<PAGE> 1
<PAGE>2
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
_X_ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
OR
____ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1998
Commission File Number 001-14359
CYGNET FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
<TABLE>
<S> <C>
Delaware 86-0721358
(State or other jurisdiction of (I.R.S. employer
Incorporation or organization) identification no.)
</TABLE>
2525 E. Camelback Road,
Suite 1150
Phoenix, Arizona 85016
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (602) 852-6600
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days.
Yes _X_ No ___
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:
See attached Explanatory Note.
<PAGE>3
EXPLANATORY NOTE
This Form 10-Q relates to Cygnet Financial Corporation (the "Company" or
"Cygnet"), a subsidiary formed by Ugly Duckling Corporation in connection with
an anticipated rights offering and spinoff of the Company. In reviewing this
Form 10-Q, please consider the following:
1. The rights offering and split up were never concluded as a result of a
lack of investor interest. Accordingly, Cygnet remains a wholly owned
subsidiary of Ugly Duckling Corporation and none of its stock is publicly
traded. The Company has sought a "no action letter" from the Securities and
Exchange Commission to discontinue reporting requirements pursuant to Section
15(d) of the Securities Exchange Act of 1934 as soon as practicable.
2. The following report assumes that the split up of Cygnet took place and
that the assets were transferred to and liabilities assumed by it in
conjunction with the split up. None of these transactions have actually
transpired.
3. The operations attributed to Cygnet Financial Corporation in this
report are included as "discontinued operations" in the financial statements
of Ugly Duckling Corporation which makes periodic reports, proxy statements
and other filings with the Securities and Exchange Commission under the
Securities Exchange Act of 1934, and should be read in light of those
disclosures. Although the split up did not occur pursuant to the rights
offering, Ugly Duckling is still continuing to explore alternatives for
formally separating its dealership and non-dealership operations (those that
were to be transferred to Cygnet Financial Corporation), although there can be
no assurance that Ugly Duckling Corporation will ultimately be successful in
this regard.
<PAGE>4
CYGNET FINANCIAL CORPORATION
FORM 10-Q
TABLE OF CONTENTS
PART I. FINANCIAL STATEMENTS 5
ITEM 1. Financial Statements 5
NOTES TO CONDENSED COMBINED FINANCIAL STATEMENTS 8
ITEM 2. 10
PART II. OTHER INFORMATION 15
ITEM 1. Legal Proceedings. 15
ITEM 2. Changes in Securities. 15
ITEM 3. Defaults Upon Senior Securities. 15
ITEM 4. Submission of Matters to a Vote of Security Holders. 15
ITEM 5. Other Information. 15
ITEM 6. Exhibits and Reports on Form 8-K. 16
SIGNATURE 17
Exhibit 27 19
Exhibit 99 20
<PAGE>5
Part I.?FINANCIAL STATEMENTS
ITEM 1. Financial Statements
<TABLE><CAPTION>
CYGNET FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED COMBINED BALANCE SHEETS
September 30, 1998 and December 31, 1997
(in thousands)
<S> <C> <C>
September 30,1998 December 31,1997
----------------- ---------------
ASSETS
Cash and Cash Equivalents $451 $1,225
Finance Receivables, Net 29,605 9,274
Notes Receivable 27,120 21,861
Property and Equipment, Net 3,205 646
Goodwill, Net 1,118 1,178
Other Assets 7,605 5,850
------ ------
$69,104 $50,034
====== ======
LIABILITIES AND STOCKHOLDER'S EQUITY
Liabilities:
Accrued Expenses and Other Liabilities 3,285 $548
Advances from Affiliate 20,312 9,106
Notes Payable 5,507 380
------ ------
Total Liabilities 29,104 10,034
Stockholder's Equity:
Preferred Stock; $.001 par value,
500,000 shares authorized,
none issued and outstanding - -
Common Stock; $.001 par value,
14,000,000 shares authorized,
one share issued and outstanding - -
Additional Paid-in Capital 40,000 40,000
Retained Earnings - -
------ ------
Total Stockholder's Equity 40,000 40,000
------ ------
Commitments and Contingencies - -
------ ------
69,104 $50,034
====== ======
</TABLE>
See accompanying notes to Condensed Combined Financial Statements.
<PAGE> 6
<TABLE><CAPTION>
CYGNET FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED COMBINED STATEMENTS OF OPERATIONS
(In thousands, except shares used in computation)
<S> <C> <C>
Three Months ended Nine Months ended
September 30, September 30,
------------------ -----------------
<S> <C> <C> <C> <C>
1998 1997 1998 1997
-------- --------- --------- -------
Revenues:
Interest Income $3,901 $3,117 $10,283 $3,254
Servicing Fees 6,738 - 11,675 -
Net Gain on Sale of
Repossessed Collateral 1,304 - 2,412 -
Other Income 5 221 128 221
-------- --------- --------- -------
11,948 3,338 24,498 3,475
-------- --------- --------- -------
Operating Expenses:
Provision for Credit Losses 479 226 1,445 226
Selling and Marketing 28 - 64 9
General and Administrative 9,132 1,067 18,133 2,075
Write-Off of Offering Costs 2,000 - 2,000 -
Depreciation and Amortization 241 38 470 100
Other 222 - 222 -
-------- --------- --------- -------
12,102 1,332 22,334 2,411
-------- --------- --------- -------
Earnings (Loss) before Interest Expense (154) 2,006 2,164 1,064
Interest Expense 956 738 2,671 775
-------- --------- --------- -------
Earnings (Loss) before Income Taxes (1,110) 1,268 (507) 289
Income Taxes (Benefit) (433) 510 (189) 116
-------- --------- --------- -------
Net Earnings (Loss) $(677) $758 $(318) $173
======== ========= ========= =======
Basic / Diluted Earnings (Loss) per share $(677) $758 $(318) $173
======== ========= ========= =======
Shares used in computation 1 1 1 1
======== ========= ========= =======
</TABLE>
See accompanying notes to Condensed Combined Financial Statements.
