U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 1998
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from _______________ to _________________
Commission file number: 000-22600
EMPLOYEE SOLUTIONS, INC.
(Exact name of registrant as specified in its charter)
Arizona 86-0676898
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
6225 North 24th Street, Phoenix, Arizona 85016
(Address of principal executive offices)
Issuer's telephone number: (602) 955-5556
Securities registered pursuant to Section 12(b) of
the Act:
Title of each class: Name of each exchange on which registered:
None N/A
---- ---
Securities registered pursuant to Section 12(g)
of the Act:
No Par Value Common Stock
Rights to Purchase Shares of Series A Junior Participating Preferred Stock
(Title of Class)
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such report(s)), and (2) has been subject to such filing
requirements for the past 90 days.
Yes |X| 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: 31,794,495 Common shares, no
par value were outstanding as of July 31, 1998.
<PAGE>
EMPLOYEE SOLUTIONS, INC.
FORM 10-Q
Quarterly Report for the Period Ended June 30, 1998
- --------------------------------------------------------------------------------
INDEX
<TABLE>
<CAPTION>
Page
PART I. Financial Information Number
------
<S> <C> <C>
Item 1. Financial Statements
Consolidated Balance Sheets - June 30, 1998 and
December 31, 1997 2
Consolidated Statements of Operations for the
Quarters and Six Months Ended June 30, 1998 and 1997 3
Consolidated Statement of Changes in Stockholders'
Equity for the Six Months Ended June 30, 1998 4
Consolidated Statements of Cash Flows for the
Six Months Ended June 30, 1998 and 1997 5
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 19
Item 3. Quantitative and Qualitative Disclosure About Market Risk 29
PART II. Other Information
Item 1. Legal Proceedings 30
Item 4. Submission of Matters to a Vote of Security Holders 30
Item 5. Other Matters 31
Item 6. Exhibits and Reports on Form 8-K 32
Signatures 33
</TABLE>
- --------------------------------------------------------------------------------
<PAGE>
Item 1. Financial Statements
EMPLOYEE SOLUTIONS, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------
June 30, December 31,
(In thousands of dollars, except share data) 1998 1997
- -------------------------------------------------------------------------------------------------
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 17,703 $ 40,110
Investments and marketable securities 19,221 --
Restricted cash and investments -- 19,000
Accounts receivable, net 43,836 57,467
Receivables from insurance companies 9,630 7,070
Prepaid expenses and deposits 6,258 4,562
Income taxes receivable 5,963 4,080
Deferred income taxes 3,977 4,138
-------- --------
Total current assets 106,588 136,427
Property and equipment, net 4,920 3,159
Deferred income taxes 485 485
Goodwill and other assets, net 67,960 67,146
-------- --------
Total assets $179,953 $207,217
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Bank overdrafts $ 3,201 $ --
Accrued salaries, wages and payroll taxes 34,400 43,263
Accounts payable 5,690 4,363
Accrued workers' compensation and healthcare 5,891 24,586
Other accrued expenses 7,938 5,886
-------- --------
Total current liabilities 57,120 78,098
-------- --------
Deferred income taxes 698 517
-------- --------
Long-term debt 85,000 85,000
-------- --------
Other long-term liabilities 1,211 1,213
-------- --------
Commitments and contingencies
STOCKHOLDERS' EQUITY
Class A convertible preferred stock, nonvoting, no par value, 10,000,000
shares authorized, no shares issued and outstanding -- --
Common stock, no par value, 75,000,000 shares authorized, 31,784,495
shares issued and outstanding June 30, 1998, and 31,683,120 shares
issued and outstanding December 31, 1997 34,675 34,420
Retained earnings 1,239 7,866
Unrealized gain on investment securities 10 103
-------- --------
Total stockholders' equity 35,924 42,389
-------- --------
Total liabilities and stockholders' equity $179,953 $207,217
======== ========
- -------------------------------------------------------------------------------------------------
</TABLE>
The accompanying notes are an integral part of these consolidated
balance sheets.
2
<PAGE>
EMPLOYEE SOLUTIONS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------
Quarter ended June 30, Six months ended June 30,
(In thousands of dollars, except share ---------------------------- ----------------------------
and per share data) 1998 1997 1998 1997
- ------------------------------------------------------------------------------ ----------------------------
<S> <C> <C> <C> <C>
Revenues $ 254,399 $ 226,058 $ 475,329 $ 422,024
------------ ------------ ------------ ------------
Cost of revenues:
Salaries and wages of worksite employees 213,057 182,439 393,741 338,348
Healthcare and workers' compensation 15,639 16,038 29,906 31,109
Payroll and employment taxes 17,232 15,696 33,745 30,414
------------ ------------ ------------ ------------
Cost of revenues 245,928 214,173 457,392 399,871
------------ ------------ ------------ ------------
Gross profit 8,471 11,885 17,937 22,153
Selling, general and administrative expenses 12,340 8,499 20,111 15,912
Depreciation and amortization 1,544 1,083 2,830 2,048
------------ ------------ ------------ ------------
Income (loss) from operations (5,413) 2,303 (5,004) 4,193
Other income (expense):
Interest income 376 252 1,146 447
Interest expense (2,152) (1,123) (4,272) (2,065)
Other 2 (58) 5 (58)
------------ ------------ ------------ ------------
Income (loss) before provision for income taxes (7,187) 1,374 (8,125) 2,517
Income tax provision (benefit) (1,465) 550 (1,498) 1,007
------------ ------------ ------------ ------------
Net income (loss) $ (5,722) $ 824 $ (6,627) $ 1,510
============ ============ ============ ============
Net income (loss) per common and
common equivalent share:
Basic $ (.18) $ .03 $ (.21) $ .05
Diluted $ (.18) $ .03 $ (.21) $ .05
Weighted average number of common and
common equivalent shares outstanding:
Basic 31,766,725 30,888,061 31,734,062 30,840,094
============ ============ ============ ============
Diluted 31,766,725 32,003,224 31,734,062 32,549,438
============ ============ ============ ============
- --------------------------------------------------------------------------------------------------------------
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
3
<PAGE>
EMPLOYEE SOLUTIONS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------
Unrealized Total
(In thousands of dollars, Preferred Common Retained Gain on Stockholders'
except share data) Stock Stock Earnings Investments Equity
- ------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
BALANCE, December 31, 1997 $ -- $ 34,420 $ 7,866 $ 103 $ 42,389
Issuance of 101,375 shares of common
stock in connection with exercise of
common stock options -- 186 -- -- 186
Tax benefit related to the exercise of
stock options -- 69 -- -- 69
Change in unrealized net gains,
net of applicable taxes -- -- -- (93) (93)
Net loss -- -- (6,627) -- (6,627)
--------- -------- -------- -------- --------
BALANCE, June 30, 1998 $ -- $ 34,675 $ 1,239 $ 10 $ 35,924
========= ======== ======== ======== ========
- ------------------------------------------------------------------------------------------------------
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
4
<PAGE>
EMPLOYEE SOLUTIONS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------
Six months ended June 30,
----------------------------
(In thousands of dollars) 1998 1997
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Cash received from customers $ 488,960 $ 405,409
Cash paid to suppliers and employees (487,622) (397,140)
Cash paid in loss portfolio transfer (19,950) --
Interest received 1,146 447
Interest paid (4,163) (2,065)
Income taxes paid, net (43) (3,900)
---------- ----------
Net cash (used in) provided by operating activities (21,672) 2,751
---------- ----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment (2,251) (1,143)
Business acquisitions (796) (4,307)
Deferred cost disbursements (633) --
Change in investments and marketable securities (19,221) --
Change in restricted cash and investments 19,000 (2,500)
---------- ----------
Net cash used in investing activities (3,901) (7,950)
---------- ----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of long-term debt -- 4,500
Payment of deferred loan costs (221) --
Proceeds from issuance of common stock 186 414
Increase (decrease) in bank overdraft 3,201 (86)
---------- ----------
Net cash provided by financing activities 3,166 4,828
---------- ----------
Net decrease in cash and cash equivalents (22,407) (371)
CASH AND CASH EQUIVALENTS, beginning of period 40,110 10,980
---------- ----------
CASH AND CASH EQUIVALENTS, end of period $ 17,703 $ 10,609
========== ==========
- ----------------------------------------------------------------------------------------------------------
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
5
<PAGE>
EMPLOYEE SOLUTIONS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(CONTINUED)
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------
Six months ended June 30,
-----------------------------
1998 1997
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C>
RECONCILIATION OF NET INCOME (LOSS) TO NET CASH
(USED IN) PROVIDED BY OPERATING ACTIVITIES:
Net income (loss) $ (6,627) $ 1,510
---------- ----------
ADJUSTMENTS TO RECONCILE NET INCOME (LOSS) TO
NET CASH (USED IN) PROVIDED BY OPERATING
ACTIVITIES:
Depreciation and amortization 2,830 2,048
Loss on sale of fixed assets -- 58
Decrease (increase) in accounts receivable, net 13,631 (15,568)
Increase in insurance company receivables (2,560) (1,047)
Increase in prepaid expenses and deposits (1,696) (1,512)
Decrease (increase) in deferred income taxes, net 342 (2,173)
(Increase) decrease in other assets (1,528) 1,187
(Decrease) increase in accrued salaries,
wages and payroll taxes (8,863) 13,834
(Decrease) increase in accrued workers'
compensation and health insurance (18,695) 4,153
Increase (decrease) in accounts payable 1,327 (796)
Increase in income taxes payable/receivable (1,883) (720)
Decrease in other accrued expenses and long-term liabilities 2,050 1,777
---------- ----------
(15,045) 1,241
---------- ----------
Net cash (used in) provided by operating activities $ (21,672) $ 2,751
========== ==========
- ----------------------------------------------------------------------------------------------------------
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
6
<PAGE>
EMPLOYEE SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1998
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
Nature of Corporation
Employee Solutions, Inc. (together with its subsidiaries, "ESI" or the
"Company") is a leading professional employer organization (PEO) providing
employers throughout the United States with comprehensive employee payroll,
human resources and benefits outsourcing services. The Company's integrated
outsourcing services include payroll processing and reporting, human resources
administration, employment regulatory compliance management, risk
management/workers' compensation services, retirement and healthcare programs,
and other products and services provided directly to worksite employees. At June
30, 1998, ESI serviced approximately 1,960 client companies with approximately
47,400 worksite employees in 47 states.
The Company conducts its business on a national scale across many industries and
is not concentrated to any material extent within a single local market or
industry, although the transportation industry, at approximately 27%, represents
the largest concentration of clients, including one client, US Xpress
Enterprises, Inc. (US Xpress), that generated approximately 20% of total
revenues and a negative contribution to gross profit in the first six months of
1998. The Company has terminated its agreement with this client effective August
19, 1998.
Basis of Presentation
The accompanying unaudited consolidated financial statements of 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 quarter and six months ended June
30, 1998 are not necessarily indicative of the results that may be expected for
the year ending December 31, 1998. For further information, refer to the
consolidated financial statements and footnotes thereto included in the
Company's Annual Report on Form 10-K for the year ended December 31, 1997.
