FIVE YEAR SUMMARY OF SELECTED FINANCIAL DATA Year Ended December 31, ---------------------------------------------- (IN THOUSANDS, EXCEPT PER SHARE AND OPERATING DATA) 1996 1995 1994 1993 1992 - --------------------------------------------------- ------- ------- -------- ------- ------- Revenue $196,728 $154,173 $94,478 $53,061 $27,948 Cost of services 124,268 97,401 58,062 32,047 16,320 - -------------------------------------------------------------------------------------------------------- Gross profit 72,460 56,772 36,416 21,014 11,628 Selling, general and administrative expenses 51,538 39,847 26,335 15,471 9,680 - -------------------------------------------------------------------------------------------------------- Income from operations 20,922 16,925 10,081 5,543 1,948 Other/income (expense), net 1,107 713 303 (80) (62) - -------------------------------------------------------------------------------------------------------- Income before income taxes & extraordinary item 22,029 17,638 10,384 5,463 1,886 Income taxes 8,811 7,280 4,194 2,237 765 - -------------------------------------------------------------------------------------------------------- Income before extraordinary item 13,218 10,358 6,190 3,226 1,121 Extraordinary item-utilization of net operating loss carryforward -- -- -- -- 480 - -------------------------------------------------------------------------------------------------------- Net income $13,218 $10,358 $ 6,190 $ 3,226 $ 1,601 - -------------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------------- Net earnings per share $0.83 $0.65 $0.41 $0.24 $0.11 - -------------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------------- Weighted average common and common equivalent shares outstanding 15,990 15,992 14,958 13,620 13,352 - -------------------------------------------------------------------------------------------------------- SELECTED OPERATING DATA: Number of branch offices open at period end 51 42 34 25 20 BALANCE SHEET DATA: Working capital $51,812 $33,994 $19,207 $ 3,215 $ 1,862 Total assets 64,403 47,811 26,581 9,011 4,440 Redeemable Preferred Stock -- -- -- -- 2,239 Stockholders' equity (deficit) 55,667 38,461 19,972 3,601 (181) - -------------------------------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Alternative Resources Corporation-Registered Trademark- (ARC) has experienced substantial growth in revenue and earnings driven by industry trends toward component outsourcing of Information Services operations, increased penetration of existing clients, expansion into new markets, increased productivity of existing branch offices, the opening of new branch offices and the introduction of new services. Essentially all of ARC's revenue is generated from technical resource services that offer the benefits of outsourcing while allowing Information Services operations managers to retain strategic control over their operations. ARC provides its clients with a variety of service offerings to meet their needs. On shorter term projects, clients have maximum flexibility to start and stop projects at any time. On longer term projects, where employee continuity is required, ARC provides a comprehensive benefits package to the technical employee without increasing the client's hourly bill rate. Historically, while the gross margins on longer term projects have been lower than those on shorter term projects because of the cost of providing additional benefits, longer term projects carry lower administrative costs because of the long term commitments made by the client. The Company's Smartsourcing-Registered Trademark- Solutions are becoming a more significant part of ARC's business. Under a Smartsourcing-Registered Trademark-arrangement, wherein ARC may take over an entire or component part of a client's IT operations, the Company may provide for flexibility in invoicing arrangements other than more traditional hourly billing. Such arrangements may include fixed price or per unit billing, as well as commitments by ARC to meet specific service levels. Management believes that Smartsourcing-Registered Trademark-revenue is an important measure of clients' confidence and willingness to engage ARC to provide more comprehensive IT staffing solutions. One of the primary factors impacting ARC's gross margin is the volume of business with its major clients. ARC offers its largest clients volume discounts from list prices in order to encourage increased and continued usage of ARC's services. ARC believes these discounts have contributed significantly to its revenue growth. During 1996, ARC continued to invest in initiatives to drive future growth. As such, selling, general and administrative expenses as a percentage of revenue increased primarily due to start up costs associated with the Middle Market and Smartsourcing-Registered Trademark- Solutions initiatives. RESULTS OF OPERATIONS The following table sets forth the percentage of revenue represented by certain line items of ARC's consolidated statements of operations for the periods indicated: YEAR ENDED DECEMBER 31, 1996 1995 1994 - ------------------------------------------------------------- REVENUE 100.0% 100.0% 100.0% COST OF SERVICES 63.2 63.2 61.4 - ------------------------------------------------------------- GROSS PROFIT 36.8 36.8 38.6 SELLING, GENERAL AND ADMINISTRATIVE EXPENSES 26.2 25.8 27.9 - ------------------------------------------------------------- INCOME FROM OPERATIONS 10.6 11.0 10.7 OTHER INCOME, NET 0.6 0.4 0.3 - ------------------------------------------------------------- INCOME BEFORE INCOME TAXES 11.2 11.4 11.0 INCOME TAXES 4.5 4.7 4.4 - ------------------------------------------------------------- NET INCOME 6.7% 6.7% 6.6% - ------------------------------------------------------------- - ------------------------------------------------------------- FISCAL 1996 COMPARED TO