UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended SEPTEMBER 30, 1995
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _______ to _______________
Commission File Number 0-17338
HOMEOWNERS GROUP, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 65-0033743
State or other jurisdiction of (I.R.S. Employer
incorporation or organization Identification No.)
6365 TAFT STREET, HOLLYWOOD, FLORIDA 33024
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (305) 983-0350
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
On November 3, 1995, there were 5,558,350 shares of the registrant's common
stock issued and outstanding.
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PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
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HOMEOWNERS GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, DECEMBER 31,
1995 1994
-------------------- ------------------
(UNAUDITED) (AUDITED)
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ASSETS:
Current assets:
Cash and cash equivalents $2,934,717 $5,875,844
Trading securities 9,007,494 8,261,915
Miscellaneous receivables 1,213,500 1,153,188
Deferred home warranty acquisition costs 5,544,833 5,677,322
Refundable income taxes 1,277,449 1,816,149
Current portion of deferred income taxes 5,135,151 4,880,781
Prepaid expenses and other current assets 987,422 1,281,693
-------------------- ------------------
Total current assets 26,100,566 28,946,892
Restricted cash 3,160,000 1,407,851
Non-current securities available for sale 3,680,793 4,078,966
Property and equipment - net 2,870,101 2,009,165
Other assets 1,492,801 1,177,026
Deferred and refundable income taxes - net of current portion 1,332,601 1,579,345
-------------------- ------------------
TOTAL $38,636,862 $39,199,245
==================== ==================
LIABILITIES AND STOCKHOLDERS' EQUITY:
Current liabilities:
Accounts and accrued expenses payable $9,011,813 $10,296,813
Current maturities of long term debt 1,551,772 1,065,487
Deferred home warranty revenue 16,059,691 16,118,752
-------------------- ------------------
Total current liabilities 26,623,276 27,481,052
Long term debt - net of current portion 2,671,010 3,316,845
Commitments and contingencies
Stockholders' equity:
Common stock - $0.01 par value; 45,000,000 shares
authorized; 5,558,350 shares issued and outstanding
at September 30, 1995 and December 31, 1994 55,584 55,584
Additional paid-in capital 7,458,288 7,458,288
Retained earnings 1,773,347 902,289
Unrealized holding gain (loss) on securities available for sale 55,357 (14,813)
-------------------- ------------------
Total stockholders' equity 9,342,576 8,401,348
-------------------- ------------------
TOTAL $38,636,862 $39,199,245
==================== ==================
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SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
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HOMEOWNERS GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
NINE MONTHS ENDED THREE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
1995 1994 1995 1994
---------------- ---------------- -------------- ----------------
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OPERATING REVENUE $33,593,030 $40,551,900 $11,540,238 $10,337,294
OPERATING COSTS AND EXPENSES:
Direct expenses 25,899,415 30,581,226 9,267,857 10,398,346
General and administrative expenses 7,008,609 9,529,644 2,055,903 3,522,273
Unusual items - 1,787,355 - 1,787,355
---------------- ---------------- -------------- ----------------
Total 32,908,024 41,898,225 11,323,760 15,707,974
---------------- ---------------- -------------- ----------------
OPERATING INCOME (LOSS) 685,006 (1,346,325) 216,478 (5,370,680)
OTHER INCOME (EXPENSE):
Investment income - net 1,041,872 43,966 148,520 87,809
Other income (expense) - net (291,820) (93,230) (119,921) (90,617)
---------------- ---------------- -------------- ----------------
Total 750,052 (49,264) 28,599 (2,808)
INCOME (LOSS) BEFORE INCOME TAXES 1,435,058 (1,395,589) 245,077 (5,373,488)
(PROVISION) BENEFIT FOR INCOME TAXES (564,000) 417,004 (103,000) 2,036,339
---------------- ---------------- -------------- ----------------
NET INCOME (LOSS) $871,058 ($978,585) $142,077 ($3,337,149)
================ ================ ============== ================
PER SHARE AMOUNTS:
Net income (loss) $0.16 ($0.18) $0.03 ($0.60)
================ ================ ============== ================
Weighted average common shares outstanding 5,558,350 5,558,350 5,558,350 5,558,350
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SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
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HOMEOWNERS GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
1995 1994
----------------- ------------------
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Cash flows from operating activities:
Net income (loss) $871,058 ($978,585)
Adjustments:
Depreciation and amortization 430,333 606,527
Allowance for loss on franchising fee revenue - 3,112,328
Provision (benefit) for deferred income taxes (589,000) 1,439,000
Foreign currency translation adjustment - 43,280
(Gain) loss on sales of investments (445,989) 428,620
Unrealized holding loss on securities available for sale 70,170 30,593
Other net changes in assets and liabilities:
Increase in miscellaneous receivables (60,312) (318,587)
(Increase) Decrease in deferred home warranty acquisition costs 132,489 (247,132)
Decrease in refundable income taxes - 319,781
(Increase) decrease in deferred income taxes 1,120,074 (1,998,531)
Increase in prepaid expenses and other assets (50,012) (2,322,574)
Increase (decrease) in accounts and accrued expenses payable (1,285,000) 1,907,182
Increase (decrease) in deferred home warranty revenue (59,061) 1,114,016
Payments on reserve for loss on reinsurance portfolio transfer - (727,915)
Payments for purchases of trading securities (830,264) (8,276,460)
Proceeds from sales of trading securities 1,176,935 6,004,760
----------------- ------------------
Net cash provided by operating activities 481,421 136,303
----------------- ------------------
Cash flows from investing activities:
Property and equipment expenditures (1,262,761) (943,379)
Purchases of securities classified as available for sale (1,245,890) (5,705,806)