<PAGE>7
<TABLE><CAPTION>
CYGNET FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED COMBINED STATEMENTS OF CASH FLOWS
Nine Months Ended September 30, 1998 and 1997
(In thousands)
<S> <C> <C>
1998 1997
---------- ------------
Cash Flows from Operating Activities:
Net Earnings (Loss) $(318) $173
Adjustment to Reconcile Net Earnings
(Loss) to Net Cash Provided by
Operating Activities:
Provision for Credit Losses 1,445 226
Depreciation and Amortization 470 100
(Increase) Decrease in Other Assets (1,755) 39
Increase in Accrued Expenses and Other Liabilities 2,737 394
---------- ------------
Net Cash Provided by Operating Activities 2,579 932
---------- ------------
Cash Flows from Investing Activities:
Increase in Finance Receivables (38,788) (9,264)
Collections of Finance Receivables 27,648 1,723
Increase in Notes Receivable (7,118) (9,314)
Collections of Notes Receivable 1,859 4,012
Purchase of Property and Equipment (2,969) (140)
Payment for Acquisition of Assets - (9,098)
---------- ------------
Net Cash Used in Investing Activities (19,368) (22,081)
---------- ------------
Cash Flows from Financing Activities:
Increase in Notes Payable 5,225 -
Payment of Note Payable (98) (120)
Advances from Affiliate 10,888 10,230
Contribution of Additional Paid-in Capital - 12,205
---------- ------------
Net Cash Provided by Financing Activities 16,015 22,315
---------- ------------
Net Increase (Decrease) in Cash and Cash
Equivalents (774) 1,166
Cash and Cash Equivalents at Beginning of Period 1,225 -
---------- ------------
Cash and Cash Equivalents at End of Period $451 $1,166
========== ============
Supplemental Statement of Cash Flows Information:
Contribution of certain assets of the Company $- $27,795
========== ============
Assumption of note payable $- $500
========== ============
</TABLE>
See accompanying notes to Condensed Combined Financial Statements.
<PAGE>8
CYGNET FINANCIAL CORPORATION
NOTES TO CONDENSED COMBINED FINANCIAL STATEMENTS
(Unaudited)
Note 1. Basis of Presentation
The accompanying unaudited condensed combined financial statements of Cygnet
Financial Corporation ("Cygnet" or the "Company") have been prepared in
accordance with generally accepted accounting principles for interim financial
information and pursuant to rules and regulations of the Securities and
Exchange Commission. Accordingly, they do not include all of the information
and footnotes required by generally accepted accounting principles for a
complete financial statement presentation. In the opinion of management, such
unaudited interim information reflects all adjustments, consisting only of
normal recurring adjustments, necessary to present the Company's financial
position and results of operations for the periods presented. The results of
operations for interim periods are not necessarily indicative of the results
to be expected for a full fiscal year. The Condensed Combined Balance Sheet as
of December 31, 1997 was derived from audited combined financial statements as
of that date, but does not include all the information and footnotes required
by generally accepted accounting principles. It is suggested that these
condensed combined financial statements be read in conjunction with the
Company's audited combined financial statements included in the Company's
registration statement on Form S-1 (File No. 333-57323), as amended and
originally filed on August 4, 1998.
The combined financial statements contained herein reflect the results of
operations, financial position, changes in stockholder's equity and cash flows
of the Company, as if the Company were a separate entity operating the bulk
purchasing and certain loan servicing operations, the third party dealer
financing operations (not the branch office operations), and substantially all
other Ugly Duckling non-dealership assets and contract rights for the periods
presented. The combined financial statements have been prepared using the
historical basis in the assets and liabilities and historical results of
operations of the Company. See "Explanatory Note" above.
Note 2. Terminated Rights Offering
In April 1998, the Ugly Duckling Corporation announced that its Board of
Directors had directed management to proceed with separating its dealership
operations from its bulk purchasing and third party loan servicing operations
and the collateralized dealer finance program. In June 1998, Ugly Duckling
formed Cygnet, a new wholly-owned subsidiary, to effectuate a split-up of Ugly
Duckling into two public companies (the "Split-up") with Cygnet to operate the
non-dealership activities, which include the Cygnet dealer program and the
bulk purchasing and third party loan servicing operations. A proposal to
effect the Split-up through a rights offering (the "Rights Offering") was
approved by Ugly Duckling's stockholders at Ugly Duckling's annual
stockholder's meeting held in August 1998. Ugly Duckling subsequently issued
rights to its stockholders that granted each holder the opportunity to
purchase one (1) share of Company common stock, at a subscription rate of
$7.00 per share, for every four (4) shares of Ugly Duckling common stock held
(the "Rights"). Due to a lack of shareholder participation, however, the
Rights Offering was canceled in September 1998, no assets were transferred to
or liabilities assumed by the Company, and the Company remains a wholly owned
subsidiary of Ugly Duckling Corporation. See "Explanatory Note" above.
<PAGE>9
During the third fiscal quarter of 1998, Cygnet wrote-off costs totaling
approximately $2,000,000 related to the terminated rights offering.
Note 3. Use of Estimates
The preparation of financial statements requires management to make estimates
and assumptions that affect the reported amount of assets and liabilities,
disclosure of contingent assets and liabilities at the date of the financial
statement, and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ materially from those
estimates.
Note 4. Reclassifications
Certain reclassifications have been made to previously reported information to
conform to the current presentation.
Note 5. Earnings (Loss) Per Share
Net Earnings (Loss) per common share amounts are based on the weighted average
number of common shares and Common Stock equivalents outstanding for the
periods ended September 30, 1998 and 1997 (in thousands, except shares
outstanding):
<TABLE><CAPTION>
<S> <C> <C>
Three Months Ended Nine Months Ended
September 30 September 30,
-------------------- ----------------
<S> <C> <C> <C> <C>
1998 1997 1998 1997
--------- ---------- --------- -------
Net Earnings (Loss) $(677) $758 $(318) $173
========= ========== ========= =======
Basic EPS-Weighted Average Shares
Outstanding 1 1 1 1
========= ========== ========= =======
Basic Earnings Per Share:
Net Earnings (Loss) $(677) $758 $(318) $173
========= ========== ========= =======
Basic EPS-Weighted Average Shares
Outstanding 1 1 1 1
Effect of Diluted Securities:
Warrants - - - -
Stock Options - - - -
--------- ---------- --------- -------
Dilutive EPS-Weighted Average Shares
Outstanding 1 1 1 1
========= ========== ========= =======
Diluted Earnings Per Share:
Net Earnings (Loss) $(677) $758 $(318) $173
========= ========== ========= =======
<PAGE>10
ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION OF THE COMPANY
This Quarterly Report on Form 10-Q contains forward looking statements.
Additional written or oral forward looking statements may be made by the
Company (defined below) from time to time in filings with the Securities and
Exchange Commission or otherwise. Such forward looking statements are within
the meaning of that term in Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as amended.