FISCAL 1995 REVENUE. Revenue increased by 27.6% from $154.2 million in 1995 to $196.7 million in 1996, primarily as a result of an increase in the hours of service provided MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CONTINUED to clients from 4.8 million in 1995 to 5.7 million in 1996, and, to a lesser extent, an increase in the average revenue per project hour. The increase in hours of service was primarily due to increased productivity of existing branch offices. Branch offices opened prior to the beginning of 1995 contributed 86.9% of ARC's revenue growth from 1995 to 1996. The increase in average revenue per project hour reflects demand for technical employees with higher skills and an increase in prices. GROSS PROFIT. Gross profit increased by 27.6% from $56.8 million in 1995 to $72.5 million in 1996, primarily as a result of an increase in hours of service provided to clients. Gross margin remained unchanged at 36.8% for 1995 and 1996. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and administrative expenses increased from $39.8 million in 1995 to $51.5 million in 1996, primarily due to increased commissions, bonuses and staffing expenses associated with revenue and profitability growth, start up expenses associated with the new Middle Market initiative, investment in the infrastructure for sales and delivery of our Smartsourcing-Registered Trademark- and Smartsourcing+sm services, and an increased number of branch offices and their related operating costs. Selling, general and administrative expenses increased as a percentage of revenue from 25.8% in 1995 to 26.2% in 1996, primarily due to the costs associated with the Middle Market and Smartsourcing-Registered Trademark- initiatives. INCOME FROM OPERATIONS. Income from operations increased from $16.9 million in 1995 to $20.9 million in 1996, and decreased as a percentage of total revenue from 11.0% to 10.6%. PROVISION FOR INCOME TAXES. The provision for income taxes increased from $7.3 million, or an effective tax rate of 41.3%, in 1995 to $8.8 million, or an effective tax rate of 40.0%, in 1996. The decrease in the effective tax rate in 1996 is the result of a tax planning initiative implemented at the beginning of the year. NET INCOME. Net income increased from $10.4 million in 1995 to $13.2 million in 1996, and remained unchanged as a percentage of total revenue at 6.7%. FISCAL 1995 COMPARED TO FISCAL 1994 REVENUE. Revenue increased by 63.2% from $94.5 million in 1994 to $154.2 million in 1995, primarily as a result of an increase in the hours of service provided to clients from 3.3 million in 1994 to 4.8 million in 1995, and, to a lesser extent, an increase in the average revenue per project hour. The increase in hours of service was primarily from increased productivity of existing branch offices. Branch offices opened prior to the beginning of 1994 contributed 85.1% of ARC's revenue growth from 1994 to 1995. The increase in average revenue per project hour reflects demand for technical employees with higher skills. GROSS PROFIT. Gross profit increased by 55.9% from $36.4 million in 1994 to $56.8 million in 1995, primarily as a result of an increase in hours of service provided to clients. Gross margin decreased from 38.6% in 1994 to 36.8% in 1995, principally from increased volume discounts and the higher benefits costs of services associated with an increase in longer term projects. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and administrative expenses increased from $26.3 million in 1994 to $39.8 million in 1995, primarily due to increased commissions, bonuses and staffing expenses associated with revenue and profitability growth, an increased number of branch offices and client support sites and related operating costs, and increased expenses associated with the growth of the management team and related support MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CONTINUED at the corporate headquarters. Selling, general and administrative expenses decreased as a percentage of revenue from 27.9% in 1994 to 25.8% in 1995, reflecting greater operating efficiencies and economies of scale gained from a larger revenue base. INCOME FROM OPERATIONS. Income from operations increased from $10.1 million in 1994 to $16.9 million in 1995, and increased as a percentage of total revenue from 10.7% to 11.0%. PROVISION FOR INCOME TAXES. The provision for income taxes increased from $4.2 million, or an effective tax rate of 40.4%, in 1994 to $7.3 million, or an effective tax rate of 41.3%, in 1995. NET INCOME. Net income increased from $6.2 million in 1994 to $10.4 million in 1995, and increased as a percentage of total revenue from 6.6% to 6.7%. LIQUIDITY AND CAPITAL RESOURCES Prior to its initial public offering, ARC financed its operations through private placements of equity securities, a bank line of credit and cash generated from operations. On May 9, 1994, ARC received $10.6 million of net proceeds from the sale of Common Stock in its initial public offering, of which $888,000 was used to repay all of its then outstanding debt. Net cash flow from operations was $1.1 million, $4.1 million and $3.8 million in 1994, 1995 and 1996, respectively. Positive cash flows in 1994, 1995 and 1996 resulted from significant increases in earnings for those periods, partially offset in all three periods by increases in accounts receivable resulting from higher revenues. In addition, in 1996, cash flow from operations was reduced by a decrease in payroll and related expenses, as these liabilities were paid prior to the fiscal year end. Working capital increased from $19.2 million at December 31, 1994 to $34.0 million at December 31, 1995 and $51.8 million at December 31, 1996. On June 21, 1995, ARC received $7.2 million of net proceeds from the sale of 314,850 shares of its Common Stock pursuant to an over-allotment option granted