ITEM 1. Business
Overview
QC Holdings, Inc. and its subsidiaries provide various financial services (primarily payday loans) and sell used vehicles and earn finance charges from the related vehicle financing contracts. References below to “we”, “us” and “our” may refer to QC Holdings, Inc. exclusively or to one or more of our subsidiaries. Originally formed in 1984, we were incorporated in the state of Kansas in 1998 and have provided various retail consumer products and services during our 28-year history.
We operate primarily through our wholly-owned subsidiaries, QC Financial Services, Inc., QC Auto Services, Inc., QC Loan Services, Inc., QC E-Services, Inc., QC Canada Holdings Inc. and QC Capital, Inc. QC Financial Services, Inc. is the 100% owner of QC Financial Services of California, Inc., Financial Services of North Carolina, Inc., QC Financial Services of Texas, Inc., Express Check Advance of South Carolina, LLC, QC Advance, Inc., Cash Title Loans, Inc. and QC Properties, LLC. QC Canada Holdings Inc. is the 100% owner of Direct Credit Holdings Inc. and its wholly owned subsidiaries (collectively, Direct Credit).
We evaluate and report on our business units as three operating segments (Financial Services, Automotive and E-Lending). The Financial Services segment includes branches in the United States that offer payday loans, installment loans, credit services, check cashing services, title loans, money transfers and money orders. The Automotive segment consists of our buy here, pay here operations. The E-Lending segment includes the Internet lending operations in Canada. We evaluate the performance of our segments based on, among other things, gross profit, income from continuing operations before income taxes and return on invested capital.
The following table sets forth the revenue and percentage of total revenue for each operating segment.
The following table summarizes our gross profit (loss), gross margin (gross profit as a percentage of revenues) and loss ratio (losses as a percentage of revenues) of each operating segment for the years ended December 31, 2011 and 2012.
(a) Excludes 38 branches that are scheduled to close during first half of 2013.
Financial Services
Revenues from our financial services are primarily derived by providing short-term consumer loans, known as payday loans, which represented approximately 66.0% of our total revenues for the year ended December 31, 2012. We earn fees for various other financial services, such as installment loans, credit services, check cashing services, title loans, open-end credit, debit cards, money transfers and money orders. We operated 466 short-term lending branches in 23 states as of December 31, 2012. In all states in which we offer payday loans, we fund our payday loans directly to the customer and receive a fee.
We entered the payday loan industry in 1992, and believe that we were one of the first companies to offer the payday loan product in the United States. We have served the same customer base since 1984, beginning with a rent-to-own business and continuing with check cashing services in 1988. We sold our rent-to-own branches in 1994.
Since 1998, we have been primarily engaged in the business of providing payday loans through our branch network in the United States, with principal values that typically range from $100 to $500. Payday loans provide customers with cash in exchange for a promissory note with a maturity of generally two to three weeks and supported by that customer’s personal check for the aggregate amount of the cash advanced plus a fee. To repay a cash advance from one of our branches, customers may pay with cash, in which case their personal check is returned to them, or they may allow the check to be presented to the bank for collection. The fee for payday loans in the United States varies from state to state, based on applicable regulations, and generally ranges from $15 to $20 per $100 borrowed, although recent legislation in a few states has capped the fee below $2 per $100 borrowed. Based on the cost structure required to operate a storefront location, we spend approximately $10 to $11 per $100 borrowed, exclusive of loan losses. As a result, in states where a fee cap below that cost level is mandated, without additional fees, we are unable to operate at a profit.
During 1999 and 2000, we tripled our size as a result of several acquisitions. These acquisitions were funded in part by internally generated cash flow and in part by proceeds received from a minority investor in October 1999. From 2001 through June 30, 2004, we focused primarily on de novo growth, using cash flow from operations and borrowings under a revolving credit facility to fund the expenditures required. In the second half of 2004 and 2005, we initiated an aggressive growth plan and opened 219 de novo branches and acquired 39 branches, which were funded by proceeds from our initial public offering and internally generated cash flow.
In response to changes in the overall market and unfavorable legislation in several states, we have closed a significant number of branches over the last five years. During this period, we opened 26 de novo branches, acquired 1 branch and closed 157 branches. The following table sets forth our de novo branch openings, branch acquisitions and branch closings since January 1, 2008.
(a) In December 2010, we announced that we would close 21 branches during the first half of 2011 as a result of the negative impact from changes in payday lending laws in Arizona, Washington and South Carolina. In 2011, we closed 18 of the branches and decided that the remaining 3 branches would remain open. These 18 branches are included in the 2011 total for branches closed during the year.
(b) In December 2012, we decided that we would close 38 branches during first half of 2013. The ending branch number for 2012 includes these 38 branches; however, these branches are included as part of discontinued operations during 2012.
On December 1, 2006, we acquired all the issued and outstanding membership interests in Express Check Advance of South Carolina, LLC (ECA) for approximately $16.3 million, net of cash acquired. The acquisition was funded with a draw on our revolving credit facility.
During March and April 2007, we acquired 13 payday and installment loan branches in Illinois and Missouri. Shortly after the acquisition, we closed six of the payday loan branches that were located near six of our existing branches and transferred the loans receivable to those branches. In the future, we anticipate there could be similar opportunities for consolidation-type acquisitions.
We evaluate opportunities for product and geographic diversification and for new branch development to complement existing branches within a given state or market. Additionally, we utilize a disciplined acquisition strategy when evaluating possible businesses. During 2013, we expect to open approximately 10 branches providing short-term loan products.
Generally, branch closings have been associated with (i) negative changes in the legislative or regulatory environment in a state, (ii) overlapping branch locations (as a result of acquisitions), or (iii) markets where we believed long-term growth potential was minimal. We review the financial metrics of each branch to determine if trends exist with respect to declining loan volumes and revenues that might require the closing of the branch. In those instances, we evaluate the need to close the branch based on several factors, including the length of time the branch has been open, geographic location, competitive environment, proximity to another one of our branches and long-term market potential.
During 2012, we closed 24 branches in various states (which included four branches that were consolidated into nearby branches). In addition, we decided to close 38 underperforming branches during first half of 2013, the majority of which are located in states (South Carolina, Washington and Colorado) where we have been subject to unfavorable changes to payday loans in recent years. We recorded approximately $699,000 in pre-tax charges during 2012 associated with these planned closures. The charges included a $398,000 loss for the disposition of fixed assets, $263,000 for lease terminations and other related occupancy costs and $38,000 for other costs.
During 2011, we closed 24 branches in various states (which included four branches that were consolidated into nearby branches) and sold one branch. We recorded approximately $553,000 in pre-tax charges during 2011 associated with these closures. The charges included a $283,000 loss for the disposition of fixed assets, $252,000 for lease terminations and other related occupancy costs and $18,000 for other costs.
During 2010, we closed 34 branches in various states and decided that we would close 21 branches primarily in Arizona, Washington and South Carolina during first half 2011 due to unfavorable changes to the payday loan laws in each of those states during 2010. During 2011, we closed 18 of the 21 branches and decided that the remaining three branches would remain open. As a result, we recorded approximately $1.8 million in pre-tax charges during 2010 associated with these closings. The charges included $916,000 representing the loss on the disposition of fixed assets, $671,000 for lease terminations and other related occupancy costs, $155,000 in severance and benefit costs and $33,000 for other costs.
During 2009, we closed 32 branches in various states (which included six branches that were consolidated into nearby branches). As a result of these closings, we recorded approximately $1.7 million in pre-tax charges during 2009 to reflect fixed asset write-offs and termination of lease obligations, the majority of which is included in discontinued operations in the consolidated financial statements.
During third quarter 2008, we closed 13 of our 32 branches in Ohio, primarily due to a new law that went into effect on September 1, 2008 that severely restricts the profitability of offering payday loans. In addition, we closed 11 of our lower performing branches in various other states during 2008 by consolidating those branches into nearby branches.
During 2007, we closed 34 of our branches in various states (the majority of which were consolidated into nearby branches), and we terminated the de novo process on eight branches that were never opened. In addition, a new law went into effect in Oregon that capped the interest rate that may be charged on a payday loan to 36% per annum, which translates to a fee of approximately $1.38 per $100 borrowed. As a result of the new law, we closed our eight branches in Oregon during third quarter 2007.
We will continue to evaluate our branch network to determine the ongoing viability of each branch, particularly in states where legislative and regulatory changes have occurred. To the extent that we close branches during 2013, we would incur certain closing costs, which would include non-cash charges for the write-off of fixed assets and cash charges for the settlement of lease obligations.
Automotive
In September 2007, we entered into the buy here, pay here segment of the used automotive market in connection with ongoing efforts to evaluate alternative products that serve our customer base. In January 2009, we purchased two buy here, pay here locations in Missouri for approximately $4.2 million. As of December 31, 2012, we operated five buy here, pay here lots, three of which are located in Missouri and the other two in Kansas. These locations sell used vehicles and earn finance charges from the related vehicle financing contracts. In May 2009, we opened a service center to provide reconditioning services on our inventory of vehicles and repair services for our customers.
E-Lending
On September 30, 2011, through a wholly-owned subsidiary, QC Canada Holdings Inc., we acquired 100% of the outstanding stock of Direct Credit, a British Columbia company engaged in short-term, consumer Internet lending in certain Canadian provinces. Direct Credit was founded in 1999 and has developed and grown a proprietary Internet-based lending platform in Canada. The acquisition of Direct Credit is part of the implementation of our strategy to diversify by increasing product offerings and distribution, as well as expanding our presence into international markets.
Industry Background
Payday Loan Industry
The payday loan industry began its rapid growth in 1996, when there were an estimated 2,000 payday loan branches in the United States. According to Community Financial Services Association (CFSA), industry analysts estimate that the industry has approximately 18,300 payday loan branches in the United States and approximately 1,400 payday loan and check cashing retail locations in Canada. During 2012, the branches in the United States extended approximately $30 billion in short-term credit to millions of middle-class households that experienced cash-flow shortfalls between paydays. As the branch count grew over the last decade, a greater number of Internet-based payday loan providers emerged. Industry analysts estimated that Internet-based payday loan providers extended approximately $18.6 billion to their customers during 2012. In the last few years, the rate of growth for these Internet providers has exceeded that of the branch-based lenders. We believe this trend will continue into the foreseeable future as consumers become more comfortable transacting electronically. Industry analysts have suggested that the volume of short-term loans transacted over the Internet will exceed the volume through bricks-and-mortar locations within the next three to five years.
We believe our industry is highly fragmented, with the larger companies operating approximately 50% of the total industry branches. After a number of years of growth, the industry has contracted slightly in the past few years, primarily due to changes in laws that govern the payday product. Absent changes in regulations and laws, we do not expect significant fluctuations in the industry’s number of branches in the foreseeable future.
Payday loan customers typically are middle-income, middle-educated individuals who are a part of a young family. Research studies by the industry and academic economists, as well as information from our customer database, have confirmed the following about payday loan customers:
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more than half earn between $25,000 and $50,000 annually;
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the majority are under 45 years old;
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more than half have attended college, and one in five has a bachelor’s degree or higher;
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more than 40% are homeowners, and about half have children in the household; and
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all have steady incomes and all have checking accounts.
In addition, at least two-thirds of industry customers say they have at least one other alternative to using a payday loan that offers quick access to money, such as overdraft protection, credit cards, credit union loans or savings accounts. We believe that our customers choose the payday loan product because it is quick, convenient and, in many instances, a lower-cost or more suitable alternative for the customer than the other available alternatives.
Buy Here, Pay Here Industry
The market for used car sales in the United States is significant. The used vehicle industry is highly fragmented, with sales typically occurring through one of three channels: (i) the used vehicle retail operations of manufacturers’ franchised new car dealerships, (ii) independent used vehicle dealerships and (iii) individuals who sell used vehicles in private transactions. We operate in the buy here, pay here segment of the independent used car sales and finance market. Buy here, pay here dealers typically sell and finance used vehicles to individuals with limited credit histories or past credit problems. Buy here, pay here dealers are characterized by their sale of older, higher mileage cars; relatively small inventories of vehicles; and their requirements that customers make installment payments weekly or bi-weekly (to coincide with a customer’s payday) in person at the dealership.
The used vehicle financing segment is highly fragmented and is served by a variety of financing sources that include independent finance companies, buy here, pay here dealers, and select traditional lending sources such as banks, savings and loans, credit unions and captive finance subsidiaries of vehicle manufacturers. Many traditional lending sources have historically avoided the sub-prime market due to its relatively high credit risk and the associated collection efforts and costs.
Our Services
Our primary business is offering payday loans through our network of branches in the United States and over the Internet in Canada through our subsidiary Direct Credit. In addition, we offer other consumer financial services, such as installment loans, credit services, check cashing services, title loans, open-end credit, money transfers and money orders. We also operate in the buy here, pay here segment of the used automobile market.
The following table sets forth the percentage of total revenue for payday loans and the other services we provide.
Payday Loans
To obtain a payday loan from one of our branch locations, a customer must complete a loan application, provide a valid identification, maintain a personal checking account, have a source of income sufficient to loan some amount to the customer, and not otherwise be in default on a loan from us. Upon completion of a loan application, the customer signs a promissory note and provides us with a check for the principal loan amount plus a specified fee, which varies by state. State laws typically limit fees to a range of $15 to $20 per $100 borrowed, although recent legislation in a few states has capped the fee below $2 per $100 borrowed. Loans generally mature in two to three weeks, on or near the date of a customer’s next payday. Our agreement with customers provides that we will not cash their check until the due date of the loan. The customer’s debt to us is satisfied by:
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payment of the full amount owed in cash in exchange for return of the customer’s check;
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deposit of the customer’s check with the bank and its successful collection;
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automated clearing house (ACH) payment; or where applicable, renewal of the customer’s loan after payment of the original loan fee in cash.
We offer renewals only in states that allow them, and, subject to more restrictive requirements under state law, we comply with the recommended best practices set forth by the CFSA and offer no more than four consecutive renewals per customer after the initial loan. We also require that the customer sign a new promissory note and provide a new check for each payday loan renewal. If a customer is unable to meet his or her current repayment for a payday loan, the customer may qualify for an extended payment plan (EPP). In most states, the terms of our EPP conform to the CFSA best practices and guidelines. Certain states have specified their own terms and eligibility requirements for an EPP. Generally, a customer may enter into an EPP once every 12 months, and the EPP will call for scheduled payments (without any additional interest or fees) that coincide with the customer’s next four paydays. In some states, a customer may enter into an EPP more frequently. We will not engage in collection efforts while a customer is enrolled in an EPP. If a customer misses a scheduled payment under the EPP, our personnel may resume normal collection procedures. We do not offer an EPP for our installment loans, nor does the third party lender in Texas offer an EPP to its customers.
To obtain a payday loan from us via the Internet in Canada, our Canadian customers fill out and digitally sign an online application and submit a digital copy of their most recent bank statement. With respect to the underwriting process, we maintain a set of criteria that all applicants must meet and we use internal screening tools during the account origination process to evaluate an applicant’s credit worthiness.
During 2012, approximately 89.8% of our U.S. payday loan volume was repaid by the customer returning to the branch and settling their obligation by either payment in cash of the full amount owed or by renewal of the payday loan through payment of the original loan fee and signing a new promissory note accompanied by a new check. With respect to the remaining 10.2% of U.S. payday loan volume, we presented the customer’s check to the bank for payment of the payday loan. Approximately 43.6% of items presented to the bank were collected and approximately 56.4% were returned to us due to insufficient funds in the customer’s account, which equates to gross losses of approximately 5.8% of total loan volume. If a customer’s check is returned to us for insufficient funds or any other reason, we initiate collection efforts. During 2012, our efforts resulted in approximately 57.4% collection of the returned items, which includes cash received totaling $685,000 for the sale of older debt. As a result, our overall provision for payday loan losses during 2012 was approximately 2.5% of total payday loan volume (including Internet lending). On average, our overall provision for payday loan losses has historically ranged from 2% to 5% of total payday loan volume based on market factors, average age of our branch base, rate of unit branch growth and effectiveness of our collection efforts.
In 2012, our customers averaged approximately six two-week payday loans (out of a possible 26 two-week loans). The average term of a loan to our customers was 17 days for each of the years ended December 31, 2010 and 2011 and 18 days for the year ended December 31, 2012.
Our business is seasonal due to the fluctuating demand for payday loans during the year. Historically, we have experienced our highest demand for payday loans in January and in the fourth calendar quarter. As a result of the receipt by customers of their income tax refunds, demand for payday loans has historically declined in the balance of the first calendar quarter and the first month of the second quarter. Our loss ratio historically fluctuates with these changes in payday loan demand, with a higher loss ratio in the second and third calendar quarters and a lower loss ratio in the first and fourth calendar quarters.
Installment Loans
We began offering branch-based installment loans to customers in our Illinois branches during second quarter 2006 and expanded that product offering to customers in additional states during 2009 and 2010. In 2012, we introduced new installment loan products (signature loans and auto equity loans) to meet customer demand for longer-term loan options. These new products are higher-dollar and longer-term installment loans that are centrally underwritten and distributed through our existing branch network. The installment loans are payable in monthly installments (principal plus accrued interest) with terms ranging from 12 to 48 months, and all loans are pre-payable at any time without penalty. The fee for an installment loan varies based on the amount borrowed and the term of the loan. As of December 31, 2012, we offered our installment loan products to customers in 200 of our branches in 10 of the 23 states in which we operate.
The process for obtaining a signature or auto equity installment loan is similar to that of obtaining a payday loan. Our customers submit applications in-person at one of our branches along with photo identification, bank account information, personal references, and proof of income. The application and customer information is forwarded to our central underwriting department for approval. We adhere to more stringent underwriting criteria for installment loans than for short-term consumer loans, running credit reports for all centrally approved installment loan customers.
Signature loans are unsecured installment loans with a typical term of 6 to 36 months and a principal balance of up to $3,000. Fees and interest vary based on the size and term of the loan and whether the customer pays with cash/check or uses recurring ACH payments. During 2012, the average principal amount of a signature loan was $1,882 and the average term was 18 months. In 2012, our signature loans accounted for 1.6% of revenue and were offered in 106 locations.
Auto equity loans are higher-dollar installment loans secured by the borrower’s auto title with a typical term of 12 to 48 months and a principal balance of up to $15,000. Fees and interest vary based on the size and term of the loan. During 2012, the average principal amount of an auto equity loan was $3,068 and the average term was 25 months.
We offer branch-based installment loans to customers in eight states across our branch network. Branch-based installment loans are very similar to payday loans in principal amount, fees and interest, but allow the customer to repay the loan in bi-weekly installments. The loans are not centrally underwritten and have much smaller balances and higher interest rates than our signature and auto equity installment loans. In 2012, branch-based installment loans accounted for 10.1% of revenue and were offered in 93 locations.
Other Financial Services
We also offer other consumer financial services, such as credit services, check cashing services, title loans, open-end credit, money transfers and money orders. Together, these other financial services constituted 9.9%, 10.6% and 9.1% of our revenues for the years ended December 31, 2010, 2011 and 2012, respectively.
In Texas, through one of our subsidiaries, we operate as a credit service organization (CSO) on behalf of consumers in accordance with Texas laws. We charge the consumer a CSO fee for arranging for an unrelated third-party to make a loan to the consumer and for providing related services to the consumer, including a guarantee of the consumer’s obligation to the third-party lender. We also service the loan for the lender. The CSO fee is recognized ratably over the term of the loan. We are not involved in the loan approval process or in determining the loan approval procedures or criteria. As a result, loans made by the lender are not included in our loan receivable balance and are not reflected in the consolidated balance sheet. We absorb all risk of loss, however, through our guarantee of the consumer’s loan from the lender.
We offered check cashing services in 400 of our 466 branches as of December 31, 2012. We primarily cash payroll, government assistance, tax refund, insurance and personal checks. Before cashing a check, we verify the customer’s identification and the validity of the check. Our fees for this service averaged 2.8%, 2.8% and 2.7% of the face amount of the check in 2010, 2011 and 2012, respectively. If a check cashed by us is not paid for any reason, we record the full face value of the check as a loss in the period when the check was returned unpaid. We then contact the customer to initiate the collection process. Check cashing revenues are typically higher in the first quarter due primarily to customers’ receipt of income tax refund checks.
We also offer title loans, which are short-term consumer loans. Typically, we advance or will loan up to 25% of the estimated value of the underlying vehicle for a term of 30 days, secured by the customer’s vehicle. Generally, if a customer has not repaid a loan after 30 days, we charge the receivable to expense and we initiate collection efforts. Occasionally, we hire an agent to initiate repossession. We offered title loans in 184 branches as of December 31, 2012.
We are also an agent for the transmission and receipt of wire transfers for MoneyGram. Through this network, our customers can transfer funds electronically to more than 293,000 locations in more than 197 countries and territories throughout the world. Additionally, our branches offer MoneyGram money orders.
In Virginia we currently offer the open-end credit product through a limited number of branches. The open-end credit product is very similar to a credit card as the customer is granted a grace period of 25 days to repay the loan without incurring any interest. Further, we are responsible for providing the borrower with a monthly statement and we require the borrower to make a monthly payment based on the outstanding balance. In addition to interest earned on the outstanding balance, the open-end credit product also includes a monthly membership fee.
Automotive
We had five buy here, pay here car locations as of December 31, 2012. As an operator of buy here, pay here locations, we sell and finance used cars to individuals who may or may not have a bank account, have limited credit histories or past credit problems. We purchase our inventory of vehicles primarily through auctions. Generally, our buyer purchases vehicles between six and 10 years of age with 90,000 to 130,000 miles, and pay between $3,000 and $8,000 per vehicle. The vehicles acquired are carried in inventory at the amount of purchase price plus vehicle reconditioning costs (not to exceed its net realizable value).
We provide financing to substantially all of our customers who purchase a vehicle at one of our buy here, pay here locations. Our finance contract typically includes a down payment or a trade-in allowance ranging from $200 to $2,000 and an average term of 33 months. We require payments to be made on a weekly, bi-weekly, semi-monthly or monthly basis to coincide with the customer’s pay date. The average principal amount for buy here, pay here loans originated during 2012 was approximately $10,245. We provide a limited warranty on most of the vehicles we sell.
All of our retail installment contracts are serviced by employees at the locations. The majority of our customers make their payments in person at the dealership where they purchased their vehicle, although some customers send their payments through the mail. Each location closely monitors its customer accounts using our point-of-sale software that stratifies past due accounts by the number of days past due. We also have a corporate collections team, which monitors policies, procedures and the status of accounts at the dealership level. We believe that the timely response to past due accounts is critical to collections success.
In December 2012, we completed two transactions involving $17.2 million principal amount of our automobile loans receivable. We received approximately $11.9 million in cash proceeds in exchange for relinquishing our right, title and interest in the automobile loans receivable. We are subject to recourse provisions requiring us to re-purchase certain automobile loans receivable in the event of a default. We used the net proceeds we received to make a prepayment of the term loan under our credit agreement.
With respect to the transfer of $17.2 million in automobile loans receivable, we treated $16.1 million of this amount as a sale and recognized a $2.6 million loss from the sale in the other income component of the Consolidated Statements of Income. We were unable to satisfy certain criteria for sale accounting treatment with respect to the transfer of $1.1 million in principal amount of automobile loans receivable. These transferred assets have been classified as collateralized receivables and the cash proceeds received (approximately $618,000) from the transfer of these automobile loans receivable have been classified as a secured borrowing in the consolidated balance sheets.
Our automotive locations experience seasonality as automobile sales peak during the first quarter of each year, primarily as a result of the receipt by customers of their income tax refunds, which are used as down payments for a vehicle. Automobile sales in the final three quarters are generally lower than the first quarter. In addition, vehicle acquisition costs tend to increase in the second half of the year as companies build inventories for the expected first quarter volumes.
Business Strategy
We historically have expanded our business by opening de novo branches and through acquisitions. De novo growth allows us to leverage our regional, area and branch managers’ knowledge of their local markets to identify strong prospective branch locations and to train managers and employees at the outset on our strategy and procedures. From 1998 through 2012, we acquired 241 short-term lending branches. We review and evaluate acquisitions as they are presented to us. Because of our position in the industry, potential sellers have offered to sell to us from as few as one branch to groups of 100 branches or more.
In recent years, we have reversed the growth of our branch network and closed stores that were unprofitable. We have focused on growing revenue by introducing new products that serve our existing loyal customer base and increasing profitability by streamlining operations. As part of our efforts to introduce new products and diversify our revenue stream, we are currently in the process of accelerating the growth of our longer-term, centrally underwritten installment loan product to our existing branch network. We continually evaluate opportunities for product and geographic expansion and for new branch development to complement existing branches within a given state or market.
We intend to continue to evaluate acquisition opportunities presented to us in the buy here, pay here segment of the used car market. In addition, we are currently in the process of restructuring our Automotive segment. Historically, we have carried all of our automobile loans receivable on our balance sheet; however, in December 2012, we sold roughly 90% of our automobile loans receivable to a third party. Additionally, while the Automotive segment has been funded from our operations, we are evaluating a forward flow arrangement whereby sales of automobiles are funded directly by a third-party lender. We believe these changes will enhance profitability as a result of improved net credit expense, in addition to enabling us to reduce the capital requirements of the business going forward.
We believe the acquisition of Direct Credit broadens our product platform and distribution, as well as expands our presence by entering into international markets. Although the Canadian market is much smaller than the U.S. market, there is still significant room for organic growth, and Direct Credit is a scalable platform with a competitive method for funding loans. In addition, Direct Credit’s online technology can be used as a platform for future expansion into other markets, and we are currently leveraging Direct Credit’s online business model to develop an Internet-based lending platform for customers in the United States. A viable U.S. Internet presence will help us further diversify our revenue base and offer our customers another financing alternative.
Locations
The following table shows the number of short-term lending branches by state that were open as of December 31 from 2008 to 2012:
(a) For 2010, the total includes 21 branches (primarily in Arizona, Washington and South Carolina) that were scheduled to close during first half of 2011. During 2011, we closed 18 of the 21 branches and decided that the remaining three branches would remain open. For 2012, the total includes 38 branches (primarily in South Carolina, Washington, Colorado and Oklahoma) that are scheduled to close during first half of 2013.
We generally choose branch locations in high traffic areas providing visible signage and easy access for customers. Branches are generally in small strip-malls or stand-alone buildings. We identify de novo branch locations using a combination of market analysis, field surveys and our own site-selection experience.
Our branch interiors are designed to provide a pleasant, friendly environment for customers and employees. Branch hours vary by market based on customer demand, but generally branches are open from 9:00 a.m. to 7:00 p.m., Monday through Friday, with shorter hours on Saturdays. Branches are generally closed on Sundays.
Our short-term lending branches located in the states of Missouri, California and Kansas represented approximately 22%, 15% and 5%, respectively, of total revenues for the year ended December 31, 2012. Our short-term lending branches located in the states of Missouri, California, Kansas and New Mexico represented approximately 33%, 17%, 7% and 5%, respectively, of total gross profit for the year ended December 31, 2012. To the extent that laws and regulations are passed that affect our ability to offer loans or the manner in which we offer loans in any one of those states, our financial position, results of operations and cash flows could be adversely affected. In recent years, we have experienced several negative effects resulting from law changes, for example:
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The Arizona payday loan statutory authority expired by its terms on June 30, 2010, and the expiration of this law had a significant adverse effect on the revenues and profitability of our Arizona branches. For the year ended December 31, 2011, revenues and gross profit from the Arizona branches declined by $1.5 million and $1.4 million respectively, from the same period in the prior year. Prior to the expiration of the Arizona payday loan law, branches in Arizona accounted for more than 5% of our revenues and gross profits.
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In March 2011, a new payday law became effective in Illinois that imposes customer usage restrictions that affected revenues and profitability negatively. The Illinois law provides for an overlap of the previous lending approach with loans issued under the new law for a period of one year, which extended the time period over which the negative effects of the new law occurred. During 2011, revenues from branches in Illinois declined by $2.4 million and gross profit declined by $2.2 million. For the year ended December 31, 2012, revenues and gross profit from Illinois declined by $2.0 million and $1.8 million, respectively, from the year ended December 31, 2011. Prior to the change in Illinois payday loan law, branches in Illinois accounted for more than 5% of our revenues and gross profits.
There was an effort in Missouri to place a voter initiative on the statewide ballot in November 2012, which was intended to preclude any lending in the state with an annual rate over 36%. The supporters of the voter initiative did not submit a sufficient number of valid signatures to place the initiative on the ballot in November 2012. However, a similar initiative was submitted to the Missouri Secretary of State in December 2012 for inclusion on the November 2014 ballot subject to the proponents submitting the required number of valid signatures in support of the initiative.
Advertising and Marketing
Our advertising and marketing efforts are designed to build customer loyalty and introduce new customers to our services. Our corporate marketing function is focused on strategically positioning us as a leader in the payday lending marketplace as well as creating awareness of our Kansas City automotive locations. Our marketing department oversees direct mail offerings to current, former and prospective customers, as well as engages in building and supervising branch-level marketing programs. Branch-level efforts include flyers, coupons, special offers, local direct mail, radio, television or outdoor advertising. In conjunction with marketing partners, we develop promotional materials, and maintain a considerable presence in Yellow Page directories throughout the country.
In Canada, our advertising and marketing strategy is designed to produce substantial lead generation through both direct and indirect channels. Direct channels include our websites and through our proprietary database. Our advertising efforts through indirect channels include placing ads on highly visited websites (such as Google, The Microsoft Network (MSN) and Yahoo), search engine optimization and maintaining a presence in the Yellow Page directories.
Technology
We maintain an integrated system of applications and platforms for transaction processing. The systems provide customer service, internal control mechanisms, compliance monitoring, record keeping and reporting. We have one primary point-of-sale system utilized by the majority of our branches in the United States as of December 31, 2012. We work closely with our point-of-sale software vendor to enhance and continually update the application. In our Virginia branches, we utilize a second point-of-sale system that can accommodate the open-end credit product. For our buy here, pay here locations, we implemented a separate system that manages the automobile business.
Our systems provide our branches with customer information and history to enable our customer service representatives to perform transactions in an efficient manner. The integration of our systems allows for the accurate and timely reporting of information for corporate and field administrative staff. Information is distributed from our point-of-sale system to our corporate accounting systems to provide for daily reconciliation and exception alerts.
On a daily basis, transaction data is collected at our corporate headquarters and integrated into our management information systems. These systems are designed to provide summary, detailed and exception information to regional, area and branch managers as well as corporate staff. Reporting is separated by areas of operational responsibility and accessible through Internet connectivity.
Direct Credit developed a proprietary loan processing and management system through which all transactions are being processed. The system incorporates customary internal control mechanisms, contract and loan lifecycle management, disbursement and payment handling, record keeping and reporting capabilities. The integrated system provides our customer service personnel with customer information, including a history of loan activity, as well as accurate and timely reporting of loan activity for management.
We also maintain and test a comprehensive disaster recovery plan for all critical host systems. The disaster recovery plan is routinely updated to reflect new requirements and business systems. As part of the plan, we have a contract with a third-party to replicate all essential host data changes to the off-site location in Dallas, Texas, which provides immediate access to needed technologies, if necessary.
Security
The principal security risks to our operations are theft or improper use of personal consumer data, robbery and employee theft. We have put in place extensive branch security systems, technology security measures, dedicated security personnel and management information systems to address these areas of potential loss.
We store and process large amounts of personally identifiable information, that consists primarily of customer information. We utilize a range of technology solutions and internal controls and procedures, including data encryption, two-factor authentication, secure tunneling and intrusion prevention systems, to protect and restrict access to and use of personal consumer data.
To protect against robbery, the majority of employees in our branches work behind bullet-resistant glass and steel partitions, and the back office, safe and computer areas are locked and closed to customers. Our security measures in each branch include safes, electronic alarm systems monitored by third parties, control over entry to customer service representative areas, detection of entry through perimeter openings, walls and ceilings and the tracking of all employee movement in and out of secured areas. Employees use cellular phones to ensure safety and security whenever they are outside the secure customer service representative area. Additional security measures include remote control over alarm systems, arming/disarming and changing user codes and mechanically and electronically controlled time-delay safes.
