UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended JUNE 30, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _______ to __________________
Commission File Number 0-17338
HOMEOWNERS GROUP, INC.
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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 (I.R.S. 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 (305) 983-0350
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
YES X NO ___
On August 10, 1997, there were 5,558,350 shares of the registrant's common stock
issued and outstanding.
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PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
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HOMEOWNERS GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
JUNE 30, DECEMBER 31,
1997 1996
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(UNAUDITED) (AUDITED)
<S> <C> <C>
ASSETS:
Current assets:
Cash and cash equivalents $2,548,116 $1,833,977
Trading securities 4,282,542 4,927,225
Current portion of securities available for sale 2,894,219 507,050
Miscellaneous receivables 1,237,193 990,644
Deferred home warranty acquisition costs 5,709,021 6,137,476
Refundable income taxes 0 28,000
Current portion of deferred income taxes 8,741,428 6,336,602
Prepaid expenses and other current assets 819,972 840,250
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Total current assets 26,232,490 21,601,224
Restricted cash 660,000 660,000
Non-current portion of securities available for sale 5,253,513 7,417,599
Property and equipment - net 4,309,661 4,403,030
Other assets 526,019 432,755
Deferred and refundable income taxes - net of current portion 773,420 3,239,965
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TOTAL $37,754,924 $37,754,573
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LIABILITIES AND STOCKHOLDERS' EQUITY:
Current liabilities:
Accounts payable $2,817,535 $1,122,885
Accrued expenses 6,360,331 7,088,961
Litigation settlement 4,067,751 3,881,567
Current maturities of long term debt 1,903,825 1,191,601
Deferred home warranty revenue 16,861,493 17,768,964
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Total current liabilities 32,010,934 31,053,978
Long term debt - net of current portion 1,843,115 2,940,711
Commitments and contingencies
Stockholders' equity:
Common stock - $0.01 par value; 45,000,000 shares
authorized; 5,558,350 shares issued and outstanding
at June 30, 1997 and December 31, 1996 55,584 55,584
Additional paid-in capital 7,458,288 7,458,288
Retained earnings (3,676,019) (3,799,406)
Unrealized holding gain (loss) on securities available for
sale, net 63,022 45,418
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Total stockholders' equity 3,900,875 3,759,884
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TOTAL $37,754,924 $37,754,573
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SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
2
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<CAPTION>
HOMEOWNERS GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
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1997 1996 1997 1996
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<S> <C> <C> <C> <C>
OPERATING REVENUE $11,869,593 $11,548,135 $22,854,090 $21,931,058
OPERATING COSTS AND EXPENSES:
Direct expenses 8,835,072 9,213,870 17,500,540 17,493,762
General and administrative expenses 2,572,901 2,371,840 5,167,240 4,843,342
---------------------------------------- ------------------------------------------
Total 11,407,973 11,585,710 22,667,780 22,337,104
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OPERATING INCOME (LOSS) 461,620 (37,575) 186,310 (406,046)
OTHER INCOME (EXPENSE):
Investment income - net 184,249 98,428 289,810 189,788
Other income (expense) - net (121,103) (105,435) (275,733) (212,163)
---------------------------------------- ------------------------------------------
Total 63,146 (7,007) 14,077 (22,375)
INCOME BEFORE
INCOME TAXES 524,766 (44,582) 200,387 (428,421)
PROVISION FOR INCOME TAXES 195,000 (20,000) 77,000 (159,000)
---------------------------------------- ------------------------------------------
NET INCOME (LOSS) $329,766 ($24,582) $123,387 ($269,421)
======================================== ==========================================
PER SHARE AMOUNTS:
Net income (loss) $0.06 ($0.00) $0.02 ($0.05)
======================================== ==========================================
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING 5,558,350 5,558,350 5,558,350 5,558,350
</TABLE>
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
3
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<TABLE>
<CAPTION>
HOMEOWNERS GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30,
1997 1996
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<S> <C> <C>
Cash flows from operating activities:
Net income (loss) $123,387 ($269,421)
Adjustments:
Depreciation and amortization 605,222 385,529
Provision (benefit) for deferred income taxes 105,200 (64,000)
(Gain) loss on trading securities 235,743 149,601
Other net changes in assets and liabilities:
Increase in miscellaneous receivables (246,549) (88,462)
Decrease in deferred home warranty acquisition costs 428,455 77,072
Increase in deferred income taxes (15,301) (237,726)
Increase in prepaid expenses and other assets (110,753) (174,151)
Increase in accounts payable 1,694,650 490,612
