, FORM 10-Q SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the Quarterly Period Ended September 30, 2001 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 Commission File No. 1-14771 MICROFINANCIAL INCORPORATED (Exact name of Registrant as specified in its Charter) Massachusetts 04-2962824 (State or other jurisdiction of (I.R.S. Employer Identification No.) Incorporation or Organization) 950 Winter Street, Waltham, MA 02451 (Address of Principal Executive Offices) (781) 890-0177 (Registrant's Telephone Number, Including Area Code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(b) of the Securities and Exchange act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X] Yes [ ] No As of November 10, 2001, 12,836,946 shares of the registrant's common stock were outstanding. MICROFINANCIAL INCORPORATED TABLE OF CONTENTS Page Part I FINANCIAL INFORMATION Item 1 Financial Statements (unaudited): Condensed Consolidated Balance Sheets December 31, 2000 and September 30, 2001 3 Condensed Consolidated Statements of Operations Three and nine months ended September 30, 2000 and 2001 4 Condensed Consolidated Statements of Cash Flows Three and nine months ended September 30, 2000 and 2001 5 Notes to Condensed Consolidated Financial Statements 7 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations 13 Item 3 Quantitative and Qualitative Disclosures about Market Risk 16 Part II OTHER INFORMATION Item 1 Legal Proceedings 17 Item 6 Exhibits and Reports on Form 8-K 18 Signatures 19 2 MICROFINANCIAL INCORPORATED CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands, except share data) (Unaudited) December 31, September 30, --------------- -------------- 2000 2001 ---- ---- ASSETS Net investment in leases and loans: Receivables due in installments $405,437 $401,895 Estimated residual value 35,368 38,431 Initial direct costs 9,321 7,842 Loans receivable 12,080 4,306 Less: Advance lease payments and deposits (400) (317) Unearned income (132,687) (115,440) Allowance for credit losses (40,924) (37,773) --------------- -------------- Net investment in leases and loans $288,195 $298,944 Investment in service contracts 12,553 13,467 Cash and cash equivalents 17,957 21,576 Property and equipment, net 11,505 18,733 Other assets 12,392 14,738 --------------- -------------- Total assets $342,602 $367,458 =============== ============== LIABILITIES AND STOCKHOLDERS' EQUITY Notes payable $201,991 $208,337 Subordinated notes payable 4,785 3,162 Capitalized lease obligations 859 951 Accounts payable 1,605 2,262 Dividends payable 573 642 Other liabilities 5,433 6,426 Income taxes payable 2,333 (7) Deferred income taxes payable 29,000 36,420 --------------- -------------- Total liabilities 246,579 258,193 --------------- -------------- Commitments and contingencies - - Stockholders' equity: Preferred stock, $.01 par value; 5,000,000 shares authorized; 0 shares issued at 12/31/00; 0 shares issued at 9/30/01 - - Common stock, $.01 par value; 25,000,000 shares authorized; 13,410,646 shares issued at 12/31/00; 13,410,646 shares issued at 9/30/01 134 134 Additional paid-in capital 47,900 47,724 Retained earnings 55,291 67,672 Treasury stock (669,700 shares of common stock at 12/31/00, 573,700 shares of common stock at 9/30/01), at cost (7,234) (6,197) Notes receivable from officers and employees (68) (68) --------------- -------------- Total stockholders' equity 96,023 109,265 --------------- -------------- Total liabilities and stockholders' equity $342,602 $367,458 =============== ============== The accompanying notes are an integral part of the condensed consolidated financial statements. 3 MICROFINANCIAL INCORPORATED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except share and per share data) (Unaudited) For the three months ended For the nine months ended September 30, September 30, ---------------------------------- ---------------------------------- 2000 2001 2000 2001 ---- ---- ---- ---- Revenues: Income on financing leases and loans $18,435 $18,105 $50,925 $54,897 Income on service contracts 2,184 2,186 6,557 6,420 Rental income 7,564 9,744 20,235 28,131 Loss and damage waiver fees and other 1,519 2,767 4,474 8,293 Service fees 3,837 3,320 10,931 10,952 ---------------------------------- ---------------------------------- Total revenues 33,539 36,122 93,122 108,693 ---------------------------------- ---------------------------------- Expenses: Selling general and administrative 6,879 7,905 20,047 25,613 Provision for credit losses 10,576 15,064 28,145 37,150 Depreciation and amortization 2,808 3,618 7,395 10,700 Interest 4,124 3,252 10,849 10,645 ---------------------------------- ---------------------------------- Total expenses 24,387 29,839 66,436 84,108 ---------------------------------- ---------------------------------- Income before provision for income taxes 9,152 6,283 26,686 24,585 Provision for income taxes 3,851 2,644 11,284 10,348 ---------------------------------- ---------------------------------- Net income $5,301 $3,639 $15,402 $14,237 ================================== ================================== Net income per common share - basic $0.42 $0.28 $1.21 $1.11 ================================== ================================== Net income per common share - diluted $0.42 $0.28 $1.20 $1.10 ================================== ================================== Weighted-average shares used to compute: Basic net income per share 12,705,337 12,825,139 12,733,833 12,775,519 ---------------------------------- ---------------------------------- Fully diluted net income per share 12,760,298 13,094,690 12,808,371 12,988,959 ---------------------------------- ---------------------------------- The accompanying notes are an integral part of the condensed consolidated financial statements. 