ITEM 1. BUSINESS.
INTRODUCTION
The following discussion relates to The FINOVA Group Inc. and its subsidiaries (collectively "FINOVA" or the "Company"), including FINOVA Capital Corporation and its subsidiaries ("FINOVA Capital").
GENERAL
The FINOVA Group Inc. is a financial services holding company. Through its principal subsidiary, FINOVA Capital, the Company provides a broad range of financing and capital market products. FINOVA concentrates on lending to mid-size businesses. FINOVA Capital has been in operation since 1954.
FINOVA extends revolving credit facilities, term loans and equipment and real estate financing primarily to "middle-market" businesses with financing needs falling generally between $500,000 and $35 million.
FINOVA operates in 18 specific industry or market niches under three market groups. FINOVA selected these niches because its expertise in evaluating the creditworthiness of prospective customers and its ability to provide value-added services enables the Company to differentiate itself from its competitors. That expertise and ability also enable FINOVA to command pricing that provides a satisfactory spread over its borrowing costs.
FINOVA seeks to maintain a high quality portfolio and to minimize non-earning assets and write-offs. FINOVA uses clearly defined underwriting criteria and stringent portfolio management techniques. The Company diversifies its lending activities geographically and among a range of industries, customers and loan products.
Due to the diversity of FINOVA's portfolio, the Company believes it is better able to manage competitive changes in its markets and to withstand the impact of deteriorating economic conditions on a regional or national basis. There can be no assurance, however, that competitive changes, borrowers' performance, economic conditions or other factors will not result in an adverse impact on FINOVA's results of operations or financial condition.
FINOVA generates interest, leasing, fees and other income through charges assessed on outstanding loans, loan servicing, leasing, brokerage and other activities. FINOVA's primary expenses are the costs of funding the loan and lease business, including interest paid on debt, provisions for credit losses, marketing expenses, salaries and employee benefits, servicing and other operating expenses and income taxes.
FINOVA's principal executive offices are located at 1850 North Central Avenue, P.O. Box 2209, Phoenix, Arizona 85002-2209, telephone (602) 207-4900. FINOVA also has business development offices throughout the U.S. and in London, U.K. and Toronto, Canada.
BUSINESS GROUPS
FINOVA operates the following principal lines of business under three market groups:
Commercial Finance
- Business Credit offers collateral-oriented revolving credit facilities and term loans for manufacturers, distributors, wholesalers and service companies. Typical transaction sizes range from $500,000 to $3 million.
- Commercial Services (formerly Factoring Services) offers full service factoring and accounts receivable management services for entrepreneurial and larger firms, primarily in the textile and apparel industries. The annual factored volume of these companies is generally between $5 million and $25 million. This line provides accounts receivable financing and loans secured by equipment and real estate.
- Corporate Finance provides a full range of cash flow-oriented and asset-based term and revolving loan products for manufacturers, wholesalers, distributors, specialty retailers and commercial and consumer service businesses. Typical transaction sizes range from $2 million to $35 million.
- Distribution & Channel Finance (formerly Inventory Finance) provides inbound and outbound inventory financing, combined inventory/accounts receivable lines of credit and purchase order financing for equipment distributors, value-added resellers and dealers nationwide. Transaction sizes generally range from $500,000 to $30 million.
- Growth Finance provides collateral based working capital financing primarily secured by accounts receivable. Typical transaction sizes range from $100,000 to $1 million and are made to small and midsize businesses with annual sales under $10 million.
- Rediscount Finance offers revolving credit facilities to the independent consumer finance industry including sales, automobile, mortgage and premium finance companies. Typical transaction sizes range from $1 million to $35 million.
Specialty Finance
- Commercial Equipment Finance offers equipment leases, loans and "turnkey" financing to a broad range of midsize companies. Specialty markets include the corporate aircraft and emerging growth technology industries, primarily biotechnology and electronics. Typical transaction sizes range from $500,000 to $15 million.
- Communications Finance specializes in term financing to advertising and subscriber-supported businesses, including radio and television stations, cable operators, outdoor advertising firms and publishers. Typical transaction sizes range from $1 million to $40 million.
- Franchise Finance offers equipment, real estate and acquisition financing for operators of established franchise concepts. Transaction sizes generally range from $500,000 to $15 million.
- Healthcare Finance offers a full range of working capital, equipment and real estate financing products for the U.S. healthcare industry. Transaction sizes typically range from $500,000 to $25 million.
- Portfolio Services provides customized receivable servicing and collections for timeshare developers and other generators of consumer receivables.
- Public Finance provides tax-exempt term financing to state and local governments, non-profit corporations and entities using industrial revenue or development bonds. Typical transaction sizes range from $100,000 to $5 million.
- Resort Finance focuses on construction, acquisition and receivables financing of timeshare resorts worldwide as well as term financing for established golf resort hotels and receivables funding for developers of second home communities. Typical transaction sizes range from $5 million to $35 million.
- Specialty Real Estate Finance provides term financing for hotel, anchored retail office and owner-occupied properties. Typical transaction sizes range from $5 million to $30 million.
- Transportation Finance structures equipment loans, leases, acquisition financing and leveraged lease equity investments for commercial and cargo airlines worldwide, railroads and operators of other transportation related equipment. Typical transaction sizes range from $5 million to $30 million. Through FINOVA Aircraft Investors, LLC, FINOVA also seeks to use its market expertise and industry presence to purchase, upgrade and resell used commercial aircraft.
Capital Markets
- Realty Capital specializes in providing capital markets-funded commercial real estate financing products and commercial mortgage banking services. Typical transaction sizes range from $1 million to $5 million.
- Investment Alliance provides equity and debt financing for midsize businesses in partnership with institutional investors and selected fund sponsors. Typical transaction sizes range from $2 million to $15 million.
- Loan Administration provides in-house servicing for FINOVA's commercial loan products as well as servicing and sub-servicing of other mortgage and consumer loans, including residential real estate, mobile homes, automobiles and other consumer products.
FINOVA is a Delaware corporation. The Company was incorporated in 1991 to serve as the successor to The Dial Corp's financial services businesses. In March 1992, Dial transferred those businesses to FINOVA in a spin-off. Since that time, FINOVA has increased its total assets from $2.6 billion at December 31, 1992 to $10.5 billion at December 31, 1998. Income from continuing operations increased from $36.8 million in 1992 to $169.7 million in 1998. Management believes FINOVA ranks among the largest independent commercial finance companies in the U.S., based on total assets. FINOVA's common stock is traded on the New York Stock Exchange under the symbol "FNV."
PORTFOLIO COMPOSITION
The total assets under management consist of FINOVA's net investment in financing transactions plus certain assets that are owned by others but managed by the Company and are not reported on the Company's balance sheet (securitized assets and participations sold). The Company's investment in financing transactions is primarily settled in U.S. dollars.
INVESTMENT IN FINANCING TRANSACTIONS
The following tables detail FINOVA's investment in financing transactions (before reserve for credit losses) at December 31, 1998, 1997, 1996, 1995 and 1994.
INVESTMENT IN FINANCING TRANSACTIONS BY TYPES OF FINANCING (DOLLARS IN THOUSANDS)
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(1) Excludes managed assets serviced under the mini-CMBS structure due to the expected short-term nature of the servicing rights. For further discussion see Annex A, Note C.
INVESTMENT IN FINANCING TRANSACTIONS BY LINE OF BUSINESS DECEMBER 31, 1998 (DOLLARS IN THOUSANDS)
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(1) Represents original or renegotiated market rate terms, excluding impaired transactions.
(2) The Company earned income totaling $4.7 million on repossessed assets during 1998, including $2.4 million in Specialty Real Estate Finance, $1.0 million in Resort Finance, $0.9 million in Healthcare Finance, $0.2 million in Rediscount Finance and $0.2 million in Commercial Equipment Finance.
(3) Transportation Finance includes $419.7 million of aircraft financing business booked through the London office.
(4) Excludes $537.6 million of assets securitized and participations sold which the Company manages, including securitizations of $300.0 million in Corporate Finance and $136.1 million in Franchise Finance and participations of $49.3 million in Corporate Finance, $21.4 million in Communications Finance, $5.4 million in Resort Finance, $6.9 million in Rediscount Finance, $3.8 million in Business Credit, $12.6 million in Transportation Finance and $2.1 million in Distribution & Channel Finance.
(5) Primarily includes other assets retained from disposed or discontinued operations.
INVESTMENT IN FINANCING TRANSACTIONS BY LINE OF BUSINESS DECEMBER 31, 1997 (DOLLARS IN THOUSANDS)
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(1) Represents original or renegotiated market rate terms, excluding impaired transactions.
(2) The Company earned income totaling $4.1 million on repossessed assets during 1998, including $3.1 million in Specialty Real Estate Finance and $1.0 million in Resort Finance.
(3) Transportation Finance includes $302.9 million of aircraft financing business booked through the London office.
(4) Excludes assets securitized and participations sold which the Company manages, including securitizations of $300.0 million in Corporate Finance and $36.6 million in Franchise Finance and participations of $40.2 million in Corporate Finance, $61.0 million in Communications Finance, $8.5 million in Transportation Finance, $4.6 million in Rediscount Finance, $5.1 million in Resort Finance and $1.9 million in Distribution & Channel Finance.
(5) Primarily includes other assets retained from disposed or discontinued operations.
INVESTMENT IN FINANCING TRANSACTIONS BY LINE OF BUSINESS DECEMBER 31, 1996 (DOLLARS IN THOUSANDS)
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(1) Represents original or renegotiated market rate terms, excluding impaired transactions.
(2) The Company earned income totaling $5.1 million on repossessed assets during 1996, including $4.4 million in Specialty Real Estate Finance and $0.7 million in Resort Finance.
(3) Transportation Finance includes $160.8 million of aircraft financing business booked through the London office.
(4) Excludes assets securitized and participations sold which the Company manages, including securitizations of $300.0 million in Corporate Finance and participations of $24.6 million in Corporate Finance, $27.5 million in Communications Finance, $4.8 million in Rediscount Finance, $4.4 million in Resort Finance and $3.2 million in Distribution & Channel Finance.
(5) Reflects assets retained by FINOVA subsequent to the sale of the Manufacturer and Dealer Services' line of business.
INVESTMENT IN FINANCING TRANSACTIONS BY LINE OF BUSINESS DECEMBER 31, 1995 (DOLLARS IN THOUSANDS)
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(1) Represents original or renegotiated market rate terms, excluding impaired transactions.
(2) The Company earned income totaling $4.2 million on repossessed assets during 1995, including $3.2 million in Specialty Real Estate Finance, $0.6 million in Resort Finance and $0.4 million in Communications Finance.
(3) Transportation Finance includes $144 million of aircraft financing business booked through the London office.
(4) Excludes $200 million of securitized assets which are managed by the Company.
INVESTMENT IN FINANCING TRANSACTIONS BY LINE OF BUSINESS DECEMBER 31, 1994 (DOLLARS IN THOUSANDS)
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(1) The Company earned income totaling $3.3 million on repossessed assets during 1994, including $2.0 million in Specialty Real Estate Finance, $0.8 million in Communications Finance and $0.5 million in Resort Finance.
(2) Transportation Finance includes $66.9 million of aircraft finance business booked through the London office.