Because we have high volumes of cash and negotiable instruments at our locations, daily monitoring, unannounced audits and immediate response to irregularities are critical. We have an internal auditing department that, among other things, performs periodic unannounced branch audits and cash counts at randomly selected locations. We self-insure for employee theft and dishonesty at the branch level.
Competition
Payday Loan Industry
We offer payday loans through our retail branches in the United States and over the Internet in Canada. We believe that the primary competitive factors for retail branches in the payday loan industry are location and customer service. With respect to Internet lending, the primary competitive factors are advertising to develop leads and customer service (which includes timely distribution of funds after a loan is approved and professional collection efforts). For each distribution type (branches and Internet), the other distribution method is also a competitive factor. Branch-based lending is faced with a growing number of customers migrating to the ease of the online transaction. From an online lending perspective, customers remain rooted to the immediacy of cash-in-hand when the transaction is completed in a branch.
In addition to storefront payday loan locations and Internet lending, we also currently compete with services such as overdraft protection offered by traditional financial institutions, payday loan-type products offered by some banks and credit unions, and other financial service entities and retail businesses that offer payday loans or other similar financial services, as well as a growing Internet-based payday loan segment. Some of our competitors have larger and more established customer bases and substantially greater financial, marketing and other resources than we have.
Buy Here, Pay Here Industry
The used automobile retail industry is highly competitive and fragmented. We compete principally with other independent buy here, pay here dealers, and to a lesser degree with (i) the used vehicle retail operations of franchised automobile dealerships, (ii) independent used vehicle dealers, and (iii) individuals who sell used vehicles in private transactions. We compete for both the purchase and resale of used vehicles.
We believe the principal competitive factors in the sale of used vehicles include (i) the availability of financing to consumers with limited credit histories or past credit problems, (ii) the breadth and quality of vehicle selection, (iii) pricing, (iv) the convenience of a dealership’s location, (v) limited warranty and (vi) customer service. We believe that our buy here, pay here locations are competitive in each of these areas.
Regulations
We are subject to regulation by federal, state, local and foreign governments, which affects the products and services we provide. In general, these regulations are designed to protect consumers and not to protect our stockholders.
Regulation of Short-term Lending
Our United States payday and other consumer lending activities are subject to regulation and supervision primarily at the state level. In those jurisdictions where we make consumer loans directly to consumers (currently all states in which we operate other than Texas), we are licensed as a payday, title or installment lender where required and are subject to various state regulations regarding the terms of our consumer loans and our policies, procedures and operations relating to those loans. In some states, payday lending is referred to as deferred presentment, deferred deposit or consumer installment loans. Typically, state regulations limit the amount that we may lend to any consumer and, in some cases, the number of loans or transactions that we may make to any consumer at one time or in the course of a year. These state
regulations also typically restrict the amount of finance or service charges or fees that we may assess in connection with any loan or transaction and may limit a customer’s ability to renew a loan. We must also comply with the disclosure requirements of the Federal Truth-In-Lending Act and Regulation Z promulgated by the Board of Governors of the Federal Reserve System pursuant to that Act, as well as the disclosure requirements of state statutes (which are usually similar or more extensive then federal disclosure requirements). These state statutes also often specify minimum and maximum maturity dates for payday loans and, in some cases, specify mandatory cooling-off periods between transactions. Our collection activities regarding past due loans may also be subject to consumer protection laws and regulations relating to debt collection practices adopted by the various states, and some states restrict the content of advertising regarding our payday loan activities. Additionally, we are subject to the Equal Credit Opportunity Act, the Gramm-Leach-Bliley Act, and with respect to our credit services agreement with a third-party lender, the Fair Debt Collection Practices Act.
During the last few years, legislation has been introduced in the U.S. Congress and in certain state legislatures that would prohibit or severely restrict payday loans. In July 2010, the U.S. Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act. Among other things, this legislation established the Consumer Financial Protection Bureau (CFPB), which has broad supervisory powers over providers of consumer credit products in the United States such as those offered by us. The CFPB now has the power to create rules and regulations that specifically apply to payday lending. As of February 2013, no such rules have been proposed.
In March 2011, a new payday law became effective in Illinois that imposes customer usage restrictions. During 2009, payday loan-related legislation that severely restricts customer access to payday loans was passed in South Carolina, Washington, Wisconsin, Virginia and Kentucky. These law changes adversely affected our revenues and operating income during 2010, 2011 and 2012. In 2008, Ohio legislators passed a law that placed a 28% cap on payday loans, which is equivalent to a fee of approximately $1.07 per $100 borrowed. Absent additional transaction fees, this law would effectively preclude offering payday loans in Ohio. In October 2007, a new federal law prohibited loans of any type to members of the military and their family with charges in excess of 36% per annum. This federal legislation has the practical effect of banning payday lending to the military. In Oregon, legislative action placed a 36% cap on payday loans, which went into effect July 1, 2007, effectively banning payday loans in Oregon as of that date. Similarly, a ballot initiative in Montana that took effect January 1, 2011, had the practical effect of banning payday loans in that state.
We continue, with others in the payday loan industry, to inform and educate legislators and to oppose legislative or regulatory action that would prohibit or severely restrict payday loans. For example, it requires an approximate cost of $10 to $11 per $100 borrowed to operate a storefront location, exclusive of loan losses. As a result, in states where a 36% or lower cap is mandated, without additional fees, we are unable to operate at a profit. These types of legislative or regulatory actions have had and in the future could have a material adverse effect on our loan-related activities and revenues. Moreover, similar action by states where we are not currently conducting business could result in us having fewer opportunities to expand.
Prior to September 30, 2005, we originated payday loans at all of our locations, except for branches in North Carolina and Texas. In North Carolina, prior to the closure of our North Carolina branches during October and November 2005, we had an arrangement with a Delaware state-chartered bank to originate and service payday loans for that bank in North Carolina. We entered into the arrangement with the bank in April 2003. Under the terms of the agreement, we marketed and serviced the bank’s loans in North Carolina, and the bank sold to us a pro rata participation in loans that were made to its borrowers. In September 2005, we terminated the arrangement with the bank.
In February 2005, we entered into a separate arrangement with a different Delaware state-chartered bank to originate and service payday loans for that bank in Texas. In September 2005, we terminated the arrangement and began operating as a credit services organization in our Texas branches. The two Delaware banks for which we previously acted as a marketer and servicing provider are subject to supervision and
regular examinations by the Delaware Office of the State Bank Commissioner and the FDIC. The decision to close our branches in North Carolina and to terminate our agreement with the Delaware bank offering loans in Texas reflected the difficult operating environment associated with guidelines issued by the FDIC. In July 2003, the FDIC issued guidelines governing permissible arrangements between a state-chartered bank and a marketer and servicing provider of the bank’s payday loans. In March 2005, the FDIC issued revised guidelines. The revised FDIC guidelines also imposed various limitations on bank payday loans, which effectively limited the benefits of the bank model in places like North Carolina and Texas. In February 2006, the FDIC reportedly advised FDIC-insured banks that they could no longer offer payday loans through marketing and servicing agents.
As a result of our prior arrangements with the two Delaware banks, our activities regarding loans made by those banks are also subject to examination by the FDIC and the other regulatory authorities to which the banks are subject. To the extent an examination involves review of those loans and related processes, the regulatory authority may require us to provide requested information and to grant access to our locations, personnel and records.
Regulation of Credit Services Organization
We are subject to regulation and licensing in Texas with respect to our CSO under Chapter 393 of the Texas Finance Code, which requires the annual registration of our CSO with the secretary of state and annual licensing with the Office of Consumer Credit Commissioner. We must also comply with various disclosure requirements, which include providing the consumer with a disclosure statement and contract that detail the services to be performed by the CSO and the total cost of those services along with various other items. In addition, our CSO is required to obtain a credit service organization bond and a third-party collector bond for each branch in Texas in the amount of $10,000 each from a surety company authorized to do business in Texas.
Regulation of Check Cashing
We are subject to regulation in several jurisdictions in which we operate that require the registration or licensing of check cashing companies or regulate the fees that check cashing companies may impose. Some states require fee schedules to be filed with the state, while others require the conspicuous posting of the fees charged for cashing checks at each branch. In other states, check cashing companies are required to meet minimum bonding or capital requirements and are subject to record-keeping requirements. We are licensed in each of the states or jurisdictions in which a license is currently required for us to operate as a check cashing company and have filed our schedule of fees with each of the states or other jurisdictions in which such a filing is required. To the extent those states have adopted ceilings on check cashing fees, the fees we currently charge are at or below the maximum ceiling.
Regulation of Money Transmission and Sale of Money Orders
We are subject to regulation in several jurisdictions in which we operate that (1) require the registration or licensing of money transmission companies or companies that sell money orders and (2) regulate the fees that such companies may impose. In some states, companies engaged in the money transmission business are required to meet minimum bonding or capital requirements, are prohibited from commingling the proceeds from the sale of money orders with other funds and are subject to various record-keeping requirements. We are licensed in each of the states or jurisdictions in which a license is currently required for us to operate as a money transmitter. In some states we act as agent for MoneyGram in the sale of money orders. Certain states, including California where we operate 74 branches, have enacted so-called “prompt remittance” statutes, which specify the maximum time for payment of proceeds from the sale of money orders to the recipient of the money orders. These statutes limit the number of days, known as the “float,” that we have use of the money from the sale of a money order.
Buy Here, Pay Here Regulation
Each of our automobile sale locations is licensed to sell automobiles by the state of Kansas or Missouri, as applicable. In addition, state laws limit the maximum interest rate we can charge consumers on the automobile loans. We must also comply with the disclosure requirements of the Federal Truth-In-Lending Act and Regulation Z promulgated by the Board of Governors of the Federal Reserve System pursuant to that Act, as well as the disclosure requirements of certain state statutes (which are usually similar or equivalent to those federal disclosure requirements). Our collection activities regarding past due loans may also be subject to consumer protection laws and regulations relating to debt collection practices adopted by the various states. The limited warranties we provide on most of the used automobiles we sell are subject to federal regulation under the Magnuson-Moss Warranty Act. That law governs the disclosure requirements for warranty coverage and our duties in honoring those warranties.
The buy here pay here industry is also regulated by the CFPB. The provisions of this legislation are in the early stages of implementation, and, to our knowledge, there presently are no CFPB proposed rules and regulations that specifically apply to the buy-here pay-here industry.
Foreign Regulation
The Canadian federal legislation falls under Section 347 of the Canadian Criminal Code and defines the criminal rate of interest as an effective annual rate of 60%. On May 3, 2007, the Canadian Federal Government enacted Bill C-26, providing an exemption to Section 347 for loans with a term of 62 days or less and for an amount of $1,500 or less. The exemption is applied on a Province-by-Province basis and is available where a Province has enacted legislation that restricts the amount that can be charged for a payday loan.
The following provinces have enacted payday loan legislation and established payday loan regulations:
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Alberta, in effect since September 1, 2009
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British Columbia, in effect since November 1, 2009
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Manitoba, in effect since October 18, 2010
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Nova Scotia, in effect since August 1, 2009
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Ontario, in effect since December 15, 2009
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Saskatchewan, in effect since January 1, 2012
Currency Reporting Regulation
Regulations promulgated by the United States Department of the Treasury under the Bank Secrecy Act require reporting of transactions involving currency in an amount greater than $10,000. In general, every financial institution must report each deposit, withdrawal, exchange of currency or other payment or transfer that involves currency in an amount greater than $10,000. In addition, multiple currency transactions must be treated as a single transaction if the transactions are by, or on behalf of, any one person and result in either cash in or cash out totaling more than $10,000 during any one business day. In addition, the regulations require institutions to maintain information concerning sales of monetary instruments for cash amounts between $3,000 and $10,000. The records maintained must contain certain identifying information about the purchaser. The rule states that no sale may be completed unless the required information is obtained. We believe that our point-of-sale system, employee training programs and internal control processes support our compliance with these regulatory requirements.
Also, money services businesses are required by the Money Laundering Act of 1994 to register with the United States Department of the Treasury. Money services business transactions include check cashing, wire transfers and money orders. Money services businesses must renew their registrations every two years, maintain a list of their agents, update the agent list annually and make the agent list available for examination. In addition, the Bank Secrecy Act requires money services businesses to file a Suspicious Activity Report for any transaction conducted or attempted involving amounts individually or in total equaling $2,000 or greater, when the money services business knows or suspects that the transaction involves funds derived from an illegal activity, the transaction is designed to evade the requirements of the Bank Secrecy Act or the transaction is considered so unusual that there appears to be no reasonable explanation for the transaction.
The USA PATRIOT Act includes a number of anti-money laundering measures designed to prevent the banking system from being used to launder money and to assist in the identification and seizure of funds that may be used to support terrorist activities. The USA PATRIOT Act includes provisions that directly impacts check cashers and other money services businesses. Specifically, the USA PATRIOT Act requires all check cashers to establish certain programs to identify accurately the individual conducting the transaction and to detect and report money-laundering activities to law enforcement. We have established various procedures and continue to monitor and evaluate any such transactions and believe we are in compliance with the USA PATRIOT Act.
The U.S. Treasury, through the Internal Revenue Service, regularly conducts audits of our operations for compliance with the Bank Secrecy Act and the USA PATRIOT ACT.
Privacy Regulation
We are subject to a variety of federal and state laws and regulations that seek to protect the confidentiality of a customer’s identity by restricting the use of personal information obtained from a customer. We have identified our systems that capture and maintain non-public personal information, as that term is used in the privacy provisions of the Gramm-Leach-Bliley Act and it’s implementing federal regulations. We disclose our privacy information policies and our policies relating to destruction of certain information to our customers as required by that law. We have systems in place intended to safeguard this information as required by the Gramm-Leach-Bliley Act.
Zoning and Other Local Regulation
We are also subject to increasing levels of zoning and other local regulations, such as regulations affecting the granting of business licenses. Certain municipalities have used or are attempting to use these types of regulatory authority to restrict the growth of the payday loan industry. These zoning and similar local regulatory actions can affect our ability to expand in that municipality and may affect a seller’s ability to transfer licenses or leases to us in conjunction with an acquisition. For example, several cities in Texas have passed local ordinances governing certain loan provisions including refinancing and extensions. Our Texas locations experienced a 7% decline in revenues and a gross profit decline of 17% in 2012 compared to 2011 largely due to the passage of these ordinances.
Employees
On December 31, 2012, we had 1,563 U.S. employees, consisting of 1,351 branch personnel, 106 field managers and 106 corporate office employees. In addition, Direct Credit had approximately 23 employees as of December 31, 2012.
As discussed in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of this report (Item 7), we announced to our employees in January 2013 a restructuring plan for the organization. The restructuring plan includes a 10% workforce reduction in field and corporate employees primarily due to the decision in 2012 to close 38 underperforming branches during the first half of 2013.
We believe our relationship with our employees is good, and we have not suffered any work stoppages or labor disputes. We do not have any employees that operate under a collective bargaining agreement.
Available Information
We file annual and quarterly reports, proxy statements, and other information with the United States Securities and Exchange Commission, copies of which can be obtained from the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. Information on the operation of the Public Reference Room can be obtained by calling the SEC at 1-800-SEC-0330.
Reports we file electronically with the SEC via the SEC’s Electronic Data Gathering, Analysis and Retrieval system (EDGAR) may be accessed through the Internet. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC, at www.sec.gov. We make available free of charge our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, amendments to those reports and our proxy statement on our website at www.qcholdings.com as soon as reasonably practical after each filing has been made with, or furnished to, the SEC. The SEC filings and additional information about QC Holdings, Inc. can be obtained under the “Investment Center” section of our website. The contents of these websites are not incorporated into this report. Further, our references to the URL’s for these websites are intended to be inactive textual references only.
ITEM 1A.
ITEM 1A. Risk Factors
The payday loan industry is highly regulated under state laws. Changes in state laws governing lending practices could negatively affect our business revenues and earnings.
Our business is regulated under numerous state laws and regulations, which are subject to change and which may impose significant costs or limitations on the way we conduct or expand our business. As of December 31, 2012, 33 states and the District of Columbia had legislation permitting or not prohibiting payday loans. The remaining 17 states did not have laws specifically authorizing the payday loan business or have laws that effectively preclude us from offering the payday loan product by capping the interest fee we can earn at an annual percentage rate of 36% or lower, which makes offering the payday product in those states unprofitable. During 2012, we made payday loans directly in 20 of these 33 states. In addition, in Texas we operate as a credit services organization, assisting our customers in Texas in obtaining loans from an unrelated third-party lender.
During the last few years, legislation has been adopted in some states in which we operate or operated that prohibits or severely restricts payday loans. For example, legislation that prohibits or severely restricts payday loans has been adopted in Montana (2010 via a ballot initiative) South Carolina (2009), Washington (2009), Kentucky (2009), Ohio (2008), Virginia (2008), New Mexico (2007), Oregon (2006) and Illinois (2005 and 2011). Some states, including Mississippi and Arizona, which are states in which we operate, have sunset provisions in their payday loan laws that require renewal of the laws by the state legislatures at periodic intervals. The Arizona payday loan statutory authority expired by its terms on June 30, 2010 and the termination of this law had a significant adverse effect on our revenues and profitability for the years ended December 31, 2010 and 2011. In February 2011, the sunset provision of the Mississippi payday loan law was extended from July 1, 2012 to July 1, 2015.
In recent years, including 2012, more than 200 bills have been introduced in state legislatures nationwide, including bills in virtually every state in which we are doing business, to revise the current law governing payday loans in that state. In certain instances, the bills, if adopted, would effectively prohibit payday loans in that state. In other instances, the bills, if adopted, would amend the payday loan laws in ways that would adversely affect our revenues and earnings in that state. Any of these bills, or future proposed legislation or regulations prohibiting payday loans or making them less profitable or unprofitable, could be passed in any of these states at any time, or existing payday loan laws could expire or be amended. Legislative changes (or failures to extend payday lending laws) have had a significant adverse effect on our business, revenues and earnings in New Mexico, Arizona, Washington, South Carolina, Illinois, Virginia and certain other states in recent years.
Voter initiatives to limit or prohibit payday lending can result in expensive ballot campaigns and changes to state laws, both of which can adversely affect our results of operations.
State laws can be changed by ballot initiative or referendum in certain states. A 2010 ballot initiative in Montana precluded payday lending on profitable terms, thus effectively prohibiting payday lending in Montana. Similarly, the prospect of a ballot initiative in Oregon during 2006 led to legislation that effectively prohibits payday lending in that state. After those measures were passed, we closed all our branches in Montana and Oregon. Ballot initiatives can also be expensive to oppose and are more susceptible to emotion than deliberations in the normal legislative process. We have spent substantial amounts in the past related to ballot initiatives and would expect to do so in the future if another ballot initiative is proposed.
There was an effort in Missouri to place a voter initiative on the statewide ballot in November 2012, which was intended to preclude any lending in the state with an annual rate over 36%. The supporters of the voter initiative did not submit a sufficient number of valid signatures to place the initiative on the ballot in November 2012. However, a similar initiative was submitted to the Missouri Secretary of State in December 2012 for inclusion on the November 2014 ballot subject to the proponents submitting the required number of valid signatures in support of the initiative.
If the Missouri ballot initiative is placed on the ballot in 2014 and passes, we would be forced to cease our payday lending operations in Missouri, which would have a material adverse effect on our results of operations. In 2012, our Missouri branches accounted for approximately 22% and 33% of our total revenues and gross profits, respectively. The loss of revenues and gross profit would likely cause us to violate one or more of the financial covenants under our current credit agreement and our outstanding subordinated notes and would likely result in an immediate termination of our regular cash dividend on our common stock.
Changes in state regulations or interpretations of state laws and regulations governing lending practices could negatively affect our business, revenues and earnings, and the costs of regulatory compliance are increasing.
Statutes authorizing payday loans typically provide state agencies that regulate banks and financial institutions with significant regulatory powers to administer and enforce the law. Under statutory authority, state regulators have broad discretionary power and may impose new licensing requirements, interpret or enforce existing regulatory requirements in different ways or issue new administrative rules, even if not contained in state statutes, that affect the way we do business and may force us to terminate or modify our operations in particular states. They may also impose rules that are generally adverse to our industry. Furthermore, to the extent that a state determined that our lack of compliance warranted termination of our license, we would be precluded from operating in that state and may be required to report that license termination to other states pursuant to notification requirements or upon the licensing renewal process in those other states.
States have generally increased their regulatory and compliance requirements for payday loans in recent years, and our branches are subject to examination by state regulators in most states. We have taken or been required to take certain corrective actions as a result of self-audits or state audits of our branches and the level of regulation and compliance costs have increased and we anticipate that they will continue to increase.
Additionally, in many states, the attorney general has scrutinized or continues to scrutinize the payday loan statutes and the interpretations of those statutes. For instance, in September 2005, the New Mexico Attorney General promulgated regulations (later withdrawn) that would have had the practical effect of limiting the fees and interest on payday loans to 54% per annum, thus effectively prohibiting payday lending in New Mexico. Similarly, in December 2009, the Arizona Attorney General filed a lawsuit against us in Arizona state court alleging that we violated various state consumer protection statutes.
Future interpretations of state law in other jurisdictions or promulgation of regulations or new interpretations, similar to the prior actions in New Mexico or the ruling by the North Carolina Commissioner of Banks as discussed below, could have an adverse impact on our ability to offer payday loans in those states and an adverse impact on our earnings.
The payday loan industry is regulated under federal law. Changes in federal laws and regulations governing lending practices could negatively affect our business.
Although states provide the primary regulatory framework under which we offer payday loans, certain federal laws (in addition to the Dodd-Frank Act discussed immediately below) also affect our business. For example, because payday loans are viewed as extensions of credit, we must comply with the federal Truth-in-Lending Act and Regulation Z adopted under that Act. Additionally, we are subject to the Equal Credit Opportunity Act, the Gramm-Leach-Bliley Act, and with respect to our CSO business in Texas,
the Fair Debt Collection Practices Act. These regulations also apply to any lender with which we do business in Texas through our credit services organization business. A failure to comply with any of these federal laws and regulations could have a material adverse effect on our business, results of operations and financial condition.
Additionally, anti-payday loan legislation, including 36% interest rate cap bills that would effectively prohibit payday lending, have been introduced in the U.S. Congress in the past. Earlier federal efforts culminated in federal legislation that limits the interest rate and fees that may be charged on any short-term loans, including payday loans, to any person in the military to 36% per annum, which became effective October 1, 2007 and effectively bans payday lending to members of the military or their families. Future federal legislative or regulatory action that restricts or prohibits payday loans could have a material adverse impact on our business, results of operations and financial condition, and a 36% interest rate cap or similar federal limit, without the inclusion of meaningful fees, would effectively require us to cease our payday loan operations nationally.
The Dodd-Frank Act authorizes the CFPB to adopt rules that could potentially have a serious impact on our ability to offer short-term consumer loans and also empowers the CFPB and state officials to bring enforcement actions against companies that violate federal consumer financial laws.
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, or the Dodd-Frank Act, created the Consumer Financial Protection Bureau, or CFPB. The CFPB became operational in July 2011, although it did not have the ability to oversee non-depository institutions and write rules until a permanent director was installed. President Obama appointed a permanent director in December 2011 without confirmation by the U.S. Senate, using the President’s recess appointment power.
The CFPB has regulatory, supervisory and enforcement powers over providers of consumer financial products and services, including explicit supervisory authority to examine and require registration of payday lenders. Included in the powers afforded the CFPB is the authority to adopt rules describing specified acts and practices as being “unfair,” “deceptive” or “abusive,” and hence unlawful. The director of the CFPB has suggested that payday and title lending should be a regulatory priority, and the CFPB has already conducted public hearings to obtain public input regarding the payday loan industry. Accordingly, it is possible that at some time in the future the CFPB will propose and adopt rules making payday or title loan lending services materially less profitable or impractical, forcing us to modify or terminate certain product offerings, including payday and title loans. The CFPB could also adopt rules imposing new and potentially burdensome requirements and limitations with respect to our other lines of business. Any such rules could have a material adverse effect on our business, results of operation and financial condition or could make the continuance of our current business impractical or unprofitable.
In addition to Dodd-Frank’s grant of regulatory and supervisory powers to the CFPB, Dodd-Frank gives the CFPB authority to pursue administrative proceedings or litigation for violations of federal consumer financial laws (including the CFPB’s own rules). In these proceedings, the CFPB can obtain cease and desist orders (which can include orders for restitution or rescission of contracts, as well as other kinds of affirmative relief) and monetary penalties ranging from $5,000 per day for violations of federal consumer financial laws to $25,000 per day for reckless violations and $1.0 million per day for knowing violations. Also, where a company has violated Title X of Dodd-Frank or CFPB regulations under Title X, Dodd-Frank empowers state attorneys general and state regulators to bring civil actions for the kind of cease and desist orders available to the CFPB (but not for civil penalties). If the CFPB or one or more state officials believe we have violated the foregoing laws or regulations, they could exercise their enforcement powers in ways that would have a material adverse effect on us.
The CFPB staff has an ongoing examination of various companies in the payday loan industry, including an examination of us in 2012. We believe that a primary purpose of this initial round of industry examinations is for the CFPB staff to obtain baseline information about the industry as a precursor to considering and implementing future regulation of the industry. We cannot predict the scope of any future rules or regulations, which could have a material adverse effect on our business, results of operations and financial condition.
Litigation and regulatory actions directed toward our industry and us could adversely affect our operating results, particularly in certain key states.
During the last few years, our industry has been subject to regulatory proceedings, class action lawsuits and other litigation regarding the offering of payday loans, and we could suffer losses from interpretations of state laws in those lawsuits or regulatory proceedings, even if we are not a party to those proceedings. In recent years, we have experienced a higher number of purported class action lawsuits by our customers against us. In 2011, we reached a settlement in a purported class action lawsuit in Missouri. We presently have pending against us class action lawsuits in North Carolina and Canada as described under Item 3, “Legal Proceedings.” The consequences of an adverse ruling in any of the current cases or future litigation or proceedings could cause us to have to refund fees or interest collected on payday loans, to refund the principal amount of payday loans, to pay treble or other multiple damages, to pay monetary penalties or to modify or terminate our operations in particular states. We may also be subject to adverse publicity arising out of current or future litigation. Defense of these pending lawsuits is time consuming and expensive, and the defense of these or future lawsuits or proceedings, even if we are successful, could require substantial time and attention of our senior officers and other management personnel that would otherwise be spent on other aspects of our business and could require the expenditure of significant amounts for legal fees and other related costs. Any of these events could have a material adverse effect on our business, results of operations and financial condition.
Additionally, regulatory actions taken with respect to one financial service that we offer could negatively affect our ability to offer other financial services. For example, if we were the subject of regulatory action related to our check cashing, title loans or other products, that regulatory action could adversely affect our ability to maintain our licenses for payday lending. Moreover, the suspension or revocation of our license or other authorization in one state could adversely affect our ability to maintain licenses in other states. Accordingly, a violation of a law or regulation in otherwise unrelated products or jurisdictions could affect other parts of our business and adversely affect our business and operations as a whole.
Judicial decisions, CFPB rule-making or amendments to the Federal Arbitration Act could render the arbitration agreements we use illegal or unenforceable.
We include pre-dispute arbitration provisions in our loan agreements. These provisions are designed to allow us to resolve customer disputes through individual arbitration rather than in court. Our arbitration agreements contain certain consumer-friendly features, including terms that require in-person arbitration to take place in locations convenient for the consumer and provide consumers the option to pursue a claim in small claims court. Our arbitration provisions, however, explicitly provide that all arbitrations will be conducted on an individual and not on a class basis. They do not generally have any impact on regulatory enforcement proceedings.
While many courts, particularly federal courts, have concluded that the Federal Arbitration Act requires the enforcement of arbitration agreements containing class action waivers of the type we use, in cases involving other parties, an increasing number of courts, including courts in California, Missouri, Washington, New Jersey, and a number of other states, have concluded that arbitration agreements with class action waivers are “unconscionable” and hence unenforceable, particularly where a small dollar amount is in controversy on an individual basis.
Congress has considered legislation that would generally limit or prohibit mandatory pre-dispute arbitration in consumer contracts and has adopted such a prohibition with respect to certain mortgage loans and also certain consumer loans to members of the military on active duty and their dependents. Furthermore, Dodd-Frank directs the CFPB to study consumer arbitration and report to Congress, and it authorizes the CFPB to adopt rules limiting or prohibiting consumer arbitration, consistent with the results of its study. Any such rule would apply to arbitration agreements entered into more than six months after the final rule becomes effective (and not to prior arbitration agreements).
Any judicial decisions, legislation or other rules or regulations that impair our ability to enter into and enforce pre-dispute consumer arbitration agreements could significantly increase our exposure to class action litigation. Such litigation could have a material adverse effect on our business, results of operations and financial condition.
The concentration of our revenues and gross profits in Missouri and other certain states could adversely affect us.
Our branches operate in 23 states. For the year ended December 31, 2012, branches located in Missouri, California and Kansas represented approximately 42% of our total revenues and 57% of our total gross profit. Revenues from branches located in Missouri and California represented 22% and 15%, respectively, of our total revenues for the year ended December 31, 2012. Gross profit from branches in Missouri and California represented 33% and 17%, respectively, of our total gross profit for the year ended December 31, 2012. While we believe we have a diverse geographic presence, for the near term we expect that significant revenues and gross profit will continue to be generated by certain states, largely due to the currently prevailing economic, demographic, regulatory, competitive and other conditions in those states. Changes to prevailing economic, demographic, regulatory or any other conditions, including the legislative, regulatory, ballot referendum or litigation risks discussed above, in the markets in which we operate could lead to a reduction in demand for our payday loans, a decline in our revenues or an increase in our provision for doubtful accounts, any of which could result in a deterioration of our financial condition.
For example, amendments to the South Carolina law and Washington law became effective January 1, 2010. Prior to these new laws in South Carolina and Washington, revenues from each state were approximately 7% and 5%, respectively, of our total revenues. In South Carolina, the maximum loan size was raised, but the new law also created a database to enforce a one loan per customer limit. In Washington, amendments to its law created a database to enforce a one loan per customer limit and to place a usage limit on customers at eight loans per year. Similarly, the Arizona payday loan statutory authority expired by its terms on June 30, 2010 and prior to that event, Arizona represented approximately 8% of total revenues. The changes in the payday lending laws in each of these states had a significant adverse effect on our revenues and profitability.
In March 2011, a new payday law became effective in Illinois that imposes customer usage restrictions that will negatively affect revenues and profitability. This type of customer restriction, when passed in other states such as Washington, South Carolina and Kentucky, has resulted in a 30% to 60% decline in annual revenues and a more significant decline in gross profit, depending on the types of alternative products that competitors may offer within the state. The Illinois law provides for an overlap of the previous lending approach with loans issued under the new law for a period of one year, which extended the time period over which the negative effects of the new law occurred.
There was an effort in Missouri to place a voter initiative on the statewide ballot in November 2012, which was intended to preclude any lending in the state with an annual rate over 36%. The supporters of the voter initiative did not submit a sufficient number of valid signatures to place the initiative on the ballot in November 2012. However, a similar initiative was submitted to the Missouri Secretary of State in December 2012 for inclusion on the November 2014 ballot subject to the proponents submitting the required number of valid signatures in support of the initiative. If this initiative is placed on the ballot in 2014 and the measure passes, we would be unable to operate our payday loan branches in Missouri and be forced to close those locations in the state.
We lack product and business diversification. Accordingly, our future revenues and earnings are more susceptible to fluctuations than a more diversified company.
