<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
-----------
FORM 10-Q/A-2
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarter ended June 30, 1998 Commission file number 0-20526
-----------
ARCADIA FINANCIAL LTD.
(Exact name of registrant as specified in its charter)
MINNESOTA 41-1664848
(State or other jurisdiction (I.R.S. Employer Identification
Of incorporation or organization) Number)
7825 WASHINGTON AVENUE SOUTH, MINNEAPOLIS, MN 55439-2435
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (612) 942-9880
-----------
Indicate by checkmark 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
--- ---
The number of shares of the Common Stock of the registrant outstanding as
of July 31, 1998 was 39,129,964.
<PAGE>
The undersigned registrant hereby amends its Quarterly Report on Form
10-Q for the quarter ended June 30, 1998 to amend Items 1 and 2 of Part I in
their entirety. Such amendments reflect a restatement of the Company's
consolidated balance sheets and related consolidated statements of operations
and comprehensive income, shareholders' equity and cash flows resulting from
a change in account policy with respect to the valuation and accounting for
the Company's finance income receivable. Refer to Note 2 to the Unaudited
Consolidated Financial Statements for additional information.
FORM 10-Q/A-2 INDEX
<TABLE>
<CAPTION>
Page
----
<C> <S> <C>
PART I FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements 3
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations 12
SIGNATURES 24
</TABLE>
The financial information for the interim periods presented herein is
unaudited. In the opinion of management, all adjustments necessary (which are of
a normal recurring nature) have been included for a fair presentation of the
results of operations. The results of operations for an interim period are not
necessarily indicative of the results that may be expected for a full year or
any other interim period.
SAFE HARBOR STATEMENT UNDER THE
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
Certain statements under the caption "Management's Discussion and Analysis
of Financial Condition and Results of Operations" and elsewhere in this Form
10-Q constitute "forward-looking statements" within the meaning of the Private
Securities Litigation Reform Act of 1995. Such forward-looking statements may be
identified by the use of terminology such as "may," "will," "expect,"
"anticipate," "estimate," "should," or "continue" or the negative thereof or
other variations thereon or comparable terminology. Such forward-looking
statements are subject to certain risks and uncertainties that could cause
actual results to differ materially from historical results or from those
results presently anticipated or projected. Such factors include, among other
things, the following: delinquency and loan loss rates which vary from
assumptions; modifications to the Company's retail disposition program;
accounting and regulatory changes; interest rate fluctuations; difficulties or
delays in the securitization of automobile loans; availability of adequate
short- and long-term financing; general economic and business conditions; and
other matters set forth under the caption "Cautionary Statements" in exhibit
99.1 to the Company's June 30, 1998, Quarterly Report on Form 10-Q filed August
8, 1998.
2
<PAGE>
ARCADIA FINANCIAL LTD.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
(RESTATED) (RESTATED)
(DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) JUNE 30, 1998 DECEMBER 31, 1997
------------- -----------------
<S> <C> <C>
ASSETS
Cash and cash equivalents $ 8,160 $ 17,274
Due from securitization trust 133,551 107,207
Auto loans held for sale 15,480 49,133
Finance income receivable 554,629 602,454
Furniture, fixtures and equipment 16,756 17,371
Other assets 30,225 32,483
--------- ---------
Total assets $ 758,801 $ 825,922
--------- ---------
--------- ---------
LIABILITIES AND SHAREHOLDERS' EQUITY
Amounts due under warehouse facilities $ 53,962 $ 30,880
Senior notes 366,149 365,640
Subordinated notes 49,681 50,772
Capital lease obligations 4,366 5,368
Deferred income taxes - 11,506
Accounts payable and accrued liabilities 39,368 26,302
--------- ---------
Total liabilities 513,526 490,468
Commitments and contingencies
Shareholders' equity:
Capital stock, $.01 par value, 100,000,000 shares authorized:
Common stock 38,966,697 and 38,813,735 shares issued
and outstanding, respectively 390 388
Additional paid-in capital 323,775 322,819
Accumulated other comprehensive income 9,080 3,704
Retained earnings (deficit) (87,970) 8,543
--------- ---------
Total shareholders' equity 245,275 335,454
--------- ---------
Total liabilities and shareholders' equity $ 758,801 $ 825,922
--------- ---------
--------- ---------
</TABLE>
See notes to unaudited consolidated financial statements.
3
<PAGE>
ARCADIA FINANCIAL LTD.
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
(UNAUDITED)
<TABLE>
<CAPTION>
(RESTATED) (RESTATED)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
---------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 1998 1997 1998 1997
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Revenues:
Net interest margin $ 20,971 $ 20,821 $ 40,918 $ 38,879
Gain (loss) on sale of loans (87,298) 21,672 (60,298) (60,159)
Servicing fee income 20,184 16,061 39,850 30,013
---------- ---------- ---------- ----------
Total revenues (46,143) 58,554 20,470 8,733
EXPENSES:
Salaries and benefits 15,773 15,115 33,120 29,593
General and administrative and other operating expenses 38,918 23,810 67,405 49,975
---------- ---------- ---------- ----------
Total operating expenses 54,691 38,925 100,525 79,568
Long-term debt and other interest expense 12,908 10,651 25,693 18,242
---------- ---------- ---------- ----------
Total expenses 67,599 49,576 126,218 97,810
---------- ---------- ---------- ----------
Operating income (loss) before income taxes and
extraordinary item (113,742) 8,978 (105,748) (89,077)
Income tax expense (benefit) (12,273) 3,412 (9,235) (33,850)
---------- ---------- ---------- ---------
Income (loss) before extraordinary item (101,469) 5,566 (96,513) (55,227)
Extraordinary item, net of tax - - - (15,828)
---------- ---------- ---------- ----------
Net income (loss) (101,469) 5,566 (96,513) (71,055)
Other comprehensive income (loss):
Net unrealized gain (loss) on finance income receivables 1,081 2,342 3,105 1,757
Income tax provision (benefit) related to other (3,042) 891 (3,271) 669
comprehensive income
---------- ---------- ---------- ----------
4,123 1,451 5,376 1,088
---------- ---------- ---------- ----------
COMPREHENSIVE INCOME (LOSS) $(97,346) $ 7,017 $(91,137) $(69,967)
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
BASIC EARNINGS PER SHARE:
Net income (loss) per share before extrordinary item $ (2.60) $ 0.14 $ (2.48) $ (1.43)
Extraordinary item per share - - - (0.41)
---------- ---------- ---------- ----------
Net income (loss) per share $ (2.60) $ 0.14 $ (2.48) $ (1.84)
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
DILUTED EARNINGS PER SHARE:
Net income (loss) per share before extraordinary item $ (2.60) $ 0.14 $ (2.48) $ (1.43)
Extraordinary item per share - - - (0.41)
---------- ---------- ---------- ----------
Net income (loss) per share $ (2.60) $ 0.14 $ (2.48) $ (1.84)
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
Weighted average shares outstanding:
Basic 38,966,697 38,702,011 38,965,549 38,558,754
Diluted 38,966,697 39,182,748 38,965,549 38,558,754
</TABLE>
See notes to unaudited consolidated financial statements.