Increase (decrease) in accrued expenses payable (728,630) 948,307
Increase in litigation settlement 186,184 0
Decrease in deferred home warranty revenue (907,471) (120,166)
Purchases of trading securities (234,474) (198,633)
Proceeds from sales of trading securities 772,683 2,173,322
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Net cash provided by operating activities 1,908,345 3,071,884
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Cash flows from investing activities:
Property and equipment expenditures (474,086) (953,951)
Purchases of securities classified as available for sale (4,145,440) (2,152,116)
Proceeds from sale of securities classified as available for sale 3,810,692 1,373,516
----------------------- ----------------------
Net cash used in investing activities (808,834) (1,732,551)
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Cash flows from financing activities:
Repayments of debt (399,999) (663,243)
Amortization of discount on long term debt 14,626 101,165
Borrowings under capital lease obligation 0 536,250
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Net cash used in financing activities (385,373) (25,828)
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Net increase (decrease) in cash and cash equivalents 714,138 1,313,505
Cash and cash equivalents at beginning of period 1,833,977 997,336
----------------------- ----------------------
Cash and cash equivalents at end of period $2,548,115 $2,310,841
======================= ======================
SUPPLEMENTAL DISCLOSURE:
Cash paid during the period for:
Interest
Income taxes
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SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
4
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HOMEOWNERS GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1997
(Unaudited)
1. GENERAL
The consolidated balance sheet as of June 30, 1997 and the consolidated
statements of income and cash flows for the three and six month periods ended
June 30, 1997 and 1996 have been prepared by the Company, without audit. In the
opinion of management, all adjustments, which include only normal recurring
adjustments necessary to present fairly the financial position, results of
operations and cash flows at June 30, 1997, and for the periods presented, have
been made.
Certain information and footnote disclosures normally included in financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted. These consolidated financial statements should
be read in conjunction with the consolidated financial statements and notes
included in the Company's 1996 Annual Report on Form 10-K, as amended, filed
with the Securities and Exchange Commission.
2. COMMITMENTS AND CONTINGENCIES
The Company is currently undergoing an examination by the Internal Revenue
Service of its tax returns for the years 1993, 1994 and 1995, and has received
Notices of Proposed Adjustments from the Internal Revenue Service with respect
to its federal income tax returns for those years. These notices would disallow
losses totaling approximately $20.5 million, which would result in the Company
being liable for approximately $7 million of tax, plus interest and possible
penalties. The Company believes that the returns as originally filed are correct
in all material respects, and intends to vigorously contest the IRS position.
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.
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 judgment
is recorded in accrued and other expenses in the accompanying consolidated
balance sheets. In May, 1996, the Company entered into a definitive merger
agreement with The Cross Country Group, Inc. ("Cross Country"), pursuant to
which Cross Country agreed to purchase all of the outstanding shares of the
Company for $2.06 per share in cash. Under the terms of the merger agreement,
Cross Country agreed to pay the balance due to Acceleration National Insurance
Company ("ANIC") under a settlement agreement, upon closing of the Merger.
Pursuant to the settlement agreement, on September 4, 1996, the Company paid to
ANIC the full amount of its 1994 federal income tax refund, together with
interest, which totaled $1,401,485. The remaining balance due bears interest at
the rate of 10% per annum from September 1, 1996 until the settlement amount is
paid in full. An affiliate of Cross Country purchased the
5
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judgment from ANIC as of October 31, 1996, for approximately $2.75 million. The
Cross Country affiliate agreed, under certain conditions, to take no action to
collect on the judgment before July 1, 1997. The Company guaranteed the
obligation of HMS and pledged the shares of HMS and another subsidiary of the
Company to secure such guarantee. HMS and the subsidiary granted to Cross
Country security interests in their assets so that Cross Country would agree to
forebear on collection. The Merger Agreement expired on August 7, 1997 at 11:59
p.m. In the event the judgment creditor proceeds to execute on its judgment, it
is likely that the Company will be without adequate resources to pay the full
amount due. In such event, the Company would be forced to seek alternatives to
paying the remaining unpaid balance of the judgment. No other alternatives are
presently being considered. See further discussion in MANAGEMENT'S DISCUSSION
AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - RECENT
DEVELOPMENTS.
