UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K/A
AMENDMENT NO. 5
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 [FEE REQUIRED]
For the fiscal year ended December 31, 1995
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
For the transition period from _______ to _____________
Commission File Number 0-17338
HOMEOWNERS GROUP, INC.
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(Exact name of registrant as specified in its charter)
DELAWARE 65-0033743
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State or other jurisdiction of (IRS Employer
incorporation or organization Identification No.)
400 SAWGRASS CORPORATE PARKWAY, SUNRISE, FLORIDA 33325
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (954) 845-9100
Securities registered pursuant to Section 12(b) of the Act:
Name of each exchange
Title of Each Class on which registered
NONE NOT APPLICABLE
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Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK, PAR VALUE $.01 PER SHARE
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(Title of Class)
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 by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ X ]
Based upon the closing market price of the registrant's common stock as of March
27, 1996 of $1.38, the aggregate market value of the voting stock held by
non-affiliates of the registrant is $6,326,818.
Number of shares of common stock outstanding as of March 27, 1996, is 5,558,350.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the definitive Proxy Statement for the Annual Meeting of
Stockholders are incorporated by reference as Part III of this Annual Report.
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ITEM 6: SELECTED FINANCIAL DATA
<S> <C> <C> <C> <C> <C>
Years Ended December 31, 1995 1994 1993 1992 1991
---- ---- ---- ---- ----
STATEMENT OF OPERATIONS (in thousands)
Operating revenue $44,692 $53,194 $51,397 $45,578 $42,986
Income (loss) from continuing operations
before income taxes 2,208 (742) 5,361 3,891 (116)
Income (loss) from continuing operations 1,361 (658) 3,216 1,879 275
Discontinued operation:
Loss from operation of discontinued
reinsurance segment (3,216) -- (6,228) -- --
Estimated loss on reinsurance
portfolio transfer -- -- (9,009) -- --
Net income (loss) (1,855) ($658) ($12,021) $1,879 $275
CASH FLOW FROM OPERATING ACTIVITIES
(in thousands) ($667) $3,046 ($1,557) $2,755 $2,454
Dividends Declared Per
Common Share $0.00 $0.00 $0.10 $0.20 $0.20
Balance Sheet (in thousands)
Cash and investments $17,054 $19,625 $18,154 $19,176 $26,133
Total assets 38,757 39,527 45,894 41,068 38,705
Long-term debt, net of current portion 2,592 3,317 3,107 22 66
Deferred home warranty revenue
in excess of deferred home
warranty acquisition costs 10,572 10,441 9,994 8,196 6,906
Stockholders' equity 6,365 8,152 8,782 21,820 21,084
PER SHARE DATA
Income (loss) from continuing operations $0.25 ($0.12) $0.58 $0.34 $0.05
Discontinued operation:
Loss from operation of discontinued (0.58) -- (1.12) -- --
reinsurance subsidiary
Estimated loss on reinsurance -- -- (1.62) -- --
portfolio transfer
Net income (loss) ($0.33) ($0.12) ($2.16) $0.34 $0.05
Stockholders' equity $1.15 $1.47 $1.58 $3.93 $3.79
WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING (in thousands) 5,558 5,558 5,559 5,561 5,566
KEY BUSINESS INDICATORS:
Member offices 15,240 16,137 19,798 19,838 19,273
Home warranty contracts sold 105,324 112,737 100,914 82,672 78,836
RATIOS
Pre-tax margin on income from
continuing operations 5% (1)% 10% 9% (0)%
Margin on income from
continuing operations 3% (1)% 6% 4% 1%
Effective income tax rate 38% (11)% (40)% 52% (337)%
Return from continuing operations
on beginning assets 3% (1)% 8% 5% 1%
Return from continuing operations
on average stockholders' equity 30% (8)% 21% 9% 1%
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NOTE: CERTAIN AMOUNTS REFLECT RECLASSIFICATIONS FROM AMOUNTS REPORTED PREVIOUSLY
TO CONFORM TO CURRENT PRESENTATION.
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INDEPENDENT AUDITORS' REPORT
To The Board Of Directors of
Homeowners Group, Inc.
Sunrise, Florida:
We have audited the accompanying consolidated balance sheets of Homeowners
Group, Inc. and its subsidiaries (the "Company") as of December 31, 1995 and
1994 and the related consolidated statements of operations, stockholders' equity
and cash flows for each of the three years in the period ended December 31,
1995. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonably assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of the Company at December 31, 1995
and 1994 and the results of its operations and its cash flows for each of the
three years in the period ended December 31, 1995, as restated, in conformity
with generally accepted accounting principles.
As discussed in Note 3, the accompanying financial statements have been restated
for changing the method of recognizing revenue and expenses related to
memberships.
/s/ DELOITTE & TOUCHE LLP
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Deloitte & Touche LLP
Certified Public Accountants
Miami, Florida
March 27, 1996
(April 8, 1997 as to Note 3)
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
The following table presents certain relationships deemed to be pertinent
indicators of the Company's results of operations:
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<CAPTION>
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1995 1994 1993
$ % of $ % of $ % of
revenue* revenue* revenue*
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<S> <C> <C> <C> <C> <C> <C>
Warranty revenue $37,181 83.5% $38,911 73.1% $31,954 62.2%
Membership & other revenue 6,258 13.7 11,755 22.1 16,702 32.5
E&O brokerage 1,253 2.8 2,528 4.8 2,742 5.3
Total operating revenue 44,692 100.0 53,194 100.0 51,398 100.0
Warranty costs 29,244 78.7 32,317 83.1 26,784 83.8
Membership & other costs 4,358 70.4 7,255 61.7 9,172 55.0
E&O brokerage 648 51.7 512 20.3 386 14.1
Total direct costs 34,250 76.8 40,084 75.4 36,342 70.8
Unusual items -- -- 1,787 3.4 -- --
G&A expense 9,262 20.8 12,013 22.8 12,268 23.9
Operating income (loss) 1,180 2.5 (690) (1.3) 2,788 5.3
* DIRECT COSTS ARE PRESENTED AS A PERCENTAGE OF THE RELATED REVENUES.
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</TABLE>
1995 COMPARED TO 1994
Home Warranty Operations:
Home warranty revenue, totaling $37,181,000 and representing 84% of total
operating revenue for 1995, decreased 4% from the 1994 figure of $38,911,000, or
74% of total operating revenue, due primarily to declines in home warranty
contract sales. The decrease in contract sales is primarily due to the loss of
membership. Due to the Company's warranty revenue recognition method, which
recognizes contract revenue over the one year term of the contract, warranty
revenue for any period of time is also impacted by production in the eleven
months immediately preceding that period. 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
expense and acquisition costs, as a percentage of related operating revenue
decreased to 79% in 1995 from 83% in 1994, primarily due to a 2% decrease in
average claim severity and a 1% increase in warranty claim frequency. Claim
frequency experienced in 1995 returned to the 1993 levels, after the unusually
high frequency experienced in 1994, as a result of the severe weather patterns
experienced across the country throughout the first eight months of 1994.
Through December, 1995 the winter season has been extremely severe, resulting in
negative experience in the last quarter of the year. This trend has continued
into the first quarter of 1996, and has had a significant negative impact on the
Company's cash position and its results of operations.
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The 1995 warranty acquisition cost ratio of 36% is slightly lower than the 1994
ratio, which approximated 38%. 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, at this time, does not expect such a change to occur.
The amount of general and administrative ("G&A") expenses of the home warranty
operation, which primarily include allocated fixed costs, decreased
significantly from the prior year period, and as a percentage of related
revenue. The 1995 expenses were positively impacted by the work-force reduction
that took place in September 1994.
Membership and Other Operations:
Membership and other related revenue of $6,258,000 in 1995 was 47% lower than
1994 revenue of $11,755,000, which is primarily related to 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/placement fees. Further impacting the membership results is
the 6% decline in the Company's membership base from the prior year level. These
factors have caused continuing decreases in related revenue and earnings in
1995, and reflect the continuing effects of the change in Company's E&O
carriers. As a result of this change and the related increased competitive
pressures within the E&O market, the Company has been unable to retain some of
its Members as participants in its current E&O program. Additionally, attraction
of new full members is more difficult, due to premium quotes which are not
competitive for certain brokers and also due to declinations by the Company's
primary insurance carrier of certain other brokers.
In 1995, the Company changed its method of recognizing revenue and expenses
related to the annual new membership and renewal membership revenues and
expenses. Prior to 1995, the Company recognized these items upon collection of
the membership fees and upon payment of the associated commission expenses.
Currently, these revenue items are deferred as collected and the expense items
are deferred when paid, and both items are subsequently recognized in the income
statement on a straight line basis over the membership period, generally one
year. This change in revenue and expense recognition method was deemed to be a
correction of an error, and the accompanying consolidated balance sheets and
statements of operations have been restated to reflect the appropriate
accounting for these items. The current year effect on revenue and associated
direct costs recognized approximates 2% and 1%, respectively, of the current
year total membership revenue and expense totals.
Throughout 1995, the Company continued to focus on attracting new members and
retaining existing members who have either been declined coverage by CNA or who
have obtained their E&O coverage through another entity, as participants in the
Company's warranty and Consumer Reach programs. A new membership program
targeted at brokers desiring to use the Company's warranty was introduced in
mid-1995. This strategy has somewhat reduced the negative impact of the loss of
members on other revenues, evidenced by the 1995 fourth quarter improvements in
first year warranty contract sales, as compared to prior quarters.
Direct expense of the membership operations approximated 70% of related revenue
for 1995 and 62% of related revenue for 1994. The disproportionate cost ratio is
related primarily to the results of the CORs, which were particularly impacted
by the membership declines, especially in the states of California and Texas.
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Also impacting the direct cost ratio is the effect of promotional discounting of
some of the Company's membership programs, a step the Company has taken to ease
the membership transition and retain some of its top producing members.
As with the home warranty operations, G&A expenses of the Company's membership
and other operations decreased from 1994 totals, due to the September 1994
work-force reduction, combined with the focus on controlling costs.
E&O Operations:
E&O related revenue for 1995, totaling $1,253,000 was 50% lower than the 1994
revenue of $2,528,000. The decrease in this revenue relates to the decline in
the Company's membership base, which has a corresponding effect on the premium
volume of the program and, thus, the commissions earned.
Direct expenses of the E&O operations increased from $512,000 in 1994 to
$648,000 in 1995. Under the current E&O program, the Company has agreed to pay 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, and, as 1994 was a transition year, the 1995 increase was
anticipated. As the premium volume under the new program grows, the commission
paid to the Affiliates will grow proportionately.
United Kingdom Operations:
HGC was liquidated in 1995, and there were no activities of HGC to include in
the 1995 financial statements. HGC did not generate any significant revenue and
incurred an operating loss of $761,000 in 1994, exclusive of the charges
recorded by the parent company in writing off the net assets of this subsidiary.