Proceeds from sale of investments classified as available for sale 997,802 5,729,535
----------------- ------------------
Net cash used in investing activities (1,510,849) (919,650)
----------------- ------------------
Cash flows from financing activities:
Repayments of debt (507,375) (340,127)
Amortization of discount on long term debt 207,825 212,376
Purchases of restricted cash (1,752,149) -
Borrowings under capital lease obligation 140,000 425,884
----------------- ------------------
Net cash provided by (used in) financing activities (1,911,699) 298,133
----------------- ------------------
Net decrease in cash and cash equivalents (2,940,127) (485,214)
Cash and cash equivalents at beginning of period 5,875,844 7,530,452
Cash and cash equivalents at end of period $2,934,717 $7,045,238
================= ==================
SUPPLEMENTAL DISCLOSURE:
Cash paid during the period for:
Interest $215,272 $162,326
Income taxes 30,814 412,093
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SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
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HOMEOWNERS GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
THREE MONTHS ENDED
SEPTEMBER 30,
1995 1994
----------------- ------------------
<S> <C> <C>
Cash flows from operating activities:
Net income (loss) $142,077 ($3,337,149)
Adjustments:
Depreciation and amortization 149,977 224,034
Allowance for loss on franchising fee revenue - 3,112,328
Provision for deferred income taxes (1,466,000) (631,000)
Foreign currency translation adjustment - 54,336
Loss on sale of investments 55,089 126,365
Unrealized holding loss on securities available for sale 329 7,662
Other net changes in assets and liabilities:
Increase (decrease) in miscellaneous receivables (164,265) 2,845,544
Increase in deferred home warranty acquisition costs (567,061) (244,873)
Decrease in refundable income taxes - 479,688
Increase (decrease) in deferred income taxes 1,554,838 (1,998,531)
Increase in prepaid expenses and other assets (59,324) (1,700,930)
Decrease in accounts and accrued expenses payable (634,938) (339,731)
Increase in deferred home warranty revenue 2,191,089 915,849
Payments on reserve for loss on reinsurance portfolio transfer - (12,500)
Payments for purchases of trading securities (405,748) (70,511)
Proceeds from sales of trading securities 30,684 -
----------------- ------------------
Net cash provided by (used in) operating activities 826,747 (569,419)
----------------- ------------------
Cash flows from investing activities:
Property and equipment expenditures (566,867) (534,761)
Purchases of securities classified as available for sale (274,323) (2,151,287)
Proceeds from sale of securities classified as available for sale 29,180 2,101,344
----------------- ------------------
Net cash used in investing activities (812,010) (584,704)
----------------- ------------------
Cash flows from financing activities:
Repayments of debt (139,323) (205,728)
Amortization of discount on long term debt 68,332 64,733
Purchases of restricted cash (1,252,149) -
----------------- ------------------
Borrowings under capital lease obligation - 215,346
----------------- ------------------
Net cash provided by (used in) financing activities (1,323,140) 74,351
----------------- ------------------
Net decrease in cash and cash equivalents (1,308,403) (1,079,772)
Cash and cash equivalents at beginning of period 4,243,120 8,125,010
Cash and cash equivalents at end of period $2,934,717 $7,045,238
================= ==================
SUPPLEMENTAL DISCLOSURE:
Cash paid during the period for:
Interest $69,364 $75,667
Income taxes 14,478 253,283
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SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
5
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HOMEOWNERS GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 1995
(Unaudited)
1. GENERAL
The consolidated balance sheet as of September 30, 1995 and the consolidated
statements of income and cash flows for the three and nine month periods ended
September 30, 1995 and 1994 have been prepared by the Company, without audit. In
the opinion of management, all adjustments, which include only normal recurring
adjustments necessary to present fairly the financial position, results of
operations and cash flows at September 30, 1995, and for the periods presented,
have been made.
Certain information and footnote disclosures normally included in financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted. These consolidated financial statements should
be read in conjunction with the consolidated financial statements and notes
included in the Company's 1994 Annual Report on Form 10-K, filed with the
Securities and Exchange Commission.
2. FRANCHISE OPERATIONS
Effective July 14, 1995, the Company terminated the Colorado franchise
agreement, thus making Colorado a Company Owned Region. The Company also entered
into agreements to manage the Kansas, Oklahoma, Missouri territory and the
Arizona, New Mexico territory. Additionally, effective July 14, 1995, the
Company purchased a nominal interest in the Arizona, New Mexico territory. The
Company has combined administrative functions of (i) the Kansas, Oklahoma and
Missouri regions with the Texas region and (ii) the Arizona, New Mexico regions
with the California region, which the Company believes will generate savings in
overhead expenses after the initial implementation costs.
3. CONTINGENCIES
In December 1991, Acceleration National Insurance Company ("Acceleration"), the
insurer of the Company's E&O program through April 1991, brought suit against
the Company for damages related to the 1986-1991 E&O program. Willis Corroon,
the Company's insurance broker at the time, and Meridian, the reinsurer of the
program at the time, are also defendants in this suit. Meridian is a
wholly-owned subsidiary of Willis Corroon. The complaint alleges breach of
contract, unjust enrichment, negligent misrepresentation and mismanagement of
claims operations. Currently, Acceleration's total claim is in excess of
$10,000,000. Under the Acceleration program, the Company had two letters of
credit (`LOC's') totaling $2,059,000 issued to Acceleration. Actuarial studies
indicated that funds available and anticipated investment income on the
Acceleration pool would not be sufficient to cover related claims and expenses.
