U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q/A
Amendment No. 1 to
FORM 10-Q
(Mark One)
[X] Quarterly report under Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended September 30, 1996
------------------
[ ] Transition report under Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from ______________ to _____________
Commission file number 0-22600
----------
EMPLOYEE SOLUTIONS, INC.
------------------------
(Exact Name of Registrant as Specified in Its Charter)
Arizona 86-0676898
- ------------------------------- ------------------------------------
(State or Other Jurisdiction of (I.R.S. Employer identification No.)
Incorporation or Organization)
2929 E. Camelback Road, Suite 220, Phoenix, Arizona 85016
- -------------------------------------------------------------------------------
(Address of Principal Executive Offices)
602-955-5556
- -------------------------------------------------------------------------------
(Registrant's Telephone Number, Including Area Code)
- -------------------------------------------------------------------------------
(Former Name, Former Address and Former Fiscal Year,
if Changed Since Last Report)
Indicate by check mark whether the registrant: (1) 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
----- -----
APPLICABLE ONLY TO ISSUERS INVOLVED IN
BANKRUPTCY PROCEEDINGS DURING THE
PRECEDING FIVE YEARS
Indicate by check mark whether the registrant has filed all documents
and reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 after the distribution of securities under a plan confirmed
by a court.
Yes No
APPLICABLE ONLY TO CORPORATE ISSUERS
State the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date: 30,550,894 Common
Shares, no par value, were outstanding as of November 12, 1996.
1
<PAGE>
The Company is filing this amendment to its Report on Form 10-Q for the
period ended September 30, 1996 to correct the following typographical errors:
-- Brackets have been placed around the number $6,321
appearing in the Consolidated Statements of Cash Flows for the nine months ended
September 30, 1996.
-- Brackets have been placed around the number $13,480
appearing in the Consolidated Statements of Cash Flows for the nine months ended
September 30, 1996.
-- In the second line of the table appearing in Note 6 of the
Notes to the Consolidated Financial Statements, the line item "net loss" has
been corrected to read "net income(loss)."
-- In the third and fourth paragraphs under the heading
'Liquidity and Capital Resources' in the section titled "Management's Discussion
and Analysis of Financial Condition and Results of Operations," the amount of
cash equivalents and the amounts of cash on deposit at Camelback at September
30, 1996 has been corrected to agree with the balance sheet.
In addition, the discussion in the second paragraph of 'Liquidity and
Capital Resources' has been expanded to reference cash flows from financing
activities relating to borrowings under the Company's credit facility.
2
<PAGE>
EMPLOYEE SOLUTIONS, INC.
FORM 10-Q/A
Amendment No. 1 to
FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1996
INDEX
<TABLE>
<CAPTION>
Page
Number
------
<S> <C>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets - September 30, 1996 and
December 31, 1995. 4
Consolidated Statements of Operations for the
Three Months and Nine Months Ended September 30, 1996 and 1995. 5
Consolidated Statement of Changes in Stockholders'
Equity for the Nine Months Ended September 30, 1996. 6
Consolidated Statements of Cash Flows for the
Nine Months Ended September 30, 1996 and 1995. 7
Notes to Consolidated Financial Statements. 9
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations. 13
</TABLE>
SIGNATURES
3
<PAGE>
EMPLOYEE SOLUTIONS, INC.
CONSOLIDATED BALANCE SHEETS
($ in thousands except share data)
<TABLE>
<CAPTION>
September 30, 1996 December 31,1995
------------------ ----------------
ASSETS
<S> <C> <C>
Current Assets:
Cash and cash equivalents .................................... $ 12,088 $ 14,029
Restricted cash .............................................. 9,000 2,743
Accounts receivable, net ..................................... 35,939 7,845
Notes receivable, including related parties .................. 458 107
Prepaid expenses and deposit ................................. 1,422 379
Deferred income taxes ........................................ 360 334
-------- --------
Total Current Assets .................................. 59,267 25,437
Property and equipment, net ........................................... 1,047 440
Other assets, net ..................................................... 44,661 10,963
-------- --------
Total Assets ............................................. $104,975 $ 36,840
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Bank overdraft ............................................... $ 1,168 $ 3,752
Accrued salaries, wages and payroll taxes .................... 18,767 6,681
Accrued workers' compensation and health insurance ........... 3,132 2,463
Accrued pension contributions ................................ 1,480 131
Accounts payable ............................................. 1,697 983
Income taxes payable ......................................... 414 2,207
Other accrued expenses ....................................... 3,204 631
-------- --------
Total Current Liabilities ............................. 29,862 16,848
-------- --------
Deferred income taxes ................................................. 52 49
Revolving line of credit .............................................. 33,300 --
-------- --------
Commitments and Contingencies
Stockholders' Equity:
Class A convertible preferred stock, non-voting, no par value,
10,000,000 shares authorized,
none issued and outstanding ................................ -- --
Common stock, no par value, 75,000,000 shares authorized,
and 30,550,894 shares issued and outstanding in 1996,
26,747,196 shares issued and 26,652,272 shares
outstanding in 1995 ........................................ 27,710 15,938
Retained earnings ............................................ 14,051 4,336
Treasury stock, no shares of common stock in 1996 and
94,924 shares in 1995, at cost ............................. -- (331)
-------- --------
Total Stockholders' Equity ................................... 41,761 19,943
-------- --------
Total Liabilities and Stockholders' Equity ................... $104,975 $ 36,840
======== ========
</TABLE>
The accompanying notes are an integral part of these
consolidated balance sheets.
4
<PAGE>
EMPLOYEE SOLUTIONS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
($ in thousands except share data)
<TABLE>
<CAPTION>
Three Months Ended September 30, Nine Months Ended September 30,
-------------------------------- --------------------------------
1996 1995 1996 1995
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Revenues ...................................... $ 125,238 $ 33,436 $ 290,180 $ 91,395
Cost of revenues .............................. 112,864 29,809 261,310 83,308
------------ ------------ ------------ ------------
Gross profit .................................. 12,374 3,627 28,870 8,087
Selling, general and administrative expenses .. 5,706 1,442 12,681 4,143
Depreciation and amortization ................. 562 84 1,216 229
------------ ------------ ------------ ------------
Income from operations ................... 6,106 2,101 14,973 3,715
------------ ------------ ------------ ------------
Other income (expenses):
Interest income ....................... 220 72 630 150
Interest expense ...................... (399) (8) (406) (14)
Minority interest ..................... -- 45 -- 169
------------ ------------ ------------ ------------
(179) 109 224 305
------------ ------------ ------------ ------------
Income before
provision for income taxes ............ 5,927 2,210 15,197 4,020
Income tax provision .......................... 1,681 1,005 5,482 1,814
------------ ------------ ------------ ------------
Net income ............................... $ 4,246 $ 1,205 $ 9,715 $ 2,206
============ ============ ============ ============
Net income per common
and common equivalent shares outstanding:
-Primary ............................ $ .13 $ .05 $ .30 $ .08
-Fully diluted ...................... $ .13 $ .05 $ .30 $ .08
Weighted average number of common
and common equivalent shares outstanding:
-Primary ............................. 33,020,742 26,226,280 32,446,593 26,173,880
-Fully diluted ....................... 33,043,173 26,226,280 32,817,451 26,173,880
============ ============ ============ ============
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
5
<PAGE>
EMPLOYEE SOLUTIONS, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1996
($ in thousands except share data)
<TABLE>
<CAPTION>
Total
Preferred Common Retained Treasury Stockholders'
Stock Stock Earnings Stock Equity
-------- -------- -------- -------- -------------
<S> <C> <C> <C> <C> <C>
BALANCE at December 31, 1995 ............. $ -- $ 15,938 $ 4,336 $ (331) $ 19,943
Issuance of 434,622 shares of common stock
in connection with exercise of
stock options ............................ -- 1,976 -- -- 1,976
Issuance of 2,816,000 shares of common stock
in connection with exercise of warrants... -- 6,547 -- -- 6,547