Our primary business activity is offering and servicing payday loans. We also provide certain related services, such as installment loans, check cashing, title loans, credit services, open-end credit, money transfers and money orders, which accounted for approximately 9% of our revenues in 2012. In 2007, we entered the buy here, pay here automobile business, but those revenues accounted for only 13% of our total revenue in 2012. In 2011, we entered the Canadian Internet payday lending market with our acquisition of Direct Credit. That acquisition provides geographic diversification and product distribution diversification; however it does not provide core business diversification. As noted above, with unfavorable legislative and regulatory changes, the revenues in our payday loan business are declining, which has adversely affected our overall revenues and earnings. Our lack of product and business diversification has and is likely to continue to inhibit the opportunities for growth of our business, revenues and profits.
Our recent expansion into Canada exposes us to new risks, including risks associated with monitoring and complying with Canadian laws and regulations, foreign currency fluctuation risks, and tax risks, all of which could adversely affect our results of operations.
On September 30, 2011, we completed our first acquisition of a Canadian payday lending company. In Canada, the Canadian Parliament amended the federal usury law in 2007 to permit each province to assume jurisdiction over and the development of laws and regulations regarding our industry. To date, Ontario, British Columbia, Alberta, Manitoba, Saskatchewan and Nova Scotia have passed legislation regulating short-term consumer lenders and each has, or is in the process of adopting, regulations and rates consistent with those laws. In general, these regulations require lenders to be licensed, set maximum fees and regulate collection practices. Our Canadian subsidiaries currently offer payday loans through the Internet to residents of each of these provinces. There may be future changes to or interpretations of the Canadian federal law or the provincial laws and regulations that could have a detrimental effect on our consumer lending business in Canada. Additionally, there are increased risks to us associated with monitoring and complying with Canadian laws, including the risk that we may overlook laws or regulations with which we are less familiar.
Additionally, while the full-year 2012 revenue of our new Canadian subsidiaries is not material to our overall U.S. revenues, we expect our Canadian business to grow, which could expose us to greater risk associated with foreign currency fluctuations and changes in foreign tax rates, both of which could adversely affect our results of operations. We do not presently plan to hedge our exposure to the Canadian dollar. Furthermore, our financial results may be negatively affected to the extent tax rates in Canada increase or exceed those in the United States or as a result of the imposition of withholding requirements on foreign earnings.
Finally, the new Canadian scope of our operations may contribute to increased costs that could negatively impact our results of operations. Because international operations increase the complexity of an organization, we may face additional administrative costs in managing our business, including particularly technology-related costs, than we would if we only conducted operations domestically. In addition, most countries typically impose additional burdens on non-domestic companies through the use of local regulations, tariffs and labor controls. Unexpected changes to the foregoing could negatively affect our results of operations.
Our inability to introduce or manage new products efficiently and profitably could have a material adverse effect on our business, results of operations and financial condition.
We continue to explore potential new products and businesses to serve our customers and to diversify our business. For example, in 2006 and 2007, we began offering installment loans in Illinois and New
Mexico, respectively; and in October 2007, we opened our first buy here, pay here automobile sales and finance lot. New products in Illinois, New Mexico, as well as in Virginia and other states, have been in response to changes in payday loan laws in those states making payday lending unprofitable, and therefore not economically feasible, under current state law or regulations in those states. We also intend to introduce additional services and products in the future in order to continue to diversify our business. In 2012, we introduced new installment loan products (signature loans and auto equity loans) to meet high customer demand for longer-term loan options. These new products are higher-dollar and longer-term installment loans that are centrally underwritten and distributed through our existing branch network. In order to offer new products and to enter into new businesses, we may need to comply with additional regulatory and licensing requirements. Each of these new products and businesses is subject to risk and uncertainty and requires significant investment of time and capital, including additional marketing expenses, legal costs, acquisition costs and other incremental start-up costs. Due to our lack of experience in offering certain new products and businesses, we may not be successful in identifying or introducing any new product or business in a timely or profitable manner. Additionally, loan losses for new products may be higher than we initially expected. For example, we offered an open-end credit product to our Virginia customers for a brief period in 2008 and 2009, before discontinuing the product due to significantly higher than anticipated loan losses (in 2011, we re-introduced this product on a limited basis with various key structural changes). Furthermore, we cannot predict the demand for any new product or service. Our failure to introduce a new product or service efficiently and profitably or low customer demand for any of these new products or services, could have a material adverse effect on our business, results of operations and financial condition.
General economic conditions affect our revenues and loan losses, and accordingly, our results of operations have been adversely affected by the general economic slowdown. The effect on our business of the recent credit crisis and ongoing economic recession is still continuing.
It is difficult to gauge the continuing impact of the 2008-2009 economic recession, the resultant high unemployment and the ongoing economic malaise on our customers and on our business. We have experienced fluctuations in our loan losses and revenues that appear to correspond to broader economic events and trends.
Provision for losses is one of our largest operating expenses, constituting 22.5% of total revenues for the year ended December 31, 2012, with payday loan losses constituting most of the losses. During each period, if a customer does not repay a payday loan when due and the check we present for payment to the bank is returned, all accrued fees, interest and outstanding principal are charged off as uncollectible. Any changes in economic factors that adversely affect our customers could result in a higher loan loss experience than anticipated, which could adversely affect our loan charge-offs and operating results. For example, we believe our loan losses increased during the second half of 2007 as a result of the turmoil in the sub-prime lending markets and its ripple effect throughout the United States economy. As another example, we believe that our loan loss experience in third quarter 2005 was adversely affected as a result of an increase in customer bankruptcies prior to a significant change in the bankruptcy laws in October 2005. Similar difficult financial and economic markets and conditions could increase our loan losses and adversely affect our results of operations and financial condition.
While the immediate economic crisis of 2008 and 2009 appears to have passed, we believe that the continuing effects of that recession are adversely affecting our customers and their borrowing habits. We experienced lower payday loan demand in 2009 than initially expected, which we believe is attributable in part to the reports nationally of overall consumer efforts to reduce debt. We believe our customers are more sophisticated than portrayed in the media by certain consumer groups and that our customers restrict borrowings in circumstances when risk of non-repayment is increased. We believe this has occurred when gasoline prices have spiked at various times over the last four years and also occurred in fourth quarter 2008 due to the national credit crisis. We believe that lower customer loan demand in 2010, 2011 and 2012 is directly related to the continuing effects of the 2008-09 recession. We believe these adverse economic pressures on our customers are continuing in 2013 and will continue for the foreseeable future, which has had, and is expected to continue to have, an adverse effect on our revenues and earnings.
Continuing disruptions in the credit markets from the national credit crisis are negatively affecting the availability and cost of commercial credit, which could adversely affect our future borrowing ability and costs.
We believe that disruptions in the capital and credit markets in 2008 and 2009 adversely affected the availability and cost of commercial credit for our business. In addition, uncertainty as to the economic recovery and changing and increased regulation coming out of the recession, including the Dodd-Frank Act, have been additional disruptions to the capital and credit markets for our industry. We believe that these factors directly and adversely affected the terms of our credit agreement, which we renegotiated in fall 2011, approximately 15 months before the maturity of the prior credit agreement. See the discussion immediately below of the terms of the new credit agreement and the requirement that we obtain $3.0 million of subordinated debt as a condition to that new credit agreement. We believe that these factors may also affect our ability to refinance the current revolving credit facility on favorable terms, if at all, and our ability to incur additional indebtedness to fund acquisitions, business ventures and distributions to our stockholders or other corporate purposes. Our current credit facility matures on September 30, 2014. The reduced availability under our new revolving credit facility, or the inability to refinance our current credit facility, could require us to take measures to conserve cash until the markets stabilize or until alternative credit arrangements or other funding for our business needs can be arranged. Such measures could include deferring capital expenditures, including acquisitions, and reducing or eliminating cash dividends on our common stock and our stock repurchase program.
From time to time, we utilize borrowings under our credit facility to fund our liquidity and capital needs, and these borrowings, which increase our leverage and reduce our financial flexibility, are subject to various restrictions and covenants.
On September 30, 2011, we entered into an amended and restated credit agreement (current credit agreement) with a syndicate of banks to replace our prior credit agreement. As a condition to entering into the current credit agreement, the lenders required that we issue $3.0 million of subordinated notes. The prior credit agreement provided for a term loan of $50 million maturing December 2012 and a revolving line of credit (including provision permitting the issuance of letters of credit and swingline loans) of up to $45 million. The current credit agreement provides for a term loan of $32 million and a revolving line of credit (including provisions permitting the issuance of letters of credit and swingline loans) in the aggregate principal amount of up to $27 million. We paid off the term loan in December 2012. The terms of our current credit agreement and the subordinated notes include provisions that directly or indirectly affect our ability to repurchase our common stock on the open market or in negotiated transactions, our ability to pay cash dividends on our common stock, and our ability to pursue acquisitions or other strategic ventures that would require us to borrow additional amounts.
We typically use substantially all of our available cash generated from our operations to repay borrowings on our revolving credit facility on a current basis and to fund the scheduled amortization repayments under the term loan, and we have limited cash balances (other than cash balances needed at the branch level). We expect that a substantial portion of our liquidity needs, including amounts to pay future cash dividends on our common stock, will be funded primarily from borrowings under our revolving credit facility. As of December 31, 2012, we had approximately $2.0 million available for future borrowings under this facility, compared to $12.5 million of availability on the revolving credit facility as of December 31, 2011. Due to the seasonal nature of our business, our borrowings are historically the lowest during the first calendar quarter and increase during the remainder of the year. If our existing sources of liquidity are insufficient to satisfy our financial needs, we may need to raise additional debt or equity in the future. If we were unable to sell equity or raise additional debt, our ability to finance our current operations would likely be adversely affected.
Our revolving credit facility contains restrictions and limitations that could significantly affect our ability to operate our business.
Our revolving credit facility contains a number of significant covenants that could adversely affect our business. These covenants restrict our ability, and the ability of our subsidiaries to, among other things:
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incur additional debt;
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create liens;
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effect mergers or consolidations;
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make investments, acquisitions or dispositions;
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pay dividends, repurchase stock or make other payments; and
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enter into certain sale and leaseback transactions.
As a result, our ability to respond to changing business and economic conditions and to secure additional financing, if needed, may be significantly restricted, and we may be prevented from engaging in transactions that might further our corporate strategies. Our obligations under the credit facility are guaranteed by each of our existing and future domestic subsidiaries. The borrowings under the revolving credit facility are guaranteed by all of our operating subsidiaries (other than the foreign subsidiaries) and are secured by liens on substantially all of our personal property including the personal property of our U.S. subsidiaries. In the event of our insolvency, liquidation, dissolution or reorganization, the lenders under our credit facility and any other then existing debt of ours would be entitled to payment in full from our assets before distributions, if any, were made to our stockholders.
The breach of any covenant or obligation in our credit facility will result in a default. If there is an event of default under our credit facility, the lenders could cause all amounts outstanding thereunder to be due and payable. If we are unable to repay, refinance or restructure our indebtedness under our credit facility when it comes due, at maturity or upon acceleration, the lenders could proceed against the collateral securing that indebtedness.
As of September 30, 2012, we were not in compliance with certain financial covenants (minimum consolidated EBITDA and fixed charge coverage ratio) as set forth in the current credit agreement. On November 7, 2012, we entered into an amendment to the current credit agreement to (i) permanently reduce the minimum consolidated EBITDA requirement through the term of the facility; (ii) reduce the fixed charge coverage ratio requirement for each of the quarters ended September 30, 2012, December 31, 2012 and March 31, 2013; and (iii) allow for the sale of our automobile receivables, subject to approval of terms by the lenders, provided proceeds are used to reduce the outstanding balance of the term loan. We sold our auto receivables in December 2012 and paid off the term loan with the proceeds. We are currently in compliance with these new covenants.
We depend on loans and cash management services from banks to operate our business. If banks decide to stop making loans or providing cash management services to us, it could have a material adverse effect on our business, results of operations and financial condition.
We depend on borrowings under our revolving credit facility to fund loans, capital expenditures, smaller acquisitions, cash dividends and other needs. If consumer banks decide not to lend money to companies in our industry or to us, our ability to borrow at competitive interest rates (or at all), our ability to operate our business and our cash availability would likely be adversely affected.
Certain banks have notified us and other companies in the payday loan and check cashing industries that they will no longer maintain bank accounts for these companies due to reputation risks and increased compliance costs of servicing money services businesses and other cash intensive industries. While none of our primary depository banks has requested that we close our bank accounts or placed other restrictions on how we use their services, if any of our larger current or future depository banks were to take such actions, we could face higher costs of managing our cash and limitations on our ability to grow our business, both of which could have a material adverse effect on our business, results of operations and financial condition.
Media reports and public perception of payday loans as being predatory or abusive could adversely affect our business.
Consumer advocacy groups and certain media reports advocate governmental action to prohibit or severely restrict payday loans. The consumer groups and media reports typically focus on the cost to a consumer for this type of loan, which is higher than the interest typically charged by credit card issuers. This difference in credit cost is more significant if a consumer does not promptly repay the loan, but renews, or rolls over, that loan for one or more additional short-term periods. The consumer groups and media reports typically characterize these payday loans as predatory or abusive toward consumers. If this negative characterization of our payday loans becomes widely accepted by consumers, demand for our payday loans could significantly decrease, which could adversely affect our results of operations and financial condition. Negative perception of our payday loans or other activities could also result in our industry being subject to more restrictive laws and regulations and greater exposure to litigation.
If estimates of our loan losses are not adequate to absorb actual losses, our financial condition and results of operations may be adversely affected.
We maintain an allowance for loan losses at levels to cover the estimated incurred losses in the collection of our loan portfolio outstanding at the end of each applicable period. Our methodology for estimating the allowance for payday loan loses utilizes a four-step approach, which reflects the short-term nature of the loan portfolio at each period-end, the historical collection experience in the month following each reporting period-end and any fluctuations in recent general economic conditions. We also maintain allowances for loan losses with respect to our installment and automobile finance loans, which are computed using separate methodologies based on historical data, as well as industry and economic factors. Our allowance for loan losses was $8.3 million on December 31, 2012. Our allowance for loan losses is an estimate, and if actual loan losses are materially greater than our allowance for losses, our financial condition and results of operations could be adversely affected.
A reduction in the availability or access to sources of used car inventory adversely affects our buy here, pay here business by increasing the costs of vehicles purchased.
We acquire vehicles for our Automotive business primarily through auctions, but occasionally through wholesalers, new car dealers and individuals. A reduction in the availability of inventory normally results in an increase in the cost of vehicles, which adversely affects the profit margin of that business. We are limited in our ability to pass on increased costs to our customers, who are normally credit impaired with limited flexibility in the car payments they can afford. Over the past few years, used car inventories have been reduced and our costs of obtaining used vehicles have increased. The increased cost of sales directly and adversely affected our results of operations in 2012 and is expected to continue to adversely affect our gross margins for the Automotive segment in 2013. The overall new car sales volumes in the United States have decreased in the last few years and this has had, and could continue to have, a significant negative effect on the supply of vehicles available to us.
The payday loan industry is subject to various local rules and regulations. Changes in these local regulations could have a material adverse effect on our business, results of operations and financial condition.
In addition to state and federal laws and regulations, our business is subject to various local rules and regulations such as local zoning regulations and permit licensing. Any actions taken in the future by local zoning boards or other governing bodies to require special use permits for, or impose other restrictions on, payday lenders could impact our growth strategy and have a material adverse effect on our business, results of operations and financial condition. For example, several cities in Texas have passed local ordinances governing certain loan provisions including refinancing and extensions. Our Texas locations experienced a 7% decline in revenues and a gross profit decline of 17% in 2012 compared to 2011 largely due to the passage of these ordinances.
Any disruption in the availability of our information systems could adversely affect operations at our branches.
We rely upon our information systems to manage and operate our branches and business. Each branch is part of an information network that permits us to maintain adequate cash inventory, reconcile cash balances daily, report revenues and loan losses timely and, in Texas, to access the third-party lender’s loan approval system. Our security measures could fail to prevent a disruption in the availability of our information systems and/or our back-up systems could fail to operate properly. Any disruption in the availability of our information systems could adversely affect our operations and our results of operations.
Our headquarters is currently located at a single location in Overland Park, Kansas. Our information systems and administrative and management processes are primarily provided to our regions and branches from this location, which could be disrupted if a catastrophic event, such as a tornado, power outage or act of terror, destroyed or severely damaged the headquarters. While we maintain redundant facilities in Texas with a third-party vendor, any catastrophic event could nonetheless adversely affect our operations and our results of operations.
Improper disclosure of personal data could result in liability and harm our reputation.
We store and process large amounts of personally identifiable information, that consists primarily of customer information. There have been widespread reports recently of hackers penetrating the firewalls of major financial institutions and technology companies for apparent purpose of obtaining personally identifiable information and to disrupt the technologies and operations of those global companies. While we may not be as visible of a target to foreign or domestic hackers, our resources available to protect our systems and our customer information are substantially less than the resources of the national and global companies that are reporting they have been hacked. It is possible that our security controls over personal data, our training of employees, and other practices we follow may not prevent the improper disclosure of personally identifiable information. Such disclosure could harm our reputation and subject us to liability under laws that protect personal data, resulting in increased costs or loss of revenue.
The goal of our enterprise risk management efforts is not to eliminate all systemic risk.
We have devoted significant time and energy to develop our enterprise risk management program and expect to continue to do so in the future. The goal of enterprise risk management is not to eliminate all risk, but rather to identify, assess and rank risk. Nonetheless, our efforts to identify, monitor and manage risks may not be fully effective. Many of our methods of managing risk and exposures depend upon the implementation of state regulations and other policies or procedures affecting our customers or employees. Management of operational, legal and regulatory risks requires, among other things, policies and procedures, and these policies and procedures may not be fully effective in managing these risks.
While many of the risks that we monitor and manage are described in this Risk Factors section of this report, our business operations could also be affected by additional factors that are not presently described in this section or known to us or that we currently consider immaterial to our operations.
Our quarterly results have fluctuated in the past and may fluctuate in the future. If they fluctuate in the future, the market price of our common stock could also fluctuate significantly.
Our quarterly results have fluctuated in the past and are likely to continue to fluctuate in the future. If they do so, our quarterly revenues and operating results may be difficult to forecast. It is possible that our future quarterly results of operations will not meet the expectations of securities analysts or investors. This could cause a material drop in the market price of our common stock.
Our business will continue to be affected by a number of factors, including the various risk factors set forth in this section, any one of which could substantially affect our results of operations for a particular fiscal quarter. Our quarterly results of operations can vary due to:
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fluctuations in payday and installment loan demand as well as changes in the demand for used automobiles;
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fluctuations in our loan loss experience;
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regulatory and legislative activity restricting our business;
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perceptions regarding possible future regulatory or legislative changes to our business;
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the initiation, management and/or resolution of significant legal actions; and
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changes in broad economic factors, such as energy prices, average hourly wage rates, inflation or bankruptcy.
We have a significant amount of goodwill and intangible assets, which is subject to periodic review and testing for impairment.
A significant portion of our total assets at December 31, 2012 is comprised of goodwill. In accordance with generally accepted accounting principles, we review the recoverability of goodwill on an annual basis or more frequently whenever events occur or circumstances indicate that the asset might be impaired. We assess the fair value of our reporting units based on weighted average of valuations based on market multiples and discounted cash flow estimates. Unfavorable trends in our industry and unfavorable events or disruptions to our operations can affect these multiples and estimates. As a result of our annual impairment test of goodwill performed as of December 31, 2012 we recorded a $1.7 million non-cash impairment charge to goodwill for our E-Lending reporting unit. In addition, we performed an impairment test on our indefinite lived intangible assets and determined that the trade name associated with the ECA acquisition was impaired and recorded a charge of $600,000. Significant impairment charges, although not affecting cash flow, could have a material adverse impact on our operating results and financial position.
The market price of our common stock may be volatile even if our quarterly results do not fluctuate significantly.
Even if we report stable or increased earnings, the market price of our common stock may be volatile. There are a number of factors, beyond earnings fluctuations, that can affect the market price of our common stock, including the following:
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the introduction, passage or adoption of state or federal legislation or regulation that could adversely affect our business;
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the announcement of court decisions adverse to us or our industry;
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a decrease in market demand for our stock;
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downward revisions in securities analysts’ estimates of our future earnings;
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announcements of new products or services developed or offered by us;
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the degree of customer acceptance of new products or services offered by us; and
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general market conditions and other economic factors.
The market price of our common stock has been volatile in the past and is likely to be volatile in the future.
When our common stock is a “penny stock,” you may have difficulty selling our common stock in the secondary trading market.
The SEC has adopted regulations that generally define a “penny stock” to be any equity security that has a market price of less than $5.00 per share or with an exercise price of less than $5.00 per share. Additionally, if the equity security is not registered or authorized on a national securities exchange or NASDAQ, the equity security also would constitute a “penny stock.” These regulations require the delivery, prior to certain transactions involving a penny stock, of a risk disclosure schedule explaining the penny stock market and the risks associated with it. Disclosure is also required in certain circumstances regarding compensation payable to both the broker-dealer and the registered representative and current quotations for the securities. In addition, monthly statements are required to be sent disclosing recent price information for the penny stocks. Since December 2008, our common stock has frequently traded below $5.00 per share and has, from time to time, fallen within the definition of penny stock. Any time that our common stock is classified as a “penny stock” for purposes of these regulations, the ability of broker-dealers to sell our common stock and the ability of stockholders to sell our common stock in the secondary market will be limited. As a result, the market liquidity for our common stock may be adversely affected by the application of these penny stock rules.
Competition in the retail financial services industry is intense and could cause us to lose market share and revenues.
We believe that the primary competitive factors in the payday loan industry are branch location, customer service and availability to transact through online or mobile applications. In addition to storefront payday loan locations, we also currently compete with services, such as overdraft protection offered by traditional financial institutions, payday loan-type products offered by some banks and credit unions, and other financial service entities and retail businesses that offer payday loans or other similar financial services, as well as a growing Internet-based payday loan segment. Some of our competitors have larger and more established customer bases and substantially greater financial, marketing and other resources than we have. As a result of competition from our direct competitors and competing products and services, we could lose market share and our revenues could decline, thereby affecting our earnings and potential for growth.
If we lose key managers or are unable to attract and retain the talent required for our business, our operating results could suffer.
Our future success depends to a significant degree upon the members of our senior management, particularly Darrin J. Andersen, our President and Chief Executive Officer. We believe that the loss of the services of Mr. Andersen or any or our other senior officers could adversely affect our business. Our efforts to expand into other businesses and product lines also depend upon our ability to attract and retain additional skilled management personnel for those businesses or product lines. We do not have employment agreements with any of our executive officers. To the extent that we are unable to attract and retain the talent required for our business, our operating results could suffer.
Regular turnover among our branch managers and branch-level employees makes it more difficult for us to operate our branches and increases our costs of operation.
We experience high turnover among our branch managers and our branch-level employees. In 2012, we sustained approximately 25% turnover among our branch managers and approximately 62% turnover among our branch-level employees. Turnover interferes with implementation of branch operating strategies. High turnover in the future would perpetuate these operating pressures and increase our operating costs.
Additionally, high turnover creates challenges for us in maintaining high levels of employee awareness of and compliance with our internal procedures and external regulatory compliance requirements.
Our executive officers, directors and principal stockholders may be able to exert significant control over our strategic direction.
Our directors and executive officers own or have the power to vote approximately 56% of our outstanding common stock as of December 31, 2012. Don Early, our Chairman of the Board, and Mary Lou Early, our Vice Chairman of the Board, owned approximately 47.4% directly and 1.4% indirectly of our outstanding common stock as of December 31, 2012. The election of each director requires a plurality of the shares voting for directors at a meeting of stockholders at which a quorum is present. Approval of a significant corporate transaction, such as a merger or consolidation of the company, a sale of all or substantially all of its assets or a dissolution of the company, requires the affirmative vote of a majority of the outstanding shares of our common stock. Other actions requiring stockholder approval require the affirmative vote of a majority of the shares of common stock voting on the matter, provided that a quorum is present. A quorum requires the presence of a majority of the shares outstanding. As a result, one or more stockholders owning a relatively low percentage of the outstanding shares of our common stock could, acting together with Mr. and Mrs. Early, control all matters requiring our stockholders’ approval, including the election of directors and approval of significant corporate transactions. As a result, this concentration of ownership may delay, prevent or deter a change in control or change in board composition, could deprive our stockholders of an opportunity to receive a premium for their common stock as part of a sale of the company or its assets and might reduce the market price of our common stock.
Future sales of shares of our common stock in the public market could depress our stock price.
As of December 31, 2012, our officers and directors held approximately 9.9 million shares of common stock, a substantial majority of which are “restricted securities” under the Securities Act and are eligible for future sale in the public market at prescribed times pursuant to Rule 144 under the Securities Act, or otherwise. In addition, Mr. Early, who directly owns approximately 43.5% of our outstanding shares, has demand registration rights, which permit him to require the company to register all or any part of those shares for resale by Mr. Early. Sales of a significant number of these shares of common stock in the public market could reduce the market price of our common stock. The daily trading volume in our stock, since our initial public offering in July 2004, has been low, and is frequently under 10,000 shares traded in a day. Accordingly, the sale of even a relatively small number of shares by our officers or directors could reduce the market price of our common stock.
In addition, Mr. Early’s heirs or his estate may be required to sell a significant portion of that stock upon his death. We do not maintain key man life insurance on the life of Mr. Early. If a substantial block of our common stock were sold by Mr. Early’s heirs or estate, it would likely significantly reduce the market price of our common stock.
Our anti-takeover provisions could prevent or delay a change in control of our company even if the change of control would be beneficial to our stockholders.
Provisions of our articles of incorporation and bylaws as well as provisions of Kansas law could discourage, delay or prevent a merger, acquisition or other change in control of our company, even if the change in control would be beneficial to our stockholders. These provisions include:
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authorizing the issuance of “blank check” preferred stock that could be issued by our board of directors without a stockholder vote to increase the number of outstanding shares and thwart a takeover attempt;
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limitations on the ability of stockholders to call special meetings of stockholders; and
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establishing advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings.
We can redeem common stock from a stockholder who is or becomes a disqualified person.
Federal and state laws and regulations applicable to providers of payday loans may now, or in the future, restrict direct or indirect ownership or control of providers of payday loan services by disqualified persons (such as convicted felons). Our articles of incorporation provide that we may redeem shares of our common stock to the extent deemed necessary or advisable, in the judgment of our board of directors, to prevent the loss, or to secure the reinstatement or renewal, of any license or permit from any governmental agency that is conditioned upon some or all of the holders of our common stock possessing prescribed qualifications or not possessing prescribed disqualifications. The redemption price will be the average of the daily closing sale prices per share of our common stock for the 30 consecutive trading days immediately prior to the redemption date fixed by our board of directors. At the discretion of our board of directors, the redemption price may be paid in cash, debt or equity securities or a combination of cash and debt or equity securities.
ITEM 1B.
ITEM 1B. Unresolved Staff Comments
None.
ITEM 2.
ITEM 2. Properties
In February 2005, we entered into a seven-year lease for new corporate headquarters in Overland Park, Kansas, where we lease approximately 39,000 square feet. In January 2011, we amended this lease agreement to extend the lease term and modify the lease payments. The lease was extended through October 31, 2017 and includes a renewal option for an additional five years. In the opinion of management, the corporate office space leased is adequate for existing and foreseeable future operating needs. Prior to April 2005, our corporate headquarters were located in a 10,000 square foot company-owned building located in Kansas City, Kansas, which is presently leased to an unrelated tenant. In addition, we own three branch locations, in St. Louis, Missouri, Grandview, Missouri and Jackson, Mississippi. All our other branch locations are leased. Our average branch size is approximately 1,600 square feet with average rent of approximately $2,200 per month. Leases are generally executed with a minimum initial term of between three to five years with multiple renewal options. We complete all necessary leasehold improvements and required maintenance.
In August 2008, we purchased an auto sales facility in Overland Park, Kansas. The facility includes three buildings (with a total of 7,982 square feet) and parking spaces on approximately 1.6 acres of land. All our other auto locations are leased.
ITEM 3.
ITEM 3. Legal Proceedings
North Carolina. On February 8, 2005, we, two of our subsidiaries, including our subsidiary doing business in North Carolina, and Mr. Don Early, our Chairman of the Board and Chief Executive Officer, were sued in Superior Court of New Hanover County, North Carolina in a putative class action lawsuit filed by James B. Torrence, Sr. and Ben Hubert Cline, who were customers of a Delaware state-chartered bank for whom we provided certain services in connection with the bank’s origination of payday loans in North Carolina, prior to the closing of our North Carolina branches in fourth quarter 2005. The lawsuit alleges that we violated various North Carolina laws, including the North Carolina Consumer Finance Act, the North Carolina Check Cashers Act, the North Carolina Loan Brokers Act, the state unfair trade practices statute and the state usury statute, in connection with payday loans made by the bank to the two plaintiffs through our retail locations in North Carolina. The lawsuit alleges that we made the payday loans to the plaintiffs in violation of various state statutes, and that if we are not viewed as the “actual lenders or makers” of the payday loans, our services to the bank that made the loans violated various North Carolina statutes. Plaintiffs are seeking certification as a class, unspecified monetary damages, and treble damages and attorney fees under specified North Carolina statutes. Plaintiffs have not sued the bank in this matter and have specifically stated in the complaint that plaintiffs do not challenge the right of out-of-state banks to enter into loans with North Carolina residents at such rates as the bank’s home state may permit, all as authorized by North Carolina and federal law.
In July 2011, the parties completed a weeklong hearing on our motion to enforce our class action waiver provision and our arbitration provision. In January 2012, the trial court denied our motion to enforce our class action and arbitration provisions. We have appealed this ruling to the North Carolina Court of Appeals. It is expected that the court will issue a decision by April 2013.
There were three similar purported class action lawsuits filed in North Carolina against three other companies unrelated to us. The plaintiffs in those three cases were represented by the same law firms as the plaintiffs in the case filed against us. Settlements in each of the three companion cases were reached by the end of 2010; however, the settlements do not provide reasonable guidance on settlement in our case.
Canada. On September 30, 2011, we acquired all the outstanding shares of Direct Credit, a British Columbia company engaged in short-term, consumer Internet lending in certain Canadian provinces. On October 18, 2011, Matthew Lee, an alleged Alberta, Canada resident sued Direct Credit, all of its subsidiaries and three former directors of those subsidiaries in the Supreme Court of British Columbia in a purported class action. The plaintiff alleges that Direct Credit and its subsidiaries violated Canada’s criminal usury laws by charging interest on its loans at rates higher than 60%. The plaintiff purports to represent all Canadian borrowers of the subsidiary who resided outside of British Columbia.
Plaintiff seeks (i) class certification for the class described above, (ii) a declaration that loan fees collected in excess of the 60% limit in the cited usury statute are held by the defendants in constructive trust for the benefit of the class members, (iii) an accounting and restitution to plaintiff and class members of all loan fees received by the defendants, (iv) a declaration that the collection of the loan fees in excess of 60% per annum constitutes an unconscionable trade act or practice under the Canadian Business Practices Consumer Protection Act, (v) an order to restore to the class members the loan fees collected by defendants in excess of 60% per annum, and (vi) interest thereon. Direct Credit has not yet answered the civil claim of the plaintiff, but intends to defend itself, its subsidiaries and its former directors vigorously.
California. On August 13, 2012, we were sued in the United States District Court for the South District of California in a putative class action lawsuit filed by Paul Stemple. Mr. Stemple alleges that the we used an automatic telephone dialing system with an “artificial or prerecorded voice” in violation of the Telephone Consumer Protection Act, 47 U.S.C. 227, et seq. The complaint does not identify any other members of the proposed class, nor how many members may be in the proposed class.
This matter is in the early stages of litigation. We have filed an answer denying all claims.
Other Matters. We are also currently involved in ordinary, routine litigation and administrative proceedings incidental to our business, including customer bankruptcies and employment-related matters from time to time. We believe the likely outcome of any other pending cases and proceedings will not be material to our business or our financial condition.
ITEM 4.
ITEM 4. Mine Safety Disclosures
Not applicable.