Principles of Consolidation
The consolidated financial statements include the activities of Employee
Solutions, Inc. and its wholly owned subsidiaries from their respective
acquisition dates. All acquisitions were accounted for as purchases. All
significant intercompany accounts and transactions have been eliminated.
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements, and
the reported amounts of revenues and expenses during the reporting period. The
nature of the Company's business requires significant estimates to be made in
the areas of workers' compensation and medical reserves and revenue recognized
for retrospectively rated insurance policies. The actual results of these
estimates may be unknown for a period of years. Actual results could differ from
those estimates.
Statement of Comprehensive Income
The Company adopted Statement of Financial Accounting Standards No. 130 (SFAS
No. 130), "Reporting Comprehensive Income," January 1, 1998. As of June 30,
1998, the effect of SFAS No. 130 is not material.
7
<PAGE>
Employee Solutions, Inc. June 30, 1998
- --------------------------------------------------------------------------------
Cash and Cash Equivalents and Investments and Marketable Securities
Cash and cash equivalents consist of cash and highly liquid investments with
original maturities of three months or less. All cash equivalents are invested
in high quality investment grade instruments, such as commercial paper, at June
30, 1998 and December 31, 1997. In January 1998, the Company implemented an
investment program to invest excess cash proceeds from its October 1997 senior
note offering. Proceeds have been invested in liquid investment grade
instruments, such as commercial paper and government securities with maturities
primarily ranging from 90 days up to one year. Both cash and cash equivalents
and investments and marketable securities are reflected in the financial
statements and are stated at fair market value. Substantially all cash and cash
equivalents are not insured at June 30, 1998.
Loss Portfolio Transfer
On April 22, 1998, the Company completed a risk transfer of all of its pre-1998
workers' compensation claims liability to a third party insurer, rated AAA by
Standard & Poor's, effected through a Loss Portfolio Transfer (LPT) valued as of
February 28, 1998. In exchange for a premium of $19.9 million (paid primarily
from restricted cash and investments), the Company acquired reinsurance of $35
million to insure its pre-1998 workers' compensation losses. Based upon the
advice of its outside actuaries, the Company believes that the risk that
pre-1998 liability could exceed the $35 million aggregate limit is extremely
remote, although there can be no assurance. The LPT provides for profit sharing
opportunities with the Company based on ultimate paid claims, though there can
be no assurance whether or when a profit will be realized. No charge to earnings
was recorded in connection with this transaction in 1998 or is expected in
future periods, although a use of cash from operations has been recorded in the
second quarter of 1998.
Net Income Per Common and Common Equivalent Share
In February 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 128 (SFAS No. 128), "Earnings per Share." The
earnings per share amounts for quarter and six months ended June 30, 1997 have
been restated to conform to the 1998 presentation as required by SFAS No. 128.
The computation of adjusted net income and weighted average common and common
equivalent shares used in the calculation of net income per common share is as
follows:
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------
Quarter ended June 30,
--------------------------------------------------------------
1998 1997
(In thousands of dollars, except --------------------------- --------------------------
share and per share data) Basic Diluted Basic Diluted
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Weighted average of
common shares outstanding 31,766,725 31,766,725 30,888,061 30,888,061
Dilutive effect of options
and warrants outstanding -- -- -- 1,115,163
----------- ----------- ---------- -----------
Weighted average of
common and common
equivalent shares 31,766,725 31,766,725 30,888,061 32,003,224
=========== =========== ========== ===========
Net income (loss) $ (5,722) $ (5,722) $ 824 $ 824
Adjustments to net income -- -- -- (20)
----------- ----------- ---------- -----------
Adjusted net income (loss) for
purposes of the income per
common share calculation $ (5,722) $ (5,722) $ 824 $ 804
=========== =========== ========== ===========
Net income (loss) per common and
common equivalent share $ (0.18) $ (0.18) $ 0.03 $ 0.03
============= ========== ========== ===========
- ----------------------------------------------------------------------------------------------------------
</TABLE>
8
<PAGE>
Employee Solutions, Inc. June 30, 1998
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------
Six months ended June 30,
--------------------------------------------------------------
1998 1997
(In thousands of dollars, except --------------------------- --------------------------
share and per share data) Basic Diluted Basic Diluted
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Weighted average of
common shares outstanding 31,734,062 31,734,062 30,840,094 30,840,094
Dilutive effect of options
and warrants outstanding -- -- -- 1,709,344
----------- ----------- ---------- -----------
Weighted average of
common and common
equivalent shares 31,734,062 31,734,062 30,840,094 32,549,438
=========== =========== ========== ===========
Net income (loss) $ (6,627) $ (6,627) $ 1,510 $ 1,510
Adjustments to net income -- -- -- (32)
----------- ----------- ---------- -----------
Adjusted net income (loss) for
purposes of the income per
common share calculation $ (6,627) $ (6,627) $ 1,510 $ 1,478
=========== =========== ========== ===========
Net income (loss) per common and
common equivalent share $ (0.21) $ (0.21) $ 0.05 $ 0.05
============= ========== ========== ===========
- ----------------------------------------------------------------------------------------------------------
</TABLE>
The calculation of weighted average common and common equivalent shares for
purposes of calculating the June 30, 1998 diluted earnings per share, excludes
approximately 1,196,052 weighted average shares of options, warrants, and
contingently issuable shares computed under the treasury stock method, as their
effects would be anti-dilutive.
(2) LONG-TERM DEBT:
Note Offering
On October 21, 1997, the Company issued $85 million of 10% Senior Notes due 2004
(the Notes) in an Offering (the Offering) exempt from registration under the
Securities Act of 1933 as amended (Securities Act). Interest under the Notes is
payable semi-annually commencing April 15, 1998, and the Notes are not callable
until October 2001 subject to the terms of the Indenture under which the Notes
were issued. In April 1998, the Company completed an exchange offer for these
notes which was registered under the Securities Act. The Notes contain certain
covenants which, among other things, limit the Company's ability to incur any
future indebtedness.
The Notes are general unsecured obligations of the Company and are
unconditionally guaranteed on a joint and several basis by certain of the
Company's wholly-owned current and future subsidiaries. The Company's
wholly-owned insurance subsidiary, which is a non-guarantor subsidiary, is
subject to certain statutory and contractual restrictions which limit its
ability to pay dividends or make loans to the Company or other subsidiaries. The
financial statements presented below include the separate or combined financial
position as of June 30, 1998 and December 31, 1997; the results of operations
for the quarter and six months ended June 30, 1998 and June 30, 1997 and the
statements of cash flows for the six months ended June 30, 1998 and June 30,
1997, of Employee Solutions, Inc. (Parent), the guarantor subsidiaries
(Guarantors) and the subsidiaries which are not guarantors (Non-guarantors).
9
<PAGE>
Employee Solutions, Inc. June 30, 1998
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<TABLE>
<CAPTION>
Balance Sheets
- ----------------------------------------------------------------------------------------------------------
June 30, 1998
-----------------------------------------------------------------
Non-
(In thousands of dollars) Parent Guarantors Guarantors Eliminating Consolidated
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 5,554 $ 8,314 $ 3,835 $ -- $ 17,703
Investments and marketable securities 19,109 -- 112 -- 19,221
Restricted cash and investments -- -- -- -- --
Accounts receivable, net 15,562 25,934 2,340 -- 43,836
Receivables from insurance companies -- 5,334 4,296 -- 9,630
Prepaid expenses and deposits 4,398 1,771 89 -- 6,258
Income taxes receivable 5,963 -- -- -- 5,963
Deferred income taxes 3,977 -- -- -- 3,977
Due from affiliates 14,322 (14,995) 4,447 (3,774) --
--------- ----------- ---------- ----------- ------------
Total current assets 68,885 26,358 15,119 (3,774) 106,588
Property and equipment, net 4,552 347 21 -- 4,920
Deferred income taxes 485 -- -- -- 485
Goodwill and other assets, net 33,144 34,512 304 -- 67,960
Investment in subsidiaries 51,409 -- -- (51,409) --
--------- ----------- ---------- ----------- ------------
Total assets $ 158,475 $ 61,217 $ 15,444 $ (55,183) $ 179,953
========= =========== ========== =========== ============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Bank overdrafts $ -- $ 3,201 $ -- $ -- $ 3,201
Accrued salaries, wages and payroll taxes 12,419 20,243 1,738 -- 34,400
Accounts payable 1,280 4,390 20 -- 5,690
Accrued workers' compensation
and healthcare 1,779 1,499 2,613 -- 5,891
Income taxes payable 152 (143) (9) -- --
Other accrued expenses 4,512 1,253 2,173 -- 7,938
Due to affiliates 16,711 (9,470) (3,467) (3,774) --
--------- ----------- ---------- ----------- ------------
Total current liabilities 36,853 20,973 3,068 (3,774) 57,120
--------- ----------- ---------- ----------- ------------
Deferred income taxes 698 -- -- -- 698
--------- ----------- ---------- ----------- ------------
Long-term debt 85,000 -- -- -- 85,000
--------- ----------- ---------- ----------- ------------
Other long-term liabilities -- 1,211 -- -- 1,211
--------- ----------- ---------- ----------- ------------
Commitments and contingencies
STOCKHOLDERS' EQUITY
Class A convertible preferred stock -- -- -- -- --
Common stock, no par value 34,675 2,622 771 (3,393) 34,675
Additional paid in capital -- 26,342 50 (26,392) --
Retained earnings 1,239 10,069 11,555 (21,624) 1,239
Unrealized gain on
investment securities 10 -- -- -- 10
--------- ----------- ---------- ----------- ------------
Total stockholders' equity 35,924 39,033 12,376 (51,409) 35,924
--------- ----------- ---------- ----------- ------------
Total liabilities and stockholders'
equity $ 158,475 $ 61,217 $ 15,444 $ (55,183) $ 179,953
========= =========== ========== =========== ============
- ----------------------------------------------------------------------------------------------------------
</TABLE>
10
<PAGE>
Employee Solutions, Inc. June 30, 1998
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Balance Sheets
- ----------------------------------------------------------------------------------------------------------
December 31, 1997
-----------------------------------------------------------------
Non-
(In thousands of dollars) Parent Guarantors Guarantors Eliminating Consolidated
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 22,692 $ 11,848 $ 5,570 $ -- $ 40,110
Restricted cash and
investments -- -- 19,000 -- 19,000
Accounts receivable, net 20,822 34,360 2,285 -- 57,467
Receivables from insurance
companies -- 5,430 1,640 -- 7,070
Prepaid expenses and deposits 2,822 1,465 275 -- 4,562
Income taxes receivable 4,080 -- -- -- 4,080
Deferred income taxes 4,138 -- -- -- 4,138
Due from affiliates 30,346 (1,122) 12,855 (42,079) --
--------- ----------- ---------- ----------- ------------
Total current assets 84,900 51,981 41,625 (42,079) 136,427
Property and equipment, net 2,857 276 26 -- 3,159
Deferred income taxes 485 -- -- -- 485