Such statements may include, but not be limited to, year 2000 matters,
projections of revenues, income, or loss, capital expenditures, plans for
future operations, financing needs or plans, and plans relating to products or
services of the Company, as well as assumptions relating to the foregoing. The
words "believe," "expect," "intend," "anticipate," "estimate," "project," and
similar expressions identify forward looking statements, which speak only as
of the date the statement was made. Forward looking statements are inherently
subject to risks and uncertainties, some of which cannot be predicted or
quantified. Future events and actual results could differ materially from
those set forth in, contemplated by, or underlying the forward looking
statements. The Company undertakes no obligation to publicly update or revise
any forward looking statements, whether as a result of new information, future
events, or otherwise. Statements in this Quarterly Report, including the Notes
to the Condensed Combined Financial Statements and "Management's Discussion
and Analysis of Results of Operations and Financial Condition of the Company,"
describe factors, among others, that could contribute to or cause such
differences. Additional risk factors that could cause actual results to differ
materially from those expressed in such forward looking statements are set
forth in Exhibit 99 which is attached hereto and incorporated by reference
into this Quarterly Report on Form 10-Q and the Company's prospectus dated
August 4, 1998, filed with the Securities and Exchange Commission.
Introduction
General. Cygnet Financial Corporation (the "Company"), a wholly-owned
subsidiary of Ugly Duckling Corporation ("Ugly Duckling"), was formed on June
1, 1998 for the purpose of consummating a transaction whereby Ugly Duckling
would split-up its operations into two publicly-held companies. Although a
rights offering intended to effect the split up has been abandoned, Ugly
Duckling continues to explore alternatives to separate its dealership and non-
dealership operations. The combined financial statements contained herein and
this discussion reflect the results of operations, financial position,
changes in stockholder's equity and cash flows of the Company, as if the
Company were a separate entity (See "Explanatory Note" above) operating the
bulk purchasing and certain loan servicing operations, the third party dealer
financing operations (not the branch office operations), and substantially
all other Ugly Duckling non-dealership assets and contract rights for the
periods presented. The combined financial statements have been prepared using
the historical basis in the assets and liabilities and historical results of
operations of the Company.
The Company provides qualified independent used car dealers with
warehouse purchase facilities and operating credit lines pursuant to its
Cygnet dealer program ("Cygnet Dealer Program"). In addition, the Company
purchases loan portfolios in bulk and services loan portfolios on behalf of
third parties. The Company targets its products and services primarily to the
sub-prime segment of the automobile financing industry, which focuses on
selling and financing the sale of used cars to sub-prime borrowers.
<PAGE>11
Bulk Purchasing and Loan Servicing. The Company believes bulk purchase
and large servicing transactions are efficient methods of purchasing or
obtaining servicing rights to sub-prime automobile finance receivables. In
this regard, the Company has effected certain transactions with various
parties, pursuant to which the Company has acquired significant servicing and
other rights.
The Company was actively involved in the bankruptcy proceedings of First
Merchants Acceptance Corporation ("FMAC"). FMAC was in the business of
purchasing and securitizing loans made primarily to sub-prime borrowers by
various Third Party Dealers. In various transactions relating to the FMAC
bankruptcy proceedings, the Company, among other things, (l) purchased the
secured claims of certain creditors of FMAC, sold the contracts securing such
claims at a profit to a third party purchaser ("Contract Purchaser"),
guaranteed the purchaser a specified return on the contracts and obtained a
related guarantee from FMAC secured by, among other things, the stock of
certain entities holding residual interests and certain equity certificates
in various securitized loan pools of FMAC, and entered into servicing
arrangements with respect to such contracts; (2) made debtor-in-possession
loans to FMAC, and received interest income therefrom; (3) entered into
various servicing agreements with respect to receivables in the securitized
pools of FMAC; (4) obtained rights to receive certain payments with respect to
distributions on residual interests in such securitized pools and obtained
certain interests in charged off receivables in such pools; (5) obtained
rights to certain fees; and (6) obtained the FMAC servicing platform.
On February 9, 1998, Ugly Duckling Corporation announced that it had
entered into a servicing and transition agreement with Reliance Acceptance
Corporation ("Reliance"). Reliance filed a voluntary petition for relief
under Chapter 11 of the United States bankruptcy code on February 9, 1998 (the
"Plan"). The Plan was confirmed on July 2, 1998 and the Company began
servicing certain loan portfolios on behalf of Reliance on August 1, 1998. In
connection with the respective servicing agreements, the Company is entitled
to receive certain incentive payments related to such agreements should
certain events transpire.
Cygnet Dealer Program. Through the Cygnet Dealer Program, the Company
either purchases finance receivables under its Dealer Collection Program or
provides traditional revolving lines of credit under its Asset-Based Loan
Program. Under the Dealer Collection Program, the Company generally purchases
finance receivables on a full recourse basis from Third Party Dealers for 60%
to 75% of the principal amount of the respective contract. The Company's
Asset Based Loan Program is similar to traditional asset-based lending
relationships. The Company generally advances 65% of the principal amount of
the contract. Under both programs, the Third Party Dealer retains
responsibility for servicing the contracts. The Third Party Dealer is
generally entitled to a fee of 20% to 25% of gross collections for servicing
the contracts purchased under the Dealer Collection Program; however, the
Company does not pay a servicing fee to Third Party Dealers for servicing
contracts under the Asset Based Loan Program.
<PAGE> 12
Results Of Operations
For Three Months Ended September 30, 1998
Compared To Three Months Ended September 30, 1997
Revenues increased by 257.9% to $11.9 million for the three month period ended
September 30, 1998 compared to $3.3 million in the three month period ended
September 30, 1997. Revenues increased as a result in increases in Interest
Income of $784,000, Servicing Fees of $6.7 million and Net Gain on Sale of
Repossessed Collateral of $1.3 million over the comparable period in 1997.
Total operating expenses increased by 809.2% to $12.1 million for the three
month period ended September 30, 1998 compared to $1.3 million in the three
month period ended September 30, 1997. This increase included a charge in the
third fiscal quarter of 1998 of $2.0 million to write off offering costs
related to a rights offering of the Company's stock that was cancelled due to
lack of investor interest and an increase in General and Administrative
expenses of $8.1 million. Net Loss for the three month period ended
September 30, 1998 totaled $318,000 compared to earnings of $173,000 in the
comparable period in 1997.
Results Of Operations
For Nine Months Ended September 30, 1998
Compared To Nine Months Ended September 30, 1997
Revenues increased by 605.0% to $24.5 million for the nine month period
ended September 30, 1998 compared to $3.5 million in the nine month period
ended September 30, 1997. Revenues increased as a result of increases in
Interest Income of $7.0 million, Servicing Fees of $11.7 million and Net Gain
on Sale of Repossessed Collateral of $2.4 million over the comparable period
in 1997. Total operating expenses increased by 826.7% to $22.3 million for the
nine month period ended September 30, 1998 compared to $2.4 million in the
nine month period ended September 30, 1997. This increase included a charge
in the third fiscal quarter of 1998 of $2.0 million to write off offering
costs related to the terminated rights offering by the Company's parent. The
increase is primarily due to an increase in General and Administrative
Expenses of $16.1 million over the comparable period in 1997 due to the
Company's expansion of it's loans servicing and Cygnet Dealer Program
operations. Net Loss for the nine month period ended September 30, 1998
totaled $318,000 compared to earnings of $173,000 in the comparable period in
1997.
