1
U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(MARK ONE)
[X] Annual Report pursuant Section 13 or 15(d) of the Securities Exchange Act of
1934 For the fiscal year ended May 31, 2000
or
[ ] Transition report pursuant to section 13 or 15(d) of the Securities Exchange
Act of 1934 For the transition period from to
Commission File Number 000-28709
--------------------------------
THE CREDIT STORE, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 87-0296990
(State or other jurisdiction of incorporation or (I.R.S. Employer Identification Number)
organization)
3401 NORTH LOUISE AVENUE
SIOUX FALLS, SOUTH DAKOTA 57107 (800) 240-1855
(Address of principal executive offices (Registrant's telephone number,
and zip code) including area code)
Securities registered pursuant to Section 12(b) of the Act:
Name Of Each Exchange
Title Of Each Class On Which Registered
------------------- ---------------------
Common Stock, AMERICAN STOCK EXCHANGE
par value $0.01 per
Share
Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK, PAR
VALUE $0.001
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months, and (2) has been subject to such filing requirements
for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
Aggregate market value of common stock held by non-affiliates of Registrant,
based upon the last sale price of the Common Stock reported on the Over The
Counter Bulletin Board on August 1, 2000 was $75,306,524. Common stock
outstanding at August 1, 2000: 34,761,965 shares.
1
2
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's definitive proxy statement filed with the
Securities and Exchange Commission in connection with the solicitation of
proxies for the Registrant's 2000 Annual Meeting of Shareholders are
incorporated by reference in Part III, Items 10, 11, 12 and 13 of this Form
10-K.
2
3
PART I
This Form 10-K contains forward-looking statements within the meaning
of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. All forward-looking statements are
inherently uncertain as they are based on current expectations and assumptions
concerning future events or our future performance. Readers are cautioned,
therefore, not to place undue reliance on these forward-looking statements,
which are only predictions and speak only as of the date this report was filed.
Forward-looking statements are not descriptions of historical facts. The words
or phrases "will likely result," "look for," "may result," "will continue," "is
anticipated," "expect," "project," or similar expressions are intended to
identify forward-looking statements, and are subject to numerous known and
unknown risks and uncertainties. Actual results could differ materially from
those currently anticipated due to a number of factors, including those
identified below under the heading Cautionary Statements and Factors That May
Affect Future Results, and in the Company's other filings with the Securities
and Exchange Commission. The Company undertakes no obligation to update or
publicly announce revisions to any forward-looking statements to reflect future
events or developments.
ITEM 1. BUSINESS
The Credit Store, Inc. (the "Company") is a technology based, financial
services company that provides credit card products to consumers who may
otherwise fail to qualify for a traditional unsecured bank credit card. The
Company reaches these consumers by acquiring portfolios of non-performing
consumer receivables and offering a new credit card to those consumers who agree
to pay all or a portion of the outstanding amount due on their debt and who meet
the Company's underwriting guidelines. The new card is issued with an initial
balance and credit line equal to the agreed repayment amount. After the
consumers have made a certain number of on-time payments on their outstanding
credit card balance, the Company seeks to sell or securitize the credit card
receivables generated by this business strategy. The Company offers other forms
of settlement to those consumers who do not accept the credit card offer.
GENERAL DEVELOPMENT OF BUSINESS
The Company was incorporated in 1972 in Utah as Valley West Development
Corporation, changed its corporate domicile to Delaware in 1995, and changed its
name to Credit Store, Inc. on October 8, 1996. Prior to October 8, 1996, the
Company discontinued operations of its prior line of business, which was
unrelated to its current operations. On December 4, 1996, the Company acquired
from Taxter One LLC ("Taxter") all the capital stock of Service One Holdings
Inc. ("Holdings"). At the time of the acquisition, Holdings' sole asset was the
capital stock of Service One International Corporation ("SOIC"), which had been
engaged since January 1996 in the business of acquiring non-performing consumer
debt portfolios, and the marketing and servicing of credit cards generated from
these portfolios. From 1982 through December 1995, SOIC had been a marketer and
servicer of secured credit cards for a South Dakota bank under a contractual
arrangement which expired in December 1995. Following the acquisition of
Holdings, the Company engaged directly, and through SOIC and its affiliates, in
the acquisition of non-performing consumer debt and the marketing and servicing
of credit cards generated from these portfolios. In February 1998, Holdings and
Credit Store Mortgage, Inc., a wholly-owned subsidiary of the Company, were each
merged into the Company. In March 1998, SOIC was merged into the Company and the
Company name was changed to The Credit Store, Inc.
3
4
NARRATIVE DESCRIPTION OF BUSINESS
The Company is primarily in the business of providing credit card
products to consumers who may otherwise fail to qualify for a traditional
unsecured bank credit card. The Company primarily focuses on consumers who have
previously defaulted on a debt and reaches these consumers by acquiring their
defaulted debt. The Company acquires these defaulted accounts in large
portfolios typically from the original lender for a nominal percentage of the
face amount of the debt, ranging from 0.50% to 3.00%. Through its direct mail
and telemarketing operations, the Company locates and offers a new credit card
to those consumers who agree to pay all or a portion of the outstanding amount
due on their debt and who meet the Company's underwriting guidelines. The new
card is issued with an initial balance and credit line equal to the agreed
repayment amount. The Company's objective is to ultimately sell and/or
securitize these receivables at a price in excess of the Company's investment in
the receivables. To date, the Company has considered an account available to
sell or securitize ("seasoned") when the consumer has made eight or more on-time
payments on the consumer's outstanding credit card balance.
Under the Company's marketing approach, consumers are offered an
opportunity to settle their debt, typically at a discount, to transfer the
settled amount to a newly issued unsecured MasterCard(R) or Visa(R) credit card,
and to begin establishing a positive credit history on their newly issued card
by making timely and consistent payments. After making principal payments on the
transferred balance, the consumer can begin using the credit card for new
purchases or cash advances and may be granted increased credit limits over time
based on their payment performance. The Company's credit card offer is
attractive to those consumers who, given the nonperforming status of their debt,
are typically receiving few or no solicitations from traditional credit card
companies. Many of these consumers cannot easily obtain an unsecured credit
card, want to improve their credit standing or have experienced the negative
aspects of not having access to the credit card payment system for travel and
the daily purchase of goods and services. The Company's approach differs from
traditional credit card companies that compete for new customers through mass
marketing and direct mail campaigns on the basis of interest rates, fees, and
services offered.
INDUSTRY OVERVIEW
The Company operates in the consumer finance industry, competing with
issuers of revolving credit products and other buyers of non-performing consumer
debt.
The United States Federal Reserve reported that American consumers owed
an aggregate of $1.43 trillion of debt at the end of April 2000, exclusive of
home mortgages, and that the size of the revolving credit market in the United
States was in excess of $621 billion as of the end of April 2000, up from $570
billion in April 1999. The United States Federal Reserve also reported that
pools of securitized revolving credit assets totaled $322 billion at the end of
April 2000, up from $276 billion in April 1999. The Company believes that the
purchasing convenience associated with unsecured credit cards has driven the
growth of credit cards and has made them the preferred consumer credit vehicle.
In addition, the Company believes that the purchase of consumer goods and
services over the Internet will continue to fuel the demand for credit cards.
The Company also believes that the relative liquidity and predictability of
these assets has fostered the widespread acceptance of revolving credit
securitizations by investors.
4
5
While traditional banking organizations have enjoyed significant
advantages in consumer lending compared to non-bank providers of consumer loans,
greater access to capital and the emergence of securitization markets, coupled
with technological advances, has allowed non-banks to compete effectively with
banks in this arena. The Company believes that future success in the credit card
industry will continue to be experienced primarily by highly focused
organizations that are adept at using information and technology to market their
products and manage risk within their portfolios.
Credit card issuers make credit cards available to their clients in a
variety of ways. Many issuers offer cards as a convenience to existing clients,
a strategy to create greater affinity and client loyalty. This is generally the
case with credit cards offered by department stores, who offer private label
credit cards, as well as smaller banks and credit unions. In contrast, the
larger credit card issuers, who control the vast majority of the market, use
mass mailing of credit card offers to consumers as the most cost-effective means
of achieving the growth rates they seek. Often this process is accomplished by
obtaining a list of names of individuals who meet the issuer's credit guidelines
from one of the national credit bureaus.
The Company, however, sources its customers by purchasing charged-off
consumer debt from banks and finance companies and believes that the purchase of
charged-off debt is an efficient means to source new credit card customers in
its target market. The Company believes that the market for buying and selling
non-performing consumer debt portfolios has expanded due to a steadily
increasing volume of charged-off consumer debt coupled with a shift by
originating institutions toward selling their portfolios of non-performing
consumer loans. Historically, originating institutions had relied upon large
internal collection staffs for their initial collection efforts and outside
collection agencies for accounts delinquent more than 180 days. As buyers
emerged to purchase non-performing debt, originating institutions have
increasingly sold these portfolios for cash. Institutions will usually sell
accounts when the market prices exceed the net present value of retaining and
working the accounts. In deciding whether to sell accounts, sellers also
evaluate the potential return on investment of reinvesting the cash proceeds
from portfolio sales in the core operations of originating and servicing new
loans.
According to Faulkner & Gray, a leading receivables management
publisher, the sales volume of charged-off debt by initial credit grantors has
grown from $2.5 billion in 1990, to $18.5 billion in 1998, to an estimated $42.0
billion in 1999. The 1999 estimate includes resale volume which accounted for
approximately 25% of the 1999 estimate. Sellers have developed a variety of ways
to sell non-performing receivables. Some originating institutions pursue auction
type sales by constructing a portfolio of receivables and seeking bids from
specially invited competing parties. This approach has resulted in an increase
in the number of receivables portfolios offered for sale by account brokers.
Other means of selling receivables include privately negotiated direct sales
when the originating institution contacts known, reputable purchasers.
Originating institutions have also entered into "forward flow" sales contracts.
These contracts require an originating institution to sell some or all of its
receivables that meet specified criteria, such as balance size and elapsed time
since delinquency, to a single purchaser during a specified period of time for
an agreed upon price.
BUSINESS OPERATIONS
The Company's operations integrate the following disciplines: (1)
portfolio acquisitions and divestitures; (2) marketing and card origination; (3)
customer service and collections; and (4) receivables sales and securitizations.
5
6
PORTFOLIO ACQUISITIONS AND DIVESTITURES:
The Company acquires non-performing credit card receivables, consumer
installment loans, and automobile deficiencies on a nationwide basis, from a
wide range of originating institutions, including banks and finance companies.
The Company has acquired in excess of $4.8 billion in receivables. These
portfolios have been purchased by the Company for prices typically ranging from
0.50% to 3.00% of the receivable balance. A typical portfolio contains between
5,000 and 150,000 consumer accounts that have been typically charged-off by the
original lending institution and have passed through various stages of
collection efforts. The size of each account has typically ranged between $1,000
and $6,000, with an average balance of approximately $2,100.
The consumer debt and credit card industries generally categorize
delinquent and charged-off accounts into three groups: primary, secondary and
tertiary. Primary accounts are typically 120 to 270 days past due and are in the
process of being placed with collection agencies or collection attorneys for the
first time. Secondary accounts are 270 to 360 days past due and may have already
been placed with one collection agency. Tertiary accounts have already been
placed unsuccessfully with more than two collection agencies. The Company
acquires primarily tertiary accounts.
The Company has also purchased "bankruptcy" and "out of statute"
accounts. A "bankruptcy account" is one in which the debtor has filed a
bankruptcy petition and may have had its debt discharged. The Company is not
presently offering credit cards to bankruptcy accounts. An "out of statute"
account is one in which the statute of limitations for collection of the debt
has expired. Debt that is "out of statute" will not be enforced by a court of
law. Accordingly, the likelihood of recoveries from such accounts is lower than
on accounts that are currently enforceable by a court of law.
The Company continually seeks new and continuing sources of
non-performing portfolios for purchase. Once such portfolios are located, an
acquisition team is responsible for coordinating due diligence, stratifying and
analyzing the portfolio characteristics, projecting conversions to new credit
cards and the total cash collections on the accounts. The acquisition team is
also responsible for preparing bid proposals for review and approval by senior
management, processing and tracking the bids, documenting and closing the
purchase, and coordinating the receipt of account documentation and media for
acquired portfolios.
The Company uses its proprietary analytical methodology and database to
evaluate a potential portfolio purchase. The Company has developed a large and
valuable database of performance characteristics from the $4.8 billion of
receivables it has purchased since inception that enables it to estimate future
portfolio performance. This methodology and database comprise the model which
the Company uses to analyze and price the potential portfolio purchase. The
Company believes that its methodology permits it to accurately price portfolio
purchases so it may realize an appropriate return on capital from its new credit
card originations and the subsequent cash flows generated from these new credit
cards.
The Company has developed a discipline of reselling portfolios into the
secondary market. In general, the Company resells portfolios when the price that
other debt buyers are willing to pay exceeds the net present value of the cash
flows that the Company expects to generate over the remaining life of the
portfolio. To date, the company has resold approximately $1.6 billion of
non-performing debt into the secondary market through auctions and directly
negotiated transactions.
6
7
MARKETING AND CARD ORIGINATION:
MARKETING. Once a portfolio acquisition is completed, the receivables
and accounts in an acquired portfolio are processed by the Company's marketing
and card origination departments. The Company believes that its consumer
friendly and hands-on approach to the consumer is a key component of its
business strategy. Many of the receivables acquired by the Company represent
obligations of individuals who have, in the past several years, experienced some
life-altering event, such as divorce, career displacement or major medical
illness, and have recovered or currently are recovering financially from their
setback. Potential customers are contacted through direct mail and by telephone
and offered the opportunity to settle their debt and obtain an unsecured credit
card which can be used to make new purchases. A customer who accepts the
Company's offer, and meets the Company's underwriting guidelines, is issued a
new unsecured credit card by one of the Company's unaffiliated issuing banks.
The card has an outstanding balance and credit limit equal to the amount agreed
upon by the customer to settle the outstanding debt. As the customer makes
principal payments on the outstanding balance, the customer frees up the credit
limit for new purchases. In addition, the Company may increase the credit limit
for customers who make a certain number of payments on the settled amount. The
Company reports the payment history on the credit card to the major credit
bureaus. The Company believes that its credit card product provides its
customers with an opportunity to establish a positive payment history on their
credit record by making timely and consistent payments on their new credit
cards.
The Company believes its credit card product affords it more
flexibility in working with the consumer than the originating institution or
third-party collection agency who are simply attempting to recover all or a
portion of the amount owed on an account. Factors that contribute to this
increased flexibility include: (i) the Company is able to settle the account
with the consumer at an amount that fits within the consumer's budget because
the Company acquired the account at a typical range of 0.50% to 3.00% of the
actual outstanding balance; (ii) the Company offers a new unsecured credit card
which has utility to the consumer due to its revolving nature; (iii) the Company
is not limited by many of the cultural and regulatory constraints that influence
account resolution decisions of banks, savings and loan and other financial
institutions; and (iv) the Company is not bound by the limited time periods to
resolve receivables faced by third-party collection agencies.
CARD ORIGINATION. In the Company's experience, much of the account
information contained in the portfolios it acquires is stale. Accordingly, once
a particular portfolio has been purchased, a "scrubbing" process begins.
Scrubbing describes the process of electronically updating phone numbers and
addresses on each account purchased and searching for bankrupt and deceased
accounts. Scrubbing is done pursuant to an agreement with a third party that
specializes in locating consumers with little or no credit history. The Company
has also developed proprietary models which allow it to focus on accounts with
the best marketing potential. The Company believes that using third-party
scrubbing services produces quality results and allows it to efficiently focus
its resources on marketing and servicing its customers. Contemporaneously with
the initial scrubbing, the Company conducts an analysis to determine which
accounts in the acquired portfolio should be returned to the seller because they
do not meet the criteria established for each account under the terms of the
portfolio acquisition agreement. Although the terms of each portfolio
acquisition agreement differ, examples of accounts that may be returned under
the typical portfolio acquisition agreement include debts paid off prior to the
Company's acquisition, debts in which the consumer filed bankruptcy prior to the
Company's acquisition and debts in which the consumer was deceased prior to the
Company's acquisition. Typically, the agreement with the seller of the portfolio
allows the Company to return such non-qualifying accounts in the portfolio for a
specified period of time, which is generally between 120 and 180 days from the
date of purchase. Under the
7
8
typical portfolio acquisition agreement, the seller either replaces a returned
account or refunds the portion of the purchase price attributable to the
account.
Once the portfolio has been scrubbed, the Company uses both direct mail
and phone contact to market the credit card product. The Company operates a
25,000 square foot direct mail and account file storage center (the "Mail
Center") in Sioux Falls, South Dakota. The Mail Center is equipped with
high-speed printing, folding, inserting, zip sorting and mailing equipment
capable of sending 180,000 pieces per day. Having its direct mail operations
in-house allows the Company to manage high quality direct mail campaigns in a
cost-effective manner. The Mail Center is linked electronically with the
Company's Operation Center, allowing the Mail Center to receive database
information to print and mail specific mail campaigns. The Company also
maintains a trained sales force that operates from the Company's Sioux Falls,
South Dakota headquarters. The group is supported by a state-of-the-art
auto-dialer, which enables sales agents to effectively manage their large
inventory of accounts. The Company employs approximately 70 sales agents (35 per
shift) which results in 100,000 to 150,000 production hours annually. The
Company currently has space and system capacity to significantly expand its
telemarketing sales force. The auto-dialer enhances productivity via high-speed
dialing coupled with a screening process to detect no-answers, nonexistent
numbers and answering machines. This technology allows sales agents to
concentrate their efforts on actual customers. In addition to outgoing calls,
the Company receives incoming calls that are prompted by mailings. Incoming
calls are routed directly to the telemarketing department where sales agents
service the inquiry.
The sales agents are trained to understand the customer base, keeping
in mind that the individual has experienced collection efforts employed by
several agencies. The Company believes the utility of an unsecured credit card
often is a major benefit to this segment of consumers because they may not
qualify for a traditional unsecured account. The Company also believes that an
important feature of its program is the opportunity to settle an old account and
to gain the opportunity to establish a positive payment history on one's credit
record by making timely and consistent payments on a new credit card.
The table below summarizes the Company's standard credit card program as
currently offered:
Initial Credit Line: Settlement Amount
Annual Fee: $0 the 1st year; $35 annual thereafter
Interest Rate: 18.9% or 19.9%
Grace Period: 25 Days
Late Fee: $10.00
Over Limit Fee: $10.00
Cash Advance Fee: Greater of 2% or $2.00
Minimum Payment: Greater of 3% or $10.00
Applicants who meet defined underwriting or exception criteria are
notified of acceptance into the program and issued a card. Although the initial
credit limit of the credit card is fully utilized when issued, an applicant
regains availability of credit on the card as and to the extent the applicant
makes principal payments. The applicant may also earn additional credit by
establishing a positive payment history with the Company. Applicants failing to
meet the defined underwriting or exception criteria are notified of denial in
accordance with the Equal Credit Opportunity Act. Such applicants are offered
installment and lump sum payment options to settle their debt. Historically,
over 90% of the applicants have qualified for the credit card.
8
9
Once a customer has accepted the offer and has cleared the underwriting
process, the relevant data is transmitted to First Data Resources, Inc. ("FDR")
to establish the new account on FDR's credit card processing system. The Company
has arranged, through two unaffiliated banks, to issue the credit cards and for
FDR to provide certain cardholder services including data processing, card
issuance, monthly customer statement processing, and customer correspondence.
FDR is a subsidiary of First Data Corporation, a provider of information
processing and related services, including cardholder processing and merchant
processing, for major financial institutions throughout the United States. The
Company believes that outsourcing these services to FDR gives the Company
certain operational efficiencies and the flexibility to handle additional
growth.
The Company also offers the convenience of an Automatic Payment Program
to its customers, whereby the customer authorizes the Company to withdraw from
the customer's bank account the monthly minimum credit card payment.
Approximately 18% of the Company's customers are currently using the Automatic
Payment Program. Accounts on the Automatic Payment Program have a lower
incidence of delinquency than those accounts that are not on the Automatic
Payment Program.
For any customer who does not wish to maintain a new credit card
account but who agrees to settle the previously charged-off debt account, the
Company has established a resolutions department whereby the customer can make
an installment or lump sum payment to settle the obligation.