Goodwill and other assets, net 32,105 34,625 416 -- 67,146
Investment in subsidiaries 46,477 -- -- (46,477) --
--------- ----------- ---------- ----------- ------------
Total assets $ 166,824 $ 86,882 $ 42,067 $ (88,556) $ 207,217
========= =========== ========== =========== ============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Bank overdrafts $ -- $ -- $ -- $ -- $ --
Accrued salaries, wages and
payroll taxes 20,253 21,422 1,588 -- 43,263
Accounts payable 1,082 2,318 963 -- 4,363
Accrued workers' compensation
and healthcare 1,612 2,211 20,763 -- 24,586
Other accrued expenses 2,612 2,541 733 -- 5,886
Due to affiliates 13,359 22,243 6,477 (42,079) --
--------- ----------- ---------- ----------- ------------
Total current liabilities 38,918 50,735 30,524 (42,079) 78,098
--------- ----------- ---------- ----------- ------------
Deferred income taxes 517 -- -- -- 517
--------- ----------- ---------- ----------- ------------
Long-term debt 85,000 -- -- -- 85,000
--------- ----------- ---------- ----------- ------------
Other long-term liabilities -- 1,213 -- -- 1,213
--------- ----------- ---------- ----------- ------------
Commitments and contingencies
STOCKHOLDERS' EQUITY
Class A convertible preferred stock -- -- -- -- --
Common stock, no par value 34,420 2,622 771 (3,393) 34,420
Additional paid in capital -- 26,342 50 (26,392) --
Retained earnings 7,866 5,970 10,722 (16,692) 7,866
Unrealized gain on
investment securities 103 -- -- -- 103
--------- ----------- ---------- ----------- ------------
Total stockholders' equity 42,389 34,934 11,543 (46,477) 42,389
--------- ----------- ---------- ----------- ------------
Total liabilities and stockholders'
equity $ 166,824 $ 86,882 $ 42,067 $ (88,556) $ 207,217
========= =========== ========== =========== ============
- ----------------------------------------------------------------------------------------------------------
</TABLE>
11
<PAGE>
Employee Solutions, Inc. June 30, 1998
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Statements of Operations
- ----------------------------------------------------------------------------------------------------------
For the Quarter Ended June 30, 1998
------------------------------------------------------------------
Non-
(In thousands of dollars) Parent Guarantors Guarantors Eliminating Consolidated
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Revenues $ 82,763 $ 162,789 $ 9,122 $ (275) $ 254,399
---------- ----------- ---------- ----------- ------------
Cost of revenues:
Salaries and wages of
worksite employees 69,611 134,686 8,760 -- 213,057
Healthcare and workers'
compensation 4,331 11,433 (125) -- 15,639
Payroll and employment taxes 5,926 10,558 748 -- 17,232
---------- ----------- ---------- ----------- ------------
Cost of revenues 79,868 156,677 9,383 -- 245,928
---------- ----------- ---------- ----------- ------------
Gross profit 2,895 6,112 (261) (275) 8,471
Selling, general and
administrative expenses 8,338 3,971 31 -- 12,340
Intercompany selling, general
and administrative expense 179 67 29 (275) --
Depreciation and amortization 1,139 396 9 -- 1,544
---------- ----------- ---------- ----------- ------------
Income (loss) from operations (6,761) 1,678 (330) -- (5,413)
Other income (expense):
Interest income 220 23 133 -- 376
Interest expense and other (2,223) (3) 76 -- (2,150)
---------- ----------- ---------- ----------- ------------
Income (loss) before provision
for income taxes (8,764) 1,698 (121) -- (7,187)
Income tax provision (benefit) (2,207) 810 (68) -- (1,465)
--------- ----------- ---------- ----------- ------------
(6,557) 888 (53) -- (5,722)
Income from wholly-owned
subsidiaries 835 -- -- (835) --
---------- ----------- ---------- ----------- ------------
Net income (loss) $ (5,722) $ 888 $ (53) $ (835) $ (5,722)
========== =========== ========== =========== ============
- ----------------------------------------------------------------------------------------------------------
</TABLE>
12
<PAGE>
Employee Solutions, Inc. June 30, 1998
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Statements of Operations
- ----------------------------------------------------------------------------------------------------------
For the Quarter Ended June 30, 1997
------------------------------------------------------------------
Non-
(In thousands of dollars) Parent Guarantors Guarantors Eliminating Consolidated
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Revenues $ 125,224 $ 94,622 $ 22,133 $ (15,921) $ 226,058
---------- ----------- ---------- ----------- ------------
Cost of revenues:
Salaries and wages of
worksite employees 91,290 72,098 11,248 7,803 182,439
Healthcare and workers'
compensation 20,936 12,994 4,572 (22,464) 16,038
Payroll and employment taxes 7,211 7,547 938 -- 15,696
---------- ----------- ---------- ----------- ------------
Cost of revenues 119,437 92,639 16,758 (14,661) 214,173
---------- ----------- ---------- ----------- ------------
Gross profit 5,787 1,983 5,375 (1,260) 11,885
Selling, general and
administrative expenses 5,519 2,883 97 -- 8,499
Intercompany selling, general
and administrative expense 279 934 47 (1,260) --
Depreciation and amortization 576 498 9 -- 1,083
---------- ----------- ---------- ----------- ------------
Income (loss) from operations (587) (2,332) 5,222 -- 2,303
Other income (expense):
Interest income 8 (19) 263 -- 252
Interest expense and other (1,206) 55 (30) -- (1,181)
---------- ----------- ---------- ----------- ------------
Income (loss) before provision
for income taxes (1,785) (2,296) 5,455 -- 1,374
Income tax provision (benefit) (981) (918) 2,449 -- 550
--------- ----------- ---------- ----------- ------------
(804) (1,378) 3,006 -- 824
Income from wholly-owned
subsidiaries 1,628 -- -- (1,628) --
---------- ----------- ---------- ----------- ------------
Net income (loss) $ 824 $ (1,378) $ 3,006 $ (1,628) $ 824
========== =========== ========== =========== ============
- ----------------------------------------------------------------------------------------------------------
</TABLE>
13
<PAGE>
Employee Solutions, Inc. June 30, 1998
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Statements of Operations
- ----------------------------------------------------------------------------------------------------------
For the Six Months Ended June 30, 1998
------------------------------------------------------------------
Non-
(In thousands of dollars) Parent Guarantors Guarantors Eliminating Consolidated
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Revenues $ 152,430 $ 305,728 $ 18,544 $ (1,373) $ 475,329
---------- ----------- ---------- ---------- -----------
Cost of revenues:
Salaries and wages of
worksite employees 125,990 251,915 15,836 -- 393,741
Healthcare and workers'
compensation 7,986 21,408 512 -- 29,906
Payroll and employment taxes 11,972 20,273 1,500 -- 33,745
---------- ----------- ---------- ---------- -----------
Cost of revenues 145,948 293,596 17,848 -- 457,392
---------- ----------- ---------- ---------- -----------
Gross profit 6,482 12,132 696 (1,373) 17,937
Selling, general and
administrative expenses 14,449 5,552 110 -- 20,111
Intercompany selling, general
and administrative expense 490 821 62 (1,373) --
Depreciation and amortization 2,041 776 13 -- 2,830
---------- ----------- ---------- ---------- -----------
Income (loss) from operations (10,498) 4,983 511 -- (5,004)
Other income (expense):
Interest income 577 43 526 -- 1,146
Interest expense and other (4,417) (1) 151 -- (4,267)
---------- ----------- ---------- ---------- ----------
Income (loss) before provision
for income taxes (14,338) 5,025 1,188 -- (8,125)
Income tax provision (benefit) (2,779) 927 354 -- (1,498)
--------- ----------- ---------- ---------- ----------
(11,559) 4,098 834 -- (6,627)
Income from wholly-owned
subsidiaries 4,932 -- -- (4,932) --
---------- ----------- ---------- ---------- -----------
Net income (loss) $ (6,627) $ 4,098 $ 834 $ (4,932) $ (6,627)
========== =========== ========== ========== ==========
- ----------------------------------------------------------------------------------------------------------
</TABLE>
14
<PAGE>
Employee Solutions, Inc. June 30, 1998
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Statements of Operations
- ----------------------------------------------------------------------------------------------------------
For the Six Months Ended June 30, 1997
------------------------------------------------------------------
Non-
(In thousands of dollars) Parent Guarantors Guarantors Eliminating Consolidated
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Revenues $ 225,670 $ 180,076 $ 41,303 $ (25,025) $ 422,024
---------- ----------- ---------- ---------- -----------
Cost of revenues:
Salaries and wages of
worksite employees 181,390 138,980 17,978 -- 338,348
Healthcare and workers'
compensation 23,690 18,429 11,454 (22,464) 31,109
Payroll and employment taxes 16,134 12,709 1,571 -- 30,414
---------- ----------- ---------- ---------- -----------
Cost of revenues 221,214 170,118 31,003 (22,464) 399,871
---------- ----------- ---------- ---------- -----------
Gross profit 4,456 9,958 10,300 (2,561) 22,153
Selling, general and
administrative expenses 10,809 4,902 201 -- 15,912
Intercompany selling, general
and administrative expense 634 1,837 90 (2,561) --
Depreciation and amortization 1,066 966 16 -- 2,048
---------- ----------- ---------- ---------- -----------
Income (loss) from operations (8,053) 2,253 9,993 -- 4,193
Other income (expense):
Interest income 17 9 421 -- 447
Interest expense and other (2,176) 53 -- -- (2,123)
---------- ----------- ---------- ---------- ----------
Income (loss) before provision
for income taxes (10,212) 2,315 10,414 -- 2,517
Income tax provision (benefit) (4,085) 926 4,166 -- 1,007
--------- ----------- ---------- ---------- -----------
(6,127) 1,389 6,248 -- 1,510
Income from wholly-owned
subsidiaries 7,637 -- -- (7,637) --
---------- ----------- ---------- ---------- -----------
Net income (loss) $ 1,510 $ 1,389 $ 6,248 $ (7,637) $ 1,510
========== =========== ========== ========== ===========
- ----------------------------------------------------------------------------------------------------------
</TABLE>
15
<PAGE>
Employee Solutions, Inc. June 30, 1998
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Statements of Cash Flows
- ----------------------------------------------------------------------------------------------------------
For the Six Months Ended June 30, 1998
------------------------------------------------------------------
Non-
(In thousands of dollars) Parent Guarantors Guarantors Eliminating Consolidated
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
RECONCILIATION OF NET INCOME TO
NET CASH PROVIDED BY (USED IN)
OPERATING ACTIVITIES:
Net income (loss) $ (6,627) $ 4,098 $ 834 $ (4,932) $ (6,627)
---------- ----------- ---------- ----------- ------------
ADJUSTMENTS TO RECONCILE
NET INCOME TO NET CASH
PROVIDED BY (USED IN)
OPERATING ACTIVITIES:
Depreciation and amortization 2,041 776 13 -- 2,830
Decrease (increase) in accounts
receivable, net 5,260 8,426 (55) -- 13,631
Decrease (increase) decrease in insurance
company receivable -- 96 (2,656) -- (2,560)
(Increase) decrease in prepaid
expenses and deposits (1,576) (306) 186 -- (1,696)
Increase in deferred income taxes, net 342 -- -- -- 342
(Increase) decrease in other assets (1,663) 261 (126) -- (1,528)
Increase (decrease) from inter-
company transactions 14,715 (18,362) (1,285) 4,932 --
(Decrease) increase in accrued salaries,
wages, and payroll taxes (7,834) (1,179) 150 -- (8,863)
Increase (decrease) in accrued workers'
compensation and health insurance 167 (712) (18,150) -- (18,695)
Increase in income taxes payable/receivable (1,883) -- -- -- (1,883)
Increase (decrease) in accounts payable 198 2,072 (943) -- 1,327
(Decrease) increase in other accrued
expenses and long-term liabilities 2,051 (1,432) 1,431 -- 2,050
---------- ----------- ---------- ----------- ------------
11,818 (10,360) (21,435) 4,932 (15,045)
---------- ----------- ---------- ----------- ------------
Net cash provided by (used in)
operating activities 5,191 (6,262) (20,601) -- (21,672)