Reduction of Work-force:
In early September 1994, the Company underwent an organizational restructuring,
reducing its total work-force by approximately 20%. This restructuring resulted
in annual cost savings of approximately $1,700,000 in 1995, through reductions
in salary, benefits and payroll tax expenses, excluding the effects of any other
personnel or staffing changes. The 1994 one time charge for severance pay and
related benefits, totaling $1,063,000 is included in "Unusual items" in the
accompanying consolidated statements of operations. Approximately $400,000 of
this total relates to an agreement to terminate the employment contract between
the Company and its former Chairman of the Board of Directors.
Other Income (Expense):
Investment income approximated $1,367,000 in 1995, an increase of approximately
1000% from the 1994 level of $120,000. Unrealized holding gains/losses on
trading securities are included in the Company's earnings for the period, and
unrealized gains/losses on securities available for sale are reported as a
separate component of stockholders' equity. In 1994, rising interest rates
caused the Company's investments in debt securities to generate significant
unrealized holding losses, especially on its trading securities portfolio, which
have been included in the Company's consolidated statements of operations. In
1995, this trend reversed, and the Company recognized significant income.
Investment income is generated primarily from the securities currently invested
by the Company's regulated home warranty subsidiaries, as well as from
additional investment of funds generated through the sales of warranty products.
Funds generated through the other
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operations of the Company's business are generally invested in highly liquid
overnight investments, and therefore earn a minimal amount of interest over the
course of a year.
Income Taxes:
The Company's 1995 effective tax rate on income from continuing operations was
38.4%, as compared to a benefit of 11.3% on income from continuing operations in
1994.
As a result of losses generated by the current year Acceleration judgment (see
Discontinued Operations below), the 1994 work-force reduction and termination of
its UK operations, combined with the prior year losses generated by the
Company's discontinued reinsurance operations, the Company has recognized
significant income tax benefits in 1993 and 1994. A portion of the Company's
1993 and 1994 pre-tax losses was carried back for income tax purposes, to offset
taxable income earned in the prior three years, generating tax refunds for the
Company. The remaining pre-tax losses give rise to significant deferred tax
benefits, which will be recognized in future years, as the temporary book to tax
differences which create the deferred tax benefits become deductible for tax
purposes. The total deferred tax benefit which is expected to be realized in
future years approximates $8.2 million at December 31, 1995. Based upon
management's estimates of future taxable income and of the positive and negative
evidence regarding the likelihood of ultimate recognition of this benefit, it
has been determined that no valuation allowance is necessary. This determination
was based on the Company's taxable earnings history, exclusive of non-recurring
charges, and the period anticipated for full recognition, assuming the Company
maintains its current level of taxable income, exclusive of non-recurring
charges.
Discontinued Operations:
In December 1995, a judgment was awarded against a wholly owned subsidiary of
the Company in the amount of $5,156,022. This judgment related to the Company's
1991 and prior E&O program, which was carried by Acceleration National Insurance
Companies (ANIC). Under this program, the Company was partially responsible for
the claims reported by its participating brokers. With the change in carriers to
CNA, in 1993, the Company removed itself from any risk bearing position in
connection with the claims reported under its E&O program, and currently no
longer operates in this capacity. Accordingly, the judgment amount was reported
in discontinued operations in the accompanying consolidated statements of
operations.
1994 COMPARED TO 1993
Home Warranty Operations:
Home warranty revenue, totaling $38,911,000 and representing 74% of total
operating revenue for 1994, increased 22% over the 1993 figure of $31,954,000,
or 62% of total operating revenue, due primarily to growth in home warranty
contract sales, which outpaced growth in other revenue sources. Due to the
Company's warranty revenue recognition method, which recognizes contract revenue
over the one year term of the contract, warranty revenue for any period of time
is also impacted by production in the eleven months immediately preceding that
period. Management believes that much of this improvement can be attributed to a
sales and marketing strategy focused on educating Members about the value of the
home warranty. Improvements in the percentage of Members selling the Company's
warranty, from 19.4% in December 1993 to 22% in December 1994, indicate the
success of this strategy. The improvement in home warranty contract sales is
also partially attributable to the new SellerTrack program introduced in 1993,
which targets the home seller directly. Upon enrollment in the Consumer Reach
program, Members are notified that participation in
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this program requires that they use the Company's warranty product exclusively.
Management periodically reviews the warranty revenue recognition rates, and the
current review did not result in any revisions, as the current rates did not
differ significantly from current claims experience. 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 expense and
acquisition costs, as a percentage of related operating revenue, decreased to
83% in 1994 from 84% in 1993, primarily due to a 7% decrease in average claim
severity, offset by a 4% increase in warranty claim frequency. Claim frequency
experienced in 1994 was negatively impacted by the unusually severe weather
patterns experienced across the country throughout the first eight months of
1994 and appears to be consistent with industry trends. Through December, 1994
the winter season has been unusually mild, resulting in positive experience in
the second half of the year. Also impacting 1994 claims experience, in late
1993, the Company introduced in several states, a warranty with a $35 deductible
as opposed to the standard $100 deductible, which has contributed somewhat to
the increased claims frequency and decreased average severity. Such trends are
consistent with industry experience. The 1994 warranty acquisition cost ratio of
38% is slightly higher than the 1993 ratio, which approximated 37%. 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, at this
time, does not expect such a change to occur. Fourth quarter 1994 and
preliminary 1995 results thus far reflect some leveling of current warranty
production. In 1995, it will be more difficult for the Company to continue to
exceed the 1994 record production levels. At this time, management anticipates
that production in 1995 will approximate or be less than production levels seen
in the comparable periods of the preceding year, as the membership declines
begin to more heavily impact warranty production, primarily in the COR.
The amount of general and administrative ("G&A") expenses of the home warranty
operation, which primarily include allocated fixed costs, decreased slightly
from the prior year period, and as a percentage of related revenue. Management
has focused on controlling costs Company-wide. In addition, the 1994 fourth
quarter expenses have been positively impacted by the work-force reduction that
took place in September 1994. Approximately $470,000 of the expense incurred in
this restructuring was allocated to the warranty product.
Membership and Other Operations:
Membership related revenue of $11,755,000, as restated, in 1994 was 30% lower
than 1993 revenue of $16,702,000, as restated, which is primarily related to the
changing mix of the membership base, as 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/placement fees. Further impacting the
membership results, is the 20% decline in the Company's membership base from the
prior year level. These factors have caused continuing decreases in related
revenue and earnings in 1994, and reflect the continuing effects of the
transition to the Company's current E&O program. As a result of this transition
and the related increased competitive pressures within the E&O market, the
Company has been unable to retain some of its Members as participants in its
current E&O program. Additionally, attraction of new full members is more
difficult, due to premium quotes which are not competitive for certain brokers
and also due to declinations by the Company's primary insurance carrier of
certain other brokers.
Throughout 1994, the Company has attempted to attract new members and retain
existing members who have either been declined coverage by the new insurance
carrier or who have obtained their E&O coverage through another entity, as
participants in the Company's warranty and Consumer Reach programs. Originally
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designed to reduce the effects of the loss in transaction and membership related
fees, this strategy has been only marginally effective in regaining that lost
revenue, as those members who are retained as participants in the Company's
other programs are generally not required to pay any significant membership
fees.
As a result of the transition to the CNA/Schinnerer E&O program, which is based
on anticipated as opposed to actual closings for participants electing an
annually funded program, the number of closings by Members reported to the
Company is no longer totally indicative of the Company's membership strength or
results of operations. Further, Members who do not participate in the Company's
E&O program do not report closing information to the Company. Based on the
history of its existing Members, and the number of closings reported by
transactional participants, the Company believes that its current membership
participates in approximately 30% of all transactions nationally, consistent
with the 1993 experience.
Direct expense of the membership operations, as restated for each year,
approximated 62% of related revenue for 1994 and 55% of related revenue for
1993, declining only 21% from 1993, despite the 30% decline in revenue. The
disproportionate cost ratio is related primarily to the expenses of the Consumer
Reach program, certain phases of which are still in the development stage and
are not yet generating adequate revenue to offset the expenses incurred. Also
impacting the direct cost ratio is the effect of promotional discounting of some
of the Company's membership programs, a step the Company has taken to ease the
membership transition and retain some of its top producing members.
As with the home warranty operations, G&A expenses of the Company's membership
and other operations decreased from 1993 totals, due to management's focus on
controlling costs Company-wide. Also, the 1994 fourth quarter expenses have been
positively impacted by the work-force reduction that took place in September
1994. Approximately $414,000 of the workforce restructuring charge was allocated
to membership and other operations, while the full amount of the UK write-off
was included in this classification.
E&O Operations:
E&O related revenue for 1994, totaling $2,528,000 was 8% lower than the 1993
revenue of $2,742,000. The 1994 revenue includes commissions earned on the new
E&O program of approximately $1,002,000 and nearly $1,443,000 of E&O
reimbursement on the prior E&O program. The expense reimbursement earned in 1993
was a fixed percentage of total premiums collected, and is reported net of
expenses incurred primarily in processing applications of the insured Members on
behalf of the insurer. The decrease in this revenue relates to the decline in
the Company's membership base, which has a corresponding effect on the premium
volume of the program and, thus, the commissions earned.
Operating costs and expenses of the E&O operations increased from $2,459,000 in
1993 to $2,724,000 in 1994, including $180,000 related to the workforce
reduction that took place September 1994. Under the new E&O program, the Company
has agreed to pay 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. Consequently, as the premium volume
under the new program grows, the commission paid to the Affiliates will grow
proportionately.
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United Kingdom Operations:
HGC did not generate any significant revenue and incurred an operating loss of
$761,000 in 1994, exclusive of the charges recorded by the parent company in
writing off the net assets of the subsidiary, as described below. HGC incurred a
loss of $869,000 in the year ended December 31, 1993.
In the second quarter of 1994, the Company received a letter of intent for the
purchase of its 80% interest in HGC, however, the proposed transaction was not
consummated, due to the potential buyer's inability to obtain financing.
Consequently, the Company ceased funding HGC's operations in the third quarter
of 1994, effectively closing down the UK operation. The one time charges for
severance pay, the balance due under the subsidiary's lease agreement and the
write-off of the subsidiary's net assets, related to the termination of that
operation, totaled approximately $724,000. These charges were accrued in the
third quarter, and are included in the "Unusual items" caption in the
accompanying consolidated statements of operations. The UK operations are
reported in the Membership and Other category in the accompanying table.
Reduction of Work-force:
In early September 1994, the Company underwent an organizational restructuring,
reducing its total work-force by approximately 20%. This restructuring is
expected to result in annual cost savings of approximately $1,700,000, through
reductions in salary, benefits and payroll tax expenses, excluding the effects
of any other personnel or staffing changes. The one time charge for severance
pay and related benefits, totaling $1,063,000 is included in "Unusual items" in
the accompanying consolidated statements of operations. Approximately $400,000
of this total relates to an agreement to terminate the employment contract
between the Company and its former Chairman of the Board of Directors.