4 MICROFINANCIAL INCORPORATED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (Unaudited) For the three months ended For the nine months ended September 30, September 30, ------------------------------- -------------------------------- 2000 2001 2000 2001 ---- ---- ---- ---- Cash flows from operating activities: Cash received from customers $44,709 $45,271 $130,537 $140,398 Cash paid to suppliers and employees (7,139) (11,733) (25,396) (32,703) Cash paid for income taxes (1,064) (573) (8,701) (5,280) Interest paid (4,401) (3,378) (11,360) (11,418) Interest received 421 326 1,192 1,094 ------------------------------- -------------------------------- Net cash provided by operating activities 32,526 29,913 86,272 92,091 ------------------------------- -------------------------------- Cash flows from investing activities: Investment in lease contracts (35,554) (22,863) (117,496) (71,514) Investment in inventory 0 (813) 0 (3,302) Investment in direct costs (1,654) (1,257) (6,336) (4,140) Investment in service contracts (865) (1,661) (3,233) (4,620) Investment in Resource Leasing Corporation 0 0 0 (6,900) Investment in fixed assets (695) (433) (1,816) (1,290) Repayment of notes from officers 22 0 25 0 Investment in notes receivable (23) (23) (93) (70) Repayment of notes receivable 23 0 285 6 ------------------------------- -------------------------------- Net cash used in investing activities (38,746) (27,050) (128,664) (91,830) ------------------------------- -------------------------------- Cash flows from financing activities: Proceeds from secured debt 30,995 17,440 146,378 75,293 Repayment of secured debt (22,112) (22,396) (73,421) (76,085) Proceeds from refinancing of secured debt 109,500 136,898 343,057 345,897 Prepayment of secured debt (109,500) (130,555) (358,057) (339,555) Proceeds from short term demand notes payable 0 0 144 889 Repayment of short term demand notes payable 0 (18) (446) (92) Proceeds from issuance of subordinated debt 0 0 0 2,875 Repayment of subordinated debt (2,250) (1,500) (4,250) (4,500) Proceeds from exercise of common stock options 12 282 60 810 Repayment of capital leases (132) (131) (389) (387) Purchase of treasury stock 0 0 (1,595) 0 Payment of dividends (572) (640) (1,594) (1,787) ------------------------------- -------------------------------- Net cash provided by financing activities 5,941 (620) 49,887 3,358 ------------------------------- -------------------------------- Net increase in cash and cash equivalents: (279) 2,243 7,495 3,619 Cash and cash equivalents, beginning of period: 18,836 19,333 11,062 17,957 ------------------------------- -------------------------------- Cash and cash equivalents, end of period: $ 18,557 $ 21,576 $ 18,557 $ 21,576 =============================== ================================ (continued on following page) The accompanying notes are an integral part of the condensed consolidated financial statements. 5 MICROFINANCIAL INCORPORATED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (Continued) (Unaudited) For the three months ended For the nine months ended September 30, September 30, -------------------------------- ------------------------------- 2000 2001 2000 2001 ---- ---- ---- ---- Reconciliation of net income to net cash provided by operating activitites: Net Income $5,301 $3,639 $15,402 $14,237 Adjustments to reconcile net income to cash provided by operating activities Depreciation and amortization 2,808 3,618 7,395 10,700 Provision for credit losses 10,576 15,064 28,145 37,150 Recovery of equipment cost and residual value, net of revenue recognized 9,813 6,370 32,637 25,164 Decrease in current taxes 0 (573) (159) (2,340) Increase in deferred income taxes 2,842 2,644 3,074 7,420 Change in assets and liabilities: Decrease (increase) in other assets 419 (1,205) (1,174) (1,113) (Decrease) increase in accounts payable 340 134 570 (384) Increase (decrease) in accrued liabilities 427 222 383 1,257 -------------------------------- ------------------------------- Net cash provided by operating activities $32,526 $29,913 $86,273 $92,091 ================================ =============================== Supplemental disclosure of noncash activities: Property acquired under capital leases $38 $138 $109 $479 Accrual of common stock dividends $572 $642 $572 $642 (Concluded) The accompanying notes are an integral part of the consolidated financial statements. 6 MICROFINANCIAL INCORPORATED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (tables in thousands, except share and per share data) (Unaudited) (A) Nature of Business: MicroFinancial Incorporated (the "Company") which operates primarily through its wholly-owned subsidiary, Leasecomm Corporation, is a specialized commercial finance company that primarily leases and rents "microticket" equipment and provides other financing services in amounts generally ranging from $400 to $3,000 with an average amount financed of approximately $1,500 and an average lease term of 44 months. The Company does not market its services directly to lessees but sources leasing transactions through a network of independent sales organizations and other dealer based origination networks nationwide. The Company funds its operations primarily through borrowings under its credit facilities, issuances of subordinated debt and on balance sheet securitizations. (B) Summary of Significant Accounting Policies: Basis of Presentation: The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles and the rules and regulations of the Securities and Exchange Commission for interim financial statements. Accordingly, the interim statements do not include all of the information and disclosures required for the annual financial statements. In the opinion of the Company's management, the condensed consolidated financial statements contain all adjustments, consisting only of normal recurring adjustments, considered necessary for a fair presentation of these interim results. These financial statements should be read in conjunction with the consolidated financial statements and notes included in the Company's Annual Report and Form 10-K for the year ended December 31, 2000. The results for the nine-month period ended September 30, 2001 are not necessarily indicative of the results that may be expected for the full year ended December 31, 2001. The balance sheet at December 31, 2000 has been derived from the audited financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2000. Allowance for Credit Losses: The Company maintains an allowance for credit losses on its investment in leases, loans and service contracts at an amount that it believes is sufficient to provide