In connection with the transfer of the net assets of POMG to CNA and the
assumption by CNA of the obligations of POMG under certain Realtor's errors and
omissions policies, the Company guaranteed the performance by Sphere Drake
Insurance, PLC ("Sphere Drake"), a third party reinsurance company, under a $5
million reinsurance treaty purchased by POMG to protect it from losses in excess
of a predetermined amount. This guarantee was secured by $3 million cash
collateral posted by the Company, which amount is reported as restricted cash in
the accompanying consolidated balance sheet. The Company agreed, if necessary,
to pay an additional $2 million, related to the guarantee, out of future
commissions. On April 10, 1996, CNA issued a Notice of Arbitration to the
reinsurer with respect to its refusal to honor the reinsurance treaty. The
Company, CNA and Sphere Drake engaged in settlement discussions with respect to
the reinsurance treaty, and have finalized a settlement agreement under which
Sphere Drake will pay $2.5 million to CNA. CNA will draw the balance of the $5
million reinsurance recoverable from the collateral account. As a result of the
settlement negotiations, the Company recorded a loss provision of $2.5 million
for the guaranty in its consolidated statements of operations for 1996. The
restricted cash amount is presented net of the $2.5 million reserve in the
accompanying consolidated balance sheets. The Company expects to receive the
balance of the collateral fund, plus interest, over the $2.5 million settlement
with Sphere Drake, less any fees related to the arbitration, which are
estimated to total approximately $100,000.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RECENT DEVELOPMENTS
In May, 1996, Homeowners Group, Inc. ("HOMG" or the "Company") entered into a
definitive merger agreement under which, as amended, The Cross Country Group,
Inc. ("Cross Country") agreed to acquire the Company.
In connection with the Merger Agreement, an affiliate of Cross Country
purchased, for approximately $2.75 million, the $5.2 million judgment (the
"Judgment") obtained by Acceleration National Insurance Company ("ANIC") against
Homeowners Marketing Services ("HMS"), a subsidiary of the Company. The purchase
price of the judgment reflected a $1.4 million payment previously made by the
Company and the prior settlement with ANIC to reduce the required payment to
$4.4 million. The Cross Country affiliate also agreed, under certain conditions,
to take no action to collect on the Judgment before January 31, 1997.
The Merger Agreement was further modified to extend the date of closing to July
1, 1997. The Company also entered into an amendment to the agreement with the
affiliate of Cross Country which holds the Judgment, extending the date through
which the Cross Country affiliate agreed, under certain conditions, to take no
action to collect on the Judgment until the earlier of July 1, 1997 or
termination of the merger agreement. The Company guaranteed the obligation of
HMS and pledged the shares of HMS and another subsidiary of the Company to
secure such guarantee. HMS and the subsidiary also granted security interests in
their assets. In the event the judgment creditor proceeds to execute on its
judgment, it is likely that the Company will be without adequate resources to
pay the full amount due.
Cross Country and its affiliates now hold approximately 29.7% of the Company's
outstanding common stock.
7
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In June, 1997, The Company received Notices of Proposed Adjustments from the
Internal Revenue Service with respect to its federal income tax returns for the
years ended December 31, 1993, 1994 and 1995. These notices proposed to disallow
losses totaling approximately $20.5 million, which would result in the Company
being liable for approximately $7 million of tax, plus interest and possible
penalties. The Company believes that the returns as originally filed are correct
in all material respects, and intends to vigorously contest the IRS position.
Based upon these notices, The Cross Country Group informed the Company that it
was not willing to proceed with the proposed Merger with the Company at this
time. As a result, the Homeowners Group Special Meeting of Stockholders that was
scheduled for June 19, 1997 was postponed.
On August 7, 1997, the Agreement and Plan of Merger and the agreement of Cross
Country's affiliate to forebear from taking action on the judgment expired. The
parties continue to engage in discussions. Also, on August 8, 1997, the Company
announced that it had received inquiries from other potential acquirers.