---------- ----------- ---------- ----------- ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment (2,122) (129) -- -- (2,251)
Business acquisitions (430) (344) (22) -- (796)
Deferred cost disbursements (633) -- -- -- (633)
Change in investments
and marketable securities (19,109) -- 18,888 -- (221)
---------- ----------- ---------- ----------- ------------
Net cash (used in) provided by
investing activities (22,294) (473) 18,866 -- (3,901)
---------- ----------- ---------- ----------- ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock 186 -- -- -- 186
Increase in bank overdraft -- 3,201 -- -- 3,201
Payment of deferred
loan costs (221) -- -- -- (221)
---------- ----------- ---------- ----------- ------------
Net cash (used in) provided by
financing activities (35) 3,201 -- -- 3,166
---------- ----------- ---------- ----------- ------------
Net decrease in cash and cash
equivalents (17,138) (3,534) (1,735) -- (22,407)
CASH AND CASH EQUIVALENTS,
beginning of period 22,692 11,848 5,570 -- 40,110
---------- ----------- ---------- ----------- ------------
CASH AND CASH EQUIVALENTS,
end of period $ 5,554 $ 8,314 $ 3,835 $ -- $ 17,703
========== =========== ========== =========== ============
- ----------------------------------------------------------------------------------------------------------
</TABLE>
16
<PAGE>
Employee Solutions, Inc. June 30, 1998
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Statements of Cash Flows
- ----------------------------------------------------------------------------------------------------------
For the Six Months Ended June 30, 1997
-----------------------------------------------------------------
Non-
(In thousands of dollars) Parent Guarantors Guarantors Eliminating Consolidated
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
RECONCILIATION OF NET INCOME TO
NET CASH (USED IN) PROVIDED
BY OPERATING ACTIVITIES:
Net income (loss) $ 1,510 $ 1,389 $ 6,248 $ (7,637) $ 1,510
--------- ----------- ---------- ----------- ------------
ADJUSTMENTS TO RECONCILE
NET INCOME TO NET CASH
(USED IN) PROVIDED BY
OPERATING ACTIVITIES:
Depreciation and amortization 1,066 966 16 -- 2,048
Increase in accounts receivable, net (7,884) (6,220) (1,464) -- (15,568)
(Increase) decrease in insurance
company receivable -- (2,147) 1,100 -- (1,047)
Increase in prepaid expenses and deposits (544) (545) (423) -- (1,512)
Increase in deferred
income tax asset, net (652) (1,521) -- -- (2,173)
Decrease in other assets -- 1,245 -- -- 1,245
Increase (decrease) from inter-
company transactions (22) (2,489) (5,126) 7,637 --
Increase in accrued salaries,
wages, and payroll taxes 6,168 6,532 1,134 -- 13,834
Increase (decrease) in accrued workers'
compensation and health insurance 1,432 (252) 2,973 -- 4,153
(Decrease) increase in accounts payable 496 (1,571) 279 -- (796)
Increase (decrease) in income taxes payable 468 (1,188) -- -- (720)
Increase in other accrued expenses 95 1,673 9 -- 1,777
--------- ----------- ---------- ----------- ------------
623 (5,517) (1,502) 7,637 1,241
--------- ----------- ---------- ----------- ------------
Net cash (used in) provided by
operating activities 2,133 (4,128) 4,746 -- 2,751
--------- ----------- ---------- ----------- ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment (1,143) -- -- -- (1,143)
Business acquisitions (4,032) (56) (219) -- (4,307)
Change in restricted cash
and investments -- -- (2,500) -- (2,500)
--------- ----------- ---------- ----------- ------------
Net cash used in investing
activities (5,175) (56) (2,719) -- (7,950)
--------- ----------- ---------- ----------- ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of long-term debt 4,500 -- -- -- 4,500
Proceeds from issuance of common stock 414 -- -- -- 414
Decrease in bank overdraft and other -- (86) -- -- (86)
--------- ----------- ---------- ----------- ------------
Net cash provided by
financing activities 4,914 (86) -- -- 4,828
--------- ----------- ---------- ----------- ------------
Net (decrease) increase in cash and cash
equivalents 1,872 (4,270) 2,027 -- (371)
CASH AND CASH EQUIVALENTS,
beginning of period 2,435 6,747 1,798 -- 10,980
--------- ----------- ---------- ----------- ------------
CASH AND CASH EQUIVALENTS,
end of period $ 4,307 $ 2,477 $ 3,825 $ -- $ 10,609
========= =========== ========== =========== ============
- ----------------------------------------------------------------------------------------------------------
</TABLE>
17
<PAGE>
Employee Solutions, Inc. June 30, 1998
- --------------------------------------------------------------------------------
(3) ACCOUNTING PRONOUNCEMENTS NOT YET ADOPTED:
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133 (SFAS No. 133), Accounting for Derivative
Instruments and Hedging Activities. The statement establishes accounting and
reporting standards requiring that every derivative instrument be recorded on
the balance sheet at its fair value. SFAS No. 133 is effective for financial
statements for periods ending after June 15, 1998. Adoption of SFAS No. 133
would have an immaterial effect on the June 30, 1998 and 1997 financial
statements.
(4) CONTINGENCIES:
As previously reported, the Company and certain of its present and former
directors and executive officers have been named as defendants in ten actions
filed between March 1997 and May 1997. While the exact claims and allegations
vary, they all allege violations by the Company of Section 10(b) of the Exchange
Act, and Rule 10b-5 promulgated thereunder, with respect to the accuracy of
statements regarding Company reserves and other disclosures made by the Company
and certain directors and officers. These suits were filed after a significant
drop in the trading price of the Company's Common Stock in March 1997. The suits
have been consolidated before the U.S. District Court in Phoenix, Arizona, and a
Consolidated Amended Complaint (Complaint) was filed on April 7, 1998. The
Complaint has been provisionally certified a class action on behalf of
purchasers of Company securities from November 14, 1995 through March 13, 1997,
inclusive. The Complaint seeks the award of compensatory damages in an amount to
be determined at trial, including interest thereon, and costs of the action,
including attorneys' fees. On August 11, 1998 the court denied the Company's
motion to dismiss the Complaint. The court has indicated that it will issue an
opinion which specifies the basis for its denial of the Company's motion. Trial
has been set in the action for January 19, 1999. The Company believes that the
Complaint is without merit and it intends to defend the consolidated action
vigorously. However, the ultimate resolution of the consolidated actions could
have a material adverse effect on the Company's results of operations and
financial condition.
The State of Ohio recently issued a preliminary assessment of $2.57 million
(plus penalty) relating to sales taxes potentially applicable to certain types
of services. While the Company believes that no tax ultimately will be payable
based on the preliminary assessment, there can be no assurance that this will be
the case.
From time to time, the Company is named as a defendant in lawsuits in the
ordinary course of business. These lawsuits are not expected to have a material
impact on the Company's financial position or results of operations.
The Company believes that it has meritorious defenses to the lawsuits facing it,
including those mentioned above, and intends to assert such defenses vigorously.
However, it is not possible to predict whether such defenses will be
successfully asserted in all cases. The Company would be required to record an
expense and liability as to any matter if, at any time in the future, it became
probable that the Company would not prevail in such matter.
(5) SUBSEQUENT EVENT - THIRD QUARTER RESTRUCTURING CHARGE:
On August 11, 1998, the Company announced a restructuring and cost-reduction
plan primarily involving the closing of remote payroll processing centers and
other offices and various other expense reduction strategies. Where offices are
being closed or consolidated, the Company will maintain an active sales and
customer service presence to meet the local needs of customers and to support
internal growth. Back office functions will be consolidated at the Company's
Phoenix, Arizona headquarters to take advantage of recent investments in systems
upgrades. The Company announced that it would take a restructuring charge in the
third quarter of 1998 in an amount estimated to range between $1.7 million and
$2.0 million, consisting primarily of lease cancellation costs and severance.
18
<PAGE>
Employee Solutions, Inc. June 30, 1998
- --------------------------------------------------------------------------------
ITEM 2. - 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, 1997. 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 (which include
statements in the future tense and statements using the terms "believe,"
"anticipate," "expect," "intend" or similar terms) 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 this Management's Discussion
and Analysis (particularly in "Outlook: Issues and Risks") in addition 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
Report on Form 10-K for the year ended December 31, 1997, as well as those
factors discussed elsewhere herein or in any document incorporated herein by
reference.
Results of Operations -- Overview
On August 11, 1998, the Company announced a restructuring and cost-reduction
plan primarily involving the closing of remote payroll processing centers and
other offices and various other expense reduction strategies. Where offices are
being closed or consolidated, the Company will maintain an active sales and
customer service presence to meet the local needs of customers and to support
internal growth. Back office functions will be consolidated at the Company's
Phoenix, Arizona headquarters to take advantage of recent investments in systems
upgrades. The Company announced that it would take a restructuring charge in the
third quarter of 1998 in an amount estimated to range between $1.7 million and
$2.0 million, consisting primarily of lease cancellation costs and severance.
The following is a summary of certain factors which affect results of operations
and which have generally applied to the Company in all periods presented.
Revenues
The most significant components of the Company's revenues are payments received
from customers for gross salaries and wages paid to PEO worksite employees and
the Company's service fee. The Company negotiates service fees on a
client-by-client basis based on factors such as market conditions, client needs
and services requested, the clients' workers' compensation and benefit plan
experience, Company administrative resources required, expected profit, and
other factors. These are generally expressed as a fixed percentage of the
client's gross salaries and wages except for certain costs, primarily employer's
healthcare contributions, which are billed to clients on an add-on basis.
Because the service fees are negotiated separately with each client and vary
according to circumstances, the Company's service fees, and therefore its gross
margin, will fluctuate based on the Company's client mix.
Revenues from stand-alone risk management/workers' compensation services consist
primarily of gross premiums charged to clients for such services.
Costs of Revenues
The Company's direct costs of revenues include salaries and wages paid to
worksite employees, employment related taxes, costs of health and welfare
benefit plans, and workers' compensation insurance costs.
The largest component of direct costs is salaries and wages to worksite
employees. Although this cost is generally directly passed through to clients,
the Company may be responsible for payment of these costs even if not reimbursed
by its clients.
Employment related taxes consist of the employer's portion of payroll taxes
required under FICA, which includes Social Security and Medicare; and federal
and state unemployment taxes. The federal tax rates are defined by the
appropriate federal regulations. State unemployment rates are subject to change
each year based on, among other matters, claims histories and vary from state to
state.