an adequate provision against losses in its portfolio. The allowance is determined principally on the basis of the historical loss experience of the Company and the level of recourse provided by such leases, loans and service contracts, if any. In addition, the allowance reflects management's judgment of the additional loss potential considering current economic conditions and the nature and characteristics of the underlying lease portfolio. The Company determines the necessary periodic provision for the credit losses taking into account actual and expected losses in the portfolio as a whole and the relationship of the allowance to the net investment in leases, loans and service contracts. The following table sets forth the Company's allowance for credit losses as of December 31, 1999, 2000 and September 30, 2001 and the related provision, charge-offs and recoveries for the year ended December 31, 2000 and the nine months ended September 30, 2001. 7 MICROFINANCIAL INCORPORATED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (tables in thousands, except share and per share data) (Unaudited) Balance at December 31, 1999 $41,719 Provision for credit losses 36,029 Provision for other asset credit losses 2,883 ------------- Total provisions for credit losses 38,912 Charge-offs (including $1,064 in other asset charge-offs) 57,145 Recoveries 19,257 ------------- Charge-offs, net of recoveries 37,888 ------------ Balance of allowance for credit losses at December 31, 2000 $40,924 ============ Balance of other asset reserve at December 31, 2000 $1,819 ============ Provision for credit losses 37,150 Provision for other asset credit losses 0 ------------- Total provisions for credit losses 37,150 Charge-offs (including $1,340 in other asset charge-offs) 56,146 Recoveries 14,505 ------------- Charge-offs, net of recoveries 41,641 ------------ Balance of allowance for credit losses at September 30, 2001 $37,773 ============ Balance of other asset reserve at September 30, 2001 $479 ============ At December 31, 2000 and September 30, 2001, other assets included prepayments and deposits of $6,394,000 and $4,724,000 respectively, and receivables totaling $7,817,000 and $10,493,000, respectively. The other asset reserve reflects management's judgement of loss potential considering current economic conditions and the nature of the underlying receivables. Earnings Per Share: The Company applies the principles set forth in Statement of Financial Accounting Standard No. 128, "Earnings Per Share." ("SFAS No.128") which specifies the computation, presentation and disclosure requirements for net income per share. Basic net income per common share is computed based upon the weighted-average number of common shares outstanding during the period. Dilutive net income per common share gives effect to all dilutive potential common shares outstanding during the period. Under SFAS No. 128, the computation of dilutive earnings per share does not assume the issuance of common shares that have an antidulitive effect on the net income per share. Options to purchase 830,000 shares of common stock were not included in the computation of diluted earnings per share for the three months ended September 30, 2000 because their effects were antidilutive. There were no antidilutive shares for the three months ended September 30, 2001. Options to purchase 831,752 and 40,609 shares of common stock were not included in the computation of diluted earnings per share for the nine months ended September 30, 2000 and 2001, respectively because their effects were antidilutive. 8 MICROFINANCIAL INCORPORATED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (tables in thousands, except share and per share data) (Unaudited) For three months ended For six months ended September 30, September 30, --------------------------- --------------------------- 2000 2001 2000 2001 ---- ---- ---- ---- Net Income $ 5,301 $ 3,639 $ 15,402 $ 14,237 Shares used in computation: Weighted average common shares outstanding used in computation of net income per common share 12,705,337 12,825,139 12,733,833 12,775,519 Dilutive effect of common stock options 54,961 269,551 74,537 213,440 Shares used in computation of net income per common share assuming dilution 12,760,298 13,094,690 12,808,370 12,988,959 --------------------------- --------------------------- Net income per common share $0.42 $0.28 $1.21 $1.11 Net income per common share assuming dilution $0.42 $0.28 $1.20 $1.10 Notes Payable: On December 21, 1999, the Company entered into a revolving line of credit and term loan facility with a group of financial institutions whereby it may borrow a maximum of $150,000,000 based upon qualified lease receivables, loans, rentals and service contracts. On August 22, 2000, the revolving line of credit and term loan facility was amended and restated where by the Company may now borrow a maximum of $192,000,000 based upon qualified lease receivables, loans, rentals and service contracts. Outstanding borrowings with respect to the revolving line of credit bear interest based at Prime minus 0.25% for Prime Rate Loans, the prevailing rate per annum as offered in the London Interbank Offered Rate (LIBOR) plus 1.75% for LIBOR Loans or the seven day Money Market rate plus 2.00% for Swing Line advances. If the LIBOR Loans are not renewed upon their maturity they automatically convert into prime rate loans. Swing Line advances have a 7-day maturity and upon their maturity they automatically convert into prime rate loans. In addition, the Company's aggregate outstanding principal amount of Swing Line advances shall not exceed $10 million. The prime rates at December 31, 2000, and September 30, 2001 were 9.50% and 6.00% respectively. The 90-day LIBOR rates December 31, 2000, and September 30, 2001 were 6.403% and 2.56%, respectively. The 7-day Money Market rates December 31, 2000, and September 30, 2001 were 6.63% and 3.13%, respectively. The Company had borrowings outstanding under these agreements with the following terms: 9 MICROFINANCIAL INCORPORATED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (tables in thousands, except share and per share data) (Unaudited) December 31, 2000 September 30, 2001 ----------------- ------------------ Type Rate Amount Rate Amount - ---- ---- ------ ---- ------ (in thousands) (in thousands) Prime 9.2500% $17,260 5.7500% $7,683 Swing Line 8.8100% 5,076 LIBOR 8.2500% 12,000 4.3750% 70,000 LIBOR 8.5625% 17,500 5.3125% 17,500 LIBOR 8.2500% 50,000 ---------------- ---------------- Total Outstanding $101,836 $95,183 ================ ================ Outstanding borrowings are collateralized by leases, loans, rentals and service contracts pledged specifically to the financial institutions. All balances under the revolving line of credit will be automatically converted to a term loan on September 30, 2002 provided the line of credit is not renewed and no event of default exists at that date. All converted term loans are payable over the term of the underlying leases, loans, rentals and service contracts, but in any event not to exceed 36 monthly installments. The most restrictive covenants of the agreement have minimum net worth and income requirements. BLT III had one series of notes outstanding, the 1998-A Notes. In November 1998, BLT III issued the 1998-A Notes in aggregate principal amount of $40,769,000. All outstanding amounts under the 1998-A notes were repaid in September 2001. MFI I has three series of notes outstanding, the 2000-1 Notes, the 2000-2 Notes, and the 2001-3 Notes. In March 2000, MFI I issued the 2000-1 Notes in aggregate principal amount of $50,056,686. In December 2000, MFI I issued the 2000-2 Notes in aggregate principal amount of $50,561,633. In September 2001, MFI I issued the 2001-3 Notes in aggregate principal amount of $39,397,354. Outstanding borrowings are collateralized by a specific pool of lease receivables. In September 2001, MFI II, LLC was formed and issued one series of notes, the 2001-1 Notes in aggregate principal amount of $10,000,000. Outstanding borrowings are collateralized by a specific pool of lease receivables as well as the excess cash flow from the MFI I collateral. These notes are subordinate to the three series of notes issued by MFI I. At December 31, 2000 and September 30, 2001,BLT III, MFI I and MFI II had borrowings outstanding under the series of notes with the following terms: December 31, 2000 September 30, 2001 ----------------- ------------------ Series Rate Amount Rate Amount - ------ ---- ------ ---- ------ (in thousands) (in thousands) BLT III 1998-A Notes 6.0300% $12,252 6.0300% $0 MFI I 2000-1 Notes 7.3750% 36,995 7.3750% 23,999 2000-2 Notes 6.9390% 50,562 6.9390% 38,615 2001-3 Notes 5.5800% 39,397 MFI II LLC 2001-1 Notes 8.0000% 10,000 ----------------- ----------------- Total Outstanding $99,809 $112,011 ================= ================= 10 MICROFINANCIAL INCORPORATED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (tables in thousands, except share and per share data) (Unaudited) The Company also had other notes payable which totaled $346,000 and $339,000 at December 31, 2000 and September 30, 2001, respectively. The notes are due on demand and bear interest at a rate of prime minus 1.00%. The Company also borrowed $804,000 against the cash surrender value of the life insurance policies held on key officers. The interest rates on these loans range from 5.05% to 8.00%. Stock Options: Under the 1998 Equity Incentive Plan (the "1998 Plan") which was adopted on July 9, 1998 the Company had reserved 2,000,000 shares of the Company's common stock for issuance pursuant to the 1998 Plan. The Company granted a total of 400,000 options during the nine months ended September 30, 2001. A total of 1,786,000 options were outstanding at September 30, 2001 of which 414,000 were vested. Dividends: On September 19, 2001 the Company's Board of Directors approved a dividend of $.050 per common share for all outstanding common shares as of September 28, 2001 which was paid on October 15, 2001. Acquisition of Resource Leasing Corporation: On January 3, 2001, the Company acquired the rental and lease portfolio, along with certain other assets and assumed certain liabilities of Resource Leasing Corporation ("Resource"), for $10,700,000 subject to a $1,000,000 holdback on deliverables in connection with certain software included in the acquired assets. In December 2000, the Company made a prepayment on that purchase of $2,800,000 which was reflected in other assets at December 31, 2000. The remaining $6,900,000 was paid on January 3, 2001. This transaction was accounted for under the purchase method of accounting, and accordingly, the results of operations of Resource, for the period from the acquisition date, are included in the consolidated financial statements. The purchase price was allocated to the assets purchased and liabilities assumed based on fair values at the date of acquisition and did not result in the recording of excess costs over the fair value of assets acquired. Since the acquisition did not have a material impact on the Company's consolidated financial statements, and Resource does not meet the quantitative thresholds for disclosure as a separate operating segment, segment reporting as required under Statement of Financial Accounting Standards No. 131, is not applicable. New Accounting Pronouncements: In June 2001, the FASB issued Statement of Financial Accounting Standards No. 141, "Business Combinations"("SFAS No. 141"). SFAS No. 141 addresses financial accounting and reporting for business combinations and amends or supercedes a number of interpretations concerning business combinations. SFAS No. 141 requires companies to use the purchase method of accounting for all business combinations, whereas previous interpretations provided for the use of another method (pooling of interests method) if certain criteria were met. This statement also amends the recognition policies of intangible assets and goodwill and provides for additional disclosure requirements for business combinations. The provisions for this statement apply to all business combinations initiated after June 30, 2001. In June 2001, the FASB issued Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets"("SFAS No. 142"). This statement supercedes APB Opinion No. 17, "Intangible Assets"("APB No. 17") and addresses financial accounting and reporting for intangible