the nine month 2010 period include a gain of $66,200,000 from the sale of the Company’s investment in LPH for cash consideration of $85,000,000 and a gain of $94,900,000 from the sale of 30,000,000 common shares of Fortescue for net cash proceeds of $121,500,000. Net securities gains (losses) are net of impairment charges, which were not material for the three month 2010 period, and $2,700,000 during the three month 2009 period, and $1,700,000 and $29,600,000 during the nine month 2010 and 2009 periods, respectively. The C ompany’s decision to sell securities and realize security gains or losses is generally based on its evaluation of an individual security’s value at the time, the prospect for changes in its value in the future and/or the Company’s liquidity needs. The decision could also be influenced by the status of the Company’s tax attributes. The timing of realized security gains or losses is not predictable and does not follow any pattern from year to year.
Investment income declined $600,000 and $6,800,000 in the three and nine month periods ended September 30, 2010 as compared to the same periods in 2009, principally due to lower interest rates on a lower amount of fixed income securities. Other income, which increased $15,800,000 and $38,900,000 in the three and nine month periods ended September 30, 2010 as compared to the same periods in 2009, includes $36,100,000 and $19,700,000 for the three month periods ended September 30, 2010 and 2009, respectively, and $104,400,000 and $50,200,000 for the nine month periods ended September 30, 2010 and 2009, respectively, related to Fortescue’s Pilbara iron ore and infrastructure project in Western Australia. The Company is entitled to receive 4% of the revenue, net of government royalties, invoiced from certain a reas of Fortescue’s project. Amounts are payable semi-annually within thirty days of June 30th and December 31st of each year. Depreciation and amortization expenses include prepaid mining interest amortization of $2,500,000 and $2,400,000 for the three months ended September 30, 2010 and 2009, respectively, and $7,400,000 and $5,000,000 for the nine months ended September 30, 2010 and 2009, respectively, which is being amortized over time in proportion to the amount of ore produced. Other income for the nine month 2010 and 2009 periods also includes gains for legal settlements of $2,100,000 and $10,500,000, respectively, and for the nine month 2009 period gains of $6,000,000 on the repurchase of an aggregate $35,600,000 principal amount of the Company’s 7% Senior Notes. In addition, investment and other income reflects income of $400,000 and $200,000 for the three months ended September 30, 2010 and 2009, respectively, and $1,000,000 and $1,000,000 for the nine months ended September 30, 2010 and 2009, respectively, related to the accounting for mark-to-market values of Corporate derivatives.
The decrease in interest expense for the nine month 2010 period as compared to the same period in 2009 primarily reflects decreased interest expense related to the 3¾% Convertible Senior Subordinated Notes, $123,500,000 of which were converted principally in the second quarter of 2009; and decreased interest expense related to the 7% Senior Notes, which were repurchased principally during the first quarter of 2009.
Salaries and incentive compensation expense decreased in the three and nine month 2010 periods as compared to the same periods in 2009 principally due to lower accrued incentive bonus expense related to the Company’s Senior Executive Annual Incentive Bonus Plan and lower share-based compensation expense. Bonus accruals under this plan are based on a percentage of pre-tax profits as defined in the plan. The Company recorded share-based compensation expense relating to grants made under the Company’s senior executive warrant plan and the fixed stock option plan of $600,000 and $2,700,000 for the three month periods ended September 30, 2010 and 2009, respectively, and $3,300,000 and $8,100,000 for the nine month periods ended September 30, 2010 and 2009, respectively. Share-based compensation expense declined for the three and nine month 2010 periods as compared to the same periods in 2009 due to the warrants previously granted under the Company’s senior executive warrant plan becoming fully vested.
Selling, general and other expenses for the three and nine month 2010 periods includes $8,400,000 for Corporate’s portion of the defined benefit pension plan settlement charge, and $1,000,000 of aggregate losses related to the repurchase of certain of the Company’s debt securities during the third quarter of 2010. The change in selling, general and other expenses during the nine month 2010 period as compared to the same period in 2009 also reflects $25,300,000 of expenses incurred relating to the induced conversion of the Company’s 3¾% Convertible Senior Subordinated Notes during 2009, $3,000,000 of decreased amortization of debt issuance costs principally related to the debt conversions and the repurchased indebtedness in 2009, and $1,500,000 of higher corporate aircraft expense. Selling, g eneral and other expenses for the three and nine month 2010 periods also reflect $1,100,000 and $1,200,000, respectively, of higher legal fees as compared to the same periods in 2009.