On August 12, 1997, the Company was notified that the Company's securities have
been delisted from the Nasdaq stock market effective with the close of business
August 12, 1997, as the Company no longer meets the net tangible assets
requirement. The securities of the Company may immediately be eligible to trade
on the OTC Bulletin Board.
BUSINESS ENVIRONMENT
The Company, through its Homeowners Marketing Services, Inc. ("HMS") subsidiary,
has developed a national network of real estate brokers ("Members"), enrolled by
the Company's franchisees ("Affiliates") and the field sales force employed in
the Corporate Owned Regions ("COR"). The Company offers various types of
memberships including a "full membership," under which participating brokers
have access to all of the Company's products and services, and a "limited
membership," under which participating brokers have access to certain of the
Company's products and services.
Members generally pay an initial membership fee and annual renewal fees, in
order to retain the rights of membership. Full members participate in the
Company's Errors & Omissions insurance ("E&O") program and pay marketing or
placement fees to the Company for access to the program. Members also have the
right to use products and services provided by other vendors with which the
Company has made preferred arrangements.
Membership provides access to home warranty contracts and the real estate
brokers E&O insurance, in addition to access to the following programs: a
membership-wide referral networking system (REFNET/Registered trademark/), the
HMS BuyerTrack/Registered trademark/ Follow-Up System, the HMS Consumer Reach
Program, a monthly real estate publication (HMS NETWORKING/Registered trademark/
Magazine), the HMS Risk Management System/Registered trademark/, and certain
advertising and public relations materials.
8
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HOME WARRANTY CONTRACTS
The Company offers, through its Members, home warranty contracts for a fixed
fee, paid at the time of closing of residential sale transactions participated
in by HMS Members. The home warranty contract provides for the repair or
replacement, at the Company's discretion, of major mechanical systems and
certain appliances of a residence which malfunction as a result of normal wear
and tear during the term of the contract. The Company currently offers a home
warranty contract for sale in every state in which the Company operates, with
the exceptions of Connecticut and New Hampshire. The Company and the home
warranty contract offered are subject to insurance type regulations in 17 of the
states in which contracts are sold.
Funds received for the home warranty contracts are deferred upon receipt and
recognized as revenue over the contract term (generally one year) in proportion
to historical experience of home warranty repair costs incurred. The direct
costs of acquiring the contracts, which are generally a fixed portion of the
related revenue, are recorded in the same manner. Repair costs under home
warranty contracts, which are expensed as mechanical break-downs are reported to
and are authorized by the Company, represent the direct expense which typically
varies most with respect to related revenue. A significant portion of repair
costs generally relates to heating and air conditioning systems, water heaters
and plumbing. The frequency and severity of such repair costs vary with changing
weather patterns.
ERRORS & OMISSIONS AND OTHER INSURANCE PRODUCTS
The Company also markets real estate brokers' E&O liability insurance to its
Members, through its HOMS Insurance Agency, Inc. ("HOMS") subsidiary. This
insurance generally provides limits of between $100,000 and $1,000,000 per loss
and from $100,000 to $1,000,000 aggregate per policy year. The policies
generally provide coverage for wrongful acts which occur during the term of the
policy and are reported up to 60 days after expiration of the policy and all
claims after expiration for which notice of wrongful act is given prior to
expiration. The policy provides for a deductible per loss and covers the real
estate brokerage firm and all officers, partners, stockholders, employees,
salespersons and sales associates or independent contractor brokers of the
brokerage firm. The Company is not subject to reinsurance risk under the current
program.
SEASONALITY
Most of the Company's revenue is generated at the time of residential resale
closings. These closings generally follow a seasonal pattern. First quarter
volume is usually the lowest, third quarter the highest, and second and fourth
quarters are about equal. Claims under home warranty contracts are generally
higher in the summer and winter months, while general and administrative
expenses are usually incurred evenly from quarter to quarter. As a result, the
Company's operating results in the second half of a given year are generally
better than the results in the first half.
9
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RESULTS OF OPERATIONS
SIX MONTHS ENDED JUNE 30, 1997 AS COMPARED TO JUNE 30, 1996
Home Warranty Operations:
Home warranty revenue, totaling $20,755,000 and representing 91% of total
operating revenue for the six months ended June 30, 1997, increased 8% from the
corresponding 1996 figure of $19,159,000, or 87% of total operating revenue.