Liquidity and Capital Resources
The Company requires capital to support lending activities under its
Cygnet Dealer Program, the purchase of bulk finance receivable portfolios, the
purchase of property and equipment, and for working capital and general
corporate purposes. The Company historically has funded its capital
requirements through equity contributions and advances by Ugly Duckling
Corporation and operating cash flow.
Cash Flows. The Company's Net Cash Provided by Operating Activities
totaled $21 million in the nine months ended September 30, 1998 which was
largely offset by Net Cash Used in Operating Activities of $19.4 million for
the nine month period ended September 30, 1998. Net Cash Provided by Financing
Activities for 1997 was $21.2 million, all of which was provided by Ugly
<PAGE>13
Duckling Corporation. The Company's Net Cash Provided by Financing Activities
decreased by 28.6% or $2.5 million to $6.3 million for the nine month period
ended September 30, 1998 was primarily the result of a $5.0 million credit
facility and $10.9 million in advances from the Company's parent.
Capital Expenditures and Commitments. The Company has secured a credit
facility with a third party lender pursuant to which the lender has provided
the Company $5 million in the form of subordinated debt. The debt bears
interest at 12% per annum, payable quarterly in arrears, with the principal
balance and all accrued but unpaid interest payable in full on the third
anniversary of the initial funding date. The debt is subordinated in right of
payment to all existing and future debt of the Company. The Company is also
required to maintain a debt to tangible equity ratio not greater than 3 to 1,
calculated as of the end of each quarterly period. Ugly Duckling is obligated
to issue a total of 115,000 warrants to the lenders by December 31, 1998, if
the loan is not paid in full by that date. The loan is guaranteed by Ugly
Duckling Corporation.
The Company intends to finance its future capital requirements through
advances from its parent, operating cash flows and supplemental borrowings.
Year 2000
The Company has performed a preliminary study (review and assessment) of
its computer systems and third parties' (e.g. vendors and customers) computer
systems in order to evaluate its exposure to Year 2000 issues. The Company
continues to plan and evaluate appropriate courses of corrective action,
including replacement of certain systems whose associated costs would be
recorded as assets and amortized, or modification of its existing systems,
which costs would be expensed as incurred. The Company expects to make the
necessary replacements, modifications or changes to its computer information
systems to enable proper processing of transactions relating to the Year 2000
and beyond. The Company also has had discussions with certain of its vendors
and customers regarding actions to be taken to resolve any Year 2000 issues
arising from the Company's dependence on third parties' computer systems. The
amount expensed by the Company on Year 2000 issues to date has not been
material. In addition, the Company does not believe that the costs of
modifying or replacing its computer information systems in order to enable
proper processing of transactions relating to the Year 2000 and
beyond?estimated to be $700,000-will be material to its financial position or
results of operations. The Company believes, however, that resolution of all
Year 2000 issues will be significant to the Company's business and operations
and there can be no assurance that the Company will be able to completely
resolve all Year 2000 issues in a timely fashion or that the ultimate impact
of the Year 2000 issues will not be material to the Company. Accordingly,
failure to resolve Year 2000 issues in a timely fashion could have a material
adverse effect on the Company's business, financial condition, and results of
operations. See "Risk Factors - Risks Relating to the Business - Data
Processing and Technology and Year 2000 at Exhibit 99."
The Company is in the process of converting its loan processing and
collections systems to Affiliated Computer Services, Inc. ("ACS"), a third
party service bureau that processes transactions using Shaw Systems
Associates, Inc. ("Shaw") software and other products ("Shaw Products"). Shaw
has certified to ACS that a significant portion of the Shaw Products that ACS
uses to process the Company's transactions are Year 2000 compliant. Based upon
a Shaw certification and a representation from ACS to the Company, the Company
believes that Shaw has also undertaken to provide additional Year 2000
compliant Shaw Products to ACS as such systems become compliant. ACS would
<PAGE>14
then make available for the Company's processing of transactions these
additional Year 2000 compliant Shaw Products. The ACS Agreement requires that
the ACS systems processing the Company's transaction be fully Year 2000
compliant by January 1, 1999. However, the Company's sole remedy if ACS does
not comply with this requirement is to terminate the ACS Agreement and convert
to another system, which would be costly and disruptive to operations and
could have a material adverse effect on the Company's business and operations.
The Company's business and operations also could be adversely affected if
other entities (e.g., vendors and customers) not affiliated with the Company
do not appropriately address their own Year 2000 compliance issues. Further,
certain of the Company's own applications are not Year 2000 compliant at this
time.
Inflation
Increases in inflation generally result in higher interest rates. Higher
interest rates on the Company's expected borrowings would decrease the
profitability of the Company's existing portfolio. The Company has sought to
limit this risk by (i) maintaining a portion of its investment portfolio in
the floating rate Asset Based Loan Program and (ii) limiting the maturity of
finance receivable contracts. If the Company's borrowing rates increase, then
the Company will seek to further limit the negative impact on earnings by
increasing the purchase discount at which the Company purchases finance
receivables and/or require higher stated annual percentage rates on finances
receivables which are purchased. To date, inflation has not had a significant
impact on the Company's operations.
Accounting Matters
In June 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 130, "Reporting Comprehensive Income"
(SFAS No. 130) which became effective for the Company on January 1, 1998. SFAS
No. 130 establishes standards for reporting and displaying comprehensive
income and its components in a full set of general purpose financial
statements. The Company had no comprehensive income.
In February, 1998, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 132, "Employer's Disclosures
About Pensions and Other Postretirement Benefits" ("SFAS No. 132"), which
becomes effective for the Company January 1, 1999. SFAS No. 132 establishes
standards for the information that public enterprises report in annual
financial statements. The Company believes the adoption of SFAS No. 132 will
not have a material impact on the Company.
<PAGE>15
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.
From time to time, the Company, in the ordinary course of business, receives
complaints from borrowers relating to alleged violations of federal and state
consumer lending or other similar laws and regulations. While most of these
complaints typically are made directly to the lender or to various consumer
protection organizations and are subsequently resolved, the Company is named
occasionally as a defendant in civil suits filed by borrowers in state, local
or small claims courts. Additionally, in the ordinary course of business,
the Company is a defendant in various other types of legal proceedings. The
Company believes that the ultimate disposition of these matters on a
cumulative basis will not have a material adverse effect on the Company;
however, there can be no assurance in this regard.