assets, but not those acquired in a business combination at acquisition. SFAS No. 142 addresses financial accounting and reporting of goodwill and other intangible assets subsequent to their acquisition, assigning a definite or indefinite useful life to these assets. Goodwill and other intangible assets having an indefinite useful life will not be amortized, but rather tested at least 11 MICROFINANCIAL INCORPORATED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (tables in thousands, except share and per share data) (Unaudited) annually for impairment. It also provides guidance on how to define, measure and record impairment losses on goodwill and other intangible assets and provides for additional disclosures regarding these assets in years subsequent to their acquisition. The provisions for this statement are required to be applied for fiscal years beginning after December 15, 2001, although earlier adoption is permitted. In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 143 "Accounting for Asset Retirement Obligations". SFAS No. 143 provides new accounting standards for recording of liabilities related to legal obligations to retire tangible long-lived assets. The Statement requires an entity to recognize at fair value a liability associated with an asset retirement obligation in the period in which the liability is both incurred and in which the fair value is determinable. The provisions of this Statement are effective for the Company's fiscal year ended December 31, 2003, although earlier application is permitted. In August 2001, the FASB issued SFAS No. 144 "Accounting for the Impairment or Disposal of Long Lived Assets". SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of a long-lived asset or group of assets. This pronouncement, which supercedes and amends several earlier interpretations, establishes a single comprehensive statement to provide impairment accounting guidance for tangible long lived assets to be either held and continued to be used by the entity or disposed of by sale or by some other means. This Statement will be effective for the first quarter of the Company's fiscal year ending December 31, 2002, although earlier application is permitted The Company has not completed its evaluation of SFAS Nos. 141, 142, 143 and 144 and has not yet determined their effect on it's consolidated financial statements. Reclassification of Prior Year Balances: Certain reclassifications have been made to prior years' consolidated financial statements to conform to the current presentation. Commitments and Contingencies: Please refer to Part II Other Information, Item 1 Legal Proceedings for information about pending litigation of the Company. The September 11 Events The terrorist attacks of September 11, 2001 caused a significant loss of life and property. Fortunately, the Company has not experienced any significant losses as a direct result of the September 11 Events. The Company did however experience a slight business slow down in the weeks directly following the attacks. There can be no assurance that any potential impact associated with the September 11 Events would not have a material adverse effect on the Company's business, financial condition, or results of operations. 12 ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Three months ended September 30, 2001 as compared to the three months ended September 30, 2000. Net income for the three months ended September 30, 2001 was approximately $3.6 million, a decrease of $1.7 million or 32% from the three months ended September 30, 2000. This represents diluted earnings per share for the three months ended September 30, 2001 of $0.28 per share on weighted average outstanding shares of 13,094,690 as compared to $0.42 per share on weighted average outstanding shares of 12,760,298 for the three months ended September 30, 2000. Total revenues for the three months ended September 30, 2001 were $36.1 million, an increase of $2.6 million, or 8%, from the three months ended September 30, 2000. The increase was primarily due to an increase of $2.2 million, or 22%, in rental and service contract income, and $731,000, or 14% in fee and other income offset by a decrease of $330,000, or 2% in financing leases and loans. The decrease in income on financing leases and loans was due to the decreased number of leases originated primarily resulting from the Company's change in its credit approval process. The increase in rental and service contract income is a result of the increased number of lessees that have continued to rent their equipment beyond their original lease term, an increase in the rental business originated through our Resource Leasing division, and an increase in orginations in rental and service contracts. The increase in fee income and other income is the result of increased fees from the lessees related to the collection and legal process employed by the Company, and the addition of a new line of business of selling equipment. Selling, general and administrative expenses increased by $1 million or 15%, for the three months ended September 30, 2001, as compared to the three months ended September 30, 2000. Compensation and personnel related expenses increased by $500,000 or 11%, due to an increase in overall compensation levels and an increase in the number of employees needed to maintain the Company's portfolio, including the addition of the personnel employed by Resource Leasing Corporation. Also, cost of goods sold increased by $750,000, or 100%, due to the Company's acquisition of Resource Leasing Corporation, and the addition of a new line of business of selling new and refurbished equipment. Depreciation and amortization increased by $800,000, or 29%, due to the increased number of rental contracts, including the addition of the Resource Leasing portfolio of rental contracts, and amortization of the Company's investment in service contracts. The Company's provision for credit losses increased by $4.5 million or 42%, for the three months ended September 30, 2001 as compared to the three months ended September 30, 2000. This increase is a result of the Company's historical policy, based on experience, of providing a provision for credit losses based