CARDHOLDER SERVICES:
The Company believes that in order to maximize the customer's payment
performance, it is imperative to have a sophisticated, highly structured
hands-on approach to educating and servicing the customers and addressing
situations that would result in default without attention and assistance from
the Company. The retention group, the cardholder services group, and the
servicing (collections) group are key components of the Company's credit card
servicing and collections functions.
The retention group conducts, among other services, the Company's
"Welcome Aboard" program by verifying that the customer has received the credit
card and that the customer thoroughly understands the program and how to use the
credit card. In addition, the retention group places calls to customers at other
critical junctures, including approximately fifteen days prior to the first
payment due date and at various other specified times if a customer becomes
delinquent in his payments. The retention group also pursues all first payment
defaults. These calls are a part of the Company's educational approach with
customers that stresses the importance and benefits of making timely and
consistent payments.
The cardholder services group handles calls from customers regarding
their accounts, including balance inquiries, billing inquires and disputes,
requests for replacement cards, requests for temporary credit line increases and
requests for evidence of account activity. Cardholder services representatives
counsel the customer on use of the card and continue the process of instilling
the importance and benefits of making timely and consistent payments.
The servicing group is responsible for collection of delinquent credit
card accounts in a prompt, professional and thorough manner in order to reduce
net credit losses. The Company uses state of the art predictive and power
dialing technology to maximize collector productivity, and heavily emphasizes
the "instant payment" products such as Western Union Quick Collect. Collection
calls are prioritized using Adaptive Control (a Fair, Isaac scoring model
implemented through the FDR servicing platform) and are based on models
9
10
developed by the Company for its specific customer base. The Company maintains a
strict re-age policy which allows accounts to be re-aged if the cardholder
displays a desire to correct the status of the account as well as an ability to
continue making monthly payments on the account. The Company has systemic
restrictions in place which prevent customer service representatives from
performing unauthorized re-aging of accounts. In an effort to maximize cash
flow, the settlement of an account may be negotiated in cases where the Company
has determined that the account is destined to become a charge-off and there is
no potential to retain the customer. Accounts are charged off and taken as a
loss either after formal notification of bankruptcy or when they become
contractually 180 days past due, which time period the Company recently extended
from 120 days based on general industry practices. Accounts identified as fraud
losses are immediately reserved for and charged off no later than 90 days after
the last activity. Charged-off accounts are referred to the Company's
Resolutions Department for further recovery efforts.
FINANCINGS, RECEIVABLE SALES, AND SECURITIZATIONS:
An important piece of the Company's business strategy is to securitize
seasoned receivables and/or sell seasoned receivables to third parties for cash,
thereby realizing a gain in an amount equal to the excess of the cash proceeds
from the sale or securitization over the Company's cost basis in the
receivables. To date, the Company has considered an account available to sell or
securitize when the consumer has made eight or more on-time payments on the
consumer's outstanding credit card balance.
The Company uses a variety of debt instruments to fund its operations
and portfolio acquisitions including subordinated debt, senior secured debt, and
non-recourse debt. The ability to borrow based on the collateral value of its
asset base is integral to the operations and growth plans of the Company.
The Company has significant ongoing cash needs to fund its operations
and to fund the purchase of non-performing consumer debt portfolios. The
Company's ability to sell or securitize the receivables and/or finance these
receivables on-balance sheet is critical to the future and growth of the
business. In order to finance, sell or securitize its receivables, the Company
maintains a detailed database concerning the status and performance of each of
the receivables in its portfolio. Maintaining this database is necessary for the
Company to provide historical performance information to potential lenders and
purchasers of its receivables. Potential lenders and purchasers assess the
Company's portfolio of receivables according to a variety of factors including
monthly repayment rates by the cardholders and annualized default rates.
COMPETITIVE CONDITIONS
The Company experiences competition in all segments of its business
operations. The Company competes with a wide range of third-party collection
companies and other financial services companies seeking to purchase portfolios
of non-performing consumer debt and with traditional collection companies
seeking consignments of such debt for collection. The Company also competes with
companies that provide financing to consumers that have previously defaulted on
a debt obligation. As more buyers enter the market to purchase portfolios of
non-performing consumer debt, the price for the purchase of such portfolios may
increase and the Company's business strategy may become less profitable or
viable. Some of these competitors may have substantially greater personnel and
financial resources than the Company. In addition, to the extent consumers with
negative credit history have less difficulty obtaining credit, especially
obtaining unsecured credit cards, there may be less consumer demand for the
Company's product. The Company believes it competes effectively
10
11
based on what it believes are superior information technology capabilities,
which enable it to evaluate and purchase receivables more effectively than some
of its competitors. Further, the Company believes it differentiates itself from
most of its competitors through its innovative credit card program, which allows
the consumer to resolve a prior obligation in a positive manner.
The Company anticipates that additional competitors will seek to enter
its niche within the financial services market. Because of the high costs in
developing and servicing a credit card program and the high costs of acquiring
non-performing consumer debt, the Company believes that new competitors will
likely be large, established finance companies.
GOVERNMENT REGULATION
The Company's collection practices, business operations and credit card
receivables are subject to numerous federal and state consumer protection laws
and regulations imposing licensing and other requirements with respect to
purchasing, collecting, making and enforcing consumer loans. The Company
conducts periodic compliance reviews and, if necessary, implements procedures to
bring the Company into compliance with all applicable state and federal
regulatory requirements. The failure to comply with such statutes or regulations
could have a material adverse effect on the Company's results of operations or
financial condition.
The Fair Debt Collection Practices Act and comparable state statutes
establish specific guidelines and procedures that debt collectors must follow to
communicate with consumer debtors, including the time, place and manner of such
communications. It is the Company's policy to comply with the provisions of the
Fair Debt Collection Practices Act and comparable state statutes in all of its
collection activities, although it may not be specifically subject thereto. If
these laws apply to some or all of the Company's collection activities, the
Company's failure to comply with such laws could have a material adverse effect
on the Company.
As a purchaser of consumer receivables, the Company may acquire certain
receivables subject to legitimate claims, defenses or rights of offset on the
part of the consumer. As a result, the Company may not be able to collect
certain receivables it has purchased. For example, the Company, as previously
described, acquires "out of statute" accounts which are subject to a statute of
limitations defense, and may also acquire some credit card accounts where
customers cannot be held liable for, or their liability may be limited with
respect to, charges to a credit card account that were a result of an
unauthorized use of a credit card.
While the Company itself is not a credit card issuer, because many of
its receivables are originated through credit card transactions, certain of the
Company's operations are affected by federal and state consumer protection and
related laws and regulations that apply to the marketing and extension of credit
by a credit card issuer. Significant laws include the Federal Truth-In-Lending
Act, the Fair Credit Billing Act, the Equal Credit Opportunity Act, the Fair
Credit Reporting Act, the federal Credit Repair Organization Act, and the
Electronic Funds Transfer Act (and the Federal Reserve Board's regulations which
relate to these Acts), as well as comparable statutes in those states in which
customers reside or in which the originating institutions are located. State
laws may also limit the interest rate and the fees that a credit card issuer or
other consumer lender may impose on its customers. Among other things, the laws
and regulations applicable to credit card issuers impose disclosure requirements
when a credit card account is advertised, when it is applied for and when it is
opened, at the end of monthly billing cycles and at year end. Federal law
requires credit card issuers to disclose to consumers the interest rates, fees,
grace periods and balance calculation methods associated with their credit card
11
12
accounts, among other things. In addition, customers are entitled under current
laws to have payments and credits applied to their credit card accounts
promptly, to receive prescribed notices and to require billing errors to be
resolved promptly. In addition, some laws prohibit certain discriminatory
practices in connection with the extension of credit. Failure by the originating
institutions or the Company to comply with applicable statutes, rules and
regulations could create claims and/or rights of offset by the customers which
could have a material adverse effect on the Company.
Changes in any such laws or regulations, or in the interpretation or
application thereof, could have a material adverse effect on the Company.
Various proposals which could affect the Company's business have been introduced
in Congress in recent years, including, among others, proposals relating to
imposing a statutory cap on credit card interest rates, substantially revising
the laws governing consumer bankruptcy, limiting the use of social security
numbers, permitting affiliations between banks and commercial, insurance or
securities firms, and other regulatory restructuring proposals. There have also
been proposals in state legislatures in recent years to restrict telemarketing
activities, impose statutory caps on consumer interest rates, limit the use of
social security numbers and expand consumer protection laws. It is impossible to
determine whether any of these proposals will become law and, if so, what impact
they will have on the Company.
Due to the consumer-oriented nature of the collections and credit card
industry, there is a risk that the Company or other industry participants may be
named as defendants in litigation involving alleged violations of federal and
state laws and regulations, including consumer protection laws and consumer law
torts, including fraud. A significant judgment against the Company or within the
industry in connection with any such litigation could have a material adverse
effect on the Company's results of operations or financial condition. See "Item
3 - Legal Proceedings."
EMPLOYEES
As of May 31, 2000, the Company had 305 employees. No employee group is
covered under a collective bargaining agreement. The Company conducts on-site
training in all facets of its business and does not anticipate difficulties in
hiring from the local market. The Company believes its relationship with its
employees is good.
TECHNOLOGY AND SYSTEMS
The Company utilizes a variety of management information and
telecommunications systems to enhance productivity in all areas of its business.
The Company utilizes the latest technology in its operations and employs
multiple levels of backup to minimize the risk of systemic breakdown. The
Company believes that advanced technology is key to maintaining a competitive
advantage and seeks to maximize the use of technology. New technologies are
continually evaluated for business appropriateness and cost effectiveness.
The Company uses a proprietary credit card origination and servicing
system ("NOCS") which puts all aspects of the Company's operation on a seamless
platform from the time a new portfolio is purchased until an account is
converted to a new credit card and set up on the First Data Resources credit
card servicing platform. NOCS includes specialized applications for telesales,
underwriting, non-card collections, payment processing, account scrubbing,
portfolio stratification, and customer service.
12
13
The overall computing platform is client-server, Windows NT/SQL based,
and is scaleable to accommodate the Company's growth plans. The Company employs
the latest technology in telephony, including a predictive auto-dialer and voice
recognition technology. The telephony platform is capable of supporting in
excess of 2,000 workstations and the Company believes it is easily expandable to
accommodate the Company's growth plans.
The Company uses FDR as its third party processor of credit card data
and merchant interchange. FDR also processes and mails the monthly cardholder
statements. FDR, the largest card processor in the world, provides these
services to major financial institutions throughout the United States.
The Company uses image-based technology and processing to minimize
paper flow wherever possible. The Company has also invested in the latest
electronic data warehousing technologies to support its data mining strategies.
The Company believes data warehousing gives it a distinct competitive advantage
in the portfolio analysis and acquisitions aspect of its business. In addition,
the Company believes data warehousing will give it an advantage in the
securitization markets through its ability to provide a sophisticated level of
performance detail to investors.
THIRD-PARTY SERVICING
At May 31, 2000, the Company serviced over 27,000 accounts subject to
third party servicing agreements. The Company intends to concentrate on
servicing its own accounts and accounts that it has either securitized or sold
to third party investors.
ITEM 2. PROPERTIES
The Company's headquarters consist of a 30,000 square foot leased
facility in Sioux Falls, South Dakota. The lease expires on September 30, 2011.
The Company owns an additional 5 acres of undeveloped property adjacent to this
site that can be utilized for expansion purposes.
The Company's Mail Center consists of a separate 25,000 square foot
leased facility in Sioux Falls, South Dakota. The lease was renewed to extend
the terms of the lease for one year commencing on March 1, 2000 and ending on
February 28, 2001.
The Company also leases approximately 4,500 square feet of additional
office space in Sioux Falls, South Dakota. The lease commenced on June 1, 2000
and expires on May 31, 2001.
ITEM 3. LEGAL PROCEEDINGS
The Company, in the ordinary course of business, receives
notices of consumer complaints from regulatory agencies and reviews these
complaints in accordance with internal policy. Certain of the litigation pending
against the Company is described below.
During 1996 and 1998, the Company, and certain former officers and
directors were sued in three class actions. These class actions generally allege
that the persons in the class were purportedly solicited to
13
14
voluntarily repay debt that had been discharged in bankruptcy, and that the
Company had violated other provisions of federal or state law, including
violations of the Bankruptcy Code, the Fair Debt Collection Practices Act, the
Truth in Lending Act, various state consumer protection laws and, in one case,
RICO. The Company was sued (i) in 1996 in the United States District Court for
the Northern District of Illinois in an action entitled Louis G. Apostol, as
Administrator for the Estate of Curtis Kim v. M. Reza Fayazi, et al.; (ii) in
1998 in the United States District Court for the District of Rhode Island in an
action entitled McGlynn v. The Credit Store, Inc., et al.; and (iii) in the
United States District Court for the Northern District of Illinois in an action
entitled Le v. The Credit Store, Inc., et al. The complaints in these actions
seek monetary damages, declaratory judgments that the agreements reached with
plaintiffs have no legal effect, injunctive relief to prohibit defendants from
purchasing or selling debts that have been discharged in bankruptcy and to
rescind any such agreements, and to require cessation of collection efforts and
the removal of debts from credit reports, and in one case criminal contempt.
While the Company has admitted no liability or wrongdoing, the parties have
executed a settlement agreement, which also consolidated these three cases for
settlement purposes. The settlement agreement will be subject to court approval.
On May 27, 1999, the Company was sued on behalf of a class of Florida
debtors in the United States District Court for the District of Florida in an
action entitled McIntyre v. Credit Store Inc. On May 21, 1999, the Company was
sued on behalf of a class of Arizona debtors in the United States District Court
for the District of Arizona in an action entitled Bingham v. The Credit Store,
Inc. Both actions allege that communications sent by the Company to class
members violate the Fair Debt Collection Practices Act and similar state laws in
connection with attempts to collect out of statute debt. Both complaints seek
monetary damages and declaratory judgments that the Company's mailers violate
statutory provisions.
In February 2000, the Company was sued in United States District Court
for the District of New York in an action entitled Sturm v. Bank of New York.
The suit alleges that communications sent by the Company to class members
violate the Fair Debt Collection Practices Act. The complaint seeks monetary
damages for the alleged violations as well as for restitution and unjust
enrichment. While the Company has admitted no liability or wrongdoing, the
parties have negotiated and are in the process of executing a settlement
agreement. The settlement agreement will be subject to court approval.
In February 2000, the Company and certain officers and directors were
sued in United States District Court for the Northern District of Illinois in an
action entitled Greene v. Burke, et al., No. 000 1039 (N.D. IL.). The suit was
brought on behalf of a class of certain Illinois debtors alleging violations of
the Fair Debt Collection Practices Act, the Federal Credit Repair Organization
Act, and the Illinois Credit Services Organization Act arising out of the
Company's attempts to collect out-of-statute debts. The complaint seeks actual,
statutory and punitive damages on behalf of the class.
The Company is defending itself vigorously in these lawsuits. The
Company does not believe that pending litigation and regulatory complaints
involving the Company will have a material adverse effect on the consolidated
financial position and results of operations. However, a significant judgment
against the Company in one or more of the lawsuits could subject the Company to
a monetary judgment and/or require the Company to modify its methods of
operation, either of which could have a material adverse effect on the Company's
results of operations or financial condition.
14
15
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
By written consent of majority shareholder dated July 19, 2000, the
majority shareholder approved a proposal to amend The Credit Store, Inc. Amended
1997 Stock Option Plan by increasing the number of shares of Common Stock
available for issuance under the plan by 4.0 million shares. The amendment
increased the number of shares available for issuance under the plan to a total
of 8.0 million shares.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET PRICE OF AND DIVIDENDS ON THE COMPANY'S COMMON STOCK AND RELATED
STOCKHOLDER MATTERS
Prior to August 27, 2000, the Company's Common Stock was traded on the
Over the Counter Bulletin Board under the trading symbol "PLCR". Effective
August 28, 2000, the Company's Common Stock will be traded on the American Stock
Exchange under the trading symbol "CDS".
The high and low bid prices for the Company's Common Stock for each
quarter for the past two fiscal years were as follows:
Period High Low
-------------- ------------ -----------
1999 First Quarter $ 3 7/8 $ 1 7/8
Second Quarter 2 3/4 1 3/4
Third Quarter 2 15/16 1 7/8
Fourth Quarter 2 5/8 1 15/16
2000 First Quarter $ 3 17/32 $ 2 13/32
Second Quarter 5 7/15 2 9/16
Third Quarter 5 1/4 3 15/16
Fourth Quarter 5 1/2 3 3/4
As of August 1, 2000, there were 260 holders of record of the Company's
Common Stock.
The Company has not paid any cash dividends on its Common Stock and
does not anticipate paying cash dividends in the foreseeable future. The Company
anticipates that it will follow a policy of retaining earnings, if any, to
finance the expansion and development of the Company. The Board of Directors of
the Company will review its dividend policy from time to time to determine the
feasibility and desirability of paying dividends, after giving consideration to
the Company's results of operations, financial condition, capital requirements
and such other factors as the Board of Directors deems relevant.
15
16
Each issued and outstanding share of Series A Preferred Stock and
Series B Preferred Stock will be entitled, as and when declared by the Board of
Directors, to receive, out of any assets at the time legally available therefor,
dividends at the rate of 5% per share, per annum. Such dividends on the Series A
and Series B Preferred Stock are prior in preference to any outstanding shares
of Common Stock or of Preferred Stock, other than Series D and Series E
Preferred Stock.
Subject to the right of the holders of the Series B Preferred Stock to
receive a preferential dividend, the holders of shares of Series C Preferred
Stock will be entitled, as and when declared by the Board of Directors, to
receive, out of any assets at the time legally available therefor, dividends at
the rate of 6% per share per annum, payable in cash commencing on December 31,
1997. Such dividends on the Series C Preferred Stock are prior in preference to
any declaration or payment of any distribution on any outstanding shares of
Common Stock or any Preferred Stock, other than Series A, Series B, Series D and
Series E Preferred Stock.
The holder of shares of Series D Preferred Stock will be entitled, as
and when declared by the Board of Directors, to receive, out of any assets at
the time legally available therefor, dividends at the rate of 8% per share per
annum, payable in cash commencing on December 31, 1998 and thereafter on the
last day of December of each year that any such shares are outstanding. Such
dividends on the Series D Preferred Stock are prior in preference to any
declaration or payment of any distribution on any other outstanding shares of
Common Stock or of Preferred Stock, other than Series E Preferred Stock.
The holders of shares of Series E Preferred Stock shall be entitled to
receive, out of any assets at the time legally available therefor and when and
as declared by the Board of Directors of the Company, dividends calculated on
the stated value per share at the rate of 8% per share per annum, payable in
cash commencing on December 31, 1998, and thereafter on the last day of December
of each year that any such shares shall be outstanding. Such dividends on the
Series E Preferred Stock are prior in preference to any declaration or payment
of any distribution on any other outstanding shares of Common Stock or Preferred
Stock.
Other than the foregoing, the Company does not anticipate the
declaration or payment of any dividends in the foreseeable future. There can be
no assurance that cash dividends of any kind will ever be paid.
RECENT SALES OF UNREGISTERED SECURITIES
The Company issued the following securities during the prior three
fiscal years without registering the securities under the Securities Act:
Issuance of Capital Stock:
1. On January 2, 1998, the Company privately sold 1,250,000 shares of
Common Stock to the Lancer Group for aggregate consideration of $2.5
million.
2. On February 2, 1998, the Company privately sold 1,250,000 shares of
Common Stock to the Lancer Group for aggregate consideration of $2.5
million.
16
17
3. On May 29, 1998, the Company issued 10,000 shares of Series D Preferred
Stock to J.L.B. of Nevada, Inc. ("JLB")in exchange for JLB agreeing to
cancel $10.0 million of the principal outstanding under the $10.0
million Subordinated Promissory Note dated August 1, 1997.
4. On August 31, 1998, the Company issued 10,000 shares of Series E
Preferred Stock to JLB in exchange for JLB agreeing to cancel $10.0
million of the principal outstanding under the $20.0 million
Subordinated Promissory Note dated August 1, 1997.
Grant of Stock Options and Warrants:
1. On December 15, 1997, the Company granted options to purchase 935,500
shares of Common Stock under the Amended 1997 Stock Option Plan at an
exercise price of $2.00 per share to employees, granted options to
purchase 1,000,000 shares of Common Stock under the Amended 1997 Stock
Option Plan at an exercise price of $2.00 per share to a director of
the Company and granted options to purchase 600,000 shares of Common
Stock at an exercise price of $2.00 per share to employees.