4
<PAGE>
ARCADIA FINANCIAL LTD.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
(RESTATED)
SIX MONTHS ENDED
JUNE 30,
---------------------------------------
(DOLLARS IN THOUSANDS) 1998 1997
--------------- ----------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ (96,513) $ (71,055)
Adjustments to reconcile net income to net cash used in
operating activities:
Depreciation and amortization 5,138 3,262
(Increase) decrease in assets:
Automobile loans held for sale:
Purchases of automobile loans (1,159,784) (1,557,818)
Sales of automobile loans 1,159,976 1,522,135
Repayments of automobile loans 33,461 24,496
Finance income receivable 53,201 (22,740)
Due from securitization trusts (26,344) 8,865
Prepaid expenses and other assets 1,026 1,739
Increase (decrease) in liabilities:
Deferred income taxes (11,506) (42,882)
Accounts payable and accrued liabilities 13,066 14,794
--------------- ----------------
Total cash used in operating activities (28,279) (119,204)
CASH FLOWS FROM INVESTING ACTIVITIES:
Net purchase of furniture, fixtures and equipment (2,655) (5,006)
Collections on subordinated certificates 527 572
--------------- ----------------
Total cash used in investing activities (2,128) (4,434)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from issuance of Common Stock 304 2,485
Proceeds from borrowings under warehouse facilities 1,512,737 1,074,410
Repayment of borrowings under warehouse facilities (1,489,655) (1,087,828)
Unsecured subordinated notes, net (1,091) (1,947)
Repayments of long-term debt - (145,000)
Proceeds from issuance of long term debt - 300,000
Deferred debt issuance cost - (5,127)
Reduction of capital lease obligations (1,002) (1,277)
--------------- ----------------
Total cash provided by financing activities 21,293 135,716
--------------- ----------------
Net increase (decrease) in cash and cash equivalents (9,114) 12,078
Cash and cash equivalents at beginning of period 17,274 16,057
--------------- ----------------
Cash and cash equivalents at end of period $ 8,160 $ 28,135
--------------- ----------------
--------------- ----------------
Supplemental disclosures of cash flow information:
Non cash activities:
Additions to capital leases - $ 132
Cash paid for:
Interest $ 28,928 $ 14,656
</TABLE>
See notes to unaudited consolidated financial statements.
5
<PAGE>
ARCADIA FINANCIAL LTD.
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
(UNAUDITED)
<TABLE>
<CAPTION>
FOR THE SIX MONTHS ENDED JUNE 30, 1998
-----------------------------------------------------------------------------------
ACCUMULATED
NUMBER OF COMMON ADDITIONAL RETAINED OTHER
COMMON PAR PAID IN EARNINGS COMPREHENSIVE
SHARES VALUE CAPITAL (DEFICIT) INCOME TOTAL
----------- ---------- ------------- ------------- -------------- --------------
<S> <C> <C> <C> <C> <C> <C>
(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)
BALANCE, DECEMBER 31, 1997, AS RESTATED 38,813,735 $ 388 $ 322,819 $ 8,543 $ 3,704 $ 335,454
Exercise of options and warrants 39,357 1 104 - - 105
Issuance of Common Stock:
Benefit plans 113,605 1 198 - - 199
Amortization of deferred compensation - - 654 - - 654
Unrealized gain on financed income receivable - - - - 5,376 5,376
Net loss, as restated - - - (96,513) - (96,513)
------------ --------- ------------- ------------- -------------- --------------
BALANCE, JUNE 30, 1998, AS RESTATED 38,966,697 $ 390 $ 323,775 $ (87,970) $ 9,080 $ 245,275
------------ --------- ------------- ------------- -------------- --------------
------------ --------- ------------- ------------- -------------- --------------
</TABLE>
See notes to unaudited consolidated financial statements.
6
<PAGE>
ARCADIA FINANCIAL LTD.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE QUARTER ENDED JUNE 30, 1998
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION. The interim financial statements have been
prepared by the Company pursuant to the rules and regulations of the
Securities and Exchange Commission applicable to quarterly reports on Form
10-Q. Certain information and footnote disclosures normally included in
financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted pursuant to such rules
and regulations, although management believes that the disclosures present
fairly the financial position of the Company and its subsidiaries for the
periods presented. These financial statements should be read in conjunction
with the audited consolidated financial statements and related notes and
schedules included in the Company's 1997 Annual Report on Form 10-K/A filed
March 30, 1998.
The consolidated financial statements include the accounts of the
Company and its wholly-owned subsidiaries. All significant intercompany
accounts and transactions have been eliminated.
Certain reclassifications have been made to the June 30, 1997 balances
to conform to current period presentation.
USE OF ESTIMATES
In conformity with generally accepted accounting principles, management
utilizes assumptions and estimates that affect the reported value of finance
income receivable and the gain on sale of automobile receivables. Such
assumptions include, but are not limited to, estimates of loan prepayments,
defaults, recovery rates and present value discount. The Company uses a
combination of its own historical experience, industry statistics and
expectation of future performance to determine such estimates. The Company's
estimation process is evaluated on a regular basis and modified when deemed
necessary. Modifications to the estimation process may result in changes in
estimates utilized to determine the carrying value of finance income
receivable. Actual results may differ from the Company's estimates due to
numerous factors both within and beyond the control of Company management.
Changes in these factors could require the Company to revise its assumptions
concerning the amount of voluntary prepayments, the frequency and/or severity
of defaults and the recovery rates associated with the disposition of
repossessed vehicles. The range of assumptions, as well as actual
performance, are reflective of the risk characteristics of the loans within
specific securitization pools.
The Company adopted Statement of Financial Accounting Standards No.130,
"Reporting Comprehensive Income" ("SFAS 130"), effective January 1, 1998.
SFAS 130 establishes standard for reporting comprehensive income and its
components in a full set of financial statements. The new standard requires
that all items that are required to be recognized under accounting standards
as components of comprehensive income, including an amount representing total
comprehensive income, be reported in a financial statement that is displayed
with the same prominence as other financial statements. Pursuant to SFAS 130,
the Company has reported comprehensive income in the accompanying
consolidated financial statements. Prior year financial statements have been
reclassified to conform to the requirements of SFAS 130.
7
<PAGE>
2. ACCOUNTING CHANGE
Pursuant to the FASB's Special Report, "A Guide to Implementation of
Statement 125 on Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities, Second Edition," dated December 1998, and
public comments from the Securities and Exchange Commission released on
December 8, 1998, during the fourth quarter of 1998 the Company changed its
accounting policy with respect to the valuation and accounting for its
finance income receivable to the "cash-out" method. Finance income receivable
represents the Company's retained interest in estimated future cash flows
from securitization transactions. Under the "cash-in" method previously used
by the Company, (i) the assumed discount period for measuring the present
value of future cash flows ended when these cash flows were deposited into
the securitization trust accounts and (ii) any initial deposits to spread
accounts were recorded at face value. Under the "cash-out" method, the
assumed discount period for measuring the present value of future cash flows
from the trusts ends when cash, including return of the initial deposits, its
distributed to the Company on an unrestricted basis. Prior period financial
statements have been restated to reflect this change on a retroactive basis.