As of September 30, 2010 and December 31, 2009, the Company has a full valuation allowance against its net federal deferred tax asset, including its available NOLs, which aggregated approximately $6,000,000,000 at December 31, 2009. As a result, the Company did not record any regular federal income tax expense for the three and nine month periods ended September 30, 2010. Prior to September 30, 2010, the Company had been recording provisions or benefits for deferred federal minimum taxes payable, due to material unrealized security gains reflected in accumulated other comprehensive income and in income related to associated companies. If these gains were realized, the Company would be able to use its NOLs to fully offset the regular federal income taxes that would be due, but prior to the election descr ibed below the Company would have had to pay federal minimum taxes. Although the payment of federal minimum taxes generates a minimum tax credit carryover, it is fully reserved for in the net deferred tax asset valuation allowance. Accordingly, for the nine month period ended September 30, 2009, the Company recorded provisions for deferred federal minimum taxes payable of $18,800,000 in accumulated other comprehensive income and $12,800,000 in income related to associated companies. In addition, income tax expense for the nine month periods ended September 30, 2010 and 2009 includes state and foreign income taxes.
The Worker, Homeownership, and Business Assistance Act of 2009 provided taxpayers a special election for extended net operating loss carryback benefits, and with respect to any net operating loss for which the election was made, eliminated the limitation that applies to using the NOL to reduce alternative minimum taxable income. In September 2010, the Internal Revenue Service provided additional guidance with respect to application of the law, and the Company made the election with respect to its 2008 NOL. As a result, the Company has NOLs that fully offset approximately $3,000,000,000 of federal minimum taxable income (a potential savings of $60,000,000 of future federal minimum taxes), and no federal regular or minimum income tax would be payable on such income. The consolidated statement of operation s for the nine month period ended September 30, 2010 reflects the reversal of $11,600,000 of deferred federal minimum tax liabilities which had been recorded in prior periods.
Associated Companies
Income (losses) related to associated companies for the three and nine month periods ended September 30, 2010 and 2009 includes the following (in thousands):
| | | For the Three Month | | | For the Nine Month | |
| | | Period Ended September 30, | | | Period Ended September 30, | |
| | | 2010 | | | 2009 | | | 2010 | | | 2009 | |
| | | | | | | | | | | | | |
| ACF | | $ | 211,539 | | | $ | 73,320 | | | $ | 182,216 | | | $ | 268,297 | |
| Jefferies | | | 81,866 | | | | 286,654 | | | | (39,597 | ) | | | 639,869 | |
| Berkadia | | | 3,043 | | | | – | | | | 13,336 | | | | – | |
| JHYH | | | 72 | | | | 23,596 | | | | 2,588 | | | | 30,620 | |
| Pershing Square | | | 2,110 | | | | 6,873 | | | | 3,033 | | | | (4,638 | ) |
| HomeFed Corporation | | | 222 | | | | 678 | | | | (670 | ) | | | 388 | |
| Garcadia | | | 4,030 | | | | 2,738 | | | | 11,364 | | | | (26,201 | ) |
| Keen Energy | | | – | | | | (3,753 | ) | | | – | | | | (6,457 | ) |
| CLC | | | 23,804 | | | | 5,697 | | | | (13,064 | ) | | | 7,758 | |
| Wintergreen | | | – | | | | – | | | | – | | | | 1,078 | |
| Shortplus | | | – | | | | – | | | | – | | | | (397 | ) |
| Other | | | (5,356 | ) | | | (3,345 | ) | | | (13,301 | ) | | | (17,436 | ) |
| Income related to associated companies | | | | | | | | | | | | | | | | |
| before income taxes | | | 321,330 | | | | 392,458 | | | | 145,905 | | | | 892,881 | |
| Income tax (expense) benefit | | | 3,382 | | | | (12,941 | ) | | | 8,079 | | | | (25,678 | ) |
| Income related to associated companies, | | | | | | | | | | | | | | | | |
| net of taxes | | $ | 324,712 | | | $ | 379,517 | | | $ | 153,984 | | | $ | 867,203 | |
As discussed above, the Company accounts for its investments in ACF and Jefferies at fair value, resulting in the recognition of unrealized gains (losses) for the difference between the market value and the cost of the investments. The Company’s investment in ACF was sold on October 1, 2010.
During the third quarter of 2010, the Company fully redeemed its interest in Pershing Square by transferring its equity into a larger, more diversified investment partnership fund managed by the same manager. The Company’s percentage ownership interest in this larger investment partnership is much smaller and does not qualify for the equity method of accounting.
As discussed above, for the nine month period ending September 30, 2009, the Company’s equity in losses of Garcadia includes impairment charges for goodwill and other intangible assets aggregating $32,300,000.