As a result, the Company, in December 1991, provided a reserve of $2,059,000
against its investments to cover their possible loss under the Acceleration
agreement. This provision was included in unusual charges in the 1991
consolidated statement of income. In October 1992, Acceleration called the
LOC's, based upon its contention that the program pool was depleted. The
underlying investments were liquidated and the required proceeds surrendered to
Acceleration. The
6
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transaction was charged against the reserve, thus eliminating it. The Company
disputes all claims of Acceleration, including its obligation under the LOC's,
and believes it is entitled to damages from Acceleration for mismanagement. The
Company has filed both an answer and a counterclaim, seeking substantial
damages, well in excess of those sought by Acceleration. The Company denies the
balance of Acceleration's claims, and is seeking damages for claims
mismanagement by Acceleration during the period in which Acceleration undertook
that responsibility. Trial in this matter commenced November 6, 1994, and is
anticipated to be concluded by December 31, 1995. After taking into
consideration the evaluation of outside legal counsel, the Company has
determined, and legal counsel concurs, that the potential loss in connection
with this matter is zero to $2,500,000 and that no particular estimate within
this range is more probable than another, and that the likelihood of any verdict
in excess of this range is remote. Accordingly, no additional provision has been
made in connection with this matter.
In connection with the transfer of the net assets of POMG Insurance Company, Ltd
("POMG") to Continental Casualty Company ("CNA"), the Company is obligated to
pay CNA $5,000,000 (the "CNA Obligation") over a period estimated to be five
years toward the ultimate settlement of the transferred losses and expenses. A
separate fund, the `Holdback Fund,' has been established to accumulate the
aforementioned $5,000,000 from the Company, additional funds to be contributed
by Victor O. Schinnerer ("Schinnerer"), the program and underwriting manager,
and CNA over the same period, and investment income earned on these funds, to
pay claims and expenses related to the reinsured policies in excess of the net
assets transferred from POMG. If the ultimate reinsured losses and related
expense are less than the transferred net assets of POMG, combined with the
assets in the Holdback Fund, CNA will distribute the remaining assets among the
Company, Schinnerer and itself according to a predetermined formula. However,
management believes that a refund is unlikely. In addition, the Company has
guaranteed the validity of a $5,000,000 reinsurance treaty, one of the POMG
assets transferred to CNA, by posting $3,000,000 in cash collateral. The
reinsurance treaty was purchased by POMG from a third party reinsurance company,
to protect it from losses in excess of a predetermined amount. The Company has
agreed, if necessary, to pay the additional $2,000,000 related to the guarantee
from future commissions if the reinsurer fails to honor its commitment for
reasons other than its solvency. As of March 31, 1995, claims had exceeded the
predetermined amount but the reinsurer has not yet honored the program
administrator's request to remit the amounts due CNA under the reinsurance
treaty, and has requested additional information from the program administrator.
The Company has not recorded a provision for this guarantee, as management,
based on the opinion of its special insurance counsel, has determined that the
cover note relating to the reinsurance contract is a binding agreement,
enforceable in accordance with its terms and that various objections to coverage
voiced by the reinsurer do not support a material basis for it to successfully
deny coverage.
7
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
RECENT DEVELOPMENTS
In early 1995, the Company received several inquiries from unaffiliated third
parties relating to various proposed transactions with the Company, including
the purchase of all of the outstanding shares of the Company. Consequently, the
Company formed a Special Committee of the Board of Directors to evaluate the
alternatives available to the Company.
The Committee retained the investment banking firm of Raymond James & Associates
to assist it in evaluating the inquiries and alternatives available to the
Company. The Committee has examined various options that may enhance stockholder
value, including an alliance with a financial or strategic investor and/or a
business combination with an entity complementary to existing operations. The
Company is currently in exclusive negotiations with Warrantech Corporation,
relating to the possible acquisition by Warrantech of all of the outstanding
shares of the Company in exchange for shares of Warrantech's common stock. The
formal terms and conditions of a transaction have not been fully resolved. There
can be no assurance that an agreement will be reached.
Effective November 9, 1995, Mr. Dean Woodman retired from the Company's Board of
Directors and tendered his resignation letter, due to personal commitments.
BUSINESS ENVIRONMENT
HMS MEMBERSHIP NETWORK
The Company, through its Homeowners Marketing Services, Inc. ("HMS") subsidiary,
has developed a national network of real estate brokers ("Members"), enrolled by
the Company's franchisees ("Affiliates") and the field sales force employed in
the Corporate Owned Regions ("COR"). The Company offers various types of
memberships including a "full membership," under which participating brokers
have access to all of the Company's products and services, and a "limited
membership," under which participating brokers have access to certain of the
Company's products and services.
Members generally pay an initial membership fee and annual renewal fees, in
order to retain the rights of membership. Full members participate in the
Company's Errors & Omissions insurance ("E&O") program and pay marketing or
placement fees to the Company for access to the program. Members also have the
right to use products and services provided by other vendors with which the
Company has made preferred arrangements.
Membership provides access to home warranty contracts and the real estate
brokers E&O insurance, in addition to access to the following programs: a
membership-wide referral networking system (REFNET(Registered Trademark)), the
HMS BuyerTrack(Registered Trademark) Follow-Up System, the HMS Consumer Reach
Program, a monthly real estate publication (HMS NETWORKING(Registered Trademark)
Magazine), the HMS Risk Management System(Registered Trademark), and certain
advertising and public relations materials.
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HOME WARRANTY CONTRACTS
The Company offers, through its Members, home warranty contracts for a fixed
fee, paid at the time of closing of residential sale transactions participated
in by HMS Members. The home warranty contract provides for the repair or
replacement, at the Company's discretion, of major mechanical systems and
certain appliances of a residence which malfunction as a result of normal wear
and tear during the term of the contract. The Company currently offers a home
warranty contract for sale in every state in which the Company operates, with
the exception of Connecticut. The Company and the home warranty contract offered
are subject to insurance type regulations in 17 of the states in which contracts
are sold.
Funds received for the home warranty contracts are deferred upon receipt and
recognized as revenue over the contract term (generally one year) in proportion
to historical experience of home warranty repair costs incurred. The direct
costs of acquiring the contracts, which are generally a fixed portion of the
related revenue, are recorded in the same manner. Repair costs under home
warranty contracts, which are expensed as mechanical break-downs are reported to
and are authorized by the Company, represent the direct expense which typically
varies most with respect to related revenue. A significant portion of repair
costs generally relates to heating and air conditioning systems, water heaters
and plumbing. The frequency and severity of such repair costs vary with changing
weather patterns, and are impacted by the deductibles selected by the purchasers
of the warranty contracts.