Other Income:
Investment income approximated $120,000 in 1994, a decrease of 95% from the 1993
level of $2,599,000. The 1993 earnings are the result of profit taking initiated
in the second quarter of 1993 on the Company's previously unrealized gains on
investments. Originally intended to be reinvested in diversified debt and equity
funds, essentially all equity securities were sold. However, due to the capital
and operating needs of POMG, which has since been discontinued, management was
not able to reinvest these funds. Further discussion of POMG is presented in the
"Discontinued Operations" section herein. The Company's investment results in
1994 have been severely impacted by market interest rates increases, as well as
the impact of implementation of Statement of Financial Accounting Standards,
SFAS No. 115, "Accounting for Certain Investments in Debt and Equity
Securities," in January 1994. SFAS 115 expands the use of fair value accounting
for certain debt and equity securities that are either held for trading purposes
or are available for sale. This standard requires that unrealized holding
gains/losses on trading securities be included in the Company's earnings for the
period, and that unrealized gains/losses on securities available for sale be
reported as a separate component of stockholders' equity. In 1994, rising
interest rates have caused the Company's investments in debt securities to
generate significant unrealized holding losses, especially on its trading
securities portfolio, which have been included in the Company's consolidated
statements of operations, as required by the new standard. Investment income is
generated primarily from the securities currently invested by the Company's
regulated home warranty subsidiaries, as well as from additional investment of
funds generated through the sales of warranty products. Funds generated through
the other operations of the Company's business are generally invested in highly
liquid overnight investments, and therefore earn a minimal amount of interest
over the course of a year.
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Income Taxes:
The Company's effective tax rate in 1994 was a benefit of 11.3%, as compared to
a 40% provision on income from continuing operations in 1993. As a result of the
losses generated by the 1994 work-force reduction and the termination of its UK
operations, combined with the prior year losses generated by the Company's
discontinued reinsurance operations, the Company has recognized significant
income tax benefits in 1993 and 1994. A portion of the Company's 1993 and 1994
pre-tax losses has been carried back for income tax purposes, to offset taxable
income earned in the prior three years, generating tax refunds for the Company.
The remaining pre-tax losses give rise to significant deferred tax benefits,
which will be recognized in future years, as the temporary book to tax
differences which create the deferred tax benefits become deductible for tax
purposes. The total deferred tax benefit which is expected to be realized in
future years approximates $6.5 million at December 31, 1994. Based upon
management's estimates of future taxable income and of the positive and negative
evidence regarding the likelihood of ultimate recognition of this benefit, it
has been determined that no valuation allowance is necessary. This determination
was based on the Company's taxable earnings history, exclusive of non-recurring
charges, and the period anticipated for full recognition, assuming the Company
maintains its current level of taxable income, exclusive of non-recurring
charges.
Discontinued Operations:
In connection with the Company's discontinued reinsurance operation, the Company
is obligated to pay CNA $5,000,000 over a period originally estimated to be
three years. In 1994, the Company revised its estimate of the repayment term of
the CNA obligation to five years, and, accordingly, adjusted the net present
value of the obligation, based upon the new repayment term. In addition, the
Company revised its estimate of expenses incurred relative to the reinsurance
portfolio transfer, and consequently, recorded an adjustment for the additional
balances due. The net effect of these two adjustments had no impact on the
Company's consolidated results of operations. In consideration for CNA's
assumption of POMG's reinsurance obligations, the Company transferred POMG's net
assets, excluding intercompany balances, which approximated $6,100,000 at
December 31, 1993, to CNA. The Company contributed an additional $1,000,000 to
POMG immediately prior to the transfer of assets, bringing the total to
$7,100,000, consisting of the following:
NATURE CARRYING VALUE
---------------------------- --------------
Cash and investments $ 25,700,000
Assumed reinsurance premiums
receivable 6,000,000
Reinsurance recoverable 5,000,000
Other receivables 500,000
Accounts payable and accrued
expenses (1,000,000)
Reinsurance loss and loss
adjustment reserve (29,100,000)
------------
Net assets $ 7,100,000
============
The Company is further obligated to pay CNA $5,000,000 over a period originally
estimated to be three years toward the ultimate settlement of the transferred
losses and expenses. CNA will maintain a separate accounting for the POMG net
assets. Additionally, a separate fund, the "Holdback Fund," has been established
to accumulate the aforementioned $5,000,000 from the Company, additional funds
to be
11
<PAGE>
contributed by Schinnerer 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 POMG net assets. If the ultimate reinsured losses and
related expenses 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. Until the $5,000,000
obligation is fulfilled, certain covenants will be in effect restricting the
indebtedness and dividend levels of the Company.
In connection with the transfer of POMG's net assets to CNA, the Company
guaranteed the validity of a $5,000,000 reinsurance recoverable, one of the POMG
assets transferred to CNA. This asset represents amounts recoverable from a
third party insurance company under a reinsurance treaty purchased by POMG to
protect it from losses in excess of a predetermined amount. The Company has
posted approximately $1,250,000 from its refundable income taxes in November
1994. The balance is due in three instalments of $250,000, $250,000 and
$1,250,000, which must be posted in April, June and July of 1995, respectively.
The Company has agreed, if necessary, to pay an additional $2,000,000 related to
the guarantee out of future commissions. 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 $5,000,000 reinsurance contract is
valid.
Certain amounts in the Company's 1993 and 1992 consolidated financial statements
have been reclassified to reflect POMG as a discontinued operation. Losses
incurred by POMG through September 30, 1993, the discontinued operations
measurement date, totaled approximately $6,200,000, net of income tax benefits
of $3,800,000. Additionally, the transaction resulted in a loss, including a
provision for POMG operating losses during the phase out period, of
approximately $9,000,000. This loss is comprised of the following:
NATURE CARRYING VALUE
------------------------------- --------------
Net assets transferred $7,100,000
Provision for losses during the
phase out period 2,800,000
Discounted value of additional
obligation to CNA 4,500,000
Income tax benefit (5,400,000)
----------
After-tax loss $9,000,000
==========
Under the CNA program, underwriting is performed on an individual insured basis,
whereas, AIG and all previous insurers of the Company's program performed
program underwriting. As this is a significant change in philosophy, management
believes that certain of its Members will benefit individually while others will
not benefit, and may choose to obtain alternate E&O coverage outside of the HMS
membership network. While the acceptance of any new program is uncertain,
management believes that the strategic alliance with CNA and Schinnerer, whose
E&O policies provide the most comprehensive coverage available, will ultimately
enable the Company to maintain its position in the market, and consequently will
benefit the Company's core warranty and membership operations.
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.
12
<PAGE>
Consequently, cash flow has been adequate to meet current obligations. As a
result of decreases in home warranty production growth in 1995 as compared to
1994, cash collected on warranty contracts in 1995 was approximately $2,600,000
below 1994.
As discussed previously, the Company's membership and related revenues were
negatively affected by the decrease in new and renewal members and in the
related fees generated by the Company's membership. In 1995, the Company
continued to provide its Affiliates with various discounted membership options.
The Company's cash flow from membership operations continued to be significantly
impacted. However, the Company expects that cash flow generated from its
warranty and other operations, in combination with the cost saving measures
implemented, will be sufficient to meet its operating needs on an ongoing basis.
In 1995, net cash used in operating activities totaled $667,000, as compared to
cash provided by operations of $3,046,000 in 1994. This increased usage of cash
is primarily due to the decline in warranty production in 1995 from the
comparable 1994 levels. Also impacting operating cash flows are various payments
for claims payable, Affiliate and Member commissions and E&O premium
remittances. In 1995, the Company used $2,207,000 in investing activities, as
compared to $3,502,000 in 1994, primarily due to increased expenditures for
property and equipment, offset by decreases in trading activity in the Company's
portfolio of securities available for sale. The increases in property and
equipment expenditures relate to investments in the Company's processing
environment technology, and also to leasehold improvements made in the Company's
new office building. Net cash used in financing activities totaled $2,005,000 in
1995, as compared to $1,038,000 in the comparable 1994 period, due to the
additional collateral placed on deposit with CNA, and to increasing debt
repayments, primarily on the CNA obligation.
Cash paid for income taxes is generally expected to approximate 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 $1,277,000. A portion of the prior year losses, and the current
year loss have generated NOL carryforwards that will be used to offset future
taxable income. Despite these NOL carry forwards, the Company will be required
to make estimated tax payments until certain of the losses generated for
financial statement purposes become deductible for tax purposes. The Company
intends to file for further refunds of taxes paid in prior years. During 1994
the Company received $2.7 million as a refund of Federal income taxes paid
during 1993 and 1992, and a portion of the taxes paid in 1991. The application
for refund filed by the Company in 1995, approximating $1.3 million is still
pending.
In consideration for CNA's assumption of POMG's reinsurance obligations, which
is more fully discussed in the BUSINESS ERRORS & OMISSIONS INSURANCE section
herein, the Company has agreed to pay CNA $5,000,000 over a period estimated to
be five years from the commencement of the CNA E&O program toward the ultimate
settlement of the transferred losses and expenses. The agreements with CNA
impose certain restrictive covenants until the $5,000,000 CNA Obligation is
satisfied. These covenants include limits on dividends and on future borrowings.
The funds due to CNA are a senior obligation of the Company, secured by an
interest in the common stock of the Company's HOMS subsidiary and in the
Company's Member list. Through December 31, 1999, the Company and its Affiliates
must provide CNA/Schinnerer with right of first refusal on E&O insurance offered
to its membership. The Company forwards half of its commissions earned under the
CNA E&O program to CNA, to be applied as debt repayments on the obligation until
its satisfaction.
As of December 31, 1995, the net present value of the balance due to CNA under
this obligation was $3,601,000. During 1995 the Company made principal
repayments of approximately $329,000 against the obligation. In addition to the
assets transferred to CNA, the Company has guaranteed the validity of a
13
<PAGE>
$5,000,000 reinsurance recoverable, one of the POMG assets transferred. This
guarantee is secured by $3,000,000 cash collateral posted by the Company. The
Company has agreed, if necessary, to pay an additional $2,000,000 out of future
commissions related to the guarantee. 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 further reduce its collected commission by more than 50%
under these agreements. The Company has not recorded a provision for this
guarantee, based upon the opinion of its special insurance counsel, 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.
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 HMS. On December 16, 1995, a jury verdict in the amount
of $5,156,022 was rendered in favor of the Plaintiff and against HMS, in the
following matter: ACCELERATION NATIONAL INSURANCE COMPANY, PLAINTIFF, VS.