2. On January 16, 1998, the Company granted options to purchase 170,500
shares of Common Stock under the Amended 1997 Stock Option Plan at an
exercise price of $2.50 per share to employees.
3. On April 30, 1998, the Company issued to Coast Business Credit, a
division of Southern Pacific Bank, a warrant to purchase 650,247 shares
of the Common Stock at an exercise price of $2.50. The warrant was
issued in connection with a loan from Coast Business Credit to the
Company.
4. On August 3, 1998, the Company granted options to purchase 10,000
shares of Common Stock under the Amended 1997 Stock Option Plan at an
exercise price of $3.00 per share to employees.
5. On August 10, 1998, the Company granted options to purchase 300,000
shares of Common Stock under the Amended 1997 Stock Option Plan at an
exercise price of $2.70 per share to employees.
6. On September 15, 1998, the Company granted options to purchase 10,000
shares of Common Stock under the Amended 1997 Stock Option Plan at an
exercise price of $2.00 per share to employees.
7. On November 23, 1998, the Company granted options to purchase a total
of 150,000 shares of Common Stock under the Amended 1997 Stock Option
Plan at an exercise price of $2.00 per share to two directors of the
Company.
8. On February 15, 1999, the Company granted options to purchase 13,000
shares of Common Stock under the Amended 1997 Stock Option Plan at an
exercise price of $2.38 per share to employees.
9. On March 17, 1999, the Company granted options to purchase 200,500
shares of Common Stock under the Amended 1997 Stock Option Plan at an
exercise price of $2.00 per share to employees.
10. On March 18, 1999, the Company issued a warrant to purchase 1,000,000
shares of Common Stock to Business Transactions Express, Inc. at an
exercise price of $2.00 per share. The warrant was issued in connection
with the execution of a strategic modeling services agreement between
the Company and Business Transactions Express, Inc.
17
18
11. On March 22, 1999, the Company granted options to purchase 3,500 shares
of Common Stock under the Amended 1997 Stock Option Plan at an exercise
price of $2.30 per share to employees.
12. On March 29, 1999, the Company granted options to purchase 3,500 shares
of Common Stock under the Amended 1997 Stock Option Plan at an exercise
price of $2.30 per share to employees.
13. On April 15, 1999, the Company granted options to purchase 75,000
shares of Common Stock under the Amended 1997 Stock Option Plan at an
exercise price of $2.19 per share to a director of the Company.
14. On June 1, 1999, the Company granted options to purchase 503,000 shares
of Common Stock under the Amended 1997 Stock Option Plan at an exercise
price of $2.40 per share to employees.
15. On May 29, 1999, the Company issued a warrant to purchase 4,000,000
shares of Common Stock to JLB at an exercise price of $3.25 per share
issued as partial consideration for JLB's forgiveness of certain
interest owed to JLB by the Company.
16. On July 26, 1999, the Company granted options to purchase 10,000 shares
of Common Stock under the Amended 1997 Stock Option Plan at an exercise
price of $2.88 per share to employees.
17. On August 1, 1999, the Company granted options to purchase 22,000
shares of Common Stock under the Amended 1997 Stock Option Plan at an
exercise price of $3.00 per share to employees.
18. On August 3, 1999, the Company granted options to purchase 10,000
shares of Common Stock under the Amended 1997 Stock Option Plan at an
exercise price of $2.97 per share to employees.
19. On August 27, 1999, the Company granted options to purchase 10,000
shares of Common Stock under the Amended 1997 Stock Option Plan at an
exercise price of $2.69 per share to a consultant.
20. On September 1, 1999, the Company granted options to purchase 1,500
shares of Common Stock under the Amended 1997 Stock Option Plan at an
exercise price of $2.75 per share to employees.
21. On September 10, 1999, the Company issued a warrant to purchase 25,000
shares of Common Stock to Cappello Capital Corp. at an exercise price
of $2.56 per share. The warrant was issued in connection with Cappello
Capital Corp. providing financial advisory services to the Company.
22. On September 16, 1999, the Company granted options to purchase 8,000
shares of Common Stock under the Amended 1997 Stock Option Plan at an
exercise price of $2.75 per share to employees.
23. On October 18, 1999, the Company granted options to purchase 2,000
shares of Common Stock under the Amended 1997 Stock Option Plan at an
exercise price of $2.75 per share to employees.
24. On October 25, 1999, the Company granted options to purchase 5,000
shares of Common Stock under the Amended 1997 Stock Option Plan at an
exercise price of $3.13 per share to employees.
18
19
25. On November 8, 1999, the Company granted options to purchase 10,000
shares of Common Stock under the Amended 1997 Stock Option Plan at an
exercise price of $3.88 per share to employees.
26. On November 19, 1999, the Company granted options to purchase 310,000
shares of Common Stock under the Amended 1997 Stock Option Plan at an
exercise price of $3.44 per share to employees and a consultant.
27. On November 29, 1999, the Company granted options to purchase 15,000
shares of Common Stock under the Amended 1997 Stock Option Plan at an
exercise price of $5.00 per share to employees.
28. On December 1, 1999, the Company granted options to purchase 2,000
shares of Common Stock under the Amended 1997 Stock Option Plan at an
exercise price of $4.69 per share to employees.
29. On January 10, 2000, the Company granted options to purchase 3,500
shares of Common Stock under the Amended 1997 Stock Option Plan at an
exercise price of $4.03 per share to employees.
30. On March 1, 2000, the Company granted options to purchase 2,000 shares
of Common Stock under the Amended 1997 Stock Option Plan at an exercise
price of $4.00 per share to employees.
31. On March 20, 2000, the Company granted options to purchase 5,500 shares
of Common Stock under the Amended 1997 Stock Option Plan at an exercise
price of $4.00 per share to employees.
32. On April 3, 2000, the Company granted options to purchase 2,000 shares
of Common Stock under the Amended 1997 Stock Option Plan at an exercise
price of $4.00 per share to employees.
33. On April 17, 2000, the Company granted options to purchase 7,500 shares
of Common Stock under the Amended 1997 Stock Option Plan at an exercise
price of $4.00 per share to employees.
34. On April 24, 2000, the Company granted options to purchase 3,500 shares
of Common Stock under the Amended 1997 Stock Option Plan at an exercise
price of $3.88 per share to employees.
35. On May 1, 2000, the Company granted options to purchase 2,000 shares of
Common Stock under the Amended 1997 Stock Option Plan at an exercise
price of $4.88 per share to employees.
36. On May 15, 2000, the Company granted options to purchase 10,000 shares
of Common Stock under the Amended 1997 Stock Option Plan at an exercise
price of $4.50 per share to employees.
The sales and issuance described in paragraphs 1-4 under "Issuances of
Capital Stock" and in paragraphs 3, 15 and 21 under "Grant of Stock Options and
Warrants" above were deemed to be exempt from registration under the Securities
Act by virtue of Rule 4(2), Regulation D promulgated thereunder or Rule 701 of
the Securities Act. The sales and issuances under Rule 4(2) and Regulation D
were conducted in a manner to avoid a public offering, were made to a limited
number of financially sophisticated persons or entities with a high net worth
and were not made pursuant to any general advertising or general solicitation.
The sales and issuances under Rule 701 were offered and sold either pursuant to
a written compensatory benefit plan or pursuant to a written contract relating
to compensation.
19
20
Appropriate legends are affixed to the stock certificates issued in the
aforementioned transactions. Similar legends were imposed in connection with any
subsequent sales of any of these securities. All recipients either received
adequate information about the Company or had access, through employment or
other relationships, to such information.
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data presented below should be read in
conjunction with the Company's consolidated financial statements and the notes
thereto. The selected consolidated statement of operations data with respect to
the year ended December 31, 1995 and the period from January 1, 1996 to October
8, 1996 and the selected consolidated balance sheet data at December 31, 1995
and at October 8, 1996 are derived from the audited consolidated financial
statements of the Company's predecessor. The consolidated statement of
operations data with respect to the years ended May 31, 1997, 1998, 1999, and
2000 and the consolidated balance sheet data at May 31, 1997, 1998, 1999, and
2000 are derived from, and are qualified by reference to, the Company's audited
consolidated financial statements. The consolidated financial statements as of
and for the years ended May 31, 1998, 1999 and 2000 were audited by Grant
Thornton LLP, independent auditors, and the consolidated financial statements as
of and for the year ended May 31, 1997 were audited by Tanner & Co., independent
auditors. The following financial information should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" below.
PREDECESSOR(1) COMPANY
---------------------------------------------------------------------------------------
JANUARY
FOR THE YEAR 1, 1996
ENDED DECEMBER 31 TO FOR THE YEAR ENDED MAY 31
----------------- OCTOBER 8, ------------------------------------------------------
1995 1996 1997 1998 1999 2000
----------------- ------------ ----------- ------------ ------------ -------------
CONSOLIDATED STATEMENT OF
OPERATIONS DATA:
Income from credit
card receivables* $ 971,174 $ 3,951,602 $ 6,438,460 $ 9,706,247
Revenue in excess of
cost recovered* 3,934 8,138,122 22,308,908 21,396,561
Securitization income and
asset sales* - - 11,851,080 12,599,265
Servicing fees and
other income $6,528,503 $ 2,078,506 1,601,228 1,292,596 1,564,356 2,684,554
---------- - --------- ------------ ------------ ----------- -----------
Total revenue 6,258,503 2,078,506 2,576,336 13,382,320 42,162,804 46,386,627
Provision for losses - - 1,494,001 6,483,736 4,607,081 5,680,975
---------- - --------- ------------ ------------ ----------- -----------
Net revenue 6,258,503 2,078,506 1,082,335 6,898,584 37,555,723 40,705,652
Net income (loss) 2,727,711 (1,512,488) (14,405,555) (29,445,031) 3,875,680 3,072,195
Dividends on
preferred stock* (7,397) (399,996) (1,799,999) (2,000,000)
---------- ----------- ------------ ------------ ----------- -----------
Net income (loss)
applicable to common
shareholders $2,727,711 $(1,512,488) $(14,412,952) $(29,845,027) $ 2,075,681 $ 1,072,195
========== =========== ============ ============ =========== ===========
Net income (loss) per share, $ 0.55 $ (0.30) $ (0.56) $ (0.90) $ 0.06 $ 0.03
basic ========== =========== ============ ============ =========== ===========
Net income (loss) per share,
diluted $ 0.55 $ (0.30) $ (0.56) $ (0.90) $ 0.05 $ 0.03
========== =========== ============ ============ =========== ===========
20
21
PREDECESSOR(1) COMPANY
---------------------------------------------------------------------------------------
JANUARY 1,
FOR THE YEAR 1996 TO
ENDED DECEMBER 31 OCTOBER 8, FOR THE YEAR ENDED MAY 31
------------------- -------------------------------------------------------
1995 1996 1997 1998 1999 2000
--------------- -------------- ------------- ------------ ------------ -------------
CONSOLIDATED BALANCE SHEET
DATA:
Cash and cash equivalents and $ 279,357 $ 58,162 $ 2,685,581 $ 8,205,071 $ 4,283,930 $ 2,448,879
restricted cash
Investments in
non-performing
consumer debt, net* 8,193,453 5,672,515 3,016,697 9,648,090
Credit card receivables, net* 2,566,909 12,919,970 18,631,403 24,244,200
Total assets 524,579 2,884,860 24,743,871 39,723,418 45,780,956 64,388,192
Notes payable - 1,158,336 428,973 5,902,041 6,086,766 23,609,326
Subordinated notes and
accrued interest payable-related
party - 880,000 10,446,043 31,807,322 19,246,595 19,139,028
Total liabilities 279,960 4,007,145 18,118,396 47,366,528 33,692,311 50,013,724
Total stockholders'
equity (deficit) 244,619 (1,122,285) 6,625,475 (7,643,112) 12,088,645 14,374,468
SELECTED CONSOLIDATED OPERATING
DATA:
Outstanding balance of
non-performing debt
acquired during the period* $1,067,579,343 $890,634,206 $891,904,454 $1,771,707,748
Credit card receivables owned
and managed* 35,709,395 84,830,552 89,149,715 96,127,819
Number of accounts
owned and managed* 26,803 84,351 94,278 76,732
Total employees, end
of period* 233 292 305 305
- ---------------------
* Information not applicable for predecessor company.
(1) The information for the fiscal year ended December 31, 1995 and for the
period from January 1, 1996 to October 8, 1996 relates to SOIC, the
Company's predecessor. See "Item 1 -- Business -- General Development of
Business".
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion of the Company's financial condition and
results of operations should be read in connection with the Company's
consolidated financial statements and notes thereto appearing elsewhere herein.
The following discussion contains certain forward-looking statements that
involve risk and uncertainties. The Company's actual results could differ
materially from those discussed herein. Factors that could cause or contribute
to such differences include, but are not limited to, risks and uncertainties
related to the need for additional funds, the rapid growth of the operations and
the ability of the Company to operate profitably after the initial growth period
is completed. For a more extensive discussion of such risks and uncertainties,
see "Cautionary Statements and Factors that may Affect Future Results" below.
21
22
OVERVIEW
The Credit Store, Inc. is a technology based, financial services
company that provides credit card products to consumers who may otherwise fail
to qualify for a traditional unsecured bank credit card. The Company reaches
these consumers by acquiring portfolios of non-performing consumer receivables
and offering a new credit card to those consumers who agree to pay all or a
portion of the outstanding amount due on their debt and who meet the Company's
underwriting guidelines. The new card is issued with an initial balance and
credit line equal to the agreed repayment amount. After the consumers have made
a certain number of on-time payments on their outstanding credit card balance,
the Company seeks to finance, sell, or securitize the credit card receivables
generated by this business strategy. The Company offers other forms of
settlement to those consumers who do not accept the credit card offer.
INVESTMENTS IN NON-PERFORMING CONSUMER DEBT AND THE IMPACT OF COST
RECOVERY ACCOUNTING. The Company accounts for its investments in non-performing
consumer debt in accordance with the provisions of the American Institute of
Certified Public Accountants' Practice Bulletin 6, "Amortization of Discounts on
Certain Acquired Loans," which prescribes two methods (yield method and cost
recovery method) for amortizing the excess of face value over the purchase price
of acquired portfolios. Under Practice Bulletin 6, a company may use the yield
method of accounting if the company has the experience and data to predict the
amount and timing of collections that will be received from the acquired
portfolio. Under the yield method, the acquirer makes an estimate of the amount
and timing of cash flows from an acquired portfolio and accretes these cash
flows into income over the economic life of the acquired portfolio according to
an internal rate of return established for the acquired portfolio. Given the
Company's short history, the Company believed it was required to use the cost
recovery method to account for the acquired portfolios and adopted cost recovery
in fiscal year 1998. Under the cost recovery method, the Company records the
purchase price of a portfolio and any costs directly related to the purchase as
an investment in non-performing consumer debt on the balance sheet. Cash flows
related to the acquired portfolio are applied to reduce the investment on the
balance sheet to zero prior to recognizing revenue from that portfolio. Once the
cost of a portfolio has been recovered, the ensuing cash flow is recorded as the
excess of revenue over cost recovered. The application of cost recovery can have
a material impact on revenue and net income during periods of increasing or
decreasing portfolio acquisitions. The Company made significant investments in
portfolio acquisitions during fiscal year 1998 totaling $15.6 million. The
application of cost of recovery resulted in decreased revenue during the period,
since cash flows from an acquired portfolio are applied first to reduce the
investment in that portfolio to zero, which takes between 9 and 13 months on the
average, depending upon the performance of the acquired portfolio. During the
same period, the Company expensed, as incurred, all costs to market and service
the portfolios which, when, combined with the effects of cost recovery on
revenue, contributed to the large losses experienced in fiscal 1998. During
fiscal 1999 and 2000, the majority of the portfolios acquired during the two
preceding years experienced full cost recovery, leading to a significant
increase in revenue in excess of cost recovered. In addition, portions of the
Company's performing credit card receivables had matured to the point where the
Company was able to sell and securitize certain portfolios at prices well in
excess of the cost bases of those receivables, generating gains on the sale of
those portfolios. The above factors contributed to the net income of $3.1
million in fiscal 2000 and $3.9 million in fiscal 1999 and a net loss of $29.4
million in fiscal year 1998.
22
23
RESULTS OF OPERATIONS
FISCAL YEAR ENDED MAY 31, 2000 COMPARED TO FISCAL YEAR ENDED MAY 31,
1999:
REVENUES. Total revenue for the fiscal year ended May 31, 2000 was
$46.4 million a 10% increase from $42.2 million during the year ended May 31,
1999. Income from credit card receivables increased 51% from $6.4 million to
$9.7 million due to a higher amount of funded credit card receivables during the
period. Income from credit card receivables represents interest and fees on new
advances or purchases made by holders of the Company's credit cards on an
accrual basis. Revenue in excess of costs recovered decreased 1% from $22.3
million to $21.4 million. Securitization income and asset sales increased 6%
from $11.9 million to $12.6 million primarily due to entrance into the re- sale
market of nonperforming consumer accounts. Securitization income and asset sales
represents the excess of cash proceeds over the cost basis in those assets.
During fiscal year 2000, the Company sold its retained interests in three
special purpose entities, completed a securitization of $14.3 million in
receivables, sold $1.4 million of receivables to an unaffiliated bank, and sold
non-performing assets in the market. Servicing fees and other income increased
72% from $1.6 million to $2.7 million due to the increased number of accounts
serviced. Core revenues (revenues other than securitization income and asset
sales) increased 11% from $30.3 million in fiscal year 1999 to $33.8 million in
fiscal year 2000 due to higher amount of funded credit card receivables and
increased number of accounts serviced. The provision for losses increased 23%
from $4.6 million to $5.7 million based on increasing volume of new charges
funded. The above combined to produce net revenue of $40.6 million for the
fiscal year ended May 31, 2000, an 8% increase over $37.6 million recorded for
the year ended May 31, 1999.
EXPENSES. Total operating expenses increased 7% from $31.6 million in
fiscal year 1999 to $33.7 million in fiscal year 2000 but decreased as a
percentage of core revenues from 104% to 100%. Salaries and employee benefits
increased 8% to $13.5 million from $12.5 million based on an average higher
number of full time personnel but decreased as percentage of core revenues from
41% to 40%. Professional fees decreased 4% from $2.7 million in fiscal year 1999
to $2.6 million in fiscal year 2000. Depreciation and amortization decreased 5%
from $2.6 million in fiscal year 1999 to $2.5 million in fiscal year 2000. Third
party service fees decreased 2% from $4.7 million in fiscal year 1999 to $4.6
million in fiscal year 2000 and decreased as a percentage of core revenues from
16% to 14% as the Company's cost per account declined. Communication expense
increased 18% from $2.3 million in fiscal year 1999 to $2.8 million in fiscal
year 2000 in line with increased portfolio acquisition activity. Royalty
expense, pursuant to a mutual business development agreement, increased 12% from
$1.5 million in fiscal year 1999 to $1.7 million in fiscal year 2000. The
royalty expense is accrued when new credit card accounts make their third
payment according to the terms of the cardholder agreement or when cash from
non-card accounts is collected. Increased royalty expense is due to a higher
percentage of cards reaching a third payment due to increased portfolio
acquisition activity in fiscal year 2000. Financing fees increased 416% from
$0.2 million to $1.1 million reflecting the Company's ability to obtain two
additional financing sources in fiscal year 2000. Interest expense increased 15%
from $4.0 million in fiscal year 1999 to $4.6 million in fiscal year 2000 based
on a higher average amount of debt outstanding resulting from increased
portfolio acquisition activity.
INCOME TAX BENEFIT. The above combined for income before income taxes
of $2.0 million in fiscal year 2000 compared to income before income taxes of
$1.9 million in fiscal year 1999. The Company recognized a tax benefit of $1.0
million in fiscal year 2000 resulting in net income of $3.1 million compared to
a tax benefit of $2.0 million in fiscal year 1999 resulting in net income of
$3.9 million. The tax benefit in fiscal year 2000 consists of the recognition of
$1.0 million of tax expenses related to the reclassification of comprehensive
income and
23
24
the reduction of $2.0 million of a valuation allowance related to net operating
loss carryforwards. The Company has reviewed the adequacy of its valuation
allowance and determined that based on fiscal year 2000 and 1999 pretax income
and forecasted future earnings it was more likely than not that a portion of its
net operating loss carryforward would be utilized. The Company will continue to
evaluate the remaining valuation allowance and will recognize tax benefits as
factors indicate that it is more likely than not that future tax benefits will
be realized.