Issuance of 648,000 shares in connection
with acquisition of Employee
Solutions-East, Inc. ..................... -- 3,580 -- -- 3,580
Cancellation of treasury stock ........... -- (331) -- 331 --
Net income ............................... -- -- 9,715 -- 9,715
-------- -------- -------- -------- --------
BALANCE at September 30, 1996 ............ $ -- $ 27,710 $ 14,051 $ -- $ 41,761
======== ======== ======== ======== ========
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
6
<PAGE>
EMPLOYEE SOLUTIONS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
($ in thousands)
(UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS ENDED SEPTEMBER 30,
1996 1995
---- ----
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Cash received from customers..................................... $ 262,428 $ 87,614
Cash paid to suppliers and employees............................. ( 259,319) (84,083)
Interest received................................................ 462 161
Interest paid.................................................... ( 19) (8)
Income taxes paid, net of refunds................................ ( 7,317) (1,078)
--------------- ---------
Net cash provided by (used in) by operating activities....... ( 3,765) 2,606
--------------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment............................... ( 700) (158)
Business acquisitions............................................ ( 27,691) --
Customer list.................................................... -- (141)
Cash invested in restricted accounts............................. ( 6,258) (1,351)
Disbursements for loans to related parties....................... ( 100) --
Received from collection of loans to related parties............. 13 212
Decrease (increase) in deferred acquisition and
deferred startup costs........................................... ( 95) (133)
--------------- ---------
Net cash used in investing activities........................ ( 34,831) (1,571)
--------------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from sale of stock...................................... 7,411 202
Cash overdraft................................................... ( 4,189) --
Increase in borrowings, net...................................... 33,473 --
Proceeds from paid in capital.................................... -- --
Increase in deferred offering and registration costs............. ( 40) (48)
--------------- ---------
Net cash provided by (used in) financing activities.......... 36,655 154
--------------- ---------
Net increase (decrease) in cash and cash equivalents.................. ( 1,941) 1,189
CASH AND CASH EQUIVALENTS, beginning of period........................ 14,029 1,947
--------------- ---------
CASH AND CASH EQUIVALENTS, end of period.............................. 12,088 $ 3,136
--------------- ---------
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
7
<PAGE>
EMPLOYEE SOLUTIONS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS--(Continued)
($ in thousands)
<TABLE>
<CAPTION>
NINE MONTHS ENDED SEPTEMBER 30,
1996 1995
---- ----
<S> <C> <C>
RECONCILIATION OF NET INCOME
TO NET CASH PROVIDED BY OPERATING ACTIVITIES:
Net income................................................... $ 9,715 $ 2,206
--------------- ------------
ADJUSTMENTS TO RECONCILE NET
INCOME TO NET CASH USED IN OPERATING ACTIVITIES:
Depreciation and amortization.................................... 1,216 229
Minority interest................................................ -- (169)
Write off of deferred acquisition costs.......................... -- 3
Increase in accounts receivable, net............................. ( 24,145) (3,781)
Increase in prepaid expenses and deposits........................ ( 843) 27
Decrease (increase) in deferred income tax assets................ 149 (449)
Increase in other assets......................................... ( 5) (45)
(Decrease) increase in accounts payable.......................... ( 6,321) 73
(Decrease) increase in accrued pension contributions............. 1,417 (47)
Increase in accrued salaries, wages and payroll taxes............ 13,452 1,929
(Decrease) increase in income taxes payable...................... ( 1,978) 1,205
Increase in accrued workers'
compensation and health insurance............................. 2,306 1,012
Increase in other accrued expenses............................... 1,278 431
Decrease in deferred income
tax liabilities.................................................. ( 6) (18)
--------------- ------------
( 13,480) 400
---------------- ------------
Net cash (used in) provided by operating activities.............. $( 3,765) $ 2,606
================ ===========
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
8
<PAGE>
EMPLOYEE SOLUTIONS, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 1996
NOTE 1: BASIS OF PRESENTATION
---------------------
The accompanying unaudited consolidated financial statements of Employee
Solutions, Inc. (together with its subsidiaries, the "Company") have been
prepared by the Company pursuant to the rules and regulations of the Securities
and Exchange Commission. Certain information and footnote disclosures normally
included in consolidated financial statements prepared in accordance with
generally accepted accounting principles have been omitted pursuant to such
rules and regulations. In the opinion of management the consolidated financial
statements include all adjustments, consisting only of normal recurring
adjustments, necessary in order to make the consolidated financial statements
not misleading. Results of operations for the nine month period ended September
30, 1996 are not necessarily indicative of the results that may be expected for
the year ending December 31, 1996. For further information, refer to the
consolidated financial statements and footnotes thereto included in the
Company's Form 10-K for the year ended December 31, 1995.
NOTE 2: NET INCOME PER SHARE
--------------------
The Company used the modified treasury stock method prescribed by Accounting
Principles Board Opinion No. 15 to compute net income per share for the three
month and nine month periods ended September 30, 1995 since the number of
warrants and options outstanding was in excess of 20% of common shares issued
and outstanding. The Company used the treasury stock method for the three and
nine month periods ended September 30, 1996 since the number of warrants and
options outstanding was less than 20% of common shares issued and outstanding.
The computation of adjusted net income and weighted average common and common
equivalent shares used in the calculation of net income per common and common
equivalent share is as follows (amounts in thousands except per share data):
<TABLE>
<CAPTION>
Three Months Ended September 30, Nine Months Ended September 30,
-------------------------------- -------------------------------
1996 1995 1996 1995
---- ---- ---- ----
Fully Fully Fully Fully
Primary Diluted Primary Diluted Primary Diluted Primary Diluted
------- ------- ------- ------- ------- ------- ------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Weighted
average
of common
shares
outstanding 30,515 30,515 20,818 20,818 30,290 30,290 20,766 20,766
Dilutive effect of
shares issued in
connection with
business
combinations N/A N/A 415 415 N/A N/A 415 415
Dilutive
effect of
options and
warrants
outstanding 2,506 2,528 4,993 4,993 2,157 2,527 4,993 4,993
------ ------ ------ ------ ------ ------ ------ ------
Weighted average
of common and
common
equivalent
shares 33,021 33,043 26,226 26,226 32,447 32,817 26,174 26,174
====== ====== ====== ====== ====== ====== ====== ======
</TABLE>
9
<PAGE>
<TABLE>
<CAPTION>
Three Months Ended September 30, Nine Months Ended September 30,
-------------------------------- -------------------------------
1996 1995 1996 1995
---- ---- ---- ----
Primary Fully Primary Fully Primary Fully Primary Fully
------- ----- ------- ----- ------- ----- ------- -----
Diluted Diluted Diluted Diluted
------- ------- ------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Net income $ 4,246 $ 4,246 $ 1,205 $ 1,205 $ 9,715 $ 9,715 $ 2,206 $ 2,206
Adjustment
to net
income (8) (8) 40 12 (20) (20) 233 51
------- ------- ------- ------- ------- ------- ------- -------
Adjusted net
income for
purposes of the
common and
common
equivalent
shares
calculation $ 4,238 $ 4,238 $ 1,245 $ 1,217 $ 9,695 $ 9,695 $ 2,439 $ 2,257
======= ======= ======= ======= ======= ======= ======= =======
Net income
per
common and
common
equivalent
share $ .13 $ .13 $ .05 $ .05 $ .30 $ .30 $ .08 $ .08
======= ======= ======= ======= ======= ======= ======= =======
</TABLE>
As of September 30, 1996, the Company had approximately 120,000 common stock
purchase warrants and 3,328,646 stock options outstanding.
NOTE 3: LONG-TERM DEBT
--------------
On August 1, 1996, the Company entered into a three year $35 million revolving
credit facility for the purposes of acquisition financing, working capital and
general corporate purposes. The revolving credit facility provides for various
borrowing rate options including borrowing rates based on a fixed spread of .25%
over prime or 250 basis points over the London Interbank Offered Rate (LIBOR).
The Company pays a commitment fee of 3/8% on the unused portion of the line.