Item 2. Changes in Securities.
(a) None.
(b) None.
(c) None.
(d) None.
Item 3. Defaults Upon Senior Securities.
None.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
Item 5. Other Information.
None.
<PAGE>16
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits. Description
-------- ---------------------------------------------------------
27 Financial Data Schedule
99 Cautionary Statement Regarding Forward Looking Statements
and Risk Factors
(b) Reports on Form 8-K.
During the third quarter 1998, the Company filed three reports on Form 8-
K. The first report on Form 8-K, dated August 31, 1998 and filed September 2,
1998, pursuant to Item 5 reported approval by Ugly Duckling's stockholders
during its 1998 annual meeting of Ugly Duckling proceeding with the planned
Split-up and related Rights Offering. The second report on Form 8-K, dated
and filed September 17, 1998 pursuant to Items 5 and 7 (1) reported the
initiation of an offer by Ugly Duckling to exchange shares of its common stock
for subordinated debentures ("Exchange Offer"), and (2) filed as an exhibits
to the Form 8-K a right to rescind document re the exercise of Rights and
Cygnet's press release dated September 17, 1998 titled "Cygnet Financial
Corporation Files Supplement to Rights Offering." The third report on Form 8-
K, dated September 25, 1998 and filed September 29, 1998 pursuant to Items 5
and 7 (1) reported the termination of the Rights Offering and the Split-up,
and (2) filed as an exhibit to the Form 8-K, Cygnet's press release dated
September 28, 1998 titled "Ugly Duckling Corporation and Cygnet Financial
Corporation Terminate Rights Offering."
<PAGE>17
SIGNATURE
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.
Cygnet Financial Corporation
/s/ ERIC J. SPLAVER
Eric J. Splaver
Chief Financial Officer
(Principal Financial and
Accounting Officer)
Date: November 19, 1998
<PAGE>18
EXHIBIT INDEX
Exhibits. Description
-------- ---------------------------------------------------------
27 Financial Data Schedule
99 Cautionary Statement Regarding Forward Looking Statements
and Risk Factors
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<NAME> CYGNET FINANCIAL CORP
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<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> SEP-30-1998
<CASH> 451
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<RECEIVABLES> 70,866
<ALLOWANCES> (14,141)
<INVENTORY> 0
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<TOTAL-LIABILITY-AND-EQUITY> 69,104
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<PAGE> 20
EXHIBIT-99
CAUTIONARY STATEMENT REGARDING FORWARD LOOKING STATEMENTS AND RISK FACTORS
The Company wishes to take advantage of the "safe harbor" provisions of
the Private Securities Litigation Reform Act of 1995 and is filing this
cautionary statement in connection with such safe harbor legislation. This
Form 10-Q, any other Form 10-Q, any Form 8-K, other SEC filings or any other
written or oral statements made by or on behalf of the Company may include
forward looking statements which reflect the Company's current views with
respect to future events and financial performance. The words "believe,"
"expect," "anticipate," "intend," "forecast," "project," and similar
expressions identify forward-looking statements.
The Company wishes to caution investors that any forward looking
statements made by or on behalf of the Company are subject to uncertainties
and other factors that could cause actual results to differ materially from
such statements. These uncertainties and other factors include, but are not
limited to, the Risk Factors listed below (many of which have been discussed
in prior SEC filings by the Company). Though the Company has attempted to
list important factors, the Company wishes to caution investors that other
factors may prove to be important in affecting the Company's results of
operations. In addition, new factors emerge from time to time and it is not
possible for management to predict all of such factors, nor can it assess the
impact of each such factor on the business or the extent to which any factor,
or combination of factors, may cause actual results to differ materially from
forward looking statements.
Investors are further cautioned not to place undue reliance on such
forward looking statements as they speak only of the Company's views as of
the date the statement was made. The Company undertakes no obligation to
publicly update or revise any forward looking statements, whether as a result
of new information, future events, or otherwise.
Capitalized terms not otherwise defined in this Exhibit 99 shall have
the meaning assigned to them in the Form 10-Q.
RISK FACTORS
In addition to the other information included elsewhere in this Form 10-Q,
investors should give careful consideration to the following risk factors
which may impact the Company's.
<PAGE>21
NO ASSURANCE OF PROFITABILITY
The Company's net earnings for the year ended December 31, 1997 were
$5.5 million. For the nine months ended September 30, 1998, the Company's net
loss was $318,000. The Company has experienced, and in the future is expected
to continue to experience, substantial variations in its results of
operations as a result of a number of factors, many of which are outside the
Company's control.
Substantially all of the net earnings of the Company for the year ended
December 31, 1997 were attributable to the FMAC transaction. The
profitability and cash flows of the Company in the future, at least in the
near term, will be highly dependent on its ability to successfully conclude
additional large bulk purchase and servicing transactions similar to the FMAC
and Reliance transactions. In recent months, the Company has experienced
increased competition from other companies in its consideration of
transactions similar to FMAC and Reliance. There can be no assurance that the
Company will be able to effect similar transactions in the future on terms as
favorable to the Company as the FMAC and Reliance transactions. Any inability
of the Company to locate and conclude other profitable bulk purchase or
servicing opportunities in the future could have a material adverse impact on
the Company. See "Risk Factors -- Risks Relating to the Business -- Avoidance
of Excess Servicing Capacity."
In addition, the Company believes that a significant portion of its net
earnings in future periods may be attributable to the FMAC and Reliance
transactions. However, the ability of the Company to generate earnings from
these two transactions is subject to significant contingencies. See "Risk
Factors -- Risks Relating to the Business -- Risks Related to the FMAC
Transaction" and "Risk Factors -- Risks Relating to the Business - Risks
Related to the Reliance Transaction."
The Company's ability to regain profitability also will depend upon its
ability to meet its general objectives including: (i) expanding its revenue
generating operations while not proportionately increasing its administrative
overhead; (ii) purchasing portfolios of finance receivables with an
acceptable level of credit risk; (iii) effectively collecting payments due on
the finance receivables in its portfolios and in third party portfolios; (iv)
locating sufficient financing, with acceptable terms, to fund the expansion
of the Cygnet Dealer Program and the bulk purchase of additional finance
receivables; and (v) adapting to the increasingly competitive markets in
which it operates. Outside factors, such as the economic, regulatory, and
judicial environments in which the Company operates, also will have an effect
on the Company's business.