In periods from and after January 1, 1998, workers' compensation liabilities are
fully insured under a guaranteed cost policy, subject to limited exceptions
described below. Accordingly, workers' compensation expense primarily includes
premiums paid to the Company's third party insurance carriers for workers'
compensation insurance. Workers'
19
<PAGE>
Employee Solutions, Inc. June 30, 1998
- --------------------------------------------------------------------------------
compensation expense during 1998 also includes the cost of a defined portfolio
of stand-alone policies in place at December 31, 1997 which policies expire at
various dates during 1998 and as to which the Company retains liability of
$250,000 per occurrence plus the types of fees described below; and costs under
the Company's self-insurance program in Ohio, where the Company retains
liability of $50,000 per occurrence with an aggregate liability limitation.
Prior to January 1, 1998, workers' compensation costs, whether relating to PEO
worksite employees or the Company's stand-alone risk management/workers'
compensation program, include the costs of claims up to the retention limits
relating to the Company's workers' compensation program, administrative costs,
premium taxes, and excess reinsurance and accidental death and dismemberment
insurance premiums. Accrued workers' compensation claims liability is based upon
estimates of reported and unreported claims and the related claims and claims
settlement expenses in an amount equal to the retained portion of the expected
total incurred claim. The liability recorded may be more or less than the actual
amount of the claims when they are submitted and paid. Changes in the liability
are charged or credited to operations as the estimates are revised.
Administrative costs include fees paid to the Company's insurers and costs of
claims management by third party administrators. Premium taxes include taxes and
related fees paid to various states based on premiums written. Premium for
excess reinsurance and accidental death and dismemberment relate to premium
payments to the Company's insurers for the retention of risks above specified
limits.
Healthcare and other employee benefits costs consist of medical and dental
insurance premiums, payments of and reserves for claims subject to deductibles
and the costs of vision care, disability, life insurance and other similar
benefit plans. The Company's healthcare benefit plans consist of a mixture of
fully-insured programs and partially self-insured programs with specific and, in
one program, aggregate stop-loss insurance. The Company recognizes a liability
for partially self-insured health insurance claims at the time a claim is
reported to the Company by the third party claims administrator, and also
provides for claims incurred, but not reported based on industry-wide data and
the Company's past claims experience. The liability recorded may be more or less
than the actual amount of ultimate claims. While the Company believes that its
reserves for healthcare and workers' compensation claims are adequate for future
claims payments, there can be no assurance that this will be the case. See
"Outlook: Issues and Risks" herein.
Selling, General and Administrative Expenses
The Company's primary operating expenses are personnel expenses, other general
and administrative expenses, and sales and marketing expenses. Personnel
expenses include compensation, fringe benefits and other personnel expenses
related to the Company's internal employees. Other general and administrative
expenses include rent, office supplies and expenses, legal and accounting fees,
bad debt expenses, insurance and other operating expenses. Sales and marketing
expenses include commissions and salaries to sales personnel and related
expenses.
Depreciation and Amortization
Depreciation and amortization consists primarily of the amortization of goodwill
and deferred financing costs and the depreciation of property and equipment. The
Company amortizes goodwill and deferred financing costs over periods of three to
thirty years, depending on the assets acquired, using the straight-line method.
Acquisitions generally result in considerable goodwill because PEOs generally
require few fixed assets to conduct their operations.
Acquisitions
Period-to-period comparisons may be substantially affected by the Company's
acquisition of other companies providing PEO services. The Company has accounted
for its acquisitions using the "purchase" method of accounting, whereby the
results of such acquired companies are reflected in the Company's financial
statements prospectively from the date of acquisition. In addition to increasing
revenues, acquisition activity can affect gross profits and margins because the
industry mix of the acquired companies may differ from that of the Company.
Further, during the transition period after an acquisition the Company may act
to implement pricing changes where appropriate and to eliminate client
relationships which do not meet the Company's risk or profitability profiles.
Acquisition activity historically has increased the Company's workers'
compensation expense, primarily by accelerating the Company's overall growth
rate and accelerating its exposure in specific higher-risk segments, such as
transportation. The Company also seeks to eliminate certain general and
administrative costs of acquired companies although such results may not be
achieved.
Company PEO acquisitions which have affected recent periods have included the
following: ETIC Corporation d/b/a Employers Trust (ETIC) in February 1997; CMGR
Inc. and Humasys, Inc. (collectively, "CMGR") in February 1997; and four related
PEO companies referred to as "Employee Resources Corporation" (collectively,
"ERC") in September 1997. In addition, in September 1997, the Company acquired
Phoenix Capital Management, Inc. (PCM), a PEO service provider.
20
<PAGE>
Employee Solutions, Inc. June 30, 1998
- --------------------------------------------------------------------------------
Operating Results
Margin comparisons are affected by the relative mix of stand-alone risk
management/workers' compensation services, full PEO services, TEAM Services
(TEAM) services, and transportation services acquired in the Leaseway
acquisition (LPC) in any particular period. Stand-alone risk management/workers'
compensation services and LPC tend to have higher margins compared with full PEO
services while TEAM tends to have lower margins.
Certain 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. Also, fourth quarter revenues are
typically increased by year-end bonuses and distributions paid to worksite
employees, historically resulting in little to no revenue growth from fourth to
first quarter (excluding acquisitions). In addition, the Company's first quarter
revenues tend to be adversely affected by decreased activity by various of its
transportation clients due to seasonal factors.
<TABLE>
<CAPTION>
Results of Operations--
Quarter and Six Months Ended June 30, 1998 Compared to Quarter and Six Months Ended June 30, 1997
- ----------------------------------------------------------------------------------------------------------
Quarter Ended June 30, Six Months Ended June 30,
--------------------------------- ---------------------------------
Percent Percent
(In thousands of dollars) 1998 Change 1997 1998 Change 1997
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Revenues $ 254,399 13% $226,058 $ 475,329 13% $ 422,024
Cost of revenues 245,928 15 214,173 457,392 14 399,871
Gross profit 8,471 (29) 11,885 17,937 (19) 22,153
Selling, general and administrative 12,340 45 8,499 20,111 26 15,912
Depreciation and amortization 1,544 43 1,083 2,830 38 2,048
Interest income 376 49 252 1,146 156 447
Interest expense 2,152 92 1,123 4,272 107 2,065
Net income (loss) (5,722) (794) 824 (6,627) (539) 1,510
- ----------------------------------------------------------------------------------------------------------
</TABLE>
Revenues
Revenues increased to $254.4 million for the quarter ended June 30, 1998 from
$226.1 million for the quarter ended June 30, 1997, an increase of 13%. For the
six months ended June 30, 1998, revenue was $475.3 million compared to $422.0
million for the six months ended June 30, 1997, an increase of 13%. Growth from
internal sales and acquisitions was in part offset by factors such as attrition
of clients and competitive pressures in the PEO and workers' compensation
industries. Further, the Company has transitioned its sales operations from
Atlanta to Phoenix during the first six months of 1998 which has had a
short-term impact on internal sales. During the transition period, the Company
is upgrading its sales training, sales reporting methodologies and sales related
technological tools. While the Company expects that these steps will improve
internally generated sales in the long run, there can be no assurance that this
will be the case. The Company has terminated its subscriber service agreement
with US Xpress Enterprises, Inc. (US Xpress) effective August 19, 1998. US
Xpress accounted for 20% of revenues in the quarter and a negative contribution
to gross profit. Accordingly, revenues for periods after August 19, 1998 will
exclude US Xpress. See below discussion included in Cost of revenues. The number
of worksite employees increased to approximately 47,400 covering approximately
1,960 client companies at June 30, 1998 from approximately 42,900 covering 1,444
client companies at June 30, 1997.
Revenues related to stand-alone risk management/workers' compensation services
were $587,000 for the second quarter and $1.8 million for the six months ended
June 30, 1998 compared with revenues of $3.6 million and $7.1 million for the
second quarter and six months ended June 30, 1997, respectively. The decline in
stand-alone revenues is attributable primarily to a change in business strategy,
as the Company is not marketing new stand-alone policies in 1998. This change is
the result of a determination to emphasize other PEO marketing strategies and
because of the decreased profit opportunities resulting from increased price
competition in the overall workers' compensation market. The Company's
stand-alone policies will all expire by December 31, 1998, effectively
eliminating this program.
21
<PAGE>
Employee Solutions, Inc. June 30, 1998
- --------------------------------------------------------------------------------
Cost of revenues
Cost of revenues increased 15% to $245.9 million in the quarter ended June 30,
1998 from $214.2 million for the quarter ended June 30, 1997. For the six month
period ended June 30, 1998, the cost of revenues was $457.4 million an increase
of 14% over the $399.9 million for the six month period ended June 30, 1997.
This increase is primarily due to the increase in the Company's business as
described above. The cost of revenues was adversely affected in the quarter
ended June 30, 1998 as a result of healthcare costs incurred under the US Xpress
contract. Additional costs of $1.0 million were recorded in the quarter
resulting in a loss on the US Xpress contract for the period. These additional
costs in part led to the Company's decision to terminate the US Xpress contract.
The Company intends to commence litigation or arbitration with respect to these
and other amounts.
Workers' compensation expense for the quarter and six month periods ended June
30, 1998 compared favorably to the same periods in 1997. Expenses during 1998
are determined on a guaranteed cost basis to the Company (with limited
exceptions), as compared to a partially self-insured basis in 1997.
Gross profit
The Company's gross profit margin decreased to 3.3% in the quarter ended June
30, 1998 from 5.3% in the quarter ended June 30, 1997. For the six month period
ended June 30, 1998, the gross profit margin was 3.8% compared to 5.2% for the
same period in 1997. This decrease was attributable to several factors including
the impact of repricing existing clients due to competitive factors and lower
margins on new business. The proportion of gross profit related to TEAM Services
revenues, which have lower margins, increased in the period ended June 30, 1998
relative to the same period in 1997. The gross profit margin in 1998 has
benefited from a reduction of the Company's effective state unemployment
insurance tax rate and the guaranteed cost workers' compensation program. The
Company generally earned a higher gross profit margin on revenues derived from
its stand-alone risk management/workers' compensation services than on revenues
derived from the Company's full-service PEO business, as PEO revenues generally
include significant (and substantially offsetting) revenue and expense items for
payroll and payroll-related costs for the worksite employees. Accordingly, gross
margin has been negatively impacted by the increase in PEO revenues relative to
stand-alone revenues.
Selling, general and administrative
Selling, general and administrative expenses for the quarter ended June 30, 1998
increased by approximately $3.8 million to $12.3 million, or 45%, from $8.5
million for the quarter ended June 30, 1997. Included in the quarter ended June
30, 1998 were significant charges not expected to recur in future periods, as
described below. For the six month periods ended June 30, 1998 and 1997,
respectively, selling, general and administrative expenses were $20.1 million
and $16.0 million, a 26% increase. For the quarter ended June 30, 1998, the
Company incurred non-recurring professional fees of approximately $400,000
primarily related to operational and strategic initiatives. Further, certain
receivables primarily related to former sales and marketing operations in
Atlanta totaling approximately $1.0 million were reserved for in the quarter.