HOMEOWNERS MARKETING SERVICES, INC., ET AL., DEFENDANTS, in the Court of Common
Pleas of Franklin County, Ohio. HMS has filed an appeal of the judgment. Post
judgment proceedings have been initiated in Florida and elsewhere, including
discovery in aid of execution. Although such actions were initially stayed in
Florida, on March 13, 1996, the Circuit Court for Broward County, Florida,
dismissed an action by HMS which contested the domestication of the judgment in
Florida, and no stay is presently in effect. In the event the judgment creditor
proceeds to execute on its judgment, such actions would have a material adverse
effect on the business of HMS, and could have a material adverse effect on the
liquidity of the Company. The Company's efforts to contest the domestication of
the judgment in Florida, appeal the judgment and otherwise prevent the judgment
creditor from executing on its judgment have resulted in substantial fees to
professionals and other advisors, which have further negatively impacted the
Company's liquidity.
Seventeen of the states in which the Company's subsidiaries operate 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). As of December 31, 1995, approximately $9,900,000 of cash
and investments are needed to maintain the regulated subsidiaries' required
minimum reserve and surplus levels. Of this amount, approximately $1,200,000 of
cash and investments are held by the regulated states to assure the Company's
fulfillment of its obligations to contract holders. Increases in warranty
production, as seen thus far in the first quarter of 1996, result in increases
in the Company's required reserve and surplus levels in the regulated states. In
addition, state regulators generally seek reserve balances in excess of the
minimum standards. In certain states, withdrawal of any reserves in excess of
statutory minimums requires approval from the regulatory authorities. The
Company has been advised by certain authorities that such approval will not be
granted. Accordingly, the Company maintained reserves of approximately
$14,000,000 as of December 31, 1995. The Company is currently in compliance with
all applicable surplus requirements.
The Company's 1994 work-force reduction and the closing of the UK operation,
both of which took place in September 1994, have had positive impacts on the
Company's cash position.
The Company is continuing its efforts to upgrade its current computer and
processing environments over the next two years, in an attempt to increase
operational efficiency, improve management information, and allow for future
growth in the Company's business. This plan is currently expected to have an
incremental cost of approximately $1,500,000 in excess of the cost of
maintaining, servicing and improving the existing system, over the life of the
project. Management expects that sufficient funds will be available to cover the
cost of the upgrade. If such funds are not available, this project will be
deferred.
14
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED BALANCE SHEETS
- --------------------------------------------------------------------------------------------------------------------------------
DECEMBER 31, 1995 1994
- --------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
ASSETS:
Current assets:
Cash and cash equivalents $997,336 $5,875,844
Trading securities 9,250,349 8,244,409
Current portion of securities available for sale 1,811,624 17,506
Miscellaneous receivables 1,278,044 1,153,188
Deferred home warranty acquisition costs 5,666,899 5,677,322
Refundable income taxes 1,277,449 1,816,149
Deferred income taxes 6,896,920 5,043,295
Prepaid expenses and other current assets 1,196,026 1,446,637
--------- ---------
Total current assets 28,374,647 29,274,350
Restricted cash 3,160,000 1,407,851
Non-current portion of securities available for sale 1,834,981 4,078,966
Property and equipment - net 3,581,893 2,009,165
Other assets 432,327 1,177,026
Deferred income taxes - net of current portion 1,373,608 1,579,345
--------- ---------
TOTAL $38,757,456 $39,526,703
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY:
Current liabilities:
Accounts payable $1,220,140 $1,763,718
Accrued expenses 5,647,433 9,109,466
Litigation settlement 5,156,022 -
Current maturities of long term debt 1,537,257 1,065,487
Deferred home warranty revenue 16,239,431 16,118,752
---------- ----------
Total current liabilities 29,800,283 28,057,423
Long term debt - net of current portion 2,591,929 3,316,845
Commitments and contingencies - See Note 10
Stockholders' equity:
Preferred stock - $0.01 par value; 5,000,000
shares authorized; none issued and
outstanding - -
Common stock - $0.01 par value; 45,000,000
shares authorized; 5,558,350 shares
issued and outstanding
at December 31, 1995 and 1994 55,584 55,584
Additional paid-in capital 7,458,288 7,458,288
Retained earnings (accumulated deficit) (1,201,845) 653,376
Unrealized holding gain (loss) on securities
available for sale
(net of taxes of $34,745 in 1995) 53,217 (14,813)
------ -------
Total stockholders' equity 6,365,244 8,152,435
--------- ---------
TOTAL $38,757,456 $39,526,703
=========== ===========
</TABLE>
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
15
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF OPERATIONS
- --------------------------------------------------------------------------------------------------------------------------------
Years Ended December 31, 1995 1994 1993
- --------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Operating Revenue $44,691,749 $53,194,278 $51,397,972
Operating costs and expenses:
Direct expenses 34,249,673 40,084,151 36,341,702
Unusual items - 1,787,355 -
General and administrative expenses 9,261,562 12,012,742 12,268,706
--------- ---------- ----------
Total 43,511,235 53,884,248 48,610,408
---------- ---------- ----------
Operating income (loss) 1,180,514 (689,970) 2,787,564
Other income (expenses):
Investment income, net 1,367,482 120,455 2,599,169
Other, net (340,307) (172,707) (25,558)
--------- -------- ---------
Total 1,027,175 (52,252) 2,573,611
--------- -------- ---------
Income (loss) from continuing
operations before income taxes 2,207,689 (742,222) 5,361,175
(Provision) benefit for income taxes (847,099) 84,119 (2,145,025)
--------- ------- ----------
Income (loss) from continuing operations 1,360,590 (658,103) 3,216,150
Discontinued operation:
Loss from operation of discontinued reinsurance
segment (net of income tax benefits of
$1,940,211 and $3,757,377, respectively) (3,215,811) - (6,227,680)
Loss on reinsurance portfolio transfer, including
provision of $2,787,301 for operating losses
during phase out period (net of income tax
benefits of $5,435,664) - - (9,009,563)
----------- --------- ----------
Net loss ($1,855,221) ($658,103) ($12,021,093)
=========== ========= ============
Per share information:
Income (loss) from continuing operations $0.25 ($0.12) $0.58
Loss from operation of discontinued
reinsurance segment (0.58) - (1.12)
Loss on reinsurance portfolio transfer - - (1.62)
------ ------ ------
Net loss ($0.33) ($0.12) ($2.16)
====== ====== ======
Dividends declared per common
share $0.00 $0.00 $0.10
Weighted average common shares
outstanding 5,558,350 5,558,350 5,559,191
</TABLE>
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
16
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF CASH FLOWS
- --------------------------------------------------------------------------------------------------------------------------------
Years Ended December 31, 1995 1994 1993
- --------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss ($1,855,221) ($658,103) ($12,021,093)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Loss on discontinued operation 3,215,811 - 9,009,563
Depreciation and amortization 601,884 827,919 615,700
Allowance for loss on franchising fee revenue - 3,112,328 -
Provision (benefit) for deferred income taxes on
continuing operations 292,323 1,575,345 (655,502)
Unrealized holding gain (losses) 68,030 (14,813) -
Foreign currency translation adjustment - 43,280 (12,356)
(Gain) loss on sale of securities (368,348) 642,002 (1,940,959)
Change in net assets of discontinued operation - - 410,419
Other changes in assets and liabilities:
Increase in miscellaneous receivables (124,856) (495,855) (88,280)
(Increase) decrease in deferred home warranty acquisition costs 10,423 52,572 (1,374,396)
(Increase) decrease in refundable income taxes on
continuing operations 538,700 751,483 (1,007,577)
(Increase) decrease in prepaid expenses and other assets 959,060 (2,231,844) (330,412)
Increase (decrease) in accounts payable (543,578) 488,955 355,616
Increase (decrease) in accrued expenses payable (3,462,035) (544,155) 2,550,865
Increase in deferred home warranty revenue 120,679 395,328 3,172,153
Payments on reserve for loss on reinsurance portfolio transfer - (727,915) (240,603)
Payments for purchases of trading securities (7,434,195) (8,276,460) -
Proceeds from sales of trading securities 7,314,642 8,106,104 -
--------- --------- ---------
Net cash provided by (used in) operating activities (666,681) 3,046,171 (1,556,862)
-------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Property and equipment expenditures (2,138,361) (1,313,701) (249,953)
Purchases of investments classified as available for sale (817,812) (11,149,647) -
Proceeds from sale of investments classified as available for sale 749,641 8,960,902 -
Payments for investments of continuing operations - - (19,517,221)
Proceeds from sale of investments of continuing operations - - 27,453,949
---------- ---------- ----------
Net cash provided by (used in) investing activities (2,206,532) (3,502,446) 7,686,775
---------- ---------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayments of debt (830,409) (528,951) 43,829)
Dividends paid on common stock - - (1,111,670)
Amortization of discount on long term debt 167,849 312,585 -
Borrowings under financing arrangements 409,414 425,884 -
Collateralization of contingent guarantee to CNA (1,752,149) (1,247,851) -
---------- ---------- ---------
Net cash used in financing activities (2,005,295) (1,038,333) (1,155,499)
---------- ---------- ---------
Net increase (decrease) in cash and cash equivalents (4,878,508) (1,494,608) 4,974,414
Cash and cash equivalents at beginning of year 5,875,844 7,370,452 2,396,038
--------- --------- ---------
Cash and cash equivalents at end of year $997,336 $5,875,844 $7,370,452
========= ========== ==========
SUPPLEMENTAL DISCLOSURE:
Cash paid during the period for:
Interest $285,911 $322,665 $4,884
Income taxes 31,442 328,007 548,126
</TABLE>
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
17
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
- ------------------------------------------------------------------------------------------------------------------------------
FOREIGN
HOLDING CURRENCY
COMMON PAID IN RETAINED GAIN TRANSLATION TOTAL
STOCK CAPITAL EARNINGS (LOSS) ADJUSTMENT EQUITY
- ------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
BALANCE AT
DECEMBER 31, 1992 $55,584 $7,458,288 $14,337,023 $ - ($30,927) $21,819,968
Prior period adjustment (448,615) (448,615)
Net loss for the year (12,046,364) (12,046,364)
Foreign currency
translation loss (12,356) (12,356)
Dividends declared
on common stock (555,835) (555,835)
----------------------------------------------------------------------------------------------
BALANCE AT
DECEMBER 31, 1993 55,584 7,458 1,311,480 - (43,283) 8,782,069
----------------------------------------------------------------------------------------------
Net loss for the year (658,103) (658,103)
Unrealized holding loss (14,813) (14,813)
Foreign currency
translation gain 43,283 43,283
----------------------------------------------------------------------------------------------
BALANCE AT
DECEMBER 31, 1994 55,584 7,458,288 653,377 (14,813) - 8,152,436
----------------------------------------------------------------------------------------------
Net loss for the year (1,855,221) (1,855,221)
Unrealized holding gain 68,030 68,030
-----------------------------------------------------------------------------------------------
BALANCE AT
DECEMBER 31, 1995 $55,584 $7,458,288 ($1,201,845) $53,217 $ - $6,365,244
-----------------------------------------------------------------------------------------------
</TABLE>
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
18
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
1. THE COMPANY
- --------------------------------------------------------------------------------
Homeowners Group, Inc. ('HOMG') and its subsidiaries (collectively the
'Company') provide home warranty contracts, access to real estate errors and
omissions liability insurance ('E&O') and other products and services primarily
to residential real estate brokerage firms and agents. The Company enters into
agreements with real estate brokerage firms and agents ('Members') which grant
Members the right to use the products and services provided by the Company. The
Company generally markets its products and services through franchise agreements
whereby the third party operators ('Affiliates') have exclusive geographic
territories in which to enroll real estate brokerage firms as Members. Through
December 31, 1995, the Company had entered into agreements with Affiliates for
territories encompassing 39 states and the District of Columbia. In 1995, the
Company markets directly in California, Florida, except Northwest Florida which
territory has been granted to an Affiliate, Colorado, Indiana, Iowa, Nebraska,
North Dakota, South Dakota and Hawaii, ('Corporate-Owned Regions'), and is a 45%
partner in a partnership which directly enrolls Members in Texas. In 1994 and
part of 1995, the Company also directly enrolled Members in Maine,
Massachusetts, New Hampshire and Vermont, however, in May 1995, the Company
franchised this New England territory. During 1995, the Company entered into
management agreements, whereby it began managing the operations and
administration of the Kansas, Missouri, Oklahoma, Arizona and New Mexico
territories.