NET INCOME (LOSS). Dividends on preferred stock have accumulated but
have not been declared and are not yet payable. The Company, however, treats the
dividends as declared and payable for the purpose of calculating net income
applicable to common shareholders and earnings per share. Preferred dividends
for fiscal year 2000 increased 11% from $1.8 million in fiscal year 1999 to $2.0
million. After the effect of preferred dividends, net income applicable to
common shareholders in fiscal year 2000 was $1.1 million compared to net income
applicable to common shareholders of $2.1 million for fiscal year 1999.
FISCAL YEAR ENDED MAY 31, 1999 COMPARED TO FISCAL YEAR ENDED MAY 31,
1998:
REVENUES. Total revenue for the fiscal year ended May 31, 1999 was
$42.2 million, a 215% increase from $13.4 million during the year ended May 31,
1998. The increase was primarily due to a combination of increased revenues from
a maturing credit card portfolio, portfolio securitizations and portfolio sales.
Income from credit card receivables increased 63% from $4.0 million to $6.4
million due to an increase in the weighted average credit card receivables
funded. Revenue in excess of costs recovered increased 174% from $8.1 million to
$22.3 million due to increased cash flow related to acquired portfolios and the
effect of fully recovering the acquisition costs on the majority of the
portfolios acquired during the two previous fiscal years. The Company's
performing credit card receivables had matured to the stage where the Company
achieved the sale or securitization of approximately $27.4 million in
receivables. The Company's securitization income and asset sales resulted in an
$11.9 million gain which represents the excess of cash proceeds over the cost
basis in those assets. There were no such sales in the previous fiscal year.
Servicing fees and other income increased 21% from $1.3 million to $1.6 million
due to a higher average number of accounts under management subject to a
servicing fee. Core revenues, that is all revenues other than gains on sales,
increased 127% to $30.3 million, in fiscal year 1999 from $13.4 million in
fiscal year 1998 due to the effect of fully recovering the acquisition costs of
the majority of portfolios in the two previous years through the cost recovery
methodology of applying payments received. The provision for losses decreased
29% from $6.5 million to $4.6 million based on the experience of a more matured
portfolio. The above combined to produce net revenue of $37.6 million for the
fiscal year ended May 31, 1999, a 452% increase over the $6.8 million recorded
for the year ended May 31, 1998.
EXPENSES. Salaries and employee benefits decreased 6% from $13.3
million to $12.5 million based on an average lower number of full-time personnel
Professional fees decreased 36% from $4.2 million in fiscal year 1998 to $2.7
million in fiscal year 1999 as the Company moved beyond its startup period
requiring fewer outside professional services. Depreciation and amortization
decreased 19% from $3.2 million in fiscal year 1998 to $2.6 million in fiscal
year 1999. Fiscal year 1998 included an $0.8 million writedown of existing
software systems. Third party card service fees increased 36% from $3.5 million
in fiscal year 1998 to $4.7 million in fiscal year 1999, in line with the
increase in the average number of accounts under management. Communication
expense increased 12% from $2.0 million in fiscal year 1998 to $2.3 million in
fiscal year 1999 largely in line with increased marketing campaigns on existing
portfolios of non-performing debt. Royalty expense, pursuant to a mutual
business development agreement, increased 644% from $0.2 million in fiscal year
24
25
1998 to $1.5 million in fiscal year 1999. Increased royalty expense is due to a
higher percentage of cards reaching a third payment due to a more thorough sales
process and better account retention in the early months of a new account.
Interest expense decreased 15% from $4.8 million in fiscal year 1998 to $4.0
million in fiscal year 1999 based on a lower average amount of debt outstanding
due to the conversion of $10.0 million of subordinated debt to preferred stock
in May 1998 and the conversion of $10.0 million of subordinated debt in August
1998 and a reduction in the interest rate on senior debt.
INCOME TAX BENEFIT. The above combined for income before income taxes
of $1.9 million in fiscal year 1999 compared to a loss before income taxes of
$29.4 million in fiscal year 1998. The Company recognized a tax benefit of $2.0
million for the year ended May 31, 1999 due to the reduction of a valuation
allowance related to net operating loss carryforwards. No tax benefit was
recognized for the year ended May 31, 1998.
NET INCOME (LOSS). Dividends on preferred stock have accumulated but
have not been declared and are not yet payable. The Company, however, treats the
dividends as declared and payable for the purpose of calculating net income
applicable to common shareholders and earnings per share. Preferred dividends
for fiscal year 1999 increased 350% from $0.4 million in fiscal year 1998 to
$1.8 million due to the previously discussed conversion of debt to Series D and
E Preferred Stock. After the effect of preferred dividends, net income
applicable to common shareholders in fiscal year 1999 was $2.1 million compared
to a net loss applicable to common shareholders of $29.8 million for fiscal year
1998.
LIQUIDITY AND CAPITAL RESOURCES
The Company seeks to maintain an adequate level of liquidity through
active management of assets and liabilities. Because the characteristics of its
assets and liabilities change, liquidity management is a dynamic process
affected significantly by the maturity of the Company's assets and the
seasonality of the credit card business, which places significant demands on
funding new charges and cash advances during certain times of the year,
including the year-end holiday season.
At May 31, 1998, the Company had $8.2 million of cash and cash
equivalents, compared to $4.2 million at May 31, 1999 and $2.4 million at May
31, 2000. The Company maintains restricted cash reserves at two banks to
facilitate the funding of new charges and advances on its customer's credit
cards. These restricted balances were $1.0 million at May 31, 1998, $0.8 million
at May 31, 1999, and $1.0 million at May 31, 2000. The Company believes it has
sufficient cash and cash equivalents from its receivables portfolio and credit
lines to operate its business over the next twelve months.
A significant source of liquidity for the Company has been the sale and
securitization of credit card receivables. During the fiscal year ended May 31,
2000, the Company sold its retained interest in three special purpose entities
("SPEs") to the senior beneficial interest holder for approximately $8.6 million
in cash, realizing a pretax gain of approximately $6.5 million. In May 2000, the
Company completed a $12.1 million securitization of seasoned credit card
receivables ("Receivables") which had a principal balance of approximately $14.2
million with an unconsolidated wholly-owned SPE. The SPE provided $10.0 million
for the purchase and the remaining $2.1 million of the purchase price was
recorded by the Company as retained interest. The Company recognized a pretax
gain of approximately $3.8 million.
25
26
During the fiscal year ended May 31, 1999, the Company sold
approximately $7.0 million in face amount of receivables to an unaffiliated bank
for $5.0 million and raised approximately $13.0 million from three
securitizations of credit card receivables totaling $20.4 million. The Company
intends to securitize receivables in the capital markets and sell receivables to
unaffiliated credit card banks in the ordinary course of business.
The Company also maintains a senior secured revolving credit line with
Coast Business Credit, a division of Southern Pacific Bank. The credit line was
established in April 1998 for $5.0 million and was subsequently increased to
$10.0 million in June 1999, and to $15.0 million in December 1999. The line of
credit expires in July 2001 and is secured by substantially all of the Company's
assets. Borrowings under the credit line are based on a formula, which is
dependent primarily upon the performance and maturing of the Company's credit
card receivables. There was $13.4 million outstanding under the credit line at
May 31, 2000.
The Company has also received secured financing from a related party,
J.L.B. of Nevada, Inc., which is subordinated to the senior secured revolving
credit line. The principal amount outstanding on these notes totaled $17.3
million at May 31, 2000. In August 1998, $10.0 million of this debt was
converted to Series E preferred stock.
On September 20, 1999, the Company entered into a repurchase agreement
with Bank of Hoven. Under the agreement, the bank purchased credit card
receivables from the Company. The initial agreement had a purchase price of $3.0
million which was increased to $6.0 million in March 2000. The agreement is up
for renewal in September 2000. For accounting purposes, the repurchase agreement
is treated as a financing transaction.
In October 1999, through a bankruptcy remote SPE, the Company
established a $17.5 million secured revolving credit line with General Electric
Capital Corporation to finance the acquisition of non-performing consumer debt
portfolios. There was $1.8 million outstanding under the credit line at May 31,
2000. The transfer of receivables to this SPE by the Company does not qualify
for sale treatment under SFAS 125. The SPE is fully consolidated with the
Company's financial results.
During the year ended May 31, 2000, the Company established a new
wholly-owned qualified special purpose entity (SPE), TCS Funding IV, Inc. (TCS
IV), for the purpose of purchasing performing credit card receivables from the
Company. TCS IV entered into a $40.0 million credit facility with a lending
institution to finance the purchase of credit card receivables. The initial
$12.1 million sale of credit card receivables to the SPE (that is also discussed
above) included receivables with a principal balance of approximately $14.2
million. TCS IV provided $10.0 million for the purchase and the remaining $2.1
million of the purchase price was recorded by the Company as retained interest.
The TCS IV credit facility requires interest payments only during the
first 18 months and allows for multiple advances during this period up to $40.0
million. Borrowings in excess of $10.0 million are governed by a borrowing base
and are contingent upon the senior beneficial interests receiving a minimum BBB-
rating from a nationally recognized rating agency. The credit facility advances
70% of the receivables balance, of which 5% must be deposited into a reserve
account. The Company is in the process of attaining a rating on behalf of TCS
IV. The terms of the credit facility require that all credit cards receivables
purchased by TCS IV must be current with a minimum of eight payments made on
each account and must meet certain other eligibility requirements.
26
27
During the first 18 months of the credit facility, after new charges
are funded and fees and interest are paid, excess cash collections can be used
by the SPE to purchase additional accounts from the Company or pay down the
senior beneficial interest. Following the first 18 months, all cash collections
relating to the senior debt interest in the receivables are used to repay
principal, after the payment-related servicing fees and interest are made. All
new charges on the sold accounts are either sold to the SPE or contributed in
exchange for a retained interest until such time as the senior debt interest is
paid down. While the senior debt interest is in place, there are restrictions on
payments that can be made by the Company to certain related parties.
CAPITAL EXPENDITURES AND PORTFOLIO ACQUISITIONS
During fiscal year 2000, the Company invested $13.8 million to acquire
portfolios of non-performing consumer debt, an increase of 60% over the $8.6
million invested in fiscal year 1999, which was a 45% decrease from the $15.6
million invested in fiscal year 1998. The decrease in fiscal year 1999 was due
in part to a shortage of available financing for the industry in general and a
shortage of available portfolios for purchase by the Company that met the
Company's requirements and were available for acceptable prices. During fiscal
year 2000 the Company also invested $4.1 million to acquire a portfolio of fully
performing credit card receivables, at a discount.
The Company invested $0.9 million in property and equipment during
fiscal year 2000 compared to $1.1 million in fiscal year 1999 and $4.2 million
in fiscal year 1998. A large portion of the hardware commitments to build the
Company's business platform was made in fiscal year 1998.
The Company plans to make continued investments in technology and
non-performing portfolios, the amount of which will depend on the amount of
financing and new capital available for such investments. The Company believes
that its asset securitization programs, together with the revolving credit
facility, long term debt issuance, equity issuance, and cash flow from
operations, will provide adequate liquidity to the Company for meeting
anticipated cash needs, although no assurance can be given to that effect.
INFLATION
The Company believes that inflation has not had a material impact on
its results of operations for the fiscal years ended May 31, 1998, 1999 and
2000.
MARKET RISK
Market risk is the risk of loss from adverse changes in market prices
and rates. The Company's principal market risk is due to changes in interest
rates. These changes affect the Company directly in its lending and borrowing
activities, as well as indirectly as interest rates may impact the payment
performance of the Company's credit card holders.
To manage the Company's direct risk to market interest rates,
management actively monitors the interest rates and the interest sensitive
components of the Company's balance sheet to minimize the impact changes in
interest rates have on the fair value of assets, net income and cash flow.
Management seeks to minimize the impact of changes in interest rates on the
Company primarily by matching asset and liability repricings.
27
28
The Company's credit card receivables earn interest at a fixed annual
percentage rate. The Company's fixed annual percentage rate credit card
receivables have no stated maturity or repricing period. However, the Company
may reprice its credit card receivables upon providing the required prior notice
to the customer, which is generally no more than 60 days. The interest rates on
the Company's liabilities are generally indexed to the prime rate. These
characteristics of the Company's receivables and liabilities expose the Company
to repricing risk, which results from differences between the timing of rate
changes and the timing of cash flows, which could impact net interest income if
liabilities reprice more often than assets. The principal objective of the
Company's asset/liability risk management activities is to monitor and control
the Company's exposure to adverse effects resulting from movements of interest
rates over time. The Company has not entered into derivative transactions to
hedge repricing risk.
CAUTIONARY STATEMENTS AND FACTORS THAT MAY AFFECT FUTURE RESULTS
This Form 10-K contains forward-looking statements within the meaning
of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. All forward-looking statements are
inherently uncertain as they are based on current expectations and assumptions
concerning future events or our future performance. Readers are therefore
cautioned not to place undue reliance on these forward-looking statements, which
are only predictions and speak only as of the date this report was filed.
Forward-looking statements are not descriptions of historical facts. The words
or phrases "believes," "expects," "may," "will," "could," "should," "seeks,"
"pro forma," "as adjusted," "look for," "project," "anticipates," or similar
expressions are intended to identify forward-looking statements, and are subject
to numerous known and unknown risks and uncertainties. Actual results could
differ materially from those currently anticipated due to a number of factors,
including those identified in the "Risk Factors" below, and in the Company's
other filings with the Securities and Exchange Commission. The Company
undertakes no obligation to update or publicly announce revisions to any
forward-looking statements to reflect future events or developments.
THE COMPANY MAY NOT GENERATE SUFFICIENT CASH FLOWS FROM ITS RECEIVABLES
TO FUND ITS OPERATIONS. The Company is primarily in the business of providing
credit card products to consumers who have previously defaulted on a debt. Prior
to the Company's acquisition of the receivables, the originating institutions
and intermediary owners, if any, have generally made numerous attempts, using
both in-house and third-party collection agencies, to collect on the
non-performing accounts. The Company acquires the receivables at a discounted
price and believes it can successfully generate cash flows on the new credit
card accounts in excess of its acquisition cost for the receivables. While the
Company believes its knowledge of the market and its ability to collect and
convert non-performing accounts into new credit card accounts enables the
Company to minimize the higher risks inherent in the purchase of non-performing
debt, no assurance can be given that the Company has adequate protection against
these risks. In the event that the conversion of charged-off accounts to credit
card accounts and/or the collection on receivables is less than anticipated, or
if the new credit card accounts experience higher delinquency rates or losses
than anticipated, the Company may not be able to generate sufficient cash from
its receivables to cover the costs associated with purchasing the receivables
and running its business.
THE COMPANY MAY NOT BE ABLE TO MANAGE ITS GROWTH OR OBTAIN THE
RESOURCES NECESSARY TO ACHIEVE ITS GROWTH PLANS. If the Company cannot manage
its growth, it may experience fluctuations in net income or sustain net losses.
Since inception, the Company has grown rapidly,
28
29
placing significant demands on its management, administrative, operational and
financial resources. The Company seeks to continue its growth trends, which
could place additional demands on its resources. Future growth will depend on
numerous factors, including the development of additional relationships with
banks willing to issue credit cards for the Company, the availability of
additional non-performing portfolios for purchase and the availability of
financing to purchase these portfolios and finance its ongoing operations, the
ability to sell and securitize the Company's seasoned credit card receivables,
the ability to maintain a high quality of customer service, and the recruitment,
motivation and retention of qualified personnel.
Sustained growth also may require the implementation of enhancements to
the Company's operational and financial systems and may require additional
management, operational and financial resources. There can be no assurance that
the Company will be able to manage its expanding operations effectively or to
maintain its historical level of cash flows from the portfolios it has
purchased, or that it will be able to maintain or accelerate its growth. The
failure of the Company to manage growth could harm the Company's results of
operations or financial condition.
THE COMPANY'S QUARTERLY OPERATING RESULTS MAY FLUCTUATE. The timing of
portfolio acquisitions along with the timing of its credit card receivables
sales and securitizations can affect the timing of recorded income and result in
periodic fluctuations in the Company's quarterly operating results. The timing
of any sale or securitization transaction is affected by a number of factors
beyond the Company's control including market conditions and the presence of
investors and lenders interested in the Company's seasoned credit card accounts.
An account is seasoned when a consumer has made a certain number of on-time
payments on the consumer's outstanding credit card balance.
THE COMPANY'S CASH REQUIREMENTS MAY FLUCTUATE FROM PERIOD TO PERIOD.
The Company may experience seasonal fluctuations in cash requirements due to a
variety of factors beyond the Company's control including the rate at which
customers pay down their credit card balance and the rate at which the customers
make new purchases and cash advances on their accounts. The Company may
experience higher cash requirements during the year-end holiday season and at
other times during the year when customers make new purchases on their credit
cards at a faster rate than they pay their debts.
THE COMPANY HAS INCURRED NET LOSSES AND HAS AN ACCUMULATED DEFICIT. The
Company has incurred substantial net losses and had an accumulated deficit of
approximately $37.2 million at May 31, 2000. There can be no assurance that the
Company will be able to maintain profitability long enough to recover the
accumulated deficit. Significant expenditures have been made to build the
infrastructure necessary to acquire charged-off portfolios, market and create
new credit card accounts from these portfolios, and service the resulting base
of credit card accounts. Results of operations will depend upon numerous factors
including without limitation, costs associated with the purchase of charged-off
consumer debt portfolios and the marketing, origination and servicing of the
Company's credit card receivables, the revenue generated from the Company's
credit card portfolio, the availability of additional financing to purchase
non-performing consumer debt portfolios and finance working capital, the
performance of the Company's receivables, the ability to sell and securitize the
Company's credit card receivables, and the market acceptance of the Company's
products and services.
THE COMPANY MAY BE UNABLE TO MEET ITS ADDITIONAL FINANCING
REQUIREMENTS. There is no assurance that the Company will be able to meet its
future liquidity requirements. The Company has a substantial ongoing need for
liquidity to finance its operations, and this need is expected to increase along
with
29
30
the growth in the Company's business. The Company's primary operating cash
requirements include the purchase of non-performing portfolios, the marketing,
servicing and collection of credit cards, and ongoing administrative expenses.
The Company funds its cash requirements through a combination of cash flow from
operations, asset sales and securitizations, loans and other financing
transactions. In the event additional financing is unavailable to the Company
and additional receivable sales and securitizations are not completed, the
Company's ability to operate its business would be limited and its financial
condition, operating results or cash flows could be materially adversely
affected.
THE COMPANY USES ESTIMATES IN ITS SECURITIZATION ACCOUNTING. The
Company uses gain on sale accounting, pursuant to which the Company records the
unrealized gain from the sale of receivables in securitization transactions as a
component of comprehensive income and as retained interest in securitized
receivables on the balance sheet. The unrealized gain is an estimate based upon
management's assessment of future payment and default rates and other
considerations in light of conditions existing at the time of the estimate. If
actual default rates, with respect to those receivables included in
securitizations, are higher than the Company projected at the time of sale of
the receivables, the Company would be required to record a charge to
comprehensive income in future periods which would also reduce the Company's
retained interest on the balance sheet.
LACK OF MATURITY OF THE COMPANY'S CREDIT CARD PORTFOLIO MAY RESULT IN
INCREASED DELINQUENCIES AND DEFAULTS. The average age of a credit card issuer's
portfolio of accounts is an indicator of the stability of delinquency and
default levels of that portfolio; a portfolio of older accounts generally
behaves more predictably than a newly originated portfolio. The majority of the
credit card receivables owned by the Company are less than three years old as of
May 31, 2000. As a result there can be no assurance as to the levels of
delinquencies and defaults, which may affect the Company's earnings through net
charge-offs over time. Any material increases in delinquencies and defaults
above management's expectations would have a material adverse effect on the
Company's results of operations and financial condition.
THE MARKET FOR THE COMPANY'S CREDIT CARD RECEIVABLES IS LIMITED. The
Company's future is highly dependent upon the Company's ability to sell or
securitize its portfolios of credit cards that have been generated from
non-performing debt. Although to date the Company has sold several portfolios
and completed several securitizations, no assurance can be given that any more
will be sold or securitized. While there have been securitizations completed by
companies that purchase non-performing consumer debt portfolios and subsequently
attempt to collect on these accounts, the Company is unaware of any significant
securitization of credit card receivables generated from portfolios of
non-performing debt. The Company believes that the market for receivables of
this nature is limited and that there can be no assurance that any such market
will develop to the stage where the Company can be assured of buyers for it's
securitizations and portfolio sales.