(3) Includes transactions in Europe and elsewhere (including the U.S.) originated from the Company's London office. Also, includes $39.2 million of Consumer Finance assets, of which $4.8 million were nonaccruing. Consumer Finance accounts were generally considered nonaccruing after being 180 days delinquent.
The Company's geographic portfolio diversification at December 31, 1998 was as follows:
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(1) Other includes all other states which, on an individual basis, represent less than 2% of the total and international, which represents approximately 6% of the total.
The following is an analysis of the reserve for credit losses for the years ended December 31:
Included above is a specific impairment reserve of $37.1 million at December 31, 1998, which applies to $98.7 million of the $225.7 million of impaired loans. The remaining $170.5 million of the reserve for credit losses is designated for general purposes and represents management's best estimate of potential losses in the portfolio considering delinquencies, loss experience and collateral. At December 31, 1997, the specific impairment reserve was $20.2 million, which applied to $52.3 million of the $158.0 million of impaired loans. Additions to general and specific reserves are reflected in current operations. Management may transfer reserves between the general and specific reserves as appropriate.
Write-offs and recoveries by line of business, during the years ended December 31, were as follows:
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(1) Includes FINOVA Capital Ltd. (UK).
(2) Excludes average participations sold in which FINOVA has transferred credit risk.
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A further breakdown of the portfolio by line of business can be found in Annex A, Notes C and D.
COST AND USE OF BORROWED FUNDS
FINOVA Capital relies on borrowed funds as well as internal cash flow to finance its operations. It also has raised funds through the sale or securitization of assets, but does not rely on those methods as a primary source of capital.
The following table reflects the approximate average pre-tax effective cost of borrowed funds and pre-tax equivalent rate earned on accruing assets for FINOVA Capital for each of the periods listed:
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(1) Includes the effects of interest rate swap and hedge agreements.
(2) Earning assets are net of average nonaccruing assets and average deferred taxes applicable to leveraged leases.
(3) Earned amounts are net of depreciation.
(4) Represents operating margin as a percentage of average earning assets.
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The effective costs presented above include costs of commitment fees and related borrowing costs. They do not necessarily predict future costs of funds. For further information on FINOVA Capital's cost of funds, refer to Annex A, Notes E and F.
Following are the ratios of income to combined fixed charges and preferred stock dividends ("ratio") for each of the past five years:
Variations in interest rates generally do not have a substantial impact on the ratio because fixed-rate and floating-rate assets are generally matched with liabilities of similar rate and term.
Income for combined fixed charges, for purposes of the computation of the above ratio, consists of income from continuing operations before income taxes and fixed charges. Combined fixed charges include interest and related debt expense, a portion of rental expense representative of interest, and preferred stock dividends grossed up to a pre-tax basis.
MATCHED FUNDING POLICY
FINOVA Capital follows a "matched funding" policy. Under that policy, it funds its floating-rate assets (loans and leases to FINOVA's borrowers) with floating-rate liabilities (FINOVA's debt) and fixed-rate assets with fixed-rate liabilities, to the extent feasible. This policy helps protect FINOVA from changes in interest rates. For further discussion on FINOVA Capital's debt and matched funding policy, see Annex A, Notes E and F.
CREDIT RATINGS
FINOVA Capital currently has investment-grade credit ratings from the following rating agencies:
In addition, FINOVA Finance Trust, a subsidiary trust of the Company, issued mandatory redeemable convertible preferred securities ("TOPrS") in December 1996 having investment-grade ratings as follows:
For further information relating to the TOPrS, refer to Annex A, Note G.
Standard & Poor's Ratings Group changed on February 26, 1999 its rating of the TOPrS from BBB+ to BBB. The rating change was not a downgrade, but resulted from the new rating scale under which Standard & Poor's Ratings Group rates preferred stock two notches below the corporate or counter party credit rating of an investment-grade issuer such as FINOVA.
There can be no assurance that these ratings will be maintained. The ratings can be modified at any time. A credit rating is not a recommendation to buy, sell or hold securities. Each rating should be evaluated independently of any other rating. None of FINOVA Capital's subsidiaries have applied for credit ratings.
RESIDUAL REALIZATION EXPERIENCE
Each year since its inception, FINOVA Capital and its predecessors have earned total proceeds from the sale of assets upon lease termination (other than foreclosures) in excess of carrying amounts. There can be no assurance, however, that those results can be achieved in future years. Actual proceeds will depend on current market values for those assets at the time of sale. While market values are generally beyond the control of FINOVA, the Company has some discretion in the timing of sales of the assets. Sales proceeds on lease terminations in excess of carrying amounts are reported as gains on disposal of assets when the assets are sold.
Income from leasing transactions is affected by gains from asset sales on lease termination and, hence, can be somewhat less predictable than income from non-leasing activities. During the five years ended December 31, 1998, the proceeds to FINOVA Capital from sales of assets on early
termination of leases and at the expiration of leases have exceeded the carrying amounts and estimated residual values as follows:
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(1) Excludes foreclosures for credit reasons, which are immaterial.
The estimated residual value of direct finance and leveraged lease assets in the accounts of FINOVA Capital at December 31, 1998 was 37.3% of the original cost of those assets (30.1% excluding the original costs of the assets and residuals applicable to real estate leveraged leases, which typically have higher residuals than other leases). The financing contracts and leases outstanding at that date had initial terms ranging generally from one to 25 years. The average initial term weighted by carrying amount at inception and the average remaining term weighted by remaining carrying amount of financing contracts at December 31, 1998 for financing contracts excluding leveraged leases were 7.5 and 5.4 years, respectively, and for leveraged leases were approximately 18.9 and 11.4 years, respectively. The comparable average initial term and remaining term at December 31, 1997 for financing contracts excluding leveraged leases were 7.6 and 5.1 years, respectively, and for leveraged leases were approximately 17.5 and 11.9 years, respectively. FINOVA Capital uses either employed or outside appraisers to determine the collateral value of assets to be leased or financed and the estimated residual or collateral value thereof at the expiration of each lease. Actual proceeds could differ from those appraised values.
For a discussion of accounting for lease transactions, refer to Annex A, Notes A and C.
BUSINESS DEVELOPMENT AND COMPETITION
FINOVA Capital develops business primarily through direct solicitation by its own sales force. Customers are also introduced by independent brokers and referred by other financial institutions and other sources.
FINOVA Capital is engaged in an extremely competitive activity. It competes with banks, insurance companies, leasing companies, the credit units of equipment manufacturers and other finance companies. Some of these competitors have substantially greater financial resources and are able to borrow at costs below those of FINOVA Capital. FINOVA Capital's principal means of competition is through a combination of service, structure and innovation in transactions, the interest rate charged for money and concentration in focused market niches. The interest rate FINOVA Capital charges for money is a function of its borrowing costs, its operating costs and other factors. While many of FINOVA Capital's larger competitors are able to offer lower interest rates based upon their lower borrowing costs, FINOVA Capital seeks to maintain the competitiveness of the interest rates it offers by emphasizing strict control of its operating costs. FINOVA's ability to manage costs is, in part, dependent on factors beyond the Company's control, such as the cost of funds, outside litigation expenses and competitive salaries.
CREDIT QUALITY
FINOVA Capital has maintained a high-quality asset base through the use of clearly defined underwriting standards, portfolio management techniques, monitoring of covenant compliance and active collections and workout efforts.
RISK MANAGEMENT
FINOVA Capital generally investigates its prospective customers through a review of historical financial statements, published credit reports, credit references, discussions with management, analysis of location feasibility, personal visits and collateral appraisals and inspections. In many cases, depending upon the results of its credit investigations and the nature of the financing being provided, FINOVA Capital obtains additional collateral or guarantees from others. As part of its underwriting process, FINOVA Capital considers the management, industry, financial position and collateral being provided by a proposed borrower or lessee. The purpose, term, amortization and amount of any proposed transaction generally must be clearly defined and within established corporate guidelines. In addition, FINOVA attempts to avoid undue concentrations in any one customer, industry or geographic region.
- Management. FINOVA Capital considers the reputation, experience and depth of management; quality of product or service; adaptability to changing markets and demand; and prior banking, finance and trade relationships.
- Industry. FINOVA Capital evaluates critical aspects of each industry to which it lends, including general trend, seasonality and cyclicality; governmental regulation; the effects of taxes; the economic value of goods or services provided; and potential environmental or other liabilities.
- Financial. FINOVA Capital's review of a prospective borrower normally includes a thorough analysis of the borrower's financial performance. Items considered include net worth; composition of assets and liabilities; debt service coverage; liquidity; sales growth and earning power; and cash flow generation and reliability.
- Collateral. FINOVA Capital regards collateral as an important factor in a credit evaluation and, for collateral dependent transactions, has established maximum loan to value ratios, normally ranging from 60%-90%, for each of its lines of business.
The underwriting process includes, in addition to the analysis of the factors noted above, the design and implementation of transaction structures and strategies to mitigate identified risks; a review of transaction pricing relative to product-specific return requirements and acknowledged risk elements; a multi-step, interdepartmental review and approval process with varying levels of authority based on the size of the transaction; and periodic interdepartmental reviews and revision of underwriting guidelines.
FINOVA Capital also monitors portfolio concentrations in the areas of total exposure to a single borrower and related entities, within a given geographical area and with respect to an industry and/or product type within an industry. FINOVA Capital has established concentration guidelines for each line of business. Geographic concentrations are reviewed periodically and evaluated based on historic loan experience and prevailing market and economic conditions.
FINOVA Capital's financing contracts and leases generally require the customer to pay taxes, license fees and insurance premiums and to perform maintenance and repairs at the customer's expense. Contract payment rates are based on several factors, including the cost of borrowed funds, term of contract, credit-worthiness of the prospective customer, type and nature of collateral and other security and, in leasing transactions, the timing of tax effects and estimated residual values. In direct finance lease transactions, lessees generally are granted an option to purchase the equipment at the end of the lease term at its then fair market value or, in some cases, are granted an
option to renew the lease at its then fair rental value. The extent to which lessees exercise their options to purchase leased equipment varies from year to year, depending on, among other factors, the state of the economy, the financial condition of the lessee, interest rates and technological developments.
PORTFOLIO MANAGEMENT
In addition to the review at the time of original underwriting, FINOVA Capital attempts to preserve and enhance the earnings quality of its portfolio through proactive management of its financing relationships with its clients. This process includes the periodic appraisal or verification of the collateral to determine loan exposure and residual values; sales of residuals and warrants to generate supplemental income; and review and management of covenant compliance. The Portfolio Management department or dedicated personnel within the business units regularly review financial statements to assess customer cash flow performance and trends; periodically confirm operations of the customer; conduct periodic reappraisals of the underlying collateral; seek to identify issues concerning the vulnerabilities of the customer; seek to resolve outstanding issues with the borrower; periodically review and address covenant compliance issues; and prepare periodic summaries of the aggregate portfolio quality and concentrations for management review.
Evaluation for loan impairment is performed as a part of the portfolio management review process. When a loan is determined to be impaired, a write-down is taken or an impairment reserve is established based on the difference between the recorded balance of the loan ("carrying amount") and the fair value of the asset.