by ARC in connection with a secondary public offering of shares by certain selling stockholders of ARC. ARC believes its cash balances and funds from operations will be sufficient to fund continued expansion of its office network and to meet all of its anticipated cash requirements for at least the next 12 months. CONSOLIDATED BALANCE SHEETS ASSETS YEAR ENDED DECEMBER 31, 1996 1995 - ------------------------------------------------------------------------------------------ (IN THOUSANDS EXCEPT NUMBER OF SHARES AND PER SHARE DATA) CURRENT ASSETS: Cash and cash equivalents $ 2,310 $ 1,903 Short-term investments 20,868 15,077 Trade accounts receivable, net of allowance for doubtful accounts of $528 in 1996 and $579 in 1995 33,207 24,621 Prepaid expenses 455 518 Other receivables 2,403 664 Deferred income taxes 960 309 - ------------------------------------------------------------------------------------------ TOTAL CURRENT ASSETS 60,203 43,092 - ------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------ PROPERTY AND EQUIPMENT: Office equipment 3,103 2,140 Furniture and fixtures 1,427 889 Software 420 363 Leasehold improvements 307 95 - ------------------------------------------------------------------------------------------ 5,257 3,487 Less accumulated depreciation and amortization 2,377 1,433 - ------------------------------------------------------------------------------------------ NET PROPERTY AND EQUIPMENT 2,880 2,054 - ------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------ OTHER ASSETS: Long-term investments 1,026 2,460 Deposits and other assets 294 205 - ------------------------------------------------------------------------------------------ TOTAL OTHER ASSETS 1,320 2,665 - ------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------ TOTAL ASSETS $ 64,403 $ 47,811 - ------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------ LIABILITIES AND STOCKHOLDERS' EQUITY - ------------------------------------------------------------------------------------------ (in thousands except number of shares and per share data) CURRENT LIABILITIES: Accounts payable $ 324 $ 437 Payroll and related expenses 5,969 6,082 Accrued expenses 1,632 2,161 Income taxes payable 466 418 - ------------------------------------------------------------------------------------------ TOTAL CURRENT LIABILITIES 8,391 9,098 - ------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------ Deferred rent payable 345 252 - ------------------------------------------------------------------------------------------ TOTAL LIABILITIES 8,736 9,350 - ------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------ STOCKHOLDERS' EQUITY: Preferred Stock ($.01 par value; 1,000,000 shares authorized; none issued and outstanding) -- -- Common Stock ($.01 par value; 50,000,000 and 20,000,000 shares authorized, 15,651,391 and 15,347,027 shares issued and outstanding in 1996 and 1995, respectively) 157 153 Additional paid-in capital 23,003 19,052 Unrealized loss on available-for-sale securities (28) -- Cumulative translation adjustment 43 (18) Retained earnings 32,492 19,274 - ------------------------------------------------------------------------------------------ TOTAL STOCKHOLDERS' EQUITY 55,667 38,461 - ------------------------------------------------------------------------------------------ TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 64,403 $ 47,811 - ------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------ SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. CONSOLIDATED STATEMENTS OF OPERATIONS Year Ended December 31, 1996 1995 1994 - -------------------------------------------------------------------------------------- (IN THOUSANDS EXCEPT PER SHARE DATA) Revenue $ 196,728 $ 154,173 $ 94,478 Cost of services 124,268 97,401 58,062 - -------------------------------------------------------------------------------------- Gross profit 72,460 56,772 36,416 Selling, general and administrative expenses 51,538 39,847 26,335 - -------------------------------------------------------------------------------------- Income from operations 20,922 16,925 10,081 Other income, net 1,107 713 303 - -------------------------------------------------------------------------------------- Income before income taxes 22,029 17,638 10,384 Income taxes 8,811 7,280 4,194 - -------------------------------------------------------------------------------------- NET INCOME $ 13,218 $ 10,358 $ 6,190 - -------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------- PER SHARE AMOUNTS: Primary $ 0.83 $ 0.65 $ 0.51 Fully diluted $ 0.83 $ 0.65 $ 0.41 - -------------------------------------------------------------------------------------- WEIGHTED AVERAGE COMMON AND COMMON EQUIVALENT SHARES OUTSTANDING: Primary 15,985 15,861 12,037 Fully diluted 15,990 15,992 14,958 - -------------------------------------------------------------------------------------- SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY NOTES UNREALIZED RECEIVABLE LOSS ON CUMULATIVE TOTAL ADDITIONAL FROM SALE AVAILABLE- FOREIGN STOCK- PREFERRED STOCK COMMON STOCK PAID-IN OF COMMON RETAINED FOR-SALE EXCHANGE HOLDERS SHARES AMOUNT SHARES AMOUNT CAPITAL STOCK EARNINGS SECURITIES GAIN/LOSS EQUITY - ---------------------------------------------------------------------------------------------------------------------------------- (IN THOUSANDS) BALANCE AT DECEMBER 31, 1993 6 $ 630 4,114 $ 41 $ 283 $(96) $ 2,743 $ -- $ -- $ 3,601 Conversion of Class B Convertible Preferred Stock to Common Stock (6) (630) 8,820 89 541 -- -- -- -- -- Issuance of Common Stock -- -- 1,717 17 10,617 -- -- -- 10,634 Repurchase of Common Stock -- -- (4) -- (1) 1 -- -- -- -- Exercise of stock options -- -- 134 1 68 -- -- -- -- 169 Note repayment -- -- -- -- -- 95 -- -- -- 95 Dividend accretion -- -- -- -- -- -- (17) -- -- (17) Accrual of stock registration rights -- -- -- -- (700) -- -- -- -- (700) Net income -- -- -- -- -- -- 6,190 -- -- 6,190 - ---------------------------------------------------------------------------------------------------------------------------------- BALANCE AT DECEMBER 31, 1994 -- -- 14,781 148 10,908 -- 8,916 -- -- 19,972 Issuance of Common Stock -- -- 315 3 7,207 -- -- -- -- 7,210 Exercise of stock options -- -- 251 2 811 -- -- -- -- 813 Repurchase of Common Stock -- -- (24) -- (738) -- -- -- -- (738) Issuance of Common Stock under employee stock purchase plan -- -- 24 -- 589 -- -- -- -- 589 Translation adjustment -- -- -- -- -- -- -- -- (18) (18) Expiration of stock registration rights -- -- -- -- 275 -- -- -- -- 275 Net income -- -- -- -- -- -- 10,358 -- -- 10,358 - ---------------------------------------------------------------------------------------------------------------------------------- BALANCE AT DECEMBER 31, 1995 -- -- 15,347 153 19,052 -- 19,274 -- (18) 38,461 Exercise of stock options -- -- 304 4 2,909 -- -- -- -- 2,913 Repurchase of Common Stock -- -- (55) -- (1,500) -- -- -- -- (1,500) Issuance of Common Stock under employee stock purchase plan -- -- 55 -- 1,305 -- -- -- -- 1,305 Translation adjustment -- -- -- -- -- -- -- -- 61 61 Unrealized loss on available-for- sale securities -- -- -- -- -- -- -- (28) -- (28) Tax benefit recognized on stock options exercised -- -- -- -- 1,237 -- -- -- -- 1,237 Net income -- -- -- -- -- -- 13,218 -- -- 13,218 - ---------------------------------------------------------------------------------------------------------------------------------- BALANCE AT DECEMBER 31, 1996 -- $ -- 15,651 $157 $23,003 $ -- $32,492 $(28) $ 43 $55,667 - ---------------------------------------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------------------------------------- SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended December 31, 1996 1995 1994 - ------------------------------------------------------------------------------------------------------- (in thousands) CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 13,218 $ 10,358 $ 6,190 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 946 748 311 Deferred income tax benefit (651) (326) (186) Allowance for doubtful accounts (51) 403 81 Change in assets and liabilities: Trade accounts receivable (8,535) (9,824) (7,787) Prepaid expenses 63 (90) (167) Other receivables (502) (355) (258) Deposits and other assets (30) (49) (16) Accounts payable (113) (36) 120 Payroll and related expenses (113) 2,565 1,554 Accrued expenses (529) 270 1,244 Income taxes payable 48 369 (64) Deferred rent payable 93 65 72 - ------------------------------------------------------------------------------------------------------- NET CASH PROVIDED BY OPERATING ACTIVITIES 3,844 4,098 1,094 ======================================================================================================= CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of property and equipment (1,770) (1,551) (1,083) Purchases of available-for-sale securities (24,152) -- -- Redemptions of available-for-sale securities 4,620 -- -- Purchases of held-to-maturity securities -- (19,533) (17,440) Redemptions of held-to-maturity securities 15,147 12,503 6,933 - ------------------------------------------------------------------------------------------------------- NET CASH USED IN INVESTING ACTIVITIES (6,155) (8,581) (11,590) ======================================================================================================= CASH FLOWS FROM FINANCING ACTIVITIES: Net proceeds from sale of Common Stock -- 7,210 10,634 Payments received on stock options exercised 2,913 813 169 Dividends paid on Preferred Stock -- -- (17) Payments received on Common Stock notes -- -- 95 Repurchase of Common Stock (1,500) (738) -- Issuance of Common Stock under employee stock purchase plan 1,305 589 -- Accrued stock registration rights -- (200) (225) Net short-term repayments -- -- (2,014) Cash overdraft (repayments) -- (1,288) 1,288 - ------------------------------------------------------------------------------------------------------- NET CASH PROVIDED BY FINANCING ACTIVITIES 2,718 6,386 9,930 ======================================================================================================= NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 407 1,903 (566) CASH AND CASH EQUIVALENTS AT THE BEGINNING OF THE YEAR 1,903 -- 566 - ------------------------------------------------------------------------------------------------------- CASH AND CASH EQUIVALENTS AT THE END OF THE YEAR $ 2,310 $ 1,903 $ -- ======================================================================================================= SUPPLEMENTAL DISCLOSURES: Cash paid for interest $ -- $ -- $ 32 Cash paid for income taxes 9,753 7,275 4,446 ======================================================================================================= SUPPLEMENTAL DISCLOSURE OF NONCASH FINANCING ACTIVITIES: Tax benefit on stock options exercised $ 1,237 $ -- $ -- Accrual (expiration) of stock registration rights -- (275) 475 ======================================================================================================= SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION AND NATURE OF THE BUSINESS. Alternative Resources Corporation (the "Company") was incorporated in Delaware on March 8, 1988. The Company provides comprehensive information technology services that allow clients to stay focused on mission-critical activities of their business. Customized solutions vary based on the nature and length of client projects, the degree of day-to-day management responsibility clients wish to delegate, and the flexibility desired. The Company focuses on five information technology environments including: 1) help desk, 2) desktop and workstation computing (PC/LAN), 3) client/server support, 4) voice and data communications (LANs/WANs), and 5) mainframe and midrange computer operations. PRINCIPLES OF CONSOLIDATION. The operations of the Company are conducted through a parent holding company and two operating subsidiaries. The accompanying consolidated financial statements include the financial position and results of operations of the Company and its subsidiaries with all intercompany transactions eliminated in their entirety. USE OF ESTIMATES. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. CASH EQUIVALENTS. Cash equivalents include all deposits in banks and highly liquid investments with original maturities of three months or less. INVESTMENT SECURITIES. The Company classifies its investment securities purchased before December 31, 1995 as held-to-maturity and records such securities at amortized cost. Held-to-maturity securities are those securities which the Company has the ability and intent to hold until maturity. Investment securities purchased after December 31, 1995 are classified as available-for-sale and are recorded at fair market value, with unrealized holding gains or losses, if any, recorded as a separate component of stockholders' equity. The Company does not invest in trading securities. Realized gains and losses from the sale of available-for-sale securities are determined on a specific identification basis. Interest income is recognized when earned. PROPERTY AND EQUIPMENT. Property and equipment are recorded at cost and depreciated using the straight-line method over the estimated useful lives of the respective assets ranging from three to five years. Leasehold improvements are amortized using the straight-line method over the life of the related leases, generally three to five years. TRANSLATION OF FOREIGN CURRENCIES. Assets and liabilities of the Company's Canadian branch are translated at the rate of exchange in effect on the balance sheet date; income and expenses are translated at the weighted average rates of exchange prevailing during the year. The related translation adjustments are reflected as a cumulative translation adjustment in stockholders' equity. Foreign currency realized and unrealized gains and losses for the years presented were not material. REVENUE RECOGNITION. Revenues are recognized, net of volume discounts, as services are performed. INCOME TAXES. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. STOCK COMPENSATION PLANS. Prior to January 1, 1996, the Company accounted for its stock-based compensation plans in accordance with the provisions of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," ("APB 25") and related interpretations. Under APB 25, no compensation cost has been recognized for its stock option plan and its employee stock purchase plan. On January 1, 1996, the Company adopted Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," ("Statement 123") which permits entities to recognize as expense over the vesting period the fair value of all stock-based awards on the date of grant. Alternatively, Statement 123 also allows entities to continue to apply the provisions of APB 25 and provide pro forma net income and pro forma earnings per share disclosures for its stock-based compensation plans in 1995 and future years as if the fair-value-based method defined in Statement 123 had been applied. The Company has elected to continue to apply the provisions of APB 25 and provide the pro forma disclosure provisions of Statement 123. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONTINUED FAIR VALUE OF FINANCIAL INSTRUMENTS. The carrying amounts of the Company's financial instruments approximate their fair values due to the short maturity of these instruments. COMPUTATION OF EARNINGS PER SHARE. The primary earnings per common and common equivalent share amounts for the years ended December 31, 1996, 1995 and 1994 have been computed using the weighted average number of common and dilutive common equivalent shares outstanding for each year. Net income used in the calculation of primary earnings per share for the year ended December 31, 1994 was reduced by the accretion of dividends on Class B Convertible Preferred Stock, 8%, $0.10 par value per share (the "Class B Convertible Preferred Stock"). Dilutive common equivalent shares consist of the shares issuable upon exercise of stock options (using the treasury stock method). The fully diluted earnings per share amounts have been computed using the higher average market price during 1996 and the higher ending market price in 1995 and 1994, in applying the treasury stock method for stock options. Dilutive common equivalent shares consist of the shares issuable upon conversion of the Class B Convertible Preferred Stock (as if converted to Common Stock on the original date of issuance) and the exercise of stock options (using the treasury stock method). Pursuant to Securities and Exchange Commission Staff Accounting Bulletin No. 83, Common Stock and options for Common Stock granted by the Company during the 12 months immediately preceding the date of the Company's initial public offering (using the treasury stock method and the mid-point of the proposed public offering price per share) have been included in the calculation of common and common equivalent shares in 1994 as if they were outstanding for all periods presented. RECLASSIFICATION. Certain 1995 and 1994 balances have been reclassified to conform with the 1996 presentation. (2) INVESTMENTS The aggregate fair value, gross unrealized holding gains, gross unrealized holding losses and amortized cost of investments by security type and class of security as of December 31, 1996 were (in thousands): GROSS UNREALIZED HOLDING ------------------- AGGREGATE AMORTIZED FAIR VALUE GAINS (LOSSES) COST - --------------------------------------------------------------------------------- AVAILABLE-FOR-SALE: US TREASURY AND FEDERAL AGENCY DEBT SECURITIES $7,275 $ 31 $ (14) $ 7,258 