In October 1991, the Company acquired an 80% interest in a British subsidiary
which began marketing home warranty contracts in the United Kingdom in February
1992. The home warranty contract program and other insurance products offered by
this subsidiary were completely underwritten by Lloyd's of London, thereby
eliminating any underwriting risk to the Company. In the third quarter of 1994,
the Company ceased funding the UK operation, effectively closing down the
subsidiary. Accordingly, there was no foreign operations activity in 1995. See
further discussion of this transaction in Note 9.
Although the Company's home warranty contracts are generally not considered to
be insurance products, the Company is subject to insurance-type regulations in
many of the states in which the home warranty contracts are sold. Certain of
these states require that reserves be maintained to cover future repairs for the
remaining terms of the warranty contracts (generally one year). As of December
31, 1995, approximately $9,900,000 of cash and securities were needed to
maintain the regulated subsidiaries' minimum reserve and surplus levels.
Increases in warranty production, as seen thus far in the first quarter of 1996,
result in increases in the Company's required reserve and surplus levels in the
regulated states. In addition, state regulators generally seek reserve balances
in excess of the minimum standards. In certain states, withdrawal of any
reserves in excess of statutory minimums requires approval from the regulatory
authorities. The Company has been advised by certain authorities that such
approval will not be granted. Accordingly, the Company maintained reserves of
approximately $14,000,000 as of December 31, 1995. The Company is currently in
compliance with all applicable surplus requirements.
As warranty production increases, the Company's required reserve and surplus
levels increase, which reduces the cash available to the Company to fund its
operations. During 1995, the Company's membership and related revenues continued
to be negatively impacted by the 1993 change in insurance carriers, both in
terms of numbers of new and renewal members, and in the fees generated by the
Company's membership. Throughout 1995 and 1994, the Company provided its
Affiliates with various discounted membership options to ease the transition,
and to maintain competitiveness in the marketplace. As a result of these
factors, the Company's cash flow from membership operations has been
significantly impacted. However, the Company expects that cash flow generated
from warranty and other operations will be sufficient to meet its needs on an
ongoing basis. See also Note 2, for discussion of the Company's cash collateral
requirements relative to the 1993 transfer of its discontinued reinsurance
operations and Note 10 for discussion of other commitments and contingencies
impacting cash flow.
2. DISCONTINUED REINSURANCE OPERATIONS
- --------------------------------------------------------------------------------
In December 1992, the Company formed its own reinsurance subsidiary, POMG
Insurance Company, Ltd. ('POMG'), which acquired certain net assets from
Meridian Insurance Company, Ltd. ('Meridian'), the previous reinsurer of the
Company's E&O program. The acquisition was accounted for as a purchase, and
there was no monetary consideration given and no loss recorded on the
transaction. Through this transaction, POMG replaced Meridian as the reinsurer
of all E&O policies written beginning May 1, 1991. In December 1992, the
subsidiary purchased a $5,000,000 aggregate stop loss reinsurance policy to
further protect it from the risk of loss in excess of a predetermined amount on
the first two E&O policy years.
Under the E&O program immediately prior to POMG's formation, the Company was
originally required to provide a $7,000,000 letter of credit ('LOC') to the
reinsurer which was required to be secured by US Government securities
approximating $8,400,000 (cost and market). The amount of the LOC required to be
posted by the Company was subject to change at the discretion of the insurer,
based on contract
19
<PAGE>
volume and underwriting risk. In the event that funds available in the E&O
program pool, together with investment income earned thereon, were insufficient
to cover the claims and expenses incurred by the program, the Company's US
Government securities would have been used to fund payment under the LOC's.
Pursuant to the formation of POMG, the $7,000,000 LOC issued in 1991 to Meridian
was reissued by POMG to a subsidiary of American International Group, Inc.
('AIG'), the insurer of the Company's E&O program at that time. In December
1992, AIG raised the LOC amount to $16,000,000 based on their periodic
evaluation of underwriting performance and premium volume. Concurrent with the
agreement reached with Continental Casualty Company ('CNA'), which is discussed
further below, the LOC was canceled, and the Company is no longer obligated
under any LOC's. As a result, the Company is not subject to any insurance risk
in relation to the CNA E&O program.
In the second and third quarters of 1993, the E&O program experienced
significant losses. Effective December 1, 1993, CNA replaced POMG as the
reinsurer of the E&O policies issued through November 30, 1993 to the Company's
Members by certain subsidiaries of AIG. This transaction took place through a
novation of previous reinsurance agreements in effect. For policies issued from
December 1, 1993 forward, CNA became the insurer, and the Company began
marketing CNA policies to its Members through Victor O. Schinnerer and Company,
Inc. ('Schinnerer'), CNA's exclusive program and underwriting manager. Pursuant
to the agreement with CNA, the Company discontinued POMG's operations. The
Company, through its HOMS Insurance Agency, Inc. ('HOMS') subsidiary acts solely
in the capacity of an insurance broker. Under the terms of the agreements, the
Company receives a fixed percentage of the E&O premiums collected as a
commission. The Company pays a portion of these commissions to the Affiliates
generating the premium volume. In February 1994, the Company, CNA and AIG
entered into definitive agreements, effective as of December 1, 1993, setting
forth the terms described above.
In consideration for CNA's assumption of POMG's reinsurance obligations, the
Company transferred POMG's net assets, excluding intercompany balances, to CNA.
These net assets approximated $6,100,000 at December 31, 1993. The Company
contributed an additional $1,000,000 to POMG immediately prior to the transfer
of assets, bringing the total to $7,100,000, consisting of the following:
NATURE CARRYING VALUE
- ----------------------------------------------------------
Cash and investments $25,700,000
Assumed reinsurance premiums
receivable 6,000,000
Reinsurance recoverable 5,000,000
Other receivables 500,000
Accounts payable and
accrued expenses (1,000,000)
Reinsurance loss and loss
adjustment reserve (29,100,000)
-----------
Net assets $ 7,100,000
===========
The Company is further 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. CNA is maintaining a separate accounting for
the POMG net assets. Additionally, 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 Schinnerer 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 POMG net assets. If the ultimate
reinsured losses and related expenses 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 connection with the transfer of POMG's net assets to CNA, the Company
guaranteed the validity of a $5,000,000 reinsurance recoverable, one of the POMG
assets transferred to CNA. This asset represents amounts recoverable from a
third party insurance company under the reinsurance treaty purchased by POMG.
This guarantee is secured by $3,000,000 cash collateral posted by the Company.
This amount is reported as restricted cash in the accompanying consolidated
balance sheet. The Company has agreed, if necessary, to pay an additional
$2,000,000, related to the guarantee, out of future commissions. The Company has
not recorded a provision for this guarantee, based on the opinion of its special
insurance counsel, 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 agreements with CNA impose certain restrictive covenants until the
$5,000,000 CNA Obligation is satisfied. These covenants include limits on
dividends and on future borrowings. The funds due to CNA are a senior obligation
of the Company, secured by an interest in the common stock of the Company's HOMS
subsidiary and in the Company's Member list. For a five year period ending
November 30, 1998, the Company and its Affiliates must provide CNA/Schinnerer
with right of first refusal on E&O insurance offered to its membership.
Revenue, including investment earnings, of the discontinued operation
approximated $16,571,000 through September 30, 1993, the discontinued operations
measurement date. Losses incurred by POMG through September 30, 1993 totaled
approximately $6,200,000, net of income tax benefits of $3,800,000.
Additionally, the transaction resulted in a loss, including a provision for POMG
operating losses during the phase out period, of approximately $9,000,000. This
loss is comprised of the following:
20
<PAGE>
NATURE CARRYING VALUE
- ----------------------------------------------------------
Net assets transferred $ 7,100,000
Provision for losses during
the phase out period 2,800,000
Discounted value of CNA
obligation 4,500,000
Income tax benefits (5,400,000)
------------
After-tax loss $ 9,000,000
============
On December 16, 1995, a jury verdict in the amount of $5,156,022 was rendered in
favor of the Plaintiff and against Homeowners Marketing Services, Inc. ("HMS"),
a subsidiary of the Company, in the following matter: Acceleration National
Insurance Company, Plaintiff, vs. Homeowners Marketing Services, Inc., et al.,
Defendants, in the Court of Common Pleas of Franklin County, Ohio. This amount
has been accrued as an adjustment to the Company's loss from discontinued
reinsurance operation, and reported net of taxes in the amount of $2,036,629 in
the accompanying consolidated statements of operations.
3. RESTATEMENT OF FINANCIAL INFORMATION
- --------------------------------------------------------------------------------
In 1995, the Company changed its method of recognizing revenue and expenses
related to the annual new membership and renewal membership revenues and
expenses. Prior to 1995, the Company recognized these items upon collection of
the membership fees and upon payment of the associated commission expenses.