The receivables are non-customer related and include investments in sales
personnel and strategic sales partners in the form of loans or commission
advances. During the current quarter, the Company also wrote down approximately
$1.6 million in accounts receivable relating to recent collection difficulties
associated with the discontinuation of the Company's stand-alone workers'
compensation program. Commission expense increased in the current quarter due to
the increase in revenues discussed above and an increase in commissionable
business. In addition, the Company also incurred approximately $200,000 in
professional fees associated with the recently-terminated SES acquisition
effort. On August 11, 1998, the Company announced a restructuring and
cost-reduction plan that includes initiatives intended to significantly reduce
selling, general and administrative costs. There can be no assurance that such
initiatives can be implemented successfully and without certain disruptions in
client service.
Depreciation and amortization
Depreciation and amortization represents depreciation of property and equipment
and amortization of organizational costs, customer lists and goodwill. For the
quarter ended June 30, 1998, depreciation and amortization expense totaled $1.5
million compared to $1.1 million for the quarter ended June 30, 1997. Total
depreciation and amortization expense for the six months ended June 30, 1998 was
$2.8 compared to $2.0 million for the six month period ended June 30, 1997. The
increase was due primarily to goodwill amortization resulting from acquisitions
in 1997, depreciation of communication and computer systems and the installation
of a new fully-integrated accounting system in 1998. Goodwill amortization of
these acquisitions was recognized from the date of acquisition. See "Liquidity
and Capital Resources" below regarding the Company's issuance of $85 million in
10% Senior Notes due 2004, in particular as to the approximately $3.3 million in
offering expenses which will be amortized over the term of the Notes.
22
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Employee Solutions, Inc. June 30, 1998
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Interest
Interest expense for the quarter ended June 30, 1998 totaled $2.2 million
compared to $1.1 million for the quarter ended June 30, 1997. For the six month
period ended June 30, 1998, interest expense totaled $4.3 million compared to
$2.1 million for the six months ended June 30, 1997. The increase in interest
expense is primarily due to increased borrowings including the Company's
issuance of $85 million in 10% Senior Notes due 2004. For the quarter ended June
30, 1998 interest income totaled $376,000 compared to $252,000 for the quarter
ended June 30, 1997. Interest income totaled $1.1 million for the six months
ended June 30, 1998 compared to $447,000 for the same period ended June 30,
1997. The increase in interest income is primarily due to interest earned on
cash held at the corporate level including excess proceeds from the note
offering, and restricted cash and investments held for the future payment of
workers' compensation claims at the Company's wholly owned insurance subsidiary,
Camelback. Interest income decreased in the second quarter of 1998 and is
expected to decrease in future periods as a result of the LPT which reduced
restricted cash and investments by approximately $20.0 million in April 1998.
Effective tax rate
The Company's effective tax rate provides for federal, state and local income
taxes. For the six months ended June 30, 1998, the Company recognized an
effective tax rate benefit of 18% compared to a provision of 40% for the six
months ended June 30, 1997. The Company's effective tax rate will vary from time
to time depending primarily on the mix of profits derived from the Company's
various profit centers, the magnitude of nondeductible items relative to overall
profitability and other factors. The Company's estimated effective tax rate for
financial reporting purposes for 1998 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 under a Company sponsored program.
Liquidity and Capital Resources
The Company defines liquidity as the ability to mobilize cash to meet operating,
capital and acquisition financing needs. The Company's primary source of cash in
the quarter ended June 30, 1998 was from operating activities.
Cash used by operating activities was $21.7 million for the six months ended
June 30, 1998 compared to cash provided by operating activities of $2.8 million
for the six months ended June 30, 1997. Excluding, the effects of the loss
portfolio transfer and interest paid on the senior notes, cash flow from
operations was $3.3 million for the six months ended June 30, 1998. Operating
cash flows are derived from customers for full PEO services rendered by the
Company and for stand-alone risk management/workers' compensation services.
Payments from PEO 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 Company's TEAM Services and LPC operations extend credit
terms generally from 7 to 45 days as is customary in their respective market
segments. Stand-alone risk management/workers' compensation services are billed
in accordance with individual policies. The Company also extends credit terms
for certain of its stand-alone risk management/workers' compensation clients by
billing less than the expected premium over the policy term, with the difference
paid on a deferred basis after the end of a policy year. If the Company expands
in these market segments or enters into new market segments, or extends credit
terms to additional clients, its working capital requirements may increase.
Included in other assets is a receivable of approximately $2.9 million from a
single stand-alone client as to which disputes have risen. The Company has
initiated litigation against the former client seeking, among other remedies,
collection of the receivable. While the Company believes that it will prevail in
the litigation, there can be no assurance that this will be the case and an
adverse outcome could result in the write-off of all or a substantial portion of
the unreserved balance of the receivable.
Cash used in investing activities was $3.9 million and $8.0 million in the six
months ended June 30, 1998 and 1997, respectively. Included in investing
activities is $19.2 million of cash representing the Company's investment in
marketable securities until such funds are needed. The Company expects to use
certain of the net proceeds from the Note Offering (see below) to finance future
acquisitions. Future acquisitions are expected to be a significant use of cash.
See "Outlook: Issues and Risks-Management of Rapid Growth." In addition, the
Company is in arbitration with certain selling shareholders related to the CMGR
and ETIC acquisitions. The Company is in the process of resolving such matters
which may result in the payment of additional purchase price. Such payments, if
any, are not expected to be material to the Company's financial position. For
the six months ended June 30, 1998 and 1997, capital expenditures were $2.3
million and $1.1 million, respectively. Capital expenditures in 1998 consisted
primarily of computer equipment to enhance the Company's ability to support the
Company's increased client base and the centralization of payroll processing and
accounting systems. During 1998, the Company expects to continue to invest in
additional computer and technological equipment. Although the Company
continuously reviews its capital
23
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Employee Solutions, Inc. June 30, 1998
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expenditure needs, management expects that 1998 capital expenditures will
continue in order to meet the needs of the Company's base of worksite employees.
Cash provided in financing activities was $3.2 million for the six months ended
June 30, 1998 compared to cash provided by financing activities of $4.8 million
for the same period in 1997. Cash flows from financing activities during 1997
resulted primarily from the Company's borrowings.
At June 30, 1998 and December 31, 1997, the Company had cash and cash
equivalents of $17.7 million and $40.1 million, respectively. Cash and cash
equivalents are generally invested in high investment grade instruments with
maturities of less than 90 days. Certain amounts of restricted cash and
investments (see below) may have maturities beyond 90 days but are highly
liquid. The Company generally maintains large cash balances to meet its daily
payroll and payroll tax obligations. The Company is implementing a nationwide
cash management program to minimize the requirement for cash on hand, though as
the business continues to grow, cash requirements to meet daily obligations will
increase. In April, 1998 the Company completed an LPT which resulted in a one
time payment of $19.9 million funded primarily from restricted cash and
investments (see below).
On April 22, 1998, the Company completed a risk transfer of all of its pre-1998
workers' compensation claims liability to a third party insurer rated AAA by
Standard & Poor's, effected through an LPT valued as of February 28, 1998. In
exchange for a premium of $19.9 million (paid primarily from restricted cash and
investments), the Company acquired reinsurance of $35 million to insure its
pre-1998 workers compensation losses. Based upon the advice of its outside
actuaries, the Company believes that the risk that pre-1998 liability could
exceed the $35 million aggregate limit is extremely remote, although there can
be no assurance. The LPT provides for profit sharing opportunities with the
Company based on ultimate paid claims, though there can be no assurance whether
or when a profit will be realized. No charge to earnings was recorded in
connection with this transaction in 1998 or is expected in future periods,
although a use of cash has been recorded in the second quarter of 1998.
Under Bermuda law, Camelback must maintain statutory capital and surplus in an
amount based primarily on premium volume. Bermuda law also regulates the
circumstances under which Camelback may transfer funds to its parent company,
whether via loan, dividend or otherwise. Primarily due to the transition to a
guaranteed cost workers' compensation program effective January 1, 1998 and the
LPT completed in April 1998, these provisions of Bermuda law do not materially
impact the Company.
At June 30, 1998 and December 31, 1997, the Company had working capital of $49.5
million and $58.3 million, respectively.
Note Offering
On October 21, 1997, the Company issued $85 million of Notes in an Offering (the
Offering) effected as an exempt offering under the Securities Act of 1933 as
amended (Securities Act). Interest under the Notes is payable semi-annually
commencing April 15, 1998, and the Notes are not callable until October 2001
subject to the terms of the Note Agreement. The Company incurred expenses
related to the Offering of approximately $3.3 million and will amortize such
costs over the life of the Notes. In April 1998, the Company completed an
exchange offer for these notes which was registered under the Securities Act.
The indenture under which the Notes were issued includes certain restrictions on
use of cash, and other expenditures, by the Company including limitations on
dividends, repurchases of Company shares and the incurrence of new indebtedness.
Amended Credit Facility
In connection with the Offering, the Company entered into an amended and
restated credit facility (the "Amended Credit Facility") which provided for a
revolving line of credit of $20.0 million, including letters of credit drawn
thereunder. The Amended Credit Facility includes various borrowing rate options
including borrowing rates at the prime rate or 175 basis points over London
Interbank Offered Rate (LIBOR). The Company will pay a commitment fee of 25
basis points on the unused portion of the line and letter of credit fees of 75
to 175 basis points per annum. The Amended Credit Facility will mature on August
1, 1999. The Amended Credit Facility includes various financial and other
covenants and is secured by substantially all of the Company's assets. As a
result of 1997 and 1998 performance, the Company is not in compliance with
certain financial covenants under the Amended Credit Facility. Because the
Company believes its current liquidity is sufficient to meet its anticipated
needs, and in conjunction with the Company's overall cost reduction initiatives,
the Company has initiated negotiations to reduce the facility and revise certain
of its terms in order to reduce the fees payable thereafter.
24
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Employee Solutions, Inc. June 30, 1998
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Outlook: Issues and Risks
The following issues and risks, among others (including those discussed
elsewhere herein), should also be considered in evaluating the Company's
outlook.
Restructuring and Cost-Reduction Plan
On August 11, 1998, the Company announced a restructuring and cost-reduction
plan primarily involving the closing of remote payroll processing centers and
other offices and various other expense reduction strategies. Where offices are
being closed or consolidated, the Company will maintain an active sales and
customer service presence to meet the local needs of customers and to support
internal growth. Back office functions will be consolidated at the Company's
Phoenix, Arizona headquarters to take advantage of recent investments in systems
upgrades. The Company announced that it would take a restructuring charge in the
third quarter of 1998 in an amount estimated to range between $1.7 million and
$2.0 million, consisting primarily of lease cancellation costs and severance.
While the Company believes that the plan will result in long-term improvements
in its operational and customer service capabilities (in addition to significant
operating expense reductions), there can be no assurance that the plan will not
result in client attrition due to short-term disruptions in client service or
that the recently-implemented systems upgrades will perform as intended.