Total costs incurred in obtaining this facility were approximately $400,000 and
will be amortized over the life of the facility. The line matures on August 1,
1999 and the maximum borrowing decreases $1.5 million per quarter beginning
February 1, 1998. The principal loan covenants are as follows as defined in the
Agreement: current ratio of at least 1.4 to 1; total liabilities to net worth of
not more than 2 to 1; total funded debt to earnings before taxes, depreciation
and amortization of 2 to 1. The facility includes certain other covenants and is
secured by substantially all of the Company's assets.
The Company borrowed approximately $23.5 million under the revolving credit
facility on August 1, 1996 to finance its acquisition of Leaseway. As of
September 30, 1996 $33.3 million was outstanding under the line. In October,
1996, the Company increased the line of credit by $10.0 million to $45.0 million
in anticipation of additional acquisition financing. Costs related to such
increase were approximately $100,000 and will be amortized over the remaining
life of the facility.
NOTE 4: COMMON STOCK SPLITS
-------------------
On December 18, 1995 and June 26, 1996, the Board of Directors authorized
two-for-one common stock splits, effected in the form of a 100% stock dividend,
effective on January 16, 1996 and July 26, 1996 respectively, to shareholders of
record at the close of business on January 2, 1996 and July 12, 1996. In this
report, all per share amounts and numbers of shares, including options and
warrants, have been restated to reflect the stock splits.
10
<PAGE>
NOTE 5: ACQUISITION OF LEASEWAY PERSONNEL CORPORATION AND LEASEWAY
-----------------------------------------------------------------------
ADMINISTRATIVE PERSONNEL, INC.
------------------------------
The Company completed the acquisition of the principal assets of Leaseway
Personnel Corporation. and Leaseway Administrative Personnel, Inc.
(collectively, "Leaseway") effective August 1, 1996 for approximately $24
million in cash, plus deferred acquisition costs of approximately $150,000. The
Company acquired the assets of Leaseway through Logistics Personnel Corp.
("LPC") (formerly, Employee Solutions of Florida, Inc.) a wholly owned
subsidiary. LPC is an employee leasing company providing permanent and temporary
private carriage truck drivers, as well as non-driver employees, including
warehouse workers, mechanics, dispatchers, and administrative personnel to
approximately 180 clients in 41 states.
NOTE 6: UNAUDITED PRO FORMA FINANCIAL INFORMATION
-----------------------------------------
The following unaudited pro forma combined financial data give effect to the
combined historical results of operations of the Company, ESI America, Team
Services and Leaseway for the nine months ended September 30, 1996 and 1995, and
assumes that the acquisitions had been effective as of the beginning of the
periods.
The pro forma information is not indicative of the actual results which would
have occurred had the acquisitions been consummated at the beginning of such
periods or of future consolidated operations of the Company and accordingly,
does not reflect results that would occur from a change in management and
planned restructuring of the operations of the acquired companies. The pro forma
financial information is based on the purchase method of accounting and reflects
adjustments to eliminate nonrecurring general, administrative and other
expenses, to amortize the excess purchase price over the underlying value of net
assets acquired and to adjust income taxes for the pro forma adjustments.
($ in thousands except share data)
<TABLE>
<CAPTION>
Nine Months Ended Nine Months Ended
September 30, 1996 September 30, 1995
------------------ ------------------
<S> <C> <C>
Total revenues $373,450 $300,253
Net income (loss) 10,446 (136)
Net loss per common and common
equivalent share
-Primary $ .32 ($ .01)
-Fully diluted $ .32 ($ .01)
Weighted average number of common and
common equivalent shares outstanding
-Primary 32,446,593 26,173,880
-Fully diluted 32,817,451 26,173,880
</TABLE>
NOTE 7: CONTINGENCIES
-------------
The Company has received a letter from the Arizona Department of Economic
Security indicating that the Company has been assigned a higher state
unemployment tax rate for calendar year 1994. In consultation with legal counsel
the Company believes that based on Arizona Revised Statutes it is entitled to
the lower rate. If it is ultimately determined that the higher rate applies, the
Company would owe $500,000 (before interest and the income tax effect) more than
11
<PAGE>
is reflected in the Company's September 30, 1996 and December 31, 1995,
financial statements. As of September 30, 1996, the compounded interest totaled
approximately $125,000.
The Company was named as a defendant in a lawsuit filed by M & M Building
Services, Inc. in the Superior Court of Arizona, Maricopa County, in March 1996
challenging the manner in which the Company billed plaintiff for payroll taxes.
The complaint alleges improper billing practices and other causes of action and
seeks unspecified damages. The suit purports to be brought as a class action,
although no class action certification has yet been sought. The Company intends
to defend the matter vigorously.
With the exception of the foregoing action, the Company is not a party to any
material pending legal proceedings other than ordinary routine litigation
incidental to its business that the Company believes would not have a material
adverse effect on its financial condition or results of operations.
The Company received payroll tax penalty notices from the Internal Revenue
Service and various states, relating to the acquired operations of Hazar
alleging certain late payment of payroll taxes. The penalties proposed to be
assessed against the Company total approximately $572,000, and the penalties to
be assessed against Hazar, its predessessor total approximately $390,000 for the
period during which the Company performed designated manatement services on
behalf of the predessessor.
The Company believes that it has defenses to these actions, and has objected
vigorously to payment of such past taxes and penalties. However, it is not
possible to predict if the Company will be successful in abating these taxes and
penalties, or other unanticipated claims which could arise in the future. The
Company would be required to record these amounts as an additional expense and
liability if, at any time in the future, it became apparent that it was probable
that the Company would not prevail in these matters.
NOTE 8: SUBSEQUENT EVENTS
-----------------
Acquisition of McClary-Trapp Companies
The Company completed the acquisition of the principal assets of the
McClary-Trapp Companies effective November 1, 1996 for approximately $9.6
million in cash and $1.1 million in unregistered shares of the Company's common
shares for a total purchase price of $10.7 million, plus deferred acquisition
costs. The Company's unregistered common shares were valued at the average
closing price on the NASDAQ National Market for October 1996 and have certain
registration rights. McClary-Trapp Companies lease approximately 2,000 employees
to a client base consisting primarily of light industrial, transportation and
service companies.
NOTE 9: NEW ACCOUNTING PRONOUNCEMENTS
-----------------------------
Statement of Financial Accounting Standards No. 123, Accounting for Stock Based
Compensation (SFAS 123), is required to be adopted by the Company in fiscal
1996. Pursuant to the provisions of SFAS 123, the Company will continue to
account for transactions with its employees pursuant to Accounting Principles
Board Opinion No. 25, Accounting for Stock Issued to Employees. Therefore, this
statement will not have a material effect on the Company's financial position or
its results of operations when adopted. However, SFAS 123 will require the
Company to disclose what earnings per share and net income would have been had
the effects of SFAS 123 been presented in the statement of operations.
Management has not calculated the pro forma effects, but expects that the pro
forma disclosures will be materially lower than reported net income and earnings
per share.
12
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
-------------------------------------------------
CONDITION AND RESULTS OF OPERATIONS
-----------------------------------
The following discussion should be read in conjunction with, and is
qualified in its entirety by, the Company's Consolidated Financial Statements
and the Notes thereto appearing elsewhere herein and in the Company's Report on
Form 10-K for the year ended December 31, 1995. Historical results are not
necessarily indicative of trends in operating results for any future period.
Except for the historical information contained herein, the discussion in
this Form 10-Q contains or may contain forward-looking statements that involve
risks and uncertainties. The Company's actual results could differ materially
from those discussed here. Factors that could cause or contribute to such
differences include, but are not limited to, those discussed in "Item 1 --
Business" and "Item 7--Management's Discussion and Analysis of Financial
Condition and Results of Operations" of the Company's Form 10-K for the year
ended December 31, 1995 as well as those factors discussed elsewhere herein or
in any document incorporated herein by reference.
Results of Operations--Three Months Ended September 30, 1996 Compared to Three
Months Ended September 30, 1995.