The effects of the restatement on the consolidated balance sheet at December
31, 1997 and the consolidated statements of operations and comprehensive
income and shareholders' equity for the three months ended June 30, 1998 and
1997 are as follows:
<TABLE>
<CAPTION>
AT JUNE 30, 1998 AT DECEMBER 31, 1997
---------------------------------- ----------------------------------
ORIGINALLY AS ORIGINALLY AS
(IN MILLIONS, EXCEPT PER SHARE DATA) REPORTED RESTATED REPORTED RESTATED
-------------- --------------- -------------- ---------------
<S> <C> <C> <C> <C>
BALANCE SHEET:
Finance income receivable $ 568,534 $ 554,629 $ 622,282 $ 602,454
Deferred income taxes - - 18,846 11,506
Shareholders' equity 259,180 245,275 347,942 335,454
</TABLE>
<TABLE>
<CAPTION>
THREE MONTHS ENDED JUNE 30,
-------------------------------------------------------------------------
1998 1997
---------------------------------- ----------------------------------
ORIGINALLY AS ORIGINALLY AS
REPORTED RESTATED REPORTED RESTATED
-------------- --------------- -------------- ---------------
<S> <C> <C> <C> <C>
STATEMENT OF OPERATIONS:
Revenues $ (47,737) $ (46,143) $ 58,839 $ 58,554
Income tax expense (benefit) (21,419) (12,273) 3,520 3,412
Net Income (loss) (93,917) (101,469) 5,743 5,566
Basic earnings per share $ (2.41) $ (2.60) $ 0.15 $ 0.14
Diluted Earnings per share (2.41) (2.60) 0.15 0.14
</TABLE>
8
<PAGE>
ARCADIA FINANCIAL LTD.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE QUARTER ENDED JUNE 30, 1998
3. FINANCE INCOME RECEIVABLE
The following table sets forth the components of finance income receivable:
<TABLE>
<CAPTION>
(RESTATED) (RESTATED)
AT AT
JUNE 30, DECEMBER 31,
1998 1997
-------------- --------------
<S> <C> <C>
(DOLLARS IN THOUSANDS)
Estimated cash flows on loans sold, net of estimated prepayments $1,173,434 $1,009,800
Deferred servicing income (102,855) (88,282)
Reserve for loan losses (429,182) (235,599)
-------------- --------------
Undiscounted cash flows on loans sold, net of estimated prepayments 641,397 685,919
Discount to present value (86,768) (83,465)
-------------- --------------
$ 554,629 $ 602,454
-------------- --------------
-------------- --------------
Reserve for loan losses as a percentage of servicing portfolio 8.44% 4.75%
The following represents the roll-forward of the finance income receivable
balance:
(DOLLARS IN THOUSANDS)
BALANCE, DECEMBER 31, 1997, AS RESTATED $ 602,454
Present value of estimated future cash flows from current period securitizations 117,338
Interest earned on spread accounts 7,314
Recognition of present value effect of discounted cash flows 23,608
Unrealized gain on retained assets 3,105
Less:
Spread account recourse reduction amount (1) (25,000)
Excess cash flows released to the Company (2) (59,690)
Change in estimates of charge-offs, recovery rates and prepayments (114,500)
--------------
BALANCE, JUNE 30, 1998, AS RESTATED $ 554,629
--------------
--------------
</TABLE>
- -------------
(1) In May 1998, the Company and its provider of asset-backed securities
insurance entered into an arrangement whereby the Company was allowed to
receive $25 million of cash from certain spread accounts sooner than it
would have absent such arrangement. The arrangement may be extended on an
annual basis upon mutual arrangement by and between the Company and its
provider of asset-backed securities insurance. The Company pays a monthly
fee to its provider of asset-backed securities insurance to maintain the
arrangement. The $25 million will be replenished in the relevant spread
accounts by means of a $3 million reduction in the level of monthly cash
releases from the spread accounts. The replishment period will begin in May
1999, unless the terms of the arrangement are extended.
(2) Includes $7.0 million that has been restricted pursuant to an arrangement
between the Company and its provider of asset-backed securities insurance.
Such arrangement provides that, if any insured securitization trust exceeds
the specified portfolio performance test as defined within the trust
agreement, the Company may, in lieu of retaining excess cash from that
securitization trust in the related spread accounts, pledge an equivalent
amount of cash, which has the effect of preventing the violation of the
portfolio performance test. Such pledged amounts are included in cash and
cash equivalents. Restrictions on the pledged amounts may be lifted if the
portfolio performance tests are met and maintained for the related
securitization trusts as defined in the arrangement, the violations are
waived, or the loans within the securitization trust are repurchased by the
Company.
9
<PAGE>
ARCADIA FINANCIAL LTD.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE QUARTER ENDED JUNE 30, 1998
<TABLE>
<CAPTION>
4. OTHER ASSETS AT AT
JUNE 30, DECEMBER 31,
1998 1997
-------------- --------------
<S> <C> <C>
(DOLLARS IN THOUSANDS)
Advances due to servicer $ 5,612 $ 6,072
Deferred debt issuance costs 10,814 11,518
Investment in subordinated certificates 2,337 2,864
Servicing fee receivable 4,706 4,389
Prepaid expenses 1,275 1,078
Repossessed assets 397 1,181
Other assets 5,084 5,381
-------------- --------------
$30,225 $32,483
-------------- --------------
-------------- --------------
<CAPTION>
5. SUBORDINATED NOTES AT AT
JUNE 30, DECEMBER 31,
1998 1997
-------------- --------------
<S> <C> <C>
(DOLLARS IN THOUSANDS)
Senior subordinated notes, Series 1996-A $30,000 $30,000
Junior subordinated notes 19,681 20,772
-------------- --------------
$49,681 $50,772
-------------- --------------
-------------- ---------------
</TABLE>
10
<PAGE>
ARCADIA FINANCIAL LTD.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE QUARTER ENDED JUNE 30, 1998
6. EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted earnings
per share for each of the three and six month periods ended June 30:
<TABLE>
<CAPTION>
(RESTATED) (RESTATED)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------------- -------------------------------
(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS) 1998 1997 1998 1997
--------------- -------------- -------------- ---------------
<S> <C> <C> <C> <C>
Numerator:
Net income (loss) before
extraordinary item $ (101,469) $ 5,566 $ (96,513) $ (55,227)
--------------- -------------- -------------- ---------------
--------------- -------------- -------------- ---------------
Denominator:
Denominator for basic earnings per
share - weighted average shares 38,966,697 38,702,011 38,965,549 38,558,754
Dilutive effect of options and warrants (1) - 480,737 - -
--------------- -------------- -------------- ---------------
Denominator for diluted earnings per
share - adjusted weighted average
shares 38,966,697 39,182,748 38,965,549 38,558,754
--------------- -------------- -------------- ---------------
--------------- -------------- -------------- ---------------
Basic earnings (loss) per share before
extraordinary item $ (2.60) $ 0.14 $ (2.48) $ (1.43)
--------------- -------------- -------------- ---------------
--------------- -------------- -------------- ---------------
Diluted earnings (loss) per share before
extraordinary item $ (2.60) $ 0.14 $ (2.48) $ (1.43)
--------------- -------------- -------------- ---------------
--------------- -------------- -------------- ---------------
</TABLE>
- --------------
(1) For the three and six months ended June 30, 1998 and the six months ended
June 30, 1997, the weighted average shares under the diluted computation have an
anti-dilutive effect; therefore diluted earnings per share are shown equal to
basic earnings per share.