Any of these factors could result in the periodic inefficient or
underutilization of the Company's resources and could cause the Company's
operating results to fluctuate significantly from period to period, including
on a quarterly basis. There can be no assurance that the Cygnet Dealer
Program or the FMAC or Reliance transactions or similar transactions effected
in the future will be profitable, or if they are, that such profitability can
be sustained. The Company's inability to achieve or maintain any or all of
its objectives could have a material adverse effect on the Company's
business, financial condition, or results of operations.
<PAGE>22
DEPENDENCE ON UNIQUE TRANSACTIONS; QUARTERLY FLUCTUATIONS
As noted above, the Company's profitability will depend significantly on
its ability to effect large bulk purchase and servicing transactions,
including, among others, transactions similar to the FMAC and Reliance
transactions. Because each potential opportunity typically presents a unique
set of risks and circumstances, each transaction must be separately
structured, evaluated, and negotiated. This process typically consumes
substantial amounts of executive management time and attention with no
assurance of a successful conclusion. Accordingly, there can be no assurance
that future opportunities of this type can be identified and concluded on
terms favorable to the Company. The failure to identify and conclude such
transactions on a continual basis could have a material adverse effect on the
Company. See "Risk Factors -- Risks Relating to the Business -- No Assurance
of Profitability" "-- Dependence on Key Personnel" and "-- Avoidance of
Excess Servicing Capacity." In addition, the timing of effectuation of future
transactions may result in wide variation in financial results on a quarterly
basis. Moreover, the Company may evaluate opportunities for favorable
transactions in industries other than the sub-prime automobile financing
market. To the extent the Company purchases portfolios of loan receivables in
industries other than the used car industry, such transactions are likely to
present a different set of risks and challenges for which the Company may be
less prepared as a result of its relative lack of experience in that
industry.
DEPENDENCE UPON KEY PERSONNEL
The Company's success will depend upon the continued services of the
Company's senior management, particularly its Chief Executive Officer, Mr.
Ernest C. Garcia, II, as well as the Company's ability to attract additional
members to its management team with experience in the bulk purchasing and
servicing industry and the used car dealer financing industry. The unexpected
loss of the services of any of the Company's key management personnel, or its
inability to attract new management when necessary, could have a material
adverse effect upon the Company. The Company does not currently plan to
maintain any key person life insurance on any of its executive officers.
The continued services of Mr. Garcia are critical to the future success
of the Company. In particular, in the bulk purchasing and servicing line of
business, the Company's success depends significantly on Mr. Garcia's ability
to (i) purchase portfolios of finance receivables at discounts sufficient to
generate profits and (ii) secure servicing of finance receivable portfolios
with sufficient volume and fees to generate profits. In particular, it is
expected that the Company will rely heavily on Mr. Garcia's expertise in
identifying opportunities to purchase or service large portfolios of finance
receivables. Losing the services of Mr. Garcia could adversely impact the
Company's ability to attract profitable bulk purchasing and servicing
opportunities and in turn could have a material adverse effect on the
Company.
<PAGE>23
CONVERSION TO NEW SERVICING PLATFORMS
The Company is dependent upon its information systems to properly
account for and monitor its finance receivables portfolio, its loan servicing
operations and the Cygnet Dealer Program loan portfolio. The Cygnet Dealer
Program portfolio is currently tracked on an internally developed custom
software system. However, the Company recently signed a service bureau
agreement (the "ACS Agreement") with ACS to process the loan portfolios owned
or serviced by the Company. Due to the unique characteristics of the Cygnet
Dealer Program, ACS will be required to make a number of custom software
enhancements to enable the Cygnet Dealer Program to run on the ACS system.
The Company anticipates that implementation of the custom software changes
and conversion from the Company's in-house system to the ACS system will be
completed by December 31, 1998. In addition to the ACS system, the Company is
developing a custom loan underwriting and funding software module to
interface between the Third Party Dealers' systems and the ACS system. During
1999, the Company intends to migrate the dealers from their separate stand
alone loan systems to the ACS system for purposes of loan servicing and
collections. An extended delay in the conversion to the ACS system, in the
development of the custom loan underwriting and funding software module, or
in migrating the dealers to the ACS system for loan servicing and
collections, could have a negative impact on the Company's ability to
efficiently collect, account for and monitor the Cygnet Dealer Program loan
portfolio. Only a portion of the ACS systems is fully Year 2000 compliant.
Further, the Company bears certain risks related to Year 2000 in connection
with applications and systems of other vendors, the Company's equipment, and
the Company's customers. See "Risk Factors -- Risks Relating to the Business
- - Data Processing and Technology and Year 2000" and "Management's Discussion
and Analysis of Financial Condition and Results of Operations of the Company-
- - Year 2000."
The conversion of both the Cygnet Dealer Program or other servicing
functions to ACS and the assimilation of additional portfolios to the ACS
platform may result in various implementation and integration issues that
could temporarily interrupt the Company's ability to effectively collect,
monitor and account for the Cygnet Dealer Program and to service the
respective portfolios without serious disruption. Any such issues or
interruptions could result in an increase in contract delinquencies and
charge-offs in the respective portfolios and in the Cygnet Dealer Program,
which, depending on the severity of the matter, could result in the Company
being removed as the servicer for the respective portfolios and have other
material adverse consequences to the Company. See "Risk Factors -- Risks
Relating to the Business -- Risks Relating to the FMAC Transaction" and "Risk
Factors -- Risks Relating to the Business - Risks Relating to the Reliance
Transaction."
DATA PROCESSING AND TECHNOLOGY AND YEAR 2000
The success of any participant that engages in the financing and
servicing of loan receivables, particularly those with a focus on the sub-
prime industry, including the Company, depends in large part on its ability
to continue to adapt its technology, on a timely and cost-effective basis, to
meet changing customer and industry standards and requirements.
<PAGE>24
As noted above, it is anticipated that the existing Cygnet Dealer
Program and other loan servicing functions will be converted to the ACS
system in the latter half of 1998. Pursuant to the ACS Agreement, the ACS
systems must be fully Year 2000 compliant by January 1, 1999. However, the
Company's sole remedy if ACS does not comply with this requirement is to
terminate the ACS Agreement and convert to another system, which would be
costly and disruptive and could have a material adverse effect on the
Company's business.
In addition to the ACS Year 2000 issues, the Company also continues to
bear risks related to the Year 2000 issue and could be materially adversely
affected if other entities (e.g., vendors or customers) not affiliated with
the Company do not appropriately address their own Year 2000 compliance
issues. Further, certain of the Company's own applications are not Year 2000
compliant at this time. The Company anticipates that resolution of all Year
2000 issues will be significant to the Company's business and operations.