($ in thousands)
Percent
1996 Change 1995
---- ------- ----
Revenues $ 125,238 275% $ 33,436
Cost of revenues 112,864 279% 29,809
Gross profit 12,374 241% 3,627
Selling, general and administrative 5,706 295% 1,442
Depreciation and amortization 562 569% 84
Interest income (expense), net (179) (375)% 64
Net income 4,246 252% 1,205
Net income for the three months ended September 30, 1996 was $4.2 million
or $0.13 per fully diluted share, reflecting significant growth from third
quarter 1995 net income of $1.2 million or $0.05 per fully diluted share.
Revenues of $125.2 million for the three months ended September 30, 1996 were
275% higher than the same period in 1995. The growth results from the
integration of several acquisitions including Hazar, Inc. and certain of its
subsidiaries ("Hazar"), Pokagon Office Services, Inc., Employer Sources, Inc.,
Ashlin Transportation Services, Inc., TEAM Services, and Leaseway Personnel
Corp.; the growth in the Company's risk management/workers' compensation
program; the success of direct sales and marketing efforts of Employee
Solutions-East, Inc. ("ESEI"), and the efficient administration of existing
business.
Revenues
Revenues increased from $33.4 million for the three months ended September
30, 1995 to $125.2 million for the three months ended September 30, 1996, a 275%
increase. The increase in revenues was partially due to sales from the Company's
expanded sales force through ESEI. Acquisitions occurring after the quarter
ended September 30, 1995 accounted for a significant increase in revenues
between the periods. The number of leased employees increased from approximately
5,650 at September 30, 1995 to approximately 28,000 at September 30, 1996. In
1995, the Company commenced placing risk management/workers' compensation
services to clients which are not employee-leasing clients of the Company. As of
September 30, 1996, the Company provided
13
<PAGE>
risk management/workers' compensation services to approximately 17,000
non-leased employees compared to 9,600 at September 30, 1995 (of which 4,000
were employees of Hazar, Inc. and 1,600 were employees of Employer Sources,
Inc.). The significant components of revenues are payments received from
customers for gross salaries and wages paid to leased employees and the
Company's service fee which includes, but is not limited to, related payroll
charges, risk management/workers' compensation services, health care benefits,
and retirement benefits, as well as payments received from stand-alone risk
management/workers' compensation clients.
Cost of Revenues
Cost of revenues, which primarily includes salaries and wages paid to
leased employees, related payroll taxes, health care and workers' compensation
insurance costs and retirement benefit costs, increased 279% from $29.8 million
in the three months ended September 30, 1995 to $112.9 million in the three
months ended September 30, 1996. This increase is primarily due to the increase
in the Company's business as explained in the paragraph above.
Gross Profit
The Company's gross profit margin decreased from 10.8% in the three months
ended September 30, 1995 to 9.9% in the three months ended September 30, 1996.
This decrease primarily was attributable to the conversion of approximately
4,000 Hazar employees into employee leasing from stand-alone risk
management/workers' compensation on October 2, 1995, the effective date of the
Company's acquisition of such assets, partially offset by improved results in
workers' compensation. Gross profit margin on revenues derived from risk
management/workers' compensation services provided to non-leased employees tends
to be significantly higher than gross profit margin on revenues derived from the
Company's employee leasing clients because the gross profit margin calculation
with respect to employee leasing clients includes significant (and substantially
offsetting) revenue and expense items relating to payroll and payroll-related
costs associated with the leased employees. Accordingly, the margin is affected
in significant part by the mix of revenues derived from employee leasing clients
and clients for which the Company provides only risk management/workers'
compensation services.
Workers' compensation costs decreased on a per leased employee basis during
the three months ended September 30, 1996 compared to 1995 due to the Company's
ability to execute effectively its risk management programs which include
on-site safety programs, active claims management, application of managed care
techniques, and efficient execution of claims processing overall. Workers'
compensation expense did not increase significantly during the quarter ended
September 30, 1996 compared to the quarter ended June 30, 1996. Accordingly,
workers' compensation reserves did not change materially at September 30, 1996
compared to reserve levels at June 30, 1996. During the quarter ended September
30, 1996, the Company substantially completed the integration into the Company's
risk management/workers' compensation system of certain recently-acquired
companies. The integration generally resulted in a reduction in the number of
claims arising from these acquired operations. The Company also has increased
the number of claims managers in the field to 34, (of which 15 came to the
Company through the Leaseway acquisition), at September 30, 1996 compared to 16
at June 30, 1996 and three at September 30, 1995. The average number of active
claims handled by the 19 non-Leaseway claims managers at September 30, 1996 was
approximately 20, compared to an average of approximately 30 for the 16 active
claims managers at June 30, 1996. The Company believes that a continuous focus
on maintaining this low ratio of cases per field manager is a significant factor
in controlling workers' compensation expense. In this regard, the Company
continues to implement a policy whereby the maximum number of active claims for
which each claims manager will be responsible is 50. Based on industry data, the
Company believes that this maximum is significantly less than the industry
average. The level of gross profit margin reported for the three months ended
September 30, 1996 may not be sustainable in future periods.
Selling, General and Administration
Selling, general and administrative expenses increased by $4.3 million or
295% from $1.4 million for the three months ended September 30, 1995 to $5.7
million for the three months ended September 30, 1996. As a percent of gross
profit, selling, general and administrative expenses increased from 40% to 46%
during the three-month periods ended September 30, 1995 and 1996, respectively.
Factors contributing to the increase in selling, general and administrative
expenses in the third quarter 1996 over 1995 are the integration of the
operations of various acquisitions including, the acquisition by the Company of
the remaining 99% interest in ESEI effective January 1, 1996, an increase from
57 corporate employees at September 30, 1995 to approximately 190 at September
30, 1996,
14
<PAGE>
resulting in a significant increase in personnel costs, and the expansion of the
Company's office space. Additionally, the Company results reflected a full
quarter of expense for Team Services and two months of expenses for Leaseway
Personnel, both recent acquisitions which historically have maintained a higher
ratio of selling, general and administrative expense to gross profit than the
Company. These factors which caused increases in selling, general and
administrative expense were partially mitigated by improved systems utilization
and economies of scale achieved within the Company's operations, including
consolidation of certain acquired companies' administration. The Company's
general liability insurance costs have increased due in part to the added
corporate staff and increased costs for directors' and officers' liability
insurance. Commission expenses increased in the three month period ended
September 30, 1996 compared to 1995 due to the increase in revenues discussed
above. Selling, general and administrative expenses are expected to continue to
increase to meet the needs of new business. The most extensive growth in
selling, general and administrative expenses has been in the area of risk
management/workers' compensation services. This trend is expected to continue
into the foreseeable future.
Depreciation and Amortization
Depreciation and amortization represented depreciation of property and
equipment and amortization of organizational costs, customer lists and goodwill
in the three months ended September 30, 1996 and 1995. The increase was due
primarily to depreciation of new phone and computer systems and goodwill
amortization resulting from acquisitions, with Hazar and Leaseway Personnel
Corp. being the most significant.
Interest
Interest income increased from $72,622 for the three months ended September
30, 1995 to $219,044 for the three months ended September 30, 1996, primarily
due to interest earned on both the restricted cash held for the future payment
of workers' compensation claims at Camelback and cash held at the corporate
level raised through the exercise of common stock purchase warrants and through
operations. Interest expense increased from $7,876 for the three months ended
September 30, 1995 to $398,500 for the three months ended September 30, 1996,
primarily due to interest accrued on the Company's revolving line of credit
which was first utilized in August 1996. The line had an average outstanding
balance of $29.5 million for August and September 1996. The Company anticipates
its interest expense will significantly increase in future periods due to
amounts borrowed under its new revolving credit facility. See, "Liquidity and
Capital Resources."