As discussed in the 2009 10-K, Keen became a consolidated subsidiary of the Company in November 2009.
Discontinued Operations
Domestic Real Estate
As discussed above, in August 2010, the Company sold its operating retail shopping center in Long Island, New York for cash consideration of $17,100,000 and recorded a pre-tax and after tax gain on sale of discontinued operations of $4,600,000. Historical operating results for this business were not material.
Property Management and Services
As discussed above, in September 2010, the Company sold ResortQuest, recognized a gain on disposal of $35,300,000, and classified its historical operating results as a discontinued operation during the third quarter. Pre-tax income of ResortQuest was $8,400,000 and $6,900,000 for the three months ended September 30, 2010 and 2009, respectively, and $10,900,000 and $6,400,000 for the nine months ended September 30, 2010 and 2009, respectively.
Telecommunications
As discussed above, in October 2010, the Company sold STi Prepaid. Pre-tax income (loss) of STi Prepaid was $5,300,000 and $(100,000) for the three months ended September 30, 2010 and 2009, respectively, and $1,900,000 and $1,200,000 for the nine months ended September 30, 2010 and 2009, respectively.
Other Operations
As discussed above, in September 2010, the Company classified its power production business that burns waste biomass to produce electricity as held for sale and recorded a charge of $25,300,000 to reduce the carrying amount of the business to its fair value. The power production business was previously included in other operations. The Company expects to sell the business within the next twelve months. Pre-tax losses of this business, including the impairment charge, were $26,100,000 and $29,500,000 for the three and nine month 2010 periods, respectively, and $1,800,000 and $7,200,000 for the three and nine month 2009 periods, respectively.
Other
During the nine month 2010 period and the third quarter of 2009, the Company received and recognized as income from discontinued operations $9,500,000 and $8,600,000, respectively, of distributions from its subsidiary, Empire, which has been undergoing a voluntary liquidation since 2001. The Company had classified Empire as a discontinued operation in 2001 and fully wrote-off its remaining book value based on its expected future cash flows at that time. Although Empire no longer writes any insurance business, its orderly liquidation over the years has resulted in reductions to its estimated claim reserves that enabled Empire to pay the distribution, with the approval of the New York Insurance Department. Since future distributions from Empire, if any, are subject to New York insurance law or the approval of the New York Insurance Department, income will only be recognized when received.
During the third quarter of 2009, the Company received 636,300 of its common shares in connection with the resolution of a lawsuit related to its former subsidiary, WilTel, and recorded income from discontinued operations of $15,200,000 based on the market value of the common shares. These shares were originally issued in connection with the acquisition of WilTel in 2003, and had been held in a fund for certain claims made against WilTel prior to the Company’s ownership. The resolution of the lawsuit found that the claimants were not entitled to the shares and they were returned to the Company.
Cautionary Statement for Forward-Looking Information
Statements included in this Report may contain forward-looking statements. Such statements may relate, but are not limited, to projections of revenues, income or loss, development expenditures, plans for growth and future operations, competition and regulation, as well as assumptions relating to the foregoing. Such forward-looking statements are made pursuant to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995.
Forward-looking statements are inherently subject to risks and uncertainties, many of which cannot be predicted or quantified. When used in this Report, the words “will,” “could,” “estimates,” “expects,” “anticipates,” “believes,” “plans,” “intends” and variations of such words and similar expressions are intended to identify forward-looking statements that involve risks and uncertainties. Future events and actual results could differ materially from those set forth in, contemplated by or underlying the forward-looking statements.
Factors that could cause actual results to differ materially from any results projected, forecasted, estimated or budgeted or may materially and adversely affect the Company’s actual results include but are not limited to the following: potential acquisitions and dispositions of our operations and investments could change our risk profile; dependence on certain key personnel; economic downturns and the current recession; changes in the market prices of publicly traded securities and entities that invest in publicly traded securities, particularly during times of increased volatility in securities prices; changes in the U.S. housing and commercial real estate markets; risks associated with the increased volatility in raw material prices and the availability of key raw materials; declines in the prices of base metals (primarily iro n ore and copper); natural gas supplies and prices and the supply of drilling rigs in the marketplace; compliance with government laws and regulations; changes in mortgage interest rate levels or the lack of available consumer credit; lack of liquidity and turmoil in the capital markets; obtaining significant funding and regulatory approvals to develop large scale energy projects and for medical product development and clinical trial activities; substantial investments in companies whose operating results are greatly affected by the economy and financial markets; changes in existing government and government-sponsored mortgage programs and the loss of or changes in Berkadia’s relationships with the related bodies; a decrease in consumer spending or general increases in the cost of living; intensified competition in the operation of our businesses; our ability to generate sufficient taxable income to fully realize our net deferred tax asset; weather related conditions and significant natural disasters, including hurricanes, tornadoes, windstorms, earthquakes and hailstorms; our ability to insure certain risks economically; dividend payments on our common shares; changes in government tax policies in foreign and domestic jurisdictions; new financial legislation that could affect the market value of certain of the Company’s investments; the impact of the oil spill in the Gulf Coast. For additional information see Part I, Item 1A. Risk Factors in the 2009 10-K, Part II, Item 1A. Risk Factors in the Form 10-Q for the quarter ended June 30, 2010 and Part II, Item 1A. Risk Factors contained herein.