DELINQUENCIES AND WORKOUTS
FINOVA Capital monitors the timing of payments on its accounts. For term loans and leases, when an invoice is 10 days past due, the customer is generally contacted, and a determination is made as to the extent of the problem, if any. A commitment for immediate payment is pursued and the account is observed closely. If satisfactory results are not obtained in communication with the customer, the guarantor(s) are usually contacted to advise them of the situation and the potential obligation under the guarantee agreement. If an invoice becomes 31 days past due, it is reported as delinquent. A notice of default is generally sent prior to an invoice becoming 45 days past due and, between 60 and 90 days past the due date, if satisfactory negotiations are not underway, outside counsel generally is retained to help protect FINOVA Capital's rights and to pursue its remedies.
When accounts become more than 90 days past due income recognition is usually suspended, and FINOVA Capital vigorously pursues its legal remedies. Foreclosed or repossessed assets are considered to be nonperforming, and are reported as such unless the assets generate sufficient cash to result in a reasonable rate of return. Those accounts are continually reviewed, and write- downs are taken as deemed necessary. While pursuing collateral and obligors, FINOVA Capital generally continues to negotiate the restructuring or other settlement of the debt, as appropriate.
Management believes that collateral values significantly reduce loss exposure and that the reserve for credit losses is adequate. For additional information regarding the reserve for credit losses, see Annex A, Note D.
GOVERNMENTAL REGULATION
FINOVA Capital's domestic activities, including the financing of its operations, are subject to a variety of federal and state regulations such as those imposed by the Federal Trade Commission, the Securities and Exchange Commission, the Consumer Credit Protection Act, the Equal Credit Opportunity Act and the Interstate Land Sales Full Disclosure Act. Additionally, a majority of states have ceilings on interest rates chargeable to customers in financing transactions. Some of FINOVA Capital's financing transactions and mortgage broker activities are subject to additional government regulation. For example, aircraft leasing is regulated by the Federal Aviation Administration , and
Communications Finance is regulated by the Federal Communication Commission. FINOVA Capital's international activities are also subject to a variety of laws and regulations of the countries in which the business is conducted.
EMPLOYEES
At December 31, 1998, the Company had 1,262 employees compared to 958 at December 31, 1997. The increase primarily included employees from FINOVA Realty Capital ("FRC"), which was not consolidated until 1998, and employees from companies acquired in 1998. None of the employees were covered by collective bargaining agreements. FINOVA believes its employee relations are satisfactory.
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Certain statements in this report are "forward-looking," in that they do not discuss historical fact but instead note future expectations, projections, intentions or other items. These forward-looking statements include matters in the sections of this report captioned "Business" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Quantitative and Qualitative Disclosures About Market Risk". They are also made in documents incorporated in this report by reference, or in which this report may be incorporated, such as a prospectus.
Forward-looking statements are subject to known and unknown risks, uncertainties and other factors that may cause FINOVA's actual results or performance to differ materially from those contemplated by the forward-looking statements. Many of those factors are noted in conjunction with the forward-looking statements in the text. Other important factors that could cause actual results to differ include:
- The results of FINOVA's efforts to implement its business strategy. Failure to fully implement its business strategy might result in decreased market penetration, adverse effects on results of operations and other adverse results.
- The effect of economic conditions and the performance of FINOVA's borrowers. Economic conditions in general or in particular market segments could impact the ability of FINOVA's borrowers to operate or expand their businesses, which might result in decreased performance for repayment of their obligations or reduce demand for additional financing needs. The rate of borrower defaults or bankruptcies may increase.
- Actions of FINOVA's competitors and FINOVA's ability to respond to those actions. As noted in "Business Development and Competition," FINOVA seeks to remain competitive without sacrificing prudent lending standards. Doing business under those standards becomes more difficult, however, when competitors offer financing with lower pricing or less stringent criteria. FINOVA may not be successful in maintaining and continuing asset growth at historic levels.
- The cost of FINOVA's capital. That cost depends on many factors, some of which are beyond FINOVA's control, such as its portfolio quality, ratings, prospects and outlook. Changes in the interest rate environment may reduce or eliminate profit margins.
- Changes in government regulations, tax rates and similar matters. For example, government regulations could significantly increase the cost of doing business or could eliminate certain tax advantages of some of FINOVA's financing products.
- Necessary technological changes (including those addressing "Year 2000" data systems issues) may be more difficult, expensive or time consuming than anticipated.
- Costs or difficulties related to integration of acquisitions.
- Other risks detailed in FINOVA's other SEC reports or filings.
FINOVA does not intend to update forward-looking information to reflect actual results or changes in assumptions or other factors that could affect those statements. FINOVA cannot predict the risk from reliance on forward-looking statements in light of the many factors that could affect their accuracy.
ITEM 2.
ITEM 2. PROPERTIES.
FINOVA's principal executive offices are located in premises leased from FP Arizona, Inc. in Phoenix, Arizona. FINOVA Capital operates various additional offices in the United States, one in Canada and one in Europe. All these properties are leased. Alternative office space could be obtained without difficulties in the event leases are not renewed. FINOVA has entered into a lease agreement for new executive offices which are presently under construction. Those facilities are expected to be completed in the fourth quarter of 1999.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
FINOVA is a party either as plaintiff or defendant to various actions, proceedings and pending claims, including legal actions, some of which involve claims for compensatory, punitive or other damages in significant amounts. Litigation often results from FINOVA's attempts to enforce its lending agreements against borrowers and other parties to those transactions. Litigation is subject to many uncertainties. It is possible that some of the legal actions, proceedings or claims could be decided against FINOVA. Although the ultimate amount for which FINOVA may be held liable, if any, is not ascertainable, FINOVA believes that any resulting liability would not materially affect its financial position or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of security holders during the fourth quarter of 1998.
OPTIONAL ITEM. EXECUTIVE OFFICERS OF REGISTRANT.
Set forth below is information with respect to those individuals who serve as executive officers of FINOVA, including those officers of FINOVA Capital who are responsible for its principal business units.
PART II
ITEM 5.
ITEM 5. MARKET PRICE OF AND DIVIDENDS ON THE REGISTRANT'S COMMON EQUITY & RELATED SHAREOWNER MATTERS.
The FINOVA Group Inc.'s common stock trades on the New York Stock Exchange. The following tables summarize the high and low market prices as reported on the New York Stock Exchange Composite Tape and the cash dividends declared from January 1, 1997 through December 31, 1998. Amounts have been restated to give effect to a stock split effective October 1, 1997.
Quarterly dividends have been paid on the first business day of each calendar quarter. FINOVA anticipates it will continue to pay regular quarterly dividends on the first business day of January, April, July and October. In February 1999, the Board of Directors declared a dividend of $0.16 per share, payable April 1, 1999, for shareowners of record on February 26, 1999. The declaration of dividends and their amounts are at the discretion of the Board of Directors of FINOVA, and there can be no assurance that additional dividends will be declared.
FINOVA Capital is restricted in its ability to pay dividends to The FINOVA Group Inc. The agreements pertaining to long-term debt include various restrictive covenants and require the maintenance of certain defined financial ratios with which FINOVA and FINOVA Capital have complied. Under one of these covenants, dividend payments from FINOVA Capital to FINOVA Group are limited to 50 percent of accumulated earnings after December 31, 1991.
As of February 26, 1999, there were approximately 22,200 holders of record of The FINOVA Group Inc.'s common stock. The closing price of the common stock on that date was $50 13/16.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
The following table summarizes selected financial data of FINOVA, which have been derived from the audited Consolidated Financial Statements of FINOVA for each of the years ended December 31, 1998, 1997, 1996, 1995 and 1994. The information set forth below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations," the Consolidated Financial Statements of FINOVA and the Notes included in Annex A, as well as the remainder of this report. Prior years have been reclassified to conform to 1998 presentation and restated to exclude operations which were discontinued in 1996 and to reflect a two-for-one stock split in 1997; for further detail, see Annex A, Note H.
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(1) Managed assets exclude participations.
(2) Managed assets exclude financing contracts held for sale.
(3) Equity in 1998, 1997 and 1996 includes the TOPrS noted above.
(4) Return represents income from continuing operations.
(5) Average funds employed excludes deferred taxes applicable to leveraged leases.
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ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
See pages 3 -- 12 of Annex A.
ITEM 7A
ITEM 7A QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
See pages 12 -- 13 of Annex A.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS & SUPPLEMENTARY DATA.
1. Financial Statements -- See Item 14 hereof and Annex A.
2. Supplementary Data -- See Condensed Quarterly Results included in Supplemental Selected Financial Data of Notes to Consolidated Financial Statements included in Annex A.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING & FINANCIAL DISCLOSURE.
NONE.
PART III
ITEM 10.
ITEM 10. DIRECTORS & EXECUTIVE OFFICERS OF THE REGISTRANT.
The information concerning FINOVA's directors is incorporated by reference from FINOVA's Proxy Statement issued in connection with its 1999 Annual Meeting of Shareowners (the "Proxy Statement").
For information regarding FINOVA's executive officers, see the Optional Item in Part I, following Item 4.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The information required by this item is incorporated by reference from the Proxy Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS & MANAGEMENT.
The information required by this item is incorporated by reference from the Proxy Statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS & RELATED TRANSACTIONS.
The information required by this item is incorporated by reference from the Proxy Statement.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) Documents filed.
1. Financial Statements.
(i) The following financial statements of FINOVA are included in Annex A:
2. All Schedules have been omitted because they are not applicable or the required information is shown in the financial statements or related notes.
3. Exhibits.
- --------------- * Filed with this report.
+ Relating to management compensation.
(b) Reports on Form 8-K.
A report on Form 8-K, dated January 14, 1999, was filed by FINOVA which reported under Items 5 and 7 the revenues, net income and selected financial data and ratios for the fourth quarter and year ended December 31, 1998 (unaudited).
A report on Form 13-D, dated January 6, 1999, was filed by FINOVA which reported under Item 4 the Agreement and Plan of Merger between FINOVA and Sirrom Capital Corporation.
SIGNATURES
Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized in the capacities indicated, in Phoenix, Arizona on March 1, 1999.
THE FINOVA GROUP INC.
By: /s/ SAMUEL L. EICHENFIELD
------------------------------------ Samuel L. Eichenfield Chairman, President and Chief Executive Officer (Chief Executive Officer)
By: /s/ BRUNO A. MARSZOWSKI
------------------------------------ Bruno A. Marszowski Senior Vice President -- Controller and Chief Financial Officer (Chief Accounting and Financial Officer)
Pursuant to the requirements of the Securities Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated:
- ---------------
* Signed pursuant to Powers of Attorney dated February 11, 1999.
ANNEX A
THE FINOVA GROUP INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
A-ii
THE FINOVA GROUP INC.
FINANCIAL HIGHLIGHTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
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- --------------- (1) Includes assets sold under securitization and participation agreements that are managed by the Company; however, excludes managed assets serviced under the mini-CMBS structure due to the expected short-term nature of the servicing rights.
(2) Includes average securitizations and participations of $484.5 million, $388.9 million and $327.4 million for 1998, 1997 and 1996, respectively.
(3) Represents average funds employed excluding average deferred taxes on leveraged leases of $275.9 million, $234.4 million and $237.8 million for 1998, 1997 and 1996, respectively, and average nonaccruing assets.