STATE AND MUNICIPAL DEBT SECURITIES 7,299 4 (29) 7,324 CORPORATE DEBT SECURITIES 4,880 3 (23) 4,900 - -------------------------------------------------------------------------------- TOTAL AVAILABLE-FOR-SALE 19,454 38 (66) 19,482 - -------------------------------------------------------------------------------- HELD-TO-MATURITY: US TREASURY AND FEDERAL AGENCY DEBT SECURITIES 760 6 -- 754 STATE AND MUNICIPAL DEBT SECURITIES 1,680 1 (7) 1,686 - -------------------------------------------------------------------------------- TOTAL HELD-TO-MATURITY 2,440 7 (7) 2,440 ================================================================================ TOTAL INVESTMENTS $21,894 $ 45 $ (73) $21,922 ================================================================================ Held-to-maturity securities at December 31, 1995 consisted of $17.5 million of debt securities with an estimated fair market value that approximated cost. The aggregate fair value and amortized cost of investments by contractual maturity as of December 31, 1996 were (in thousands): AGGREGATE AMORTIZED FAIR VALUE COST - --------------------------------------------------------------------- AVAILABLE-FOR-SALE: MATURITY WITHIN 1 YEAR $18,428 $18,456 MATURITY AFTER 1 YEAR WITHIN 5 YEARS 1,026 1,026 - --------------------------------------------------------------------- TOTAL 19,454 19,482 - --------------------------------------------------------------------- HELD-TO-MATURITY: MATURITY WITHIN 1 YEAR 2,440 2,440 - --------------------------------------------------------------------- TOTAL INVESTMENTS $21,894 $21,922 - --------------------------------------------------------------------- - --------------------------------------------------------------------- Proceeds from sales of available-for-sale securities during 1996 were $628,000. Realized gains and losses from these sales were not material in 1996. The net unrealized loss during 1996 recorded as a separate component of stockholders' equity was $28,000. (3) REDEEMABLE PREFERRED STOCK During 1994, the holders of the Class B Convertible Preferred Stock converted their shares into 8,820,000 shares of Common Stock. Dividends of $17,000 were accreted and paid to the holders of Class B Convertible Preferred Stock for the year ended December 31, 1994. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONTINUED (4) STOCKHOLDERS' EQUITY On May 2, 1994, the Company filed an amended and restated Certificate of Incorporation effecting a seven-for-one split of the Company's Common Stock. All common share and per share amounts have been adjusted retroactively to give effect to the stock split. Additionally, the amended and restated Certificate of Incorporation effected an increase in the number of authorized shares of Common Stock to 20,000,000 and authorized 1,000,000 shares of Preferred Stock. In May 1994, the Company issued 1,716,500 shares of Common Stock in connection with an initial public offering of the Company's Common Stock. In 1994, the Company accrued $700,000 as an estimate of the costs to be incurred for registration rights granted to Wind Point Partners II, L.P. with a corresponding reduction in additional paid-in-capital. Approximately $200,000 and $225,000 were utilized for registration rights exercised in 1995 and 1994, respectively, and additional paid-in-capital was increased by $275,000 as the remaining registration rights expired. On May 22, 1995, the Company's Board of Directors approved a two-for-one split of the Company's Common Stock. All common share and per share amounts have been adjusted retroactively to give effect to the stock split. In June 1995, the Company issued 314,850 shares of Common Stock in connection with a secondary public offering of the Company's Common Stock. In April 1996, the Company amended the Certificate of Incorporation to increase the number of authorized shares of Common Stock to 50,000,000. (5) LEASES The Company leases its office facilities under noncancelable operating leases. Rental expense for operating leases during 1996, 1995 and 1994 was $2,257,000, $1,608,000 and $1,091,000, respectively. Future minimum lease payments under noncancelable operating leases (with initial or remaining lease terms in excess of one year) as of December 31, 1996 are (in thousands): YEAR ENDING DECEMBER 31, AMOUNT - ---------------------------------------- 1997 $ 2,592 - ---------------------------------------- 1998 2,413 - ---------------------------------------- 1999 2,099 - ---------------------------------------- 2000 1,698 - ---------------------------------------- 2001 1,076 - ---------------------------------------- THEREAFTER 2,608 - ---------------------------------------- TOTAL $12,486 - ---------------------------------------- - ---------------------------------------- (6) OTHER INCOME (EXPENSE), NET Other income (expense), net for the years ended December 31, 1996, 1995 and 1994, is comprised of the following (in thousands): 1996 1995 1994 - --------------------------------------------------- INTEREST INCOME $1,107 $713 $329 INTEREST EXPENSE -- -- (25) - --------------------------------------------------- $1,107 $713 $304 =================================================== (7) INCOME TAXES Income tax expense (benefit) is summarized as follows for the years ended December 31, 1996, 1995 and 1994 (in thousands): 1996 1995 1994 - ---------------------------------------------------- CURRENT: FEDERAL $8,312 $6,230 $3,584 STATE 1,150 1,376 796 - ---------------------------------------------------- TOTAL CURRENT 9,462 7,606 4,380 - ---------------------------------------------------- DEFERRED: FEDERAL (576) (279) (161) STATE (75) (47) (25) - ---------------------------------------------------- TOTAL DEFERRED (651) (326) (186) - ---------------------------------------------------- $8,811 $7,280 $4,194 ==================================================== The