11
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
Substantially all of the Company's revenues are derived from the
purchase, securitization and servicing of consumer automobile loans
originated in 45 states primarily by car dealers affiliated with major
foreign and domestic manufacturers. Loans are purchased through 18 regional
buying centers (or "hubs") located in 15 states, supplemented by a network of
dealer development representatives ("DDRs") which develop and maintain
relationships with car dealers operating within each "hub's" immediate market
area or in surrounding market areas referred to as "spokes." Credit approval
and loan processing are generally performed at the "hub" or at the Company's
headquarters in Minneapolis, Minnesota. The Company acts as the servicer of
all loans originated and securitized by it in return for a monthly servicing
fee. To perform its servicing responsibilities the Company operates a
national customer service center in Minneapolis, Minnesota and four regional
collection centers located in Charlotte, North Carolina; Dallas, Texas;
Denver, Colorado; and Minneapolis, Minnesota.
THREE AND SIX MONTHS ENDED JUNE 30, 1998 AND 1997
RESULTS OF OPERATIONS
CHANGES IN ACCOUNTING ESTIMATES AND NON-RECURRING CHARGES
Included in the Company's financial results for the three and six
months ended June 30, 1998, are two non-cash charges totaling $125 million.
The non-cash charges include a pre-tax $114.5 million charge to gain on sale
of loans associated with a change in accounting estimates to reflect (i) a
higher estimate of the frequency of defaulted receivables (ii) a reduction in
assumed loan loss recovery rates, (iii) a reduction in estimated voluntary
loan prepayments, and (iv) additions to general reserves applicable to
unanticipated changes in the future performance of the existing portfolio of
receivables. An additional $10.5 million pre-tax charge relates to the
elimination of the Company's retail remarketing program and other
organizational changes designed to improve future operating efficiencies.
Historically, management's estimate of the frequency of loan
defaults was based on actual credit performance incurred to date segregated
by each securitization transaction and loan product (Premier and Classic) as
well as comparisons to externally-generated industry information when
available. In response to a perception of increased risk within the consumer
finance industry and the Company's dependence on internal historical
experience as an indicator of future credit performance, management commenced
a project to identify what it hoped would be a more predictive alternative to
estimating future performance of its servicing portfolio to not only improve
the Company's assessment of its finance income receivable carrying amount but
also to enhance the Company's pricing of its loan products. This project
focused on identifying correlations between the credit performance of the
loans in the Company's servicing portfolio and the credit characteristics of
each contract at the time of origination, including externally-developed
credit score, loan-to-value ratio, debt-to-income ratio and payment-to-income
ratio. The Company's decision to obtain and utilize a credit score from a
nationally recognized independent credit scoring company rather than
utilizing its own internally-developed credit score was based on its desire
to reduce the subjectivity of the analysis. As a result of this project,
management determined that the combination of externally-developed credit
score and loan-to-value ratio was most predictive of future loan performance.
Using the information derived from this process, management was then able to
segregate the loans in its servicing portfolio into eight distinct tranches
of credit performance that management believes provide a higher level of
precision in estimating future default experience than its previous
methodology. As a result, management determined in June 1998 that it was
necessary to revise its estimate with respect to the frequency of future loan
defaults and reduce the carrying value of its finance income receivable by
approximately $67 million.
12
<PAGE>
In addition to the frequency of loan defaults, the valuation of the
Company's finance income receivable is based in part on an estimate of the
recovery upon the disposition of repossessed vehicles. Although the Company
was reserved for and realized recovery rates slightly above 50% on the sale
of repossessed vehicles during the first six months of 1998, management
believes that market pressure on used car prices will force future recovery
rates downward and therefore, believes that it is appropriate to lower the
estimated recovery rate to 45%. This decrease to the Company's estimated
recovery rate, taking into consideration the increase in the estimated
frequency of defaults discussed above, led to a further reduction in the
carrying value of finance income receivable of approximately $51 million.
A third component in the valuation of finance income receivable is
an estimate of the amount and timing of voluntary prepayments of loans.
Historically, management has estimated the percentage of receivables it
expects to prepay on a monthly basis and has assumed that such monthly
prepayment speed would remain constant throughout the life of the
securitization trust. A detailed analysis of the Company's actual prepayment
data indicated, however, that for an extended period of time prepayment
speeds have performed slower than expected and have progressively declined as
a securitization trust ages. As a result, management determined that it was
appropriate to reduce its prepayment speed assumption, which resulted in an
increase to its finance income receivable carrying value of approximately $49
million.
Finally, to provide for current uncertainties related to the
consumer finance industry and the remaining subjectivity of the estimates
used in valuing the finance income receivable, management believes that it
was appropriate to increase its finance income receivable reserves by an
additional $45.5 million.
Also during the second quarter of 1998, the Company decided to
discontinue its retail remarketing operations and finalized plans aimed at
reducing infrastructure costs and improving operating efficiencies. After a
detailed review during the past 18 months, the Company determined that its
retail remarketing operation which was responsible for the liquidation of
repossessed vehicles through retail consignment lots did not provide an
adequate risk-adjusted return commensurate with the attention necessary by
management to operate such strategy and therefore decided to cease such
operations. Also during this time period, the Company conducted an exhaustive
study of substantially all Company functions and developed a plan which
includes further consolidation of the Company's servicing and collection
operations into its four regional collection centers and streamlining of
other operating procedures. As a result, the Company has recognized a $10.5
million pre-tax charge through other operating expenses associated with
estimated severance and benefit costs, termination or subleasing of certain
lease commitments, and legal expenses associated with the operational changes.
Included in the Company's financial results during the three and six
month periods ended June 30, 1997, are two special charges taken in March
1997. These charges included a non-cash pre-tax charge of approximately $103
million, due primarily to a change in accounting estimate related to the
assumed recovery rates on repossessed vehicles and modifications to the
Company's retail disposition strategy, and an extraordinary charge of
approximately $15.8 million, net of tax, due to the early extinguishment of
the Company's 13% Senior Term Notes, due 2000 (the "13% Notes").
13
<PAGE>
NET INTEREST MARGIN. The components of net interest margin for each
of the three and six months ended June 30 were:
<TABLE>
<CAPTION>
(RESTATED) (RESTATED)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------------- -------------------------
1998 1997 1998 1997
------------ ------------ ----------- ------------
<S> <C> <C> <C> <C>
(DOLLARS IN THOUSANDS)
Interest income on loans, net $ 6,753 $ 8,961 $ 13,032 $ 17,131
Interest income on short-term investments
and other cash accounts 2,887 2,807 5,947 5,171
Recognition of present value discount 12,031 9,229 23,608 17,411
Provision for credit losses on loans held for sale (700) (176) (1,669) (834)
------------ ------------ ----------- ------------
Net interest margin $ 20,971 $ 20,821 $ 40,918 $ 38,879
------------ ------------ ----------- ------------
------------ ------------ ----------- ------------
</TABLE>
Net Interest Margin increased slightly for the three months ended
June 30, 1998 compared to the three months ended June 30, 1997, and increased
5% for the six months ended June 30, 1998 compared to the same period in
1997. The increase in net margin is primarily due to an increase in the
recognition of present value discount reflecting the growth in the Company's
finance income receivable and related present value discount applied to the
estimate of future cash flows. The 25% and 24% decrease in interest income on
loans during the three and six month periods ended June 30, 1998 and 1997,
respectively, is primarily due to a reduction in loan purchasing volume.