(4) Includes nonaccruing assets classified as discontinued operations at December 31, 1996.
(5) Excludes participations sold of $101.5 million, $121.4 million and $64.5 million for 1998, 1997 and 1996, respectively, in which the Company has transferred credit risk.
(6) Excludes financing contracts held for sale of $241.9 million for 1998.
(7) Average funds employed excludes average deferred taxes on leveraged leases.
(8) Shares for 1997 and 1996 have been adjusted to reflect a two-for-one stock split on October 1, 1997.
(9) Diluted earnings per share include the dilutive potential of options, restricted stock and convertible preferred stock.
(10) Represents net income before preferred dividends plus non-cash taxes, loss provision and goodwill amortization. Excluding non-cash mini-CMBS transactions, cash earnings per share were $4.24 for 1998. See Note C of Notes to Consolidated Financial Statements for a further discussion of the mini-CMBS transactions.
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THE FINOVA GROUP INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion relates to The FINOVA Group Inc. and its subsidiaries (collectively, "FINOVA" or the "Company"), including FINOVA Capital Corporation and its subsidiaries (collectively, "FINOVA Capital").
RESULTS OF OPERATIONS
The following table summarizes FINOVA's operating results for the years ended December 31, 1998, 1997 and 1996:
1998 COMPARED TO 1997
Net income for 1998 increased 22.0% to $169.7 million from $139.1 million in 1997. The increase was due to the growth in average earning assets, the expansion of the fee-related businesses and higher gains on disposal of assets. Partially offsetting these increases were a higher provision for credit losses, increased operating expenses and a higher effective tax rate. Net income in 1998 included a full year of FINOVA Realty Capital ("FRC") and AT&T Capital's Inventory Finance unit, both of which were acquired in the fourth quarter of 1997. See Note B of Notes to Consolidated Financial Statements for further discussion.
INTEREST MARGINS EARNED. The net spread from the portfolio is represented by interest margins earned, which is the difference between (a) income earned from financing transactions and (b) interest expense and depreciation on operating leases and other owned assets. Interest margins earned increased 15.6% to $472.5 million in 1998 from $408.9 million in 1997, due primarily to a 16.1% increase in average earning assets in 1998.
Average earning assets, which represents the average of FINOVA's investment in financing transactions less nonaccruing assets and deferred taxes related to leveraged leases, increased to $8.54 billion in 1998 from $7.36 billion in 1997. The increase was primarily due to a 20.2% increase in funded new business of $3.98 billion compared to $3.31 billion in 1997, partially offset by normal amortization of the portfolio and prepayments during the year.
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VOLUME-BASED FEES. Volume-based fees are generated by FINOVA's Distribution & Channel Finance (formerly Inventory Finance), Commercial Services (formerly Factoring Services) and FRC lines of business. These fees are predominantly based on volume-originated business rather than the balance of outstanding financing transactions during the year. The 66.3% increase in volume-based fees to $77.7 million in 1998 from $46.7 million in 1997 was primarily due to fee-based volume increasing by 60.1% to $7.26 billion in 1998 compared to $4.53 billion in 1997. The increased volume was attributable to the addition of FRC and AT&T Capital's Inventory Finance unit.
The increase in volume-based fees in 1998 was the major reason for the growth of FINOVA's operating margin as a percentage of average earning assets to 6.4% in 1998 from 6.2% in 1997. The interest rate spread portion of this margin declined slightly to 5.5% from 5.6% principally due to the increase in the Company's debt leverage during 1998.
PROVISION FOR CREDIT LOSSES. The provision for credit losses increased 18.8% to $82.2 million in 1998 compared to $69.2 million in 1997. The increase in the provision reflected the growth in managed assets of 19.1% to $10.55 billion in 1998 from $8.86 billion in 1997 and an increase in net write-offs in 1998 to $56.8 million compared to $43.2 million in 1997. The higher level of write-offs in 1998 was primarily due to prior credit problems experienced in FINOVA's Commercial Services line of business which had write-offs of $35.7 million in 1998 principally related to the business' wholesale textile customers. The 1998 Commercial Services write-offs represent problems identified in 1997 that the Company believed could be worked out. Unfortunately, the results of those efforts were unsuccessful, resulting in increased write-offs for 1998. Commercial Services is refocusing its portfolio to include more retail customers and other industries. Net write-offs by line of business and other changes in the reserve for credit losses can be found in Note D of Notes to Consolidated Financial Statements.
GAINS ON DISPOSAL OF ASSETS. Gains on disposal of assets were $55.0 million in 1998 compared to $30.3 million in 1997. Gains on disposal of assets include the sale of loans via the commercial mortgage backed securities ("CMBS") market, the sale of assets coming off lease and the sale of other assets. Net gains from the CMBS market totaled $18.9 million in 1998 and included gross gains of $51.7 million partially offset by hedge losses, commissions and expenses of $24.3 million and $8.5 million of reserves. The other $36.1 million of net gains in 1998 resulted from the sale of assets coming off lease, Franchise Finance loans and other assets. While, in the aggregate, FINOVA has historically recognized gains on the disposal of assets it holds, the timing and amount of these gains are sporadic in nature. There can be no assurance FINOVA will recognize such gains in the future, depending, in part, on market conditions at the time of disposal. See Note C of Notes to Consolidated Financial Statements for further discussion of gains on disposal of assets.
OPERATING EXPENSES. Operating expenses, which include selling, administrative and other expenses were generally higher in all major categories and increased to $241.1 million in 1998 compared to $190.5 million in 1997. This increase was partially attributable to the growth in managed assets during the year and to incentives paid to employees based on performance criteria such as new business, profitability and the increased value of FINOVA's stock. Also contributing to the increase was the addition of FRC, which has a higher operating cost structure than other FINOVA lines of business, including over 80 business development officers and support staff. Operating expenses were 43.8% of operating margin for 1998 compared to 41.8% in 1997. Due to FINOVA's expansion into activities that use gains from the sale of assets to cover operating expenses, a more appropriate ratio to measure efficiency is operating expenses as a percentage of operating margin plus gains. Using this measurement, operating expenses were 39.8% of operating margin plus gains for 1998 compared to 39.2% in 1997. See Note O of Notes to Consolidated Financial Statements for additional detail.
INCOME TAXES. Income taxes were $108.5 million in 1998 compared to $83.1 million in 1997. The increase was primarily due to higher pre-tax income and a higher effective tax rate in 1998 due
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to the realization of certain tax credits in 1997. See Note J of Notes to Consolidated Financial Statements for further discussion of income taxes.
PREFERRED DIVIDENDS. Dividends, net of tax, paid on $111.6 million of outstanding Company-obligated mandatory redeemable convertible preferred securities ("TOPrS") was $3.8 million in 1998 compared to $4.0 million in 1997.
1997 COMPARED TO 1996
Net income for 1997 increased 18.9% to $139.1 million from $117.0 million in 1996. The increase reflected growth in managed assets, increased fee-related business, higher gains on disposal of assets and a lower effective income tax rate, partially offset by higher provisions for credit losses and increased operating expenses. Income from continuing operations for 1997 increased to $139.1 million from $116.5 million in 1996. Continuing operations in 1996 excluded the operating results of FINOVA's discontinued Manufacturer & Dealer Services line of business ("MDS") and FINOVA Medical Systems and a $6 million gain resulting from the sale of MDS.
INTEREST MARGINS EARNED. Interest margins earned increased 20.1% to $408.9 million in 1997 from $340.5 million in 1996 due primarily to a higher level of average earning assets.
Average earning assets increased 16.3% to $7.36 billion in 1997 from $6.32 billion a year earlier. This increase primarily resulted from a 20.8% increase in funded new business of $3.31 billion compared to $2.74 billion in 1996, and, to a lesser extent, from portfolios purchased during 1997 (totaling $122 million). These increases were partially offset by the normal amortization of the portfolio and prepayments during the year.
VOLUME-BASED FEES. Volume-based fees increased 63.5% to $46.7 million in 1997 compared to $28.6 million in 1996. The increase was primarily due to fee-based volume of $4.53 billion in 1997 that was 54.3% higher than the fee-based volume of $2.94 billion in 1996. Contributing to the increase in fee-based business were the acquisitions of FRC (formerly Belgravia Capital Corporation) and AT&T Capital's Inventory Finance unit in the fourth quarter of 1997.
The 54.3% increase in fee-based volume in 1997 was a primary factor in the improvement of FINOVA's operating margin as a percentage of average earning assets to 6.2% in 1997 from 5.8% in 1996. Lower aggregate borrowing costs and lower leverage in 1997 also contributed to the improvement in the operating margin.
PROVISION FOR CREDIT LOSSES. The provision for credit losses increased 65.7% to $69.2 million in 1997 compared to $41.8 million in 1996. In addition to growth in FINOVA's managed assets, the increase in the provision for credit losses primarily resulted from an increase in net write-offs to $43.2 million in 1997 from $28.7 million in 1996. The higher net write-offs in 1997 were primarily attributable to FINOVA's Commercial Services line of business, due to credit problems experienced among the line's wholesale textile customers. Total net write-offs for FINOVA's other lines of business were lower in 1997 than in 1996.
FINOVA's net write-offs during 1997 represented 0.54% of average managed assets (excluding average participations) compared to 0.41% in 1996. Details of net write-offs and other changes in the reserve for credit losses can be found in Note D of Notes to Consolidated Financial Statements.
GAINS ON DISPOSAL OF ASSETS. Gains on disposal of assets totaled $30.3 million in 1997, higher than the $12.9 million in 1996. In addition to the sale of assets coming off lease, FINOVA recognized a significant gain from the early termination of a real estate leveraged lease transaction in 1997.
OPERATING EXPENSES. Operating expenses were higher in 1997 than in 1996, primarily as a result of increased costs necessary to manage FINOVA's larger portfolio. Also contributing to the increase in operating expenses were incentives paid to employees based on performance criteria such as new business, profitability and the increased value of FINOVA's stock (which increased by 54.7% to $49 11/16 per share at year-end). The Company also incurred additional costs in administer- A-5
ing problem loan accounts in 1997, including an increase with respect to the Commercial Services line of business.
As a percentage of operating margin, operating expenses declined slightly to 41.8% in 1997 from 41.9% in 1996. See Note O of Notes to Consolidated Financial Statements for further detail of operating expenses.
INCOME TAXES. Income taxes were higher in 1997 than in 1996 due to the increase in pre-tax income. Partially offsetting the increase was a lower effective tax rate in 1997 of 36.7% compared to 37.3% in 1996, principally caused by FINOVA's ability to use certain capital loss carryforwards in 1997. See Note J of Notes to Consolidated Financial Statements for further discussion of income taxes.
PREFERRED DIVIDENDS. During 1997, a subsidiary trust sponsored and wholly owned by FINOVA had $111.6 million (net of transaction costs) outstanding of TOPrS. FINOVA paid dividends of $4.0 million, after tax, on these securities during 1997.
FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
Managed assets at December 31, 1998 increased 19.1% to $10.55 billion from $8.86 billion at December 31, 1997. The increase was the result of a 20.2% increase in funded new business of $3.98 billion in 1998 compared to $3.31 billion in 1997, partially offset by normal loan and lease amortization and prepayments.