Because of the Company's warranty revenue recognition policy under which
warranty revenue is recognized over the contract term, generally twelve months,
the revenue earned is impacted by warranty production in the preceding eleven
months, as well as current period production. Consequently, revenue recognition
generally lags behind production, and the revenue increase experienced in the
first six months of 1997, as compared to the comparable 1996 period is due
primarily to the impact of higher warranty production in the last six months of
1996, as compared to the corresponding period for 1995. Warranty contract sales
in the first six months of 1997 were 4% higher than in the 1996 first six
months, as a result of increased sales opportunities corresponding to increased
residential resale transactions during the first half of 1997. This trend is
consistent with industry experience. The impact of this increase in warranty
contract sales will continue to affect warranty revenue recognition, at a slower
rate in future quarters, due to the warranty revenue recognition method, as
discussed above. Renewal warranty contract sales in the first six months of 1997
were 10% higher than in the 1996 first six months. There have been no major
pricing changes which would have significantly affected warranty revenue.
Direct expenses of the warranty product, which consist primarily of claims
expenses and acquisition costs, as a percentage of related operating revenue,
decreased to 77% in 1997 from 80% in 1996. This decrease was experienced in
spite of the impact of the harsher winter weather in the first quarter of 1997
as compared to the first quarter of 1996, and the extremely hot summer weather
in May and June of 1997. Average severity increased by 1.4% during the 1997
first quarter, while frequency decreased 1.4% from the 1996 levels.
The 1997 warranty acquisition cost ratio is approximately 2.5% lower than the
comparable 1996 ratio. The Company's acquisition costs vary in different
locations, and as the volume of contract sales shifts between geographic
regions, the Company's overall acquisition cost ratio changes. The acquisition
cost ratio is expected to remain relatively stable at its current level,
assuming that the warranty product mix and geographic distribution do not change
significantly. Management, does not expect a significant change to occur in the
near future.
Membership and Other Operations:
Membership related revenue was 26% lower than in the comparable prior year
period, which reflects the continuing impact of the reduction in Full E&O
membership on the Company's membership revenue stream. As of June 30, 1997, only
approximately 24% of the Company's membership participated in the Company's E&O
program, as opposed to approximately 31% as of June 30, 1996. These members
generate the bulk of the Company's membership revenue. The remaining 76% of the
Company's membership does not pay the marketing/placement fees associated with
Full E&O membership. Additionally, non E&O members often pay a reduced annual
membership or renewal fee, or these fees may even be waived.
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Direct expenses of the membership operations declined by 38% and approximated
68% of related revenue for the first six months of 1997 and 67% of related
revenue for the comparable prior year period. The decreasing cost ratio results
from the impact of certain fixed cost programs which were discontinued in late
1996.
E&O Brokerage Operations:
E&O brokerage revenue for the six months ended June 30, 1997, totaled $386,000,
a decrease of 18% from $471,000 in the first six months of 1996. The decrease
relates to the continuing declines in the Company's Full E&O membership base
discussed above.
Direct costs of the E&O brokerage operations increased from $380,000 or 81% of
related revenue in the 1996 first six months to $275,000 or 71% of related
revenue in the comparable 1997 period. The Company pays 25% of the commission it
earns on the E&O premiums collected to the Affiliates generating the premium
volume.
G&A Expense:
General and administrative expenses ("G&A") increased from $4,843,000 in the
first six months of 1996 to $5,167,000 in the first six months of 1997,
primarily due to decreases in payroll and depreciation expenses. As a percentage
of revenue, G&A was 22.6% for the first six months of 1997, compared to 22.1% in
the first six months of 1996.
Other Income (net):
Other income, net is comprised of net investment income in excess of interest
expense. Investment income is generated primarily from the trading securities
currently invested by the Company's regulated home warranty subsidiaries, as
well as from additional investments of funds generated through sales of warranty
products. Net investment income increased by 52%, from a net gain of $190,000
for the six months ended June 30, 1996 to a net gain of $290,000 in the current
year equivalent period. Approximately $127,000 of realized holding losses are
included in the 1996 figure related to realized holding losses on the Company's
investment portfolio of trading securities, as compared to realized holding
losses of $78,000 in the 1997 first six months. Interest expense of
approximately $275,000 in the 1997 first six month period relates primarily to
the Judgment and the CNA obligation. The Company's investment in a joint venture
in an Internet access provider generated losses of approximately $90,000 in the
1996 six month period. The Company stopped funding this venture in December,
1996, and thus there are no expenses related to this venture included in the
1997 results.