reasons for the difference between the effective tax rates and the corporate Federal income tax rate for the years ended December 31, 1996, 1995 and 1994, are as follows: PERCENTAGE OF EARNINGS BEFORE INCOME TAXES 1996 1995 1994 - ------------------------------------------------------------------------- FEDERAL INCOME TAX RATE 35.0% 35.0% 35.0% ITEMS AFFECTING FEDERAL INCOME TAX RATE: STATE INCOME TAX, NET OF FEDERAL TAX BENEFIT 4.1 5.1 4.9 OTHER 0.9 1.2 0.5 - ------------------------------------------------------------------------- EFFECTIVE INCOME TAX RATE 40.0% 41.3% 40.4% ========================================================================= NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONTINUED The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1996 and 1995, are as follows (in thousands): 1996 1995 - ------------------------------------------------------------------ DEFERRED TAX ASSETS: PROPERTY AND EQUIPMENT - DEPRECIATION $71 $ -- ACCOUNTS RECEIVABLE VALUATION ALLOWANCE 271 238 DEFERRED RENT PAYABLE 138 103 ACCRUED LIABILITIES 519 266 - ------------------------------------------------------------------ GROSS DEFERRED TAX ASSETS 999 607 - ------------------------------------------------------------------ DEFERRED TAX LIABILITIES: PROPERTY AND EQUIPMENT - DEPRECIATION -- (45) CASH TO ACCRUAL ADJUSTMENT -- (139) OTHER (39) (114) - ------------------------------------------------------------------ GROSS DEFERRED TAX LIABILITIES (39) (298) - ------------------------------------------------------------------ NET DEFERRED TAX ASSET $960 $309 ================================================================== No valuation allowance for deferred tax assets has been recorded as the Company believes it is more likely than not the deferred tax assets will be realized in the future. (8) EMPLOYEE SAVINGS PLAN The Company maintains a defined contribution benefit plan ("the Plan"). The Plan covers each employee who has completed 1,000 hours of service in a 12-month period commencing with the start of employment. Contributions to the Plan are based on percentages of employee salaries plus a matching contribution by the Company in an amount to be determined at the Company's discretion. Vesting in the Company's contributions is based on length of service over a five-year period. Contributions by the Company on behalf of all employees approximated $131,000, $77,000 and $35,000 during 1996, 1995 and 1994, respectively. (9) STOCK OPTIONS During 1994, the Company amended and restated the stock option plan adopted in 1992. Under the amended and restated Incentive Stock Option Plan ("Option Plan"), officers and key employees may be granted non-qualified stock options, incentive stock options, performance units, and stock appreciation rights. The Option Plan also provides for automatic annual grants to each non-affiliate director of non-qualified stock options to purchase up to 5,000 shares of Common Stock. The purchase price per share for such options will be equal to the fair market value of a share of Common Stock on the date of grant. Any such options will be exercisable one year after the date of grant and will terminate upon the earlier of 90 days following the date on which such director ceases to serve on the Board or 10 years after the date of grant. The exercise price of incentive stock options granted under the Option Plan must be equal to at least 100% of the fair market value of the stock subject to the option on the date of grant. The incentive stock options granted by the Company may not be exercised during the first six months from the date granted and thereafter generally become exercisable at a rate of 2.38% of the total shares subject to the option on and after the first day of each calendar month thereafter. The maximum term of a stock option under the Option Plan is 10 years. In the event employment is terminated for any reason other than gross and willful misconduct, death, or disability, vested options are exercisable within 30 days after such termination of employment. Termination due to gross and willful misconduct terminates the option as of the date of the misconduct. Upon death or disablement, vested options are exercisable within six months after the date of death or disablement by the executors, administrators, or applicable guardian of the optionee. The fair value of each option is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants in 1996 and 1995, respectively: risk-free interest rates of 6.0 percent and 6.2 percent; expected lives of 4 years and 4 years; expected volatility of 32 percent and 40 percent; and no dividends are expected to be paid. The following net income and earnings per share data reflect the pro forma effect of the stock-based compensation cost for the Company's stock option plan and employee stock purchase plan in accordance with Statement 123 (in thousands, except per share data): 1996 1995 - ---------------------------------------------------------- NET INCOME AS REPORTED $13,218 $10,358 PRO FORMA $11,337 $10,059 PRIMARY EARNINGS PER SHARE AS REPORTED $0.83 $ 0.65 PRO FORMA $0.73 $ 0.67 FULLY DILUTED EARNINGS PER SHARE AS REPORTED $0.83 $ 0.65 PRO FORMA $0.71 $ 0.63 - ---------------------------------------------------------- Pro forma net income and earnings per share data reflect only options granted in 1996 and 1995. NOTES TO FINANCIAL CONSOLIDATED STATEMENTS CONTINUED Stock option transactions for the years ended December 31, 1994, 1995 and 1996 are summarized as follows (in thousands, except price data): WEIGHTED AVERAGE SHARES EXERCISE PRICE - ---------------------------------------------------------- BALANCE, DECEMBER 31, 1993 1,056 $ 1.80 OPTIONS GRANTED 748 13.46 OPTIONS CANCELED (275) 3.58 OPTIONS EXERCISED (134) 1.25 - ---------------------------------------------------------- BALANCE AT DECEMBER 31, 1994 1,395 7.75 ========================================================== OPTIONS GRANTED 1,401 27.83 OPTIONS CANCELED (305) 11.41 OPTIONS EXERCISED (251) 3.24 - ---------------------------------------------------------- BALANCE AT DECEMBER 31, 1995 2,240 20.04 ========================================================= OPTIONS GRANTED 1,092 22.62 OPTIONS CANCELED (406) 21.60 OPTIONS EXERCISED (304) 9.58 - --------------------------------------------------------- BALANCE AT DECEMBER 31, 1996 2,622 $22.08 ========================================================= For the years ended December 31, 1996, 1995 and 1994 there were 472,108, 126,588 and 86,282 options exercisable, respectively. As of December 31, 1996, no stock options were available for future grants. The weighted-average grant-date fair values of options granted during 1996 and 1995 were $8.88 and $9.42 per share, respectively. The following table summarizes information about the stock options outstanding as of December 31, 1996 (options in thousands): OPTIONS OPTIONS OUTSTANDING EXERCISABLE ----------------------------------- ----------------------- WEIGHTED AVERAGE WEIGHTED WEIGHTED RANGE OF REMAINING AVERAGE AVERAGE EXERCISE NUMBER CONTRACTUAL EXERCISE NUMBER EXERCISE PRICES OUTSTANDING LIFE PRICE EXERCISABLE PRICE - ----------------------------------------------------------------------------- $ 1-15 539 7.5 years $10 208 $ 9 - ----------------------------------------------------------------------------- 17 644 10.0 17 0 17 - ----------------------------------------------------------------------------- 19-26 432 8.4 23 126 23 - ----------------------------------------------------------------------------- 28-30 579 9.2 29 58 29 - ----------------------------------------------------------------------------- 31-38 428 9.0 33 80 33 - ----------------------------------------------------------------------------- $ 1-38 2,622 8.9 $22 472 $19 - ----------------------------------------------------------------------------- (10) EMPLOYEE STOCK PURCHASE PLAN In 1995, the Stockholders of the Company approved the Alternative Resources Corporation Employee Stock Purchase Plan (the "Stock Purchase Plan"). An aggregate of 300,000 shares of the Company's Common Stock (subject to adjustment for any dividend, stock split or other relevant changes in the Company's capitalization) may be sold pursuant to the Stock Purchase Plan. The Stock Purchase Plan covers each employee who has completed 1,000 hours of service during the last 12 calendar months preceding the enrollment date. The Stock Purchase Plan enables employees to purchase the Company's Common Stock at 85% of the market price. Employees may purchase the Company's Common Stock through the Stock Purchase Plan only by payroll deduction. Payroll deductions may not exceed 20% of the employee's gross pay or $21,250 in any one year. During 1996 and 1995, all Stock Purchase Plan shares were purchased on the open market. In 1996 and 1995, the Company's matching portion to the Stock Purchase Plan amounted to $195,000 and $149,000, respectively. As required under Statement 123, these amounts have been reflected in the pro forma net income and earnings per share data (see Note 9). (11) CONCENTRATION OF CREDIT RISK The Company provides services to clients including systems integrators, telecommunications companies, banking and financial services entities, manufacturers, distributors, health care providers and utilities throughout the United States. In 1996, 1995 and 1994, the largest client accounted for approximately 13%, 11% and 6%, and the second largest client accounted for approximately 11%, 15% and 12% of the Company's total revenues, respectively. (12) LEGAL PROCEEDINGS The Company is involved in various claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Company's consolidated financial position, results of operations or liquidity. INDEPENDENT AUDITORS' REPORT THE BOARD OF DIRECTORS AND STOCKHOLDERS ALTERNATIVE RESOURCES CORPORATION We have audited the accompanying consolidated balance sheets of Alternative Resources Corporation and subsidiaries (the Company) as of December 31, 1996 and 1995, and the related consolidated statements of operations, changes in stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1996. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Alternative Resources Corporation and subsidiaries as of December 31, 1996 and 1995, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1996 in conformity with generally accepted accounting principles. KPMG PEAT MARWICK LLP Chicago, Illinois January 21, 1997 STOCKHOLDER INFORMATION Alternative Resources Corporation completed its initial public offering on May 2, 1994, at a split-adjusted price per share of $7.00. ARC's common stock is traded on the Nasdaq National Market under the symbol "ALRC." No cash dividends have been paid on the Common Stock since the initial trading. As of December 31, 1996, ARC had 174 stockholders of record (including brokerage firms and other nominees) and 15,651,391 outstanding shares of common stock. The table shows the reported high and low sale prices of the common stock for the periods indicated during the years ended December 31, 1995 and 1996 (all price data has been restated to reflect a two-for-one stock split effective May 22, 1995): 1996 1995 ------------------- ------------------- HIGH LOW HIGH LOW - ---------------------------------------------------------------------- FIRST QUARTER $33-1/4 $24 $20-1/8 $14-3/4 - ---------------------------------------------------------------------- SECOND QUARTER 44-1/2 30-1/2 27-1/2 18 - ---------------------------------------------------------------------- THIRD QUARTER 37-1/2 20-1/2 34 25-1/2 - ---------------------------------------------------------------------- FOURTH QUARTER 30-3/4 13-1/2 33-1/4 26-3/4 - ----------------------------------------------------------------------