Effective Tax Rate
The Company's effective tax rate provides for federal, state and local
income taxes. The effective tax rate for fiscal 1996 is now estimated to be
36.1% as compared to an estimate of 41.0% used by the Company for the six months
ended June 30, 1996. The effective tax rate for the three months ended September
30, 1996 was 28.4%. This downward revision is intended to compensate for the
Company's revised estimate of its fiscal 1996 effective tax rate and reflects a
reduction resulting from the increased operations of the Company's wholly-owned
subsidiary, Camelback Insurance, Ltd. which is not subject to state income tax
because it is subject to state premium tax. While the Company's effective tax
rate will vary from time to time depending on the mix of profits derived from
Camelback and the Company's various other profit centers and other factors, the
Company believes that the downward revision in the rate applicable to profits
derived from Camelback will be continuing. The Company's estimated effective tax
rate for financial reporting purposes for 1996 is also based on estimates of the
following items that are not deductible for tax purposes:(a) amortization of
certain goodwill, and (b) one-half of the per diem allowance relating to meals
paid to truck drivers. The tax rate used in each quarter is generally an
estimate of the Company's effective tax rate for the calendar year. Part of the
estimated decrease in the effective tax rate in 1996 over 1995 results from
expected decreases in the proportion of non-deductible goodwill to income before
taxes and efforts by the Company to relieve itself of the tax burden of per
diem allowances.
Results of Operations -- Nine Months Ended September 30, 1996 Compared With the
Nine Months Ended September 30, 1995
Revenues increased from $91.4 million in 1995 to $290.2 million in 1996.
The increase in revenues was primarily due to the increased number of leased
employees, the acquisition of various companies as described above and the
revenue generated from non-leasing clients which the Company provides risk
management/workers' compensation services to their employees.
15
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Cost of revenues increased from $83.3 million in 1995 to $261.3 million in
1996. This increase was primarily due to the factors described in the paragraph
above.
The Company's gross profit margin increased from 8.8% in the nine months
ended September 30, 1995 to 9.9% in the nine months ended September 30, 1996.
This increase was attributable to the growth in the Company's risk
management/workers' compensation program, slightly offset by the Company's
higher Arizona unemployment tax rate. The level of gross profit margin reported
for the nine months ended September 30, 1996 may not be sustainable in future
periods. The margin is affected in significant part by the mix of revenues
derived from employee leasing clients and clients for which the Company provides
only risk management/workers' compensation services.
General and administrative expenses increased by $8.6 million from $4.1
million in 1995 to $12.7 million in 1996. The increase primarily is due to
acquisition activity and the factors enumerated in the sections above comparing
the quarters ended September 30, 1995 and 1996.
Depreciation and amortization represented depreciation of property and
equipment and amortization of organizational costs, customer lists and goodwill
in the nine months ended September 30, 1996 and 1995. The increase was due
primarily to depreciation of new phone and new computer systems and goodwill
amortization resulting from acquisitions, with Hazar and Leaseway Personnel
Corp. being the most significant.
Liquidity and Capital Resources
The Company defines liquidity as the ability to mobilize cash to meet
operational, capital and acquisition financing needs. The Company's primary
sources of cash have been from operations and financing activities. In the nine
month periods ended September 30, 1996 and 1995, cash provided by (used in)
operating activities was ($3.8) million and $2.6 million, respectively.
Operating cash flows are derived from customers for leasing services rendered by
the Company and for risk management/workers' compensation services provided to
non-leased employees. Payments from leasing customers typically are received on
or within a few days of the date on which payroll checks are delivered to
customers, and cover the cost of the payroll, payroll taxes, insurance, other
benefit costs and the Company's administration fee. The acquisition of Team
Services and Leaseway Personnel Corporation have impacted operating cash flows
as both companies extend credit terms as is customary in their market segments.
Cash flows from operations were impacted significantly by the working capital
needs of recently acquired Team Services and Leaseway. Specifically, for the
nine months ended September 30, 1996, Team Services and Leaseway used
approximately $7.0 million of cash from operations. Risk management/workers'
compensation services are billed in accordance with individual policies. Also,
as the Company continues to enter into new market segments, as with Team
Services and Leaseway, working capital needs are expected to increase because of
customary credit terms extended to customers. The revenues of risk
management/workers' compensation services are expected to cover the costs of
insured losses and selling, general and administrative expenses related to these
programs, though no assurance of such can be provided. Certain stand-alone
workers' comensation contracts contain payment terms where the minimum required
pay-in amount is less than the expected premium.
In the nine month periods ended September 30, 1996 and 1995, cash provided
by (used in) financing activities was $36.7 million and $154,000, respectively.
Cash flows from financing activities during the nine months ended September 30,
1996 resulted primarily from borrowings under the revolving line of credit and
the sale of the Company's Common Stock upon exercise of warrants and options
offset by cash used to fund bank overdrafts of acquired companies. Cash raised
from financing activities will be directed by management to meet the increasing
reserve and capital requirements of Camelback, to finance future acquisitions
subject to identification of suitable candidates, and for general corporate
purposes.
At September 30, 1996 and December 31, 1995, the Company had cash and cash
equivalents of $12.1 million and $14 million, respectively. Cash and cash
equivalents are invested in high investment grade instruments with maturities of
less than 90 days. Certain amounts of restricted cash (see below) may have
maturities beyond 90 days but are highly liquid. Restricted cash represents the
cash reserves set aside by the Company in a trust account for payment of future
workers' compensation losses. Trust fund balances are set based on a negotiated
amount between Reliance (see discussion of Reliance below) and the Company.
Other than for payment of losses, the Company cannot access the trust fund
without the agreement of Reliance. The Legion program, once fully implemented,
will operate similar to that of Reliance with respect to the funding of future
losses. Trust fund accounts are maintained by the company's captive insurance
subsidiary. At September 30, 1996 and December 31, 1995, approximately $9.0
million and $2.7 million were on deposit at Camelback which was held in trust as
restricted cash. At September 30, 1996 and December 31, 1995, the Company had
working capital of $29.4 million and $8.6 million, respectively.
Management expects that 1996 capital expenditures will exceed those
incurred in 1995 to meet the continued technological needs of the Company's
growing base of both leased and non-leased employees.
16
<PAGE>
The Company operates a captive offshore insurance company, Camelback
Insurance, Ltd. ("Camelback"), chartered in Bermuda. Effective June 1, 1995, the
Company began conducting substantially all of its risk management/workers'
compensation services through Camelback. Camelback was established to provide
the Company with the opportunity to enhance profitability of its risk
management/workers' compensation program through greater control of the risk
management process. Under Bermuda law, Camelback must maintain statutory capital
and surplus in an amount equal to at least 20% of the net premiums written
through the Company's fronting arrangements, provided that the percentage
requirement is reduced to 10% at such time as annualized premium volume reaches
$6,000,000. Bermuda law also regulates the circumstances under which Camelback
would be permitted to loan funds to its parent company. In the future, these
factors may limit the ability of the Company to execute its planned growth
strategy and may limit the ability of Camelback to transfer funds to its parent
company (whether via dividend or otherwise).
The Company entered into an arrangement with Reliance National Indemnity in
1994. Under the Reliance program, policies are issued which provide first dollar
workers' compensation coverage to the Company, its subsidiaries and the clients
for which the Company is responsible to provide workers' compensation insurance
coverage. While the insurance policies provide first dollar coverage, the
Company has entered into agreements with Reliance under which Camelback is
responsible for the first $250,000 of each workers' compensation occurrence with
no aggregate to limit its liability. On September 19, 1995, the Company executed
a Guarantee and Indemnification to Reliance National Risk Specialists, a
division of Reliance Insurance Company, which guarantees substantially all of
the obligations of Camelback to Reliance. Individual workers' compensation
claims in excess of $250,000 and up to the statutory limits of the states where
the Company operates are the responsibility of Reliance. Employers liability
coverage is provided under the Reliance program with a limit of $1,000,000. The
Company also carries umbrella coverage with a limit of $25,000,000 that includes
insurance coverage for employers liability. While the retention of the first
$250,000 of individual workers' compensation claims and the capital requirements
resulting from the establishment of a captive insurance subsidiary are intended
to enhance profitability, these actions increase the Company's exposure to risk
from workers' compensation claims. The Company has entered into a new agreement
with Legion Insurance Company ("Legion") for certain employee leasing programs.