Currently, these revenue items are deferred as collected and the expense items
are deferred when paid, and both items are subsequently recognized in the income
statement on a straight line basis over the membership period, generally one
year. This change in revenue and expense recognition method was deemed to be a
correction of an error, and the accompanying consolidated balance sheets and
statements of operations have been restated to reflect the appropriate
accounting for these items. The impact of these adjustments on the Company's
financial results as originally reported is summarized below:
<TABLE>
<CAPTION>
1995 1994 1993
----------------------- ------------------------ --------------------------
ORIGINALLY AS ORIGINALLY AS ORIGINALLY AS
REPORTED RESTATED REPORTED RESTATED REPORTED RESTATED
----------------------- ------------------------ --------------------------
($ IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C> <C>
Revenue $44,554 $44,692 $52,778 $53,194 $51,344 $51,398
Direct Costs 34,200 34,250 39,956 40,084 36,329 36,342
Income (loss)
from continuing
operations
before taxes 2,119 2,208 (1,031) (742) 5,319 5,361
Income tax
provision (benefit) 812 847 (198) (84) 2,128 2,145
Net income (loss)
from continuing
operations 1,307 1,361 (833) (658) 3,191 3,216
Net income (loss) ($1,909) ($1,855) ($833) ($658) ($12,046) ($12,021)
Per share data:
Net income (loss)
from continuing
operations $0.24 $0.25 ($0.15) ($0.12) $0.57 $0.58
Net income (loss) ($0.34) ($0.33) ($0.15) ($0.12) ($2.17) ($2.16)
Deferred income
taxes 6,769 6,897 4,801 5,043 7,011 7,207
Prepaid and other
current assets 1,080 1,196 1,282 1,447 628 921
Accrued expenses 5,209 5,647 8,533 9,109 10,297 10,997
Retained earnings,
at end of year ($1,006) ($1,201) $902 $653 $1,735 $1,311
</TABLE>
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
- --------------------------------------------------------------------------------
Principles Of Consolidation -- The accompanying consolidated financial
statements include the accounts of HOMG and all of its majority owned
subsidiaries. All significant intercompany transactions have been eliminated in
consolidation. The Company's 45% interest in the partnership enrolling and
servicing Members in Texas is accounted for by the equity method. The earnings
from the partnership are included in operating revenue in the accompanying
consolidated statements of operations.
Accounting Estimates -- The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
Revenue And Expense Recognition -- Home warranty contract revenue is recognized
over the life of the contract (generally one year) in proportion to historical
experience of repair costs. Direct costs incurred in acquiring the contracts are
recognized in the same manner. In the third quarter of 1993, the Company refined
its definition of direct acquisition costs to include certain additional
expenses, such as incentive bonuses paid to the Company's Members and
Affiliates, costs of personnel directly involved in acquiring the contracts, and
premium taxes. Such costs have been reclassified from amounts previously
reported according to this refinement. Repair costs under home warranty
contracts are expensed as mechanical breakdowns are reported to and repairs are
authorized by the Company. Initial and renewal membership fees and associated
commission expenses are deferred upon collection of the fees and are recognized
over the life of the membership period, generally one year. E&O premium
commissions are recognized upon collection of the related premiums. All other
revenues and expenses are recognized upon delivery or receipt of the related
products or services.
Property And Equipment -- Property and equipment is carried at cost and
depreciated on the straight-line method over their estimated useful lives, which
range from three to seven years. Leasehold improvements are amortized over the
shorter of the lease term or the estimated useful lives of the improvements.
Investments -- The Company accounts for its investments according to Statement
of Financial Accounting Standards ('SFAS') No. 115, 'Accounting for Certain
Investments in Debt and Equity Securities.' This standard requires that the
Company report at fair value the securities which are held for trading purposes,
or which are available for sale. Unrealized holding gains and losses on trading
securities are determined
21
<PAGE>
based upon the change in fair value and are included
in investment income in the accompanying consolidated statements of operations.
Unrealized holding gains on securities available for sale are also determined
based upon the changes in fair values, and are reported as a separate component
in the stockholders equity section of the balance sheet. Gains and losses on
securities are determined based upon specific identification of the securities
sold. The Company does not currently have any securities which are classified as
held to maturity.
Income Taxes -- Income taxes are provided in accordance with SFAS No. 109,
'Accounting for Income Taxes.' Under this standard, deferred tax assets and
liabilities represent the tax effects, based on current tax law, of future
deductible or taxable amounts attributable to events that have been recognized
in the financial statements.
Foreign Currency Translation -- The financial statements of the Company's
British subsidiary are translated into US dollars in accordance with SFAS No.
52, 'Foreign Currency Translation.' Net assets of the subsidiary, whose
functional currency is the British Pound Sterling, are translated at current
exchange rates, while results of operations are translated at average exchange
rates in effect for the year.
Net Income Per Common Share -- Net income per common share is based upon the
weighted average number of common shares outstanding during each year. Dilutive
stock options and warrants are included in the calculation of weighted average
shares utilizing the Treasury Stock Method. Primary and fully diluted earnings
per share are essentially the same in all years presented in the accompanying
consolidated statements of operations. The inclusion of common stock equivalents
in the 1993 computation of weighted average shares has a dilutive effect on the
per share amount of income from continuing operations, but an antidilutive
effect on the per share amounts from discontinued operations and on the net
loss. In this circumstance, in accordance with Accounting Principles Board
('APB') Opinion No. 30, the common stock equivalents are recognized for all
computations even though they have an antidilutive effect on one of the per
share amounts. The antidilution is insignificant, and does not change the per
share amounts.
Discontinued Operations -- The Company reviews the liabilities recorded in
association with its 1993 discontinued reinsurance operations annually, and
adjusts the balances as necessary. In 1995 and 1994, the Company revised its
estimate of the net present value of the CNA obligation, based upon the actual
payments remitted, and in 1994, to reflect an estimated repayment term of five
years, as opposed to the original estimated term of three years. This change in
estimate resulted in an increase in the discount on the obligation, which will
be amortized to interest expense over the life of the obligation. Further, in
both years, the Company revised its estimate of expenses incurred relative to
the reinsurance portfolio transfer, and recorded an adjustment for the
additional balances due. The net effect of these two adjustments had no impact
on the Company's consolidated results of operations.
Franchising Fee Revenue -- The Company records franchising fee revenue in
accordance with SFAS No. 45, 'Accounting for Franchise Fee Revenue.' Under this
standard, franchising revenue is recorded when all material services or
conditions related to the sale are complete, substantially all of the initial
services of the franchisor required by the franchise agreement are complete, and
no other material conditions or obligations related to the determination of
substantial performance exist.
New Accounting Pronouncements -- The Company has not adopted SFAS No. 123,
'Accounting for Stock-Based Compensation,' which established financial
accounting and reporting standards for employee stock-based compensation plans,
including stock options, stock purchase plans, restricted stock and stock
appreciation rights. SFAS No. 123 defines and encourages the use of fair value
method of accounting for employee stock-based compensation. The Company has not
determined whether it will adopt the method of measuring stock-based employee
compensation prescribed in SFAS No. 123 or continue to use the method prescribed
in Accounting Principles Board Opinion No. 25, with the disclosures required by
SFAS No. 123. SFAS No. 123 is effective for transactions entered into in fiscal
years that begin after December 15, 1995.
Reclassifications -- Certain amounts in the accompanying 1995, 1994 and 1993
consolidated financial statements have been reclassified from amounts previously
reported to conform to the current presentation.
5. UNITED KINGDOM OPERATIONS
- --------------------------------------------------------------------------------
The 1994 and 1993 general and administrative expenses incurred by the Company's
previous 80% owned British subsidiary approximated $777,000 and $882,000,
respectively, and are included in the accompanying 1994 and 1993 consolidated
statements of operations. Operating revenue generated by the subsidiary in 1994
and 1993 approximated $16,000 and $13,000, respectively. During the third
quarter of 1994, the Company ceased funding this operation, effectively closing
down the subsidiary. See further discussion of this transaction at Note 9.
22
<PAGE>
6. PROPERTY AND EQUIPMENT
- --------------------------------------------------------------------------------
Property and equipment consists of the following at December 31:
1995 1994
---- ----
Office furnishings and equipment $1,497,939 $1,403,682
Leasehold improvements 713,970 367,266
Computer equipment and software 3,985,487 2,333,972
Automobiles 47,533 47,533
Assets held under capital lease 499,032 474,359
------- -------
Total 6,743,961 4,626,812
Accumulated depreciation
and amortization (3,162,068) (2,617,647)
---------- ----------
Property & equipment--net $3,581,893 $2,009,165
========== ==========
Depreciation and amortization expense on property and equipment for the years
ended December 31, 1995, 1994 and 1993 approximated $602,000, $749,000 and
$537,000, respectively, and is included in general and administrative expenses
in the accompanying consolidated statements of operations.
7. INVESTMENTS
- --------------------------------------------------------------------------------
Investments consist of the following at December 31:
1995 1994
---- ----
Trading securities, at fair value $9,250,349 $8,244,409
Current securities available for sale 1,811,624 17,506
Non-current securities available
for sale, consisting primarily
of debt securities, at fair value 1,834,981 4,078,966
----------- -----------
Total carrying value
of investments $12,896,954 $12,340,881
=========== ===========
Information with respect to unrealized holding gains and losses, as of December
31, 1995:
UNREALIZED UNREALIZED
HOLDING GAINS HOLDING LOSSES
------------- --------------
1995
Trading securities $302,791 $22,404
Securities available for sale 87,961 -
-------- -------
Total $390,752 $22,404
======== =======
1994
Trading securities $ - $371,509
Securities available for sale 22,931 37,744
-------- --------
Total $ 22,931 $409,253
======== ========
Gross realized gains from sales of securities available for sale totaled
$106,139 for the year ended December 31, 1995. Gross unrealized holding gains
and losses from sales of securities available for sales totaled $1,744 and
$143,774, respectively, for the year ended December 31, 1994. Gains and losses
on securities are determined based upon specific identification of the
securities sold.
Contractual maturities of securities classified as available for sale as of
December 31, 1995 are as follows:
AMORTIZED MARKET
COST VALUE
--------- ------
Due in one year or less $1,793,879 $1,811,624
Due after one year through five years 1,664,062 1,705,892
Due after five years 13,672 129,089
---------- ----------
Total securities classified as
available for sale $3,571,613 $3,646,605
========== ==========
At December 31, 1995, municipal bonds and cash deposits in the amount of $1.2
million were held by various state regulatory agencies to assure performance of
the Company's obligations under home warranty contracts.