There can be no assurance that the Company will be able to completely resolve
all Year 2000 issues in a timely fashion or that the ultimate impact of the
Year 2000 issues will not be material to the Company. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations of
the Company-- Year 2000."
Pursuant to the ACS Agreement, ACS has agreed to provide enhancements
and modifications to the base system that is licensed to ACS. Some of the
enhancements and modifications will remain proprietary to ACS and will not be
licensed to the Company. If ACS or the Company breaches the ACS Agreement,
and ACS no longer provides processing services, the Company may incur
significant costs in securing a replacement processing company that will be
able to process the loans in the same manner as ACS. Further, the Company's
remaining computer applications would not be sufficient to effectively manage
the Cygnet Dealer Program or the loan servicing of finance receivables
portfolios.
The Company will be dependent on its loan servicing and collection
facilities as well as long-distance and local telecommunications access in
order to transmit and process information among its various facilities. The
Company maintains a standard program whereby it prepares and stores off site
back ups of its main system applications and data files on a routine basis.
The Company believes that it will be necessary to adopt a disaster response
plan. There can be no assurance that a failure will not occur in the interim
or that any plan adopted will prevent or enable timely resolution of any
systems failure. Further, a natural disaster, calamity, or other significant
event that causes long-term damage to any of their facilities or that
interrupts its telecommunications networks could have a material adverse
effect on the Company. With respect to the Company's servicing operations
following conversion to the ACS system, the Company will be required to rely
on the disaster response plan developed and utilized by ACS. ACS believes
that its disaster response plan is proprietary information and has not
allowed the Company to fully evaluate such plan. Therefore, if the disaster
response plan of ACS is inadequate, the occurrence of a disaster could have a
material adverse effect on the Company's business.
<PAGE>25
AVOIDANCE OF EXCESS SERVICING CAPACITY
Because of the relatively short lives of automobile finance receivables,
the portfolios the Company is currently servicing are expected to be reduced
in the near future to a point at which, if not replaced with additional
finance receivables, the Company's servicing platform and operations will
have excess capacity. For the Company's servicing operations to remain
profitable, the Company must continually service a sufficient number of
finance receivables to generate servicing income in excess of fixed overhead
costs. For example, a significant portion of servicing overhead is based on
certain fixed costs for personnel salaries and other expenses as well as
lease or other facilities costs. If portfolios being serviced are not
continually replaced with new finance receivables, the Company will be
required to reduce the number of employees in its servicing operations, and
then rehire such employees as additional portfolios are obtained. Such
practices can lead to low employee morale and to disruptions and loss of
efficiency in servicing functions and can also result in substantial
severance and facilities closure costs. Therefore, in order to maintain the
profitability of the Company's servicing operations, it will be necessary for
the Company to continue to identify and secure servicing rights to
significant portfolios of finance receivables. To an extent, each bulk
purchase and servicing transaction is a unique opportunity. There can be no
assurance that the Company will be able to identify and successfully conclude
sufficient bulk purchasing and servicing transactions to maintain the
profitability of these operations. See "Risk Factors - Risks Relating to the
Business -- No Assurance of Profitability."
Although the Company is evaluating the possibility of expanding its
servicing operations to include receivables other than auto receivables, such
as mortgages or credit card receivables, in order to mitigate its excess
capacity issues, the Company has no experience in servicing such types of
receivables and may encounter other unanticipated problems. Moreover, there
can be no assurance that such receivables could be serviced on the existing
and anticipated servicing systems of the Company without substantial
modification.
MANAGEMENT OF TRANSITION ACTIVITIES
The profitable realization of bulk purchase and servicing opportunities
requires effective management of significant transition activities, which
must be accomplished within a very short time period. These transition
activities include, among others, converting acquired or serviced loan
portfolios from the seller's or owner's servicing systems to the loan
servicing systems utilized by the Company, managing rapidly changing
servicing capacity, arranging for transition of employees, and arranging for
facilities to allow servicing. These issues are magnified as larger
portfolios of the type the Company will seek to purchase or service are
transitioned into the Company's systems, and the concurrent risks are greater
if a transition is not smoothly implemented. There can be no assurance that
the Company can successfully manage the transition of its current or
subsequent transactions. See "Risk Factors -- Risks Relating to the Business
- -- Conversion to New Servicing Platforms."
<PAGE>26
RISKS RELATED TO THE FMAC TRANSACTION
Although the Company's involvement in the FMAC bankruptcy proceedings
has been profitable, there can be no assurance that this transaction will
continue to be profitable in the future.
The Company will be required to meet certain performance criteria with
respect to servicing of the FMAC and Owned Contract portfolios. The failure
to meet the required performance criteria could result from a number of
factors, including, among others, general economic conditions that cause
increased payment delinquencies by the obligors on the contracts in the pools
being serviced, and servicing interruptions and inefficiencies caused by the
Company's anticipated servicing platform conversions or any Year 2000 issues.
See "Risk Factors -- Risks Relating to the Business -- Conversion to New
Servicing Platforms" and "Risk Factors -- Risks Relating to the Business -
Data Processing and Technology and Year 2000." The failure to meet such
performance criteria could result in "termination events" under the various
servicing agreements governing the FMAC and Owned Contract portfolios, and in
such case the Company could lose the right to service the receivables in such
portfolios and the related servicing fees. If for any reason the Company
cannot continue to service the FMAC portfolios, the Company would lose
significant benefits expected in the FMAC transaction, including ongoing
servicing fees and its right to certain distributions from residual interests
in FMAC's securitized pools, which could have a material adverse effect on
the Company.
RISKS RELATED TO THE RELIANCE TRANSACTION
The Company's ability to profitably service the Reliance portfolio is
largely dependent on its ability to effectively manage the transition
activities associated with the assumption of such servicing. See "Risk
Factors -- Risks Relating to the Business -- Management of Transition
Activities" and "Risk Factors -- Risks Relating to the Business -- Conversion
to New Servicing Platforms."
Moreover, the Company is required to meet certain performance criteria
with respect to servicing of the Reliance portfolio. A failure to meet the
required performance criteria could result from a number of factors,
including, among others, general economic conditions that cause increased
payment delinquencies by the obligors on the contracts in the pools being
serviced, and servicing interruptions and inefficiencies caused by the
Company's anticipated servicing platform conversions or any Year 2000 issues.
See "Risk Factors -- Risks Relating to the Business -- Conversion to New
Servicing Platforms" and "Risk Factors -- Risks Relating to the Business --
Data Processing and Technology and Year 2000." The failure to meet such
performance criteria could result in a "termination event" under the
servicing agreement entered into by the Company with Reliance and, in such
case, the Company could lose the right to service the Reliance portfolio.