The program is substantially on the same terms as the Reliance program except
that the Company will be responsible for the first $350,000 of each workers'
compensation occurance. The Company has paid Legion approximately $2.2 million
through September 30, 1996 of which approximately $1.5 million will be funded
into the trust accounts of a new captive insurance company which is currently
being established in the state of Hawaii. The $1.5 million to be funded into
this trust account is included in the Company's financial statements as an
account receivable at September 30, 1996. The Company will continue to fund this
program at a rate of approximately $700,000 per month through its renewal date
in August 1997. To reduce the Company's exposure to certain types of claims that
would fall into the $250,000 (or $350,000) retention, effective March 29, 1995,
the Company secured Accidental Death & Dismemberment insurance from the Federal
Insurance Company (Chubb) with a limit of $250,000 (or $350,000) for certain
categories of serious claims.
Assuming continued growth of the Company's leasing services business and
risk management/workers' compensation services program, the Company anticipates
that it will be required under its arrangements with Reliance to set aside
increasing amounts of funds for payment of claims and related administrative
costs should its arrangements with Reliance be renewed.
On August 1, 1996, the Company entered into a three year $35 million
revolving credit facility for the purposes of acquisition financing, working
capital and general corporate purposes. The revolving credit facility provides
for various borrowing rate options including borrowing rates based on a fixed
spread of .25% over prime or 250 basis points over the London Interbank Offered
Rate (LIBOR). The Company pays a commitment fee of 3/8% on the unused portion of
the line. Total costs incurred in obtaining this facility were approximately
$400,000 and will be amortized over the life of the facility. The line matures
on August 1, 1999 and the maximum borrowing decreases $1.5 million per quarter
beginning February 1, 1998. The principal loan covenants are as follows as
defined in the agreement: current ratio of at least 1.4 to 1; total liabilities
to net worth of not more than 2 to 1; total funded debt to earnings before
taxes, depreciation and amortization of 2 to 1. The facility includes certain
other covenants and is secured by substantially all of the Company's assets.
The Company borrowed approximately $23.5 million under the revolving credit
facility on August 1, 1996 to finance its acquisition of Leaseway. As of
September 30, 1996 $33.3 million was outstanding under the line. In October,
1996, the Company increased the line of credit by $10.0 million to $45.0 million
in anticipation of additional acquisition financing. Costs related to such
increase were approximately $100,000 and will be amortized over the remaining
life of the facility.
The Company completed the acquisition of the principal assets of Leaseway
Personnel Corporation. and Leaseway Administrative Personnel, Inc.
(collectively, "Leaseway") effective August 1, 1996 for approximately $24
million in cash, plus deferred acquisition costs of approximately $150,000. The
Company acquired the assets of Leaseway through Logistics Personnel Corp.
("LPC") (formerly, Employee Solutions of Florida, Inc.) a wholly owned
subsidiary. LPC is an employee leasing company providing permanent and temporary
private carriage truck drivers, as well as non-driver employees, including
warehouse workers, mechanics, dispatchers, and administrative personnel to
approximately 180 clients in 41 states.
The Company completed the acquisition of the principal assets of the
McClary-Trapp Companies effective November 1, 1996 for approximately $9.6
million in cash and $1.1 million in unregistered shares of the Company's common
shares for a total purchase price of $10.7 million, plus deferred acquisition
costs. The Company's unregistered common shares were valued at the average
closing price on the NASDAQ National Market for October 1996 and have certain
registration rights. McClary-Trapp Companies lease approximately 2,000 employees
to a client base consisting primarily of light industrial, transportation and
service companies.
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Management believes that cash generated from ongoing operations, the funds
received from recent warrant exercises, and cash available from the Company's
line of credit described above will satisfy the anticipated cash requirements of
the Company's current operations over the next 12 months, though there can be no
assurance that this will be the case. The Company's ability to continue funding
its planned operations beyond the next 12 months is dependent upon its ability
to generate sufficient cash flow to meet its obligations on a timely basis, or
to obtain additional funds through equity or debt financing, or from other
sources of financing, as may be required.
<PAGE>
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS/OUTLOOK
The statements contained in this Management's Discussion and Analysis
which are not historical facts (including statements using terms such as
"believe," "expect," "anticipate" and similar terms) are forward-looking
statements subject to risks and uncertainties that could cause actual results to
differ materially from those set forth in the forward-looking statements,
including delay or inability to conclude acquisition transactions, introductions
of competing services, cancellations of contracts, changes in applicable
regulations, general market acceptance of the Company's PEO and other services,
fluctuations in margins, customers' reorganizations, demand fluctuations, and
other factors. The other factors include those set forth in connection with the
forward-looking statements or otherwise set forth herein. Readers are also urged
to review carefully and consider the various disclosures which attempt to advise
interested parties of the factors which affect or may affect the Company's
business.
Management of Rapid Growth. The Company's success will, in part, be
dependent upon its ability to manage growth effectively. Since its formation,
the Company has experienced rapid growth which has placed certain challenges on
the Company's management and personnel resources and systems. As part of its
business strategy, the Company intends to pursue continued growth through means
such as further development of its sales and marketing capabilities,
acquisitions and marketing alliances. Although the Company intends to maintain,
and expand when necessary, its personnel, resources and systems to manage such
future growth and to assimilate operations acquired by it, there can be no
assurance that the Company will be able to maintain or expand these systems or
to otherwise manage this growth effectively. Failure to do so could adversely
affect the Company's business and financial performance.
A substantial portion of the Company's recent and anticipated growth is
attributable to its risk management/workers' compensation insurance services
program. The risks associated with rapid growth in this area include the
potential for poor underwriting due to a lack of experience with new geographic
markets and industries served, a shortage of experienced and trained personnel,
and the need to upgrade operating systems. The Company intends to convert
certain aspects of its risk management information systems to support this
growth; there can be no assurances that this conversion, or other future changes
in systems or procedures, will be successfully completed.
In addition, while management believes that significant growth can be
achieved in the future, no assurance can be made that historical growth rates
are sustainable.
Adequacy of Loss Reserves. Under its workers' compensation arrangements
with Reliance National Risk Specialists, a division of Reliance National
Indemnity Company ("Reliance") and Legion Insurance Company ("Legion"), the
Company is responsible for the first $250,000 ($350,000 for certain
transportation programs) of each workers' compensation liability occurrence with
no aggregate limit to the number of occurrences for which the Company may be
liable. Under its self-insured health insurance arrangements with Nationwide
Life Insurance Company and John Alden Life Insurance Company, the Company is
responsible for the first $100,000 and $75,000 per covered individual per year,
respectively. The Company's aggregate liability limit for its health insurance
arrangements is based upon a formula tied to anticipated claims. The Company's
reserves for losses and loss adjustment expenses under its workers' compensation
and health insurance programs are estimates of amounts needed to pay reported
and unreported claims and related loss adjustment expenses based on then-known
facts and circumstances, including industry data and historical experience.
However, the establishment of appropriate reserves is an inherently uncertain
process as the time between the occurrence of a covered loss and its settlement
may take several years. For this reason, there can be no assurance that the
Company's ultimate liability will not materially exceed its loss and loss
adjustment expense reserves. This uncertainty is compounded in the Company's
case by its rapid growth and limited experience. If the Company's reserves prove
to be inadequate due to higher than estimated losses, the Company will be
required to increase reserves or corresponding loss payments with a
corresponding reduction in the Company's net income in the period in which the
deficiency is identified. Losses in any particular period may be severe.
Government Regulation of PEOs. The Company is regulated by numerous
federal laws relating to labor, tax and employment matters. Generally, these
laws prohibit race, age, sex, disability and religious discrimination, mandate
<PAGE>
safety regulations in the workplace, set minimum wage rates and regulate
employee benefits. Because many of these laws were enacted prior to the
development of non-traditional employment relationships, such as PEO services,
many of these laws do not specifically address the obligations and
responsibilities of non-traditional employers such as the Company. As a result,
interpretive issues concerning the definition of the term "employer" in various
federal laws have arisen pertaining to the employment relationship. Unfavorable
resolution of these issues could have a material adverse effect on the Company's
results of operations or financial condition. Compliance with these laws and
regulations is time consuming and expensive. The Company's standard form of
agreement for PEO services provides that the client company is responsible for
compliance with employment and employment-related laws and regulations, and that
the parties are obligated to indemnify each other against breaches of the
agreement. However, some legal uncertainty exists with respect to the potential
scope of the Company's liability in the event of violations by its clients of
employment, discrimination and other laws.