8. INCOME TAXES
- --------------------------------------------------------------------------------
Income (loss) from continuing operations before income taxes consists of the
following for the years ended December 31:
1995 1994 1993
---- ---- ----
Domestic 2,207,689 $18,735 $6,231,721
Foreign - (760,957) (870,546)
---------- ---------- ----------
Total $2,207,689 ($742,222) $5,361,175
========== ========== ==========
The provision (benefit) for income taxes consists of the following for the
years ended December 31:
1995 1994 1993
---- ---- ----
Continuing Operations:
Current:
Federal $501,776 ($1,678,495) $2,566,527
State 53,000 19,031 234,000
------ ---------- ---------
Total 554,776 (1,659,464) 2,800,527
Deferred 292,323 1,575,345 (655,502)
------- ---------- ---------
Total provision (benefit)
on income from
continuing operations 847,099 (84,119) 2,145,025
Discontinued Operation:
Tax benefit from loss on
operation of discontinued
reinsurance segment (1,940,211) - (3,757,377)
Tax benefit from estimated
loss on reinsurance
portfolio transfer - - (5,435,664)
Tax provision on cumulative
effect of change in
accounting principal 162,514 - -
---------- ---------- ----------
Total provision (benefit)
for income taxes ($1,255,626) ($84,119) ($7,048,016)
========== ========== ==========
Tax benefits resulting from the 1993 operations of the Company's discontinued
reinsurance subsidiary have been carried back to the prior three years for
refunds of taxes paid in those years. The remaining tax benefits from the 1993
losses generated by the discontinued operation and the 1994 unusual charges will
be carried forward for realization in future years. Based upon management's
analysis of the positive and negative evidence regarding the likelihood of
realization of this asset, a valuation allowance was deemed to be unnecessary.
The Company historically has provided deferred income taxes primarily on
deferred home warranty contract revenues and acquisition costs, which are
recognized for tax purposes before recognition in the financial statements. The
Company also provides deferred income taxes on deferred marketing fee revenue
and expenses under the annually funded E&O programs. The major portion of these
benefits reverse within one year. In 1993, the Company also provided deferred
income tax benefits on the provision for loss on disposal of its discontinued
reinsurance subsidiary. The operating losses incurred by the reinsurance
subsidiary prior to its disposal generated a net operating loss carryback for
the Company of approximately $2,300,000. The components of the net deferred
income tax assets are as follows:
23
<PAGE>
1995 1994
---- ----
Deferred home warranty revenue $6,414,575 $6,381,809
Deferred home warranty acquisition costs (2,238,425) (2,247,974)
Litigation accrual 2,036,628 --
Deferred member fee revenue 487,601 652,639
Deferred member fee commissions (191,052) (270,497)
Miscellaneous (106,157) (176,492)
Current portion of provision for loss
on disposal of reinsurance
subsidiary 493,750 703,810
Current portion of deferred income ------- -------
tax asset 6,896,920 5,043,295
Non-current portion of provision for loss on
disposal of reinsurance subsidiary 991,855 1,246,805
NOL tax carryforward 342,292 298,000
Capitalized software (659,554) --
AMT credit 699,015 34,540
---------- ----------
Total deferred income tax asset $8,270,528 $6,622,640
========== ==========
Realization of the deferred tax asset is dependent on generating sufficient
taxable income during the carryforward periods. Although realization is not
assured, management believes it is more likely than not that all of the deferred
tax asset will be realized. The amount of the deferred tax asset considered
realizable, however, could be reduced in the near term, if estimates of future
taxable income during the carryforward period are reduced. In reaching this
determination, management reviewed the Company's historical performance, and
projections of future results, should the Company's performance continue at the
current level, exclusive of non-recurring events and transactions. These
projections provided positive evidence of future probable realization of the
full tax asset within the prescribed carryforward time frame. The projected
realization also considered the negative impact of charges which could result
from adverse resolution of certain outstanding contingencies; most notably the
Company's guarantee to CNA of a $5 million reinsurance recoverable, related to
the transfer of the POMG net assets. Negative evidence reviewed consisted of
several non-recurring charges incurred by the Company over the past three years.
As each of these charges was deemed to be unusual in nature, each of them
different from the other, and there was no expectation of future recurrences of
such items, the positive evidence was determined to outweigh the negative
evidence.
The provision (benefit) for income taxes on income from continuing operations
included in the accompanying consolidated statements of operations differs from
the provision (benefit) computed using the statutory federal income tax rate
(34%), due to the effects of the following items:
<TABLE>
<CAPTION>
1995 1994 1993
- ---------------------------------------------------------------------------------------------
% OF % OF % OF
$ PRETAX $ PRETAX $ PRETAX
AMOUNT INCOME AMOUNT INCOME AMOUNT INCOME
- ---------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Provision (benefit)
at statutory rate $750,614 34.0% ($252,355) (34.0)% $1,822,800 34.0%
Tax exempt income (32,640) (1.5) -- -- (34,378) (0.6)
State taxes, net of
Federal benefit 83,412 3.8 21,628 2.9 53,659 2.9
Non-deductible losses
incurred by UK
subsidiary -- -- 52,320 7.1 -- --
Other 45,713 2.1 94,288 12.7 202,944 3.8
------- ---- ------- ---- ------- ---
Provision (benefit)
on income from
continuing
operations $847,099 38.4% ($84,119) (11.3)% $2,145,025 40.0%
======== ==== ======= ==== ========= ====
</TABLE>
9. LONG TERM DEBT
- --------------------------------------------------------------------------------
Long term debt consists of the following at December 31:
1995 1994
---- ----
Net present value of obligation
to CNA, discounted at 6% $3,601,513 $4,045,671
Obligations under capital leases 319,166 336,661
Other notes payable, due in monthly
installments of $13,802 plus interest 208,507 -
--------- ---------
Total 4,129,186 4,382,332
Less current portion (1,537,257) (1,065,487)
Long term debt, net of current ---------- ----------
portion $2,591,929 $3,316,845
========== ==========
Estimated aggregate annual maturities of long term debt are as follows:
YEAR MATURITIES
---- ----------
1996 $1,537,257
1997 1,136,640
1998 1,056,747
1999 398,542
In connection with the CNA program, the Company is obligated to pay CNA $5
million. The Company makes payments against this obligation through reductions
in the commission it earns on the premiums generated under the program (see Note
2). Accordingly, the Company has agreed to meet certain minimum premium volume
levels, on an annualized basis, which will ensure that the obligation is paid in
full over the term of the agreement, with scheduled minimum repayments. If E&O
premiums fall below the specified minimum levels, CNA may review the program,
give the Company an opportunity to address the issue and then, at its option,
may stop the program and take ownership of the Company's expiration list. If, on
an annual basis, premium volume falls below the specified level, a cash payment
equal to 5% of the difference between the actual premium volume and minimum
premium volume must be made to CNA. In 1995, the Company did not meet all of the
specified financial and production requirements. However, in March 1996, the
Company and CNA entered into an amendment of the agreement, modifying the
specified minimum premium volume levels to $12 million in 1995, $13 million in
1996, $15 million in 1997 and $20 million thereafter. The agreement to market
CNA insurance exclusively to its membership has been extended through
24
<PAGE>
December 31, 1999. If, on an annual basis, premium volume falls below the
premium volume quotas of $17 million in 1995, $18 million in 1996, and $20
million for each year thereafter, but is above the specified minimum premium
volume previously disclosed, a cash payment equal to 5% of the difference
between the actual premium volume and the premium volume quota must be made to
CNA, to be applied against the obligation to CNA. As of December 31, 1995, the
balance due CNA totaled approximately $3.6 million. The cash payment due for the
1995 shortfall totals $250,000, and must be made in equal monthly instalments
between March 1996 and December 1996. The Company is currently in compliance
with the terms of the agreements as modified.
Estimated annual repayments of the CNA obligation are based on anticipated
premium volume. In 1995 and 1994, the Company revised its estimate of the net
present value of the CNA obligation, based upon the actual payments remitted,
and in 1994, to reflect an estimated repayment term of five years, as opposed to
the original estimate of three years. This change in estimate resulted in an
increase in the discount on the obligation, which will be amortized to interest
expense over the life of the obligation. The funds due to CNA, which are
recorded at net present value, are a senior obligation of the Company, secured
by an interest in the common stock of the Company's HOMS subsidiary and in the
Company's Member list.
10. UNUSUAL ITEMS
During September 1994, the Company recorded unusual charges totaling $1,787,355.
These charges represent expenses related to a reduction in the Company's
workforce and the closing of its UK operations.
In early September 1994, the Company underwent an organizational restructuring,
reducing its total work force by approximately 20%, or 40 employees, including
clerical staff, supervisors, managers and executives. This restructuring is
expected to result in annual cost savings of approximately $1,700,000, through
reductions in salary, benefits and payroll tax expenses. The charge, included in
the `Unusual items' caption in the accompanying consolidated statements of
operations, totaled approximately $1,063,000. Approximately $400,000 of this
total related to an agreement to terminate the employment contract between the
Company and its former Chairman of the Board of Directors. The plan to terminate
employees was approved and carried out prior to September 30, 1994. The benefit
arrangement awarded to the terminated employees was within the Company policy,
or according to employment contracts with certain employees. As of December 31,
1994, approximately $923,000 had been paid against the liability, and $140,000
remained accrued and unpaid. There were no adjustments to the liability other
than to reflect payments to terminated employees.
In the second quarter of 1994, the Company received a letter of intent for the
purchase of its 80% interest in HGC, however, the proposed transaction was not
consummated, due to the inability of the buyer to obtain financing. The Company,
in the third quarter of 1994 ceased funding the subsidiary, which has
effectively closed down its operations. One time charges for severance pay of
$80,000, the balance due under the subsidiary's lease agreements and other
obligations of $371,000 and write-off of the subsidiary's net assets of
$273,000, for a total of approximately $724,000, is included in the 'Unusual
items' caption in the accompanying consolidated statements of operations. As of
December 31, 1994, approximately $451,000 remained accrued and unpaid. In 1995,
the Company liquidated the subsidiary and negotiated reduced payments in full
settlement of the balances owed, resulting in payment of approximately $175,000.
The remaining accrued balance of $276,000 was reversed, and reflected in net
income in the year ended December 31, 1995.
11. COMMITMENTS AND CONTINGENCIES
- --------------------------------------------------------------------------------
The Company is subject to various lawsuits and claims arising in the normal
course of business. In the opinion of management, the resolution of these
matters will not have a material adverse effect on the Company's consolidated
financial position or results of operations.
The Company currently rents office space in Sunrise, Florida, under a lease
which expires on December 31, 2005. The lease requires annual increases of 3% of
the base rent per square foot through the end of the lease term plus actual
maintenance expenses and property tax increases. The Company also leases office
space in certain of the Corporate-Owned Regions for remaining terms of up to
three years. Future minimum annual rental payments approximate $266,000 in 1996,
$313,000 in 1997, $307,000 in 1998, $304,000 in 1999, $313,000 in 2000, and
$1,652,764 thereafter. Rental expense for 1995, 1994 and 1993 approximated
$563,000, $601,000 and $567,000, respectively, and is included in general and
administrative expenses in the accompanying consolidated statements of
operations.