PART II
ITEM 5.
ITEM 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information
We completed the public offering of our common stock on July 21, 2004 at an initial offering price of $14.00 per share. Our common stock is traded on the NASDAQ Global Market under the ticker symbol “QCCO.” The following table sets forth the high and low closing prices for each of the completed quarters since January 1, 2011:
The year-end closing prices of our common stock for 2012 and 2011 were $3.24 and $4.02, respectively.
Holders
As of March 5, 2013 there were approximately 146 holders of record and 1,422 beneficial owners of our common stock.
Dividends
The declaration of dividends is subject to the discretion of our board of directors. The future determination as to the payment of cash dividends will depend on our operating results, financial condition, cash and capital requirements and other factors as the board of directors deems relevant.
Our credit agreement requires us to maintain a Fixed Charge Coverage Ratio (as defined and computed in accordance with the credit agreement). Under our credit agreement, we are required to subtract any cash dividends paid on our common stock from our Operating Cash Flow (as defined in the agreement) amount used in computing our Fixed Charge Coverage Ratio. Thus, our credit agreement may restrict our ability to pay cash dividends in the future.
In November 2008, our board of directors established a regular quarterly dividend of $0.05 per share of our common stock. In addition to regular quarterly dividends, our board of directors has also approved special cash dividends on our common stock from time to time. For the years ended December 31, 2011 and 2012, we paid regular cash dividends to our stockholders totaling $3.6 million in each year.
The following table summarizes our cash dividends paid during 2011 and 2012.
Securities Authorized For Issuance Under Equity Compensation Plans
As of December 31, 2012, equity compensation plans approved by security holders include our 1999 Stock Option Plan and our 2004 Equity Incentive Plan.
In June 2009, at our annual meeting of stockholders, our stockholders approved an amendment to the 2004 Equity Incentive Plan to increase the number of shares of common stock available for issuance under such plan from three million shares to five million shares. The following table sets forth certain information about our securities authorized for issuance under our equity compensation plans as of December 31, 2012.
Securities remaining available for future issuance under equity compensation plans approved by security holders consist solely of shares available under the 2004 Equity Incentive Plan. Securities remaining available for future issuance under our 2004 Equity Incentive Plan may be issued, in any combination, as incentive stock options, non-qualified stock options, stock appreciation rights, performance share awards, restricted stock or other incentive awards of, or based on, our common stock.
We do not have any equity compensation plans other than the plans approved by our security stockholders.
Recent Sales of Unregistered Securities
Since July 21, 2004, the date of our initial public offering, we have not made any unregistered sales of securities.
Stock Repurchases
The board of directors has authorized us to repurchase our common stock in the open market or private purchases. The acquired shares may be used for corporate purposes, including shares issued to employees in our stock-based compensation programs. Pursuant to our credit agreement, the maximum amount of our common stock we may repurchase is $60 million.
On June 6, 2012, our board of directors extended our common stock repurchase program through June 30, 2013. The board of directors has previously authorized us to repurchase up to $60 million of our common stock in the open market and through private purchases. During 2012, we repurchased approximately 213,000 shares for approximately $791,000. As of December 31, 2012, we have repurchased a total of 5.8 million shares at a total cost of approximately $56.0 million, which leaves approximately $4.0 million that may yet be purchased under the current program. We did not repurchase any shares of our common stock during fourth quarter 2012.
Performance Graph
The following Performance Graph and related information shall not be deemed “soliciting material” or to be “filed” with the Securities and Exchange Commission, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933 or Securities Exchange Act of 1934, each as amended, except to the extent that we specifically incorporate it by reference into such filing.
The following table compares total stockholder returns on our common stock from December 31, 2007 through December 31, 2012 to the NASDAQ U.S. Index and our peer group assuming a $100 investment made on December 31, 2007 and assumes that all dividends are reinvested. The stock performance shown on the graph below is not necessarily indicative of future price performance. Our peer group consists of Cash America International, Inc., Dollar Financial Corp., EZCORP, Inc. and First Cash Financial Services, Inc.
ITEM 6.
ITEM 6. Selected Financial Data
The following table sets forth our selected consolidated financial data at the dates and for the periods indicated. Selected financial data should be read in conjunction with, and is qualified in its entirety by, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our Consolidated Financial Statements and the Notes thereto appearing elsewhere in this report.
ITEM 7.
ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following should be read in conjunction with Item 6 “Selected Financial Data” and our Consolidated Financial Statements and Notes included as Item 8 of this report.
EXECUTIVE SUMMARY
We operate primarily through our wholly-owned subsidiaries, QC Financial Services, Inc., QC Auto Services, Inc., QC Loan Services, Inc., QC E-Services, Inc., QC Canada Holdings Inc. and QC Capital, Inc. QC Financial Services, Inc. is the 100% owner of QC Financial Services of California, Inc., Financial Services of North Carolina, Inc., QC Financial Services of Texas, Inc., Express Check Advance of South Carolina, LLC, QC Advance, Inc., Cash Title Loans, Inc. and QC Properties, LLC. QC Canada Holdings Inc. is the 100% owner of Direct Credit Holdings Inc. and its wholly owned subsidiaries (collectively, Direct Credit).
We derive our revenues primarily by providing short-term consumer loans, known as payday loans, which represented approximately 66.0% of our total revenues for the year ended December 31, 2012. We earn fees for various other financial services, such as installment loans, credit services, check cashing services, title loans, open-end credit, debit cards, money transfers and money orders. We operated 466 branches in 23 states at December 31, 2012. In all states in which we offer payday loans, we fund our payday loans directly to the customer and receive a fee. Fees charged to customers vary from state to state, generally ranging from $15 to $20 per $100 borrowed, and in most cases, are limited by state law.
We began offering branch-based installment loans to customers in our Illinois branches during second quarter 2006 and expanded that product offering to customers in additional states during 2009 and 2010. In 2012, we introduced new installment loan products (signature loans and auto equity loans) to meet high customer demand for longer-term loan options. These new products are higher-dollar and longer-term installment loans that are centrally underwritten and distributed through our existing branch network. As of December 31, 2012, we offered the installment loan products to our customers in Arizona, California, Colorado, Idaho, Illinois, Missouri, New Mexico, South Carolina, Utah and Wisconsin. The installment loans are payable in monthly installments (principal plus accrued interest) with terms typically ranging from four months to 48 months, and all loans are pre-payable at any time without penalty. The fee for the installment loan varies based on the amount borrowed and the term of the loan. Generally, the amount that we advance under an installment loan ranges from $400 to $3,000. The average principal amount across all installment loan products originated during 2010, 2011 and 2012 was approximately $488, $518 and $624.
In Texas, through one of our subsidiaries, we operate as a credit service organization (CSO) on behalf of consumers in accordance with Texas laws. We charge the consumer a CSO fee for arranging for an unrelated third-party to make a loan to the consumer and for providing related services to the consumer, including a guarantee of the consumer’s obligation to the third-party lender.
In September 2007, we entered into the buy here, pay here segment of the used automotive market in connection with ongoing efforts to evaluate alternative products that serve our customer base. In January 2009, we purchased two buy here, pay here locations in Missouri for approximately $4.2 million. In May 2009, we opened a service center to provide reconditioning services on our inventory of vehicles and repair services for our customers. As of December 31, 2012, we operated five buy here, pay here lots, which are located in Missouri and Kansas. These locations sell used vehicles and earn finance charges from the related vehicle financing contracts. The average principal amount for buy here, pay here loans originated during the year ended December 31, 2012 was approximately $10,245 and the average term of the loan was 33 months.
On September 30, 2011, QC Canada Holdings Inc, our wholly-owned subsidiary, acquired 100% of the outstanding stock of Direct Credit Holdings Inc. (Direct Credit), a British Columbia company engaged in short-term, consumer Internet lending in certain Canadian provinces. Direct Credit was founded in 1999 and has developed and grown a proprietary Internet-based platform in Canada. The acquisition of Direct Credit is part of the implementation of our strategy to diversify by increasing our product offerings and distribution, as well as expanding our presence into international markets.
We have elected to organize and report on our business units as three operating segments (Financial Services, Automotive and E-Lending). The Financial Services segment includes branches that offer payday loans, installment loans, credit services, check cashing services, title loans, open-end credit, debit cards, money transfers and money orders. The Automotive segment consists of our buy here, pay here operations. The E-Lending segment includes the Internet lending operations in Canada. We evaluate the performance of our segments based on, among other things, gross profit, income from continuing operations before income taxes and return on invested capital.
Our expenses primarily relate to the operations of our branch network and automotive locations. The most significant expenses include salaries and benefits for our branch employees, provisions for losses, cost of sales and occupancy expense for our leased real estate. Regional and corporate expenses, which include compensation of employees, professional fees and equity award charges, are our other primary costs.
We also evaluate our Financial Services branches, automotive locations, and our Direct Credit operations based on revenue growth and loss ratio (which is losses as a percentage of revenues). With respect to our branch network, we also consider the length of time the branch has been open and its geographic location. We monitor newer branches for their progress to profitability and rate of loan growth.
With respect to our cost structure, salaries and benefits are one of our largest costs and are generally driven by changes in number of branches and loan volumes. Our provision for losses is also a significant expense. If a customer’s check is returned by the bank as uncollected, we make an immediate charge-off to the provision for losses for the amount of the customer’s loan, which includes accrued fees and interest. Any recoveries on amounts previously charged off are recorded as a reduction to the provision for losses in the period recovered.
We have experienced seasonality in our Financial Services segment, with the first and fourth quarters typically being our strongest periods as a result of broader economic factors, such as holiday spending habits at the end of each year and income tax refunds during the first quarter. Our Automotive locations experience seasonality as automobile sales peak during the first quarter of each year, primarily as a result of the receipt by customers of their income tax refunds, which are used as down payments for a vehicle. Automobile sales in the final three quarters are generally lower than the first quarter. In addition, vehicle acquisition costs tend to increase in the second half of the year as companies build inventories for the expected first quarter volumes.
In response to changes in the overall market, we have closed a significant number of branches over the past five years. During this period, we opened 26 de novo branches, acquired one branch and closed 157 branches. The following table sets forth our de novo branch openings, branch acquisitions and branch closings since January 1, 2008.
(a) The number of branches closed during 2012 does not include 38 branches that we decided in December 2012 that we would close during first half of 2013. However, these branches are included as part of discontinued operations in 2012.
In recent years, we have focused on growing revenue by introducing new products that serve our existing loyal customer base and increasing profitability by streamlining operations. As part of our efforts to introduce new products and diversify our revenue stream, we are currently in the process of accelerating the growth of our longer-term, centrally underwritten installment loan product to our existing branch network. We continually evaluate opportunities for product and geographic expansion and for new branch development to complement existing branches within a given state or market. Additionally, we utilize a disciplined acquisition strategy for both the payday and the buy here, pay here businesses.
We are currently in the process of restructuring our Automotive segment. Historically, we have carried all of our automobile loans receivable on our balance sheet; however, in December 2012, we sold roughly 90% of our automobile loans receivable to a third party. Additionally, while the Automotive segment has been funded from our operations, we are evaluating a forward flow arrangement whereby sales of automobiles are funded directly by a third-party lender. We believe these changes will enhance profitability as a result of improved net credit expense, in addition to enabling us to reduce the capital requirements of the business going forward.
We believe the acquisition of Direct Credit broadens our product platform and distribution, as well as expands our presence by entering into international markets. Although the Canadian market is much smaller than the U.S. market, there is still significant room for organic growth, and Direct Credit is a scalable platform with a competitive method for funding loans. In addition, Direct Credit’s online technology can be used as a platform for future growth into other markets, and we are currently leveraging Direct Credit’s online business model to develop an Internet-based lending platform for customers in the United States. A viable U.S. Internet presence will help us further diversify our revenue base and offer our customers another financing alternative.
The payday loan industry began its rapid growth in 1996, when there were an estimated 2,000 payday loan branches in the United States. According to Community Financial Services Association, industry analysts estimate that the industry has approximately 18,300 payday loan branches in the United States and approximately 1,400 payday loan and check cashing retail locations in Canada. During 2012, the branches in the United States extended approximately $30 billion in short-term credit to millions of middle-class households that experienced cash-flow shortfalls between paydays. As the branch count grew over the last decade, a greater number of Internet-based payday loan providers emerged. Industry analysts estimated that Internet-based payday loan providers extended approximately $18.6 billion to their customers during 2012. In the last few years, the rate of growth for these Internet providers has exceeded that of the branch-based lenders. We believe this trend will continue into the foreseeable future as consumers become more comfortable transacting electronically.
We believe our industry is highly fragmented, with the larger companies operating approximately 50% of the total industry branches. After a number of years of growth, the industry has contracted slightly in the past few years, primarily due to changes in laws that govern the payday product. Absent changes in regulations and laws, we do not expect significant fluctuations in the industry’s number of branches in the foreseeable future.
The payday loan industry has followed, and continues to be significantly affected by, payday lending legislation and regulation in the various states and on a national level. We actively monitor and evaluate legislative and regulatory initiatives in each of the states and nationally, and are closely involved with the efforts of the Community Financial Services Association. To the extent that states enact legislation or regulations that negatively impacts payday lending, whether through preclusion, fee reduction or loan caps, our business has been adversely affected in the past and could be further adversely affected in the future. Over the past few years, legislatures in certain states (and voter initiatives in a few states) have enacted interest rate caps from 28% to 36% per annum on payday lending. A 36% per annum interest rate translates to approximately $1.38 per $100 loaned, which effectively precludes us from offering payday loans in those states unless other transaction fees may be charged to the customer.
In the last several years, changes in laws governing payday loans have negatively affected our revenues and gross profit.
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During 2009, payday loan-related legislation that severely restricts customer access to payday loans was passed in South Carolina, Washington, Virginia and Kentucky. These law changes adversely affected our revenues and operating income during 2010. During 2010, the results from the states in which we have experienced law changes were more negative than we expected, with revenue declines and loss rates exceeding our forecasts. For the year ended December 31, 2010, revenues and gross profit from South Carolina, Washington, Virginia and Kentucky declined by $14.1 million and $9.0 million, respectively, compared to the prior year. During 2011 and 2012, as a group, these states have generated modest profits and will not return to the level of profitability experienced prior to the customer restrictions, indicative of the challenges inherent with a transition to a new law and new products.
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In Arizona, the existing payday lending law expired on June 30, 2010. While we are currently offering installment loans to our Arizona customers, our customers have not embraced this product as they did the payday loan product. For the year ended December 31, 2011, revenues and gross profit from our Arizona branches declined by $1.5 million and $1.4 million, respectively, from the prior year. Results in 2012 were slightly ahead of 2011, but we do not expect profitability to return to levels experienced prior to the expiration of the payday law.
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In March 2011, a new payday law became effective in Illinois that imposes customer usage restrictions that will negatively affect revenues and profitability. This type of customer restriction, when passed in other states such as Washington, South Carolina and Kentucky, has resulted in a 30% to 60% decline in annual revenues and a more significant decline in gross profit, depending on the types of alternative products that competitors may offer within the state. The Illinois law provides for an overlap of the previous lending approach with loans issued under the new law for a period of one year, which extended the time period over which the negative effects of the new law occurred. During 2011, our revenues declined by $2.4 million and our gross profit declined by $2.2 million. During 2012, our revenues declined by $2.0 million and our gross profit declined by $1.8 million. We expect that revenues and gross profit in Illinois for 2013 will be similar to 2012.
There was an effort in Missouri to place a voter initiative on the statewide ballot in November 2012, which was intended to preclude any lending in the state with an annual rate over 36%. The supporters of the voter initiative did not submit a sufficient number of valid signatures to place the initiative on the ballot in November 2012. However, a similar initiative was submitted to the Missouri Secretary of State in December 2012 for inclusion on the November 2014 ballot subject to the proponents submitting the required number of valid signatures in support of the initiative. If this initiative is placed on the ballot in 2014 and the measure passes, we would be unable to operate our payday loan branches in Missouri and be forced to close those locations in the state.
KEY DEVELOPMENTS
Sale of Auto Receivables. In December 2012, we completed two transactions involving $17.2 million principal amount of our automobile loans receivable. We received approximately $11.9 million in cash proceeds in exchange for relinquishing our right, title and interest in the automobile loans receivable. We are subject to recourse provisions requiring us to re-purchase certain automobile loans receivable in the event of a default. We used the net proceeds we received to make a prepayment of the term loan under our credit agreement.
With respect to the transfer of $17.2 million in automobile loans receivable, we treated $16.1 million of this amount as a sale and recognized a $2.6 million loss from the sale in the other income component of the Consolidated Statements of Income. We were unable to satisfy certain criteria for sale accounting treatment with respect to the transfer of $1.1 million in principal amount of automobile loans receivable. These transferred assets have been classified as collateralized receivables and the cash proceeds received (approximately $618,000) from the transfer of these automobile loans receivable have been classified as a secured borrowing in the consolidated balance sheets.
Direct Credit On September 30, 2011, we acquired 100% of the outstanding stock of Direct Credit, a British Columbia company engaged in short-term, consumer Internet lending in certain Canadian provinces. We paid an aggregate initial consideration of $12.4 million. We also agreed to pay a supplemental earn-out payment to the extent the EBITDA of Direct Credit’s operations as specifically defined in the Stock Purchase Agreement (generally Direct Credit’s earnings before interest, income taxes, depreciation and amortization expenses) exceeds a defined target for the twelve month period ending September 30, 2012. On the date of the acquisition, the estimated fair value of the earn-out liability was approximately $1.0 million, which was recorded as additional goodwill. In accordance with the stock purchase agreement, a supplemental earn-out payment was not required as Direct Credit’s EBITDA for the 12 month period ended September 30, 2012 did not exceed the defined target. In 2012, the full amount of the earn out liability was eliminated as a gain (approximately $1.1 million) pursuant to accounting guidance. We believe the acquisition of Direct Credit broadens our product platform and distribution, as well as expands our presence by entering into international markets.
As part of our annual impairment testing performed as of December 31, 2012, we determined that the fair value of the E-Lending reporting unit in Canada did not exceed its carrying value. As a result, we recorded a $1.6 million non-cash impairment charge to goodwill during the year ended December 31, 2012.
Amended and Restated Credit Agreement. On September 30, 2011, we entered into an amended and restated credit agreement with a syndicate of banks to replace our prior credit agreement, which was previously amended on December 7, 2007. The prior credit agreement provided for a term loan of $50 million maturing December 2012 and a revolving line of credit (including provisions permitting the issuance of letters of credit and swingline loans) of up to $45.0 million. The current credit agreement provides for a term loan of $32 million and a revolving line of credit (including provisions permitting the issuance of letters of credit and swingline loans) in the aggregate principal amount of up to $27 million. See additional information in the Liquidity and Capital Resources discussion below.
Closure of Branches. During 2012, we closed 24 of our lower performing branches in various states (which included four branches that were consolidated into nearby branches). In addition, we decided we would close 38 underperforming branches during first half of 2013. We recorded approximately $699,000 in pre-tax charges during 2012 associated with branch closures. The charges included a $398,000 loss for the disposition of fixed assets, $263,000 for lease terminations and other related occupancy costs and $38,000 for other costs. The charges recorded in 2012 do not include lease termination and severance costs associated with the 38 branches that are scheduled to close during first half of 2013 as notification to the landlords and employees occurred in January 2013.
During 2011, we closed 24 of our branches in various states (which included four branches that were consolidated into nearby branches) and sold one branch. We recorded approximately $553,000 in pre-tax charges during the year ended December 31, 2011 associated with these closures. The charges included a $283,000 loss for the disposition of fixed assets, $252,000 for lease terminations and other related occupancy costs and $18,000 for other costs.
During 2010, we closed 34 of our branches in various states and, as a result of the negative impact from changes in payday lending laws, we decided to close 21 branches in Arizona, Washington and South Carolina during first half 2011. During 2011, we closed 18 of the 21 branches and decided that the remaining three branches would remain open. We recorded approximately $1.8 million in pre-tax charges during the year ended December 31, 2010 associated with these closings. The charges included $916,000 representing the loss on the disposition of fixed assets, $671,000 for lease terminations and other related occupancy costs, $155,000 in severance and benefit costs and $33,000 for other costs.
Introduction of Alternative Loan Products. In 2012, we introduced new installment loan products (signature loans and auto equity loans) to meet high customer demand for longer-term loan options. These new products are higher-dollar and longer-term installment loans that are centrally underwritten and distributed through our existing branch network. The installment loans are payable in monthly installments (principal plus accrued interest) with terms ranging from 6 to 48 months, and all loans are pre-payable at any time without penalty. The fee for an installment loan varies based on the amount borrowed and the term of the loan. Signature loans are unsecured installment loans with a typical term of 6 to 36 months and a principal balance of up to $3,000. Fees and interest vary based on the size and term of the loan and whether the customer pays with cash/check or uses recurring ACH payments. During 2012, the average principal amount of a signature loan was $1,882 and the average term was 18 months. Auto equity loans are higher-dollar installment loans secured by the borrower’s auto title with a typical term of 12 to 48 months and a principal balance of up to $15,000. Fees and interest vary based on the size and term of the loan. During 2012, the principal amount of an auto equity loan was $3,068 and the average term was 25 months.
In fourth quarter 2011, we re-introduced the open-end credit product with various key structural changes to our customers in a limited number of Virginia branches. The open-end credit product is similar to a credit card as the customer is granted a grace period of 25 days to repay the loan without incurring any interest. In addition, we are responsible for providing our customer with a monthly statement and we require the customer to make a monthly payment based on the outstanding balance. In addition to interest earned on the outstanding balance, the open-end credit product also includes a monthly membership fee.
DISCUSSION OF CRITICAL ACCOUNTING POLICIES
Our consolidated financial statements and accompanying notes have been prepared in accordance with accounting principles generally accepted in the United States of America applied on a consistent basis. The preparation of these financial statements requires us to make a number of estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. We evaluate these estimates and assumptions on an ongoing basis. We base these estimates on the information currently available to us and on various other assumptions that we believe are reasonable under the circumstances. Actual results could vary materially from these estimates under different assumptions or conditions.
We believe that the following critical accounting policies affect the more significant estimates and assumptions used in the preparation of our financial statements.
Revenue Recognition
We record revenue from payday loans and title loans upon issuance. The term of a loan is generally two to three weeks for a payday loan and 30 days for a title loan. At the end of each month, we record an estimate of the unearned revenue, which results in revenues being recognized on a constant-yield basis ratably over the term of each loan.
We record revenues from installment loans using the simple interest method.
With respect to our CSO services in Texas, we earn a CSO fee for arranging for an unrelated third-party to make a loan to the consumer and for providing related services to the consumer, including a guarantee of the consumer’s obligation to the third-party lender. We also service the loan for the lender. The CSO fee is recognized ratably over the term of the loan.
We recognize revenue (net of sales tax) from the sale of automobiles at the time the vehicle is delivered to the customer and title has passed. In cases where we finance the vehicles, we originate an installment sale contract and use the simple interest method to recognize interest.
With respect to our open-end product, we earn interest on the outstanding balance and the product also includes a monthly non-refundable membership fee.
Generally, we recognize revenue for our other consumer financial products and services, which includes check cashing, money transfers and money orders, at the time those services are rendered to the customer, which is generally at the point of sale.
Provision for Losses and Returned Item Policy
We record a provision for losses associated with uncollectible loans. For payday loans, all accrued fees, interest and outstanding principal are charged off on the date we receive a returned check, generally within 14 days after the due date of the loan. Accordingly, the majority of payday loans included in our loans receivable balance at any given point in time are typically not older than 30 days. These charge-offs are recorded as expense through the provision for losses. Any recoveries on losses previously charged to expense are recorded as a reduction to the provision for losses in the period recovered. With respect to title loans, no additional fees or interest are charged after the loan has defaulted, which generally occurs after attempts to contact the customer have been unsuccessful. Based on state regulations and operating procedures, we stop accruing interest on installment loans between 60 to 90 days after the last payment. On automotive loans, we stop accruing interest on 60 days after the last payment.
With respect to the loans receivable at the end of each reporting period, we maintain an aggregate allowance for loan losses (including fees and interest) for payday loans, title loans, installment loans and auto loans at levels estimated to be adequate to absorb estimated incurred losses in the respective outstanding loan portfolios. We do not specifically reserve for any individual loan.
The methodology for estimating the allowance for payday and title loan losses utilizes a four-step approach, which reflects the short-term nature of the loan portfolio at each period-end, the historical collection experience in the month following each reporting period-end and any fluctuations in recent general economic conditions. First, we compute the loss/volume ratio for the last month of each reporting period. The loss/volume ratio represents the percentage of aggregate net payday and title loan charge-offs to total payday and title loan volumes during a given period. Second, we compute an adjustment to this percentage to reflect the collections experience in the month immediately following the reporting period-end. To estimate collections experience, we compute an average of the change in the loss/volume ratio from the last month of each reporting period to the immediate subsequent month-end for each of the last three years (excluding the current year). This change is then added to, or subtracted from, the loss/volume ratio computed for the last month of the current reporting period to derive an experience-adjusted loss/volume ratio. Third, the period-end gross payday and title loans receivable balance is multiplied by the experience-adjusted loss/volume ratio to determine the initial estimate of the allowance for loan losses. Fourth, we review and evaluate various qualitative factors that may or may not affect the computed initial estimate of the allowance for loan losses, including, among others, known changes in state regulations or laws, changes to our business and operating structure, and geographic or demographic developments. As of December 31, 2011, we determined that no qualitative adjustment to the allowance for payday loan losses was necessary. In connection with our decision in 2012 to close 38 branches during the first half of 2013, we recorded a $1.3 million qualitative adjustment to increase the allowance for loan losses as of December 31, 2012.
We maintain an allowance for all installment loans at a level we consider sufficient to cover estimated losses in the collection of our installment loans. The allowance calculation for installment loans is based upon historical charge-off experience (primarily a six-month trailing average of charge-offs to total volume) and qualitative factors, with consideration given to recent credit loss trends and economic factors. As of December 31, 2011, we determined that no qualitative adjustment to the allowance for installment loan losses was necessary. In connection with our decision in 2012 to close 38 branches during the first half of 2013, we recorded a $344,000 qualitative adjustment to increase our allowance for loan losses as of December 31, 2012.
The allowance calculation for auto loans is determined on an aggregate basis and is based upon our review of the loan portfolio by period of origination, industry loss experience and qualitative factors, with consideration given to changes in loan characteristics, delinquency levels, collateral values and other general economic conditions. This estimate of probable losses is primarily determined using static pool analyses prepared for various segments of the portfolio using estimated loss experience, adjusted for consideration of any current economic factors. Over the last few years, industry loss rates have generally ranged between 20% and 28% of revenues, with higher ratios during more difficult macroeconomic periods. Our level of allowance for automotive loans in prior years was higher than levels during 2011 and 2012 due to our relative inexperience in the buy here, pay here business, as well as the age of the new locations and the generally negative industry and macroeconomic environment. During 2010, the Company’s loss experience with respect to automotive loans improved significantly due to management and process enhancements. As of December 31, 2011 and December 31, 2012, the Company reviewed various qualitative factors with respect to its automotive loans receivable and determined that no qualitative adjustment was needed.
Based on the information discussed above, we record an adjustment to the allowance for loan losses through the provision for losses. The overall allowance represents our best estimate of probable losses inherent in the outstanding loan portfolios at the end of each reporting period.
The following table summarizes the activity in the allowance for loan losses:
The provision for losses in the Consolidated Statements of Income includes losses associated with the CSO and excludes loss activity related to discontinued operations.
As noted above, to the extent that macroeconomic indicators continue to be inconsistent and vary during 2013 and beyond, our estimates with respect to the allowance for loan losses could be subject to more volatility and could increase as a percentage of total outstanding loans receivable.
Our results from Financial Services and E-Lending operations are seasonal due to fluctuating demand for short-term loans during the year. Historically, we have experienced our highest demand for short-term loans in January and in the fourth calendar quarter. As a result, to the extent that internally generated cash flows are not sufficient to fund the growth in loans receivable, fourth quarter and the month of January are the most likely periods of time for utilization or increase in borrowings under our credit facility. Due to the receipt by customers of their income tax refunds, demand for short-term loans has historically declined in the balance of the first quarter of each calendar year and the first month of the second quarter. Accordingly, this period is typically when any outstanding borrowings under the credit facility would be repaid (exclusive of any other capital-usage activity, such as acquisitions, significant stock repurchases, etc.). Our loss ratio historically fluctuates with these changes in short-term loan demand, with a higher loss ratio in the second and third quarters of each calendar year and a lower loss ratio in the first and fourth quarters of each calendar year. During mid-second quarter through third quarter, periodic utilization of our credit facility is not unusual, based on the level of loan losses and other capital-usage activities. Due to the seasonality of our business, results of operations for any quarter are not necessarily indicative of the results of operations that may be achieved for the full year.
Similarly, our Automotive segment experiences seasonality as automobile sales peak during the first quarter of each year, primarily as a result of the receipt by customers of their income tax refunds, which are used as down payments for a vehicle. Automobile sales in the final three quarters are generally lower than the first quarter. In addition, vehicle acquisition costs tend to increase in the second half of the year as companies build inventories for the expected first quarter volumes.
Accounting for Leases and Leasehold Improvements
Occupancy rent costs are amortized on a straight-line basis over the lease life, which includes reasonably assured lease renewals. Similarly, leasehold improvements are amortized over the shorter of their estimated useful lives or the related lease life including reasonably assured lease renewals. The lease lives plus reasonably assured renewals have generally ranged from 1 to 15 years with an average of 7 years and usually contain cancellation clauses in the event of regulatory changes. For leases with renewal periods at our option, which are included in substantially all of our operating leases for our branches, we believe that most of the renewal options are reasonably assured of being exercised due to the following factors: (i) the importance of the branch location to the ultimate success of the branch, (ii) the significance of the property to the continuation of service to our customers and to our development of a viable customer-base and (iii) the existence of leasehold improvements whose value would be impaired if we vacated or discontinued the use of such property.
Income Taxes
In connection with the preparation of our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating current tax liability, together with assessing the differences between the financial statement and tax bases of assets and liabilities as measured by the tax rates that will be in effect when these differences reverse. These differences result in deferred tax assets and liabilities, which are included in the consolidated balance sheets. As of December 31, 2011 and 2012, we reported a net deferred tax asset in the consolidated balance sheet. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. As of December 31, 2011 and 2012, we have established valuation allowances of $532,000 and $618,000, respectively, for certain deferred tax assets.
In the ordinary course of business, many transactions occur for which the ultimate tax outcome is uncertain. In addition, respective tax authorities periodically audit our income tax returns. These audits examine our significant tax filing positions, including the timing and amounts of deductions and the allocation of income among tax jurisdictions. We adjust our income tax provision in the period in which we determine the actual outcomes will likely be different from our estimates. The recognition or derecognition of income tax expense related to uncertain tax positions is determined under the guidance as prescribed by the Financial Accounting Standards Board (FASB). As of December 31, 2011 and December 31, 2012, the accrued liability for unrecognized tax benefits was approximately $193,000 and $123,000, respectively.
As of December 31, 2011, the accumulated undistributed earnings of foreign affiliates were $133,000. As of December 31, 2012, the accumulated undistributed earnings of foreign affiliates were a deficit of $108,000. As we intend to indefinitely reinvest these earnings in the business of our foreign affiliates, no federal or state income taxes or foreign withholding taxes have been provided for amounts which would become payable, if any, on the distribution of such earnings.
Share-Based Compensation
We account for stock-based compensation expense for share-based payment awards to our employees and directors at the estimated fair value on the grant date. The fair value of stock option grants is determined using the Black-Scholes option pricing model, which requires us to make several assumptions including, but not limited to risk free interest rate, expected volatility, dividend yield and expected term of the option. Restricted stock awards are valued on the date of grant and have no purchase price. All share-based compensation is recorded net of an estimated forfeiture rate, which is based upon historical activity.