The Internal Revenue Service ("IRS") has formed a Market Segment Study
Group to examine whether PEOs, such as the Company, are the employers of
worksite employees under the Internal Revenue Code of 1986, as amended (the
"Code") applicable to employee benefit plans and consequently are able to offer
to worksite employees benefit plans that qualify for favorable tax treatment.
The Market Segment Study Group is also examining whether client company owners
are employees of PEOs under Code provisions applicable to employee benefit
plans. The Company is unable to predict the timing of the conclusions to be
reached by the IRS.
If the IRS were to determine that the Company is not the "employer" of
certain worksite employees for purposes of the Code, the tax qualified status of
401(k) plans could be revoked, and the Company's cafeteria plan and similar
employee benefits may lose favorable tax status. The Company has attempted to
structure its retirement and cafeteria benefit plans with the worksite employers
as "co-sponsors" to help protect against an adverse IRS determination applying
to Company plans, even if it were to make such a determination for other PEOs'
plans. However, certain Company plans (particularly relating to acquired
operations) do not have worksite employer co-sponsors, and there can be no
assurances that the co-employer structure would achieve favorable tax treatment.
The Company believes that, although unfavorable to the Company, a prospective
application of such a determination (that is, one applicable only to periods
after such a determination is reached) would not have a material adverse effect
on its financial position or results of operations, as the Company could
continue to make available benefit programs to its client companies at
comparable cost to the Company. However, if such a determination were applied
retroactively to disqualify benefit plans, employees' vested account balances
under 401(k) plans could become taxable, an administrative employer such as the
Company could lose its tax deductions to the extent its matching contributions
were not vested, a 401(k) plan's trust could become a taxable trust and the
administrative employer could be subject to liability with respect to its
failure to withhold applicable taxes and with respect to certain contributions
and trust earnings. Further, the employer could be come subject to liability,
including penalties, with respect to its cafeteria plan for the failure to
withhold and pay taxes applicable to salary deferral contributions by employees,
including worksite employees. However, because the Company's benefit plans and
contributions have been relatively small, the Company does not believe that a
retroactive application of any such determination would have a material adverse
effect on the Company. In light of the IRS Market Study, certain legislation has
been proposed to clarify the tax status of benefit plans in the PEO context.
However, there can be no assurance that such legislation will be adopted. Even
if adopted, the Company may need to change aspects of its operations or programs
to comply with any requirements which may ultimately be adopted.
The attractiveness to clients of a full service PEO arrangement, and
particular services and products offered by the Company, depends in part upon
the treatment of payments for those services and products of those matters under
the Code (for example, the opportunity of employees to elect to receive certain
benefits under a cafeteria plan using pre-tax dollars). Changes to the Code,
related IRS regulations or other laws and regulations, could adversely affect
the Company's business and profitability.
The Company is subject to regulation by local and state agencies
pertaining to a wide variety of labor related laws. As is the case with federal
regulations discussed above, many of these regulations were developed prior to
the emergence of the PEO industry and do not specifically address
non-traditional employers. While many states do not explicitly regulate PEOs, 15
states have passed laws that have licensing or registration requirements and at
least four
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states are considering such regulation. Such laws vary from state to state but
generally provide for monitoring the fiscal responsibility of PEOs. While the
Company believes it is licensed in all states requiring such a license, there
can be no assurance that the Company will be able to satisfy licensing
requirements or other applicable regulations of any particular state from time
to time.
Dependence on Certain Insurers. The Company believes that its risk
management/workers' compensation services program has been and will continue to
be an important competitive factor in its growth and profitability. The
Company's risk management/workers' compensation services program is being
conducted principally in coordination with Reliance. The Company's contract with
Reliance was last renewed June 1, 1996, and is subject to annual renewals. There
can be no assurance that the Company can renew on commercially reasonable terms.
The Company would be materially adversely affected by a termination of its
arrangements with Reliance if the Company could not locate similar coverage with
another insurer.
In part to lessen its dependence upon Reliance, the Company is seeking
to establish relationships with additional insurers. The Company is negotiating
an additional continuing relationship with Legion Insurance Company ("Legion")
similar to the Reliance program. Legion has already commenced providing workers'
compensation services for certain Company operations. Although the Company
intends to maintain relationships with both Reliance and Legion to provide
alternative sources of service, there can be no assurance that Company will be
able to successfully maintain both, or other, relationships on a going forward
basis.
Government Regulation Relating to Workers' Compensation Program. To
facilitate its risk management/workers' compensation programs, the Company has
formed Camelback Insurance, Ltd. ("Camelback") as a captive offshore insurance
company chartered in Bermuda, and proposes to form Camelhead Insurance, Ltd.
("Camelhead") as a captive insurance company chartered in Hawaii. Insurance
companies such as Camelhead and Camelback are subject to the insurance laws and
regulations of the jurisdictions in which they are chartered; such laws and
regulations generally are designed to protect the interests of policyholders, as
opposed to the interests of shareholders such as the Company. In general, the
regulatory authorities have broad administrative authority over insurers
domiciled in their respective jurisdictions, including authority over insurers'
capital and surplus levels, dividend payments, financial disclosure, reserve
requirements, investment parameters and premium rates. The jurisdictions also
limit the ability of an insurer transfer or loan of statutory capital and
surplus to its affiliates. The regulation of Camelhead and Camelback could
materially adversely affect the Company's operations and results.
The Company's risk management/workers' compensation services program is
conducted via "fronting" arrangements with Reliance, and the arrangements being
negotiated with Legion would also constitute fronting arrangements. The National
Association of Insurance Commissioners ("NAIC") recently adopted a model act
concerning "fronting" arrangements. No determination can be made as to whether,
or in what form, such act may ultimately be adopted by any state. The model act
requires reporting and prior approval of reinsurance transactions relating to
these arrangements, and limits the amount of premiums that can be written under
certain circumstances. At this stage, the Company is unable to predict whether
the model act will affect its relationships with Reliance or Legion.
State regulation requires licensing of any individual or entity
soliciting the sale of workers' compensation insurance within that state.
Licenses may be residential or non-residential and for both individuals and
entities. The Company formed ESI Risk Management Agency ("RMA") in 1995 to
address state regulation and licensing issues and act as the Company's sales and
marketing arm for stand-alone risk management/workers' compensation services.
Although RMA is generally not required to be licensed in any state since it is
not directly soliciting the sale of workers' compensation insurance, RMA has
undertaken to become licensed in all 50 states and the District of Columbia.
There can be no assurance that RMA will be able to obtain all of the licenses it
intends to obtain.
Acquisitions. The Company has grown substantially in recent years
through the acquisition of other companies providing employment-related
services, such as PEOs. As part of the Company's growth strategy, the Company
intends to continue to pursue acquisition opportunities. The Company is unable
to predict whether or when any prospective acquisition candidate will become
available or the likelihood that any acquisition will be completed. The Company
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competes for acquisition and expansion opportunities with entities which may
have substantially greater resources. There can be no assurance that the Company
will be able to identify suitable acquisition candidates, complete acquisitions
or integrate successfully acquired businesses into its operations. Once
integrated, acquisitions may not achieve comparable levels of revenues,
profitability or productivity as the existing operations of the Company or
otherwise perform as expected.
Even if the Company were successful in its strategy of pursuing
acquisition opportunities, there can be no assurance that such acquisitions can
be made on terms which are ultimately attractive for the Company. Although the
Company does not intend to complete acquisitions which would have a dilutive
impact on earnings, there can be no assurances that future acquisitions by the
Company will not be dilutive.