In addition, financial institutions that buy credit card receivables or
invest in securitizations may become subject to increasing regulatory burdens or
requirements that could affect the pricing or the size of the market for such
sales or securitizations. This could negatively affect the Company's
profitability and its ability to securitize or sell its credit card receivable
portfolios.
SECURITIZATIONS EXPOSE THE COMPANY TO VARIOUS RISKS. The Company
completed its first securitizations in fiscal 1999. The transactions resulted in
recognition of a gain on sale and the recording of the retained interests in the
securitizations for financial reporting purposes. These and future
securitizations reduce income from credit card receivables and revenue in excess
of cost recovered, which reduction is partially offset
30
31
by the receipt of servicing income, and the accretion income on the residual
investment in the securitizations. In addition, in accordance with SFAS 115
unrealized holding gains and losses, net of the related tax effect, are not
reflected in earnings but are recorded as a separate component of comprehensive
income until realized. A decline in the value of an available-for-sale security
below cost that is deemed other than temporary is charged to earnings and
results in the establishment of a new cost basis for the security and,
therefore, could have an adverse effect on the Company's financial position
and/or results of operations. Any downward adjustment in the carrying amount of
this or future residual interests could also have an adverse effect on the
market price of the Company's Common Stock. The Company intends to pursue
additional securitizations and portfolio sales, which will result in
fluctuations in the Company's quarterly income and will affect period-to-period
comparisons. There also can be no assurance that the Company will be able to
complete future securitizations or portfolio sales at all or on terms favorable
to it.
ADVERSE PUBLICITY MAY IMPAIR ACCEPTANCE OF THE COMPANY'S PRODUCTS.
Critics of the credit card industry have in the past focused on marketing
practices that they claim encourage consumers to borrow more money than they
should, as well as on pricing practices that they claim are either confusing or
result in prices that are too high. Increased criticism of the industry or
criticism of the Company in the future could hurt client acceptance of the
Company's products or lead to changes in the law or regulatory environment,
either of which would significantly harm the Company's business.
THE COMPANY HAS PLEDGED ALL OF ITS ASSETS WHICH MAY MAKE FUTURE
FINANCING MORE DIFFICULT. On April 30, 1998, to secure its payment and
performance under its senior secured debt financing, the Company granted the
lender a security interest in all of the Company's assets including, among other
things, all receivables, inventory and equipment. The Company had previously
pledged its assets to its major shareholder as collateral for the loans
evidenced by certain shareholder notes. All shareholder notes have been
subordinated to the Company's senior debt lender. By pledging all of its assets
to secure financings, the Company may find it more difficult to secure
additional financing in the future.
THE COMPANY DOES NOT HAVE BACKUP ARRANGEMENTS FOR ALL SERVICES AND
EXISTING ARRANGEMENTS MAY BE INSUFFICIENT. The Company, through the issuing
bank's arrangement with FDR, uses FDR for third-party processing of credit card
data and services. The Company provides credit card data to FDR on a daily basis
and such data is backed up and stored by FDR. In addition, the Company's
marketing data on its purchased portfolios is backed up on a daily basis and is
stored off-site.
While it is currently evaluating a back-up servicer for its servicing
portfolio of credit cards, the Company does not have a back-up telemarketer for
its marketing programs. In the event of a disaster or other occurrence that
closes the Company's main facility or shuts down its primary and redundant data
connections to FDR, the Company's business would be interrupted during the
period required to repair its data lines and/or facilities or to relocate to
temporary facilities. Such interruption in the Company's operations could have a
material adverse impact on its business and revenues. The Company is evaluating
back-up servicing and marketing solutions that can seamlessly move servicing and
marketing operations to alternative locations or to third-party service
providers in a manner that would minimize losses in the event of a disaster or
other occurrence that affects the Company's primary facility or data
transmission to third parties.
THE COMPANY CANNOT ISSUE ITS OWN CREDIT CARDS AND IT IS RELIANT UPON
CREDIT CARD ISSUERS. The Company is not licensed to nor does it currently have
the ability to independently issue credit cards. Accordingly, the Company is
dependent upon third-party financial institutions to issue credit cards
31
32
to the Company's customers. The Company currently has two banks through which
cards are issued. If the Company's existing credit card issuers discontinue
their agreements with the Company and the Company were unable to find a new
credit card issuer willing to issue cards to consumers with impaired credit
history, the Company would not be able to operate its business as it is
currently conducted. In addition, the Company may not be able to enter into an
agreement with an alternate provider on terms that the Company considers
favorable or in a timely manner without disruption of the Company's business.
In addition, the third-party financial institutions upon which the
Company relies are subject to extensive governmental regulation. If such
regulators were to impose additional regulations or restrictions on third-party
financial institutions in connection with issuing credit cards, such regulations
or restrictions could impose additional costs or limitations upon the Company's
operations. These costs and/or limitations could reduce the Company's
profitability and adversely affect financial results.
LABOR AVAILABILITY. The credit card industry is labor intensive and
generally experiences a high rate of turnover in personnel. A high turnover rate
among the Company's employees would increase the Company's recruiting and
training costs and could adversely impact the overall recovery of its
receivables. In addition, Sioux Falls, South Dakota experiences a low incidence
of unemployment. If the Company were unable to recruit and retain a sufficient
number of employees, it would be forced to limit its growth or possibly curtail
its operations. Growth in the Company's business will require it to continue to
recruit and train significant numbers of qualified personnel. There can be no
assurance that the Company will be able to hire, train and retain a sufficient
number of qualified employees.
THE COMPANY MAY NOT BE ABLE TO ACQUIRE ENOUGH RECEIVABLES ON FAVORABLE
TERMS TO OPERATE PROFITABLY. To obtain additional credit card customers, the
Company depends on the continued availability of non-performing portfolios that
meet its requirements. Any decrease in availability of receivables or any
increase in the cost of receivables could reduce the Company's profitability and
liquidity and have a material adverse affect on the Company's results of
operations or financial condition. The availability of portfolios of receivables
for future purchase at prices favorable to the Company depends on a number of
factors outside of the control of the Company, including the continuation of the
current growth trend in credit card and consumer installment debt. Curtailment
of that trend could result in less credit being extended by lending institutions
and consequently fewer receivables available for purchase at prices that conform
to the Company's strategy for profitable collection. In addition, to the extent
consumers with negative credit history have less difficulty in obtaining credit,
especially obtaining unsecured credit cards, there may be less consumer demand
for the Company's product. The possible entry of new competitors (including
competitors that historically have focused on the acquisition of different asset
types) may adversely affect the Company's access to portfolios. The Company's
access to receivables portfolios may also be adversely affected if traditional
credit card lenders rehabilitate their own non-performing credit card
receivables. In addition, overly aggressive pricing by competitors could have
the effect of raising the cost of portfolios of receivables above those that
conform to the Company's pricing models.
FLUCTUATIONS IN ECONOMIC CONDITIONS COULD ADVERSELY AFFECT THE
COMPANY'S BUSINESS. During strong economic cycles, available credit, including
consumer credit, generally increases and payment delinquencies and defaults
generally decrease. During periods of economic slowdown and recession, such
delinquencies and defaults generally increase. No assurances can be given that
the Company's credit card losses and delinquencies would not worsen in a weak
economic cycle. Significant increases in credit card losses would weaken the
financial condition of the Company.
32
33
THE COMPANY MAY NOT BE ABLE TO SUCCESSFULLY ANTICIPATE, INVEST IN OR
ADOPT TECHNOLOGICAL ADVANCES WITHIN ITS INDUSTRY. The Company's success is
dependent in large part on its continued investment in sophisticated
telecommunications and computer systems, including predictive dialers, automated
call distribution systems and digital switching equipment. The Company has
invested significantly in technology in an effort to remain competitive and
anticipates that it will be necessary to continue to do so. Moreover, computer
and telecommunications technologies are evolving rapidly and are characterized
by short product life cycles, which require the Company to anticipate and stay
current with technological developments. There can be no assurance that the
Company will be successful in anticipating, managing or adopting such
technological changes on a timely basis or that the Company will have the
capital resources available to invest in new technologies.
THE COMPANY IS DEVELOPING NEW PRODUCTS AND SERVICES WHICH MAY NOT BE
SUCCESSFUL. While the Company may, from time to time, develop additional
products and services, there can be no assurance that such products and services
will be completed or successfully marketed and implemented. Consumer preferences
for credit card and credit related products are difficult to predict,
specifically where consumers have experienced past credit difficulties. There
can be no assurance that the products and services introduced by the Company
will be accepted by credit card holders, or that the Company's methodology for
restructuring past consumer debt delinquency will be accepted by the consumer.
Failure to obtain significant customer satisfaction or market share for the
Company's products and services would have a material adverse effect on the
Company's operations and financial condition.
THE COMPANY IS DEPENDENT ON ITS KEY PERSONNEL. The Company is dependent
upon the continued contributions of its officers and other key employees. The
loss of the services of one or more of our executive officers or key employees
could disrupt the Company's operations. The Company has entered into employment
agreements with Martin J. Burke, its Chief Executive Officer and Chairman of the
Board of Directors, Kevin T. Riordan, its President and Chief Operating Officer,
Michael J. Philippe, its Executive Vice President and Chief Financial Officer,
and Richard S. Angel, its Executive Vice President and General Counsel. The loss
of the services of any such individual or the services of certain other officers
or key employees would cause the Company to incur costs for recruiting
replacements, could result in the loss of the valuable expertise and business
relationships, and could have a material adverse effect on the Company's
business and prospects.
THE COMPANY'S MAJOR SHAREHOLDERS ARE RELATED AND HAVE THE ABILITY TO
CONTROL SHAREHOLDER ACTIONS ON FUNDAMENTAL CORPORATE MATTERS. Jay L. Botchman, a
director of the Company, has control over the Company's affairs through his
ability to elect the Company's directors and determine the outcome of votes by
the Company's stockholders on fundamental corporate matters, including mergers,
sales of all or substantially all of the Company's assets, charter amendments
and other matters subject to stockholder approval. Generally, such actions
require approval by a majority of the outstanding shares of common stock.
However, because of the control by Mr. Botchman, the common stockholders of the
Company are not able to elect a majority of the Company's directors and would
not able to control a fundamental corporate action, such as a merger, sale of
the Company's assets, or a charter amendment.
Mr. Botchman, individually and through his control of certain entities,
beneficially owns all of the preferred stock of the Company. The terms of the
preferred stock contain certain preferential voting rights, particularly the
Company's Series A Preferred Stock. The outstanding shares of Series A Preferred
Stock represent 80% of all votes entitled to be voted at any meeting of the
Shareholders of the Company, subject to
33
34
dilution to the extent capital stock of the Company is subsequently issued.
Currently, the shares of the Series A Preferred Stock represent approximately
77.88% of all votes entitled to be voted at any meeting of the stockholders of
the Company. Finally, if Mr. Botchman were to cease to be the managing member of
Taxter, Martin J. Burke, the Company's Chief Executive Officer, would become the
managing member of Taxter.
THE COMPANY'S OPERATIONS DEPEND, IN PART, UPON THE PROTECTION OF
CERTAIN PROPRIETARY INFORMATION. The Company's operations are dependent, in
part, upon certain proprietary data and analytical computer programs, methods
and related know-how for stratifying and analyzing characteristics of
non-performing receivable portfolios, projecting conversions to new credit cards
and the total cash collections, and predicting cardholder payment performance.
The Company currently relies upon a combination of confidentiality agreements,
contract provisions and trade secret laws to protect its proprietary rights.
Although the Company intends to protect its rights vigorously, there can be no
assurance that the Company will be successful in protecting its proprietary
rights. If it is not able to protect such rights, or if such information and
data become widely available, the Company may lose a competitive advantage
within its market niche. Such loss of competitive advantage could result in
decreased revenues and profitability for the Company.
FAILURE TO COMPLY WITH CONSUMER AND DEBTOR PROTECTION LAWS AND
REGULATIONS COULD ADVERSELY AFFECT THE COMPANY'S BUSINESS. The Company's
collection practices, business operations and credit card receivables are
subject to numerous federal and state consumer protection laws and regulations
imposing licensing and other requirements with respect to purchasing,
collecting, making and enforcing consumer loans. The Company conducts periodic
compliance reviews and, if necessary, implements procedures to bring the Company
into compliance with all applicable state and federal regulatory requirements.
Failure by the Company to comply with such statutes or regulations could have a
material adverse effect on the Company's results of operations or financial
condition. In addition, due to the consumer-oriented nature of the collections
and credit card industry, there is a risk that the Company or other industry
participants may be named as defendants in litigation involving alleged
violations of federal and state laws and regulations, including consumer
protection laws, and consumer law torts, including fraud. A significant judgment
against the Company or within the industry in connection with any such
litigation could have a material adverse effect on the Company's results of
operations or financial condition. See "Item 1 - Business; Government
Regulation."
RISKS ASSOCIATED WITH PENDING LITIGATION. The Company is currently
named as a defendant in seven class action lawsuits. These lawsuits generally
allege that persons in the class were purportedly solicited to voluntarily repay
debt that had been discharged in bankruptcy, and that the Company has violated
other provisions of federal or state law, including violations of the Bankruptcy
Code, the Fair Debt Collection Practices Act, the Truth in Lending Act, various
state consumer protection laws and, in one case, RICO. A significant judgment
against the Company in one or more of the lawsuits could subject the Company to
a monetary judgment that could substantially affect the Company's liquidity and
profitability. In addition, a loss may also require the Company to modify its
methods of operation to the extent its operations are deemed to not comply with
applicable legal standards, which could have a material adverse effect on the
Company's profitability and ability to conduct its operations.
THE COMPANY HAS ACCUMULATED CASH DIVIDENDS. The Company has accumulated
approximately $4.2 million in undeclared and unpaid dividends on its preferred
stock. Although the Board of Directors has not declared, and therefore not paid,
such dividends to date, the Company may be called on to pay such dividends in
the future, assuming it has the legal capacity to do so under Delaware law. To
the extent such preferred stock remains outstanding, additional cash dividends
will accumulate. If the Company is required to
34
35
pay out such cash dividends, such payments would limit the amount of cash
available to use in other operations and may, therefore, decrease the cash
liquidity of the Company. Such a decrease in liquidity may require the Company
to seek additional financing if the Company's operations are not sufficient to
fund its cash needs.
RISK OF LOW-PRICED SECURITIES. The Securities Enforcement and Penny
Stock Reform Act of 1990 requires additional disclosure relating to the market
for penny stocks in connection with trades in any stock defined as a penny
stock. Securities Exchange Commission regulations generally define a penny stock
to be an equity security that has a market price of less than $5.00 per share,
subject to certain exceptions. As the Company does not currently satisfy the
requirements to comply with any exception, the regulations require the delivery,
prior to certain transactions involving the Company's Common Stock, of a
disclosure schedule explaining the penny stock market and the risks associated
therewith. Transactions that meet the requirements of Regulation D under the
Securities Act or transactions with an issuer not involving a public offering
pursuant to Section 4(2) of the Securities Act are exempt from the disclosure
schedule delivery requirements.
Since the Company is subject to the penny stock regulations cited
above, trading in the Company's securities is covered by Rule 15g-9 promulgated
under the Securities Exchange Act of 1934, as amended (the "Exchange Act") for
non-NASDAQ and non-national securities exchange listed securities. Under such
rule, broker/dealers who recommend such securities to persons other than
established customers and accredited investors must make a special written
suitability determination for the purchaser and receive the purchaser's written
agreement to a transaction prior to sale.
The effect of theses regulations may decrease the liquidity in the
market for the Company's Common Stock because of the additional costs and
burdens imposed.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements and the report thereon of Grant
Thornton LLP, independent certified public accountants, dated July 24, 2000 are
filed as part of this Registration Statement. See Item 14.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS
The information included in the Company's definitive proxy statement
for the 2000 Annual Meeting of Shareholders under the captions "Election of
Directors", "Executive Officers" and "Section 16(a) Beneficial Ownership
Reporting Compliance" is incorporated herein by reference.
35
36
ITEM 11. EXECUTIVE COMPENSATION
The information included in the Company's definitive proxy statement
for the 2000 Annual Meeting of Shareholders under the captions "Election of
Directors--Compensation of Directors", "Summary Compensation Table", "Option
Tables--Option Grants in Last Fiscal Year", " Option Tables--Aggregate Option
Exercises in Fiscal 2000 and Fiscal Year-End Option Values" and "Employment
Agreements" is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information included in the Company's definitive proxy statement
for the 2000 Annual Meeting of Shareholders under the caption "Security
Ownership of Principal Shareholders and Management" is incorporated herein by
reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information included in the Company's definitive proxy statement
for the 2000 Annual Meeting of Shareholders under the caption "Certain
Relationships and Related Transactions" is incorporated herein by reference.
ITEM 14. FINANCIAL STATEMENTS AND EXHIBITS
(a) Index to Financial Statements
The Financial Statements required by this item are submitted in a
separate section beginning on page F-1 of this registration statement
PAGE
Report of Independent Certified Public Accountants F-2
Consolidated Balance Sheets F-3
Consolidated Statements of Operations F-4
Consolidated Statement of Stockholders' Equity F-5
Consolidated Statements of Cash Flows F-7
Notes to Consolidated Financial Statements F-9
36
37
INDEX
Page
----
Report of Independent Certified Public Accountants.......................................................... F-2
Consolidated Financial Statements
Consolidated Balance Sheets................................................................................. F-3
Consolidated Statements of Operations....................................................................... F-4
Consolidated Statements of Stockholders' Equity............................................................. F-5
Consolidated Statements of Cash Flows....................................................................... F-7
Notes to Consolidated Financial Statements.................................................................. F-9
F-1
38
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
Board of Directors
The Credit Store, Inc.
We have audited the accompanying consolidated balance sheets of
The Credit Store, Inc. (a Delaware corporation) and subsidiaries as of May 31,
2000 and 1999, and the related consolidated statements of operations,
stockholders' equity and cash flows for each of the three years in the period
ended May 31, 2000. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with auditing standards
generally accepted in the United States of America. Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
The Credit Store, Inc. and subsidiaries as of May 31, 2000 and 1999, and the
consolidated results of their operations and their consolidated cash flows for
each of the three years in the period ended May 31, 2000 in conformity with
accounting principles generally accepted in the United States of America.
/s/ GRANT THORNTON LLP
Minneapolis, Minnesota
July 24, 2000
F-2
39
THE CREDIT STORE, INC.
CONSOLIDATED BALANCE SHEETS
MAY 31,
ASSETS 2000 1999
------------ ------------
Cash and cash equivalents $ 1,423,248 $ 3,533,930
Restricted cash 1,025,631 750,000
Accounts and notes receivable, net 2,765,882 1,150,207
Prepaid expenses 1,341,516 618,198
Amounts due from special purpose entities 9,332,890 1,230,700
Investments
Investments in nonperforming consumer debt, net 9,648,090 3,016,697
Credit card receivables, net 24,244,200 18,631,403
Investment in unconsolidated affiliate 1,279,888 1,612,648
Retained interest in securitized credit card receivables 2,142,846 5,130,372
Property and equipment, net 4,790,060 6,132,612
Goodwill, net 2,347,999 2,555,175
Deferred tax asset 2,700,000 700,000
Other assets 1,345,942 719,014
------------ ------------
$ 64,388,192 $ 45,780,956
============ ============
LIABILITIES AND STOCKHOLDERS'
EQUITY
LIABILITIES
Accounts payable and accrued expenses $ 4,499,142 $ 4,313,409
Notes payable 23,609,326 6,086,766
Capitalized lease obligations 2,766,228 4,045,541
Subordinated notes and accrued interest payable -
related party 19,139,028 19,246,595
------------ ------------
Total liabilities 50,013,724 33,692,311
------------ ------------
COMMITMENTS AND CONTINGENCIES -- --
------------ ------------
STOCKHOLDERS' EQUITY
Series A, B, C, D and E Preferred Stock 27,000,000 27,000,000
Common stock, $.001 par value; 65,000,000 shares
authorized at May 31, 2000 and 50,000,000 shares
authorized at May 31, 1999; 34,761,965 shares
issued and outstanding at May 31, 2000 and 1999 34,762 34,762
Additional paid-in capital 23,743,260 22,670,711
Unrealized gain from retained interest in securitized
credit card receivables, net of tax 638,227 2,497,148
Accumulated deficit (37,041,781) (40,113,976)
------------ ------------
Total stockholders' equity 14,374,468 12,088,645
------------ ------------
Total liabilities and stockholders' equity $ 64,388,192 $ 45,780,956
============ ============
The accompanying notes are an integral part of these statements.