ERRORS & OMISSIONS AND OTHER INSURANCE PRODUCTS
The Company also markets real estate brokers' E&O liability insurance to its
Members, through its HOMS Insurance Agency, Inc. ("HOMS") subsidiary. This
insurance generally provides limits of between $100,000 and $1,000,000 per loss
and from $100,000 to $1,000,000 aggregate per policy year. The policies
generally provide coverage for wrongful acts which occur during the term of the
policy and are reported up to 60 days after expiration of the policy and all
claims after expiration for which notice of wrongful act is given prior to
expiration. The policy provides for a deductible per loss and covers the real
estate brokerage firm and all officers, partners, stockholders, employees,
salespersons and sales associates or independent contractor brokers of the
brokerage firm. The Company is not subject to reinsurance risk under the current
program.
SEASONALITY
Most of the Company's revenue is generated at the time of residential resale
closings. These closings generally follow a seasonal pattern. First quarter
volume is usually the lowest, third quarter the highest, and second and fourth
quarters are about equal. Claims under home warranty contracts are generally
higher in the summer and winter months, while general and administrative
expenses are usually incurred evenly from quarter to quarter.
RESULTS OF OPERATIONS
NINE MONTHS ENDED SEPTEMBER 30, 1995 AS COMPARED TO SEPTEMBER 30, 1994
Home Warranty Operations:
Home warranty revenue, totaling $27,813,000 and representing 83% of total
operating revenue for the nine months ended September 30, 1995, decreased 4.5%
from the corresponding 1994 figure of $29,114,000, or
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72% of total operating revenue. This revenue decrease is due primarily to the
impact of warranty production decreases in the preceding eleven months, as
compared to the comparable prior year period because of the Company's revenue
recognition policy, under which warranty revenue is recognized over the contract
terms, generally twelve months. Although the number of members selling the
Company's home warranties has improved over 1994 levels during the first nine
months of 1995, there have been fewer sales opportunities, due to the impact on
housing sales of increasing interest rates, particularly in the first half of
the year. Also, heavy rains and flooding significantly impacted the California
real estate market in the early part of the year, resulting in further industry
wide reported declines in transactions and in opportunities for warranty sales,
as compared to 1994. The impact of this decrease in warranty contract sales will
continue to affect warranty revenue in future quarters.
Renewal warranty contract sales, which approximated 14% of total warranty
production in the first nine months of 1995, compared to 7% in the 1994, were
75% higher than in the first nine months of 1994, partially offsetting the
decline in first year warranty contract sales. The increase in renewal contract
sales is attributable to management's development of several new marketing
strategies which have increased renewal success rates to approximately 25%.
There have been no major pricing changes which would have significantly affected
warranty revenue.
Direct expenses of the warranty product, which consist primarily of claims
expenses and acquisition costs, as a percentage of related operating revenue,
decreased to 80% in the first nine months of 1995 from 84% in the comparable
1994 period, primarily due to a 3.4% decrease in average claim severity, as a
result of improved claims management and improved systems. This improvement was
achieved despite the heat wave experienced across the nation, as a result of
which July and August claims costs exceeded July and August 1994 levels, as a
percentage of related revenue.
The warranty acquisition cost ratio for the first nine months of 1995 is
slightly lower than the 1994 nine month period. As the volume of contract sales
shifts between geographic regions, the Company's overall acquisition cost ratio
changes, as the Company's acquisition costs vary in different locations. The
acquisition cost ratio is expected to remain relatively stable at its current
level, assuming that the warranty product mix and geographic distribution do not
change significantly. Management does not expect a significant change to occur
in the near future.
Franchising Operations:
Effective July 14, 1995, the Company terminated the Colorado franchise
agreement, thus making Colorado a Company Owned Region. The Company also entered
into agreements to manage the Kansas, Oklahoma, Missouri territory and the
Arizona, New Mexico territory. In connection with these agreements, the Company
will earn a management fee, to defray the costs associated with performing the
management services. Additionally, effective July 14, 1995, the Company
purchased a nominal interest in the Arizona, New Mexico territory. The Company
has combined administrative functions of (i) the Kansas, Oklahoma and Missouri
regions with the Texas region and (ii) the Arizona, New Mexico regions with the
California region, which the Company believes will generate savings in overhead
expenses after the initial implementation costs. Additionally, for these
regions, the Company has generally realized production increases over the prior
year levels, which increases should continue as improved market presence is
achieved.
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Membership and Other Operations:
Membership related revenue for the first nine months of 1995 totaled $4,845,000,
48% lower than the $9,260,000 reported in the comparable prior year period. This
decline is primarily the result of the changing mix of the Company's membership
base. A large portion of the Company's membership no longer participates in the
Company's E&O program, and is exempted from paying the associated marketing
fees. As of September 30, 1995, approximately 41% of the Company's membership
participated in the E&O program, as compared to 54% as of September 30, 1994.
Despite this decline from the prior year period, the Company has seen positive
impact from its Agent membership program. In addition, membership renewal
experience has improved over the prior year levels, while new membership
enrollments have increased by 62% over 1994 levels. Management believes that
these trends relate to the resolution of the E&O transition issues encountered
throughout 1994.
During the early and middle part of 1995, the Company introduced the Easy E&O
application, to enroll new E&O members in the field, using a point of sale
presentation. This point of sale opportunity, which was not previously available
to the Company under the CNA program, allows the Company national field
representatives to supply potential members meeting certain underwriting
criteria with an E&O insurance quote at the point of original contact and
presentation of the Company's full range of membership benefits. This
application has increased new member enrollments in two ways, first by making it
simpler to close a sale with a single sales call, and second by allowing the
sales force to increase the number of initial sales calls, instead of making
repeat calls to resent E&O quotes and to repeat sales presentations.