upon the dealer fundings and revenue recognized in any period and reflects management's judgement of loss potential considering current economic conditions and the nature of the underlying receivables. Net interest expense decreased by $870,000, or 21%, for the three months ended September 30, 2001 as compared to the three months ended September 30, 2000. This decrease resulted primarily from the Company's declining cost of funds, offset by an increased level of borrowings. Dealer fundings were $25.2 million for the three months ended September 30, 2001, down $11.5 million, or 31% as compared to the three months ended September 30, 2000. This decrease is a result of the Company's decision during the second quarter of 2000 to increase pricing and tighten its credit approval standards. The new credit policies were put into place in August of 2000. This is an ongoing effort, and is expected to continue going forward. Total cash from customers increased by $600,000 or 1% to a total of $45.3 million. This increase is primarily the result of an increase in the size of the overall portfolio. Investment in lease and loan receivables due in installments, estimated residuals, rental and service contracts were up from $478.7 million in December of 2000 to $479.2 million in September of 2001. 13 Nine months ended September 30, 2001 as compared to the nine months ended September 30, 2000. Net income for the nine months ended September 30, 2001 was approximately $14.2 million, a decrease of $1.2 million or 8% from the nine months ended September 30, 2000. This represents diluted earnings per share for the nine months ended September 30, 2001 of $1.10 per share on weighted average outstanding shares of 12,988,959 as compared to $1.20 per share on weighted average outstanding shares of 12,808,370 for the nine months ended September 30, 2000. Total revenues for the nine months ended September 30, 2001 were $108.7 million, an increase of $15.6 million, or 17%, from the nine months ended September 30, 2000. The increase was primarily due to an increase of $4 million, or 8%, in income on financing leases and loans, $7.8 million, or 29%, in rental and service contract income, and $3.8 million, 25% in fee and other income. The increase in income on financing leases and loans was due to the increased number of leases originated. The increase in rental and service contract income is a result of the increased number of lessees that have continued to rent their equipment beyond their original lease term, the acquisition of the rental portfolio of Resource Leasing Corporation, and increased originations in rental and service contracts. The increase in fee income and other income is the result of increased fees from the lessees related to the collection and legal process employed by the Company, and the addition of a new line of business of selling equipment out of existing inventory. Selling, general and administrative expenses increased by $5.6 or 28%, for the nine months ended September 30, 2001, as compared to the nine months ended September 30, 2000. Compensation and personnel related expenses increased by $3.2 million or 26%, due to an increase in overall compensation levels and an increase in the number of employees needed to maintain the Company's portfolio, including the addition of the personnel employed by Resource Leasing Corporation. Also, cost of goods sold increased by $2.6 million, or 100%, due to the Company's acquisition of the assets of Resource Leasing Corporation, and the addition of a new line of business of selling equipment. Depreciation and amortization increased by $3.3 million, or 45%, due to the increased number of rental contracts, including the addition of the Resource Leasing portfolio of rental contracts, and amortization of the Company's investment in service contracts. The Company's provision for credit losses increased by $9 million or 32%, for the nine months ended September 30, 2001 as compared to the nine months ended September 30, 2000. This increase is a result of the Company's historical policy, based on experience, of providing a provision for credit losses based upon the dealer fundings and revenue recognized in any period and reflects management's judgement of loss potential considering current economic conditions and the nature of the underlying receivables. Net interest expense decreased by $200,000, or 2%, for the nine months ended September 30, 2001 as compared to the nine months ended September 30, 2000. This decrease resulted primarily from the Company's declining cost of funds, offset by an increased level of borrowings. Dealer fundings were $87.3 million for the nine months ended September 30, 2001, down $34.1 million, or 28% as compared to the nine months ended September 30, 2000. This decrease is a result of the Company's decision during the second quarter of 2000 to increase pricing and tighten its credit approval standards. The new credit policies were put into place in August of 2000. This is an ongoing effort, and is expected to continue going forward. Total cash from customers increased by $9.9 million or 8% to a total of $140.4 million. This increase is primarily the result of an increase in the size of the overall portfolio. The terrorist attacks of September 11, 2001 caused a significant loss of life and property. Fortunately, the Company has not experienced any significant losses as a direct result of the September 11 Events. The Company did however experience a slight business slow down in the weeks directly following the attacks. There can be no assurance that any potential impact associated with the September 11 Events would not have a material adverse effect on the Company's business, financial condition, or results of operations. 