F-3
40
THE CREDIT STORE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED MAY 31,
2000 1999 1998
------------ ------------ ------------
Revenue
Income from credit card receivables $ 9,706,247 $ 6,438,460 $ 3,951,602
Revenue in excess of cost recovered 21,396,561 22,308,908 8,138,122
Securitization income and asset sales 12,599,265 11,851,080 --
Servicing fees and other income 2,684,554 1,564,356 1,292,596
------------ ------------ ------------
Total revenue 46,386,627 42,162,804 13,382,320
Provision for losses 5,680,975 4,607,081 6,483,736
------------ ------------ ------------
Net revenue 40,705,652 37,555,723 6,898,584
Expenses
Salaries and employee benefits 13,502,074 12,484,582 13,268,863
Professional fees 2,604,992 2,701,016 4,215,891
Depreciation and amortization 2,494,489 2,614,216 3,223,620
Third-party credit card services 3,972,785 4,468,992 3,486,915
Third-party scrubbing services 665,078 264,536 --
Communication expense 2,769,077 2,272,513 2,035,380
Occupancy and equipment rental 858,325 766,832 825,517
Royalty expense 1,733,412 1,541,944 207,238
Financing fees 1,092,286 211,864 90,182
Other 4,001,365 4,310,466 4,229,104
------------ ------------ ------------
Total expenses 33,693,883 31,636,961 31,582,710
------------ ------------ ------------
Operating income (loss) 7,011,769 5,918,762 (24,684,126)
Interest expense 4,981,949 4,029,491 4,760,905
------------ ------------ ------------
Income (loss) before income taxes 2,029,820 1,889,271 (29,445,031)
Income tax benefit 1,042,375 1,986,409 --
------------ ------------ ------------
NET INCOME (LOSS) 3,072,195 3,875,680 (29,445,031)
Dividends on preferred stock (2,000,000) (1,799,999) (399,996)
------------ ------------ ------------
Net income (loss), applicable to common shareholders $ 1,072,195 $ 2,075,681 $(29,845,027)
============ ============ ============
Net income (loss) per share
Basic $ 0.03 $ 0.06 $ (0.90)
Diluted $ 0.03 $ 0.05 $ (0.90)
Weighted-average common shares outstanding
Basic 34,761,965 34,761,965 33,109,781
============ ============ ============
Diluted 41,336,161 38,436,119 33,109,781
============ ============ ============
The accompanying notes are an integral part of these statements.
F-4
41
THE CREDIT STORE, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
YEARS ENDED MAY 31,
Common stock
------------------------ Series A Series B Series C Series D
Shares Amount Preferred Preferred Preferred Preferred
---------- --------- ----------- ----------- ----------- -----------
Balance at June 1, 1997 32,207,465 $ 32,208 $ 1,200,000 $ 800,000 $ 5,000,000 $ --
Net loss -- -- -- -- -- --
Issuance of Series D Preferred Stock
in exchange for $10 million
subordinated note -- -- -- -- -- 10,000,000
Issuance of common stock 2,554,500 2,554 -- -- -- --
---------- --------- ----------- ----------- ----------- -----------
Balance at May 31, 1998 34,761,965 34,762 1,200,000 800,000 5,000,000 10,000,000
Net income -- -- -- -- -- --
Unrealized gain and accretion on
retained interest in
securitization, net of tax -- -- -- -- -- --
Comprehensive income -- -- -- -- -- --
Issuance of Series E Preferred Stock
in exchange for $10 million
subordinated note -- -- -- -- -- --
Issuance of warrants in lieu of
payment of accrued interest on
subordinated debt -- -- -- -- -- --
---------- --------- ----------- ----------- ----------- -----------
Balance at May 31, 1999 34,761,965 34,762 1,200,000 800,000 5,000,000 10,000,000
Net income -- -- -- -- -- --
Unrealized gain and accretion on
retained interest in
securitization, net of tax -- -- -- -- -- --
Sale of retained interest in
securitized receivables, net of tax -- -- -- -- -- --
Comprehensive income -- -- -- -- -- --
Issuance of warrants and stock
options in lieu of payment for
services and assets -- -- -- -- -- --
---------- --------- ----------- ----------- ----------- -----------
Balance at May 31, 2000 34,761,965 $ 34,762 $ 1,200,000 $ 800,000 $ 5,000,000 $10,000,000
=========== ========= =========== =========== =========== ===========
The accompanying notes are an integral part of these statements.
F-5
42
THE CREDIT STORE, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY - CONTINUED
YEARS ENDED MAY 31,
Additional Other Total
Series E paid-in Accumulated comprehensive stockholders'
Preferred capital deficit income equity
------------ ------------ ------------ ------------- -------------
Balance at June 1, 1997 $ -- $ 14,137,892 $(14,544,625) $ -- $ 6,625,475
Net loss -- -- (29,445,031) -- (29,445,031)
Issuance of Series D Preferred Stock in
exchange for $10 million subordinated
note -- -- -- -- 10,000,000
Issuance of common stock -- 5,173,890 -- -- 5,176,444
------------ ------------ ------------ ------------ ------------
Balance at May 31, 1998 -- 19,311,782 (43,989,656) -- (7,643,112)
Net income -- -- 3,875,680 -- 3,875,680
Unrealized gain and accretion on
retained interest in securitization,
net of tax -- -- -- 2,497,148 2,497,148
------------
Comprehensive income -- -- -- -- 6,372,828
Issuance of Series E Preferred Stock in
exchange for $10 million subordinated
note 10,000,000 -- -- -- 10,000,000
Issuance of warrants in lieu of payment
of accrued interest on subordinated
debt -- 3,358,929 -- -- 3,358,929
------------ ------------ ------------ ------------ ------------
Balance at May 31, 1999 10,000,000 22,670,711 (40,113,976) 2,497,148 12,088,645
Net income -- -- 3,072,195 -- 3,072,195
Unrealized gain and accretion on
retained interest in securitization,
net of tax -- -- -- 2,062,292 2,062,292
Sale of retained interest in securitized
receivables, net of tax -- -- -- (3,921,213) (3,921,213)
------------
Comprehensive income -- -- -- -- 1,213,274
Issuance of warrants and stock options
in lieu of payment for services and
assets -- 1,072,549 -- -- 1,072,549
------------ ------------ ------------ ------------ ------------
Balance at May 31, 2000 $ 10,000,000 $ 23,743,260 $(37,041,781) $ 638,227 $ 14,374,468
============ ============ ============ ============ ============
The accompanying notes are an integral part of these statements.
F-6
43
THE CREDIT STORE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED MAY 31,
2000 1999 1998
------------ ------------ ------------
Cash flows from operating activities:
Net income (loss) $ 3,072,195 $ 3,875,680 $(29,445,031)
Adjustments to reconcile net income (loss) to net cash
used in operating activities
Provision for credit card losses 5,680,975 4,607,081 6,483,736
Amortization of discount on performing credit card
portfolio (1,344,418) -- --
Provision for losses on accounts and notes receivable 100,000 768,860 780,027
Depreciation and amortization 2,494,489 2,614,216 3,223,620
Deferred tax benefit (1,042,375) (1,986,409) --
Gain on sale of interest in affiliates (5,260,358) -- --
(Gain)loss from unconsolidated affiliates 332,760 (325,183) (277,159)
Gain on sale of credit card receivable portfolios (5,771,007) (11,851,080) --
Services received for stock options granted 38,500 -- 176,444
Changes in operating assets and liabilities:
Restricted cash (275,631) 250,000 --
Accounts and notes receivable (1,715,675) (1,426,401) (473,436)
Receivable from unconsolidated affiliate (8,102,190) (1,230,700) --
Prepaid expenses (723,318) (173,362) (327,177)
Accrued interest on funds advanced on credit cards (511,096) 82,488 (263,255)
Accrued fees (1,197,790) 291,161 (48,382)
Other assets 407,121 (177,085) (383,338)
Unearned fees 264,855 184,551 216,721
Accounts payable and accrued expenses 185,733 (193,277) 1,230,841
Accrued interest payable on subordinated notes 242,433 2,439,273 3,675,381
------------ ------------ ------------
Net cash used in operating activities (13,124,797) (2,250,187) (15,431,008)
Cash flows from investing activities:
Collection of funds advanced on credit cards 18,581,055 13,305,543 1,887,306
Collection of consumer debt 7,180,106 11,278,295 18,162,596
Funds advanced on securitized credit card receivables (1,840,282) (1,346,815) --
Proceeds from sale of credit card receivable portfolios 12,244,229 17,129,109 --
Funds advanced on credit cards (30,849,101) (29,460,286) (18,629,185)
Purchase of nonperforming consumer debt portfolios (13,811,499) (8,622,478) (15,641,657)
Proceeds from sale of beneficial interest in affiliates 8,643,233 -- --
Purchase of performing consumer debt portfolios (4,082,114) -- --
Development of proprietary software (207,587) (460,497) --
Purchase of property and equipment (737,172) (682,539) (4,170,472)
------------ ------------ ------------
Net cash provided by (used in) investing
activities (4,879,132) 1,140,332 (18,391,412)
------------ ------------ ------------
The accompanying notes are an integral part of these statements.
F-7
44
THE CREDIT STORE, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS - CONTINUED
FOR THE YEARS ENDED MAY 31,
2000 1999 1998
------------ ------------ ------------
Cash flows from financing activities:
Proceeds from debt $ 19,128,881 $ 576,643 $ 33,240,887
Payments on debt (1,956,321) (2,032,989) (101,921)
Borrowings from sale/leaseback transactions 896,018 559,713 3,146,275
Payments on capital lease obligations (2,175,331) (1,664,653) (1,943,331)
Proceeds from issuance of stock -- -- 5,000,000
------------ ------------ ------------
Net cash provided by (used in) financing
activities 15,893,247 (2,561,286) 39,341,910
------------ ------------ ------------
NET INCREASE (DECREASE) IN CASH (2,110,682) (3,671,141) 5,519,490
Cash and cash equivalents at beginning of period 3,533,930 7,205,071 1,685,581
------------ ------------ ------------
Cash and cash equivalents at end of period $ 1,423,248 $ 3,533,930 $ 7,205,071
============ ============ ============
Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest $ 4,178,571 $ 1,592,864 $ 1,006,663
Noncash financing activities:
Series D and E preferred stock issued in exchange
for subordinated note -- 10,000,000 10,000,000
Obligations assumed in lieu of payment of accrued
interest on subordinated debt -- 1,641,071 --
Issuance of warrants in lieu of payment of accrued
interest on subordinated debt -- 3,358,929 --
Issuance of warrants and stock options in lieu of
payment for services and assets 1,072,549 -- --
The accompanying notes are an integral part of these statements.
F-8
45
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MAY 31, 2000, 1999 AND 1998
NOTE A - ORGANIZATION
The Credit Store, Inc. (the "Company") is a technology based financial
services company that provides credit card products to consumers who may
otherwise fail to qualify for a traditional unsecured bank credit card. The
Company reaches these consumers by acquiring portfolios of non-performing
consumer receivables and offering a new credit card to those consumers who
agree to pay all or a portion of the outstanding amount due on their debt and
who meet the Company's underwriting guidelines. The new card is issued with
an initial balance and credit line equal to the agreed repayment amount.
After the consumers have made a certain number of on-time payments on their
outstanding credit card balance, the Company seeks to sell or securitize the
credit card receivables generated by this business strategy. The Company
offers other forms of settlement to those consumers who do not accept the
credit card offer.
NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiaries. All significant intercompany transactions have
been eliminated.
Cash and Cash Equivalents
For purposes of the statements of cash flows, cash includes all cash and
investments with original maturities of three months or less when purchased,
except restricted cash. The Company's restricted cash is on deposit with two
banks in order to facilitate funding of credit card loans. The Company
maintains its cash in bank deposit accounts, which at times may exceed
federally insured limits.
Investments
Investments in nonperforming consumer debt consist of portfolios of consumer
debt purchased by the Company, which are recorded at cost, less cost
recovered. Cost is substantially less than the remaining outstanding balance
on these portfolios. To the extent that the cost of a particular portfolio of
debt purchased exceeds the present value of the estimated amount of cash
expected to be collected, a valuation allowance would be recognized in the
amount of such impairment.
F-9
46
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
Credit card receivables consist of amounts funded by the Company for new
purchases or advances, accrued interest on new purchases and advances, and
accrued fees, less a provision for losses and unearned fees.
Investment in unconsolidated affiliate represents the Company's 50% ownership
interest in an entity involved in substantially the same business as the
Company and is recorded on the equity method of accounting.
Securitization Accounting
Statement of Financial Accounting Standards No. 125 ("SFAS No. 125"),
"Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities," requires an entity to recognize the
financial and servicing assets it controls and the liabilities it has
incurred and to derecognize financial assets when control has been
surrendered. The proceeds of securitized financial assets are allocated to
the assets sold, the servicing asset or liability and retained interest based
on their relative fair values at the transfer date in determining the gain on
the securitization transaction.
SFAS No. 125 requires an entity to recognize a servicing asset or servicing
liability each time it undertakes an obligation to service financial assets
that have been securitized and amortize it over the period of estimated net
servicing income or loss. The Company received adequate compensation for the
servicing of securitized credit card receivables and therefore no servicing
asset or liability was recorded.
Retained Interest in Securitized Credit Card Receivables
The retained interest in securitized credit card receivables is treated as a
debt security classified as available-for-sale in accordance with Statement
of Financial Accounting Standards No. 115, "Accounting for Certain
Investments in Debt and Equity Securities," and is carried at fair value.
Fair value is based on the discounted anticipated future cash flows on a
"cash out" basis. The cash out method projects cash collections to be
received only after all amounts owed to investors have been remitted.
Adjustments to fair value (net of related income taxes) are recorded as a
component of other comprehensive income.
F-10
47
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
Income on the retained interest is accrued based on the effective interest
rate applied to its original cost basis, adjusted for accrued interest and
principal payments. The effective interest rate is the internal rate of
return determined based on the timing and amounts of anticipated future cash
flows for the underlying pool of securitized credit card receivables.
The retained interest is evaluated for impairment by management monthly based
on current market and cash flow assumptions applied to the underlying
receivables. Provisions for losses are charged to earnings when it is
determined that the retained interest's original cost basis, adjusted for
accrued interest and principal payments, is greater than the present value of
expected future cash flows. No provision for losses was recorded during the
fiscal years ended May 31, 2000, 1999 and 1998.
Property and Equipment
Property and equipment are recorded at cost, less accumulated depreciation
and amortization. Depreciation and amortization are determined using the
straight-line method over the estimated useful lives of the assets or terms
of the capital lease. Expenditures for maintenance and repairs are expensed
when incurred.
Goodwill
Goodwill originating from the acquisition of companies acquired in purchase
transactions is being amortized using the straight-line method over fifteen
years. The Company evaluates the impairment of goodwill based on expectations
of future non-discounted cash flows and operating income related to purchased
businesses. As of May 31, 2000 and 1999, accumulated amortization was
$759,646 and $552,470.
Revenue Recognition
Income from credit cards receivable represents interest and fees on new
advances or purchases made by holders of the Company's credit cards on an
accrual basis.
F-11
48
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
For the portfolios of nonperforming consumer debt, revenue in excess of cost
recovery is accounted for on a pool basis using the cost recovery method of
accounting in accordance with Practice Bulletin No. 6, "Amortization of
Discounts on Certain Acquired Loans." Under the cost recovery method of
accounting, all cash receipts relating to individual portfolios of
nonperforming consumer debt are applied first to recover the cost of the
portfolios, prior to recognizing any revenue. Cash receipts in excess of cost
of acquired portfolios are then recognized as revenue.
Servicing revenues are fees related to processing and managing credit cards
for third parties. These revenues are recognized when the related services
are provided.
The Company's policy is to accrue fee income and interest on new advances on
all credit card accounts including delinquent accounts, until the account is
charged off. A credit card is contractually delinquent if the minimum payment
is not received on the specified payment due date on the customer's
statement.
For performing credit card portfolios purchased, the Company uses models to
estimate the amount and timing of future cash flows. These models are based
on historical cash collection data from performing receivable portfolios and
are used to compute an effective interest rate for income recognition. For
these portfolios the fair value of credit card receivables is based upon
discounted expected cash flows. The discount rate is based upon an acceptable
rate of return adjusted for specific risk factors inherent in each individual
portfolio.
Allowance for Credit Card Losses
The provision for possible credit card losses includes current period losses
and an amount which, in the judgment of management, is necessary to maintain
the allowance for possible credit card losses at a level that reflects known
and inherent risks in the credit card portfolio. In evaluating the adequacy
of the allowance for credit card losses, management considers several
factors, including: historical trends of charge-off activity for each credit
card portfolio as well as current economic conditions and the impact that
such conditions might have on a borrowers' ability to repay. Significant
changes in these factors could affect the adequacy of the allowance for
credit card losses in the near term. Credit card accounts are generally
charged off at the end of the month during which the credit card receivable
becomes contractually 120 days past due, with the exception of bankrupt
accounts, which are charged off immediately upon formal notification of
bankruptcy, and accounts of deceased cardholders without a surviving,
contractually liable individual, which are also charged off immediately upon
notification.
F-12
49
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
The following table summarizes information about the Company's allowance for
credit card losses.
For the years ended May 31,
---------------------------
2000 1999
----------- -----------
Balance at beginning of period $ 2,846,533 $ 3,688,091
Provision for credit card losses 5,680,975 4,607,081
Credit card receivables charged-off (6,051,670) (5,448,639)
----------- -----------
Balance at end of period $ 2,475,838 $ 2,846,533
=========== ===========
Accounts and Notes Receivable
As of May 31, 2000 and 1999, the accounts and notes receivable allowance for
doubtful accounts was $584,029 and $746,463.
Stock Based Compensation
The Company utilizes the intrinsic value method of accounting for its
stock-based employee compensation plans. Pro-forma information related to the
fair value based method of accounting is contained in note H.
Deferred Income Taxes
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial
reporting purposes and the amounts used for income tax purposes.
F-13
50
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
Net Income (Loss) Per Share
Basic net income (loss) per share is computed by dividing net income (loss)
applicable to common stockholders by the weighted-average number of common
shares outstanding during the period. Net income (loss) applicable to common
stockholders is computed by deducting dividends on preferred stock from net
income (loss). Diluted net income (loss) per share is based on the
weighted-average number of common and common equivalent shares outstanding.
The calculation takes into account the shares that may be issued upon
exercise of stock options, reduced by the shares that may be repurchased with
the funds received from the exercise, based on the average price during the
period. In computing diluted net income (loss) per share, only potential
common shares that are dilutive (those that reduce net income per share) are
included. Exercise of stock options is not assumed if the result would be
antidilutive, such as when a net loss is reported.
Comprehensive Income
Comprehensive income, as defined by SFAS No. 130, "Reporting Comprehensive
Income," includes net income (loss) and items defined as other comprehensive
income. SFAS No. 130 requires that items defined as other comprehensive
income (loss), such as unrealized gains and losses on certain investments in
debt securities, be separately classified in the financial statements. Such
disclosures are included in the consolidated statements of stockholders'
equity.
Reclassifications
Certain reclassifications have been made to prior period amounts to conform
to the current period presentation.
F-14
51
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
Use of Estimates
In preparing financial statements in conformity with accounting principles
generally accepted in the United States of America, management is required to
make estimates and assumptions that affect the reported amounts of assets and
liabilities, the disclosure of contingent assets and liabilities at the date
of the financial statements, and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates.
Significant estimates have been made by management with respect to the timing
and amount of collection of future cash flows from nonperforming consumer
debt and credit card receivables ("portfolios"). Among other things, the
estimated future cash flows of the portfolios are used to recognize
impairment in investment in nonperforming consumer debt, provision for losses
on credit card receivables and fair value of retained interest in securitized
credit card receivables. On a periodic basis, management reviews the estimate
of future collections, and it is reasonably possible that these estimates may
change based on actual results and other factors. A change could be material.