A 22% and 24% decline in loan purchasing volume (see table below)
and the timing of securitization transactions during the three and six months
ended June 30, 1998, respectively, resulted in a reduction in the average
monthly balance of loans held for sale, on which the Company earns interest
income until such loans are securitized, to $191.4 million and $187.3
million, respectively, down from $255.0 million and $246.0 million in the
same periods of 1997, respectively. The decline in purchasing volume is
primarily due to the Company's emphasis on more selective loan purchases.
During the three and six months ended June 30, 1998, the weighted average net
interest rate spread earned rose to 11.04% and 11.23% respectively, compared
with 9.82% and 9.93%, respectively, during the same periods in 1997. The rise
in net interest rate spread earned on loans held for sale is principally due
to higher average annual percentage rates ("APRs") paid by obligors primarily
resulting from a greater proportion of loan volume consisting of higher rate
Classic loans.
The Company's loan purchasing and securitization volume for each of
the three and six months ended June 30 are set forth in the table below.
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
----------------------- -----------------------
1998 1997 1998 1997
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
(DOLLARS IN THOUSANDS)
Premier $ 161,555 $ 358,543 $ 333,838 $ 761,738
Classic 411,325 379,959 823,015 758,636
---------- ---------- ---------- ----------
Total loans purchased $ 572,880 $ 738,502 $1,156,853 $1,520,374
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
Automobile loans securitized $ 571,782 $ 747,391 $1,159,976 $1,522,135
</TABLE>
GAIN ON SALE OF LOANS. During the three months ended June 30, 1998,
the Company recognized a non-recurring pre-tax charge to gain on sale of
loans of $114.5 million resulting in a loss on sale of loans of $87.3 million
and $60.3 million for the three and six months ended June 30, 1998,
respectively. Included in gain on sale of loans during the six months ended
June 30, 1997 was a non-recurring pre-tax charge of $98.0 million resulting
in a loss on sale of loans of $60.1 million. See "CHANGES IN ACCOUNTING
ESTIMATES AND NON-RECURRING CHARGES" for discussion of
14
<PAGE>
these charges. Excluding these charges, gain on sale of loans increased 26%
and 43% during the three and six months ended June 30, 1998, respectively,
compared with the same periods in 1997. The increases are primarily due to a
widening of the gross interest spread earned on loans securitized (see table
below) and a decline in the average participation rate paid to dealers for
loan originations, partially offset by the decrease in loan securitization
volume.
The following table summarizes the Company's gross interest rate
spreads for each of the three and six month periods ended June 30:
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------- ------------------
1998 1997 1998 1997
------ ------ ------ -------
<S> <C> <C> <C> <C>
Weighted average APR of loans securitized 17.06 % 15.83 % 17.05 % 15.65 %
Weighted average securitization rate 5.97 6.50 5.97 6.51
------ ------ ------ ------
Gross interest rate spread (1) 11.09 % 9.33 % 11.08 % 9.14 %
------ ------ ------ ------
------ ------ ------ ------
</TABLE>
- -----------
(1) Before gains/losses on hedging transactions.
The rise in gross interest rate spread during the three and six
months ended June 30, 1998 is primarily due to an increased proportion of
higher-yielding Classic loans, resulting in an increased average APR earned
on loans purchased and subsequently securitized, and due to a reduction in
the securitization interest rate primarily reflecting a general decline in
market interest rates.
Any unamortized balance of participations paid to dealers is
expensed at the time the related loans are securitized and recorded as a
reduction to gain on sale. Due to the increased proportion of Classic loan
purchases, which generally require lower participation rates than Premier
loans, participations paid as a percentage of the principal balance of loans
purchased declined to 2.80% and 2.83% during the three and six months ended
June 30, 1998, from 3.14% and 3.20%, respectively, in the same periods a year
ago.
Gain on sale of loans has been adjusted for net realized losses on
hedging transactions of $2.6 million and $8.4 million during the three and
six months ended June 30, 1998, compared with net realized losses of $1.6
million and $0.2 million, respectively, in the same periods a year ago.
SERVICING FEE INCOME. The components of servicing fee income for
each of the three and six months ended June 30 were:
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------------ ------------------------------
(RESTATED) (RESTATED)
1998 1997 1998 1997
-------------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
(DOLLARS IN THOUSANDS)
Contractual servicing fee income $14,251 $11,047 $28,179 $20,525
Other servicing income 5,933 5,014 11,671 9,488
-------------- ------------- ------------- -------------
Total servicing fee income $20,184 $16,061 $39,850 $30,013
-------------- ------------- ------------- -------------
-------------- ------------- ------------- -------------
</TABLE>
The Company earns contractual servicing fee income for servicing
loans sold to investors through securitizations. The servicing fee is 1% per
annum of the outstanding principal balance of the loans for all
securitizations entered into prior to September 1997 and 1.25% per annum on
loans included in and subsequent to the third quarter 1997 securitization.
The growth in contractual servicing fee income is primarily related to an
increase in the average servicing portfolio outstanding (see table below).
15
<PAGE>
Other servicing income consists primarily of collection fees, such as
late payment fees and insufficient fund charges, and interest on collection
accounts earned by the Company as servicer of the loans. The rise in other
servicing income is principally due to increases in income from late fees and
insufficient fund charges reflecting the increase in delinquency rates and
growth in the Company's servicing portfolio compared to the same periods a year
ago and increased collection account interest attributable to the growth in the
average servicing portfolio outstanding.
The following table reflects the growth in the Company's servicing
portfolio from June 30, 1997 to June 30, 1998:
<TABLE>
<CAPTION>
AT JUNE 30,
-------------------------
1998 1997
----------- ------------
<S> <C> <C>
(DOLLARS IN THOUSANDS, EXCEPT AS NOTED)
Principal balance of automobile loans held for sale $ 14,726 $ 51,487
Principal balance of loans serviced under securitizations 5,070,879 4,462,522
----------- -----------
Servicing portfolio $ 5,085,605 $ 4,514,009
----------- -----------
----------- -----------
Average unpaid principal balance (actual dollars) $ 11,609 $ 12,382
Number of loans serviced 438,063 364,553
</TABLE>
The Company's servicing portfolio increased 13% from June 30, 1997 to
June 30, 1998. This increase reflects loan purchases and subsequent
securitizations, partially offset by defaults, prepayments and scheduled
repayments. The decline in average outstanding balance of loans during the first
six months of 1998 reflects an increase in the proportion of used to new cars
financed by the Company and a reduction in loan-to-value ratios on loan
purchases during the past 18 months.
The Company's servicing fee approximates adequate compensation as
defined by SFAS 125 and therefore, the Company has not recorded a servicing
asset or liability at June 30, 1998.