Direct expenses of the membership operations approximated 68% of related revenue
for the first nine months of 1995 versus 62% of related revenue for the
comparable prior year period. The increasing cost ratio is related primarily to
increases in expenses incurred in the Corporate Owned Regions, and
implementation costs incurred related to the management contracts negotiated
with certain of the franchised territories regarding corporate management of the
operations of these territories. .
E&O Brokerage Operations:
E&O brokerage revenue for the nine months ended September 30, 1995, totaled
$935,000, a decrease of 57% from the comparable 1994 period revenue of
$2,178,000. The 1995 revenue includes commissions earned on the current E&O
program of nearly $915,000 and approximately $20,000 of E&O reimbursement earned
on the run-off of the prior E&O program. The 1994 revenue included $1,444,000 in
administrative reimbursement earned on the prior E&O program, combined with
$695,000 of commission earned on the current program. The decrease in total E&O
brokerage revenue results from the change in composition of the Company's
membership base, as 41% of the Company's membership participated in the E&O
program as of September 30, 1995, compared to 54% at September 30, 1994. The
commission rate earned currently is the same as the reimbursement rate earned
under the prior program. Under the currently program, the Company acts as an
insurance broker, and is not exposed to any reinsurance risk.
Direct costs of the E&O brokerage operations increased from $367,000 or 17% of
related revenue in the 1994 nine month period, to $446,000 or 48% or related
revenue in the comparable 1995 period. Under the current E&O program, the
Company generally pays a portion of the commission it receives on the E&O
premiums collected to Affiliates generating the premium volume. There was no
such arrangement under the previous E&O program, resulting in a higher gross
profit under the prior program. Consequently, as the revenue in
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1995 will consist almost entirely of commissions earned under the current
program, the direct cost percentage will increase until it at least approximates
the commission rate paid to Affiliates, in addition to other direct costs of
administering the program. However, certain indirect costs incurred by the
Company in administering the prior program are no longer incurred, resulting in
a comparable operating profit ratio for the new program.
Foreign Operation:
During the third quarter of 1994, the Company discontinued funding its UK
subsidiary, HGC. The Company does not expect to incur any further expenses
related to HGC during 1995 or thereafter. The liquidation of the UK subsidiary
was finalized in May 1995, with a lump sum payment of $150,000, which was used
by the Liquidator to satisfy all outstanding debts of the UK corporation. The
lump sum payment was negotiated to be less than the amount originally
anticipated and accrued in the 1994 third quarter. Due to the prior year
accrual, this payment did not impact the Company's results for 1995. Throughout
the first three quarters of 1994, the expenses incurred by HGC approximated
$225,000 per quarter.
G&A Expense:
General and administrative expenses ("G&A") decreased from $9,529,000 in the
first nine months of 1994 to $7,009,000 in the comparable 1995 period. As a
percentage of related revenue, G&A expenses decreased from 23.5% in the 1994
first nine months to 20.9% in the 1995 period. The decrease is primarily due to
declines in employee related expenses from the workforce reduction, and to the
elimination of UK G&A expenses, which approximated $777,000 in the 1994 nine
month period. Certain non-recurring G&A expenses approximating $568,000 were
incurred in the first nine months of 1995, consisting primarily of increased
legal fees for lawsuit preparation and settlements and expenses related to the
activities of the Special Committee of the Board of Directors. These expenses
have been partially offset by credits taken into income on the liquidation and
final settlement of the outstanding liabilities of the UK subsidiary.
Other Income (net):
Other income, net is comprised of net investment income in excess of interest
expense. Investment income is generated primarily from the trading securities
currently held by the Company's regulated home warranty subsidiaries, as well as
from additional investments of funds generated through sales of warranty
products. Net investment income increased from $44,000 for the nine months ended
September 30, 1994 to $1,042,000 in the comparable 1995 period. This increase is
primarily due to the stabilization and small declines in market interest rates,
causing the fair value of the Company's trading investment portfolio, consisting
mainly of debt instruments, to rebound from the previous lows experienced in
1994. Approximately $340,000 of the current year investment earnings relates to
realized holding gains on the Company's trading investment portfolio as of
September 30, 1995, as compared to realized holding losses of $192,000 in the
1994 first nine months. Interest expense of approximately $218,000 relates
primarily to the Company's obligation to CNA.
Income Taxes:
The Company's effective income tax rate for the nine month period ended
September 30, 1995, was 39%, versus a benefit of 30% in the comparable 1994
period. The 1994 tax benefit resulted from the losses incurred on the workforce
reduction and the elimination of the Company's UK subsidiary effective September
30, 1994. Management does not expect the effective income tax rate to change
substantially during the remainder of 1995.
12
<PAGE>
THREE MONTHS ENDED SEPTEMBER 30, 1995 AS COMPARED TO SEPTEMBER 30, 1994
Home Warranty Operations
Home warranty revenue, totaling $9,620,000 and representing 83% of total
operating revenue for the three months ended September 30, 1995, was 7% lower
than the corresponding 1994 figure of $10,326,000, or 76% of total operating
revenue (excluding the impact of the allowance on franchising fee revenue, which
totaled $3,250,000). This revenue decrease is due primarily to the impact of
warranty production decreases in the preceding eleven months, as compared to the
comparable prior year period because of the Company's revenue recognition
policy, under which warranty revenue is recognized over the contract term,
generally twelve months. Total warranty contract sales in the third quarter of
1995 were 3.3% higher than in the 1994 period, which relates primarily to the
increase in renewal warranty contract sales. The Company did experience some
improvement in first year contract sales as compared to the 1994 third quarter,
which were only 3.2% below the prior year, indicating significant improvements
from the early part of 1995.