Uncertainties of Extent of Employer's Legal Liability. There are many
legal uncertainties about employee relationships created by PEOs, such as the
extent of the PEO's liability for violations of employment and discrimination
laws. The Company may be subject to liability for violations of these or other
laws even if it does not participate in such violations. The Company's standard
form of client service agreement establishes the contractual division of
responsibilities between the Company and its clients for various personnel
management matters, including compliance with and liability under various
governmental regulations. However, because the Company acts as a co-employer,
and in some instances acts as sole employer, the Company may be subject to
liability for violations of these or other laws despite these contractual
provisions and even if it does not participate in such violations. The Company
has been sued from time to time in actions alleging responsibility for
employees' actions, and although it believes it has meritorious defenses, there
can be no assurances it will not be found liable. The circumstances in which the
Company acts as sole employer may expose the Company to increased risk of such
liabilities for an employees' actions. Although the client generally is required
to indemnify the Company for any liability attributable to the conduct of the
client, the Company may not be able to collect on such a contractual
indemnification claim and thus may be responsible for satisfying such
liabilities. In addition, employees of the client may be deemed to be agents of
the Company, subjecting the Company to liability for the actions of such
employees.
Health Care Reform Proposals. Various proposals for national health
care reform have been under discussion in recent years, including proposals to
extend mandatory health insurance benefits to virtually all classes of
employees. Certain reform proposals have called for the inclusion of workers'
compensation coverage in the reform package. While the Company is unable to
predict whether or in what form health care reform will be enacted, aspects of
such reform, if enacted, may have an adverse effect upon the Company's medical
and workers' compensation insurance programs.
In August 1996, the President signed into law the Health Insurance
Portability and Accountability Act of 1996, which contains the following key
provisions: (i) guaranteed access to health insurance businesses with 50 or
fewer employees; (ii) guaranteed access to health insurance for individuals who
lose group coverage; and (iii) protections for individuals with pre-existing
medical conditions. In September 1996, the President signed additional maternity
length of stay and mental health parity measures into law. There can be no
assurance that compliance with recently enacted legislation will not have a
material adverse impact on the Company's claims expense, its financial condition
or results of operations.
Claims Experience Uncertainties. State unemployment taxes and workers'
compensation expense are, in part, determined by the Company's claims
experience. Claims experience also greatly impacts the Company's health
insurance rates and claims cost from year to year. Should the Company experience
a large increase in claims activity for unemployment, workers' compensation
and/or health care, then its costs in these areas would increase. Increased
claims under partially self-insured and large deductible plans would immediately
impact negatively on the Company's earnings, while such increases in
fully-insured plans would raise the cost of such insurance at renewal. The
Company might not be able to pass these costs to its clients and may have
difficulty competing with the PEOs with lower claims rates that offer lower
rates to clients. The Company also retains the first $250,000 of exposure for
each workers' compensation claim, although the Company has obtained accidental
death and dismemberment insurance in an amount up to $500,000 per claim to limit
its exposure to certain categories of serious claims. This retainage increases
the Company's exposure to such risks.
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Potential Tax Liabilities. The Company is subject to review and audit
by federal and state taxation, labor and unemployment authorities with respect
to taxes paid by, and tax rates applicable to, the Company. From time to time,
the Company has received notices or challenges which may adversely affect its
tax rates and payments. The Company has received a letter from the Arizona
Department of Economic Security with respect to its unemployment tax rate for
the year ended December 31, 1994 which, if determined adversely to the Company,
would result in an amount due of approximately $500,000 (before interest and
income tax effect). In addition, the Company has received payroll tax penalty
notices from the IRS and various states relating to acquired Hazar operations,
alleging certain late payment of payroll taxes; the penalties proposed to be
assessed against the Company total approximately $572,000, and the penalties to
be assessed against Hazar, its predecessor, total approximately $390,000 for the
period during which the Company performed designated management services on
behalf of the predecessor. The Company believes that it has defenses to these
actions, and has objected vigorously to payment of such past taxes and
penalties. However, it is not possible to predict if the Company will be
successful in abating these taxes and penalties, or other unanticipated claims
which could arise in the future. The Company would be required to record these
amounts as additional expense and liability if, at any time in the future, it
became apparent that the Company would not prevail in these matters.
Credit Risks. The Company sometimes pays salary and wages to worksite
employees and makes various tax and benefit payments prior to reimbursement by
Company clients, and it is customary to offer credit terms in certain
industries. Whether or not payments are received from Company clients, the
Company is under a legal obligation to pay worksite employees for services
rendered. The nature of the Company's business and pricing margins is such that
a small number of client credit failures could have a material adverse effect on
its business and financial condition. The Company conducts a limited credit
investigation based on the facts of each case prior to accepting most new
clients and thus may encounter collection problems which would adversely affect
its cash flow.
Competition and Economic Conditions. The market for many of the
services provided by the Company is characterized by rapid growth and
competition. Over 2,000 PEOs compete in the United States. The Company also
competes with payroll processing firms, insurance companies and financial
institutions which provide some of the services the Company offers to its
clients. Many of these competitors have greater resources, greater assets and
larger marketing staffs than the Company.
The Company's business is also susceptible to general economic trends.
For example, recessions or other decreases in employment, could adversely affect
the demand for the Company's services and/or the number of persons employed by
the Company's clients.
Dependence Upon Certain Officers and Key Employees. The Company is
highly dependent upon the services of certain of its officers and key employees,
particularly Marvin D. Brody, its Chief Executive Officer. The loss of services
of any of these individuals would have a material adverse effect upon the
Company. The Company does not have employment agreements with Mr. Brody or
certain other of these individuals.
Quarterly Operating Results
Historically, the Company's revenues generally have increased on a
quarter to quarter basis. Revenues in the fourth quarter of each year include
the effects of the flow through of bonus payrolls of worksite employees, which
are substantially higher in December than in any other month.
Quarter to quarter comparisons can also be substantially affected by
acquisition activity and the volume of conversions from stand alone workers'
compensation services to full PEO services. In addition to increasing revenues,
acquisition activity can affect gross profits and margins because of the
transition period after an acquisition in which the Company acts to implement
pricing changes where appropriate, and to eliminate client relationships which
do not meet the Company's risk or profitability profiles. Significant numbers of
conversions from stand-alone risk management/workers' compensation to full
service PEO arrangements tend to increase gross profit amounts while decreasing
gross margins because of the addition of pass-through salaries and wages to both
revenues and costs.
Gross profit margin for continuing services generally improves from
quarter to quarter within a year, with the first quarter generally the least
favorable and the fourth quarter generally the most favorable. Employment
related taxes are based on the cumulative earnings of individual employees up to
a specified wage level. Therefore, these expenses tend to decline over the
course of a year. Since the Company's revenues for an individual client are
generally earned and collected at a relatively constant rate throughout each
year, payment of such unemployment tax obligations has a decreasing impact on
the Company's working capital and results of operations as the year progresses.
Other factors affecting the primary components of direct cost, such as the
effects of trends in medical and workers' compensation claims, adjustments to
benefit plans and other factors, can affect this trend.
Gross profit margin for continuing services generally improves from
quarter to quarter within a year, with the first quarter generally the least
favorable and the fourth quarter generally the most favorable. Employment
related taxes
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are based on the cumulative earnings of individual employees up to a specified
wage level. Therefore, these expenses tend to decline over the course of a year.
Since the Company's revenues for an individual client are generally earned and
collected at a relatively constant rate throughout each year, payment of such
unemployment tax obligations has a decreasing impact on the Company's working
capital and results of operations as the year progresses. Other factors
affecting the primary components of direct cost, such as the effects of trends
in medical and workers' compensation claims, adjustments to benefit plans and
other factors, can affect this trend.
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SIGNATURES
In accordance with the requirements of The Exchange Act, the
registrant caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
EMPLOYEE SOLUTIONS, INC.
Date: November 20, 1996 /S/ Marvin D. Brody
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Marvin D. Brody
Chief Executive Officer
/S/ Morris C. Aaron
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Morris C. Aaron
Chief Financial Officer