14 Exposure to Credit Losses The following table sets forth certain information as of December 31, 1999 and 2000 and September 30, 2001 with respect to delinquent leases, service contracts and loans. The percentages in the table below represent the aggregate on such date of the actual amounts not paid on each invoice by the number of days past due, rather than the entire balance of a delinquent receivable, over the cumulative amount billed at such date from the date of origination on all leases, service contracts, and loans in the Company's portfolio. For example, if a receivable is 90 days past due, the portion of the receivable that is over 30 days past due will be placed in the 31-60 days past due category, the portion of the receivable which is over 60 days past due will be placed in the 61-90 days past due category and the portion of the receivable which is over 90 days past due will be placed in the over 90 days past due category. The Company historically used this methodology of calculating its delinquencies because of its experience that lessees who miss a payment do not necessarily default on the entire lease. Accordingly, the Company includes only the amount past due rather than the entire lease receivable in each category. As of As of December 31 September 30 ----------- ------------ 1999 2000 2001 ---- ---- ---- Cumulative amounts billed ( in thousands) $380,380 $462,011 $530,148 31-60 days past due 1.7% 1.9% 2.2% 61-90 days past due 1.3% 1.6% 2.0% over 90 days past due 7.4% 10.0% 14.2% ---------------------------- ---------------- Total past due 10.4% 13.5% 18.4% ============================ ================ Liquidity and Capital Resources General The Company's lease and finance business is capital-intensive and requires access to substantial short-term and long-term credit to fund new leases, loans and service contracts. Since inception, the Company has funded its operations primarily through borrowings under its credit facilities, issuances of subordinated debt and its on-balance sheet securitizations. The Company will continue to require significant additional capital to maintain and expand its volume of leases, loans, rentals and service contracts, as well as to fund future acquisitions of leasing companies or portfolios. The Company's uses of cash include the origination and acquisition of leases, loans, rentals and service contracts, payment of interest expenses, repayment of borrowings under its credit facilities, subordinated debt and securitizations, payment of selling, general and administrative expenses, income taxes, capital expenditures, and the Company's stock repurchase program. The Company utilizes its credit facility to fund the origination and acquisition of leases, loans, rentals and service contracts that satisfy the eligibility requirements established pursuant to each facility. All balances under the revolving line of credit will be automatically converted to a term loan on September 30, 2002 provided the line of credit is not renewed and no event of default exists at that date. At September 30, 2001, the Company had an aggregate maximum of $192 million available for borrowing under its credit facility, of which approximately $95.2 million was outstanding as of such date. To date, cash flow from its portfolio and other fees have been sufficient to repay current amounts due under the credit facilities and subordinated debt. The Company believes that the cash flow from its operations and the amounts available under its credit facilities will be sufficient to fund the Company's operations for the foreseeable future. 15 Note on Forward Looking Information Statements in this document that are not historical facts are forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. In addition, words such as "believes," "anticipates," "expects," and similar expressions are intended to identify forward-looking statements. The Company cautions that a number of important factors could cause actual results to differ materially from those expressed in any forward-looking statements made by or on behalf of the Company. Such statements contain a number of risks and uncertainties, including but not limited to: the Company's dependence on point-of-sale authorization systems and expansion into new markets; the Company's significant capital requirements; risks associated with economic downturns; higher interest rates; intense competition; change in regulatory environment and risks associated with acquisitions. Readers should not place undue reliance on forward-looking statements, which reflect the management's view only as of the date hereof. The Company undertakes no obligation to publicly revise these forward-looking statements to reflect subsequent events or circumstances. The Company cannot assure that it will be able to anticipate or respond timely to changes which could adversely affect its operating results in one or more fiscal quarters. Results of operations in any past period should not be considered indicative of results to be expected in future periods. Fluctuations in operating results may result in fluctuations in the price of the Company's common stock. For a more complete description of the prominent risks and uncertainties inherent in the Company's business, see the risks factors described in the Company's Form S-1 Registration Statement and other documents filed from time to time with the Securities and Exchange Commission. ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market-Rate-Sensitive Instruments and Risk Management The following discussion about the Company's risk management activities includes "forward-looking statements" that involve risk and uncertainties. Actual results could differ materially from those projected in the forward-looking statements. In the normal course of operations, the Company also faces risks that are either nonfinancial or nonquantifiable. Such risks principally include country risk, credit risk and legal risk, and are not represented in the analysis that follows. Interest Rate Risk Management The implicit yield to the Company on all of its leases, loans, rentals and service contracts is on a fixed interest rate basis due to the leases, loans, rentals and service contracts having scheduled payments that are fixed at the time of origination of the lease, loan, rentals or service contract. When the Company originates or acquires leases, loans and service contracts it bases its pricing in part on the "spread" it expects to achieve between the implicit yield rate to the Company on each lease, loan or service contract and the effective interest cost it will pay when it finances such leases, loans and service contracts through its credit facilities. Increases in the interest rates during the term of each lease, loan or service contract could narrow or eliminate the spread, or result in a negative spread. The Company has adopted a policy designed to protect itself against interest rate volatility during the term of each lease, loan or service contract. Given the relatively short average life of the Company's leases, loans, rentals and service contracts, the Company's goal is to maintain a blend of fixed and variable interest rate obligations. As of September 30, 2001, the Company's outstanding fixed rate indebtedness, including indebtedness outstanding under the Company's securitizations, represented 54.1% of the Company's outstanding indebtedness. 