Renewal warranty contract sales in the third quarter of 1995 were 74% higher
than in the 1994 third quarter, which is attributable to management's
development of several new marketing strategies, resulting in an increase in
renewal success rates to approximately 25%. Renewal warranty contract sales for
the third quarter approximated 14% of total contract sales. There have been no
major pricing changes which would have significantly affected warranty revenue.
Direct expenses of the warranty product, which consist primarily of claims
expenses and acquisition costs, as a percentage of related operating revenue,
decreased to 82% in the 1995 third quarter, from 85% in the 1994 third quarter,
primarily due to the impact of a small decline in frequency of reported claims
in the 1995 period, combined with a smaller number of contracts in force. The
number of contracts in force has a more direct impact on claims costs than on
warranty revenue recognized, due to the revenue recognition method. Claims costs
generally vary with weather patterns. As a result of the heat wave experienced
across the nation in the summer months, July and August 1995 claims costs
exceeded July and August 1994 levels, as a percentage of related revenue.
The third quarter 1995 warranty acquisition cost ratio was moderately lower than
the 1994 third quarter ratio. As the volume of contract sales shifts between
geographic regions, the Company's overall acquisition cost ratio changes, since
the Company's acquisition costs vary in different locations. The acquisition
cost ratio is expected to remain relatively stable at its current level,
assuming that the warranty product mix and geographic distribution do not change
significantly. Management does not expect a significant change to occur in the
near future.
Franchising Operations:
In the 1995 third quarter, the Company commenced management of certain of its
franchised territories, under the terms of the agreements negotiated during the
second quarter of 1995. Also, in the third quarter, the Company began operating
the Colorado territory as a Corporate Owned Region. For additional discussion of
franchising operations, refer to the NINE MONTHS ENDED SEPTEMBER 30, 1995 AS
COMPARED TO SEPTEMBER 30, 1994 "Franchising Operations."
13
<PAGE>
Membership and Other Operations
Membership related revenue for the 1995 third quarter was $1,572,000, 38% lower
than the $2,526,000 reported in the comparable prior year quarter (excluding the
impact of the allowance on franchising fee revenue, which totaled $3,250,000),
which is primarily the result of the changing mix of the membership base. A
large portion of the Company's membership no longer participates in the
Company's E&O program, and is exempted from paying the associated marketing
fees. In spite of this decline, the Company has seen a positive impact from its
Agent and Warranty Sales Only membership programs. Membership renewal experience
continues to improve over the prior year levels, while new membership
enrollments have increased by 55% over 1994 levels. Management believes that
these trends result from the resolution of the E&O transition issues encountered
throughout 1994.
Direct expenses of the membership operations approximated 71% of related revenue
for the third quarter of 1995 versus 59% of related revenue for the comparable
prior year period. The increasing cost ratio is related primarily to the impact
of the decline in operating results of the COR's, which relates to expenses
incurred in implementing the management agreements for certain of the franchised
territories.
E&O Brokerage Operations:
E&O brokerage revenue for the three months ended September 30, 1995, totaled
$348,000, a decrease of 53% from the 1994 third quarter revenue of $735,000. The
1995 revenue includes commissions earned on the current E&O program. The 1994
revenue includes $372,000 of administrative reimbursement earned on the prior
E&O program, and $347,000 of commission earned on the current program. The
decrease in total E&O brokerage revenue results from the change in composition
of the Company's membership base, as only 41% of the Company's membership
participates in the E&O program as of September 30, 1995, compared to 54% at
September 30, 1994. The commission rate earned currently is the same as the
reimbursement rate earned under the prior program. Under the current program,
the Company acts as an insurance broker, and is not exposed to any reinsurance
risk.
Direct costs of the E&O brokerage operations increased from $142,000 or 19% of
related revenue in the 1994 three month period to $219,000 or 63% of related
revenue in the comparable 1995 period. Under the current E&O program, the
Company generally pays a portion of the commission it receives on the E&O
premiums collected to the Affiliates generating the premium volume. There was no
such arrangement under previous E&O programs. Thus, the gross profit earned on
the prior program was higher. Consequently, as the revenue in 1995 will consist
almost entirely of commissions earned under the current program, the direct cost
percentage will increase until it at least approximates the commission rate paid
to Affiliates, in addition to other direct costs of administering the program.
However, certain indirect costs incurred by the Company in administering the
prior program are no longer incurred in administering the current program,
making the operating profit ratio earned on the two programs more comparable
than the gross profit ratio.
Foreign Operations:
During the third quarter of 1994, the Company discontinued funding its UK
subsidiary, HGC. The Company does not expect to incur any further expenses
related to HGC.
14
<PAGE>
G&A Expense:
General and administrative expenses ("G&A") decreased from $3,522,000 in the
third quarter of 1994 to $2,056,000 in 1995. The decrease is primarily due to
declines in employee related expenses from the September 1994 workforce
reduction, and to the elimination of UK G&A expenses, which approximated
$265,000 in the 1994 third quarter. As a percentage of related revenue, G&A
decreased from 26% of revenue in the 1994 third quarter (excluding the impact of
the allowance on franchising fee revenue), to 18% in the comparable 1995 period.
Certain non-recurring G&A expenses incurred in the third quarter of 1995,
consisting primarily of increased legal fees for lawsuit preparation and
settlements and expenses related to the activities of the Special Committee of
the Board of Directors, totaled $302,000 in the 1995 third quarter.
Other Income (net):
Other income, net is comprised of net investment income in excess of interest
expense. Investment income is generated primarily from the trading securities
currently held by the Company's regulated home warranty subsidiaries as well as
from additional investments of funds generated through sales of warranty
products. Net investment income increased from $88,000 for the three months
ended September 30, 1994 to $148,000 in the 1995 period. This increase is
primarily due to the stabilization and small declines in market interest rates,
which has caused the fair value of the Company's trading investment portfolio,
consisting mainly of debt instruments, to rebound from the previous lows
experienced in 1994. Approximately $55,000 in realized holding losses on the
Company's investment portfolio of trading securities was incurred in the 1995
third quarter, as compared to realized holding losses of $121,000 in the 1994
third quarter. The realized holding losses incurred in both periods were offset
by interest and dividends earned on the trading securities and the Company's
portfolio of securities available for sale. Interest expense of approximately
$70,000 relates primarily to the CNA obligation.