FINOVA's reserve for credit losses increased to $207.6 million at December 31, 1998 from $177.1 million at year-end 1997 that primarily consisted of provisions of $82.2 million partially offset by net write-offs totaling $56.8 million. At December 31, 1998 the reserve represented 2.0% of managed assets (excluding participations sold and financing contracts held for sale) the same level as one year ago. Nonaccruing assets increased to $205.2 million at December 31, 1998 representing 2.0% of ending managed assets compared to $187.4 million in nonaccruing assets as of December 31, 1997 which constituted 2.1% of ending managed assets. The single most significant increase in nonaccruing assets was the addition of a paper-manufacturing customer in the Commercial Equipment Finance line of business. At December 31, 1998, the reserve represented 101.2% of nonaccruing assets compared to 94.5% at December 31, 1997. See Note D of Notes to Consolidated Financial Statements for more information on the reserves, net write-offs and nonaccruing assets.
The Company had total debt outstanding of $8.39 billion at December 31, 1998 or 6.5 times its equity base (shareowners' equity plus convertible preferred securities) of $1.29 billion (FINOVA Capital's leverage as of December 31, 1998 was 6.3 to 1). At December 31, 1997, the Company had debt leverage of 5.6 times its equity base ($6.76 billion debt outstanding to $1.20 billion of equity). Deferred income taxes, which are used to finance a portion of FINOVA's assets, grew 26.4% during 1998 to $347.4 million from $274.8 million at year-end 1997.
Growth in managed assets is generally financed by internally generated cash flow and borrowings. During 1998, FINOVA Capital issued $1.6 billion in new senior debt and increased its commercial paper and other short-term borrowings by $739.5 million. These funds were used to finance new business and to redeem or retire $689 million of debt. During 1997, the Company also issued approximately 1.7 million shares of its common stock as the primary consideration for the acquisition of FRC. See Note B of Notes to Consolidated Financial Statements for further detail.
FINOVA satisfies a significant portion of its cash requirements from a diversified group of worldwide funding sources and is not dependent on any one lender. FINOVA also relies on the issuance of commercial paper as a major funding source. During 1998, FINOVA Capital issued $18.4 billion of commercial paper, at a weighted average cost of 5.67% (with an average of $3.5 billion outstanding during the year) and raised $1.6 billion, as noted above, through new long-term financings of one to twelve year durations. At December 31, 1998 and 1997, commercial paper and short-term bank borrowings totaled $3.9 billion and $3.1 billion, respectively, and were supported by A-6
available unused revolving credit lines which, if not renewed, are convertible to long-term debt at FINOVA's option.
FINOVA Capital currently maintains a five-year revolving credit facility and a 364-day facility with numerous lenders, in the aggregate principal amount of $2.0 billion. Separately, FINOVA Capital also has two five-year facilities with numerous lenders for $700 million each, one 364-day facility with numerous lenders for $600 million and three 364-day facilities with three separate lenders for an aggregate principal amount of $400 million. These $4.4 billion of credit facilities support FINOVA's outstanding commercial paper and short-term borrowings. The Company intends to borrow under the domestic revolving credit agreements to refinance commercial paper and short-term bank loans if it encounters significant difficulties in rolling over its outstanding commercial paper and short-term bank loans. The Company rarely borrows under these facilities. The 364-day $1.0 billion and $600 million revolving credit agreements are subject to renewal in 1999, while the two $700 million and the other $1.0 billion credit facilities are subject to renewal in 2002. The 364- day facilities totaling $400 million are subject to renewal in 1999; however, the Company does not anticipate extending these facilities. In addition to the above, The FINOVA Group Inc. has a revolving credit facility with one lender for $25 million, which is subject to renewal in 1999.
The Company, through one subsidiary, uses a five-year multi-currency facility with a small group of lenders for $100 million. Through another subsidiary, the Company maintains a 364-day revolving credit facility with three lenders in Canada for 100 million Canadian dollars. FINOVA Capital is the guarantor of these credit facilities, which are subject to renewal in 1999.
In 1998, FINOVA Capital commenced a Euro Medium-Term Note Program allowing for the issuance of up to $1 billion of debt securities. As of December 31, 1998 there was $750 million available under the program.
In 1997, FINOVA and FINOVA Capital jointly filed a universal shelf registration statement with the SEC allowing for the issuance of $2 billion of senior debt securities, common stock, preferred stock, depositary shares and warrants to purchase common stock or debt securities, $830 million of which remained available as of December 31, 1998, of which $105 million had been designated for the issuance of medium term notes.
The agreements pertaining to long-term debt include various restrictive covenants and require the maintenance of certain defined financial ratios with which FINOVA and FINOVA Capital have complied. Under one covenant, dividend payments by FINOVA Capital to FINOVA are limited to 50 percent of accumulated earnings after December 31, 1991.
FINOVA Capital's aggregate cost of funds decreased to 6.4% for 1998 from 6.6% for 1997 as a result of declining interest rates and the elimination of costs associated with $1.15 billion of maturing interest rate hedges. FINOVA's cost of and access to capital is dependent, in large part, on its credit ratings. FINOVA Capital has maintained investment-grade ratings since 1976. FINOVA Capital currently has investment-grade ratings from the following agencies:
In addition, FINOVA Finance Trust, a subsidiary trust of FINOVA, has issued TOPrS with investment-grade ratings as follows:
None of FINOVA Capital's subsidiaries have applied for credit ratings.
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Standard & Poor's Ratings Group changed on February 26, 1999, its rating of the (TOPrS) from BBB+ to BBB. The rating change was not a downgrade, but resulted from the new rating scale under which Standard & Poor's Ratings Group rates preferred stock two notches below the corporate or counter party credit rating of an investment-grade issuer such as FINOVA.
To provide further liquidity, the Company utilized a private CMBS structure ("mini-CMBS") to sell loans warehoused by FRC. Under the structure, the Company sold loans to a trust with limited recourse. The Trust issued a senior security interest to an investment banking company and a subordinated security interest that was retained by the Company. The Company also retained the servicing rights and obligations on the assets transferred to the trust. The intent of the trust is to sell the loans into the permanent CMBS market. Until the loans are sold, interest rate risk is hedged using various instruments including Treasury rate locks. The Company recognized gains on the transfer of the loans in accordance with SFAS 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities". No gains were recorded on the subordinated interest retained by the Company.
This structure differs from many transfer and securitization vehicles in that the intent is to sell the loans in the trust within a short period of time rather than holding the loans throughout the amortization period. Once the sale of the loans by the trust is completed, there will be no further recourse or assumption risks.
FINOVA periodically repurchases its securities on the open market to fund its obligations pursuant to employee stock options, benefit plans and similar obligations. During the years 1998 and 1997, FINOVA repurchased 1,299,200 and 1,035,800 shares, respectively. This program may be discontinued at any time.
DERIVATIVE FINANCIAL INSTRUMENTS
FINOVA enters into interest rate and basis swap agreements as part of its interest rate risk management policy of match funding its assets and liabilities. The derivative instruments used are straightforward. FINOVA continually monitors its derivative position and uses derivative instruments for non-trading and non-speculative purposes only.
At December 31, 1998, FINOVA Capital had outstanding interest rate conversion agreements with notional principal amounts totaling $1.80 billion. Agreements with notional principal amounts of $700 million were arranged to effectively convert certain floating interest rate obligations into fixed interest rate obligations. These agreements require interest payments on the stated principal amount at rates ranging from 5.84% to 8.09% (remaining terms of one to ten years) in return for receipts calculated on the same notional amounts at floating interest rates. In addition, agreements with notional principal amounts of $1.10 billion were arranged to effectively convert certain fixed interest rate obligations into floating interest rate obligations. They require interest payments on the stated principal amount at the three month or six month London interbank offered rates ("LIBOR") (remaining terms of one to eight years) in return for receipts calculated on the same notional amounts at fixed interest rates of 5.77% to 7.71%.
FINOVA also enters into short-term treasury rate locks, options, swaptions and other derivative instruments to hedge interest rate risks associated with the warehousing of loans primarily for FINOVA Realty Capital. See Note F of Notes to Consolidated Financial Statements for further discussion of FINOVA's derivatives.
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SEGMENT REPORTING
Information for FINOVA's reportable segments reconciles to FINOVA's consolidated totals as follows:
FINOVA's business is organized into three market groups, which are also its reportable segments: Commercial Finance, Specialty Finance and Capital Markets. Management relies on total net revenue, income before allocations and managed assets in evaluating the business performance of each reportable segment. See Note Q of Notes to Consolidated Financial Statements for additional detail.
Total net revenue is the total of operating margin and gains on disposal of assets. Income before allocations is income before income taxes, preferred dividends, corporate overhead expenses and the unallocated portion of the provision for credit losses. Managed assets include each segment's investment in financing transactions plus securitizations and participations sold.
COMMERCIAL FINANCE. Commercial Finance includes traditional asset-based businesses that lend against collateral such as cash flows, inventory, receivables and leased assets. This segment includes the following lines of business: Business Credit, Commercial Services, Corporate Finance, Distribution & Channel Finance, Growth Finance and Rediscount Finance.
Total net revenue was $187.5 million in 1998 compared to $155.0 million in 1997, an increase of 21.0%. The increase in 1998 was primarily due to 16.9% growth in fee-based volume, which rose to $4.45 billion from $3.80 billion and 24.0% growth in average earnings assets for the group in 1998. The 1998 results include a full year of activity from AT&T Capital's Inventory Finance unit, which became part of Distribution & Channel Finance's line of business in the fourth quarter of 1997.
Income before allocations was $67.0 million in 1998 compared to $72.5 million in 1997. The decrease in 1998 was primarily due to previously reported problems experienced in the Commercial
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Services line of business related to its wholesale textile customers, which resulted in net write-offs of $35.7 million in 1998 compared to $23.3 million in 1997. As a result of the Commercial Services portfolio problems, the unit experienced higher operating expenses and a decline in fee-based volume. Commercial Services is currently refocusing its portfolio towards more retail customers and other industries. Excluding the net effects of Commercial Services, income before allocations of the Commercial Finance group would have increased 20.2% in 1998.
Managed assets grew to $3.01 billion in 1998 from $2.76 billion in 1997, an increase of 9.0%. The growth in managed assets was slowed due to compression in the Commercial Services unit, partially offset by strong growth in the Rediscount Finance operation. Fee-based businesses, which make up a portion of Commercial Finance, rely more on volume growth to increase income than asset growth. Therefore, half of the income growth (20.2% excluding Commercial Services) was due to increased fee-based volume.
SPECIALTY FINANCE. Specialty Finance includes businesses that lend to a variety of highly focused industry-specific niches. This segment includes the following lines of business: Commercial Equipment Finance, Communications Finance, Franchise Finance, Healthcare Finance, Portfolio Services, Public Finance, Resort Finance, Specialty Real Estate Finance and Transportation Finance.
Total net revenue increased 9.8% to $344.5 million in 1998 compared to $313.8 million in 1997, while income before allocations grew 10.0% to $273.7 million in 1998 compared to $248.8 million in 1997. Both increases were primarily due to 10.7% growth in average earning assets. The unit was able to keep net write-offs and operating expenses at a relatively constant rate.