CYGNET DEALER PROGRAM
The Cygnet Dealer Program provides qualified Third Party Dealers with
financing options and revolving lines of credit primarily secured by such
dealers' finance receivable portfolios. While the Company will require
dealers to meet certain minimum net worth and operating history criteria to
be considered for inclusion in the Cygnet Dealer Program, it will,
nevertheless, be extending credit to dealers who may not otherwise be able to
obtain debt financing from traditional lending institutions such as banks,
<PAGE>27
credit unions, and major finance companies. Under the Cygnet Dealer Program,
the dealer remains responsible for collection of the contract payments and
retains control of the customer relationship. All cash collections, including
regular monthly payments, payoffs, and repurchases are deposited by the
dealers into a bank account maintained by the Company. Consequently, the
Company will be subject to a high risk of credit losses due to dealer
defaults or fraudulent activities, specifically related to the collection,
depositing, and reporting of customer payments, which could have a material
adverse effect on the Company and on the Company's ability to meet its own
financing obligations.
SENSITIVITY TO INTEREST RATES
The Company anticipates that a substantial portion of its borrowing
facilities will be on a floating rate basis. Conversely, the contracts that
the Company purchases under its Dealer Collection Program (as defined herein)
and the contracts that it purchases in bulk typically bear interest at fixed
rates. Therefore, increases in interest rates would effectively reduce the
interest rate spread the Company earns on the retail installment contracts in
its portfolios. The Company can attempt to mitigate any such reduction by
reducing the advance rate under its Dealer Collection Program, increasing the
discount rate on bulk purchases, or securitizing its portfolios in order to
lock in a fixed cost of funds. However, the Company may not be able to
increase the interest rate spread on future purchases of contracts due to
market competition or restrictions placed on interest rates by various
states. Further, there can be no assurance that the Company would be
successful in the implementation of a securitization program. See "Risk
Factors -- Risks Relating to the Business -- Securitizations."
DEPENDENCE ON FINANCING
The Company has borrowed, and will continue to borrow, substantial amounts
required to fund its operations. Historically, the Company has obtained
substantially all of its working capital from its parent. There can be no
assurance that the Company will continue to be able to obtain working capital
from it's parent. In this regard, the Company's operations are highly
capital intensive. Although the Company has had discussions with various
lenders regarding a credit facility, there can be no assurance that the
Company will be able to secure financing when and as needed in the future, or
on terms acceptable to the Company.
RISKS OF INFLATION
Increases in inflation generally result in higher interest rates. Higher
interest rates on the Company's expected borrowings would decrease the
profitability of the Company's existing portfolio. The Company has sought to
limit this risk by (i) maintaining a portion of its investment portfolio in a
floating rate program and (ii) limiting the maturity of finance receivable
contracts. If the Company's borrowing rates increase, then the Company will
seek to further limit the negative impact on earnings by increasing the
purchase discount at which the Company purchases finance receivables and/or
require higher stated annual percentage rates on finances receivables which
are purchased. To date, inflation has not had a significant impact on the
Company's operations.
<PAGE>28
COMPETITION
The markets in which the Company competes are highly competitive. With
respect to its Cygnet Dealer Program and bulk purchasing and servicing
operations, the Company competes with a variety of finance companies,
financial institutions, and providers of financial services, many of whom
have significantly greater resources, including access to lower priced
capital. In addition, there are numerous financial services companies
serving, or capable of serving, these markets. While traditional financial
institutions, such as commercial banks, savings and loans, credit unions, and
captive finance companies of major automobile manufacturers, have not
consistently served the sub-prime markets, the relatively high yields that
can be earned by companies involved in sub-prime financing have encouraged
certain of these traditional institutions to enter, or contemplate entering,
these markets. Increased competition may adversely affect the Company under
the Dealer Collection Program (as described herein) by reducing the discount
at which the Company purchases contracts, may result in a decrease in the
discounts at which the Company purchases portfolios in bulk, or may result in
downward pressure on the rates charged for loan servicing, all of which could
have an adverse effect on the Company. Further, increased competition for the
bulk purchase and servicing transactions that the Company must effect to
remain profitable could have a material adverse effect on the Company's
business.
GENERAL ECONOMIC CONDITIONS; RISKS ASSOCIATED WITH SUB-PRIME MARKET
The Company's business is directly related to the ability of the
obligors on the finance receivables that the Company services, expects to
purchase in bulk, and that secure its Cygnet Dealer Program to continue to
make the required payments on such contracts, which is affected by employment
rates, prevailing interest rates, and other general economic conditions.
While the Company believes that current economic conditions favor continued
growth in the markets it serves and those in which it seeks to expand, a
future economic slowdown or recession could lead to increased delinquencies,
repossessions, and credit losses on the finance receivables that the Company
services, expects to purchase in bulk, or that secure the Cygnet Dealer
Program. Moreover, substantially all of the finance receivables that the
Company services, expects to purchase in bulk, or that secure the Cygnet
Dealer Program are with Sub-Prime Borrowers, who due to their poor credit
histories and/or low incomes are generally unable to obtain credit from
traditional financial institutions, such as banks, savings and loans, credit
unions, or captive finance companies owned by automobile manufacturers.
Because of the Company's primary focus on the sub-prime segment of the
automobile financing industry, the actual rate of delinquencies,
repossessions, and credit losses on the finance receivables that the Company
services, expects to purchase in bulk, or that secure the Cygnet Dealer
Program could be higher under adverse conditions than those experienced in
the used car sales and finance industry in general. Moreover, adverse
economic conditions that result in decreased sales of used cars could
adversely affect the dealers that participate in the Cygnet Dealer Program,
which could have a material adverse effect on such program.
<PAGE>29
INDUSTRY CONSIDERATIONS AND LEGAL CONTINGENCIES
In recent periods, several major used car finance companies have
announced major downward adjustments to their financial statements,
violations of loan covenants, related litigation, and other events. In
addition, certain of these companies have filed for bankruptcy protection.
These announcements have had a disruptive effect on the market for securities
of sub-prime automobile finance companies, have resulted in a tightening of
credit to the sub-prime markets, and could lead to enhanced regulatory
oversight. Furthermore, companies in the used vehicle financing market have
been named as defendants in an increasing number of class action lawsuits
brought by customers alleging violations of various federal and state
consumer credit and similar laws and regulations. Although the Company is not
currently a named defendant in any such lawsuits, no assurance can be given
that such claims will not be asserted against the Company in the future or
that the Company's operations will not be subject to enhanced regulatory
oversight.