Undue reliance should not be placed on these forward-looking statements, which are applicable only as of the date hereof. The Company undertakes no obligation to revise or update these forward-looking statements to reflect events or circumstances that arise after the date of this Report or to reflect the occurrence of unanticipated events.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
Information required under this Item is contained in Item 7A in the 2009 10-K, and is incorporated by reference herein.
Item 4. Controls and Procedures.
Evaluation of disclosure controls and procedures
| (a) | The Company's management evaluated, with the participation of the Company's principal executive and principal financial officers, the effectiveness of the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), as of September 30, 2010. Based on their evaluation, the Company's principal executive and principal financial officers concluded that the Company's disclosure controls and procedures were effective as of September 30, 2010. |
Changes in internal control over financial reporting
| (a) | There has been no change in the Company's internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the Company's fiscal quarter ended September 30, 2010, that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. |
PART II – OTHER INFORMATION
Item 1A. Risk Factors.
The 2009 10-K and the Form 10-Q for the quarter ended June 30, 2010 include a detailed discussion of the risk factors applicable to us. Other than as set forth below, there are no material changes from the risk factors as previously disclosed.
If we are unsuccessful in our litigation against FMG, future cash flows from the FMG Note and future results of operations would be materially and adversely affected. If it is ultimately determined that FMG can issue additional notes, the value of the FMG Note will decrease to the extent of the dilution resulting from the issuance of such additional notes.
| | 10.1 | Form of Shareholder Support and Voting Agreement dated as of July 21, 2010, among General Motors Holdings LLC, Goalie Texas Holdco Inc., Leucadia National Corporation, Phlcorp, Inc., Baldwin Enterprises, Inc., BEI Arch Holdings, LLC and BEI-Longhorn, LLC (filed as Exhibit 10.1 to the Company’s Form 8-K filed July 22, 2010). |
| | 31.1 | Certification of Chairman of the Board and Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| | 31.2 | Certification of President pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| | 31.3 | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| | 32.1 | Certification of Chairman of the Board and Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| | 32.2 | Certification of President pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| | 32.3 | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| | 101 | Financial statements from the Quarterly Report on Form 10-Q of Leucadia National Corporation for the quarter ended September 30, 2010, formatted in Extensible Business Reporting Language (XBRL): (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Operations, (iii) the Consolidated Statements of Cash Flows, (iv) the Consolidated Statements of Changes in Shareholders Equity and (v) the Notes to Consolidated Financial Statements. |
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | LEUCADIA NATIONAL CORPORATION | |
| | | (Registrant) | |
| | | | |
| | | | |
| Date: November 5, 2010 | By: | /s/ Barbara L. Lowenthal | |
| | | Name: Barbara L. Lowenthal | |
| | | Title: Vice President and Comptroller | |
| | | (Chief Accounting Officer) | |
Exhibit Index
| | 10.1 | Form of Shareholder Support and Voting Agreement dated as of July 21, 2010, among General Motors Holdings LLC, Goalie Texas Holdco Inc., Leucadia National Corporation, Phlcorp, Inc., Baldwin Enterprises, Inc., BEI Arch Holdings, LLC and BEI-Longhorn, LLC (filed as Exhibit 10.1 to the Company’s Form 8-K filed July 22, 2010). |
| | 31.1 | Certification of Chairman of the Board and Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| | 31.2 | Certification of President pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| | 31.3 | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| | 32.1 | Certification of Chairman of the Board and Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| | 32.2 | Certification of President pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| 32.3 | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| | 101 | Financial statements from the Quarterly Report on Form 10-Q of Leucadia National Corporation for the quarter ended September 30, 2010, formatted in Extensible Business Reporting Language (XBRL): (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Operations, (iii) the Consolidated Statements of Cash Flows, (iv) the Consolidated Statements of Changes in Shareholders Equity and (v) the Notes to Consolidated Financial Statements. |
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