OPERATING EXPENSES. During the three and six months ended June 30, 1998,
salaries and benefits increased 4% and 12%, respectively, from the same periods
a year ago. Beginning in the first quarter of 1998, the Company began to move
collection personnel out of buying centers into centralized sites to better
leverage collections resources and technology and to control collection
processes more tightly. While this organizational change has resulted in a
reduction in the number of collection personnel, primarily due to anticipated
improvements in efficiencies and a temporary delay in the staffing of the new
centralized sites, it has also had the effect of increasing salaries and
benefits during the second quarter and first six months of 1998 over the same
periods in 1997 due to severance expenses associated with the change.
Other operating costs, including administrative, occupancy, depreciation
and amortization, origination, servicing and collection expenses, increased 63%
and 35% for the three and six months ended June 30, 1998, respectively, compared
with the same periods in 1997. Included in operating costs during the three and
six months ended June 30, 1998 is a pre-tax charge of approximately $10.5
million. This charge is related to the elimination of the Company's retail
remarketing program and other organizational changes designed to improve
operating efficiency. (See "CHANGES IN ACCOUNTING ESTIMATES AND NON-RECURRING
CHARGES"). Included in operating costs during the first six months of 1997 was a
pre-tax charge of approximately $5.0 million primarily related to legal costs
and severance expenses for certain former executives of the Company. Excluding
these charges, other operating costs increased 19% and 27% for the three and six
months ended June 30, 1998, respectively, compared with the same periods in
1997. The increase in other operating costs is primarily a result of the higher
percentage of Classic program loans in the portfolio, since these loans
generally require greater collection efforts and related costs (including
increased telephone, fax, postage and repossession expenses) than Premier
program loans.
IMPACT OF YEAR 2000. The Company recognizes that the arrival of the Year
2000 poses a unique worldwide challenge to the ability of all computer systems
to recognize the date change from December 31, 1999 to January 1,
16
<PAGE>
2000 and, like other companies, is assessing, enhancing and updating its
computer applications and business processes to provide for their continued
functionality after said date. In connection with its initiative to replace
and enhance key operating systems, the Company has engaged outside
consultants to assist in the design and implementation of various systems
that will be Year 2000 compliant. The Company anticipates that the testing
and implementation of such systems will be completed by mid-1999, which is
prior to any anticipated impact on its operating systems. The Company
believes that with conversions to new software, the Year 2000 issue will not
pose significant operational problems for its computer systems. However, if
such conversions are not made, or are not completed in a timely manner, the
Year 2000 issue could have a material impact on the operations of the Company.
The costs associated with the Year 2000 project will be primarily
for the purchase of the new software being developed to replace and enhance
the Company's current operating systems. Consistent with its capitalization
policy, the costs of the Company's new operating software will be capitalized
and amortized over its expected useful life. As such, the Company believes
that the impact of the Year 2000 issue will not have a material effect on the
Company's results of operations.
LONG-TERM DEBT AND OTHER INTEREST EXPENSE. Long-term debt and other
interest expense increased 21% and 41% for the three and six months ended
June 30, 1998, respectively, compared to the same periods in 1997. The
increases are primarily due to the issuance of $300.0 million and $75.0
million of 11.5% Senior Notes ("the Senior Notes") in March 1997 and October
1997, respectively, partially offset by the concurrent extinguishment of
$145.0 million of the 13% Notes in March 1997.
EXTRAORDINARY ITEM. In March 1997, the Company issued $300.0 million
of its Senior Notes and utilized approximately $173.5 million of the proceeds
to repurchase and covenant defease the Company's $145.0 million of 13% Notes,
including accrued interest of $7.9 million and a premium of approximately
$20.3 million. These charges and additional professional fees incurred to
retire such debt were treated as an extraordinary item, net of tax.
FINANCIAL CONDITION
FINANCE INCOME RECEIVABLE. Finance income receivable decreased to
$554.6 million at June 30, 1998 from $602.5 million at December 31, 1997. This
9% decrease reflects a non-recurring $114.5 million pre-tax charge during the
second quarter (see "CHANGES IN ACCOUNTING ESTIMATES AND NON-RECURRING CHARGES")
partially offset by amounts capitalized upon completion of the Company's first
and second quarter securitizations related to the present value of estimated
cash flows.
DEFERRED INCOME TAX. There were no deferred income taxes at June 30,
1998 compared with a net deferred tax liability of $11.5 million at December 31,
1997. This decrease reflects the recognition of a portion of the tax benefit
from the current quarter loss from operations. In accordance with SFAS No. 109,
"Accounting for Income Taxes," the Company established a valuation allowance
during the quarter ended June 30, 1998. The valuation allowance was established
to offset the deferred tax asset associated with the Company's net operating
loss carryforward resulting in no net deferred income taxes at June 30, 1998.
ACCOUNTS PAYABLE AND ACCRUED LIABILITIES. Accounts payable and accrued
liabilities increased 50% to $39.4 million at June 30, 1998 as compared with
$26.3 million at December 31, 1997. This increase is primarily due to accruals
recorded during the second quarter of 1998 related to the elimination of the
Company's retail remarketing program and other organizational changes designed
to improve operating efficiency (see "CHANGES IN ACCOUNTING ESTIMATES AND
NON-RECURRING CHARGES").
17
<PAGE>
DELINQUENCY, CREDIT LOSS AND REPOSSESSION EXPERIENCE
The following tables describe the Company's delinquency, credit loss
and repossession experience for the periods indicated. A delinquent loan may
result in the repossession and foreclosure of the collateral for the loan.
Losses resulting from repossession and foreclosure of loans are charged against
applicable allowances.
DELINQUENCY EXPERIENCE (1):
<TABLE>
<CAPTION>
JUNE 30, 1998 DECEMBER 31, 1997
----------------------------------- --------------------------------
NUMBER OF NUMBER OF
LOANS BALANCE LOANS BALANCE
----------------- --------------- --------------- -------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Servicing portfolio at end of period 438,063 $5,085,605 411,429 $4,956,090
Delinquencies:
31-60 days 8,172 $ 96,169 8,297 $ 100,161
61-90 days 3,740 44,733 3,635 45,485
91 days or more 4,685 51,810 3,019 34,047
----------------- --------------- --------------- -------------
Total loans delinquent 31 or more days 16,597 $ 192,712 14,951 $ 179,693
Delinquencies as a percentage of
number of loans and amount
outstanding at end of period (2) 3.79 % 3.79 % 3.63 % 3.63 %
Amount in repossession (3) 4,184 $ 28,861 6,083 $ 55,300
----------------- --------------- --------------- -------------
Total delinquencies and amount in
repossession (2) (3) 20,781 $ 221,573 21,034 $ 234,993
----------------- --------------- --------------- -------------
----------------- --------------- --------------- -------------
</TABLE>
- ----------------------
(1) All amounts and percentages are based on the principal amount scheduled to
be paid on each loan. The information in the table includes previously
sold loans which the Company continues to service.
(2) Amounts shown do not include loans which are less than 31 days delinquent.
(3) Amount in repossession represents financed automobiles which have been
charged-off but not yet liquidated.