Managed assets grew to $7.21 billion in 1998 from $6.04 billion in 1997, an increase of 19.4%. The growth in managed assets was driven by new business growth of $3.08 billion in 1998 compared to $2.40 billion in 1997. Much of the growth in new business occurred in the second half of 1998. The growth was spread across all business units with Transportation Finance and Franchise Finance contributing the most to the growth in managed assets.
CAPITAL MARKETS. Capital Markets, in conjunction with institutional investors, provides commercial mortgage banking services and debt and equity capital funding. This segment includes Realty Capital, Investment Alliance and Loan Administration.
FINOVA Realty Capital was acquired in the fourth quarter of 1997, but per the acquisition agreement would not be consolidated into FINOVA until 1998. Therefore in 1997, FINOVA received a management fee equal to the net results of the unit from the time of the acquisition. This fee ($9.4 million) was reported in volume-based fees in 1997 and represented all revenues net of expenses.
Total net revenue was $50.2 million in 1998 compared to the net management fee of $9.4 million in 1997. Income before allocations was $23.2 million in 1998 compared to $9.4 million in 1997. The growth in income before allocations was primarily attributable to a higher level of originations ($2.8 billion in 1998 compared to $731 million in 1997) and an increased level of sales into the CMBS market, resulting in higher gains. See Note C of Notes to Consolidated Financial Statements for further discussion of the mini-CMBS structure.
Capital Markets was able to grow its managed asset base to $277.4 million, of which $241.9 million represents financing contracts held for sale.
YEAR 2000 COMPLIANCE
FINOVA continues to implement changes necessary to help assure accurate date recognition and data processing with respect to the year 2000. To be year 2000 compliant means (1) significant computer systems in use by FINOVA demonstrate performance and functionality that is not materially affected by processing dates on or after January 1, 2000, (2) customers and collateral
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included in FINOVA's portfolio of business are year 2000 compliant and (3) vendors of services critical to FINOVA's business processes are year 2000 compliant.
Primary internal activities related to this issue are modifications to existing computer programs and conversions to new programs. FINOVA has a five-phase plan for assuring year 2000 compliance of its internal systems:
(1) Identifying each area, function and application that could be affected by the change in date.
(2) Determining the extent to which each area, function or application will be affected by the change in date and identifying the proper course of action to eliminate adverse effects.
(3) Making the changes necessary to bring the system into year 2000 compliance.
(4) Testing the integrated system.
(5) Switching to year 2000 compliant applications.
At December 31, 1998, FINOVA estimated that 95% of the changes necessary to make mission critical systems year 2000 compliant were complete. All remaining changes are expected to be made and the systems should be tested and implemented by the end of the first quarter of 1999. Acquisitions made during 1998 are being reviewed using the same five-phase plan. The necessary modifications to make those new businesses year 2000 compliant are expected to be complete by the end of the second quarter of 1999. Similarly, acquisitions made or proposed to be made in 1999 are being reviewed with year 2000 compliance issues to be addressed in a prompt manner.
Costs incurred to bring FINOVA's internal systems into year 2000 compliance are not expected to have a material impact on FINOVA's results of operations. Maintenance and modification costs are expensed as incurred, while the costs of new hardware and software are capitalized and amortized over their estimated useful lives. FINOVA estimates it will incur approximately $300,000 in expenses and $1.8 million in capital costs related to year 2000 compliance. Estimates are reviewed and revised as necessary on a quarterly basis. Through December 31, 1998, FINOVA has incurred expenses of $158,000 and capital costs of $1.4 million.
FINOVA's aggregate cost estimate does not include time and costs that may be incurred as a result of the failure of any third parties to become year 2000 compliant. FINOVA is communicating with customers, software vendors and others to determine if their applications or services are year 2000 compliant and to assess the potential impact on FINOVA related to this issue.
Risks to FINOVA include that third parties may not have accurately assessed their state of readiness. Similarly, FINOVA cannot assure that the systems of other companies and government agencies on which FINOVA relies will be converted in a timely manner. While FINOVA believes all necessary work on internal systems will be completed in a timely fashion, there can be no guarantee that all systems will be compliant by the year 2000 and within the estimated cost. Any of these occurrences could cause a material adverse effect on FINOVA's results of operations.
FINOVA is assessing the need for contingency plans related to year 2000 compliance in the first half of 1999. It plans to develop additional contingency plans as necessary throughout 1999. FINOVA maintains and deploys contingency plans designed to address various other potential business interruptions. In some respects, these plans may address interruptions resulting from FINOVA or a third party's failure to be year 2000 compliant, but the plans have not been updated to specifically address the year 2000 issue as of December 31, 1998.
RECENT DEVELOPMENTS AND BUSINESS OUTLOOK
In October 1998, FINOVA acquired United Credit Corporation, a New York-based provider of commercial financing to small and midsize businesses, and its Patriot Funding Division. The addition formed a new division named FINOVA Growth Finance, which provides collateral-based working capital financing, primarily secured by accounts receivable. The new division provides financing A-11
ranging from $100,000 to $1 million to small and midsize businesses with annual sales under $10 million. FINOVA anticipates that this new division will serve a market segment of smaller, growth-oriented customers earlier in their maturation cycle.
In October 1998, FINOVA acquired Electronic Payment Systems, Inc. a commercial receivables servicing business headquartered in Salt Lake City, Utah, to support the activities of its Realty Capital business.
In January 1999, FINOVA reached a definitive agreement to acquire Sirrom Capital Corporation ("Sirrom"), a specialty finance company headquartered in Nashville, Tennessee, for approximately $343 million in FINOVA common stock. Sirrom provides secured loans to small, fast growing companies in the U.S. and Canada with revenues between $5 million and $50 million, for expansions, acquisitions, buyouts and other strategic ventures. The completion of the Sirrom acquisition is expected to result in an increase in the outstanding equity of FINOVA which is expected to lower the debt to equity ratio to approximately 5.2x at the time the acquisition is consummated as compared to FINOVA's leverage of 6.5x at December 31, 1998.
In February 1999, FINOVA acquired Preferred Business Credit Inc. ("PBC"), a west coast provider of commercial financing to small and mid-size businesses.
At the 1999 annual shareowners meeting, FINOVA's shareowners will consider approval of an amendment to its certificate of incorporation to increase the number of authorized shares of capital stock. If approved, the proposal will increase the number of common shares from 100 million to 400 million, and the number of preferred shares from 5 million to 20 million. The Board of Directors recommends approval of that proposal for the reasons noted in the 1999 Proxy Statement. Those reasons include:
- permitting future stock splits
- assisting in capital raising activities
- providing appropriate incentive compensation to its employees
- fulfilling its obligations to issue stock under existing contractual arrangements
- facilitating FINOVA's growth strategy.
Shareowners are urged to approve that proposal for the reasons noted above.
NEW ACCOUNTING STANDARDS
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," ("SFAS No. 133") which is effective for fiscal years beginning after June 15, 1999. This statement standardizes the accounting for derivative instruments, including certain derivative instruments embedded in other contracts, by recognition of those items as assets or liabilities in the statement of financial position and measurement at fair value. FINOVA will adopt this standard effective January 1, 2000, as required. The impact of SFAS No. 133 on the Company's financial position and results of operations has not yet been determined.
QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
FINOVA's primary market risk exposure is the volatility of interest rates. FINOVA seeks to manage interest rate risk and preserve income through a diversified borrowing base and a matched-funding policy. A diversified borrowing base consists of short and long-term debt with a fixed or variable rate. FINOVA's matched-funding policy, set by the Board of Directors or Audit Committee and administered by the Finance Committee, requires that floating-rate assets be financed with similar floating-rate liabilities and fixed-rate assets be financed with similar fixed-rate liabilities.
A-12
Under the matched-funding policy, the difference between floating-rate assets and floating-rate liabilities should not exceed 3% of total assets for any extended period.
FINOVA engages in hedging transactions using primarily interest rate swaps, and to a lesser extent, other derivative instruments to lower its interest costs and to manage its interest rate risk. Derivative instruments are used for non-trading and non-speculative purposes only. A hedge consists of a position that is substantially equal and opposite of the asset or liability being hedged. It is structured to provide a high degree of correlation at the inception of the hedge and throughout the hedge period so that hedging results will substantially offset the effects of interest rate changes on the exposed item.
Hedge transactions are authorized to be entered into with financial institutions rated "A" or better by Standard & Poors Rating Group or Moody's Investors Service, Inc., who must also be lenders or credit support providers to FINOVA or its subsidiaries. Without approval from the Finance Committee, the notional principal amount of aggregate hedges on a net basis with a given counter party cannot exceed 10% of FINOVA's total debt outstanding as of the time of entering into the derivative transaction.
FINOVA uses a sensitivity analysis model to measure the exposure of net income to increases or decreases in interest rates. The model measures the change in annual net income if interest rates on floating-rate assets, liabilities and derivative instruments increased or decreased by 100 basis points (1%), assuming no prepayments. Based on the model used, a 100 basis point shift in interest rates would affect net income by less than 6.5%.
Certain limitations are inherent in the model used in the above interest rate risk measurements. Modeling changes require certain assumptions that may oversimplify the manner in which actual yields and costs respond to changes in market interest rates. For example, the model assumes a more static composition of FINOVA's interest sensitive assets, liabilities and derivative instruments than would actually exist over the period being measured. The model also assumes that a particular change in interest rates is reflected uniformly across the yield curve regardless of the duration to maturity or repricing of specific assets and liabilities. Although the sensitivity analysis model provides an indication of FINOVA's interest rate risk exposure at a particular point in time, the model is not intended to and does not provide a precise forecast of the effect of changes in market interest rates on FINOVA's net income and will likely differ from actual results.
A-13
MANAGEMENT'S REPORT ON RESPONSIBILITY FOR FINANCIAL REPORTING
The management of The FINOVA Group Inc. is responsible for the preparation, integrity and objectivity of the financial statements and other financial information included in this Annual Report. The financial statements are presented in accordance with generally accepted accounting principles reflecting, where applicable, management's best estimates and judgments.
FINOVA's management has established and maintains a system of internal controls to reasonably assure the fair presentation of the financial statements, the safeguarding of FINOVA's assets and the prevention or detection of fraudulent financial reporting. The internal control structure is supported by careful selection and training of personnel, policies and procedures and regular review by both internal auditors and the independent auditors.
The Board of Directors, through its Audit Committee, also oversees the financial reporting of FINOVA and its adherence to established procedures and controls. Periodically, the Audit Committee meets, jointly and separately, with management, the internal auditors and the independent auditors to review auditing, accounting and financial reporting matters.
FINOVA's financial statements have been audited by Deloitte & Touche LLP, independent auditors. Management has made available to Deloitte & Touche LLP all of FINOVA's financial records and related data and has made valid and complete written and oral representations and disclosures in connection with the audit.
Management believes it is essential to conduct its business in accordance with the highest ethical standards, which are characterized and set forth in FINOVA's written Code of Conduct. These standards are communicated to and acknowledged by all of FINOVA's employees.
/s/ SAMUEL L. EICHENFIELD
-------------------------------------- Samuel L. Eichenfield Chairman, President and Chief Executive Officer
/s/ BRUNO A. MARSZOWSKI
-------------------------------------- Bruno A. Marszowski Senior Vice President -- Controller and Chief Financial Officer
/s/ DEREK C. BRUNS
-------------------------------------- Derek C. Bruns Senior Vice President -- Internal Audit
A-14
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareowners of The FINOVA Group Inc.