Income Taxes:
The Company's effective income tax rate on continuing operations for the current
six month period was 38.5%, as compared to a benefit of 37.1% in the comparable
1996 period. Management does not expect the effective income tax rate to change
substantially during the remainder of 1997, as there are no significant
permanent differences which would generate such a change.
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THREE MONTHS ENDED JUNE 30, 1997 AS COMPARED TO JUNE 30, 1996
Home Warranty Operations:
Home warranty revenue, totaling $10,738,000 and representing 90% of total
operating revenue for the three months ended June 30, 1997, increased 6% from
the corresponding 1996 figure of $10,124,000, or 88% of total operating revenue.
This revenue increase is due primarily to the impact of warranty production
increases in the preceding eleven month period, and the current period
production, as compared to the comparable 1996 and prior periods. This impact
results from the Company's warranty revenue recognition policy under which
warranty revenue is recognized over the contract term, generally twelve months.
Warranty contract sales in the second quarter of 1997 were 2% higher than in the
1996 second quarter. Renewal warranty contract sales in the second quarter of
1997 were 8% higher than in the 1996 second quarter, and approximated 14% of
total contract sales. There have been no major pricing changes which would have
significantly affected warranty revenue.
Direct expenses of the warranty product, which consist primarily of claims
expenses and acquisition costs, as a percentage of related operating revenue,
decreased to 75% in the 1997 second quarter from 80% in the 1996 second quarter.
This decrease was primarily due to the impact of an 8% increase in severity and
a 10% decrease in frequency during the 1997 second quarter, as compared to the
1996 second quarter.
The 1997 warranty acquisition cost ratio is 2% lower than the comparable 1996
ratio. The Company's acquisition costs vary in different locations, and as the
volume of contract sales shifts between geographic regions, the Company's
overall acquisition cost ratio changes. The acquisition cost ratio is expected
to remain relatively stable at its current level, assuming that the warranty
product mix and geographic distribution do not change significantly. Management,
does not expect a significant change to occur in the near future.
Membership and Other Operations:
Membership related revenue for the 1997 second quarter was 21% lower than in the
comparable prior year period, which reflects the continuing impact of the
reduction in Full E&O membership on the Company's membership revenue stream.
Direct expenses of the membership operations declined by 35% and approximated
64% of related revenue for the second quarter of 1997 and 79% of related revenue
for the comparable prior year period. The decreasing cost ratio results from the
impact of certain fixed cost programs which were discontinued in late 1996.
E&O Brokerage Operations:
E&O brokerage revenue for the three months ended June 30, 1997, totaled
$208,000, a decrease of 19% from the 1996 second quarter revenue of $255,000.
The decrease relates to the continuing declines in the Company's Full E&O
membership base.
Direct costs of the E&O brokerage operations increased from $182,000 or 71% of
related revenue in the 1996 second quarter to $191,000 or 92% of related revenue
in the comparable 1997 period.
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G&A Expense:
General and administrative expenses ("G&A") increased from $2,372,000 in the
second quarter of 1996 to $2,573,000 in the 1997 second quarter, primarily due
to increases in payroll and depreciation. As a percentage of revenue, G&A
increased from 20.5% in the 1996 second quarter, to 21.7% in the 1997 second
quarter.
Other Income (net):
Other income, net is comprised of net investment income in excess of interest
expense. Investment income is generated primarily from the trading securities
currently invested by the Company's regulated home warranty subsidiaries, as
well as from additional investments of funds generated through sales of warranty
products. Net investment income decreased from a net gain of $98,000 for the
second quarter of 1996 to a net gain of $184,000 in the current year second
quarter. This increase is primarily due to market interest rate fluctuations,
which have caused the fair value of the Company's investment portfolio,
consisting mainly of mutual funds and debt instruments, to increase from the
1996 market values. Approximately $43,000 of realized holding losses were
included in the second quarter 1996 investment income figures, as compared to
realized holding gains of $17,000 in the 1997 second quarter. Interest expense
of approximately $121,000 relates primarily to the Judgment and the CNA
obligation. The Company's investment in a joint venture in an Internet access
provider generated losses of approximately $45,000 in the 1996 second quarter.