18
<PAGE>
CREDIT LOSS/REPOSSESSION EXPERIENCE (1):
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------------- ---------------------------
1998 1997 1998 1997
-------------- ------------- ------------ -----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Average servicing portfolio outstanding during the period $5,049,786 $ 4,335,962 $ 5,025,684 $ 4,150,719
Average number of loans outstanding during the period 432,007 340,143 425,408 324,169
Number of charge-offs 8,677 5,672 16,274 10,365
Gross charge-offs (2) $ 78,947 $ 33,261 $ 131,426 $ 79,671
Recoveries (3) 4,172 2,533 7,748 4,413
------------ ------------- ------------ -----------
Net losses $ 74,775 $ 30,728 $ 123,678 $ 75,258
------------ ------------- ------------ -----------
------------ ------------- ------------ -----------
Annualized gross charge-offs as a percentage of average
servicing portfolio 6.25 % 3.07 % 5.23 % 3.84 %
Annualized net losses as a percentage of average
servicing portfolio 5.92 % 2.83 % 4.92 % 3.63 %
</TABLE>
- --------------
(1) All amounts and percentages are based on the principal amount scheduled to
be paid on each loan. The information in the table includes previously
sold loans which the Company continues to service.
(2) Gross charge-offs represent principal amounts which management estimated
to be uncollectable after the consideration of anticipated proceeds from
the disposition of repossessed assets and selling expenses.
(3) Includes post-disposition amounts received on previously charged off
loans.
The increase in delinquency rate at June 30, 1998, compared with December
31, 1997, reflects the continued rise in the proportion of Classic loans in the
Company's servicing portfolio, which approximated 50% of loans serviced at June
30, 1998, compared with 43% at December 31, 1997. Repossessed inventory has
decreased since December 31, 1997, primarily due to the Company's decision to
increase its use of wholesale disposition channels to liquidate repossessed
vehicles. During the first six months of 1998 the Company sold approximately 74%
of its repossessed inventory through wholesale channels compared with 45% in the
same period a year ago.
Annualized gross charge-offs and net losses during the three and six month
periods ended June 30, 1998, include a charge of 1.72% and 0.86%, respectively,
representing the impact of a write-down of current inventory resulting from a
revision to the estimate of net realizable value (see "CHANGES IN ACCOUNTING
ESTIMATES AND NON-RECURRING CHARGES") and the write-off of all remaining problem
loans from one of the Company's original consignment dealers which it has since
ceased doing business. The remaining increase in gross charge-offs and net
losses during the three and six months ended June 30, 1998, compared to the same
periods a year ago primarily reflects the continued rise in the proportion of
Classic loans in the Company's servicing portfolio and the increase in the
utilization of wholesale disposition channels. As previously discussed, the
Company announced that it is planning to discontinue the sale of repossessed
vehicles through retail disposition channels and anticipates that it will be
completely out of these operations by the end of 1998 (see "CHANGES IN
ACCOUNTING ESTIMATES AND NON-RECURRING CHARGES"). The Company believes that its
decision to discontinue its retail remarketing operations will enable it to
better manage its level of repossessed inventory and improve the timing of
excess cash flows released to the Company from securitization trusts as a result
of an increase in the speed at which repossessed vehicles can be liquidated.
19
<PAGE>
LIQUIDITY
The Company's business requires substantial cash to support its operating
activities. The principal cash requirements include (i) amounts necessary to
purchase and finance automobile loans pending securitization, (ii) payment of
dealer participations, (iii) cash held from time to time in restricted spread
accounts to support securitizations and warehouse facilities and other
securitization expenses, (iv) interest advances to securitization trusts, (v)
repossessed inventory, and (vi) interest expense. The Company also uses
significant amounts of cash for operating expenses. The Company receives cash
principally from interest on loans held pending securitization, from excess cash
flow received from securitization trusts and from fees earned through servicing
of loans held by such trusts. The Company has operated on a negative operating
cash flow basis and expects to continue to do so in the near future. The Company
has historically funded these negative operating cash flows principally through
borrowings from financial institutions, sales of equity securities and sales of
senior and subordinated notes. The Company may require additional capital in the
future to fund continued negative cash flows, although there can be no assurance
that the Company will have access to capital markets in the future or that
financing will be available to satisfy the Company's operating and debt service
requirements or to fund its future growth. See "Capital Resources."
PRINCIPAL USES OF CASH IN OPERATING ACTIVITIES
PURCHASE AND FINANCING OF AUTOMOBILE LOANS. Automobile loan purchases
represent the Company's most significant cash flow requirement. The Company
funds the purchase price of loans primarily through the use of warehouse
facilities. However, because advance rates under the warehouse facilities
generally provide funds from 93% to 97% of the principal balance of the loans,
the Company is required to fund the remainder of all purchases prior to
securitization with other available cash resources. The Company purchased $1.2
billion of loans during the first six months of 1998 compared to $1.5 billion
during the same period in 1997.
DEALER PARTICIPATIONS. Consistent with industry practice, the Company pays
dealers participations for selling loans to the Company. These participations
typically require the Company to advance an up-front amount to dealers.
Participations paid by the Company to dealers during the six months ended June
30, 1998 were $32.7 million, or approximately 2.83% of the principal balance of
loans purchased, compared with $48.7 million, or approximately 3.20% of loans
purchased, during the same period in 1997. The decrease in dealer participations
as an aggregate amount and as a percentage of loans purchased reflects the
growth in volume in Classic loans, which are generally associated with lower
dealer participations.
SECURITIZATION OF AUTOMOBILE LOANS. In connection with securitizations,
the Company is required to fund spread accounts related to each transaction. The
Company funds these spread accounts by foregoing receipt of excess cash flow
until these spread accounts exceed predetermined levels. In addition, for
certain securitizations prior to the third quarter of 1997, the Company has been
required to provide initial cash deposits into the spread accounts. The Company
had $241.7 million of restricted cash in spread accounts at June 30, 1998,
compared with $250.3 million at December 31, 1997. The decrease in restricted
cash in spread accounts reflects the Company's continued securitization of loan
purchases and the related accumulation of excess cash flows to levels defined
within each securitization agreement, partially offset by the release of excess
cash flows. Additionally, cash in spread accounts was reduced by $25.0 million
during the second quarter of 1998 under an agreement between the Company and its
provider of asset-backed securities insurance which allowed the Company to
receive an early release from the spread accounts. See "LIQUIDITY-OTHER CAPITAL
RESOURCES" for additional discussion.
The Company also incurs certain expenses in connection with
securitizations, including underwriting fees, credit enhancement fees, trustee
fees and other costs, which approximate 0.5% of the principal amount of the
asset-backed securities sold in the securitizations.
ADVANCES DUE TO SERVICER. As the servicer of loans sold in
securitizations, the Company periodically
20
<PAGE>
makes interest advances to the securitization trusts to provide for temporary
delays in the receipt of required interest payments from borrowers. In
accordance with the relevant servicing agreements, the Company makes advances
only in the event it expects to recover such advances through payments from the
obligor over the life of the loan.