We have audited the accompanying consolidated balance sheets of The FINOVA Group Inc. and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of income, shareowners' equity and cash flows for the years then ended. These financial statements are the responsibility of The FINOVA Group Inc's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. 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, such consolidated financial statements present fairly, in all material respects, the financial position of The FINOVA Group Inc. and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting principles.
/s/ DELOITTE & TOUCHE LLP - --------------------------------------------------------- Deloitte & Touche LLP
Phoenix, Arizona February 10, 1999
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THE FINOVA GROUP INC.
CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS)
See notes to consolidated financial statements. A-16
THE FINOVA GROUP INC.
STATEMENTS OF CONSOLIDATED INCOME (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
See notes to consolidated financial statements. A-17
THE FINOVA GROUP INC.
STATEMENTS OF CONSOLIDATED SHAREOWNERS' EQUITY (DOLLARS IN THOUSANDS)
See notes to consolidated financial statements. A-18
THE FINOVA GROUP INC.
STATEMENTS OF CONSOLIDATED CASH FLOWS (DOLLARS IN THOUSANDS)
See notes to consolidated financial statements. A-19
THE FINOVA GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
NOTE A SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION AND PRINCIPLES OF CONSOLIDATION -- The consolidated financial statements present the financial position, results of operations and cash flows of The FINOVA Group Inc. and its subsidiaries (collectively, "FINOVA" or the "Company"), including FINOVA Capital Corporation and its subsidiaries (collectively, "FINOVA Capital").
The FINOVA Group Inc. is a financial services company engaged in providing capital and collateralized financing products to commercial enterprises focusing on mid-size businesses in various market niches, principally in the United States.
These consolidated financial statements are prepared in accordance with generally accepted accounting principles. Described below are those accounting policies particularly significant to FINOVA, including those selected from acceptable alternatives:
USE OF ESTIMATES -- The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
REVENUE RECOGNITION -- For loans and other financing contracts, earned income is recognized over the life of the contract, using the interest method.
Leases that are financed by nonrecourse borrowings and meet certain other criteria are classified as leveraged leases. For leveraged leases, aggregate rental receivables are reduced by the related nonrecourse debt service obligation including interest ("net rental receivables"). The difference between (a) the net rental receivables and (b) the cost of the asset less estimated residual value at the end of the lease term is recorded as unearned income. Earned income is recognized over the life of the lease at a constant rate of return on the positive net investment, which includes the effects of deferred income taxes.
For operating leases, earned income is recognized on a straight-line basis over the lease term and depreciation is taken on a straight-line basis over the estimated useful lives of the leased assets.
For direct financing leases, unearned income is the difference between (a) aggregate lease rentals and (b) the cost of the related assets less estimated residual value at the end of the lease term. Earned income is recognized over the life of the contracts using the interest method.
Fees received in connection with loan commitments are deferred in accounts payable and accrued expenses until the loan is advanced and are then recognized over the term of the loan as an adjustment to the yield. Fees on commitments that expire unused are recognized at expiration.
Fees are also generated on the volume of purchased accounts receivable and mortgage loan originations. Fees on the volume of purchased accounts receivable represent discounts or commissions to FINOVA in return for handling the accounts receivable collection process. These fees are recognized as income in the period the receivables are purchased due to the short-term nature of the accounts receivable, which are generally collected from one to three months after purchase. Fees on mortgage loan originations represent broker commissions on the loan originations and are recognized as income in the period of origination.
A-20 THE FINOVA GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
Income recognition is generally suspended for leases, loans and other financing contracts at the earlier of the date at which payments become 90 days past due or when, in the opinion of management, a full recovery of income and principal becomes doubtful. Income recognition is resumed when the loan, lease or other financing contract becomes contractually current and performance is demonstrated to be resumed or when foreclosed or repossessed assets generate a reasonable rate of return.
CASH EQUIVALENTS -- FINOVA classifies highly liquid investments with original maturities of three months or less from date of purchase as cash equivalents.
MARKETABLE SECURITIES -- As discussed in Note K, FINOVA owns certain marketable securities, which are considered trading securities. Trading securities are stated at fair value with gains or losses recorded in income in the period they occur.
FINANCING CONTRACTS HELD FOR SALE -- Financing contracts held for sale are composed of assets held for sale and retained interest from sales to a private CMBS ("mini-CMBS") structure that are available for sale. Assets held for sale are carried at lower of cost or market with adjustment, if any, recorded in operations. Assets available for sale are carried at fair value using the specific identification method with unrealized gains and losses being recorded as a component of accumulated other comprehensive income within the equity section of the balance sheet. See Notes C and P.
RESERVE FOR CREDIT LOSSES -- The reserve for credit losses is available to absorb credit losses and is not provided for financing contracts held for sale and other owned assets, including assets on operating lease. The provision for credit losses is the charge to income to increase the reserve for credit losses to the level that management estimates to be adequate considering delinquencies, loss experience and collateral. Other factors considered include changes in geographic and product diversification, size of the portfolio and current economic conditions. Accounts are either written-off or written-down when the loss is considered probable and determinable, after giving consideration to the customer's financial condition and the value of the underlying collateral, including any guarantees. Any deficiency between the carrying amount of an asset and the net sales price of repossessed collateral is charged to the reserve for credit losses. Recoveries of amounts previously written-off as uncollectible are credited to the reserve for credit losses.
REPOSSESSED ASSETS -- Repossessed assets are carried at the lower of cost or fair value less estimated selling expenses.
RESIDUAL VALUES -- FINOVA has a significant investment in residual values in its leasing portfolios. These residual values represent estimates of the value of leased assets at the end of the contract terms and are initially recorded based upon appraisals and estimates. Residual values are periodically reviewed to determine that recorded amounts are appropriate. Actual residual values realized could differ from these estimates and updates.
GOODWILL -- FINOVA amortizes the excess of cost over the fair value of net assets acquired ("goodwill") on a straight-line basis primarily over 20 to 25 years. Goodwill at December 31, 1998 and 1997 was $299.0 million and $288.2 million (net of amortization), respectively. Amortization totaled $15.2 million ($11.1 million after-tax), $10.1 million ($6.3 million after-tax) and $9.6 million ($5.7 million after-tax) for the years ended December 31, 1998, 1997 and 1996, respectively. FINOVA periodically evaluates the carrying value of its intangible assets for impairment. This evaluation is based on projected, undiscounted cash flows generated by the underlying assets. At
A-21 THE FINOVA GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
December 31, 1998, approximately $197.6 million of goodwill (net of amortization) was deductible for federal income tax purposes over 15 years under Section 197 of the Internal Revenue Code.
PENSION AND OTHER BENEFITS -- Trusteed, noncontributory pension plans cover substantially all employees. Benefits are based primarily on final average salary and years of service. Funding policies provide that payments to pension trusts shall be at least equal to the minimum funding required by applicable regulations.
Other post-retirement benefit costs are recorded during the period the employees provide service to FINOVA. Post-retirement benefit obligations are funded as benefits are paid.
Post-employment benefits are any benefits other than retirement benefits. FINOVA records post-employment benefit costs at the time employees leave active service.
SAVINGS PLAN -- FINOVA maintains The FINOVA Group Inc. Savings Plan (the "Savings Plan"), a qualified 401(k) program. The Savings Plan is available to substantially all employees. The employee may elect voluntary wage reductions ranging from 0% to 15% of taxable compensation. The Company's matching contributions are based on employee pre-tax salary reductions, up to a maximum of 100% of the first 6% of salary contributions, the first 3% of which are matched in FINOVA stock through the Employee Stock Ownership Plan, discussed below.
EMPLOYEE STOCK OWNERSHIP PLAN -- Employees of FINOVA are eligible to participate in the Employee Stock Ownership Plan in the month following the first 12 consecutive month period during which they have at least 1,000 hours of service with FINOVA. Company contributions are made in the form of matching stock contributions of 100% of the first 3% of salary reduction contributions made by participants of the Savings Plan.
Expenses under the Savings Plan and Employee Stock Ownership Plan were $3.1 million, $2.5 million and $2.1 million in 1998, 1997 and 1996, respectively.
INCOME TAXES -- Deferred tax assets and liabilities are recognized for the estimated future tax effects attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax law.
EARNINGS PER SHARE -- Basic earnings per share exclude the effects of dilution and are computed by dividing income available to common shareowners by the weighted average amount of common stock outstanding for the period. Diluted earnings per share reflect the potential dilution that could occur if options, convertible preferred stock or other contracts to issue stock were exercised or converted into common stock. These calculations are presented for the years-ended December 31, 1998, 1997 and 1996 on the Statements of Consolidated Income and are more fully discussed in Note L.
DERIVATIVE FINANCIAL INSTRUMENTS -- As more fully described in Note F, FINOVA uses derivative financial instruments as part of its interest rate risk management policy of match funding its assets and liabilities. The derivative instruments used include interest rate swaps, which are accounted for using settlement or matched swap accounting, and to a lesser extent treasury locks, options and swaptions which are subject to hedge accounting determination.
Each derivative used as a hedge is matched with an asset or liability with which it has a high correlation. The swap agreements are generally held to maturity and FINOVA does not use derivative financial instruments for trading or speculative purposes. Upon early termination of the
A-22 THE FINOVA GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
designated matched asset or liability, the related derivative is matched to another appropriate item or marked to fair market value.
SECURITIZATIONS -- In accordance with SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," receivable transfers are accounted for as sales when legal and effective control over the transferred receivables is surrendered.
RECLASSIFICATIONS -- Certain reclassifications have been made to the prior years financial statements to conform to the 1998 presentation.
NOTE B ACQUISITIONS
During 1998 and 1997, FINOVA Capital, in transactions accounted for as purchases, acquired various businesses and portfolios having initial funds employed totaling $44 million and $122 million, respectively.
In October 1998, FINOVA acquired United Credit Corporation, a New York based provider of commercial financing to small and mid-size businesses, and its Patriot Funding Division. The addition formed a new division named FINOVA Growth Finance which provides collateral-based working capital financing, primarily secured by accounts receivable. The new division provides financing ranging from $100,000 to $1 million to small and mid-size businesses with annual sales under $10 million. This new division is serving a market segment of smaller, growth-oriented customers earlier in their maturation cycle.
In October 1998, FINOVA acquired Electronic Payment Systems, Inc., a commercial receivables servicing business headquartered in Salt Lake City, Utah, to support the activities of FINOVA Realty Capital ("FRC").
In October 1997, FINOVA purchased Belgravia Capital Corporation, a commercial mortgage banking organization, for $77.5 million of the Company's common stock (1.7 million shares), $10.0 million in cash and an agreement to pay additional amounts up to approximately $30 million per year for the next three years, contingent upon future results of the operations. To date, no additional amounts have been paid under the contingency agreement. Once assets currently held under the mini-CMBS structure, including the retained interest, have been sold into the permanent CMBS market, the Company will evaluate the contingency agreement and make payments due thereunder as appropriate. The acquisition was comprised of $91.5 million in assets, including $88.0 million in goodwill and $4.0 million in liabilities and acquisition costs. The results of these operations have been included in FINOVA's results since the date of acquisition. Goodwill related to this transaction is being amortized over 25 years.