New Accounting Pronouncements
FASB Interpretation 44, Interpretation of APB Opinion 25 ("FIN 44"), was
issued in March 2000. FIN 44 provides an interpretation of APB Opinion 25 on
accounting for employee stock compensation and describes its application to
certain transactions. FIN 44 is effective on July 1, 2000. It applies on a
prospective basis to events occurring after that date, except for certain
transactions involving options granted to nonemployees, repriced fixed
options, and modifications to add reload option features, which apply to
awards granted after December 31, 1998. The provisions of FIN 44 are not
expected to have a material effect on transactions entered into through May
31, 2000.
F-15
52
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE C - INVESTMENTS IN NONPERFORMING CONSUMER DEBT AND
CREDIT CARD RECEIVABLES
Investments in Nonperforming Consumer Debt
The Company acquires portfolios of nonperforming consumer installment debt,
credit card receivables, and automobile deficiency debt from originating
financial institutions. These debts are acquired at a substantial discount
from the actual consumer outstanding balance. The outstanding balance of the
debt acquired by the Company at May 31, 2000 and 1999 was approximately $3.1
billion and $2.0 billion. The Company's objective is to offer the consumer an
opportunity to settle these debts, typically at a discount, and transfer the
settled amount to a newly issued credit card. (See Credit Card Receivables
below.)
Investments in nonperforming consumer debt consist of the following at May
31:
2000 1999
------------ ------------
Cost of portfolios purchased including capitalized
acquisition costs of $2,109,937 and $2,079,897 $ 51,907,168 $ 38,574,174
Cost recovered (42,259,078) (35,557,477)
------------ ------------
Investment in nonperforming consumer debt $ 9,648,090 $ 3,016,697
============ ============
Credit Card Receivables
Upon settlement of the debt, a credit card is issued to the consumer with the
opening balance and credit line equal to the settlement amount. The Company
expenses origination costs including direct mail and telemarketing costs as
incurred. The Company does not record a credit card asset until the
cardholder begins to make new charges on the account. For financial statement
purposes the Company records as credit card receivables the amount funded on
new advances and purchases, accrued interest on new advances and accrued
fees, less provision for losses on credit card receivables and unearned fees.
After making principal payments on the settlement amount, the customer may
use the credit card for new purchases and cash advances up to their available
credit limit, which may be increased from time to time based on their payment
history. Total credit card balances below represent the total amount owed to
the Company by the cardholders. Available credit represents the additional
amount that the Company would be obligated to fund if the credit cards were
fully utilized by the cardholders.
F-16
53
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE C - INVESTMENTS IN NONPERFORMING CONSUMER DEBT AND
CREDIT CARD RECEIVABLES - Continued
May 31,
-------------------------
2000 1999
----------- -----------
Total credit card balances $77,832,562 $55,184,540
=========== ===========
Available credit $ 7,837,918 $ 4,296,364
=========== ===========
Principal funded on new advances and purchases $26,536,055 $21,303,274
Accrued interest on principal funded 420,383 243,489
Accrued fees 429,727 332,446
----------- -----------
27,386,165 21,879,209
----------- -----------
Less:
Provision for losses on credit card receivables $ 2,475,838 $ 2,846,533
Unearned fees 666,127 401,273
----------- -----------
3,141,965 3,247,806
----------- -----------
Credit card receivables $24,244,200 $18,631,403
=========== ===========
NOTE D - SECURITIZATION AND GAIN ON SALES OF CREDIT CARD
RECEIVABLE PORTFOLIOS
During the year ended May 31, 2000, the Company established a new
wholly-owned qualified special purpose entity (SPE), TCS Funding IV, Inc.
(TCS IV), for the purpose of purchasing performing credit card receivables
from the Company. TCS IV entered into a $40,000,000 credit facility with a
lending institution to finance the purchase of credit card receivables. The
initial approximately $12,100,000 sale of credit card receivables to the SPE
included receivables with a principal balance of approximately $14,200,000.
TCS IV provided $10,000,000 for the purchase and the remaining approximately
$2,100,000 of the purchase price was recorded by the Company as retained
interest. The transaction closed on May 31, 2000. The Company recognized a
pre-tax gain, of approximately $3,800,000. The unrealized gain of
approximately $638,000, included in the retained interest, was recorded net
of tax as a separate component of stockholders' equity.
F-17
54
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE D - SECURITIZATION AND GAIN ON SALES OF CREDIT CARD
RECEIVABLE PORTFOLIOS - Continued
At May 31, 2000, the Company recorded a receivable from the SPE for
$9,332,890. This balance represented sales proceeds due to the Company. The
receivable was guaranteed by the lending institution through an irrevocable
commitment to fund. The receivable was collected subsequent to May 31, 2000.
The TCS IV credit facility requires interest payments only during the first
18 months and allows for multiple advances during this period up to $40
million. Borrowings in excess of $10 million are governed by a borrowing base
and are contingent upon the senior beneficial interests receiving a minimum
BBB- rating from a nationally recognized rating agency. The credit facility
advances 70% of the receivables balance, of which 5% must be deposited into a
reserve account. The Company is in the process of attaining a rating on
behalf of TCS IV. The terms of the credit facility require that all credit
card receivables purchased by TCS IV must be current with a minimum of eight
payments made on each account and must meet certain other eligibility
requirements.
During the first 18 months of the credit facility, after new charges are
funded and fees and interest are paid, excess cash collections can be used by
the SPE to purchase additional accounts from the Company or pay down the
senior beneficial interest. Following the first 18 months, all cash
collections relating to the senior debt interest in the receivables are used
to repay principal, after the payment-related servicing fees and interest are
made. All new charges on the sold accounts are either sold to the SPE or
contributed in exchange for a residual interest until such time as the senior
debt interest is paid down. While the senior debt interest is in place, there
are restrictions on payments that can be made by the Company to certain
related parties.
During the year ended May 31, 2000, the Company also sold a portfolio of
receivables totaling approximately $1,400,000, with a carrying value of
approximately $644,000, for approximately $1,100,000 to an unrelated party
without recourse.
During the year ended May 31, 1999, the Company completed three
securitizations of seasoned credit card receivables ("Receivables") of
approximately $20,400,000 with three unconsolidated wholly-owned qualified
special purpose entities ("SPE's"). All receivables sold in these
transactions were current with a minimum of eight payments made on each
account. The SPE's purchased the Receivables from the Company for
approximately $17,300,000, which was funded with the sale of senior debt
interests. The remaining approximately $4,300,000 represented interest
retained by the Company.
F-18
55
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE D - SECURITIZATION AND GAIN ON SALES OF CREDIT CARD
RECEIVABLE PORTFOLIOS - Continued
Under the provisions of SFAS No. 125, the securitizations are accounted for
as sales. As a result, the Company recognized a pre-tax gain of approximately
$8,000,000 and recorded a retained interest in securitized credit card
receivables on an allocated basis in the amount of approximately $1,300,000
based on its relative fair value as discussed in Note B.
At May 31, 1999, the allocated basis amount was adjusted to a fair value of
approximately $5,100,000, resulting in approximately $3,800,000 of unrealized
gain on the retained interest in securitized credit card receivables. The
unrealized gain was recorded net of tax of approximately $1,300,000,
resulting in approximately $2,500,000, as a component of comprehensive
income. The fair value of the retained interest was estimated using a
discount rate of 23% to calculate the present value of all projected net cash
flows from the credit cards reduced by servicing costs and an annualized
default rate of 12%. The discount rate was arrived at by comparison to the
market rate on investments of similar risk and term that are available for
the company to invest in. During November 1999, the Company sold its
retained interest in the three SPE's to the lender for approximately
$8,600,000, resulting in a pre-tax gain of approximately $6,500,000.
As of May 31, 1999, the Company included $1,230,700 in amounts due from SPE's
representing funds advanced with respect to revolving period requirements and
servicing fee income which are paid to the Company on a monthly basis.
During the year ended May 31, 1999, The Company also sold a portfolio of
credit card receivables with a total credit card balance of approximately
$7,000,000 and a carrying value of approximately $2,250,000 for $5,000,000 to
an unrelated party without recourse.
F-19
56
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE E - PROPERTY AND EQUIPMENT
Property and equipment consist of the following at May 31:
Useful
life
(in years) 2000 1999
---------- ------------ ------------
Computer equipment and software 3 - 5 $ 7,289,750 $ 6,631,043
Office equipment 5 - 7 2,280,037 2,275,037
Furniture and fixtures 5 - 7 1,241,458 1,183,400
Proprietary software 5 668,084 460,497
Leasehold improvements Life of leases
669,884 654,475
------------ ------------
12,149,213 11,204,452
Less accumulated depreciation and
amortization (7,489,579) (5,202,266)
------------ ------------
4,659,634 6,002,186
Land 130,426 130,426
------------ ------------
$ 4,790,060 $ 6,132,612
============ ============
NOTE F - NOTES PAYABLE
Notes payable consist of the following at May 31:
2000 1999
----------- ----------
Note payable - bank $13,442,597 $3,644,776
Note payable - other lenders 10,065,808 2,217,714
Note payable - other 100,921 224,276
----------- ----------
$23,609,326 $6,086,766
=========== ==========
F-20
57
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE F - NOTES PAYABLE - Continued
Note Payable - Bank
On April 30, 1998, the Company entered into a financing agreement with a
bank. The revolving line of credit, may not exceed an established dollar
amount or 50% of the Company's eligible receivables as defined by the
agreement and is used for general working capital purposes. The originally
established dollar amount, which was $5,000,000, was increased to $10,000,000
on June 25, 1999 and increased to $15,000,000 on December 6, 1999. The line
is collateralized by substantially all of the Company's assets. The interest
rate, which was originally at the prime rate plus 2.75% per annum, was
reduced to prime rate plus 2.5% per annum on June 25, 1999. The agreement
expires July 29, 2001. Interest expense for the years ended May 31, 2000,
1999 and 1998 was $1,501,047, $617,249, and $27,936.
Note Payable - Other Lenders
The Company has uncollateralized installment notes with respect to purchases
of nonperforming consumer debt in addition to assuming installment
obligations from the closing of certain affiliated mortgage companies (see
Note L). The notes have various maturity dates through May 2002, with
interest rates ranging up to 23.7% per annum. The amount outstanding as of
May 31, 2000 and 1999 was $2,292,920 and $2,217,714. Interest expense for the
years ended May 31, 2000, 1999 and 1998 was $145,763, $65,353, and $51,925.
On October 15, 1999, the Company, through a bankruptcy remote special purpose
entity (SPE), entered into a revolving line of credit ("revolving line") with
a financial institution. The revolving line, which may not exceed
$17,500,000, is non-recourse to the Company and is secured by all assets of
the SPE. The revolving line is used to acquire non-performing consumer debt
portfolios. The Company services the portfolios subject to an agreement with
the SPE and purchases all new credit card receivables for a pre-determined
price. The SPE is not a Qualified SPE for accounting purposes and is fully
consolidated with the Company in the accompanying consolidated financial
statements. Interest is charged at a floating daily rate and is equal to the
reference rate plus 2.5% per annum. The agreement is in effect until August
31, 2002. The amount outstanding as of May 31, 2000 was $1,772,888. Interest
expense for the year ended May 31, 2000 was $151,547.
F-21
58
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE F - NOTES PAYABLE - Continued
On September 20, 1999, the Company entered into a repurchase agreement with a
bank. Under the agreement the bank purchased credit card receivables from the
Company for $3,000,000. The agreement had an initial repurchase date of
December 20, 1999, which has been extended to September 15, 2000. In
addition, the agreement was increased to $6,000,000 effective March 17, 2000.
Interest is charged at a rate of 15% per annum. Interest expense for the year
ended May 31, 2000 was $378,750.
At May 31, 2000, future minimum principal payments for all notes payable were
as follows:
Year Amount
---- --------
2001 $ 8,156,058
2002 13,680,381
2003 1,772,887
-----------
$23,609,326
===========
NOTE G - CAPITAL LEASE OBLIGATIONS
The Company leases computer equipment and furniture and fixtures under
long-term leases and has the option to purchase the equipment for a nominal
cost at the termination of the lease. Assets under capital leases have been
capitalized at a cost of $6,953,160 and $6,526,915, and have accumulated
amortization of $5,023,793 and $3,646,314 at May 31, 2000 and 1999.
F-22
59
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE G - CAPITAL LEASE OBLIGATIONS - Continued
Future minimum lease payments for capitalized leases are as follows at May
31, 2000:
Year Amount
---- --------
2001 $1,695,728
2002 1,325,048
2003 328,479
2004 27,282
----------
3,376,537
Less amount representing interest (610,309)
----------
$2,766,228
==========
Amortization expense for assets under capital leases for the years ended May
31, 2000, 1999 and 1998 was $1,377,479, $1,645,705 and $1,535,029.
NOTE H - STOCK OPTIONS
The Board of Directors of the Company approved the Company's 1997 Stock
Option Plan (the "Plan"). The Plan authorizes the grant of stock options
covering 4,000,000 shares of the Company's common stock. In addition, the
Board of Directors has granted stock options outside the Plan covering a
total of 1,550,000 shares of Common Stock. The Board of Directors has the
authority to determine the key employees, consultants, and directors who
shall be granted options as well as the number of options granted and the
nature of each grant. The options granted under the Plan may be either
incentive stock options or nonqualified stock options.
F-23
60
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE H - STOCK OPTIONS - Continued
Transactions during each of the three years in the period ended May 31, 2000
are summarized as follows:
Number of Weighted
shares under average
option exercise price
------------ ---------------
Outstanding at June 1, 1997 2,550,000 $5.76
Granted 3,021,000 2.45
Cancelled (1,915,000) 5.93
----------
Outstanding at May 31, 1998 3,656,000 2.93
Granted 690,500 2.35
----------
Outstanding at May 31, 1999 4,346,500 2.84
Granted 942,500 2.90
Cancelled (156,000) 2.08
----------
Outstanding at May 31, 2000 5,133,000 $2.88
==========
Options exercisable at May 31 are as follows:
1998 2,395,000 $3.39
1999 3,305,500 3.08
2000 4,750,000 2.88
The following table summarizes information about stock options outstanding at
May 31, 2000:
Options outstanding
------------------------------------------------
Weighted
average Weighted
Range of remaining average
exercise Number life exercise
prices outstanding (years) price
---------------- ----------- ------------- --------
$2.00 - $2.50 3,433,500 3.12 $2.09
$2.69 - $4.03 720,500 3.97 3.10
$4.50 - $5.50 979,000 1.90 5.48
---------
5,133,000 $2.88
========= =====
F-24
61
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE H - STOCK OPTIONS - Continued
Options exercisable
---------------------------------------
Number Weighted
Range of exercisable at average
exercise May 31, exercise
prices 2000 price
---------------- ------------------ --------
$2.00 - $2.50 3,250,500 $2.09
$2.69 - $4.03 532,500 2.96
$4.50 - $5.50 967,000 5.49
---------
4,750,000 $2.88
========= =====
On April 30, 1998, the Company granted warrants to purchase 650,247 shares of
the Company's common stock for $2.50 per share to a bank with which it has a
financing agreement. Warrants to purchase 278,677 shares were exercisable
immediately, while the remaining 371,570 warrants were exercisable on June
25, 1999, when the Company's line of credit increased to $10,000,000 (see
Note F). The fair value of the warrants was $1.01 at the date of grant. For
the year ended May 31, 2000, $357,182 of amortization was included in
interest expense.
On March 18, 1999, the Company granted a five-year warrant to a vendor to
purchase 250,000 shares of the Company's common stock at $2.00 per share.
The fair value was $0.85 per warrant. For the year ended May 31, 2000,
expense was $72,262.
The Company's proforma net income (loss) applicable to common shareholders
and basic and diluted net income (loss) per share would have been as follows
had the fair value method been used for valuing stock options granted to
employees for the year ended May 31 are as follows:
2000 1999 1998
----------- --------- -----
Net income (loss) applicable to common
shareholders $ (506,953) $50,109 $(30,214,556)
Net income (loss) per share
Basic and diluted $(0.01) $0.00 $(0.91)
F-25
62
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE H - STOCK OPTIONS - Continued
The fair value of each option grant is estimated on the date of grant using
the Black-Scholes option pricing model with the following assumptions:
For the years ended May 31,
------------------------------------------------------------------
2000 1999 1998
--------------------- -------------------- ----------------
Fair value of options granted $2.12 $1.73 $1.52
Assumptions:
Dividend yield $0 $0 $0
Volatility 90% 90% 120%
Average term 5 or 10 years 5 or 10 years 5 or 10 years
Risk-free rate of return 6.05% - 6.47% 5.75% - 5.81% 4.50%
NOTE I - INCOME TAXES
Deferred income tax assets (liabilities) consist of the following at May 31:
2000 1999
------------ ------------
Deferred tax assets
Net operating loss carryforward $ 14,291,477 $ 17,065,146
Allowance for doubtful accounts 1,389,759 1,221,619
------------ ------------
Total deferred tax assets 15,681,206 18,286,765
Less valuation allowance (10,327,461) (12,270,988)
------------ ------------
5,353,745 6,015,777
Deferred tax liabilities
Gain on sales of portfolios (2,324,961) (4,029,368)
Unrealized gain on retained interest in securitization (328,784) (1,286,409)
------------ ------------
Total deferred tax liabilities (2,653,745) (5,315,777)
------------ ------------
Net deferred tax asset $ 2,700,000 $ 700,000
============ ============
F-26
63
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE I - INCOME TAXES - Continued
The difference between the total income tax benefit and the income tax
expense computed using the applicable Federal income tax rate was as follows
for the years ended May 31:
2000 1999 1998
------------ ------------ ------------
Computed Federal income taxes at 34% $ 690,139 $ 642,352 $(10,011,311)
Increase (decrease) of deferred tax asset
valuation allowance (1,732,514) (2,628,761) 10,011,311
------------ ------------ ------------
Income tax benefit $ (1,042,375) $ (1,986,409) $ --
============ ============ ============
At May 31, 2000, the Company has a net operating loss carryforward available
to offset future taxable income of approximately $42,000,000, which will
begin to expire in 2012. The benefit of the net operating loss carryforwards
is dependent upon the tax laws in effect at the time the net operating loss
carryforwards are to be utilized and the change of control rules.
The Company continually reviews the adequacy of the valuation allowance and
recognizes those benefits only as the Company's assessment indicates that it
is more likely than not that future tax benefits will be realized. Based upon
actual pretax income and projected future earnings, the Company has reduced
the valuation allowance by $2,000,000 and $700,000 for the years ended
May 31, 2000 and 1999, respectively. The Company maintains a valuation
allowance for the remaining amount of deferred tax assets created by net
operating losses and the allowance for doubtful accounts.
NOTE J - EMPLOYEE BENEFIT PLANS
In January 1998, the Company adopted a defined contribution 401(k)
profit-sharing plan for its employees. All employees working at least 1,000
hours per year are eligible to participate in the plan. Employees can
contribute up to 15% of their salary up to $10,000 and $9,500 for the
calendar years 1999 and 1998. The plan requires the employer to match 100% of
the first 3% of compensation contributed to the plan by the employees.
Employer contributions vest at a rate of 20% per year. Additional employer
contributions are allowable at the discretion of the Board of Directors. The
Company expensed $217,271, $173,479 and $84,573 in 2000, 1999 and 1998
relating to this plan.
F-27
64
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE K - MUTUAL BUSINESS DEVELOPMENT AGREEMENTS
The Company is obligated to pay royalties to previous owners under the terms
of Mutual Business Development Agreements ("Development Agreements").
The royalty is equal to five percent of the balance transfer amount, as
defined, on all converted credit card accounts which: (i) are delivered to a
pre-securitization credit facility, (ii) become a qualifying receivable, or
(iii) meet other specified account age and payment parameters. A qualifying
receivable is defined as any converted account on which the cardholder has
made three consecutive payments within certain time restrictions. In
addition, the Company is required to pay royalties equal to five percent of
all principal cash collections on certain accounts that are not converted to
credit cards. The term of the Development Agreements expires in 2002 and the
total royalty, if earned, payable to each of the previous owners, after
certain deductions and exclusions, shall not exceed $25,000,000. For the
years ended May 31, 2000, 1999, and 1998, $1,733,412, $1,541,944, and
$207,238 of royalty expenses were incurred with $740,487, $702,075, and
$261,667 accrued at May 31, 2000, 1999, and 1998. One of the Development
Agreements was amended on September 1, 1998. The amendment clarifies the
amount and timing of payments, gives the Company a buyout option, alternate
royalty payment options, and extends the term of the agreement to May 31,
2005.