REPOSSESSED INVENTORY. At June 30, 1998, repossessed inventory managed or
owned by the Company and held for resale was $28.9 million, compared with $55.3
million at December 31, 1997. The rate of repossessed inventory turnover impacts
cash available for spread accounts under securitization trusts and,
consequently, the excess cash available for distribution to the Company. At June
30, 1998, repossessed inventory was 0.6% of the total servicing portfolio
compared with 1.1% at December 31, 1997. In June 1998, the Company decided to
discontinue liquidating its repossession inventory through retail disposition
channels and begin disposing of its repossessed vehicles exclusively through
wholesale auctions (see "CHANGES IN ACCOUNTING ESTIMATES AND NON-RECURRING
CHARGES"). Any improvement in excess cash flows due to an increase in the
inventory turnover rate may be partially reduced by lower recoveries realized
through the exclusive use of wholesale auctions and generally lower wholesale
used car prices.
INTEREST EXPENSE. Although the Company records net interest margin as
earned, a significant portion of the interest income component is generally
received in cash from excess cash flow, while the interest expense component
(primarily warehousing interest) is paid prior to securitization. The Company
also incurs interest expense related to both short-term and long-term debt
obligations.
PRINCIPAL SOURCES OF CASH IN OPERATING ACTIVITIES
EXCESS CASH FLOW. The Company receives excess cash flow from
securitization trusts, including the realization of gain on sale, the recovery
of dealer participations, and the recovery of accrued interest receivable
earned, but not yet collected, on loans held for sale prior to securitization.
Recovery of dealer participations and accrued interest receivable, which occur
throughout the life of the securitization, result in a reduction of the finance
income receivable but, because they have been considered in the original
determination of the gain on sale of loans, have no effect on the Company's
results of operations in the year in which the participations and interest are
recovered from the securitization trust. During the first six months of 1998,
the Company received $59.6 million of excess cash flow (which amount does not
include the $25 million released sooner than would otherwise have been the case
pursuant to an arrangement with the Company's provider of asset-backed
securities insurance - see "CAPITAL RESOURCES-OTHER CAPITAL RESOURCES"),
compared with $33.7 million during the same six months in 1997. Included in the
1998 cash released from spread accounts is $7.0 million of cash which is
restricted pursuant to an arrangement between the Company and its asset-backed
securities insurance provider.
SERVICING FEES. The Company receives servicing fees for servicing
securitized loans included in various securitization trusts. The servicing fee
for loans in securitization trusts is equal to one percent per annum of the
outstanding principal balance of the loans for all securitizations entered into
prior to September 1997 and 1.25 percent per annum on loans subsequently
securitized. The Company also receives collection fees, such as late payment
fees and insufficient fund charges, and interest on collection accounts earned
by the Company as servicer of the loans. During the six months ended June 30,
1998 and 1997, the Company received cash for such servicing in the amount of
$39.2 million and $27.5 million, respectively. Servicing fee income is reflected
in the Company's revenues as earned.
CAPITAL RESOURCES
The Company finances the acquisition of automobile loans primarily through
(i) warehouse facilities, pursuant to which loans are sold or financed generally
on a temporary basis, and (ii) the securitization of loans, pursuant to which
loans are sold as asset-backed securities. Additional financing is required to
fund the Company's operations.
WAREHOUSE FACILITIES. Automobile loans held for sale are funded primarily
through warehouse
21
<PAGE>
facilities. At June 30, 1998, the Company had three warehouse facilities in
place with various financial institutions and institutional lenders with an
aggregate capacity of $875.0 million, of which $821.0 million was available.
Based on anticipated loan purchasing volume during the next few quarters, the
Company decided to terminate one of its warehouse facilities with a capacity of
$175.0 million in July 1998, and eliminate the related commitment fees. The
remaining facilities expire in October 1998 and July 1999, subject to renewal or
extension at the lenders' option. Proceeds from securitizations, generally
received within seven to ten days following the cut-off date established for the
securitization transaction, are applied to repay amounts outstanding under
warehouse facilities.
SECURITIZATION PROGRAM. An important capital resource for the Company has
been its ability to sell automobile loans in the secondary markets through
securitizations. The following table summarizes the Company's securitization
transactions for the six months ended June 30, 1998, all of which were publicly
issued and rated "AAA/Aaa".
<TABLE>
<CAPTION>
REMAINING CURRENT
REMAINING BALANCE AS A CURRENT WEIGHTED GROSS
BALANCE AS PERCENTAGE WEIGHTED AVERAGE INTEREST
ORIGINAL OF JUNE 30, OF ORIGINAL AVERAGE SECURITIZATION RATE
DATE BALANCE 1998 BALANCE APR RATE SPREAD
- ---------------------- ------------ --------------- ---------------- ------------ ------------------ -------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
March 1998 $ 525,000 $ 492,057 93.73% 17.15% 5.93% 11.22%
June 1998 (1) 550,000 532,293 96.78% 17.26% 5.97% 11.29%
----------- -----------
$ 1,075,000 $ 1,024,350
----------- -----------
----------- -----------
</TABLE>
- --------------------
As of June 30, 1998, the Company had delivered $536.6 million of automobile
loans and $13.4 million of cash remained in the pre-funded portion of the
trust.
HEDGING STRATEGY
The Company enters into hedging transactions to manage its gross interest
rate spread on loans held for sale. The Company sells forward US Treasuries that
most closely parallel the average life of its portfolio of loans held for sale.
Hedging gains and losses are recognized as a component of the gain on sale of
loans on the date such loans are sold. To the extent hedging gains or losses are
significant, the resulting up-front cash payments or receipts may impact the
Company's liquidity. The Company receives the up-front gains or losses back over
time through a lower or higher spread, respectively, at the time of
securitization. During the first six months of 1998, the Company had net
realized losses on hedging transactions of $8.4 million. The Company had
unrealized losses on hedge contracts of $1.0 million that remain outstanding at
June 30, 1998.
OTHER CAPITAL RESOURCES
Historically, the Company has utilized various debt and equity financings
to offset negative operating cash flows and support its operations. No such
offerings were completed by the Company during the first six months of 1998.
In May 1998, the Company and its provider of asset-backed securities
insurance entered into an arrangement whereby the Company was allowed to receive
$25 million of cash from certain spread accounts sooner than it would have
absent such arrangement. The arrangement may be extended on an annual basis upon
mutual arrangement by and between the Company and its provider of asset-backed
securities insurance. The Company pays a monthly fee to its provider of
asset-backed securities
22
<PAGE>
insurance to maintain the arrangement. The $25 million will be replenished in
relevant spread accounts by means of a $3 million reduction in the level of
monthly cash releases from the spread accounts. Beginning in May 1999, unless
the terms of the arrangement are extended.
23
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this amendment to its
Quarterly Report on Form 10-Q be signed on its behalf by the undersigned,
thereunto duly authorized.
ARCADIA FINANCIAL LTD.
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
--------- ----- ----
<S> <C> <C>
/s/ Richard A. Greenawalt President, Chief Executive Officer, and Director March 23, 1999
- -------------------------------
Richard A. Greenawalt
/s/ John A. Witham Executive Vice President and Chief Financial Officer March 23, 1999
- ------------------------------- (Principal Financial Officer)
John A. Witham
/s/ Brian S. Anderson Senior Vice President, Corporate Controller and March 23, 1999
- ------------------------------- Assistant Secretary (Principal Accounting Officer)
Brian S. Anderson
</TABLE>
24