Management of Rapid Growth
The Company's success depends, in part, upon its ability to achieve growth and
manage this growth effectively. Since its formation, the Company has experienced
rapid growth which has challenged the Company's management, personnel, resources
and systems. As part of its business strategy, the Company intends to pursue
continued growth through its sales and marketing capabilities, acquisitions and
marketing alliances. Although the Company has expanded its management,
personnel, resources and systems to manage future growth and to assimilate
acquired operations, there can be no assurance that the Company will be able to
maintain or accelerate its growth in the future or manage this growth
effectively. Failure to do so could materially adversely affect the Company's
business and financial performance. To accommodate growth, the Company is
centralizing certain operations, which may result in temporary disruptions in
operations. The Company also is in the process of upgrading, or has recently
upgraded, certain of its systems, including upgrades to key systems in areas
such as accounting, payroll and workers' compensation. There can be no assurance
that these systems upgrades can be implemented successfully.
The Company has grown substantially in recent years through the acquisition of
other PEO and similar companies. There can be no assurance that the Company will
be able to find further attractive acquisition candidates at reasonable prices
or, if it does, that other potential acquirers will not compete successfully
with the Company for these candidates. Any significant increase in the number of
companies competing with the Company to acquire PEOs would likely increase the
cost of acquisitions and thereby limit the Company's ability to grow profitably
through acquisitions. In addition, although the Company attempts to evaluate
each acquisition candidate thoroughly prior to an acquisition, there can also be
no assurance that, once acquired, the Company will be able to achieve acceptable
levels of revenues, profitability or productivity from the acquired company.
Adequacy of Loss Reserves; Loss and Claims Experience
The Company obtained fully-insured guaranteed cost workers' compensation
coverage effective January 1, 1998, thereby eliminating, with limited
exceptions, the Company's risk retention on workers' compensation claims arising
after that date. The coverage was obtained through Stirling Cooke Risk
Management Services, Inc. under a three-year arrangement, with pricing subject
to annual review. The Company will retain risk up to $250,000 per occurrence
with respect to a defined portfolio of stand-alone policies which were in place
at December 31, 1997, which policies expire at various dates during 1998. The
Company also will retain risk up to $50,000 per occurrence for claims under
Ohio's monopolistic workers' compensation structure, with an aggregate liability
limitation. The Company believes that the transition to a guaranteed cost
program and LPT transaction will reduce the uncertainty associated with the
quarterly calculation of workers' compensation costs while providing a premium
cost structure for 1998 which compares favorably with historical costs. The
availability of coverage and premium costs in future years are subject to change
(including possible material upward adjustment of premium costs) based on loss
experience and competitive conditions in the overall workers' compensation
market.
The Company's reserves for losses and loss adjustment expenses under its
pre-1998 workers' compensation program and under the Ohio and stand-alone
programs referred to in the preceding paragraph are estimates of amounts needed
to pay reported and unreported claims and related loss adjustment expenses.
Reserves are estimates based on industry data and historical experience, and
include judgments of the effects that future economic and social forces are
likely to have on the Company's experience with the type of risk involved,
circumstances surrounding individual claims and trends that may affect the
probable number and nature of claims arising from losses not yet reported.
Consequently, loss reserves are inherently uncertain and are subject to a number
of circumstances that are highly variable and difficult
25
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Employee Solutions, Inc. June 30, 1998
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to predict. This uncertainty is compounded in the Company's case by its rapid
growth and limited experience. For these reasons, there can be no assurance that
the Company's ultimate liability will not materially exceed its loss and loss
adjustment expense reserves. If the Company's reserves prove to be inadequate,
the Company will be required to increase reserves or corresponding loss payments
with a corresponding reduction, which may be material, to the Company's
operating results in the period in which the deficiency is identified.
State unemployment taxes are, in part, determined by the Company's unemployment
claims experience. Medical claims experience also greatly impacts the Company's
health insurance rates and claims cost from year to year, and directly impacts
the Company under its self insured medical program. Should the Company
experience a large increase in claims activity for unemployment, workers'
compensation and/or healthcare, then its costs in these areas would increase. In
such a case, the Company may not be able to pass these higher costs to its
clients and would therefore have difficulty competing with PEOs with lower
claims rates that may offer lower rates to clients.
Tax Treatment
The attractiveness to clients of a full-service PEO arrangement depends in part
upon the tax treatment of payments for particular services and products under
the Code (for example, the opportunity of employees to pay for certain benefits
under a cafeteria plan using pre-tax dollars). The Internal Revenue Service
(IRS) has formed a Market Segment Study Group to examine whether PEOs, such as
the Company, are for certain employee benefit and tax purposes the "employers"
of worksite employees under the Code. The Company cannot predict either the
timing or the nature of any final decision that may be reached by the IRS with
respect to the Market Segment Study Group or the ultimate outcome of any such
decision, nor can the Company predict whether the Treasury Department will issue
a policy statement with respect to its position on these issues or, if issued,
whether such statement would be favorable or unfavorable to the Company. If the
IRS were to determine that the Company is not an "employer" under certain
provisions of the Code, it could materially adversely affect the Company in
several ways. With respect to benefit plans, the tax qualified status of the
Company's 401(k) plans could be revoked, and the Company's cafeteria and medical
reimbursement plans may lose their favorable tax status. If an adverse IRS
determination were applied retroactively to disqualify benefit plans, employees'
vested account balances under 401(k) plans would become taxable, an
administrative employer such as the Company would 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. In such event, the Company
also would face the risk of client dissatisfaction and potential litigation by
clients or worksite employees.
As the employer of record for many client companies and their worksite
employees, the Company must account for and remit payroll, unemployment and
other employment-related taxes to numerous federal, state and local tax, labor
and unemployment authorities, and is subject to substantial penalties for
failure to do so. From time to time, the Company has received notices or
challenges which may adversely affect its tax rates and payments. For example,
the State of Ohio recently issued a preliminary assessment of $2.57 million
(plus penalty) relating to sales taxes potentially applicable to certain types
of services. The Company is in the process of providing the State with
additional information which, the Company believes, demonstrates that the
assessment is in error. While the Company believes that no tax ultimately will
be payable based on the preliminary assessment, there can be no assurance that
this will be the case. In light of the IRS Market Segment Study Group and the
general uncertainty in this area, certain proposed legislation has been drafted
to clarify the employer status of PEOs in the context of the Code and benefit
plans. However, there can be no assurance that such legislation will be proposed
and adopted or in what form it would be adopted. Even if it were adopted, the
Company may need to change aspects of its operations or programs to comply with
any requirements which may ultimately be adopted. In particular, the Company may
need to retain increased sole or shared control over worksite employees if the
legislation is passed in its current form.
Credit Risks
As the employer of record for its worksite employees, the Company may be
contractually obligated to pay their wages, benefit costs and payroll taxes. The
Company typically bills a client company for these amounts in advance of or at
each payroll date, and reserves the right to terminate its agreement with the
client, and thereby the Company's liability for future payrolls to the client's
worksite employees, if payment is not received within two days of the invoice
date. Limited extended payment terms are offered in certain cases subject to
local competitive conditions. The rapid turnaround necessary to process and make
payroll payments leaves the Company vulnerable to client credit risks, some of
which may not be identified prior to the time payroll payments are made. There
can be no assurance that the Company will be able to timely terminate any
delinquent accounts or that its contractual termination rights will be
judicially enforced.
26
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Employee Solutions, Inc. June 30, 1998
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In addition, the Company has recently entered several market segments through
acquisitions in which PEOs typically advance wages, benefit costs and payroll
taxes to their clients. The Company intends to continue this practice despite
the potentially greater credit risk posed by such practices. Also, in its
stand-alone risk management/worker's compensation program, the Company has
structured certain of its clients' premium payments so that less than the full
premium is billed periodically through the policy year, with the difference to
be paid by the client on a deferred basis after the end of the policy year.
Following the completion of the Company's first series of policy audits, the
Company determined in late 1997 that collection rates from these clients would
be lower than expected, due in part to the Company's non-renewal of the affected
policies as part of the overall de-emphasis of its stand-alone program. The
Company conducts a limited credit review before accepting new clients. However,
the nature of the Company's business and pricing margins is such that a small
number of client credit failures could have an adverse effect on its business
and financial performance.
Securities Litigation
As previously reported, the Company and certain of its present and former
directors and executive officers have been named as defendants in ten actions
filed between March 1997 and May 1997. While the exact claims and allegations
vary, they all allege violations by the Company of Section 10(b) of the Exchange
Act, and Rule 10b-5 promulgated thereunder, with respect to the accuracy of
statements regarding Company reserves and other disclosures made by the Company
and certain directors and officers. These suits were filed after a significant
drop in the trading price of the Company's Common Stock in March 1997. The suits
have been consolidated before the U.S. District Court in Phoenix, Arizona, and a
Consolidated Amended Complaint (Complaint) was filed on April 7, 1998. The
Complaint has been provisionally certified a class action on behalf of
purchasers of Company securities from November 14, 1995 through March 13, 1997,
inclusive. The Complaint seeks the award of compensatory damages in an amount to
be determined at trial, including interest thereon, and costs of the action,
including attorneys' fees. On August 11, 1998 the court denied the Company's
motion to dismiss the Complaint. The court has indicated that it will issue an
opinion which specifies the basis for its denial of the Company's motion. Trial
has been set in the action for January 19, 1999. The Company believes that the
Complaint is without merit and it intends to defend the consolidated action
vigorously. However, the ultimate resolution of the consolidated actions could
have a material adverse effect on the Company's results of operations and
financial condition.
Client Relationships
The Company's subscriber agreements with its clients generally may be canceled
upon 30 days written notice of termination by either party, except where
different arrangements are required by applicable law. While the Company
believes that it has experienced favorable client retention in the past, there
can be no assurance that those relationships will continue or that historical
rates of retention will continue to be achieved. The short-term nature of most
customer agreements means that clients could terminate a substantial portion of
the Company's business upon short notice.
Through recent acquisitions and internal growth, the percentage of the Company's
clients in the transportation industry has increased. Increased concentration in
a single industry could make the Company subject to risks and trends of that
industry. Also, certain aspects of the transportation industry may be subject to
particular risks, such as the risk of property damage, injury and death from
accidents inherent in the operation of a motor vehicle. In addition, the Company
is providing driver leasing services through LPC, in which the Company acts as
sole employer, which may increase risk to the Company as a result of the direct
nature of the employment relationship.
Substantial Leverage
The Company has incurred significant debt primarily in connection with its
expansion through acquisitions and its October 1997 issuance of the Senior
Notes. As of June 30, 1998 and December 31, 1997, the Company had outstanding
senior indebtedness of approximately $85 million and stockholders' equity of
approximately $35.9 million and $42.4 million, respectively.