The following table summarizes the stock-based compensation expense reported in net income for the years ended December 31, 2010, 2011 and 2012:
As of December 31, 2012, there was $16,700 of total unrecognized compensation costs related to outstanding stock options that will be amortized over a weighted average period of one month. In addition, there was $1.5 million of total unrecognized compensation costs related to restricted stock grants that will be amortized over a weighted average period of 1.7 years.
Accounting for Goodwill and Intangible Assets
As of December 31, 2012, our goodwill and intangible assets totaled $26.1 million. Goodwill and intangible assets require significant management estimates and judgment, including the valuation and life determination in connection with the initial purchase price allocation and the ongoing evaluation for impairment.
In connection with the purchase price allocations of acquisitions, we rely on in-house financial expertise or utilize a third-party expert, if considered necessary. The purchase price allocation process requires management estimates and judgment as to expectations for the acquisition. For example, certain growth rates, discount rates and operating margins were assumed for different acquisitions. If actual growth rates, discount rates or operating margins, among other assumptions, differ from the estimates and judgments used in the purchase price allocation, the amounts recorded in the financial statements for goodwill and intangible assets could be subject to charges for impairment in the future.
We review the recoverability of goodwill and other intangible assets having indefinite useful lives using a fair-value based approach on an annual basis, or more frequently whenever events occur or circumstances indicate that the asset might be impaired. We evaluate the goodwill at the reporting unit level. We have determined that we have three reporting units, which are based on our core lending operations in the United States, our automotive operations and our E-Lending operations. For testing purposes, we have elected to aggregate all components of our core lending operations in the United States into a single reporting unit, as we believe all our core lending branches have similar economic characteristics and our components are similar with respect to the nature of the products and services, type of customer and the methods used to provide our services. We hired an independent appraiser to assist with our impairment test as of December 31, 2012. The independent appraiser assessed the fair value of our reporting units based on a weighted average of valuations using methods that included discounted cash flows and market multiples. The key assumptions used in the discounted cash flow valuations are discount rates and perpetual growth rates applied to cash flow projections. Also inherent in the discounted cash flow valuation models are past performance, projections and assumptions in current operating plans and revenue growth. These assumptions contemplate business, market and overall economic conditions. In connection with this process, the independent appraiser also provided a reconciliation of the estimated aggregate fair values of the reporting units to our market capitalization, including consideration of a control premium that represents what an investor would pay for our equity securities to obtain a controlling interest. We believe that this reconciliation is consistent with a market participant perspective. We tested trade names with indefinite lives by comparing the book value to a fair value calculated using a discounted cash flow approach on a presumed royalty rate derived from the revenues related to the trade name.
Other factors that are considered important in determining whether an impairment of goodwill or intangible assets might exist include significant continued underperformance compared to peers, significant changes in our business and products, material and ongoing negative industry or economic trends, or other factors specific to each asset being evaluated. Any changes in key assumptions about our business and our prospects, or changes in market conditions or other externalities, could result in an impairment charge and such a charge could have a material adverse effect on our financial condition and results of operations.
With respect to the impairment test performed as of December 31, 2012, we determined that there was no impairment of goodwill for our core lending and automotive units as the fair value of each these reporting units were in excess of their carrying amount based on test results from an independent appraiser. However, the test results showed that the fair value of the E-Lending unit did not exceed its carrying amount. Thus, the independent appraiser assisted with the second step of the impairment test and as a result, we recorded a $1.7 million non-cash impairment charge to goodwill for our Internet lending unit. In addition, we performed an impairment test on our indefinite lived intangible assets and determined that the trade name associated with the ECA acquisition was impaired and recorded a charge of $600,000. No impairment of goodwill or indefinite lived intangible assets was recognized during 2010 and 2011.
Foreign Currency Translations
The functional currency for our subsidiaries that serve residents of Canada is the Canadian dollar. The assets and liabilities of these subsidiaries are translated into U.S. dollars at the exchange rates in effect at each balance sheet date, and the resulting adjustments are recorded in “Accumulated other comprehensive income (loss)” as a separate component of equity. Revenue and expenses are translated at the monthly average exchange rates occurring during each period.
SUMMARY OF FINANCIAL INFORMATION
The following table sets forth our results of operations for the years ended December 31, 2010, 2011 and 2012:
SUMMARY OF OPERATING INFORMATION
The following tables set forth our branch information and other operating information for the years ended December 31, 2010, 2011 and 2012:
Results of Operations - 2012 Compared to 2011
Income from Continuing Operations
For the year ended December 31, 2012, income from continuing operations was $7.9 million compared to $11.9 million in 2011. A discussion of the various components of income from continuing operations follows.
Revenues
The following table summarizes our revenues for the years ending December 31, 2011 and 2012 and sets forth the percentage of total revenue for payday loans and the other services we provide.
Revenues totaled $180.6 million in 2012 compared to $176.6 million in 2011, an increase of $4.0 million or 2.3%. The improvement is due to the inclusion of fees and interest of approximately $8.1 million from our Canadian online lending subsidiary versus $1.9 million in 2011 and growth in the new installment product, partially offset by reduced payday loan volumes in our branches year-to-year.
Revenues from our payday loan product represent our largest source of revenues and were approximately 66.0% of total revenues for the year ended December 31, 2012. With respect to payday loan volume, we originated approximately $807.9 million in loans during 2012, which was an increase of 1.0% from the $799.9 million during 2011. This increase is primarily attributable to the inclusion of volume from Direct Credit, partially offset by a decline in payday loan volume from our Financial Services segment. The majority of the decline in payday loan volume from our Financial Services segment is due to lower volume in the state of Missouri compared to prior year, which we believe was attributable to customer uncertainty regarding the ongoing availability of the payday product given the failed effort by industry opponents to eliminate the product through a ballot referendum. In addition, customer usage restrictions resulting from changes in the payday law in Illinois that became effective in March 2011 negatively affected revenues and volume in 2012. For the year ended December 31, 2012, revenues from our branches in Illinois declined by $2.0 million from the same period in the prior year.
The average payday loan (including fee) totaled $380.62 in 2012 versus $374.30 during 2011. Average fees received from customers per loan increased from $56.80 in 2011 to $57.76 in 2012.
Revenues from installment loan fees totaled $21.3 million for the year ended December 31, 2012 compared to $16.4 million in the prior year, an increase of $4.9 million or 29.9%. The increase was primarily a result of the introduction of longer-term, higher-dollar loans distributed through our branch network and evaluated, underwritten and collected centrally in our corporate home office.
Revenues from our automotive business totaled $23.7 million for the year ended December 31, 2012, an increase of $73,000 compared to the prior year. The increase in revenue during 2012 reflects a slight increase in the average sales price per vehicle and additional interest and fees earned on a larger loan portfolio balance. We sold 1,737 vehicles in 2012 compared to 1,911 in 2011.
Revenues from credit service fees, check cashing, title loans and other sources totaled $18.8 million and $16.5 million for the years ended December 31, 2011 and 2012, respectively. The decline in revenues reflects the reduced demand for these products. We anticipate that customer demand for the payday loan product in the U.S. will continue to remain soft for the majority of our branches during 2013 due to high unemployment rates, low consumer spending and weak consumer confidence. In 2013, we plan to introduce our longer-term centrally approved installment loan products to customer in an additional 150 to 200 branches. We believe there is a reasonable demand for these types of products and, as a result, expect growth in total installment revenues in 2013 over 2012. As a result of the sale of more than 90% of our automobile loans receivable in December 3012, our financing revenue for our Automotive segment will decline significantly in 2013 versus 2012.
Operating Expenses
Total operating expenses were $124.7 million during 2012 compared to $114.7 million in 2011, an increase of $10.0 million, or 8.7%. Total operating costs, exclusive of loan losses, increased to $84.1 million during 2012 compared to $78.9 million during 2011. The increase was primarily due to the inclusion of Direct Credit for a full year in 2012 versus three months in 2011, as well as an increase in healthcare expenditures and collection-related banking costs. Occupancy costs were $18.9 million during 2012, compared to $18.4 million in 2011, an increase of $500,000. Occupancy costs as a percentage of revenues were 10.5% in both 2011 and 2012
Our provision for losses increased from $35.8 million during 2011 to $40.7 million during 2012. Our loss ratio was 20.3% during 2011 versus 22.5% during 2012. The increase in the loss ratio from 2011 to 2012 was primarily attributable to the inclusion of Direct Credit and a lower collection rate of returned items. Our charge-offs as a percentage of revenue were 37.5% during 2012 compared to 36.6% during 2011. Our collection rate was 42.2% in 2012 versus 45.6% in 2011. We received cash of approximately $685,000 from selling older debt during 2012 compared to $472,000 during 2011 (which 2012 amount does not include the sale of our Automobile receivables in December 2012).
With respect to 2013, we believe that our collections experience will be consistent with historical levels, as customers adapt to fluctuations in the broader economy.
Gross Profit
The following table summarizes our gross profit and gross margin (gross profit as a percentage of revenues) of each operating segment for the years ended December 31, 2011 and 2012.
Gross profit declined by $6.1 million, or 9.9%, from $61.9 million in 2011 to $55.8 million in 2012. The decrease year-to-year was primarily attributable to our Financial Services segment due to the uncertainty surrounding the ballot referendum in Missouri and changes in the Illinois law. For the year ended December 31, 2012, gross profit from our branches in Missouri and Illinois declined by $2.7 million and $1.8 million, respectively, from the same period in the prior year.
Regional and Corporate Expenses
Regional and corporate expenses decreased by $4.3 million, from $37.6 million during 2011 to $33.3 million during 2012. The results for 2012 include a $739,000 gain resulting from the cash settlement of an expiring life insurance policy. The results for 2011 include a $2.0 million expense resulting from the settlement of an outstanding legal matter. The remainder of the improvement year-to-year is primarily attributable to lower legal and other professional expenses.
In January 2013, we announced to our employees a restructuring plan for the organization primarily due to a decline in loan volumes over the past few years as a result of shifting customer demand, the poor economy, regulatory changes and increasing competition in the short-term credit industry. The restructuring plan includes the closing of 38 underperforming branches during the first half of 2013 (which were included as discontinued operations in 2012 as the decision to close these branches was made in December 2012) as well as a 10% workforce reduction in field and corporate employees. Excluding the effect of the closed branches, the workforce reduction and related cost savings are expected to total approximately $3.0 million to $3.5 million on an annual basis.
Interest and Other Expenses
Interest expense totaled $3.6 million for the year ended December 31, 2012 compared to interest expense of $2.6 million in 2011. The increase was a result of higher average debt balances, a higher blended borrowing rate and amortization of debt issue costs resulting from the restatement and amendment of our credit agreement in third quarter 2011.
Impairment of Goodwill and Intangible Assets
The results for 2012 include a $2.3 million goodwill and intangible impairment charge. As part of our annual impairment test of goodwill and intangible assets, we recorded a $1.7 million non-cash impairment charge to goodwill for our E-Lending reporting unit and a $600,000 charge to reduce the value of the trade name intangible asset associated with the ECA acquisition. No impairment of goodwill or indefinite lived intangible assets was recognized during 2011.
Other Expense (Income), Net
Other expenses for 2012 includes a loss of $2.6 million from the sale of automobile receivables, partially offset by a $1.1 million gain to reflect the reversal of the liability that was recorded to estimate the fair value of the contingent supplemental earn-out payment in connection with the acquisition of Direct Credit in September 2011.
Income Tax Provision
The effective income tax rate for the year ended December 31, 2012 was 41.5% compared to 37.6% in the prior year. The higher tax rate is attributable to the non-deductible nature of the impairment charges. We expect our effective tax rate for 2013 to be in the range of 38.0% to 39.0%.
Results of Operations - 2011 Compared to 2010
Income from Continuing Operations
For the year ended December 31, 2011, income from continuing operations was $11.9 million compared to $14.2 million in 2010. A discussion of the various components of income from continuing operations follows.
Revenues
Revenues totaled $176.6 million in 2011 compared to $174.6 million in 2010, an increase of $2.0 million or 1.1%. The improvement is due to the inclusion of fees and interest of approximately $1.9 million from our Canadian online lending subsidiary (Direct Credit) which was acquired on September 30, 2011 and higher automotive, installment loan and title loan revenues. These increases were substantially offset by lower payday loan volume in our branch network.
Revenues from our payday loan product represent our largest source of revenues and were approximately 66.7% of total revenues for the year ended December 31, 2011. With respect to payday loan volume, we originated approximately $799.9 million in loans during 2011, which was a decline of 3.4% from the $828.0 million during 2010. The decline in payday loan volumes is largely due to the expiration of Arizona’s payday loan law on June 30, 2010. In Arizona, we are offering an installment loan product, but customer demand is significantly lower for this product than the payday loan alternative previously available. The average payday loan (including fee) totaled $374.30 in 2011 versus $372.19 during 2010. Average fees received from customers per loan increased from $56.41 in 2010 to $56.80 in 2011. The average fee rate per $100 for 2011 was $17.92 for our Financial Services branches compared to $17.86 in the prior year.
Revenues from installment loan fees totaled $16.4 million for the year ended December 31, 2011 compared to $16.0 million in the prior year, an increase of $400,000 or 2.5%. The increase reflects an increase in installment loan volume as we began offering the installment product in additional states during 2011.
Revenues from our automotive business totaled $23.6 million for the year ended December 31, 2011, an increase of $3.7 million or 18.6% compared to the prior year. The increase reflects improved customer demand as we sold approximately 1,911 vehicles in 2011 compared to approximately 1,749 in 2010.
Revenues from credit service fees, check cashing, title loans and other sources totaled $17.3 million and $18.8 million for the years ended December 31, 2010 and 2011, respectively. The following table summarizes other revenues:
Operating Expenses
Total operating expenses were $114.7 million during 2011 compared to $110.9 million in 2010, an increase of $3.8 million, or 3.4%. Operating costs, exclusive of loan losses, increased to $78.9 million during 2011 compared to $76.4 million during 2010. The increase was primarily due to higher cost of sales for automobile purchases, which resulted from a reduced supply of used vehicles nationwide. Salaries and benefits decreased by $306,000, due to a decline in field personnel and reduced overtime. The total number of field personnel averaged 1,507 during 2011 compared to 1,650 in the prior year.
Our provision for losses increased from $34.5 million during 2010 to $35.8 million during 2011. Our loss ratio was 19.8% during 2010 versus 20.3% during 2011. The increase in the loss ratio from 2010 to 2011 was largely due to loss experience in South Carolina, Illinois and Wisconsin where customers are adjusting to new product offerings as a result of changes to lending laws. Our charge-offs as a percentage of revenue were 36.6% during 2011 compared to 37.7% during 2010. Our collection rate was 45.6% in 2011 versus 47.0% in 2010. We received cash of approximately $472,000 from selling older debt during 2011 compared to $494,000 during 2010.
Occupancy costs were $18.4 million during 2011, compared to $17.5 million in 2010, an increase of $0.9 million. Occupancy costs as a percentage of revenues increased from 10.0% in 2010 to 10.5% in 2011.
Gross Profit
Gross profit declined by $1.8 million, or 2.8%, from $63.7 million in 2010 to $61.9 million in 2011. Gross margin, which is gross profit as a percentage of revenues, decreased from 36.5% in 2010 to 35.0% in 2011. The decrease year-to-year was attributable to the changes in the Arizona law and higher cost of sales on vehicles as noted above, partially offset by improvements in the majority of the other states in which we operate. The gross margin for Financial Services segment in 2011 was 39.1% compared to 39.3% in 2010.
Regional and Corporate Expenses
Regional and corporate expenses increased by $1.6 million, from $36.0 million during 2010 to $37.6 million during 2011. The increase is primarily attributable to the $2.0 million legal accrual associated with the settlement of an outstanding legal matter, partially offset by reduced compensation. Together, regional and corporate expenses were approximately 20.6% of revenues in 2010 compared to 21.2% of revenues in 2011.
Interest and Other Expenses
Interest expense totaled $2.6 million for the year ended December 31, 2011 compared to interest expense of $2.4 million in 2010. The increase was a result of higher average debt balances and a higher interest rate associated with the subordinated debt which was entered into on September 30, 2011. Other expenses increased by $337,000 in 2011 compared to 2010 primarily due to a loss on debt extinguishment associated with the completion of an amended and restated credit agreement in third quarter 2011.
Income Tax Provision
The effective income tax rate for the year ended December 31, 2011 was 37.6% compared to 36.5% in the prior year. The lower-than-normal effective rate in each period reflects state and employment tax credits.
Discontinued Operations
During the year ended December 31, 2012, we closed 20 branches that were not consolidated into nearby branches. In addition, we decided that we would close 38 underperforming branches during the first half of 2013. We recorded approximately $664,000 in pre-tax charges during the year ended December 31, 2012 associated with these branch closures. The charges included a $375,000 loss for the disposition of fixed assets, $253,000 for lease terminations and other related occupancy costs and $36,000 for other costs. The charges recorded in 2012 do not include lease termination and severance costs associated with the 38 branches that are scheduled to close during first half of 2013 as notification to the landlords and employees occurred in January 2013.
During the year ended December 31, 2011, we closed 20 branches that were not consolidated into nearby branches and sold one branch. In addition, we announced in December 2010 that we would close 21 branches in Arizona, Washington and South Caroling during the first half of 2011 due to the negative impact from changes in those state’s payday lending laws. During 2011, we closed 18 of the 21 branches and decided that the remaining three branches would remain open and the results of these three branches have been reclassified into continuing operations. We recorded approximately $509,000 in pre-tax charges during the year ended December 31, 2011 associated with these closures. The charges included a $264,000 loss for the disposition of fixed assets, $231,000 for lease terminations and other related occupancy costs and $14,000 for other costs.
During the year ended December 31, 2010, we closed 34 of our branches in various states. With respect to these closings and the announcement in December to close branches in Arizona, Washington and South Carolina, we recorded approximately $1.8 million in pre-tax charges during 2010. The charges included a $916,000 loss for the disposition of fixed assets, $671,000 for lease terminations and other related occupancy costs, $155,000 in severance and benefit costs and $33,000 for other costs.
The operations from the branches we closed during 2010, 2011 and 2012 that were not consolidated into nearby branches are reported as discontinued operations. The Consolidated Statements of Income and related disclosures in the accompanying notes present the results of these branches as discontinued operations for all periods presented. With respect to the Consolidated Balance Sheets and related disclosures in the accompanying notes and the Consolidated Statements of Cash Flows, the items associated with the discontinued operations are included with continuing operations for all periods presented.
Summarized financial information for discontinued operations is presented below:
Liquidity and Capital Resources
Summary cash flow data is as follows:
Cash Flow Discussion
Our primary source of liquidity is cash provided by operations. On September 30, 2011, we entered into an amended and restated credit agreement with a syndicate of banks that provides for a term loan of $32 million and a revolving line of credit (including provisions permitting the issuance of letters of credit and swingline loans) in the aggregate principal amount of up to $27 million. The credit facility matures on September 30, 2014. In connection with this refinancing transaction, we issued a total of $3 million in subordinated notes to our two largest shareholders.
The credit agreement contains financial covenants related to EBITDA (earnings before interest, provision for income taxes, depreciation and amortization and non-cash charges related to equity-based compensation), fixed charge coverage, leverage, total indebtedness, liquidity and maximum loss ratio. As of September 30, 2012, we were not in compliance with certain financial covenants (minimum consolidated EBITDA and fixed charge coverage ratio) as set forth in the credit agreement. On November 7, 2012, we entered into an amendment to the credit agreement to (i) permanently reduce the minimum consolidated EBITDA requirement through the term of the facility; (ii) reduce the fixed charge coverage ratio requirement for each of the quarters ended September 30, 2012, December 31, 2012 and March 31, 2013; and (iii) allow for the sale of automobile receivables of the company, subject to approval of terms by the lenders, provided proceeds are used to reduce the outstanding balance of the term loan. We were in compliance with all covenants as of December 31, 2012.
Since fourth quarter 2008, the capital and credit markets have been volatile, with fluctuating receptivity to lending based on underlying macroeconomic factors. If the capital and credit markets continue to experience volatility and the availability of funds remains limited, it is possible that our ability to access the capital and credit markets may be limited at a time when we would like or need to do so, which could have an impact on our ability to fund our operations, refinance maturing debt or react to changing economic and business conditions.
At this time, we believe that our available short-term and long-term capital resources are sufficient to fund our working capital requirements, scheduled debt payments, interest payments, capital expenditures, income tax obligations, anticipated dividends to our stockholders, and anticipated share repurchases for the foreseeable future. If cash flows from operations, cash resources or availability under the credit agreement fall below expectations, we may be forced to suspend our quarterly dividend to stockholders, seek additional financing, decrease automobile inventory, restrict growth of the long-term installment loan product, reduce operating expenses, pursue the sale of certain assets or consider other alternatives designed to enhance liquidity.
In accordance with accounting principles generally accepted in the United States of America, amounts drawn on our revolving credit facility are shown as debt due within one year. Under the terms of our credit agreement, however, our revolving credit facility does not mature until September 2014, and no principal amounts are due thereon prior to the maturity of the credit facility. Accordingly, so long as we are in compliance with our financial and other covenants in the credit facility, we do not face a refinancing risk until the term loan and the revolving credit facility mature on September 30, 2014.
Net cash provided by operating activities was $19.9 million in 2010, $18.1 million in 2011 and $23.8 million in 2012. The decline in operating cash flows from 2010 to 2011 was due to a reduction of net income and changes in working capital items, primarily attributable to growth in loans receivable in 2011 compared to 2010. Operating cash flows increased from 2011 to 2012 as the proceeds from the sale of auto receivables were partially offset by a decline in net income year-to-year, as well as changes in working capital items.
Investing activities for each year were as follows:
•
Net cash used by investing activities for the year ended December 31, 2012 was $1.5 million which included $3.4 million in capital expenditures that was partially offset by proceeds of $739,000 from the settlement of a life insurance policy and a $1.1 million change in the restricted cash balance. The capital expenditures primarily included $1.1 million for technology and other furnishings at the corporate office and $1.3 million for technology improvements with respect to Direct Credit. The change in the restricted cash balance was a result of the payment of $1.9 million for a legal settlement in Missouri partially offset by an increase in amounts required to be held pursuant to state licensing requirements.
•
Net cash used by investing activities for the year ended December 31, 2011 was $14.9 million, which included $11.6 million for the acquisition of Direct Credit, $1.6 million for capital expenditures and $292,000 in payments of premiums on life insurance. The capital expenditures primarily included $956,000 for technology and furnishings at the corporate office. The $2.2 million change in restricted cash primarily relates to establishing a separate bank account to hold approximately $1.9 million in cash for the settlement of a legal matter in Missouri.
•
Net cash used by investing activities for the year ended December 31, 2010 was $3.3 million, which included $2.1 million for capital expenditures and $852,000 for purchases of corporate-owned life insurance on certain officers to informally fund the non-qualified deferred compensation plan. The capital expenditures primarily included $1.4 million for renovations and technology upgrades to existing and acquired branches and $512,000 for technology and other furnishings at the corporate office.
Net cash used by financing activities was $21.5 million in 2010, $1.8 million in 2011 and $26.0 million in 2012. Financing activities for each year were as follow:
•
Net cash used for financing activities for the year ended December 31, 2012 was $26.0 million, which primarily consisted of $24.7 million in repayments of indebtedness under the revolving credit facility, $32.0 million in repayments on the term loan, $3.6 million in dividend payments to stockholders and $791,000 for the repurchase of 213,000 shares of common stock. These items were partially offset by proceeds received from the borrowing of $35.2 million under the revolving credit facility. The term loan was paid off in December 2012.
•
During 2011, we received $32.0 million in proceeds from the new term loan in connection with the amended and restated credit agreement, $3.0 million in proceeds from subordinated debt and $29.9 million in proceeds from borrowings under the revolving credit facility. These items were offset by $32.6 million in repayments of indebtedness under the revolving credit facility, $27.7 million in repayments on the previous term loan, $3.6 million in dividend payments to stockholders, $1.4 million for the repurchase of 346,000 shares of common stock and $1.5 million in debt issue costs associated with the amended and restated credit agreement and the subordinated debt.
•
The use of cash for financing activities in 2010 consisted of $26.5 million in repayments of indebtedness under the credit facility, $9.9 million in repayments on the term loan, $5.4 million in dividend payments to stockholders and $3.0 million for the repurchase of 674,000 shares of common stock. These items were partially offset by proceeds received from the borrowing of $23.3 million under the credit facility.
Cash Flows from Discontinued Operations
In our statement of cash flows, the cash flows from discontinued operations are combined with the cash flows from continuing operations. During 2010, 2011 and 2012, the absence of cash flows from discontinued operations did not have a material effect on our liquidity and capital resource needs.
Liquidity and Capital Resource Discussion
Credit Facility. On September 30, 2011, we entered into an amended and restated credit agreement with a syndicate of banks to replace our prior credit agreement, which was previously amended on December 7, 2007. The current credit agreement provides for a term loan of $32 million (since retired) and a revolving line of credit (including provisions permitting the issuance of letters of credit and swingline loans) in the aggregate principal amount of up to $27 million. In connection with amending the credit agreement, we capitalized approximately $1.0 million in debt issue costs, which will be amortized over three years, and recorded a loss on debt extinguishment totaling $462,000, which is included in our Consolidated Statements of Income as part of other expense, net.
As noted above, the credit agreement contains various financial covenants, some of which were recently adjusted in connection with an amendment on November 7, 2012. We were in compliance with all covenants as of December 31, 2012.
Our obligations under the current credit agreement are guaranteed by all our operating subsidiaries (other than foreign subsidiaries), and are secured by liens on substantially all of the personal property of the company and our domestic operating subsidiaries. We pledged 65% of the stock of a recently formed Canadian subsidiary to secure our obligations under the current credit agreement. The lenders may accelerate our obligations under the current credit agreement if there is a change in control of the company, including an acquisition of 25% or more of the equity securities of the company by any person or group. The current credit agreement matures on September 30, 2014.
Borrowings under the term loan and the facility are available based on two types of loans, Base Rate loans or LIBOR Rate loans. Base Rate term loans bear interest at a rate of 2.25% plus the higher of the Prime Rate, the Federal Funds Rate plus 0.50% or the one-month LIBOR rate in effect plus 2.00%. Base Rate revolving loans bear interest at a rate ranging from 1.25% to 2.25% depending on our leverage ratio (as defined in the agreement), plus the higher of the Prime Rate, the Federal Funds Rate plus 0.50% or the one-month LIBOR rate in effect plus 2.00%. LIBOR Rate term loans bear interest at rates based on the LIBOR rate for the applicable loan period (unless the rate is less than 1.50%, in which case the agreement established a LIBOR rate floor of 1.50%) with a maximum margin over LIBOR of 4.25%. LIBOR Rate revolving loans bear interest at rates based on the LIBOR rate for the applicable loan period with a margin over LIBOR ranging from 3.25% to 4.25% depending on the Company’s leverage ratio (as defined in the agreement). The loan period for a LIBOR Rate loan may be one month, two months, three months or six months and the loan may be renewed upon notice to the agent provided that no default has occurred. As a result, the revolving credit facility is classified as debt due within one year, although the revolving credit facility, by its terms, does not mature until September 30, 2014. The credit facility also includes a non-use fee ranging from 0.375% to 0.625%, which is based upon the Company’s leverage ratio.
On December 19, 2012, we completed the sale of approximately $16.1 million principal amount of our automobile loans receivable to an unaffiliated company. We received approximately $11.3 million in cash proceeds from this sale of automobile receivables. We used the net proceeds from the sale to make a prepayment of the term loan under our credit agreement. As of December 31, 2012, the term loan was paid in full.
In addition to scheduled repayments, the term loan contained mandatory principal prepayment provisions whereby we were required to reduce the outstanding principal amount of the term loan based on our excess cash flow (as defined in the agreement) and our leverage ratio as of the most recent completed fiscal year. To the extent that our leverage ratio was greater than one, we were required to pay 75% of excess cash flow. If the leverage ratio fell below one, the mandatory payment was 50% of excess cash flow. Under the previous credit agreement, we made a $7.1 million principal payment on the term loan in March 2011, which included $5.3 million required under the mandatory prepayment provisions and the $1.8 million scheduled principal payment. In April 2012, we made a $10.7 million principal payment on the term loan, which was required under the mandatory prepayment provisions of the current credit agreement.
Subordinated Notes. As a condition to entering into the current credit agreement, the lenders required that we issue $3.0 million of senior subordinated notes. On September 30, 2011, we issued $2.5 million initial principal amount of senior subordinated notes to our Chairman of the Board. The remaining $500,000 principal amount of subordinated notes was issued to another major stockholder of the Company, who is not an officer or director of the Company. The subordinated notes bear interest at the rate of 16% per annum, payable quarterly, 75% of which is payable in cash and 25% of which is payable-in-kind (PIK) through the issuance of additional senior subordinated PIK notes. The subordinated notes mature on September 30, 2015, are subject to prepayment at our option, without penalty or premium, on or after September 30, 2014, and are subject to mandatory prepayment, without premium, upon a change of control. The subordinated notes contain events of default tied to our total debt to total capitalization ratio and our total debt to EBITDA ratio. The subordinated notes further provide that upon occurrence of an event of default on the subordinated notes, we may not declare or pay any cash dividend or distribution of cash or other property (other than equity securities of the Company) on our capital stock. As of December 31, 2012, the balance of the subordinated notes was approximately $3.2 million.
Short-term Liquidity and Capital Requirements. We believe that our available cash, expected cash flow from operations, and borrowings available under our credit facility will be sufficient to fund our liquidity and capital expenditure requirements during 2013. Expected short-term uses of cash include funding of any increases in payday, installment and automotive loans, debt repayments, interest payments on outstanding debt, dividend payments (to the extent approved by the board of directors), repurchases of company stock, and financing of new branch expansion and small acquisitions, if any.
We expect that the majority of our cash requirements will be satisfied through internally generated cash flows, with any shortfall being funded through borrowing under our revolving credit facility. If cash flows from operations, cash resources or availability under the credit agreement fall below expectations, we may be forced to suspend our quarterly dividend to stockholders, seek additional financing, decrease automobile inventory, restrict growth of the long-term installment loan product, reduce operating expenses, pursue the sale of certain assets or consider other alternatives designed to enhance liquidity.
We believe that any acquisition-related capital requirements would be satisfied by draws on our current revolving credit facility, an additional term loan under an amended credit facility or a similar debt product. Our ability to pursue business opportunities may be more constrained than in previous years as the revolving portion of the credit agreement was reduced from $45 million to $27 million when we entered into the current credit agreement in 2011. Our balance under the credit facility was approximately $25.0 million as of December 31, 2012.
In November 2008, our board of directors established a regular quarterly dividend of $0.05 per common share. The declaration of dividends is subject to the discretion of our board of directors and will depend on our operating results, financial condition, cash and capital requirements and other factors that the board of directors deems relevant. Our board of directors has also approved special cash dividends from time to time, including a special cash dividend in November 2009 and February 2010. On February 5, 2013, our board of directors declared a regular quarterly dividend of $0.05 per common share. The dividend was paid March 14, 2013, to stockholders of record as of February 28, 2013, and the total amount paid was approximately $900,000.
Our current credit agreement requires us to maintain a fixed charge coverage ratio (as defined and computed in accordance with the credit agreement). Under our credit agreement, we are required to subtract any cash dividends paid on our common stock from our Operating Cash Flow (as defined in the agreement) used in computing our fixed charge coverage ratio. Thus, our credit agreement may restrict our ability to pay cash dividends in the future.
Our board of directors has authorized us to repurchase up to $60 million of our common stock in the open market and through private purchases. The acquired shares may be used for corporate purposes, including shares issued to employees in stock-based compensation programs. As of December 31, 2012, we have repurchased a total of 5.8 million shares at a total cost of approximately $56.0 million, which leaves approximately $4.0 million that may yet be purchased under the current program, which expires June 30, 2013.
Long-term Liquidity and Capital Requirements. The following table summarizes our expected long-term capital requirements as of December 31, 2012.