NOTE L - RELATED PARTY TRANSACTIONS
At May 31, 2000 and 1999, the Company owed amounts under subordinated
promissory notes to JLB of Nevada, Inc. ("JLB"), an entity wholly owned by
Jay L. Botchman ("Botchman"), a director, totaling $16,444,940 payable on
demand with interest at 12% per annum. Interest expense on these notes was
$2,006,283, $2,307,467, and $3,635,891 for the years ended May 31, 2000,
1999, and 1998. Accrued interest related to subordinated promissory notes was
approximately $1,500,000, $1,300,000, and $4,000,000 at May 31, 2000, 1999,
and 1998. The notes are collateralized by substantially all the Company's
assets, but subordinated to the Company's revolving credit lines.
F-28
65
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE L - RELATED PARTY TRANSACTIONS - Continued
On May 29, 1999, JLB, in lieu of payment of $5,000,000 of interest on the
subordinated promissory notes, received a warrant to purchase 4,000,000
shares of the Company's common stock with an exercise price of $3.25 per
share, expiring on May 29, 2004, and the Company's assumption of equipment
and related lease obligations from a company affiliated with JLB in the
amount of approximately $1,700,000. The fair value of the warrant was
approximately $3,300,000.
On February 27, 1998, the Company issued a subordinated promissory note to
Botchman in the amount of $350,000 payable on demand with interest at 12% per
annum. The note was paid during fiscal 2000. Interest expense for the years
ended May 31, 2000, 1999 and 1998 was $18,200, $42,583, and $10,733.
The Company, through its wholly-owned subsidiary, American Credit Alliance,
Inc., has an $880,000 note payable to JLB with an interest rate of 10% per
annum. American Credit Alliance Inc. is the managing member and 50% owner of
Dakota Card Fund II, LLC, an entity that owns performing credit card
receivables. Interest expense for the years ended May 31, 2000, 1999, and
1998 was $89,467, $89,222 and $85,195. Accrued interest related to this note
payable was approximately $327,000, $238,000 and $152,649 at May 31, 2000,
1999 and 1998.
The Company made a series of investments during the period May 1997 through
December 1997 totaling $508,600 in a subprime mortgage banking company
affiliated with JLB. At May 31, 1998, the investment was written off due to
the substantial doubt regarding the mortgage banking company's ability to
continue as a going concern. In addition, the Company had a receivable due
from this company of approximately $183,000, which was also written off as of
May 31, 1998.
F-29
66
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE L - RELATED PARTY TRANSACTIONS - Continued
The Series A and B Preferred Shares were issued at $1.00 per share (total of
$2,000,000) on December 4, 1996 to a related party. The Series A Preferred
Stock, as a class, has 80% of the voting rights in the Company. The Series B
Preferred Stock has one vote per share. The shares of Series A and B
Preferred Stock have a liquidation preference of $1.00 per share and will
earn cumulative dividends at a rate of 5% per annum. After five years, (i)
the Series A and B Preferred Stock will be redeemable at the option of the
Company, and (ii) while the Series B Preferred Stock is outstanding will be
convertible at the option of the holder into Series A Preferred Stock on a
share-for-share basis.
On December 31, 1996, the Company issued 5,000 shares of Series C Preferred
Stock to a related party for $5,000,000. The Series C Preferred Stock is
non-voting and will earn cumulative dividends at 6% per annum. The shares
have a liquidation preference of $1,000 per share. The Series A and B
Preferred Stock ranks senior to the Series C with respect to dividend and
liquidation rights.
On May 29, 1998, the Company issued 10,000 shares of Series D Preferred Stock
to a related party in exchange for cancellation of a $10,000,000 Promissory
Note dated August 1, 1997. The Series D Preferred Stock is non-voting and
will earn a dividend of 8% per annum payable annually on December 31. The
shares have a liquidation preference of $1,000 per share. The Series D
Preferred Stock ranks senior to the Series A, B and C with respect to
dividend and liquidation rights. Each share of Series D Preferred Stock is
convertible into 380 shares of common stock. The agreement grants piggyback
registration rights with respect to the Common Stock issuable upon conversion
of the shares of Series D Preferred Stock.
On August 31, 1998, the Company issued 10,000 shares of Series E Preferred
Stock to a related party in exchange for agreeing to cancel a $10,000,000
subordinated promissory note. The Series E Preferred Stock is non-voting and
will earn a dividend of 8% per annum payable annually on December 31. Each
share of Series E Preferred Stock is convertible into 285 shares of common
stock at any time prior to August 31, 2001. The Series E Preferred Stock
ranks senior to the Series A, B, C and D with respect to dividend and
liquidation rights.
As of May 31, 2000, 1999, and 1998, accumulated preferred dividends
undeclared and unpaid on preferred stock amounted to approximately
$4,200,000, $2,200,000, and $400,000, respectively.
F-30
67
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE M - COMMITMENTS AND CONTINGENCIES
Operating Leases
The Company leases certain properties, vehicles and equipment under
noncancelable operating leases. Total lease rentals charged to operations
were approximately $858,000, $766,000 and $776,000, for the years ended May
31, 2000, 1999 and 1998. Future minimum lease payments under the
noncancelable operating leases are as follows:
Year ending May 31, Amount
--------
2001 $ 644,000
2002 370,000
2003 311,000
2004 290,000
2005 285,000
Thereafter 2,019,000
----------
$3,919,000
==========
Contingencies and Litigation
The Company, in the ordinary course of business, receives notices of consumer
complaints from regulatory agencies and is named as a defendant in legal
actions filed by those who have been solicited to participate in its credit
card programs. Currently pending against the Company are: (i) three class
actions on behalf of persons purportedly solicited by the Company to
voluntarily repay debt that had been discharged in bankruptcy, alleging that
the Company had violated other provisions of federal or state law, including
violations of the Bankruptcy Code, the Fair Debt Collection Practices Act,
the Truth in Lending Act, various state consumer protection laws and, in one
case, RICO, and (ii) four class actions alleging violation of the Fair Debt
Collection Practices Act and similar state laws in connection with mailers
sent to prospective customers to collect out-of-statute debt. The Company is
defending itself vigorously in these lawsuits. The Company does not believe
that pending litigation and regulatory complaints involving the Company will
have a material adverse effect on the consolidated financial position and
consolidated results of operations. However, a significant judgment against
the Company in one or more of the lawsuits could subject the Company to a
monetary judgment and/or require the Company to modify its methods of
operation, either of which could have a material adverse effect on the
Company's consolidated results of operations or consolidated financial
condition.
F-31
68
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE N - FAIR VALUE OF FINANCIAL INSTRUMENTS
The accompanying financial statements include various estimated fair value
information as of May 31, 2000, 1999 and 1998. As required by SFAS No. 107,
"Disclosures About Fair Value of Financial Instruments," such information,
which pertains to the Company's financial instruments, is based on the
requirements set forth in the statement and does not purport to represent the
aggregate net fair value of the Company. None of the Company's financial
instruments are held for trading purposes.
The following methods and assumptions were used to estimate the fair value of
each class of financial instrument for which it is practicable to estimate
fair value.
Cash, Cash Equivalents and Restricted Cash
The carrying amount approximates fair value.
Accounts and Notes Receivables
The carrying amount approximates fair value.
Amounts Due from Special Purpose Entities
The carrying amount approximates fair value.
Investments in Nonperforming Consumer Debt
The Company records investments in nonperforming consumer debt at the cost of
the purchased portfolios, net of costs recovered. As the debt was purchased
at a significant discount, the fair value of these portfolios may be
significantly higher than presented in the financial statements. The fair
value at May 31, 2000 and 1999 was estimated using a net present value
calculation of the cash flows the Company expects to generate from these
portfolios.
F-32
69
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE N - FAIR VALUE OF FINANCIAL INSTRUMENTS - Continued
Credit Card Receivables
Credit card receivables are originated with an initial interest rate of 19.9%
or 18.9%. As discussed in Note C, the settlement amount of the receivables
exceeds the credit card receivables reflected on the consolidated balance
sheet. Fair values at May 31, 2000 and 1999 have been estimated based on a
net present value of the cash flows expected to be generated by the credit
cards. The Company applied its actual static pool experience of repayment
rates and defaults to estimate fair value.
Retained Interest in Securitized Credit Card Receivables
The carrying amount approximates fair value. Fair value is estimated by
discounting anticipated future cash flows using a discount rate based on
specific factors. The anticipated future cash flows are projected on a "cash
out" basis to reflect the restriction of cash flows until the investors have
been fully paid.
Notes Payable
The carrying amount approximates fair value. Rates currently available to the
Company for debt with similar terms and remaining maturities are used to
estimate the fair value of existing debt.
Subordinated Notes and Accrued Interest Payable
Due to the related party relationship of these notes, it is not practical to
estimate fair value.
Accounts Payable and Accrued Expenses
The carrying amount approximates fair value.
F-33
70
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE N - FAIR VALUE OF FINANCIAL INSTRUMENTS - Continued
The carrying amounts and estimated fair values of the Company's financial
instruments consisted of the following:
May 31,
-----------------------------------------------------
2000 1999
------------------------- -------------------------
Carrying Estimated Carrying Estimated
value fair value value fair value
----------- ----------- ----------- -----------
Cash, Cash Equivalents and Restricted
Cash $ 2,448,879 $ 2,448,879 $ 4,283,930 $ 4,283,930
Accounts and Notes Receivable $ 2,765,882 $ 2,765,882 $ 1,150,207 $ 1,150,207
Amounts Due from Special Purpose
Entities $ 9,332,890 $ 9,332,890 $ 1,230,700 $ 1,230,700
Investments in Nonperforming Consumer
Debt $ 9,648,090 $21,000,000 $ 3,016,697 $14,400,000
Credit Card Receivables $24,244,200 $42,900,000 $18,631,403 $27,500,000
Retained Interest in Securitized Credit
Card Receivables $ 2,142,846 $ 2,142,846 $ 5,130,372 $ 5,130,372
Notes Payable $23,609,326 $23,609,326 $ 6,086,766 $ 6,086,766
Accounts Payable and Accrued Expenses $ 4,499,142 $ 4,499,142 $ 4,313,409 $ 4,313,409
Financial Accounting Standards Board Statement No. 107 excludes certain
financial instruments and all non-financial instruments from its disclosure
requirements. Accordingly, the aggregate estimated net fair value amount does
not represent, and should not be interpreted to represent, the fair value of
the Company.
F-34
71
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE O - NET INCOME (LOSS) PER SHARE
Years ended May 31,
------------------------------------------
2000 1999 1998
------------ ------------ ------------
Basic net income (loss) per share
Net income (loss) available to common
stockholders $ 1,072,195 $ 2,075,681 $(29,845,027)
============ ============ ============
Weighted-average shares outstanding 34,761,965 34,761,965 33,109,781
============ ============ ============
Basic net income (loss) per share $ 0.03 $ 0.06 $ (0.90)
============ ============ ============
Diluted net income (loss) per share
Net income (loss) available to common
stockholders $ 1,072,195 $ 2,075,681 $(29,845,027)
============ ============ ============
Weighted-average shares outstanding 34,761,965 34,761,965 33,109,781
Effect of diluted securities options 6,574,196 3,674,154 *
------------ ------------ ------------
Weighted-average of diluted shares
outstanding 41,336,161 38,436,119 33,109,781
============ ============ ============
Diluted net income (loss) per share $ 0.03 $ 0.05 $ (0.90)
============ ============ ============
*Antidilutive.
NOTE P - PREFERRED STOCK
As of May 31, 2000 and 1999, Preferred Stock consists on the following:
2000 1999
------ ------
Series A Preferred Stock, $.001 par value; 2,000,000 shares authorized;
1,200,000 shares issued and outstanding; stated at
liquidation value of $1 per share $ 1,200,000 $ 1,200,000
Series B Preferred Stock, $.001 par value; 800,000 shares authorized,
issued, and outstanding; stated at liquidation value of $1 per share 800,000 800,000
F-35
72
THE CREDIT STORE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MAY 31, 2000, 1999 AND 1998
NOTE P - PREFERRED STOCK - Continued
2000 1999
------ ------
Series C Preferred Stock, 5,000 shares authorized, issued, and
outstanding; stated at liquidation value of $1,000 per
share $ 5,000,000 $ 5,000,000
Series D Preferred Stock, $.001 par value; 10,000 shares authorized,
issued, and outstanding, convertible into 3,800,000 shares of common
stock; stated at liquidation value of $1,000 per share
Series E Preferred Stock, $.001 par value; 20,000 shares authorized 10,000,000 10,000,000
convertible into 5,700,000 shares of common stock; 10,000 shares issued
and outstanding; stated at liquidation value of $1,000 per share 10,000,000 10,000,000
----------- -----------
Total $27,000,000 $27,000,000
=========== ===========
F-36
73
(b) Index to Exhibits
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
------ -----------------------
3.1* Amended and Restated Certificate of Incorporation
3.2* Amended and Restated By-Laws
4* Specimen certificate representing shares of Common Stock
10.1* Amended and Restated Lease Agreement dated December 12, 1996 between Service One
International Corporation and Donald A. Dunham, Jr.
10.2* Amendment No. One to the Amended and Restated Lease Agreement dated June 11,
1997 between Service One International Corporation and Donald A. Dunham, Jr.
10.3* Amendment No. Two to the Amended and Restated Lease Agreement dated July 31,
1997 between Service One International Corporation and Donald A. Dunham, Jr.
10.4* Lease Agreement dated February 28, 1997 between Service One International
Corporation and Eagle Properties, L.L.C.
10.5* Addendum to Lease Agreement dated November 18, 1997 between Service One
International Corporation and Eagle Properties, L.L.C.
10.6* Mutual Business Development Agreement dated as of October 8, 1996, between
Service One International Corporation and the O. Pappalimberis Trust
10.7* Amendment dated as of December 16, 1997 to the Mutual Business Development
Agreement dated as of October 8, 1996, such amendment among O. Pappalimberis
Trust, Taxter One LLC, Service One International Corporation, Eikos Management,
LLC and Thesseus International Asset Fund
10.8* Amendment dated September 1, 1998 to the Mutual Business Development Agreement
dated as of October 8, 1996, as amended, between the Company and Eikos
Management LLC
10.9* Mutual Business Development Agreement dated as of October 8, 1996, between
Service One International Corporation and Renaissance Trust I
37
74
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
------ -----------------------
10.10* Strategic Modeling Agreement dated March 18, 1999, between the Company and
Business Transactions Express, Inc.
10.11* Warrant to purchase Common Stock of the Company issued to J.L.B. of Nevada, Inc. on
June 22, 1999
10.12* Loan and Security Agreement, dated as of April 30, 1998, between the Company and
Coast Business Credit, a division of Southern Pacific Bank
10.13* First Amendment to Loan and Security Agreement, dated as of September 30, 1998,
between the Company and Coast Business Credit, a division of Southern Pacific
Bank
10.14* Second Amendment to Loan and Security Agreement, dated as of December 1, 1998,
between the Company and Coast Business Credit, a division of Southern Pacific
Bank
10.15* Amendment Number Two to Loan and Security Agreement, dated as of April 27, 1999,
between the Company and Coast Business Credit, a division of Southern Pacific
Bank
10.16* Fourth Amendment to Loan and Security Agreement, dated as of May 27, 1999,
between the Company and Coast Business Credit, a division of Southern Pacific
Bank
10.17* Amendment Number Five to Loan and Security Agreement, dated as of June 25, 1999,
between the Company and Coast Business Credit, a division of Southern Pacific
Bank
10.18* Amendment Number Six to Loan and Security Agreement Dated as of December 6, 1999
between the Company and Coast Business Credit, a division of Southern Pacific
Bank
10.19* Security Agreement dated as of August 1, 1997, between J.L.B. of Nevada, Inc.,
Credit Store Mortgage, Inc., New Beginnings Corp., Consumer Debt Acquisitions,
Inc., Sleepy Hollow Associates, Inc., Service One Holdings Inc., Service One
International Corporation, American Credit Alliance, Inc., Service One
Receivables Acquisition Corporation, the Company, Service One Commercial
Corporation and Soiland Company
38
75
EXHIBIT
NUMBER
------
DESCRIPTION OF DOCUMENT
-----------------------
10.20* First Amendment to Security Agreement, dated as of October 23, 1997 between
J.L.B. of Nevada, Inc., the Company and Credit Store Mortgage, Inc., New
Beginnings Corp., Consumer Debt Acquisitions, Inc., Sleepy Hollow Associates,
Inc., Service One Holdings, Inc., Service One International Corporation, Service
One Receivables Acquisition Corporation, the Company, Service One Commercial
Corporation and Soiland Company
10.21* Second Amendment to Security Agreement, dated as of November 21, 1997 between
J.L.B. of Nevada, Inc., the Company, Sleepy Hollow Associates, Inc., Service One
International Corporation, American Credit Alliance, Inc. and Service One
Receivables Acquisition Corporation
10.22* Credit Agreement Dated as of October 15, 1999 among Credit Store Capital Corp.,
the Company, The Lenders Signatory thereto from time to time, and General
Electric Capital Corporation
10.23* Amended 1997 Stock Option Plan of the Company
10.24* Employment Agreement dated March 27, 1997, between the Company and Martin Burke
10.25* Letter from Martin Burke dated March 27, 1997, regarding credit card repayment
terms
10.26* Employment Agreement dated April 1, 1997, between the Company and Kevin Riordan
10.27* Employment Agreement dated June 17, 1997, between the Company and Michael
Philippe
10.28* Amendment to Employment Agreement between Company and Michael Philippe dated
December 15, 1999
10.29* Employment Agreement dated August 1, 1997, between the Company and Richard Angel
10.30* Amendment to Employment Agreement between Company and Richard Angel dated
December 15, 1999
10.31* Employment Agreement dated October 15, 1997, between the Company and Cynthia
Hassoun
39
76
EXHIBIT
NUMBER
------
DESCRIPTION OF DOCUMENT
-----------------------
10.32* Bankcard Marketing Agreement between the Company and Bank of Hoven dated
February 9, 1999
10.33* Purchase Agreement between Bank of Hoven and the Company dated February 9, 1999
10.34* Bankcard Marketing Agreement between Service One International Corporation and
First National Bank in Brookings dated October 2, 1997
10.35* Purchase Agreement between First National Bank in Brookings and Service One
International Corporation doing business as TCS Services, Inc. dated October 2,
1997
10.36* Amendment to Purchase Agreement by First National Bank in Brookings and the
Company dated August 31, 1998
10.37* Letter Agreement Regarding Bankcard Marketing Agreement and Purchasing Agreement
between the Company and First National Bank in Brookings dated August 17, 1999
10.38* Agreement Regarding Transfer of Accounts between the Company and First National
Bank in Brookings dated December 14, 1998
10.39* Subordinated Grid Promissory Note of the Company in favor of J.L.B. of Nevada, Inc. dated
August 1, 1997 in the amount of $20,000,000
10.40* Subordinated Grid Promissory Note of the Company in favor of J.L.B. of Nevada, Inc. dated
October 23, 1997 in the amount of $5,000,000
10.41* Subordinated Grid Promissory Note of the Company in favor of J.L.B. of Nevada, Inc. dated
November 21, 1997 in the amount of $5,000,000
21 List of Subsidiaries Filed Electronically
23 Consent of Independent Certified Public Accountants Filed Electronically
27.1 Financial Data Schedule Filed Electronically
-----------------------
* Incorporated by reference to the like numbered Exhibit to the Company's
Registration Statement on Form 10 filed February 24, 2000 (File No.
000-28709).
40
77
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Company has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
THE CREDIT STORE, INC.
Dated: August 29, 2000
By Martin J. Burke, III
----------------------------------
Martin J. Burke, III
Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed by the following persons on behalf of the Registrant
and in the capacities indicated as of August 29, 2000.
SIGNATURE TITLE
- ----------------------------------------------------------------- --------------------------------------------
Martin J. Burke, III Chairman of the Board
- ----------------------------------------------------------------- and Chief Executive Officer
Martin J. Burke, III
Michael J. Philippe Executive Vice President,
- ----------------------------------------------------------------- Chief Financial Officer and
Michael J. Philippe Treasurer
Jay L. Botchman Director
- -----------------------------------------------------------------
Jay L. Botchman
Barry E. Breeman Director
- -----------------------------------------------------------------
Barry E. Breeman
J. Richard Budd, III Director
- -----------------------------------------------------------------
J. Richard Budd, III
Geoffrey A. Thompson Director
- -----------------------------------------------------------------
Geoffrey A. Thompson
41