The Company's ability to make scheduled principal payments in respect of, or to
pay the interest or liquidated damages, if any, on, or to refinance, any of its
indebtedness (including the Notes) will depend on its future performance, which,
to a certain extent, is subject to general economic, financial, competitive,
regulatory and other factors beyond its control. Based upon the Company's
current level of operations, management believes that cash flow from operations
and other available cash will be adequate to meet the Company's anticipated
future requirements for working capital expenditures, scheduled lease payments
and scheduled payments of interest on its indebtedness, including the Notes, for
the foreseeable future. Due to financial covenant violations, the Company is
currently not able to borrow under the Amended Credit Facility, which had been
another source of liquidity. The Company may, however, need to refinance all or
a portion of the principal of the Notes at or prior to maturity. There can be no
assurance that the Company's business will generate sufficient cash flow from
operations, that anticipated growth will occur or that future borrowings
27
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Employee Solutions, Inc. June 30, 1998
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will be available under the Amended Credit Facility or otherwise in an amount
sufficient to enable the Company to service or refinance its indebtedness,
including the Notes, or make anticipated capital expenditures and lease
payments. In addition, there can be no assurance that the Company will be able
to effect any such refinancing on commercially reasonable terms. See "Liquidity
and Capital Resources."
The degree to which the Company is leveraged could have important consequences,
including, but not limited to, the following: (i) a substantial portion of the
Company's cash flow from operations will be dedicated to debt service and will
not be available for other purposes; (ii) the Company's ability to obtain
additional financing in the future could be limited; and (iii) the Notes
indenture and the Amended Credit Facility contain financial and restrictive
covenants that limit the ability of the Company to, among other things, borrow
additional funds. Failure by the Company to comply with such covenants could
result in an event of default which, if not cured or waived, could have a
material adverse effect on the Company's business and financial performance.
Uncertainty of Extent of PEO's Liability; Government Regulation of PEOs
Employers are regulated by numerous federal and state laws relating to labor,
tax and employment matters. Generally, these laws prohibit race, age, sex,
disability and religious discrimination, mandate 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
"co-employers" such as the Company, and 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. 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. The Company's standard forms of client
service agreement establish 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 (such as in the driver leasing program), the Company may be subject to
liability for violations of these or other laws despite these contractual
provisions, even if it does not participate in such violations. The
circumstances in which the Company acts as sole employer may expose the Company
to increased risk of such liabilities for an employee's actions. The Company has
been sued in tort actions alleging responsibility for employee actions (which it
considers to be incidental to its business). Although it believes it has
meritorious defenses, and maintains insurance (and requires its clients to
maintain insurance) covering certain of such liabilities, there can be no
assurances that the Company will not be found to be liable for damages in any
such suit, or that such liability would not have a material adverse effect on
the Company. Although the client generally is required to indemnify the Company
for any liability attributable to the conduct of the client or employee, 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.
While many states do not explicitly regulate PEOs, various states have passed
laws that have licensing or registration requirements and other states are
considering such regulation. Such laws vary from state to state but generally
provide for monitoring the fiscal responsibility of PEOs. 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.
Government Regulation Relating to Workers' Compensation Program
As part of its risk management/workers' compensation programs, the Company has
utilized Camelback, a wholly-owned insurance company subsidiary. Insurance
companies such as 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 rather than the
interests of shareholders such as the Company. In general, insurance 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 to transfer or loan statutory capital or surplus to its
affiliates. The regulation of Camelback could materially adversely affect the
Company's operations and results.
28
<PAGE>
Employee Solutions, Inc. June 30, 1998
- --------------------------------------------------------------------------------
Competition
The market for many of the services provided by the Company is highly
fragmented, with over 2,300 PEOs currently competing in the United States. Many
of these PEOs have limited operations with relatively few worksite employees,
but the Company believes that several are larger than or comparable to the
Company in size. The Company also competes with non-PEO companies, whose
offerings overlap with some of the Company's services, including payroll
processing firms, insurance companies, temporary personnel companies and human
resource consulting firms. In addition, as the PEO industry becomes better
established, the Company expects that competition will continue to increase as
existing PEO firms consolidate into fewer and better competitors and
well-organized new entrants with potentially greater resources than the Company,
including some of the non-PEO companies described above, continue to enter the
PEO market.
Year 2000 Compliance
Many computer programs process transactions based on using two digits for the
year of the transaction rather than a full four year digits (e.g. "98" for
1998). Systems that process Year 2000 transactions with the year "00" may
encounter significant processing inaccuracies or inoperability. Management has
determined that, like most other companies, it will be required to modify or
replace portions of its software so that its information systems will be able to
properly utilize dates subsequent to December 31, 1999. The Year 2000 issue will
be addressed through either the modification of existing software or conversion
to new software. However, if such transition is not completed on a timely basis,
the Year 2000 issue could have a material impact on the Company's operations.
The Company began developing its plan to address Year 2000 in 1997. The plan
includes hardware, software, electronic equipment and building systems, and
evaluates risk associated with vendor readiness. Based on developments to date,
the Company expects that the plan will be completed in a timely fashion and that
Year 2000 issues will not have a material effect on the Company's results of
operations. With respect to non-compliant software, the Company's expectation in
this regard is based upon numerous assumptions of future events including the
availability of certain resources, third party modifications and other factors,
and there can be no assurance that the Company's current expectations will be
met. Failure by third parties with which the Company interacts - particularly
federal, state and local governments - could materially adversely affect the
Company's operations.
The Company does not anticipate that the cost to achieve compliance will be
material. The Company is not able at this time to quantify the likely financial
effect of Year 2000 noncompliance by parties with which it conducts business.
The Company is in the process of evaluating contingency plans for such
noncompliance.
Item 3. Quantitative and Qualitative Disclosure About Market Risk
Not yet required by Company.
29
<PAGE>
Employee Solutions, Inc. June 30, 1998
- --------------------------------------------------------------------------------
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
Securities Class Actions
As previously reported, the Company and certain of its present and former
directors and executive officers have been named as defendants in ten actions
filed between March 1997 and May 1997. While the exact claims and allegations
vary, they all allege violations by the Company of Section 10(b) of the Exchange
Act, and Rule 10b-5 promulgated thereunder, with respect to the accuracy of
statements regarding Company reserves and other disclosures made by the Company
and certain directors and officers. These suits were filed after a significant
drop in the trading price of the Company's Common Stock in March 1997. The suits
have been consolidated before the U.S. District Court in Phoenix, Arizona, and a
Consolidated Amended Complaint (Complaint) was filed on April 7, 1998. The
Complaint has been provisionally certified a class action on behalf of
purchasers of Company securities from November 14, 1995 through March 13, 1997,
inclusive. The Complaint seeks the award of compensatory damages in an amount to
be determined at trial, including interest thereon, and costs of the action,
including attorneys' fees. On August 11, 1998 the court denied the Company's
motion to dismiss the Complaint. The court has indicated that it will issue an
opinion which specifies the basis for its denial of the Company's motion. Trial
has been set in the action for January 19, 1999. The Company believes that the
Complaint is without merit and it intends to defend the consolidated action
vigorously. However, the ultimate resolution of the consolidated actions could
have a material adverse effect on the Company's results of operations and
financial condition.
From time to time, the Company is named as a defendant in lawsuits in the
ordinary course of business. These lawsuits are not expected to have a material
adverse effect on the Company's financial position or results of operations.
Item 4. Submission of Matters to a Vote of Security Holders
The Company held its Annual Meeting of Shareholders on June 2, 1998. Of the
31,739,795 outstanding shares of the company's common stock as of the April 23,
1998 record date, 30,817,403 shares, or 97.1% of the total, were voted by proxy
or in person.
(a) At the Annual Meeting of the Shareholders, the shareholders elected six
directors. With respect to the election of directors, the following
votes were cast in favor of, or withheld authority, for each of the
following directors:
-----------------------------------------------------------------------
Directors In Favor of Withheld
------------------- ------------- ------------
Marvin D. Brody 29,467,361 1,349,992
Harvey A. Belfer 29,504,534 1,312,819
Jeffery A. Colby 29,510,634 1,306,719
Sara R. Dial 29,495,564 1,321,789
Robert L. Mueller 29,470,274 1,347,079
Quentin P. Smith, Jr. 29,520,456 1,296,897
-----------------------------------------------------------------------
(b) At the Annual Meeting of Shareholders, the shareholders also voted on a
proposal to amend the Company's 1995 Stock Option Plan to increase the
number of shares available for grants by 1,000,000 shares. With respect
to that amendment, of the reported 30,320,579 vote's cast, 26,245,148
were for, 3,940,949 were against and 134,482 abstained.
30
<PAGE>
Employee Solutions, Inc. June 30, 1998
- --------------------------------------------------------------------------------
Item 5. Other Matters
The Securities and Exchange Commission recently adopted new rules relating to
the discretionary voting of proxies at shareholder meetings. Under the new
rules, if a proponent of a matter for shareholder consideration fails to notify
the Company at least 45 days prior to the month and day of mailing the prior
year's proxy statement, then management proxies would be allowed to use their
discretionary voting authority when the proposal is raised at the annual
meeting, without any discussion of the matter in the proxy statement. This
deadline is in addition to the advance bylaw notice provisions in the Company's
bylaws; to the extent that the bylaws require a different period of time for
receipt of notice, the provisions of the bylaws override the new SEC rules.
The Company has received a notice concerning the continued listing of its Common
Stock on the NASDAQ National Market due to the recent failure to maintain a
stock price of at least $5 per share. The Company has asked for a hearing at
which it will request a temporary exception to the $5 requirement and discuss
other strategies intended to maintain a NASDAQ listing. ESI's Common Stock will
continue to trade on the NASDAQ National Market pending the outcome of the
hearing.
31
<PAGE>
Employee Solutions, Inc. June 30, 1998
- --------------------------------------------------------------------------------
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
--------
Exhibit
Number Description
------ -----------------------
27 Financial Data Schedule
(b) Reports on Form 8-K.
--------------------
Not applicable
32
<PAGE>
Employee Solutions, Inc. June 30, 1998
- --------------------------------------------------------------------------------
SIGNATURES
Pursuant to the requirements of The Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
EMPLOYEE SOLUTIONS, INC.
Date: August 14, 1998 /s/ James E. Gorman
---------------------------- ------------------------------
James E. Gorman
Chief Executive Officer
/s/ Morris C. Aaron
------------------------------
Morris C. Aaron
Chief Financial Officer
/s/ John V. Prince
------------------------------
John V. Prince
Chief Accounting Officer
33
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL
INFORMATION EXTRACTED FROM THE COMPANY'S FORM 10-Q
FOR THE PERIOD ENDED JUNE 30, 1998 AND IS
QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH
FORM 10-Q.
</LEGEND>
<MULTIPLIER> 1,000
<CURRENCY> U.S. DOLLARS
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> JUN-30-1998
<EXCHANGE-RATE> 1
<CASH> 17,703
<SECURITIES> 19,221
<RECEIVABLES> 53,466
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 106,588
<PP&E> 4,920
<DEPRECIATION> 0
<TOTAL-ASSETS> 179,953
<CURRENT-LIABILITIES> 57,120
<BONDS> 0
0
0
<COMMON> 34,675
<OTHER-SE> 1,239
<TOTAL-LIABILITY-AND-EQUITY> 179,953
<SALES> 0
<TOTAL-REVENUES> 475,329
<CGS> 0
<TOTAL-COSTS> 457,392
<OTHER-EXPENSES> 22,941
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 4,272
<INCOME-PRETAX> (8,125)
<INCOME-TAX> (1,498)
<INCOME-CONTINUING> (6,627)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (6,627)
<EPS-PRIMARY> (0.21)
<EPS-DILUTED> (0.21)
</TABLE>