(a) Represents estimated interest payments to be made on our revolving credit facility. Interest payments on the revolving credit facility are estimated based on the current interest rates at 12/31/2012 and assume that the balance remains constant through 2013.
While the borrowings on our revolving credit facility are classified as short-term obligations on our consolidated balance sheet, the credit facility, by its terms, does not mature until September 30, 2014.
As part of our business strategy, we consider acquisitions and strategic business expansion opportunities from time to time. We believe our current cash position, the availability under the credit facility and our expected cash flow from operations should provide the capital needed to fund internal growth opportunities, assuming no material acquisitions in 2013.
In response to changes in the overall market, over the past few years we have substantially reduced our branch expansion efforts. Since January 1, 2007, we have opened 46 branches with the majority (32) of those opened during 2007 and 2008. The capital costs of opening a de novo branch include leasehold improvements, signage, computer equipment and security systems, and the costs vary depending on the branch size, location and the services being offered. The average cost of capital expenditures for branches opened during 2007 and 2008 was approximately $44,000 per branch. Existing branches require minimal ongoing capital expenditure, with the majority of any expenditure related to discretionary renovation or relocation projects.
As of December 31, 2012, we operated five buy here, pay here locations. During the start-up of these operations, capital requirements are not material. As the business grows, however, the business requires ongoing replenishment of automobile inventory. Sales of automobiles are typically completed through a small down payment and an installment loan. As a result, the initial phase of a buy here, pay here operation is cash flow negative. In general, it appears that a typical location requires approximately $2.5 million to $4.0 million of capital availability over a two to four year period based on the expected volume of monthly sales. As this business progresses, we will evaluate the capital requirements and the associated return on investment.
Historically, we have carried all of our automobile loans receivable on our balance sheet; however, in December 2012 we sold approximately 90% of our automobile loans receivable to a third party. While the Automotive segment has been funded from operations, we are evaluating a forward flow arrangement whereby sales of automobiles are funded directly by a third-party lender. We also have the ability to manage the capital needs of the business through reduction of the number of automobiles held at each location, although reduced inventory levels may limit sales because of the appearance of limited vehicle selection for the customer.
On September 30, 2011, we acquired Direct Credit. Historically, the operations of Direct Credit have generated sufficient cash flows to fund its growth. In connection with growth plans as a result of the acquisition, it is anticipated that Direct Credit may require capital to maximize market opportunities. Pursuant to the current credit agreement, we may provide up to $3.0 million in working capital financing to support this growth. As we intend to indefinitely reinvest the earnings of our foreign affiliates, those earnings will not be available for repatriation.
In 2012, we introduced new installment loan products (signature loans and auto equity loans) to meet high customer demand for longer-term loan options. These new products are higher-dollar and longer-term installment loans that are centrally underwritten and distributed through our existing branch network. The signature loans carry a maximum advance amount of approximately $3,000 and a term of 6 to 36 months. Auto equity loans, which are higher-dollar, multi-pay first lien title loans, carry a maximum advance amount of $15,000 and a term of 12 months to 48 months. The growth and acceptance of these products by our customers has exceeded our expectations. As of December 31, 2012, we offered these installment loan products to customers in approximately 200 branches. In 2013, we plan to offer these products to customers in an additional 150 to 200 branches. As these products progress, we will evaluate the capital requirements needed as these products are cash flow negative in the early stages due to the long term nature of the products.
Concentration of Risk
Our short-term lending branches located in the states of Missouri, California and Kansas represented approximately 22%, 15% and 5%, respectively, of total revenues for the year ended December 31, 2012. Our short-term lending branches located in the states of Missouri, California, Kansas and New Mexico represented approximately 33%, 17%, 7% and 5%, respectively, of total gross profit for the year ended December 31, 2012. To the extent that laws and regulations are passed that affect our ability to offer loans or the manner in which we offer loans in any one of those states, our financial position, results of operations and cash flows could be adversely affected. In recent years, we have experienced several negative effects resulting from law changes, for example:
•
The Arizona payday loan statutory authority expired by its terms on June 30, 2010, and the expiration of this law had a significant adverse effect on the revenues and profitability of our Arizona branches. For the year ended December 31, 2011, revenues and gross profit from our Arizona branches declined by $1.5 million and $1.4 million respectively, from the same period in the prior year. Prior to the expiration of the Arizona payday loan law, branches in Arizona accounted for more than 5% of our revenues and gross profits.
•
In March 2011, a new payday law became effective in Illinois that imposes customer usage restrictions that will negatively affect revenues and profitability. This type of customer restriction, when passed in other states such as Washington, South Carolina and Kentucky, has resulted in a 30% to 60% decline in annual revenues and a more significant decline in gross profit, depending on the types of alternative products that competitors may offer within the state. The Illinois law provides for an overlap of the previous lending approach with loans issued under the new law for a period of one year, which extended the time period over which the negative effects of the new law occurred. During 2011, our revenues declined by $2.4 million and our gross profit declined by $2.2 million. In 2012, our revenues and gross profit from Illinois declined by $2.0 million and $1.8 million, respectively. Prior to the change of the Illinois payday loan law, branches in Illinois accounted for more than 5% of our revenues and gross profit.
There was an effort in Missouri to place a voter initiative on the statewide ballot in November 2012, which was intended to preclude any lending in the state with an annual rate over 36%. The supporters of the voter initiative did not submit a sufficient number of valid signatures to place the initiative on the ballot in November 2012. However, a similar initiative was submitted to the Missouri Secretary of State in December 2012 for inclusion on the November 2014 ballot subject to the proponents submitting the required number of valid signatures in support of the initiative.
Impact of Inflation
We do not believe that inflation has a material impact on our income or operations.
Seasonality
Our Financial Services and E-Lending businesses are seasonal due to fluctuating demand for short-term loans during the year. Historically, we have experienced our highest demand for short-term loans in January and in the fourth calendar quarter. As a result, to the extent that internally generated cash flows are not sufficient to fund the growth in loans receivable, fourth quarter and the month of January are the most likely periods of time for utilization or increase in borrowings under our credit facility. Due to the receipt by customers of their income tax refunds, demand for short-term loans has historically declined in the balance of the first quarter of each calendar year and the first month of the second quarter. Accordingly, this period is typically when any outstanding borrowings under the credit facility would be repaid (exclusive of any other capital-usage activity, such as acquisitions, significant stock repurchases, etc.). Our loss ratio historically fluctuates with these changes in short-term loan demand, with a higher loss ratio in the second and third quarters of each calendar year and a lower loss ratio in the first and fourth quarters of each calendar year. During mid-second quarter through third quarter, periodic utilization of our credit facility is not unusual, based on the level of loan losses and other capital-usage activities. Due to the seasonality of our business, results of operations for any quarter are not necessarily indicative of the results of operations that may be achieved for the full year.
Similarly, our Automotive segment experiences seasonality as automobile sales peak during the first quarter of each year, primarily as a result of the receipt by customers of their income tax refunds, which are used as down payments for a vehicle. Automobile sales in the final three quarters are generally lower than the first quarter. In addition, vehicle acquisition costs tend to increase in the second half of the year as companies build inventories for the expected first quarter volumes.
Impact of Recent Accounting Pronouncements
In July 2012, the Financial Accounting Standards Board (FASB) issued an update to existing guidance on the impairment assessment of indefinite-lived intangibles. This update simplifies the impairment assessment of indefinite-lived intangibles by allowing companies to consider qualitative factors to determine whether it is more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying amount before performing the two step impairment review process. This guidance is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. We adopted this guidance on January 1, 2012. The adoption did not have a material effect on our consolidated financial statements.
In September 2011, the FASB issued amendments to the goodwill impairment guidance, which provides an option for companies to use a qualitative approach to test goodwill for impairment if certain conditions are met. These amendments give entities the option, under certain circumstances, to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether further impairment testing is necessary. The amendments are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011 (early adoption is permitted). We adopted this standard during the year ended December 31, 2011. There was no material impact to our financial position or results of operations as a result of the adoption of this standard
In June 2011, the FASB issued guidance on the presentation of comprehensive income. We adopted this guidance effective January 1, 2012. The adoption of this guidance did not have a material effect on our consolidated financial statements.
In May 2011, the FASB issued an update to the authoritative guidance, which establishes common requirements for measuring fair value and for disclosing information about fair value measurements in accordance with US GAAP. We adopted this guidance effective January 1, 2012. The adoption of this guidance did not have a material effect on our consolidated financial statements.
Off-Balance Sheet Arrangements
In September 2005, we began operating through a subsidiary as a CSO in our Texas branches. As a CSO, we act as a credit services organization on behalf of consumers in accordance with Texas laws. We charge the consumer a fee for arranging for an unrelated third-party lender to make a loan to the consumer and for providing related services to the consumer, including a guarantee of the consumer’s obligation to the third-party lender. We also service the loan for the lender. We are not involved in the loan approval process or in determining the loan approval procedures or criteria, and we do not acquire or own any participation interest in the loans. Consequently, loans made by the lender will not be included in our loans receivable balance and will not be reflected in the Consolidated Balance Sheets. Under the agreement with the current lender, however, we absorb all risk of loss through our guarantee of the consumer’s loan from the lender. As of December 31, 2011 and December 31, 2012, the consumers had total loans outstanding with the lender of approximately $3.1 million and $2.6 million, respectively. Because of the economic exposure for potential losses related to the guarantee of these loans, we record a payable at fair value to reflect the anticipated losses related to uncollected loans. The balance of the liability for estimated losses reported in accrued liabilities was $90,000 as of December 31, 2011 and $100,000 as of December 31, 2012. The following table summarizes the activity in the CSO liability (in thousands):
ITEM 7A.
ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk
As of December 31, 2012, we have no material market risk sensitive instruments entered into for trading or other purposes, as defined by accounting principles generally accepted in the United States of America.
Interest rate risk
To the extent we have any, we invest our excess cash balances in short-term investment grade securities including money market accounts that are subject to interest rate risk. The cash and cash equivalents reflected on our balance sheet represent largely uninvested cash in our branches and cash-in-transit. The amount of interest income we earn on these funds will decline with a decline in interest rates. However, due to the short-term nature of short-term investment grade securities and money market accounts, an immediate decline in interest rates would not have a material impact on our financial position, results of operations or cash flows.
As of December 31, 2012, we had $28.2 million of indebtedness, of which $25.0 million is subject to variable interest rates (Federal Funds rates, LIBOR rates, Prime rates). If prevailing interest rates were to increase 1% (or 100 basis points) over the rates as of December 31, 2012, and the borrowings remained constant, our interest expense would have increased by $250,000 on an annualized basis.
Foreign currency exchange risk
We are subject to currency exchange rate fluctuations in Canada. We do not currently manage our exposure to risk from foreign currency exchange rate fluctuations through the use of foreign exchange forward contracts in Canada. As our Canadian operations continue to grow, we will continue to evaluate and implement foreign exchange rate risk management strategies.
ITEM 8.
ITEM 8. Financial Statements and Supplementary Data
Our Consolidated Financial Statements and Supplementary Data appear following Item 15 of this report.
ITEM 9.
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None
ITEM 9A.
ITEM 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
We maintain a system of disclosure controls and procedures that are designed to provide reasonable assurance that information, which is required to be disclosed timely, is accumulated and communicated to management in a timely fashion. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Our Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report, have concluded that our disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure and are effective to provide reasonable assurance that such information is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting. As defined in Exchange Act Rule 13a-15(f), internal control over financial reporting is a process designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer and effected by our board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we carried out an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2012 based on the criteria in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Based upon this evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2012.
Grant Thornton LLP, the independent registered public accounting firm that audited our financial statements included in this Annual Report on Form 10-K, has also audited the effectiveness of our internal control over financial reporting as of December 31, 2012 as stated in their report on page 78 of this report.
Changes in Internal Control Over Financial Reporting
Our internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15 (f)) is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. There were no changes in our internal control over financial reporting that occurred during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B. Other Information
None
PART III
ITEM 10.
ITEM 10. Directors, Executive Officers and Corporate Governance
Incorporated by reference to our Proxy Statement for our 2013 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission within 120 days after the close of the year ended December 31, 2012.
ITEM 11.
ITEM 11. Executive Compensation
Incorporated by reference to our Proxy Statement for our 2013 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission within 120 days after the close of the year ended December 31, 2012.
ITEM 12.
ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Incorporated by reference to our Proxy Statement for our 2013 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission within 120 days after the close of the year ended December 31, 2012.
ITEM 13.
ITEM 13. Certain Relationships and Related Transactions, and Director Independence
Incorporated by reference to our Proxy Statement for our 2013 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission within 120 days after the close of the year ended December 31, 2012.
ITEM 14.
ITEM 14. Principal Accounting Fees and Services
Incorporated by reference to our Proxy Statement for our 2013 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission within 120 days after the close of the year ended December 31, 2012.
PART IV
ITEM 15.
ITEM 15. Exhibits and Financial Statement Schedules
The following documents are filed as a part of this report:
(1) Financial Statements. The following financial statements, contained on pages 76 to 121 of this report, are filed as part of this report under Item 8 - “Financial Statements and Supplementary Data.”
(2) Financial Statement Schedules. All schedules have been omitted because they are not applicable, are insignificant or the required information is shown in the consolidated financial statements or notes thereto.
(3) Exhibits. Exhibits are listed on the Exhibit Index at the end of this report.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Company has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: March 14, 2013
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Report has been signed below by the following persons on behalf of the Company and in the capacities indicated on March 14, 2013.
/s/ RICHARD B. CHALKER
/s/ DON EARLY
Richard B. Chalker
Don Early
Director
Chairman of the Board
/s/ GERALD F. LAMBERTI
/s/ MARY LOU EARLY
Gerald F. Lamberti
Mary Lou Early
Director
Vice Chairman, Secretary and Director
/s/ FRANCIS P. LEMERY
/s/ DARRIN J. ANDERSEN
Francis P. Lemery
Darrin J. Andersen
Director
President and Chief Executive Officer
(Principal Executive Officer)
MARY V. POWELL
/s/ DOUGLAS E. NICKERSON
Mary V. Powell
Douglas E. Nickerson
Director
Chief Financial Officer
(Principal Financial and Accounting Officer)
/s/ JACK L. SUTHERLAND
Jack L. Sutherland
Director
QC Holdings, Inc.
Index to Consolidated Financial Statements
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
QC Holdings, Inc.
We have audited the accompanying consolidated balance sheets of QC Holdings, Inc. (a Kansas corporation) and Subsidiaries (the Company) as of December 31, 2012 and 2011, and the related consolidated statements of income, comprehensive income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2012. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of QC Holdings, Inc. and Subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2012 in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 14, 2013, expressed an unqualified opinion thereon.
/s/ GRANT THORNTON LLP
Kansas City, Missouri
March 14, 2013
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
QC Holdings, Inc.
We have audited the internal control over financial reporting of QC Holdings, Inc. (a Kansas corporation) and subsidiaries (the Company) as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by COSO.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of the Company as of and for the year ended December 31, 2012, and our report dated March 14, 2013 expressed an unqualified opinion on those financial statements.
/s/ GRANT THORNTON LLP
Kansas City, Missouri
March 14, 2013
QC HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share amounts)
See accompanying notes to consolidated financial statements.
QC HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts)
See accompanying notes to consolidated financial statements.
QC HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands)
QC HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
Years Ended December 31, 2010, 2011 and 2012
(in thousands)
See accompanying notes to consolidated financial statements.
QC HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
See accompanying notes to consolidated financial statements.
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - DESCRIPTION OF THE BUSINESS
The accompanying consolidated financial statements include the accounts of QC Holdings, Inc. and its wholly-owned subsidiaries, QC Financial Services, Inc., QC Auto Services, Inc., QC Loan Services, Inc., QC E-Services, Inc., QC Canada Holdings Inc. and QC Capital, Inc. (collectively, the Company). QC Financial Services, Inc. is the 100% owner of QC Financial Services of California, Inc., Financial Services of North Carolina, Inc., QC Financial Services of Texas, Inc., Express Check Advance of South Carolina, LLC (ECA), QC Advance, Inc., Cash Title Loans, Inc. and QC Properties, LLC. QC Canada Holdings Inc. is the 100% owner of Direct Credit Holdings Inc. and its wholly owned subsidiaries (collectively, Direct Credit). QC Holdings, Inc., incorporated in 1998 under the laws of the State of Kansas, was founded in 1984, and has provided various retail consumer financial products and services throughout its 28-year history. The Company’s common stock trades on the NASDAQ Global Market exchange under the symbol “QCCO.”
Since 1998, the Company has been primarily engaged in the business of providing short-term consumer loans, known as payday loans, with principal values that typically range from $100 to $500. Payday loans provide customers with cash in exchange for a promissory note with a maturity of generally two to three weeks and supported by that customer’s personal check for the aggregate amount of the cash advanced plus a fee. The fee varies from state to state, based on applicable regulations and generally ranges from $15 to $20 per $100 borrowed. To repay the cash advance, customers may redeem their check by paying cash or they may allow the check to be presented to the bank for collection.
The Company also provides other consumer financial products and services, such as installment loans, credit services, check cashing services, title loans, open-end credit, debit cards, money transfers and money orders. All of the Company’s loans and other services are subject to state regulation, which vary from state to state, as well as to federal and local regulation, where applicable. As of December 31, 2012, the Company operated 466 branches with locations in Alabama, Arizona, California, Colorado, Idaho, Illinois, Kansas, Kentucky, Louisiana, Mississippi, Missouri, Nebraska, Nevada, New Mexico, Ohio, Oklahoma, South Carolina, Tennessee, Texas, Utah, Virginia, Washington and Wisconsin. In December 2012, the Company decided that it would close 38 underperforming branches (primarily located in South Carolina and Washington) during first half of 2013.
The Company began offering branch-based installment loans to customers in its Illinois branches during second quarter 2006 and expanded that product offering to customers in additional states during 2009 and 2010. In 2012, the Company introduced new installment loan products (signature loans and auto equity loans) to meet high customer demand for longer-term loan options. These new products are higher-dollar and longer-term installment loans that are centrally underwritten and distributed through the Company’s existing branch network. As of December 31, 2012, the Company offered the installment loan products to its customers in Arizona, California, Colorado, Idaho, Illinois, Missouri, New Mexico, South Carolina, Utah and Wisconsin. The installment loans are payable in monthly installments (principal plus accrued interest) with terms typically ranging from four months to 48 months, and all loans are pre-payable at any time without penalty. The fee for the installment loan varies based on the amount borrowed and the term of the loan. Generally, the amount that the Company advances under an installment loan ranges from $400 to $3,000. The average principal amount across all installment loan products originated during 2010, 2011 and 2012 was approximately $488, $518 and $624, respectively.
On September 30, 2011, QC Canada Holdings Inc., a wholly-owned subsidiary of the Company, acquired 100% of the outstanding stock of Direct Credit Holdings Inc., a British Columbia company engaged in short-term, consumer Internet lending in certain Canadian provinces. Direct Credit was founded in 1999 and has developed and grown a proprietary Internet-based model into a leading platform in Canada. The acquisition of Direct Credit is part of the implementation of the Company’s strategy to diversify by increasing its product offerings and distribution, as well as by expanding its presence into international markets. See additional information in Note 4.
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
In September 2007, the Company entered into the buy here, pay here segment of the used automotive market in connection with ongoing efforts to evaluate alternative products that serve the Company’s customer base. In January 2009, the Company purchased two buy here, pay here locations in Missouri for approximately $4.2 million. In May 2009, the Company opened a service center to provide reconditioning services on its inventory of vehicles and repair services for its customers. As of December 31, 2012, the Company operated five buy here, pay here lots, which are located in Missouri and Kansas. These locations sell used vehicles and earn finance charges from the related vehicle financing contracts. The average principal amount for buy here, pay here loans originated during the year ended December 31, 2012 was approximately $10,245 and the average term of the loan was 33 months.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation. The accompanying consolidated financial statements include the accounts of the Company. All significant intercompany balances and transactions have been eliminated in consolidation.
Accounting Reclassifications. Certain reclassifications have been made to prior period financial information to conform to the current presentation. On the Consolidated Balance Sheets and Statements of Cash Flows, amounts associated with inventory have been reclassified from prepaid expenses and other current assets to be separately presented.
Use of Estimates. In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities, the 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. On an on-going basis, management evaluates its estimates and judgments, including those related to allowance for losses on loans, fair value measurements used in goodwill impairment tests, long-lived assets, income taxes, contingencies and litigation. Management bases its estimates on historical experience, empirical data and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results could differ from those estimates.
Revenue Recognition. The Company records revenue from payday and title loans upon issuance. The term of a loan is generally two to three weeks for a payday loan and 30 days for a title loan. At the end of each month, the Company records an estimate of the unearned revenue that results in revenues being recognized on a constant-yield basis ratably over the term of each loan.
The Company records revenues from installment loans using the simple interest method. With respect to the Company’s credit service organization (CSO) in Texas, the Company earns a CSO fee for arranging for an unrelated third-party to make a loan to the consumer and for providing related services to the consumer, including a guarantee of the consumer’s obligation to the third-party lender. The Company also services the loan for the lender. The CSO fee is recognized ratably over the term of the loan.
The Company recognizes revenue (net of sales tax) on the sale of automobiles at the time the vehicle is delivered to the customer and title has passed. In cases where the Company finances the vehicles, the Company originates an installment sale contract and uses the simple interest method to recognize interest.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
With respect to the open-end product, the Company earns interest on the outstanding balance and the product also includes a monthly non-refundable membership fee. The open-end credit product is very similar to a credit card as the customer is granted a grace period of 25 days to repay the loan without incurring any interest.
The Company recognizes revenues for its other consumer financial products and services, which includes check cashing, money transfers and money orders, at the time those services are rendered to the customer, which is generally at the point of sale.
The components of “Other” revenues as reported in the Consolidated Statements of Income are as follows (in thousands):
Cash and Cash Equivalents. Cash and cash equivalents include cash on hand and short-term investments with original maturities of three months or less. The carrying amount of cash and cash equivalents approximates the estimated fair value at December 31, 2011 and 2012. Substantially all cash balances are in excess of federal deposit insurance limits.
Restricted Cash. Restricted cash includes cash in certain money market accounts and certificates of deposit. The restricted cash balance at December 31, 2012 is restricted primarily due to licensing requirements in certain states. The restricted cash balance at December 31, 2011 included funds of approximately $1.9 million set aside in a separate cash account for the settlement of a legal matter in Missouri.
Inventory. Inventory primarily consists of vehicles acquired from auctions and trade-ins. Vehicle transportation and reconditioning costs are capitalized as a component of inventory. The cost of vehicle inventory is determined on the specific identification method. Vehicle inventories are stated at the lower of cost or market. Valuation allowances are established when the inventory carrying values are in excess of estimated selling prices, net of direct costs of disposal. As of December 31, 2011 and 2012, the Company had inventory of used vehicles and automotive parts totaling $3.0 million and $1.3 million, respectively. Management has determined that a valuation allowance is not necessary as of December 31, 2011 and 2012.
Loans Receivable, Provision for Losses and Allowance for Loan Losses. When the Company enters into a payday loan with a customer, the Company records a loan receivable for the amount loaned to the customer plus the fee charged by the Company, which varies from state to state based on applicable regulations.
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table summarizes certain data with respect to the Company’s payday loans:
When the Company enters into an installment loan with a customer, the Company records a loan receivable for the amount loaned to the customer. At each period end, the Company records any accrued fees and interest as a receivable, which vary from state to state based on applicable regulations.
The Company records a receivable in connection with the sale of an automobile or other vehicle at the face amount of the loan. At each period end, the Company records any accrued fees and interest as a receivable, which vary from state to state based on applicable regulations. In December 2012, the Company sold approximately $16.1 million principal amount of its automobile loans receivable to an unaffiliated company. The Company received approximately $11.3 million in cash proceeds from the sale of automobile receivables and recognized a $2.6 million loss from the sale in the other income component of the Consolidated Statements of Income. In addition, the Company transferred approximately $1.1 million in principal amount of automobile loans receivable to the unaffiliated company. In accordance with accounting guidance, these transferred assets have been classified as collateralized receivables and the cash proceeds received (approximately $618,000) from the transfer of these automobile loans receivable have been classified as a secured borrowing in the Consolidated Balance Sheets. See additional information in Note 4.
When checks are presented to the bank for payment of payday loans and returned as uncollected, all accrued fees, interest and outstanding principal are charged-off as uncollectible, generally within 14 days after the due date. Accordingly, payday loans included in the receivable balance at any given point in time are typically not older than 30 days. These charge-offs are recorded as expense through the provision for losses. Any recoveries on losses previously charged to expense are recorded as a reduction to the provision for losses in the period recovered. With respect to title loans, no additional fees or interest are charged after the loan has defaulted, which generally occurs after attempts to contact the customer have been unsuccessful. Based on state regulations and operating procedures, the Company stops accruing interest on installment loans between 60 to 90 days after the last payment. On automotive loans, the Company stops accruing interest on 60 days after the last payment.
With respect to the loans receivable at the end of each reporting period, the Company maintains an aggregate allowance for loan losses (including fees and interest) for payday loans, title loans, installment loans and auto loans at levels estimated to be adequate to absorb estimated incurred losses in the respective outstanding loan portfolios. The Company does not specifically reserve for any individual loan.
The methodology for estimating the allowance for payday and title loan losses utilizes a four-step approach, which reflects the short-term nature of the loan portfolio at each period-end, the historical collection experience in the month following each reporting period-end and any fluctuations in recent general economic conditions. First, the Company computes the loss/volume ratio for the last month of each reporting period. The loss/volume ratio represents the percentage of aggregate net payday and title loan charge-offs to total payday and title loan volumes during a given period. Second, the Company computes an adjustment to this percentage to reflect the collections experience in the month immediately following the reporting period-end. To estimate collections experience, the Company computes an average of the change in the loss/volume ratio from the last month of each reporting period to the immediate subsequent month-end for each of the last three years (excluding
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
the current year). This change is then added to, or subtracted from, the loss/volume ratio computed for the last month of the current reporting period to derive an experience-adjusted loss/volume ratio. Third, the period-end gross payday and title loans receivable balance is multiplied by the experience-adjusted loss/volume ratio to determine the initial estimate of the allowance for loan losses. Fourth, the Company reviews and evaluates various qualitative factors that may or may not affect the computed initial estimate of the allowance for loan losses, including, among others, known changes in state regulations or laws, changes to the Company’s business and operating structure, and geographic or demographic developments. As of December 31, 2011, the Company determined that no qualitative adjustment to the allowance for payday loan losses was necessary. In connection with the Company’s decision in 2012 to close 38 branches during the first half of 2013, the Company recorded a $1.3 million qualitative adjustment to increase its allowance for loan losses as of December 31, 2012.
The Company maintains an allowance for installment loans at a level it considers sufficient to cover estimated losses in the collection of its installment loans. The allowance calculation for installment loans is based upon historical charge-off experience (primarily a six-month trailing average of charge-offs to total volume) and qualitative factors, with consideration given to recent credit loss trends and economic factors. As of December 31, 2011, the Company reviewed the qualitative factors and determined that no qualitative adjustment was needed. In connection with the Company’s decision in 2012 to close 38 branches during the first half of 2013, the Company recorded a $344,000 qualitative adjustment to increase its allowance for loan losses as of December 31, 2012.
The allowance calculation for auto loans is determined on an aggregate basis and is based upon the Company’s review of the loan portfolio by period of origination, industry loss experience and qualitative factors, with consideration given to changes in loan characteristics, delinquency levels, collateral values and other general economic conditions. This estimate of probable losses is primarily determined using static pool analyses prepared for various segments of the portfolio using estimated loss experience, adjusted for consideration of any current economic factors. As of December 31, 2011 and 2012, the Company reviewed various qualitative factors with respect to its automotive loans receivable and determined that no qualitative adjustment was needed.
The Company records an allowance for other receivables based upon an analysis that gives consideration to payment recency, delinquency levels and other general economic conditions.
Based on the information discussed above, the Company records an adjustment to the allowance for loan losses through the provision for losses. The overall allowance represents the Company’s best estimate of probable losses inherent in the outstanding loan portfolio at the end of each reporting period.
On occasion, the Company will sell certain payday loan receivables that the Company had previously charged off to third parties for cash. The sales are recorded as a credit to the overall loss provision, which is consistent with the Company’s policy for recording recoveries noted above. The following table summarizes cash received from the sale of these payday loan receivables (in thousands):
Operating Expenses. The direct costs incurred in operating the Company’s business units have been classified as operating expenses. Operating expenses include salaries and benefits of employees (branch and automotive personnel as well as employees of Direct Credit), rent and other occupancy costs, depreciation and amortization of branch property and equipment, armored car and security costs, automobile costs, marketing and other costs incurred by the business units. The provision for losses is also a component of operating expenses.
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Property and Equipment. Property and equipment are recorded at cost. Depreciation is charged to operations using the straight-line method over the estimated useful lives of the assets. Buildings are depreciated generally over 39 years. Leasehold improvements are amortized using the straight-line method over the shorter of the lease term (including renewal options that are reasonably assured), which generally ranges from 1 to 15 years with an average of 7 years, or the estimated useful life of the related asset. Furniture and equipment, including data processing equipment, data processing software, and other equipment are generally depreciated from 3 to 7 years. Company-owned vehicles are depreciated over four to five years. Repair and maintenance expenditures that do not significantly extend asset lives are charged to expense as incurred. The cost and related accumulated depreciation and amortization of assets sold or disposed of are removed from the accounts, and the resulting gain or loss is included in income.
Software. Purchased software is recorded at cost and is amortized on a straight-line basis over the estimated useful life. The Company capitalizes costs for the development of internal use software, including coding and software configuration costs and costs of upgrades and enhancements. Computer software and development costs incurred in the preliminary project stage, as well as training and maintenance costs are expensed as incurred. Direct and indirect costs associated with the application development stage of internal use software are capitalized until such time that the software is substantially complete and ready for its intended use. Costs for the development of internal use software were immaterial for the years ending December 31, 2010 and 2011, and totaled $1.3 million for the year ending December 31, 2012.
Advertising Costs. Advertising costs, including related printing, postage and search engine marketing, are charged to operations when incurred. Advertising expense was $2.3 million, $2.0 million and $3.5 million for the years ended December 31, 2010, 2011 and 2012, respectively.
Goodwill and Intangible Assets. Goodwill represents the excess of consideration over the fair value of net tangible and identified intangible assets and liabilities assumed of acquired businesses using the acquisition method of accounting. Intangible assets consist of customer relationships, non-compete agreements, trade names, debt issuance costs, and other intangible assets.
Goodwill and other intangible assets having indefinite useful lives are tested for impairment using a fair-value based approach on an annual basis, or more frequently if events or changes in circumstances indicate that the assets might be impaired. The test for goodwill impairment is a two-step approach. The first step of the goodwill impairment test requires a determination of whether the fair value of a reporting unit is less than its carrying value. If so, the second step is required, which involves an analysis reflecting the allocation of the fair value determined in the first step (as if it was the purchase price in a business combination). This process may result in the determination of a new amount of goodwill. If the calculated fair value of the goodwill resulting from this allocation is lower than the carrying value of the goodwill in the reporting unit, the difference is reflected as a non-cash impairment loss. The purpose of the second step is only to determine the amount of goodwill that should be recorded on the balance sheet. The recorded amounts of other items on the balance sheet are not adjusted.