On December 16, 1995, a jury verdict in the amount of $5,156,022 was rendered in
favor of the Plaintiff and against Homeowners Marketing Services, Inc. ("HMS"),
a subsidiary of the Company, in the following matter: Acceleration National
Insurance Company, Plaintiff, vs. Homeowners Marketing Services, Inc., et al.,
Defendants, in the Court of Common Pleas of Franklin County, Ohio. The jury
determined that HMS was partially responsible for claims funding on E&O program
in which the Company's memebr-brokers had previously participated. HMS has filed
an appeal of the judgment. Post judgment proceedings have been initiated in
Florida and elsewhere, including discovery in aid of execution. Although such
actions were initially stayed in Florida, on March 13, 1996, the Circuit Court
for Broward County, Florida, dismissed an action by HMS which contested the
domestication of the judgment in Florida, and no stay is presently in effect. In
the event the judgment creditor proceeds to execute on its judgment, such
actions
25
<PAGE>
would have a material adverse effect on the business of HMS, and could
have a material adverse effect on the liquidity of the Company. The judgment,
which accrues interest at the rate of 10% per annum, is recorded in discontinued
operations in the accompanying consolidated statements of operations, and in
separately stated on the face of the accompanying consolidated balance sheets.
In February 1996, a lawsuit was filed against the Company in the Court of Common
Pleas of Bucks County, Pennsylvania, by the former franchisee of the
Pennsylvania territory, alleging breach of contact, fraud and misrepresentation,
and is seeking damages in the amount of $50,000, trebled, reimbursement of costs
and attorney's fees, and an injunction to prevent the Company from terminating
the franchise agreement. The Company believes this suit is without merit, and
has filed a motion to transfer the case to Florida and a motion to dismiss the
case. No accrual for this matter has been reflected in the accompanying
consolidated financial statements.
The Company has entered into various employment contracts with certain of its
executive officers and management personnel, which provide for salary
continuation of a minimum of six months in the event of termination without
cause. In addition, the Company entered into an agreement with an officer in
December 1995, which provides for annual compensation of $377,211, adjusted for
changes in the Consumer Price Index, through December 31, 2000, with an
automatic three year extension, unless notice of termination is given by either
party six months prior to the termination of the initial term. The agreement
also contains a change in control provision that would entitle the officer to
receive a minimum of 2.99 times the annual compensation. The agreement also
calls for certain other fringe benefits during the term of the agreement.
The Company also entered into an engagement agreement with a director, to
provide legal services to the Company for a one year period. The agreement calls
for a minimum payment of a non-refundable $100,000 retainer.
In connection with the transfer of POMG's net assets to CNA, the Company
guaranteed the validity of a $5,000,000 reinsurance recoverable, one of the POMG
assets transferred to CNA. The Company has not recorded a provision for this
guarantee, based upon the opinion of its special insurance counsel, 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.
See also Note 2.
12. STOCK OPTIONS, WARRANTS AND PURCHASE RIGHTS
- --------------------------------------------------------------------------------
The Company adopted stock option plans in 1988 authorizing issuance of up to
600,000 shares of common stock to officers and other employees. Of the
authorized shares, 300,000 may be issued as 'incentive stock options' within the
meaning of Section 422 of the Internal Revenue Code, and 300,000 may be issued
as non-qualified options. The options issued through 1992 generally become
exercisable two years after the date of grant and expire no later than ten years
after the date of grant. The options issued in 1993 generally become exercisable
over a five year period, beginning on the date of grant. Information with
respect to options under the above plans follows:
OPTION PRICE AVAILABLE
STOCK OPTIONS PER SHARE OUTSTANDING EXERCISABLE FOR GRANT
- ------------- ------------ ----------- ----------- ---------
At December 31, 1992 $5.00- $9.75 388,050 207,550 208,950
------------ ------- ------- -------
Granted 4.00 200,000 28,000 (200,000)
Canceled 5.00 - 9.75 (29,500) (29,500) 29,500
------------ -------- ------- -------
At December 31, 1993 4.00 - 9.75 558,550 206,050 38,450
Granted 2.00 80,000 (80,000)
Became exercisable 5.75 75,900
Canceled 4.00 - 9.75 (156,250) (43,650) 156,250
----------- -------- ------- -------
At December 31, 1994 2.00 - 9.00 482,300 238,300 114,700
Granted 2.00 240,000 (240,000)
Became exercisable 2.00 203,000
Canceled 2.00 - 3.00 (286,600) (224,600) 286,600
----------- -------- -------- -------
At December 31, 1995 $2.00 435,700 216,700 161,300
===== ======= ======= =======
In May 1992, effective September 1991, the Company adopted a non-employee
directors' stock option plan authorizing issuance of up to 300,000 shares of
common stock. Options under this plan become exercisable annually over the five
years following the date of grant and expire no later than ten years after the
date of grant. Options for 75,000 shares were granted at $6.50 per share on
September 26, 1991; options for 25,000 shares were granted at $5.50 per share on
January 28, 1993; options for 25,000 shares were granted at $3.375 per share on
September 23, 1993; and options for 25,000 shares were granted at $2.00 per
share on December 22, 1995. The options issued prior to 1995 were repriced in
December 1994, to $2.00 per share. All of these options remain outstanding at
December 31, 1995. Options for 80,000 shares are exercisable at December 31,
1995.
In 1988, the Company issued five-year stock purchase warrants for 100,000 shares
to outside directors and 150,000 shares to the underwriters of the initial
public offering. All 250,000 warrants expired in 1993; none had been exercised.
In 1991, the Company issued similar warrants for 25,000 shares to an outside
director. These warrants are for $10.80 per share and are exercisable at any
time until April 11, 1996. In 1990, the Company declared a dividend of one right
for each share of common stock outstanding as of November 12, 1990. The rights
will be distributed and become immediately exercisable upon the earlier of 10
days following a public announcement that a person or group of affiliated
persons has acquired the rights to acquire beneficial ownership of 20% or more
of the Company's outstanding shares or 10 days following the commencement of a
tender offer or exchange offer that would result in a person or affiliated group
beneficially owning 30% or more of the outstanding shares.
26
<PAGE>
Each right permits the holder to acquire one share of common stock for a price
of $30 per share. The rights may be redeemed by the Company at any time prior to
the tenth day after the acquisition of 20% of the outstanding shares or the
announcement of an offer for 30% of the outstanding shares. Upon the occurrence
of certain events after the rights become exercisable, each right would, subject
to certain adjustments and alternatives, entitle the holder to purchase common
stock of the Company or the acquiring entity having a market value of twice the
$30 exercise price of the right (except that acquiring persons would not be able
to exercise the rights).
The rights are intended to enable all of the Company's stockholders to realize
the long term value of their investment in HOMG. They will not prevent a
takeover, but should encourage anyone seeking to acquire the Company to
negotiate with the Board of Directors prior to attempting the takeover. The
rights will expire at the close of business November 1, 2000.
In December 1994, the Company repriced all outstanding options to $2.00 per
share, with the exception of the options granted to the current Chairman and the
former Chairman of the Board of Directors and the Chief Financial Officer. The
options granted to the Chief Financial Officer were repriced to $3.00 per share.
The options granted to the former Chairman have been canceled effective January
1995. Upon such cancellation, 100,000 options were granted to the current
Chairman of the Board, at $3.00 per share. In December 1995, all of the options
granted to the Chief Financial Officer were repriced to $2.00 per share. Also in
December 1995, 140,000 options granted to the Chairman from 1988 through 1992
were canceled, and replaced by a new grant of 140,000 options, exercisable for a
ten year period at $2.00 per share.
13. QUARTERLY FINANCIAL RESULTS (UNAUDITED)
- --------------------------------------------------------------------------------
FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER
------- ------- ------- -------
1995 (In thousands except per share amounts)
Operating revenue $10,835 $11,218 $11,540 $11,099
Income from continuing
operations before income taxes 514 676 245 773
Net income (loss) from continuing
operations 316 415 142 488
Loss from discontinued operation - - - (3,216)
Net income (loss) 316 415 142 (2,728)
Per share data:
Net income (loss) from
continuing operations $0.06 $0.07 $0.03 $0.09
Net loss from discontinued operation - - - (0.58)
Net income (loss) $0.06 $0.07 $0.03 ($0.49)
The fourth quarter 1995 results include a charge of $5,156,022, related to the
Acceleration trial judgment rendered against a wholly owned subsidiary of the
Company. See also Note 11.
27
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 of the Securities Exchange Act of
1934, the Registrant has duly caused this Annual Report to be signed on its
behalf by the undersigned, thereunto duly authorized.
HOMEOWNERS GROUP, INC.
Date: April 15, 1997 /S/ C. GREGORY MORRIS
---------------------
C. Gregory Morris, Vice-President,
Treasurer and Chief Financial Officer
28
<PAGE>
EXHIBIT INDEX
FILING IN WHICH
EXHIBIT IS
INCORPORATED BY
EXHIBIT NUMBER REFERENCE
- ----------------------------------------------------------- ------------------
11 Computation of Income Per Common Share for Each of the Filed herewith
Three Years Ended December 31, 1996
<TABLE>
<CAPTION>
EXHIBIT 11
HOMEOWNERS GROUP, INC. AND SUBSIDIARIES
COMPUTATION OF NET LOSS PER COMMON SHARE
FOR EACH OF THE THREE YEARS ENDED DECEMBER 31,
1995 1994 1993
------------ ---------- ------------
<S> <C> <C> <C>
Income (loss) from continuing operations $1,360,590 ($658,103) $3,216,150
Discontinued operation:
Loss from discontinued reinsurance operations (3,215,811) - (6,227,680)
Loss on reinsurance portfolio transfer (9,009,563)
Net loss ($1,855,221) ($658,103) ($12,021,093)
------------ ---------- ------------
CALCULATION OF PRIMARY NET INCOME (LOSS) PER COMMON SHARE:
Weighted average common shares outstanding during the year 5,558,350 5,558,350 5,558,350
Weighted average additional common shares (options) 841
------------ ---------- ------------
Weighted average primary common shares outstanding 5,558,350 5,558,350 5,559,191
------------ ---------- ------------
Income (loss) from continuing operations per common share $0.25 ($0.12) $0.58
Discontinued operation:
Per share loss from discontinued reinsurance operations (0.58) - (1.12)
Loss on reinsurance portfolio transfer - - (1.62)
------------ ---------- ----------
Primary net loss per common share ($0.33) ($0.12) ($2.16)
====== ====== ======
CALCULATION OF AVERAGE FULLY DILUTED EARNINGS (LOSS) PER COMMON SHARE:
Weighted average common shares outstanding during the year 5,558,350 5,558,350 5,558,350
Weighted average additional common shares (options) 902
------------ ---------- ----------
Weighted average fully diluted common shares outstanding 5,558,350 5,558,350 5,559,252
------------ ---------- ----------
Income (loss) from continuing operations per common share $0.25 ($0.12) $0.58
Discontinued operation:
Per share loss from discontinued reinsurance operations (0.58) - (1.12)
Loss on reinsurance portfolio transfer - - (1.62)
------------ ---------- ----------
Fully diluted net loss per common share ($0.33) ($0.12) ($2.16)
====== ====== ======
</TABLE>