The Company stopped funding this venture in December, 1996, and thus there are
no expenses related to this venture included in the 1997 results.
Income Taxes:
The Company's effective income tax rate on continuing operations for the second
three month period was 37.1%, as compared to a benefit of 45% in the comparable
1996 period.
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. As a result
of increases in home warranty production in the first six months of 1997 as
compared to the first six months of 1996, cash collected on warranty contracts
in the 1997 first six months was approximately $688,000 higher than in the
comparable 1996 period. In 1997, membership and related revenues and cash flows
continue to be negatively affected by the decrease in members and in the related
fees generated by the Company's membership, and the Company continued to provide
its Affiliates with various discounted membership options. The Company expects
that cash flow generated from its warranty and other operations, in combination
with certain cost saving measures implemented, will be sufficient to meet its
normal operating needs on an ongoing basis. However, because the agreement to
forebear from taking action on the Judgment has expired, the holder of the
Judgment is entitled to take action to collect it. In the event the judgment
creditor proceeds to execute on its judgment, it is likely that the Company will
be without adequate resources to pay the full amount due. In such event, the
Company would be forced to seek alternatives to paying the remaining unpaid
balance of the judgment.
In the first six months of 1997, net cash provided by operating activities
totaled $1,908,000, as compared to cash provided by operations of $3,072,000 in
the first six months of 1996. This decrease in cash generated from
13
<PAGE>
operations is primarily due to payments on certain accrued expenses, and to
recognition of previously deferred amounts of home warranty revenue. In the
first six months of 1997, warranty production is up only 3.6%, as compared to an
increase of 19% in the 1996 first six months over the 1995 levels. Also
impacting operating cash flows are various payments for claims payable,
Affiliate and Member commissions and E&O premium remittances. In the first six
months of 1997, the Company used $809,000 in investing activities, as compared
to $1,733,000 in the first six months of 1996, primarily due to the decreases in
purchases of property and equipment. In early 1996, certain furniture and
equipment purchases were made, related to the Company's 1996 move of its
corporate headquarters. Net cash used in financing activities totaled $385,000
in the 1997 first six months, as compared to cash used in financing activities
of $26,000 in the comparable 1996 period.
In consideration for CNA's assumption of POMG's reinsurance obligations, the
Company agreed to pay CNA $5 million by December 1999 toward the ultimate
settlement of the transferred losses and expenses. The agreements with CNA
impose certain restrictive covenants until the $5 million CNA obligation is
satisfied, including 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. The Company is currently in default with the terms of this
agreement, as it has failed to achieve the minimum premium volume quotas as
defined in the agreements, and the Company could be required by CNA to make a
payment against its obligation to the Holdback Fund in the amount of
approximately $450,000.
As of June 30, 1997, the net present value of the balance due to CNA under this
obligation was $3 million. In addition, in connection with the transfer of the
net assets of POMG to CNA and the assumption by CNA of the obligations of POMG
under certain Realtor's errors and omissions policies, the Company guaranteed
the performance by Sphere Drake Insurance, PLC ("Sphere Drake"), a third party
reinsurance company, under a $5 million reinsurance treaty purchased by POMG to
protect it from losses in excess of a predetermined amount. On April 10, 1996,
CNA issued a Notice of Arbitration to Sphere Drake, with respect to its refusal
to honor the reinsurance treaty. Accordingly, the Company, CNA and Sphere Drake
engaged in settlement negotiations with respect to the reinsurance treaty, and
have finalized a settlement agreement under which Sphere Drake will pay $2.5
million to CNA. CNA will draw the balance of the $5 million reinsurance
recoverable from the collateral account. As a result of the settlement
negotiations between CNA and Sphere Drake, in December 1996, the Company
recorded a loss provision of $2.5 million for the guarantee. The Company expects
to receive the balance of the collateral fund, plus interest, over the $2.5
million settlement with Sphere Drake, less any fees related to the arbitration
which are estimated to total approximately $100,000.