The Company evaluates the goodwill at the reporting unit level and performs its annual goodwill and indefinite life impairment test as of December 31 for all reporting units. The Company has determined that it has three reporting units, which are based on its core lending operations, automotive operations and Internet lending operations. For testing purposes, the Company has elected to aggregate all components of its core lending operations in the United States into a single reporting unit, as the Company believes all of its core lending branches have similar economic characteristics and are similar with respect to the nature of the products and services, type of customer and the methods used to provide its services. The Company hired an independent appraiser to assist with the Company’s impairment test as of December 31, 2012. The fair value of the Company’s reporting units was based on a weighted average of valuations using methods that included discounted
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
cash flows and market multiples. The key assumptions used in the discounted cash flow valuations are discount rates and perpetual growth rates applied to cash flow projections. Also inherent in the discounted cash flow valuation models are past performance, projections and assumptions in current operating plans and revenue growth. These assumptions contemplate business, market and overall economic conditions. In connection with this process, the independent appraiser also provided a reconciliation of the estimated aggregate fair values of the Company’s reporting units to its market capitalization, including consideration of a control premium that represents what an investor would pay for the Company’s equity securities to obtain a controlling interest. The Company believes that this reconciliation is consistent with a market participant perspective. The Company tests trade names with indefinite lives for impairment by comparing the book value to a fair value calculated using a discounted cash flow approach on a presumed royalty rate derived from the revenues related to the trade name.
Other factors that are considered important in determining whether an impairment of goodwill or indefinite lived intangible assets might exist include significant continued underperformance compared to peers, significant changes in the Company’s business and products, material and ongoing negative industry or economic trends, or other factors specific to each asset being evaluated. Any changes in key assumptions about the Company’s business and its prospects, or changes in market conditions or other externalities, could result in an impairment charge and such a charge could have a material adverse effect on the Company’s financial condition and results of operations.
With respect to the impairment test performed as of December 31, 2012, the Company determined that there was no impairment of goodwill for the core lending and automotive units as the fair value of each these reporting units were in excess of their carrying amount based on the tests results. However, the test results showed that the fair value of the E-Lending unit did not exceed its carrying amount. Thus, the Company hired the independent appraiser to assist with the second step of the impairment test and as a result, the Company recorded a $1.7 million non-cash impairment charge to goodwill for its E-Lending reporting unit. In addition, the Company performed an impairment test on its indefinite lived intangible assets and determined that the trade name associated with the ECA acquisition was impaired and recorded an impairment charge of $600,000. No impairment of goodwill or indefinite lived intangible assets was recognized during 2010 and 2011. See additional information in Note 10.
Impairment of Long-Lived Assets. The Company evaluates all long-lived assets, including intangible assets that are subject to amortization, for impairment whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. When the carrying amounts of these assets cannot be recovered by the undiscounted net cash flows they will generate, impairment is recognized in an amount by which the carrying amount of the assets exceeds the fair value.
Earnings per Share. The Company computes basic and diluted earnings per share using a two-class method because the Company has participating securities in the form of unvested share-based payment awards with rights to receive non-forfeitable dividends. Basic and diluted earnings per share are computed by dividing income available to common stockholders by the weighted average number of common shares outstanding during the year. The computation of diluted earnings per share gives effect to all dilutive potential common shares that were outstanding during the year. The effect of stock options and unvested restricted stock represent the only differences between the weighted average shares used for the basic earnings per share computation compared to the diluted earnings per share computation for each period presented. See additional information in Note 16.
Stock-Based Compensation. The Company recognizes in its financial statements compensation cost relating to share-based payment transactions. The stock-based compensation expense is recognized as expense over the requisite service period, which is the vesting period. See additional information in Note 17.
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Income Taxes. Deferred income taxes are recorded to reflect the tax consequences in future years of differences between the tax basis of assets and liabilities and their financial reporting amounts, based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. Income tax expense represents the tax payable for the current period and the change during the period in deferred tax assets and liabilities.
Tax guidance pertaining to uncertain tax positions issued by the Financial Accounting Standards Board (FASB) clarifies what criteria must be met prior to recognition of the financial statement benefit of a position taken or one that is expected to be taken in a tax return. The provisions of this guidance apply broadly to all tax positions taken by a company, including decisions to not report income in a tax return or to classify a transaction as tax exempt. The prescribed approach is determined through a two-step benefit recognition model. The amount of benefit to recognize is measured as the largest amount of tax benefit that is greater than 50 percent likely of being ultimately realized upon settlement. The tax position must be derecognized when it is no longer more likely than not of being sustained. See additional information in Note 14.
Treasury Stock. The Company’s board of directors periodically authorizes the repurchase of the Company’s common stock. The Company’s repurchases of common stock are recorded as treasury stock and result in a reduction of stockholders’ equity. The shares held in treasury stock may be used for corporate purposes, including shares issued to employees as part of the Company’s stock-based compensation programs. When treasury shares are reissued, the Company uses the average cost method. The Company had 3.7 million and 3.5 million shares of common stock held in treasury at December 31, 2011 and 2012, respectively.
Fair Value of Financial Instruments. The fair value of short-term payday, title, installment loans and open-end credit receivables, borrowings under the credit facility, accounts payable and certain other current liabilities that are short-term in nature approximates carrying value.
The Company estimates the fair value of its automotive loan receivables at what a third party purchaser might be willing to pay. The Company has had discussions with third parties and has sold a portfolio that indicates a 35% discount to face value would be a reasonable fair value for a negotiated third party transaction for an entire portfolio. As of December 31, 2011 and December 31, 2012, the fair value of the automotive loan receivables was $11.7 million and $1.7 million, respectively.
The Company estimates the fair value of long-term debt based upon borrowing rates available at the reporting date for indebtedness with similar terms and average maturities. As of December 31, 2011, the balance of the three-year term loan was $31.7 million and the fair value was estimated at $30.3 million. As of December 31, 2012, the term loan was paid in full. The fair value of the subordinated notes as of December 31, 2011 and 2012 approximated the carrying value.
Derivative Instruments. The Company does not engage in the trading of derivative financial instruments except where the Company’s objective is to manage the variability of forecasted interest payments attributable to changes in interest rates. In general, the Company enters into derivative transactions in limited situations based on management’s assessment of current market conditions and perceived risks.
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
On March 31, 2008, the Company entered into an interest rate swap agreement. The swap agreement was designated as a cash flow hedge and changed the floating rate interest obligation associated with the Company’s $50 million term loan into a fixed rate. Gains or losses on derivatives designated as cash flow hedges, to the extent they are effective, are recorded in other comprehensive income, and subsequently reclassified to earnings as interest expense to offset the impact of the hedged items when they occur. If it becomes probable the forecasted transaction to which a cash flow hedge relates will not occur, the derivative would be terminated and the amount in other comprehensive income would generally be recognized into earnings. The swap agreement had a maturity date of December 6, 2012. Under the swap, the Company paid a fixed interest rate of 3.43% and received interest at a rate of LIBOR. On October 3, 2011, the Company terminated the swap agreement. Prior to refinancing the term debt on September 30, 2011 that was associated with the swap, the swap was considered highly effective and therefore, the Company reported no net gain or loss during the year ended December 31, 2011. In connection with the termination of the swap agreement, the Company paid a net cash settlement of approximately $343,000. The Company’s remaining amounts deferred in accumulated other comprehensive loss were amortized into earnings as an increase to interest expense over the original term of the hedged transaction.
Foreign Currency Translations. The functional currency for the Company’s subsidiaries that serve residents of Canada is the Canadian dollar. The assets and liabilities of these subsidiaries are translated into U.S. dollars at the exchange rates in effect at each balance sheet date, and the resulting adjustments are recorded in “Accumulated other comprehensive income (loss)” as a separate component of equity. Revenue and expenses will be translated at the monthly average exchange rates occurring during each period.
NOTE 3 - ACCOUNTING DEVELOPMENTS
In July 2012, the FASB issued an update to existing guidance on the impairment assessment of indefinite-lived intangibles. This update simplifies the impairment assessment of indefinite-lived intangibles by allowing companies to consider qualitative factors to determine whether it is more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying amount before performing the two step impairment review process. This guidance is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. The Company adopted this guidance on January 1, 2012. The adoption did not have a material effect on the Company’s consolidated financial statements.
In September 2011, the FASB issued amendments to the goodwill impairment guidance, which provides an option for companies to use a qualitative approach to test goodwill for impairment if certain conditions are met. These amendments give entities the option, under certain circumstances, to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether further impairment testing is necessary. The amendments are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011 (early adoption is permitted). The Company adopted this standard during the year ended December 31, 2011. There was no material impact to the Company’s financial position or results of operations as a result of the adoption of this standard.
In June 2011, the FASB issued guidance on the presentation of comprehensive income. The Company adopted this guidance effective January 1, 2012. The adoption of this guidance did not have a material effect on the Company’s consolidated financial statements.
In May 2011, the FASB issued an update to the authoritative guidance, which establishes common requirements for measuring fair value and for disclosing information about fair value measurements in accordance with US GAAP. The Company adopted this guidance effective January 1, 2012. The adoption of this guidance did not have a material effect on the Company’s consolidated financial statements.
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
NOTE 4 - SIGNIFICANT BUSINESS TRANSACTIONS
Sale of Automobile Receivables. In December 2012, the Company completed two transactions involving $17.2 million principal amount of its automobile loans receivable. The Company received approximately $11.9 million in cash proceeds in exchange for relinquishing its right, title and interest in the automobile loans receivable. The Company used the net proceeds it received to make a prepayment of the term loan under its credit agreement. The Company is subject to recourse provisions, which requires it to re-purchase certain automobile loans receivable in the event of a default. As of December 31, 2012, the balance of the recourse liability was approximately $350,000.
With respect to the transfer of $17.2 million in automobile loans receivable, the Company treated $16.1 million of this amount as a sale and recognized a $2.6 million loss from the sale in the other income component of the Consolidated Statements of Income. The Company was unable to satisfy certain criteria for sale accounting treatment with respect to the transfer of $1.1 million in principal amount of automobile loans receivable. These transferred assets have been classified as collateralized receivables and the cash proceeds received (approximately $618,000) from the transfer of these automobile loans receivable have been classified as a secured borrowing in the Consolidated Balance Sheets.
Direct Credit Holdings. On September 30, 2011, QC Canada Holdings Inc., a wholly-owned subsidiary of the Company, acquired 100% of the outstanding stock of Direct Credit Holdings Inc. and its wholly-owned subsidiaries (collectively, Direct Credit), a British Columbia company engaged in short-term, consumer Internet lending in certain Canadian provinces. The Company paid an aggregate initial consideration of $12.4 million. The Company also agreed to pay a supplemental earn-out payment to the extent Direct Credit’s EBITDA as specifically defined in the stock purchase agreement (generally earnings before interest, income taxes, depreciation and amortization expenses) exceeded a defined target for the twelve-month period ended September 30, 2012.
The Company hired an independent appraiser to evaluate the fair value of the contingent consideration and the assets acquired and liabilities assumed. The contingent consideration and the estimated fair values of intangible assets acquired were fair value estimates obtained from an independent appraiser and were based on the information that was available to the Company as of the acquisition date. The Company believed that the information provided a reasonable basis for estimating the fair values of contingent consideration and of assets acquired and liabilities assumed, and the Company continued to monitor during the measurement period (one year from the acquisition date) any new information obtained about facts and circumstances that were present at the acquisition date (including consideration of legal matters as discussed in Note 18). The Company has not provided pro forma information because the Company believes that the acquisition of Direct Credit is not material to the Company’s consolidated financial statements. The operating results of Direct Credit are included in the Company’s Consolidated Statements of Income as of the date of acquisition. The costs incurred for the acquisition of Direct Credit were expensed as incurred and these costs were not material to the Company’s consolidated financial statements.
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table summarizes the estimated fair values of the assets acquired at the date of acquisition (in thousands):
(a) Includes cash acquired of approximately $866,000.
(b) The goodwill is currently assigned to a new reporting unit for goodwill testing purposes. The goodwill recognized is attributable primarily to the potential additional applications for software, expected corporate synergies, the assembled workforce of Direct Credit and other factors. None of the goodwill is expected to be deductible for income tax purposes.
(c) The deferred tax liability represents the net deferred income taxes recorded as an increase to goodwill primarily for the tax basis differences of intangible assets acquired in connection with the acquisition of Direct Credit. To the extent of any change to the provisional fair values of the intangible assets or other items, the Company would also expect to change the related deferred tax assets and liabilities that have been recorded at the acquisition date.
The Company believes the acquisition of Direct Credit broadens its product platform and distribution, as well as expands its presence by entering into international markets. Prior to completion of the transaction the Company amended and restated its credit agreement. The acquisition was funded with borrowings from the amended and restated credit agreement. See additional information in Note 11.
The fair value of the goodwill at the acquisition date was $7.6 million. As part of the Company’s annual impairment testing performed as of December 31, 2012, it was determined that the fair value of the E-Lending reporting unit did not exceed its carrying value. As a result, the Company recorded a $1.7 million non-cash impairment charge to goodwill during the year ended December 31, 2012. See additional information in Note 10.
The fair value of the contingent consideration arrangement at the acquisition date was $1.1 million, which was recorded in current liabilities. As of December 31, 2011, the fair value of the contingent consideration liability was $1.1 million. The fair value estimate at December 31, 2011 was determined using a probability-weighted income approach. In accordance with the stock purchase agreement, a supplemental earn-out payment was not required as Direct Credit’s EBITDA for the 12 month period ended September 30, 2012 did not exceed the defined target. During the year ended December 31, 2012, the Company recorded a reduction to the contingent consideration liability of approximately $1.1 million. This reduction is included as a gain in the other income component of the Consolidated Statements of Income. See additional information in Note 5.
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Closure of Branches. During the year ended December 31, 2012, the Company closed 24 of its lower performing branches in various states (which included four branches that were consolidated into nearby branches). In addition, the Company decided it would close 38 underperforming branches during the first half of 2013. The Company recorded approximately $699,000 in pre-tax charges during the year ended December 31, 2012 associated with branch closures. The charges included a $398,000 loss for the disposition of fixed assets, $263,000 for lease terminations and other related occupancy costs and $38,000 for other costs. The charges recorded in 2012 do not include lease termination and severance costs associated with the 38 branches that are scheduled to close during first half of 2013 as notification to the landlords and employees occurred in January 2013.
During the year ended December 31, 2011, the Company closed 24 of its branches in various states (which included four branches that were consolidated into nearby branches). The Company recorded approximately $553,000 in pre-tax charges during the year ended December 31, 2011 associated with these closures. The charges included a $283,000 loss for the disposition of fixed assets, $252,000 for lease terminations and other related occupancy costs and $18,000 for other costs.
During year ended December 31, 2010, the Company closed 34 of its branches in various states and, as a result of the negative impact from changes in payday lending laws, decided it would close 21 branches in Arizona, Washington and South Carolina during first half 2011. During 2011, the Company closed 18 of the 21 branches and decided that the other three branches would remain open. The Company recorded approximately $1.8 million in pre-tax charges during the year ended December 31, 2010 associated with these closings. The charges included $916,000 representing the loss on the disposition of fixed assets, $671,000 for lease terminations and other related occupancy costs, $155,000 in severance and benefit costs and $33,000 for other costs.
With respect to the branch closings in each of 2010, 2011 and 2012, a significant portion of the operations and closing costs are included as discontinued operations (see Note 6). When ceasing operations in Company branches under operating leases, the Company incurs certain lease contract termination costs. Accordingly, in cases where the lease contract specifies a termination fee due to the landlord, the Company records such expense at the time written notice is given to the landlord. In cases where terms, including termination fees, are yet to be negotiated with the landlord or in cases where the landlord does not allow the Company to prematurely exit its lease, but allows for subleasing, the Company estimates the fair value of any assumed sublease income that can be generated from the location and records as an expense the excess of remaining lease payments to the landlord over the projected sublease income at the cease-use date.
The following table summarizes the accrued costs associated with the closure of branches and the activity related to those charges as of December 31, 2012 (in thousands):
As of December 31, 2012, the balance of $54,000 for accrued costs associated with the closure of branches is included as a current liability on the Consolidated Balance Sheets as the Company expects that the liabilities for these costs will be settled within one year.
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Sale of Branch. In March 2011, the Company sold a branch located in California for approximately $666,000. The carrying value of the payday loan receivables, fixed assets and other assets sold was approximately $137,000, $15,000 and $2,000, respectively. The Company also recorded a disposition of goodwill totaling $135,000 due to the sale of this location. The gain from the sale of the branch, which was approximately $377,000, and its related operations are included in discontinued operations in the Consolidated Statements of Income.
NOTE 5 - FAIR VALUE MEASUREMENTS
Fair Value Hierarchy Tables. The fair value measurement accounting guidance establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. In general, fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability. Level 3 inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls has been determined based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value in its entirety requires judgment and considers factors specific to the asset or liability.
The following table presents fair value measurements for recurring financial assets as of December 31, 2011 (in thousands):
As discussed in Note 4, a supplemental earn-out payment for the acquisition related contingent consideration was not required as Direct Credit’s EBITDA for the 12 month period ended September 30, 2012 did not exceed the target as defined in the stock purchase agreement. The acquisition-related contingent consideration was initially measured and recorded at fair value as an element of consideration paid in connection with an acquisition with subsequent adjustments recognized as a gain or loss in the other income component of the Consolidated Statements of Income. The liability for this contingent consideration was classified as a Level 3 liability because the related fair value measurement, which is determined using a discounted probability-weighted approach, includes significant inputs not observable in the market. These unobservable inputs included internally-developed assumptions of the probabilities of achieving specified targets, which are used to estimate the resulting EBITDA, and the applicable discount rate. When assessing the fair value of this contingent consideration on a quarterly basis, the Company evaluated the performance of the business during the period compared to previous expectations, along with any changes to our future projections, and updated the estimated EBITDA accordingly. In addition, the Company considered changes to its cost of capital and changes to the probability of achieving the earn-out payment targets when updating the discount rate on a quarterly basis. The analysis utilized weighted average inputs, including a risk-based discount rate of 29.5%, determined using a mix of cost of debt and risk-adjusted cost of capital reasonable for the company, and EBITDA growth year-to-year ranging from 9% to 42%, determined using various scenarios for the business. The results for the year ended December 31, 2012 include a $1.1 million gain in other income related to the reduction of the contingent consideration liability.
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table presents changes to the Company’s financial liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the year ended December 31, 2012 (in thousands):
Fair Value Measurements on a Non-Recurring Basis. The Company also measures the fair value of certain assets on a non-recurring basis when events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Non-financial assets such as property, equipment, land, goodwill and intangible assets are also subject to non-recurring fair value measurements if they are deemed to be impaired. The impairment models used for non-financial assets depend on the type of asset. When the carrying amount of these assets cannot be recovered by the undiscounted net cash flows they will generate, impairment is recognized in an amount by which the carrying amount of the assets exceeds the fair value. There were no material impairments of non-financial assets for years ended December 31, 2010 and 2011. The Company evaluated its indefinite life intangibles as part of its annual impairment testing as of December 31, 2012 and determined that the trade name intangible associated with the acquisition of ECA in December 2006 was impaired. For the year ended December 31, 2012, the Company recorded an impairment charge of $600,000 to reduce the value of the trade name intangible asset. The decline in value was attributable to the prior closings of ECA branches in South Carolina and the decision to close an additional 12 branches in South Carolina during the first half of 2013.
During the year ended December 31, 2012, the Company recorded an impairment of $257,000 on fixed assets in connection with the 38 branches the Company has scheduled to close during the first half of 2013. During the year ended December 31, 2010, the Company recorded an impairment of $330,000 on fixed assets in connection with the 21 branches the Company had scheduled to close during the first half of 2011. The fair value measurements used to determine the impairments were based on the market approach based on liquidation prices of comparable assets.
The following table presents fair value measurements of certain assets on a non-recurring basis as of December 31, 2012 (in thousands):
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table presents fair value measurements of certain assets on a non-recurring basis as of December 31, 2010 (in thousands):
NOTE 6 - DISCONTINUED OPERATIONS
The Company closed 34 branches during 2010 that were not consolidated into nearby branches and announced it would close 21 branches in Arizona, Washington and South Carolina in 2011. During 2011 the Company closed 18 of the 21 branches and decided that the remaining three branches would remain open and the results of these branches were reclassified into continuing operations. In addition, the Company closed 20 branches during the year ended December 31, 2011 that were not consolidated into nearby branches and sold one branch. In 2012, the Company closed 20 branches that were not consolidated into nearby branches and decided it would close 38 branches during the first half of 2013. These branches are reported as discontinued operations in the Consolidated Statements of Income and related disclosures in the accompanying notes for all periods presented. With respect to the Consolidated Balance Sheets, the Consolidated Statements of Cash Flows and related disclosures in the accompanying notes, the items associated with the discontinued operations are included with the continuing operations for all periods presented.
Summarized financial information for discontinued operations is presented below (in thousands):
NOTE 7 - SEGMENT INFORMATION
The Company’s operating business units offer various financial services and sell used vehicles and earn finance charges from the related vehicle financing contracts. The Company has elected to organize and report on these business units as three operating segments (Financial Services, Automotive and E-Lending). The Financial Services segment includes branches that offer payday loans, installment loans, credit services, check cashing services, title loans, open-end credit, debit cards, money transfers and money orders. The Automotive segment consists of the buy here, pay here operations. The E-Lending segment includes the Internet lending operations in Canada. The Company evaluates the performance of its segments based on, among other things, gross profit, income from continuing operations before income taxes and return on invested capital.
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following tables present summarized financial information for the Company’s segments (in thousands):
(a) Represents expenses not associated with operations, which includes regional expenses, corporate expenses, depreciation and amortization, interest, other income and other expenses. For the year ended December 31, 2012, the E-Lending segment includes a $1.7 million impairment charge to goodwill partially offset by a gain of $1.1 million for the reduction in the contingent consideration liability.
(b) E-Lending primarily includes the operations of Direct Credit since the acquisition date (September 30, 2011).
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Information concerning total assets by reporting segment is as follows (in thousands):
The operations of the Financial Service and Automotive segments are all located in the United States. The operations of the E-Lending segment are located in Canada.
NOTE 8 - CUSTOMER RECEIVABLES AND ALLOWANCE FOR LOAN LOSSES
Customer receivables consisted of the following (in thousands):
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Credit quality information. In order to manage the portfolios of consumer loans effectively, the Company utilizes a variety of proprietary underwriting criteria, monitors the performance of the portfolio and maintains either an allowance or accrual for losses on consumer loans (including fees and interest) at a level estimated to be adequate to absorb credit losses inherent in the portfolio. The portfolio includes balances outstanding from all consumer loans, including short-term payday and title loans, automotive loans and installment loans. The allowance for losses on consumer loans offsets the outstanding loan amounts in the consolidated balance sheets.
The Company has $2.0 million in automotive loans receivable past due as of December 31, 2012 and approximately 28.6% of this amount was more than 60 days past due. In addition, the Company had automotive loans receivable totaling $571,000 on non-accrual status as of December 31, 2012. With respect to installment loans, the Company has approximately $3.9 million in installment loans receivable past due as of December 31, 2012 and approximately 21.4% of this amount was more than 60 days past due.
The Company had $6.9 million in automotive loans receivable that were past due as of December 31, 2011 and approximately 12.0% of this amount was more than 60 days past due. In addition, the Company had automotive loans receivable totaling $824,000 that were on non-accrual status as of December 31, 2011. With respect to installment loans, the Company had approximately $1.5 million in installment loans receivable that were past due as of December 31, 2011 and approximately 7.4% of this amount was more than 60 days past due.
Allowance for loan losses. The following table summarizes the activity in the allowance for loan losses (in thousands):
The provision for losses in the Consolidated Statements of Income includes losses associated with the CSO (see note 13 for additional information) and excludes loss activity related to discontinued operations (see note 6 for additional information).
NOTE 9 - PROPERTY AND EQUIPMENT
Property and equipment consisted of the following (in thousands):
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
In February 2005, the Company entered into a seven-year lease for a new corporate headquarters in Overland Park, Kansas. In January 2011, the Company amended its lease agreement to extend the lease term and modify the lease payments. The lease was extended with a new landlord through October 31, 2017 and includes a renewal option for an additional five years. As part of the original lease agreement and the amendment to the lease agreement, the Company received tenant allowances from the landlord for leasehold improvements totaling $1.4 million. The tenant allowances are recorded by the Company as a deferred liability and are being amortized as a reduction of rent expense over the life of the lease. As of December 31, 2011, the balance of the deferred liability was approximately $325,000, of which $269,000 was classified as a non-current liability. As of December 31, 2012, the balance of the deferred liability was approximately $270,000, of which $214,000 is classified as a non-current liability.
Depreciation and amortization expense for property and equipment totaled $4.9 million, $3.8 million and $2.7 million for the years ended December 31, 2010, 2011 and 2012, respectively.
NOTE 10 - GOODWILL AND INTANGIBLE ASSETS
Goodwill. The following table summarizes the changes in the carrying amount of goodwill for the years ended December 31, 2011 and 2012 (in thousands):
Information concerning goodwill by reporting segment is as follows (in thousands):
The Company hired an independent appraiser to perform its annual impairment test as of December 31, 2012. The Company determined that there was no impairment of goodwill for the core lending and automotive
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
units as the fair value of each these reporting units were in excess of their carrying amount based on the results of the test. However, the test results showed that the fair value of the E-Lending reporting unit did not exceed its carrying amount and a step two analysis was required to determine the amount of the impairment. For purposes of the step one analysis, the fair value of the E-Lending reporting unit was estimated using both an income approach that analyzed projected discounted cash flows and a market approach that considered other comparable companies. The amount of the impairment is calculated in a step two analysis by comparing the implied fair value of the goodwill to its carrying amount, which requires an allocation of the fair value determined in the step one analysis to the individual assets and liabilities of the reporting unit. Any remaining fair value would represent the implied fair value of goodwill on the testing date. The Company hired the independent appraiser to assist with the step two analysis and the test results showed that the implied fair value of the goodwill was $6.1 million compared to the book value of $7.8 million. As a result, the Company recorded a $1.7 million non-cash, non-tax deductible impairment charge to goodwill for its E-Lending reporting unit. The impairment of goodwill resulted from lower than expected earnings in 2012 due to lower revenues and slightly higher losses and the Company’s current expectations for future growth and profitability for the E-Lending reporting unit being lower than its previous estimates. The discount rates used for the reporting units range from 16.9% to 22.3%. A simultaneous 10% decline in the cash flow projections for the E-Lending reporting unit combined with a 100 basis point increase in the discount rates used would result in an additional pre-tax $900,000 impairment to goodwill. In the future, our estimated fair value could be negatively impacted by extended declines in our stock price, changes in macroeconomic indicators, sustained operating losses, and other factors which may affect our assessment of fair value. With respect to 2011, the Company performed its annual impairment testing of goodwill and concluded that no impairment existed at December 31, 2011.
As noted above, the Company concluded that its goodwill for the core lending and automotive reporting units was not impaired as of December 30, 2012, because the fair values of each of these reporting units were substantially in excess of their respective net book values.
Intangible Assets. The following table summarizes intangible assets (in thousands):
Intangible assets at December 31, 2011 and December 31, 2012 include customer relationships, non-compete agreements, trade names and debt issue costs. Customer relationships are amortized using the straight-line method over the weighted average useful lives ranging from three to five years. Non-compete agreements are currently amortized using the straight-line method over the term of the agreements, ranging from three to five years. The amount recorded for trade names are considered an indefinite life intangible and not subject to amortization. Costs paid to obtain debt financing are amortized to interest expense over the term of each related debt agreement using the effective interest method for term debt and the straight-line method for the revolving credit facility.
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company tests trade names with indefinite lives for impairment annually by comparing the book value to a fair value calculated using a discounted cash flow approach on a presumed royalty rate derived from the revenues related to the trade name. In 2006, the Company acquired 51 branches in South Carolina from Express Check Advance, LLC. The Company has closed the majority of these branches (31 branches as of December 31, 2012) and has decided to close 12 additional branches during first half 2013 due to a change in the payday loan law in South Carolina in 2009 that has negatively impacted revenues and gross profits in those branches over the past few years. Based on the results from its 2012 impairment testing, the Company concluded that the trade name associated with the acquisition of ECA was impaired and recorded an impairment charge of $600,000 to reduce the value of the trade name intangible asset.
Amortization expense for the years ended December 31, 2010, 2011 and 2012 was $1.2 million, $861,000 and $955,000, respectively. Annual amortization for intangible assets recorded as of December 31, 2012 is estimated to be $1.2 million for 2013, $861,000 for 2014 and $5,000 for 2015.
NOTE 11 - INDEBTEDNESS
Long-Term Debt. The following table summarizes long-term debt at December 31, 2011 and 2012 (in thousands):
On September 30, 2011, the Company entered into an amended and restated credit agreement (current credit agreement) with a syndicate of banks to replace its prior credit agreement, which was previously amended on December 7, 2007. The current credit agreement provides for a term loan of $32 million and a revolving line of credit (including provisions permitting the issuance of letters of credit and swingline loans) in the aggregate principal amount of up to $27 million. In connection with amending the credit agreement, the Company capitalized approximately $1.0 million in debt issue costs, which it is amortizing over three years, and recorded a loss on debt extinguishment totaling $462,000, which is included in the Consolidated Statements of Income as part of other expense, net. The weighted average interest rate for borrowings under the revolving line of credit at December 31, 2011 and 2012 was 3.1% and 4.3%, respectively.
The current credit agreement contains financial covenants related to EBITDA (earnings before interest, provision for income taxes, depreciation and amortization and non-cash charges related to equity-based compensation), fixed charge coverage, leverage, total indebtedness, liquidity and maximum loss ratio. As of September 30, 2012, the Company was not in compliance with certain financial covenants (minimum consolidated EBITDA and fixed charge coverage ratio) as set forth in the current credit agreement. On November 7, 2012, the Company entered into an amendment to the current credit agreement to (i) permanently reduce the minimum consolidated EBITDA requirement through the term of the facility; (ii) reduce the fixed charge coverage ratio requirement for each of the quarters ended September 30, 2012, December 31, 2012 and March 31, 2013; and (iii) allow for the sale of automobile receivables of the company, subject to approval of terms by the lenders, provided proceeds are used to reduce the outstanding balance of the term loan. As of December 31, 2012, the Company is in compliance with all of its debt covenants.
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The obligations of the Company under the current credit agreement are guaranteed by all the operating subsidiaries of the Company (other than foreign subsidiaries), and are secured by liens on substantially all of the personal property of the Company and its operating subsidiaries. The Company pledged 65% of the stock of QC Canada Holdings Inc. to secure the obligations of the Company under the current credit agreement. The lenders may accelerate the obligations of the Company under the current credit agreement if there is a change in control of the Company, including an acquisition of 25% or more of the equity securities of the Company by any person or group. The current credit agreement matures on September 30, 2014.
Borrowings under the term loan and the facility are available based on two types of loans, Base Rate loans or LIBOR Rate loans. Base Rate term loans bear interest at a rate of 2.25% plus the higher of the Prime Rate, the Federal Funds Rate plus 0.50% or the one-month LIBOR rate in effect plus 2.00%. Base Rate revolving loans bear interest at a rate ranging from 1.25% to 2.25% depending on the Company’s leverage ratio (as defined in the agreement), plus the higher of the Prime Rate, the Federal Funds Rate plus 0.50% or the one-month LIBOR rate in effect plus 2.00%. LIBOR Rate term loans bear interest at rates based on the LIBOR rate for the applicable loan period (unless the rate is less than 1.50%, in which case the agreement established a LIBOR rate floor of 1.50%) with a maximum margin over LIBOR of 4.25%. LIBOR Rate revolving loans bear interest at rates based on the LIBOR rate for the applicable loan period with a margin over LIBOR ranging from 3.25% to 4.25% depending on the Company’s leverage ratio (as defined in the agreement). The loan period for a LIBOR Rate loan may be one month, two months, three months or six months and the loan may be renewed upon notice to the agent provided that no default has occurred. As a result, the revolving credit facility is classified as debt due within one year, although the revolving credit facility, by its terms, does not mature until September 30, 2014. The credit facility also includes a non-use fee ranging from 0.375% to 0.625%, which is based upon the Company’s leverage ratio.