Income Taxes:
The Company's effective income tax rate on continuing operations for the three
month period ended September 30 1995 is 39%, versus a benefit of 38% in the
comparable 1994 period. Management does not expect the effective income tax rate
to change substantially during the remainder of 1995.
LIQUIDITY AND CAPITAL RESOURCES
The Company generally receives payment for products and services before
disbursing funds for related direct expenses. Fees from Members and from sales
of home warranty contracts are received before related marketing commissions are
paid out and before claims are made under home warranty contracts. Consequently,
cash flow has historically been more than adequate to meet current obligations.
Cash collected on warranty contracts in the first nine months 1995 was lower
than amounts collected in the comparable 1994 period by approximately
$2,576,000, as a result of the decline in home warranty contract sales.
In the first nine months of 1995, net cash provided by operating activities
totaled $482,000, as compared to $136,000 in the first nine months of 1994. This
increase in cash is primarily due to improved earnings and increased investment
income in the 1995 period as compared to 1994 experience. Also impacting
operating cash flows are various payments for claims payable, Affiliate and
Member commissions and E&O premium remittances. In the first nine months of
1995, the Company used $1,511,000 in investing activities, as compared to
$920,000 in the 1994 period, related to decreased trading activity in its
investment portfolio,
15
<PAGE>
combined with additional investments of available cash into its trading
securities portfolio and additional investments in the design and development of
the Company's computer processing environment. Net cash provided by financing
activities decreased from $298,000 in the 1994 nine month period to usage of
$1,911,000 in the comparable 1995 period, due to increasing debt repayments,
primarily on the CNA obligation and also to the July 1995 deposit of $1,752,000
to a restricted cash account to meet collateral requirements under the terms of
the CNA agreements. The CNA obligation is repaid through remittance of a portion
of the Company's commissions earned on the E&O premium volume. Consequently,
increases in premium volume will result in increases in debt repayments.
The Company provides for deferred income taxes on the excess of deferred
warranty revenue over the related deferred acquisition cost, which gives rise to
the deferred tax asset of approximately $6.5 million at September 30, 1995. As a
result, the Company generally pays taxes on the revenue collected, not on the
revenue recognized, and cash paid for income taxes generally approximates the
current income tax provision in a given year. However, due to the losses
incurred in 1993 and 1994, the Company has currently refundable income tax
benefits approximating $1.3 million and alternative minimum tax credits of
approximately $600,000. Consequently, the Company is not expected to be required
to pay any Federal income taxes in the near future. The Company has filed for
further refunds of taxes paid in prior years, and expects to receive its
refundable income taxes in the fourth quarter of 1995.
Under the terms of its agreements with CNA, the Company is required to generate
a minimum annual premium volume. The Company will not meet this quota in 1995,
due to the change in composition of its membership base, which now includes
fewer participants in its E&O program. The Company and CNA have negotiated an
amendment to this agreement for calendar year 1995, so that the minimum standard
has been reduced. The Company will be required to remit to CNA 5% of any
shortfall in actual premium volume from the minimum standard. At this time, the
Company believes that it will not meet this new minimum standard, however, the
lump sum remittance on the shortfall is not anticipated to be material.
The agreements with CNA in connection with the transfer of POMG's net assets
include several restrictive covenants on both dividends and borrowings, until
the $5,000,000 obligation to CNA is satisfied. In connection with the transfer
of POMG net assets to CNA, the Company has guaranteed the validity of a
$5,000,000 reinsurance recoverable, one of the assets transferred. This
guarantee is secured by $3,000,000 cash collateral which has been posted by the
Company. The Company has agreed, if necessary, to pay an additional $2,000,000
related to the guarantee out of future commissions, if the reinsurer fails to
honor its commitment for reasons other than its solvency. Should this occur, the
repayments on the $5,000,000 obligation will be delayed until the $2,000,000 is
paid. The Company will not be required to reduce its collected commission by
more than 50% under these agreements. The Company has not recorded a provision
for this guarantee, as management, based upon the advice of its special
insurance counsel has determined that the cover note relating to the reinsurance
contract is a binding agreement, enforceable in accordance with its terms, and
the objections voiced by the reinsurer do not support a material basis for it to
successfully deny coverage.
The liquidation of the UK subsidiary was finalized in May 1995, with a lump sum
payment of $150,000, which was used by the liquidator to satisfy all outstanding
debts of the UK corporation.
In the 1995 second quarter, the Company reached a settlement with Independent
Broker Services Corporation ("IBSC"), with respect to the lawsuit brought by
IBSC in December 1994. Under the terms of the settlement agreement, the Company
has agreed to return to IBSC, over the remainder of 1995, a portion of the
original
16
<PAGE>
franchise fees collected by the Company. As of September 30, 1995, $95,000 had
been paid, in accordance with the terms of the settlement agreement, with a
balance of approximately $255,000 due over the course of the fourth quarter. The
settlement will not impact the Company's 1995 earnings, as an allowance for this
amount was provided in the 1994 third quarter.