16 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Company's subsidiary, Leasecomm Corporation ("Leasecomm"), is periodically sued by lessees seeking to invalidate specific lease provisions, to rescind a lease, or to obtain damages as a result of alleged violations of law. Certain of these actions are filed as purported class actions but, to date, no class has been certified by any court. In two Massachusetts Superior Court cases, the courts have denied motions for class certification. One purported class action is pending in a Massachusetts Superior Court, as to which Leasecomm is awaiting a decision on its motion to dismiss the entire case, and in which no motion for class certification has been filed. Another purported class action is pending in San Mateo Superior Court, State of California, which was stayed at Leasecomm's request but as to which a settlement in principle has been reached, subject to the Court's approval (which settlement should include the certification of a class). Because of the uncertainties inherent in litigation, the Company cannot predict whether the outcome of any non-settled case will have a material adverse effect, but the Company does believe that it has meritorious defenses to these actions and is vigorously contesting them. During the past few years, the Company and Leasecomm have received subpoenas issued by regulatory authorities in connection with investigations to determine whether any complaint or other charges should be filed. Typically, these investigatory subpoenas result from complaints by individual lessees and frequently concern the conduct of Leasecomm's vendors. Leasecomm's past experience has been that such investigations do not typically result in charges against the Company or Leasecomm. To the extent that any remedial action on the part of Leasecomm may be appropriate, such action has been taken by agreement, without material effect on the Company's financial condition. At present, Leasecomm has received subpoenas from the Offices of the Attorney General of the States of Florida and Illinois, and of the Commonwealth of Massachusetts, regarding investigations that are still ongoing. While it is not possible to predict the outcome of early stage investigations which have not yet determined whether to proffer any charges, the Company's management believes that the outcome of these investigations is likely to be generally consistent with the Company's past experience. However, there can be no assurance that an adverse action in any of these matters will not have a material adverse effect. The Company filed an action in the United States District Court for the District of Massachusetts against Sentinel Insurance Company, Ltd., ("Sentinel"), Premier Holidays International, Inc., ("Premier") and Daniel DelPiano ("DelPiano") arising from Premier's October, 1999, default on its repayment obligations to the Company under a Twelve Million Dollar ($12,000,000) loan. Judgment has been entered in this case against Sentinel, which had issued a business performance insurance policy guaranteeing repayment of the loan, in the amount of Fourteen Million Dollars ($14,000,000). This judgment has not been satisfied. Sentinel is currently undergoing liquidation proceedings, and a claim in this amount has been filed with the bankruptcy court. As part of the Massachusetts litigation, Premier has asserted a counterclaim against the Company for Seven Hundred Sixty Nine Thousand Three Hundred Fifty Million Dollars ($769,350,000) in actual and consequential damages, and for Five Hundred Million Dollars ($500,000,000) in punitive damages, plus interest, cost and attorney's fees. The counterclaim is based upon an alleged representation by the Company that it would lend Premier an additional Forty-Five Million Dollars ($45,000,000), when all documents evidencing the Premier loan refer only to the Twelve Million Dollars ($12,000,000) amount actually loaned and not repaid. The Company denies any liability on the counterclaim, which the Company is vigorously contesting. Because of the uncertainties inherent in litigation, the Company cannot predict whether the outcome will have a material adverse effect. 17 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibit Index EXHIBIT DESCRIPTION OF EXHIBIT ------- ---------------------- 10.15 Amended and Restated Standard Terms and Condition of Indenture dated as of September 2001 governing the MFI Finance Corp. I, 5.5800% Lease-Backed Notes, Series 2000-3 (the "2001-3 Notes") 10.16 Supplement to Indenture dated September 2001 governing the 2001-3 Notes. 10.17 Specimen 2001-3 Note. 10.18 Standard Terms and Conditions of Servicing governing the 2001-3 Notes. 10.19 Standard Terms and Condition of Indenture dated as of September 2001 governing the MFI Finance Corp. II, LLC , 8.0000% Lease-Backed Notes, Series 2001-1 (the "2001-1 Notes") 10.20 Supplement to Indenture dated September 2001 governing the 2001-1 Notes. 10.21 Specimen 2001-1 Note. 10.22 Standard Terms and Conditions of Servicing governing the 2001-1 Notes. (b) A form 8-K was filed on October 15, 2001 to comment on expected third quarter results. 18 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. MicroFinancial Incorporated By: /s/ Peter R. Bleyleben --------------------------- President and Chief Executive Officer By: /s/ Richard F. Latour -------------------------- Executive Vice President, Chief Operating and Chief Financial Officer Date: November 14, 2001 19