In December 2012, the Company sold the majority of its automobile receivables and used the proceeds from the sale to pay down its term loan. In addition to scheduled repayments, the term loan contained mandatory principal prepayment provisions whereby the Company was required to reduce the outstanding principal amount of the term loan based on the Company’s excess cash flow (as defined in the agreement) and the Company’s leverage ratio as of the most recent completed fiscal year. To the extent that the Company’s leverage ratio was greater than one, the Company was required to pay 75% of excess cash flow. If the leverage ratio fell below one, the mandatory payment was 50% of excess cash flow. Under the previous credit agreement, the Company made a $7.1 million principal payment on the term loan in March 2011, which included $5.3 million required under the mandatory prepayment provisions and the $1.8 million scheduled principal payment. In April 2012, the Company made a $10.7 million principal payment on the term loan, which was required under the mandatory prepayment provisions of the current credit agreement.
Subordinated Debt. Under the current credit agreement, the lenders required that the Company issue $3.0 million of senior subordinated notes. On September 30, 2011, the Company issued $2.5 million initial principal amount of senior subordinated notes to the Chairman of the Board of the Company. The remaining $500,000 principal amount of subordinated notes was issued to another stockholder of the Company, who is not an officer or director of the Company. The subordinated notes bear interest at the rate of 16% per annum, payable quarterly, 75% of which is payable in cash and 25% of which is payable-in-kind (PIK) through the issuance of additional senior subordinated PIK notes. The subordinated notes mature on September 30, 2015, are subject to prepayment at the option of the Company, without penalty or premium, on or after September 30, 2014, and are subject to mandatory prepayment, without premium, upon a change of control. The subordinated notes contain events of default tied to the Company’s total debt to total capitalization ratio and total debt to EBITDA ratio. The subordinated notes further provide that upon occurrence of an event of default on the subordinated notes, the Company may not declare or pay any cash dividend or distribution of cash or other property (other than equity securities of the Company) on its capital stock. As of December 31, 2011 and December 31, 2012, the balance of the subordinated notes was approximately $3.0 million and $3.2 million, respectively.
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table summarizes future principal payments of indebtedness at December 31, 2012 (in thousands):
NOTE 12 - DERIVATIVES
Derivative instruments are accounted for at fair value. The accounting for changes in the fair value of a derivative depends on the intended use and designation of the derivative instrument. For a derivative instrument designated as a fair value hedge, the gain or loss on the derivative is recognized in earnings in the period of change in fair value together with the offsetting gain or loss on the hedged item. For a derivative instrument designated as a cash flow hedge, the effective portion of the derivative’s gain or loss is initially reported as a component of Other Comprehensive Income (OCI) and is subsequently recognized in earnings when the hedged exposure affects earnings. The ineffective portion of the gain or loss is recognized in earnings. Gains or losses from changes in fair values of derivatives that are not designated as hedges for accounting purposes are recognized currently in earnings.
Prior to amending and restating its credit agreement on September 30, 2011, the Company was exposed to certain risks relating to adverse changes in interest rates on its long-term debt and managed that risk with the use of a derivative. The Company did not enter into the derivative instrument for trading or speculative purposes.
Cash Flow Hedge. The Company entered into an interest rate swap agreement during first quarter 2008 for $49 million of its outstanding debt as a cash flow hedge to interest rate fluctuations under its prior credit facility. The swap agreement was designated as a cash flow hedge, and effectively changed the floating rate interest obligation associated with the $50 million term loan into a fixed rate. Because the term debt associated with the swap was refinanced on September 30, 2011, the hedge no longer met the criteria for accounting of a cash flow hedge. On October 3, 2011, the Company terminated the swap agreement. In connection with the termination of the swap agreement, the Company paid a net cash settlement of approximately $343,000. The Company’s net loss on this transaction was deferred in accumulated other comprehensive income and is amortized into earnings as an increase to interest expense over the original term of the hedged transaction, which was scheduled to terminate in December 2012. For the years ended December 31, 2011 and 2012, the Company has recorded interest expense totaling approximately $69,000 and $275,000, respectively related to the termination of the swap.
QC HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table summarizes the gains (losses) recognized in Other Comprehensive Income related to the interest rate swap agreement for the years ended December 31, 2011 and 2012 (in thousands):
NOTE 13 - CREDIT SERVICES ORGANIZATION
For the Company’s locations in Texas, the Company began operating as a CSO, through one of its subsidiaries, in September 2005. As a CSO, the Company acts as a credit services organization on behalf of consumers in accordance with Texas laws. The Company charges the consumer a fee for arranging for an unrelated third-party to make a loan to the consumer and for providing related services to the consumer, including a guarantee of the consumer’s obligation to the third-party lender. The Company also services the loan for the lender. The CSO fee is recognized ratably over the term of the loan. The Company is not involved in the loan approval process or in determining the loan approval procedures or criteria. As a result, loans made by the lender are not included in the Company’s loans receivable balance and are not reflected in the Consolidated Balance Sheets. As noted above, however, the Company absorbs all risk of loss through its guarantee of the consumer’s loan from the lender. As of December 31, 2011 and December 31, 2012, the consumers had total loans outstanding with the lender of approximately $3.1 million and $2.6 million, respectively. Because of the economic exposure for potential losses related to the guarantee of these loans, the Company records a payable at fair value to reflect the anticipated losses related to uncollected loans. The balance of the liability for estimated losses reported in accrued liabilities was approximately $90,000 as of December 31, 2011 and $100,000 as of December 31, 2012.
The following table summarizes the activity in the liability for CSO loan losses during the years ended December 31, 2010, 2011 and 2012 (in thousands):
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NOTE 14 - INCOME TAXES
The Company’s provision for income taxes from continuing operations is summarized as follows (in thousands):
The sources of deferred income tax assets (liabilities) are summarized as follows (in thousands):
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The Company has state tax credit carry-forwards of approximately $819,000 and $951,000 as of December 31, 2011 and December 31, 2012, respectively. The deferred tax asset, net of federal tax effect, relating to the carry-forwards is approximately $532,000 and $618,000 as of December 31, 2011 and December 31, 2012, respectively. The Company’s ability to utilize a significant portion of the state tax credit carry-forwards is dependent on its ability to meet certain criteria imposed by the state not only for the year in which the credit is generated, but also for all subsequent years in which any portion of the credit is utilized. In addition, the credits can only be utilized against the tax liabilities of specific subsidiaries in those states. During 2012 the Company obtained certification for the utilization of a portion of these credits carry forwards for the 2011 tax year in a particular jurisdiction. Also, additional credit carry forwards were generated for the 2012 tax year. Until certification to utilize these credits is received, management believes that it is not more likely than not that the benefit of these credits will be realized and, accordingly, a valuation allowance in the amount of $532,000 and $618,000 has been established at December 31, 2011 and December 31, 2012, respectively. The Company also has gross foreign net operating loss carry-forwards of approximately $445,000 that generally expire in 18 - 20 years. The Company believes it is more likely than not that these carry-forwards will be utilized prior to their expiration. Accordingly, no valuation allowance for the related deferred tax asset has been recognized.
Differences between the Company’s effective income tax rate computed for income from continuing operations and the statutory federal income tax rate are as follows (in thousands):
The effective income tax rate for the year ended December 31, 2012 was 41.5% compared to 37.6% in the prior year. The increase is primarily related to the goodwill impairment charge as a percentage of reduced pre-tax income.
As of December 31, 2012, the accumulated undistributed earnings of foreign affiliates were a deficit of $108,000. As of December 31, 2011, accumulated undistributed earnings of foreign affiliates were $133,000. As the Company intends to indefinitely reinvest these earnings in the business of its foreign affiliates, no federal or state income taxes or foreign withholding taxes have been provided for amounts which would become payable, if any, on the distribution of such earnings should they become positive in the future.
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Uncertain Tax Positions. A summary of the total amount of unrecognized tax benefits for the years ended December 31, 2011 and 2012 is as follows (in thousands):
Approximately $28,000 of the total unrecognized tax benefits at December 31, 2012, will, if ultimately recognized, impact the Company’s annual effective tax rate.
The Company records accruals for interest and penalties related to unrecognized tax benefits in interest expense and operating expense, respectively. Interest and penalties, and associated accruals, were not material in 2010, 2011 or 2012.
The Company does not anticipate any material changes in the amount of unrecognized tax benefits in the next twelve months.
The Company is subject to income taxes in the U.S. federal jurisdiction and various state and foreign jurisdictions. Tax regulations within each jurisdiction are subject to the interpretation of the related tax laws and regulations and require significant judgment to apply. In the ordinary course of business, transactions occur for which the ultimate tax outcome is uncertain. In addition, respective tax authorities periodically audit the Company’s income tax returns. These audits examine the Company’s significant tax filing positions, including the timing and amounts of deductions and the allocation of income among tax jurisdictions. The following table outlines the tax years that generally remain subject to examination as of December 31, 2012:
NOTE 15 - EMPLOYEE BENEFIT PLANS
The Company has established a defined-contribution 401(k) benefit plan that covers substantially all its full-time employees. Under the plan, the Company makes a matching contribution of 50% of each employee’s contribution, up to 6% of the employee’s compensation. The Company’s matching contributions and administrative expenses relating to the 401(k) plan were $476,000, $473,000 and $436,000 during 2010, 2011 and 2012, respectively.
In June 2007, the Company established a non-qualified deferred compensation plan for certain highly compensated employees, which permits participants to defer a portion of their compensation. Under the plan, the Company makes a matching contribution of 50% of each employee’s contribution, up to 6% of the employee’s compensation. The Company’s matching contributions and administrative expenses relating to the plan were
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$201,000, $179,000, and $188,000 during 2010, 2011 and 2012, respectively. Deferred amounts are credited with deemed gains or losses of the underlying hypothetical investments. For the years ended December 31, 2010 and 2012, the Company recognized compensation expense of approximately $280,000 and $354,000, respectively, as a result of deemed gains on the hypothetical investments. For the year ended December 31, 2011, the Company recognized a reduction in compensation expense of approximately $60,000, as a result of deemed losses on the hypothetical investments. Included in Other Liabilities (non-current) are amounts deferred under this plan of approximately $2.7 million and $3.3 million at December 31, 2011 and 2012, respectively.
The Company purchases corporate-owned life insurance policies on certain officers to informally fund the non-qualified deferred compensation plan. The cash surrender value of the life insurance policies is included in Other Assets (non-current) and totaled approximately $3.7 million and $3.4 million at December 31, 2011 and 2012, respectively. This asset is available to fund the deferred compensation liability; however, the asset is not protected from creditors of the Company. For the years ended December 31, 2010 and 2012, the Company recognized gains totaling $340,000 and $351,000, respectively, on its investments associated with the life insurance policies, reflected in the cash surrender value. For the year ended December 31, 2011, the Company recognized a loss totaling $161,000 on its investments associated with the life insurance policies, reflected in the cash surrender value.
NOTE 16 - STOCKHOLDERS’ EQUITY
Earnings Per Share. The following table presents the computations of basic and diluted earnings per share for the periods presented (in thousands, except per share data):
The Company has approximately 17.0 million and 17.2 million shares outstanding at December 31, 2011 and 2012, respectively. For financial reporting purposes, however, unvested restricted shares in the amount of approximately 661,000 shares, 928,000 shares and 604,000 shares are excluded from the determination of average common shares outstanding used in the calculation of basic earnings per share in the above table for the years ended December 31, 2010, 2011 and 2012, respectively.
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Anti-dilutive securities. Options to purchase approximately 2.7 million shares, 2.6 million shares and 2.6 million shares of common stock were excluded from the diluted earnings per share calculation for the years ended December 31, 2010, 2011 and 2012, respectively because they were anti-dilutive.
Stock Repurchases. The board of directors has authorized the Company to repurchase up to $60 million of its common stock in the open market and through private purchases. The acquired shares may be used for corporate purposes, including shares issued to employees in stock-based compensation programs. Under the announced stock repurchase program, the Company expended $2.6 million for approximately 606,000 shares, $1.1 million for approximately 273,000 shares, and $415,000 for approximately 105,000 shares during the years ended December 31, 2010, 2011, and 2012, respectively. As of December 31, 2012, the Company had approximately $4.0 million that may yet be utilized to repurchase shares under the current program. Under the current credit agreement (see Note 11), the Company may not modify the stock repurchase program to provide for repurchases in excess of $60 million. Shares received in exchange for tax withholding obligations arising from the vesting of restricted stock are included in common stock repurchased in the Consolidated Statements of Cash Flows and the Statements of Changes in Stockholders’ Equity.
Dividends. In November 2008, the Company’s board of directors established a regular quarterly cash dividend of $0.05 per share of the Company’s common stock. In addition to regular quarterly dividends, the Company’s board of directors has also approved special cash dividends on the Company’s common stock from time to time. For the year ended December 31, 2010, the Company declared dividends on its common stock of $0.30 per share. For the years ended December 31, 2011 and 2012, the Company declared dividends on its common stock of $0.20 per share, in each year.
NOTE 17 - STOCK-BASED COMPENSATION
Long-Term Incentive Stock Plans. As of December 31, 2012, the Company’s stock-based compensation plans include the 1999 Stock Option Plan and the 2004 Equity Incentive Plan (2004 Plan). Securities remaining available for future issuance under equity compensation plans approved by security holders consist solely of shares of common stock available under the 2004 Plan. The maximum number of shares of common stock of the Company originally reserved and available for issuance under the 2004 Plan was three million shares. In June 2009, at the annual meeting of the Company’s stockholders, the stockholders approved an amendment to the 2004 Plan to increase the number of shares of common stock available for issuance under such plan from three million shares to five million shares. As of December 31, 2012, there are approximately 259,000 shares of common stock available for future issuance under the 2004 Plan, which may be issued, in any combination, as incentive stock options, non-qualified stock options, stock appreciation rights, performance-based share awards, restricted stock or other incentive awards of, or based on, the Company’s common stock. In previous years, the Company has issued a combination of stock options (non-qualified) and restricted stock to its employees as part of the Company’s long-term equity incentive compensation program.
In accordance with the Company’s stock-based compensation plans, the exercise price of a stock option is equal to the market price of the stock on the date of the grant and the option awards typically vest over four years in 25% increments on the first, second, third and fourth anniversaries of the grant date. Generally, options granted will expire 10 years from the date of grant.
Restricted stock awards and performance-based share awards are valued on the date of grant and have no purchase price. Restricted stock awards typically vest over four years in 25% increments on the first, second, third and fourth anniversaries of the grant date. The vesting period for performance-based share awards is
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implicitly stated as the time period it will take for the performance condition to be met. Under the 2004 Plan, unvested shares of restricted stock and unvested performance-based share awards may be forfeited upon the termination of employment with the Company, dependent upon the circumstances of termination. Except for restrictions placed on the transferability of restricted stock, holders of unvested restricted stock and holders of unvested performance-based share awards have full stockholder’s rights, including voting rights and the right to receive cash dividends.
Share-Based Compensation. The following table summarizes the stock-based compensation expense reported in net income for the years ended December 31, 2010, 2011 and 2012 (in thousands):
The related income tax benefit was $790,000, $817,000 and $673,000 for the years ended December 31, 2010, 2011 and 2012, respectively.
Stock Options. The fair value of option grants are determined on the grant date using a Black-Scholes option-pricing model, which requires the Company to make several assumptions. The risk-free interest rate is based on the U.S. Treasury yield curve in effect for the expected term of the option at the time of the grant. The dividend yield is calculated based on the current dividend and the market price of the Company’s common stock on the grant date. The expected volatility factor used by the Company is based on the Company’s historical stock trading history. The Company computes the expected term of the option by using the simplified method, which is an average of the vesting term and original contractual term. The Company did not grant stock options during 2010, 2011 and 2012.
As of December 31, 2012, there was $16,700 of total unrecognized compensation costs related to outstanding stock options. The Company expects that these costs will be amortized over a weighted average period of one month.
The total intrinsic value of options exercised during the years ended December 31, 2011 and 2012 was $240,000 and $43,000, respectively. No options were exercised during the year ended December 31, 2010.
A summary of nonvested stock option activity and related information for the year ended December 31, 2012 is as follows:
The total fair value of options vested during 2012 was approximately $417,000.
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A summary of all stock option activity under the equity compensation plans for the year ended December 31, 2012 is as follows:
The following table summarizes information about options outstanding and exercisable at December 31, 2012:
Restricted stock grants. A summary of all restricted stock activity under the equity compensation plans for the year ended December 31, 2012 is as follows:
During 2012, the Company granted 52,500 shares of restricted stock to non-employee directors under the 2004 Equity Incentive Plan pursuant to restricted stock agreements. The shares granted to the non-employee directors vested immediately upon grant and are subject to an agreed-upon six-month holding period. The Company estimated that the fair market value of these restricted stock grants was approximately $181,000, which the Company recognized as stock-based compensation expense in the first quarter 2012.
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During 2011, the Company granted 532,040 shares of restricted stock to various employees and non-employee directors under the 2004 Equity Incentive Plan pursuant to restricted stock agreements. The grants consisted of 487,200 shares granted to employees that vest equally over four years and 44,840 shares granted to non-employee directors that vested immediately upon grant subject to an agreed-upon six-month holding period. The Company estimated that the fair market value of these restricted stock grants was approximately $2.2 million. As of December 31, 2012, the total unrecognized compensation costs related to these restricted stock grants was $1.0 million. The Company expects that these costs will be amortized over a weighted average period of 2.1 years.
During 2010, the Company granted 375,840 shares of restricted stock to various employees and non-employee directors under the 2004 Equity Incentive Plan pursuant to restricted stock agreements. The grants consisted of 335,600 shares granted to employees that vest equally over four years and 40,240 shares granted to non-employee directors that vested immediately upon grant subject to an agreed-upon six-month holding period. The Company estimated that the fair market value of these restricted stock grants was approximately $2.1 million. As of December 31, 2012, there was approximately $498,000 of total unrecognized compensation costs related to these restricted stock grants. The Company expects that these costs will be amortized over a weighted average period of 1.1 years.
In December 2009, it was determined that the Company’s executive officers would receive a one-time bonus equal to 10% of their current base salary in lieu of an increase in the base salaries of executive officers for the year ending December 31, 2010. In addition, it was determined that the majority of the executive officers would receive the one-time bonus in Company stock and two executive officers would receive the bonus in cash. As of December 31, 2009, the balance of the liability for the one-time stock bonus in lieu of base salary increases was approximately $185,000. In January 2010, the Company granted 35,800 shares that vested immediately upon grant subject to an agreed-upon six-month holding period.
As of December 31, 2012, there was $1.5 million of total unrecognized compensation costs related to the nonvested restricted stock grants. The Company estimates that these costs will be amortized over a weighted average period of 1.7 years.
The total fair value of restricted stock vested (at vest date) during the years ended December 31, 2010, 2011 and 2012 was $1.1 million, $1.0 million and $1.3 million, respectively. The Company requires employees to tender a portion of their vested shares to the Company to satisfy the minimum tax withholding obligations of the Company with respect to vesting of the shares. During 2010, 2011 and 2012, the Company repurchased shares from employees totaling approximately 68,500, 73,100, and 108,270, respectively.
Other Long-Term Incentive Compensation. In 2012, the Company adopted a new Long-Term Incentive Plan, which covers all executive officers, other than its Chairman of the Board and our Vice Chairman of the Board. The annual long-term incentive awards (LTI Awards) are made at targeted dollar levels and consist of Performance Units comprising 75% of the target value and cash-based Restricted Stock Units (RSUs) comprising 25% of the target value. The ultimate value of the Performance Units and RSUs can only be settled in cash.
Effective as of January 1, 2012, the Company granted Performance Units to various officers under the new Long-Term Incentive Plan. The value of the Performance Units will be based upon a performance measure established by our compensation committee. The performance measure for 2012 is the annual average return on assets for a three-year performance period (e.g., 2012 - 2014) at a targeted percentage return. Performance Units will be paid in cash at the end of the performance period subject to continued employment by the covered officer throughout the performance period and vest upon the occurrence of certain change in control events. As of December 31, 2012, the balance of the non-current liability for the Performance Units was approximately $242,000. For the year ended December 31, 2012, the Company recognized compensation expense of $242,000
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related to the Performance Units. Compensation expense is recognized over the performance period and is estimated based on the probability of achieving performance goals outlined in the plan. As of December 31, 2012, the total unrecognized compensation costs related to the Performance Units was approximately $484,000. The Company expects that these costs will be amortized to compensation expense over a weighted average period of 2.0 years.
Effective as of January 1, 2012, the Company granted 92,452 cash-based RSUs to various officers under the new Long-Term Incentive Plan. The RSUs vest at the end of the performance period subject to continued employment by the covered officer throughout the performance period (i.e., 3-year cliff vesting as of close of business on December 31 of the third year of the performance period) and vest upon the occurrence of certain change in control events. The payout of the RSUs will be made in cash at the end of the performance period based on number of RSUs times the average weighted trailing 3-month stock price of the Company as of December 31 of the third year of the performance period. As of December 31, 2012, the balance of the non-current liability for RSUs was approximately $101,000. For the year ended December 31, 2012, the Company recognized $101,000 in compensation expense related to the RSUs. As of December 31, 2012, the total unrecognized compensation costs related to the RSUs was $203,000. The Company expects that these costs will be amortized to compensation expense over a weighted average period of 2.0 years.
NOTE 18 - COMMITMENTS AND CONTINGENCIES
Operating Leases. The Company leases certain equipment and buildings under non-cancelable operating leases. The future minimum lease payments include payments required for the initial non-cancelable term of the operating lease plus any payments for periods of expected renewals provided for in the lease that the Company considers to be reasonably assured of exercising. The following table summarizes the future minimum lease payments as of December 31, 2012 (in thousands):
Rental expense was $10.2 million, $10.8 million and $11.5 million during the years ended December 31, 2010, 2011 and 2012, respectively.
Other. The Company is self-insured for certain elements of its employee benefits. Self-insurance liabilities are based on claims filed and estimates of claims incurred but not reported.
Under the terms of the Company’s agreement with its third-party lender in Texas, the Company is contractually obligated to reimburse the lender for the full amount of the loans and certain related fees that are not collected from the customers. See additional information in Note 13.
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Litigation. The Company is subject to various asserted and unasserted claims during the course of business. Due to the uncertainty surrounding the litigation process, except for those matters for which an accrual is described below, the Company is unable to reasonably estimate the range of loss, if any, in connection with the asserted and unasserted legal actions against it. Although the outcome of many of these matters is currently not determinable, the Company believes that it has meritorious defenses and that the ultimate cost to resolve these matters will not have a material adverse effect on the Company’s consolidated financial statements. In addition to the legal proceedings discussed below, the Company is subject to various legal proceedings arising from normal business operations.
The Company assesses the materiality of litigation by reviewing a range of qualitative and quantitative factors. These factors include the size of the potential claims, the merits of the Company’s defenses and the likelihood of plaintiffs’ success on the merits, the regulatory environment that could impact such claims and the potential impact of the litigation on its business. The Company evaluates the likelihood of an unfavorable outcome of the legal or regulatory proceedings to which it is a party in accordance with accounting guidance. This assessment is subjective based on the status of the legal proceedings and is based on consultation with in-house and external legal counsel. The actual outcomes of these proceedings may differ from the Company’s assessments.
North Carolina. On February 8, 2005, the Company, two of its subsidiaries, including its subsidiary doing business in North Carolina, and Mr. Don Early, the Company’s Chairman of the Board and Chief Executive Officer, were sued in Superior Court of New Hanover County, North Carolina in a putative class action lawsuit filed by James B. Torrence, Sr. and Ben Hubert Cline, who were customers of a Delaware state-chartered bank for whom the Company provided certain services in connection with the bank’s origination of payday loans in North Carolina, prior to the closing of the Company’s North Carolina branches in fourth quarter 2005. The lawsuit alleges that the Company violated various North Carolina laws, including the North Carolina Consumer Finance Act, the North Carolina Check Cashers Act, the North Carolina Loan Brokers Act, the state unfair trade practices statute and the state usury statute, in connection with payday loans made by the bank to the two plaintiffs through the Company’s retail locations in North Carolina. The lawsuit alleges that the Company made the payday loans to the plaintiffs in violation of various state statutes, and that if the Company is not viewed as the “actual lenders or makers” of the payday loans, its services to the bank that made the loans violated various North Carolina statutes. Plaintiffs are seeking certification as a class, unspecified monetary damages, and treble damages and attorney fees under specified North Carolina statutes. Plaintiffs have not sued the bank in this matter and have specifically stated in the complaint that plaintiffs do not challenge the right of out-of-state banks to enter into loans with North Carolina residents at such rates as the bank’s home state may permit, all as authorized by North Carolina and federal law.
In July 2011, the parties completed a weeklong hearing on the Company’s motion to enforce its class action waiver provision and its arbitration provision. In January 2012, the trial court denied the Company’s motion to enforce its class action and arbitration provisions. The Company has appealed that ruling to the North Carolina Court of Appeals. It is expected that the court will issue a decision by April 2013.
There were three similar purported class action lawsuits filed in North Carolina against three other companies unrelated to the Company. The plaintiffs in those three cases were represented by the same law firms as the plaintiffs in the case filed against the Company. Settlements in each of the three companion cases were reached by the end of 2010; however the settlements do not provide reasonable guidance on settlements in the Company’s case.
Canada. On September 30, 2011, the Company acquired all the outstanding shares of Direct Credit, a British Columbia company engaged in short-term, consumer Internet lending in certain Canadian provinces. On October 18, 2011, Matthew Lee, an alleged Alberta, Canada resident sued Direct Credit, all of its subsidiaries and
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three former directors of those subsidiaries in the Supreme Court of British Columbia in a purported class action. The plaintiff alleges that Direct Credit and its subsidiaries violated Canada’s criminal usury laws by charging interest on its loans at rates higher than 60%. The plaintiff purports to represent all Canadian borrowers of the subsidiary who resided outside of British Columbia.
Plaintiff seeks (i) class certification for the class described above, (ii) a declaration that loan fees collected in excess of the 60% limit in the cited usury statute are held by the defendants in constructive trust for the benefit of the class members, (iii) an accounting and restitution to plaintiff and class members of all loan fees received by the defendants, (iv) a declaration that the collection of the loan fees in excess of 60% per annum constitutes an unconscionable trade act or practice under the Canadian Business Practices Consumer Protection Act, (v) an order to restore to the class members the loan fees collected by defendants in excess of 60% per annum, and (vi) interest thereon. Direct Credit has not yet answered the civil claim of the plaintiff, but intends to defend itself, its subsidiaries and its former directors vigorously.
California. On August 13, 2012, the Company was sued in the United States District Court for the South District of California in a putative class action lawsuit filed by Paul Stemple. Mr. Stemple alleges that the Company used an automatic telephone dialing system with an “artificial or prerecorded voice” in violation of the Telephone Consumer Protection Act, 47 U.S.C. 227, et seq. The complaint does not identify any other members of the proposed class, nor how many members may be in the proposed class.
This matter is in the early stages of litigation. The Company has filed an answer denying all claims.
Other Matters. The Company is also currently involved in ordinary, routine litigation and administrative proceedings incidental to its business, including customer bankruptcies and employment-related matters from time to time. The Company believes the likely outcome of any other pending cases and proceedings will not be material to its business or its financial condition.
NOTE 19 - CERTAIN CONCENTRATIONS OF RISK
The Company is subject to regulation by federal and state governments in the United States that affect the products and services provided by the Company, particularly payday loans. The Company currently operates in 23 states throughout the United States and is engaged in consumer Internet lending in certain Canadian provinces. The level and type of regulation of payday loans varies greatly from state to state, ranging from states with no regulations or legislation to other states with very strict guidelines and requirements. The Company is also subject to foreign regulation in Canada where certain provinces have proposed substantive regulation of the payday loan industry.
Company short-term lending branches located in the states of Missouri, California and Kansas represented approximately 22%, 15%, 5%, respectively, of total revenues for the year ended December 31, 2012. Company short-term lending branches located in the states of Missouri, California, Kansas and New Mexico represented approximately 33%, 17%, 7% and 5%, respectively, of total gross profit for the year ended December 31, 2012. To the extent that laws and regulations are passed that affect the Company’s ability to offer loans or the manner in which the Company offers its loans in any one of those states, the Company’s financial position, results of operations and cash flows could be adversely affected. In recent years, the Company has experienced several negative effects resulting from law changes, for example:
•
The Arizona payday loan statutory authority expired by its terms on June 30, 2010, and the expiration of this law had a significant adverse effect on the revenues and profitability of the Company’s Arizona branches. For the year ended December 31, 2011, revenues and gross profit from the Arizona branches declined by $1.5 million and $1.4 million respectively, from the same period in the prior year. Prior to the expiration of the Arizona payday loan law, branches in Arizona accounted for more than 5% of the Company’s revenues and gross profits.
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•
In March 2011, a new payday law became effective in Illinois that imposes customer usage restrictions that has negatively affected revenues and profitability. This type of customer restriction, when passed in other states such as Washington, South Carolina and Kentucky, has resulted in a 30% to 60% decline in annual revenues and a more significant decline in gross profit, depending on the types of alternative products that competitors may offer within the state. The Illinois law provides for an overlap of the previous lending approach with loans issued under the new law for a period of one year, which extended the time period over which the negative effects of the new law occurred. During 2011, revenues from branches in Illinois declined by $2.4 million and gross profit declined by $2.2 million. In 2012, revenues and gross profit from Illinois declined by $2.0 million and $1.8 million, respectively. Prior to the change in the Illinois payday loan law, branches in Illinois accounted for more than 5% of the Company’s revenues and gross profits.
There was an effort in Missouri to place a voter initiative on the statewide ballot in November 2012, which was intended to preclude any lending in the state with an annual rate over 36%. The supporters of the voter initiative did not submit a sufficient number of valid signatures to place the initiative on the ballot in November 2012. However, a similar initiative was submitted to the Missouri Secretary of State in December 2012 for inclusion on the November 2014 ballot subject to the proponents submitting the required number of valid signatures in support of the initiative.
NOTE 20 - SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
The following table sets forth certain cash activities for the years ended December 31, 2010, 2011 and 2012 (in thousands):
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NOTE 21 - SELECTED QUARTERLY INFORMATION (Unaudited)
(a) The sum of the basic and diluted earnings per share for the four quarters does not equal the full year total for year ended 2012, as a result of issuances and repurchases of common stock.
(a) The sum of the basic and diluted earnings per share for the four quarters does not equal the full year total for years ended 2011, as a result of issuances and repurchases of common stock.
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NOTE 22 - SUBSEQUENT EVENTS
Restructuring. In January 2013, the Company announced to its employees a restructuring plan for the organization primarily due to a decline in loan volumes over the past few years as a result of shifting customer demand, the poor economy, regulatory changes and increasing competition in the short-term credit industry. The restructuring plan includes a 10% workforce reduction in field and corporate employees primarily due to the decision in 2012 to close 38 underperforming branches during the first half of 2013. Excluding the effect of the closed branches, the workforce reduction and related cost savings are expected to total approximately $3.0 to $3.5 million on an annual basis.
Equity Grant. On February 5, 2013, the Company granted 55,020 restricted shares to its non-employee directors under the 2004 plan. The total fair market value of the grant was approximately $188,000. The shares granted to the directors vested immediately upon the date of grant but may not be sold for six months after the date of grant.
Dividend. On February 5, 2013, the Company’s board of directors declared a regular quarterly dividend of $0.05 per common share per common share. The dividend was paid on March 14, 2013 to stockholders of record as of February 28, 2013. The amount of the dividend paid was approximately $900,000.
QC HOLDINGS, INC. AND SUBSIDIARIES
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QC HOLDINGS, INC. AND SUBSIDIARIES
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QC HOLDINGS, INC. AND SUBSIDIARIES
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QC HOLDINGS, INC. AND SUBSIDIARIES
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Exhibit
No.
Description of Document
The following information from the QC Holdings, Inc. Annual Report on Form 10-K for the year ended December 31, 2011, formatted in Extensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Income, (iii) Consolidated Statements of Stockholders’ Equity, (iv) Consolidated Statements of Cash Flows, and (v) related Notes to the Consolidated Financial Statements, tagged as blocks of text.
* Filed herewith.