In December 1991, Acceleration National Insurance Companies ("Acceleration"),
the insurer of the Company's E&O program through April 1991, brought suit
against the Company and one of its subsidiaries, alleging, under alternative
theories which include breach of contract, negligent misrepresentation and
unjust enrichment, that the release of certain funds to the Company in
connection with the E&O program, when combined with allegations relating to the
Company's handling of E&O claims, resulted in the funds currently available to
Acceleration being insufficient to satisfy the expected claims and expenses
under the Acceleration program. Acceleration's total claim is currently in
excess of $10 million. Under the Acceleration program, the Company had pledged
assets to secure letters of credit ("LOC's") in favor of Acceleration. In
October 1992, Acceleration called the LOC's and received cash proceeds from the
liquidation of the collateral investments. The Company disputes all claims of
Acceleration and has filed an answer and counterclaim, seeking substantial
damages, well in excess of those sought by Acceleration. The Company's position
is that the funds were released unconditionally with Acceleration's consent, and
the Company is therefore under no obligation to return the funds. The Company
also denies the balance of Acceleration's claims, and is seeking damages for
claims mismanagement by Acceleration during the period Acceleration undertook
that responsibility. This matter went to trial on November 6, 1995, and is
anticipated to conclude by December 31, 1995. After taking into consideration
the evaluation of outside legal counsel, management has determined, and legal
counsel concurs, that the potential range of loss in connection with this matter
is zero to $2.5 million, that no particular estimate within this range is more
likely than another and that the likelihood of any verdict in excess of this
range is remote. Consequently, no additional provision has been established in
relation to this matter.
Three of the Company's subsidiaries operate in 17 states that regulate the home
warranty business. Certain of these states require that reserves be maintained
to cover future repairs for the remaining terms of warranty contracts (generally
one year). In the second quarter of 1995, the Company restructured the
organization of its warranty company subsidiaries, in order to become more
efficient with respect to servicing warranty contract holders, and more flexible
in its cash investment alternatives. Subsequent to this restructuring, as of
September 30, 1995, approximately $8.8 million of cash and investments are
needed to maintain the regulated subsidiaries' required reserve and surplus
levels. Of this amount, approximately $1,200,000 of investments are held by the
regulated states to assure the Company's fulfillment of its obligations to
contract holders. Deferred home warranty contract revenue at September 30, 1995
exceeds the reserve requirements which would be applicable if such requirements
were in effect in all states in which the Company operates. The Company is
currently in compliance with all applicable surplus and reserve requirements.
The Company is in the design and development phase of upgrading its current
technology computer and processing environments, to increase operational
efficiency, improve management information, and allow for future growth in the
Company's business. Implementation of certain operational functions is
anticipated to begin in the fourth quarter of 1995. This upgrade is currently
expected to have an incremental cost of $1,000,000 in 1995, in excess of the day
to day costs of maintaining, servicing and improving the existing technology.
Through September 30, 1995, incremental costs of approximately $700,000 had been
capitalized in connection with this project. Management believes that sufficient
funds will be available to cover the costs of the upgrade. If such funds are not
available, a portion of this project may be deferred.
17
<PAGE>
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company incurs numerous lawsuits in the ordinary course of its home warranty
contract business, typically concerning whether claims under such home warranty
contracts are entitled to coverage. The Company does not believe any of these
suits are material to the Company's operations or financial results.
18
<PAGE>
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits and Index to Exhibits
11. Computation of Net Income per Common Share for
the three and nine month periods ended September 30,
1995 and 1994.
(b) Reports on Form 8-K
None.
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the
registrant has caused this report to be signed on its behalf by the undersigned
thereunto duly authorized.
HOMEOWNERS GROUP, INC.
November 13, 1995 By: /S/ C. GREGORY MORRIS
----------------------
C. Gregory Morris
Vice President, Treasurer and
Chief Financial Officer
19
EXHIBIT 11
<TABLE>
<CAPTION>
HOMEOWNERS GROUP, INC. AND SUBSIDIARIES
COMPUTATION OF NET INCOME PER COMMON SHARE
FOR THE THREE AND NINE MONTH PERIODS ENDED SEPTEMBER 30, 1995 AND 1994
NINE MONTHS ENDED THREE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------------- --------------------------------
1995 1994 1995 1994
-------------- --------------- --------------- ---------------
<S> <C> <C> <C> <C>
Net income (loss) $871,058 ($978,585) $142,077 ($3,337,149)
--------- ---------- --------- ------------
CALCULATION OF PRIMARY NET INCOME PER COMMON SHARE:
Weighted average common shares outstanding during the period 5,558,350 5,558,350 5,558,350 5,558,350
Weighted average additional common shares (options) 0 0 0 0
-------------- --------------- --------------- ---------------
Weighted average primary common shares outstanding 5,558,350 5,558,350 5,558,350 5,558,350
-------------- --------------- --------------- ---------------
Primary net income per common share $0.16 ($0.18) $0.03 ($0.60)
====== ======= ====== =======
CALCULATION OF FULLY DILUTED NET INCOME PER COMMON SHARE:
Weighted average common shares outstanding during the year 5,558,350 5,558,350 5,558,350 5,558,350
Weighted average additional common shares (options) 0 0 0 0
-------------- --------------- --------------- ---------------
Weighted average fully diluted common shares outstanding 5,558,350 5,558,350 5,558,350 5,558,350
-------------- --------------- --------------- ---------------
Fully diluted net income per common share $0.16 ($0.18) $0.03 ($0.60)
====== ======= ====== =======
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1995
<PERIOD-START> JAN-01-1995
<PERIOD-END> SEP-30-1995
<CASH> 2,934,717
<SECURITIES> 9,007,494
<RECEIVABLES> 1,213,500
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 26,100,566
<PP&E> 2,870,101
<DEPRECIATION> 0
<TOTAL-ASSETS> 38,636,862
<CURRENT-LIABILITIES> 26,623,276
<BONDS> 0
<COMMON> 55,584
0
0
<OTHER-SE> 9,286,992
<TOTAL-LIABILITY-AND-EQUITY> 38,636,862
<SALES> 0
<TOTAL-REVENUES> 33,593,030
<CGS> 0
<TOTAL-COSTS> 25,899,415
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 1,435,058
<INCOME-TAX> 564,000
<INCOME-CONTINUING> 871,058
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 871,058
<EPS-PRIMARY> 0.16
<EPS-DILUTED> 0.16
</TABLE>