14
<PAGE>
For a discussion of the Company's liability under the Judgment, see RECENT
DEVELOPMENTS.
Sixteen 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 June 30, 1997, approximately $11,500,000 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 six months of 1997, 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
$12,700,000 as of June 30, 1997. The Company is currently in compliance with all
applicable surplus and reserve requirements.
For a discussion of the Company's potential liability to the IRS, see RECENT
DEVELOPMENTS.
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 $750,000 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.
15
<PAGE>
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company incurs numerous lawsuits in the ordinary course of its home warranty
contract business, typically concerning whether claims under such home warranty
contracts are entitled to coverage. The Company does not believe any of these
suits are material to the Company's operations or financial results.
16
<PAGE>
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits and Index to Exhibits
11. Computation of Net Income per Common Share
for the three and six month periods ended
June 30, 1997 and 1996.
(b) Reports on Form 8-K
On June 16, 1997, the Company filed a notification
under item 5 that the IRS had provided material
Notices of Proposed Adjustments, with respect to its
federal income tax returns for the years ended
December 31, 1993, 1994 and 1995.
On July 7, 1997, the Company filed a notification
under item 5 that a Third Amendment to the Agreement
and Plan of Merger, was executed pursuant to which
the expiration date of the Merger Agreement was
extended to July 31, 1997.
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the
registrant has caused this report to be signed on its behalf by the undersigned
thereunto duly authorized.
HOMEOWNERS GROUP, INC.
August 14, 1997 By: /s/ C. GREGORY MORRIS
----------------------
C. Gregory Morris
Vice President, Treasurer and
Chief Financial Officer
17
<PAGE>
EXHIBIT INDEX
EXHIBIT PAGE
- ------- ----
11. Computation of Net Income per Common Share for the three
and six month periods ended June 30, 1997 and 1996.
27. Financial Data Schedule.
EXHIBIT 11
HOMEOWNERS GROUP, INC. AND SUBSIDIARIES
COMPUTATION OF NET INCOME (LOSS) PER COMMON SHARE
FOR THE THREE AND SIX MONTHS ENDED
<TABLE>
<CAPTION>
JUNE 30, JUNE 30,
1997 1996 1997 1996
--------------------------- --------------------------
<S> <C> <C> <C> <C>
Net income (loss) $329,766 ($24,582) $123,387 ($269,421)
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 5,558,350
Weighted average additional common shares (options) - - - -
--------------------------- --------------------------
Weighted average primary common shares outstanding 5,558,350 5,558,350 5,558,350 5,558,350
--------------------------- --------------------------
Primary net income (loss) per common share $0.06 ($0.00) $0.02 ($0.05)
===== ======= ===== =======
CALCULATION OF AVERAGE FULLY DILUTED NET INCOME (LOSS) PER COMMON SHARE:
Weighted average common shares outstanding during the year 5,558,350 5,558,350 5,558,350 5,558,350
Weighted average additional common shares (options) - - - -
--------------------------- --------------------------
Weighted average fully diluted common shares outstanding 5,558,350 5,558,350 5,558,350 5,558,350
--------------------------- --------------------------
Fully diluted net income (loss) per common share $0.06 ($0.00) $0.02 ($0.05)
===== ======= ===== =======
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> MAR-31-1998
<PERIOD-END> JUN-30-1997
<CASH> 2,548,116
<SECURITIES> 7,176,761
<RECEIVABLES> 1,237,193
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 26,232,490
<PP&E> 4,309,661
<DEPRECIATION> 0
<TOTAL-ASSETS> 37,754,924
<CURRENT-LIABILITIES> 32,010,934
<BONDS> 0
55,584
0
<COMMON> 0
<OTHER-SE> 3,845,291
<TOTAL-LIABILITY-AND-EQUITY> 37,754,924
<SALES> 0
<TOTAL-REVENUES> 11,869,593
<CGS> 0
<TOTAL-COSTS> 11,407,973
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 524,766
<INCOME-TAX> 195,000
<INCOME-CONTINUING> 329,766
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 329,766
<EPS-PRIMARY> 0.06
<EPS-DILUTED> 0.06
</TABLE>