In December 1997, FINOVA acquired the Inventory Finance unit of AT&T Capital Corporation. The acquisition, which joined FINOVA's Distribution & Channel Finance line of business, provided an opportunity for FINOVA to expand into the fast-growing telecommunications market.
A-23 THE FINOVA GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
NOTE C INVESTMENT IN FINANCING TRANSACTIONS
FINOVA provides secured financing to commercial and real estate enterprises principally under financing contracts (such as loans and other financing contracts, direct financing leases, operating leases, leveraged leases, fee-based receivables and financing contracts held for sale). At December 31, 1998 and 1997, the carrying amount of the investment in financing transactions, including the estimated residual value of leased assets upon lease termination, was $10.0 billion and $8.4 billion (before reserve for credit losses), respectively, and consisted of the following percentage of carrying amount by line of business:
Aggregate installments on investments in financing transactions at December 31, 1998 (excluding nonaccruing repossessed assets of $54.4 million and estimated residual values of $922.6
A-24 THE FINOVA GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
million) are contractually due or anticipated during each of the years ending December 31, 1999 to 2003 and thereafter as follows:
The investment in operating leases at December 31 consisted of the following:
The net investment in leveraged leases at December 31 consisted of the following:
A-25 THE FINOVA GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
The components of income from leveraged leases, after the effects of interest on nonrecourse debt and other related expenses, for the years ended December 31 were as follows:
The investment in direct financing leases at December 31 consisted of the following:
FINOVA has a substantial number of loans and leases with payments that fluctuate with changes in index rates, primarily prime interest rates and the London interbank offered rates ("LIBOR"). The investment in loans and leases with floating interest rates (excluding nonaccruing contracts and repossessed assets) was $4.75 billion and $4.34 billion at December 31, 1998 and 1997, respectively.
Income earned from financing transactions with floating interest rates was approximately $562 million in 1998, $491 million in 1997 and $436 million in 1996. The adjustments which arise from changes in index rates can have a significant effect on income earned from financing transactions; however, the effects on interest margins earned and net income are substantially offset by related interest expense changes on debt obligations with floating interest rates. FINOVA's matched funding policy is more fully described in Note F.
At December 31, 1998, FINOVA had a committed backlog of new business of approximately $1.9 billion compared to $1.6 billion at December 31, 1997. The committed backlog includes unused lines of credit totaling $549 million and $666 million at December 31, 1998 and 1997, respectively. Historically, FINOVA has booked a substantial portion of its backlog, although there can be no assurance that the trend will continue. Loan commitments and lines of credit have generally the same credit risk as extending loans to borrowers. These commitments are generally subject to the same credit quality and collateral requirements involved in lending transactions. Commitments generally have a fixed expiration and usually require payment of a fee.
SECURITIZATIONS -- In 1998 and 1997, under a separate securitization agreement, FINOVA sold loan receivables totaling $103.2 million and $36.8 million, respectively, with limited recourse. Outstanding securitized assets under this agreement were $136.1 million at December 31, 1998. FINOVA will service these loan contracts for the transferee and has deferred a portion of the proceeds to be recognized as service fee income over the term of the agreements.
During 1998, the Company utilized the mini-CMBS structure to sell loans warehoused by FRC. Under the structure, the Company sold loans to a trust with limited recourse. The trust issued a senior security interest to an investment banking company and a subordinated security interest that was retained by the Company. The Company also retained the servicing rights and obligations on the assets transferred to the trust. The intent of the trust is to sell the loans into the permanent CMBS market. Until the loans are sold, interest rate risk is hedged using various instruments including Treasury rate locks. The Company recognized gains on the transfer of the loans in A-26 THE FINOVA GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
accordance with SFAS 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities". No gains were recorded on the subordinated interest retained by the Company.
In determining the fair value of assets sold and interests retained, the Company inherently employs a variety of financial assumptions, including defaults, prepayments and discount rates. The Company assumed minimal defaults and prepayments due to the nature of the commercial mortgages and the anticipated period before sale into the permanent CMBS market. FINOVA also used discount rates ranging from approximately 6.0% to 7.0%
This structure differs from many transfer and securitization vehicles in that the intent is to sell the loans in the trust within a short period of time rather than holding the loans throughout the amortization period. Once the sale of the loans by the trust is completed, there will be no further recourse or assumption risks.
In 1998, the Company sold $724.3 million of loans into the private CMBS structure. The Company received $678.7 million in cash proceeds and retained a subordinated interest valued at $91.7 million. The Company recognized gross gains of $46.1 million. The gains were reduced by hedge losses, commissions and expenses of $21.6 million and an $8.5 million reserve resulting in net non-cash gains of $16.0 million.
In 1996 and 1995, FINOVA, under a securitization agreement, sold a total of $300 million in undivided proportionate interests in a revolving loan portfolio totaling approximately $694.5 million as of December 31, 1998. Under this agreement, there is recourse to FINOVA based on the outstanding balance of the proportionate interest sold.
In general, the servicing fees earned on securitizations are approximately equal to the cost of servicing; therefore, no material servicing assets or liabilities have been recognized.
NOTE D RESERVE FOR CREDIT LOSSES
The following is an analysis of the reserve for credit losses for the years ended December 31:
A-27 THE FINOVA GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
Net write-offs by line of business for the years ended December 31 are as follows:
An analysis of nonaccruing assets included in the investment in financing transactions at December 31 is as follows:
In addition to the repossessed assets included in the above table, FINOVA had repossessed assets with a total carrying amount of $65.3 million and $52.5 million at December 31, 1998 and 1997, respectively, which earned income of $4.7 million and $4.1 million during 1998 and 1997, respectively.
At December 31, 1998, the total carrying amount of impaired loans was $225.7 million, of which $106.0 million were revenue accruing. A reserve for credit losses of $30.9 million has been established for $74.3 million of nonaccruing impaired loans and $6.2 million has been established for $24.4 million of accruing impaired loans. At December 31, 1997, the total carrying amount of impaired loans was $158.0 million, of which $36.4 million were revenue accruing. At December 31, 1997, a reserve for credit losses of $17.8 million was established for $39.0 million of nonaccruing impaired loans and $2.4 million was established for $13.3 million of accruing impaired loans. For the three years ended December 31, 1998, 1997 and 1996, the average carrying amount of impaired loans was $172.0 million, $130.3 million and $85.1 million, respectively. Income earned on accruing impaired loans was approximately $4.0 million in all three years. Income earned on impaired loans is
A-28 THE FINOVA GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
recognized in the same manner as it is on other accruing loans. Cash collected on all nonaccruing loans is applied to the carrying amount.
Had all nonaccruing assets outstanding at December 31, 1998, 1997 and 1996 remained accruing, pre-tax income earned would have increased by approximately $19 million, $22 million and $19 million, respectively.
NOTE E DEBT
The Company satisfies its short-term financing requirements from the issuance of commercial paper supported by bank lines of credit, other bank loans and public notes. The Company's commercial paper borrowings are supported by unused revolving bank credit agreements totaling $4.4 billion. FINOVA Capital currently maintains a five-year revolving credit facility and a 364-day facility with numerous lenders, in the aggregate principal amount of $2.0 billion. Separately, FINOVA Capital also has two five-year facilities with numerous lenders for $700 million each, one 364-day facility with numerous lenders for $600 million and three 364-day facilities with three separate lenders for an aggregate principal amount of $400 million. The Company intends to borrow under the domestic revolving credit agreements to refinance commercial paper and short-term bank loans if it encounters significant difficulties in rolling over its outstanding commercial paper and short-term bank loans. The Company rarely borrows under these facilities. Under the terms of these agreements, the Company has the option to periodically select either domestic dollars or Eurodollars as the basis of borrowings. Interest is based on the lenders' prime rate for domestic dollar advances or London interbank offered rates ("LIBOR") for Eurodollar advances. The agreements also provide for a commitment fee on the unused credit. The 364-day $1.0 billion and $600 million revolving credit agreements are subject to renewal in 1999, while the two $700 million and the other $1.0 billion credit facilities are subject to renewal in 2002. The 364-day facilities totaling $400 million are subject to renewal in 1999; however, the Company does not anticipate extending these facilities. In addition to the above, the FINOVA Group Inc. has a 364-day revolving credit facility with one lender for $25 million, which is subject to renewal in 1999.
The Company, through one subsidiary, utilizes a five-year multi-currency facility with a small group of lenders for $100 million. Under the terms of this agreement, the subsidiary has the option to periodically select multiple currencies as the basis of borrowings. Interest is based on the Eurocurrency rate per annum for deposits in the relevant designated currency. Through another subsidiary, the Company maintains one 364-day revolving credit facility with three lenders in Canada for $100 million Canadian, supporting the issuance of Canadian commercial paper. Under the terms of this agreement, the subsidiary has the option to borrow Canadian dollars through either bankers' acceptances or a prime rate advance. Interest is based on the lenders' prime rate for prime advances or bankers' acceptance rates. FINOVA Capital is the guarantor of this credit facility, which is subject to renewal in 1999.
In 1998, FINOVA Capital commenced a Euro Medium-Term Note Program allowing for the issuance of up to $1 billion of debt securities. As of December 31, 1998 there was $750 million available under the program.
A-29 THE FINOVA GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
The following information pertains to all short-term financing, primarily commercial paper, issued by FINOVA Capital for the years ended December 31:
- --------------- * Exclusive of the cost of maintaining bank lines in support of outstanding commercial paper and the effects of interest rate conversion agreements.
Senior debt at December 31 was as follows:
Annual maturities of senior debt outstanding at December 31, 1998 due through June 2007 (excluding the amount supported by the revolving credit agreements expected to be renewed) approximate $775.2 million (1999), $821.3 million (2000), $951.0 million (2001), $839.4 million (2002), $504.9 million (2003) and $631.4 million (thereafter).
The agreements pertaining to senior debt and revolving credit agreements include various restrictive covenants and require the maintenance of certain defined financial ratios with which FINOVA and FINOVA Capital have complied. Under one covenant, dividend payments by FINOVA Capital are limited to 50% of accumulated earnings after December 31, 1991. As of December 31, 1998, FINOVA Capital had $118.1 million of excess accumulated earnings available for distribution.
Total interest paid is not significantly different from interest expense.
A-30 THE FINOVA GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
NOTE F DERIVATIVE FINANCIAL INSTRUMENTS
FINOVA enters into interest rate and basis swap agreements as part of its interest rate risk management policy of match funding its assets and liabilities. The derivative instruments used are straightforward. The Company continually monitors its derivative position and uses derivative instruments for non-trading and non-speculative purposes only.
FINOVA uses derivative instruments to minimize its exposure to fluctuations in interest rates. FINOVA strives to minimize its overall debt costs while limiting the short-term variability of interest expense and funds required for debt service. To achieve this objective, FINOVA diversifies its borrowing sources (short and long-term debt with a fixed or a variable rate) and seeks to maintain a portfolio that is matched funded. FINOVA's matched funding policy generally requires that floating-rate assets be financed with floating-rate liabilities and fixed-rate assets be financed with fixed-rate liabilities. FINOVA's matched funding policy also requires that the difference between floating-rate liabilities and floating-rate assets, measured as a percent of total assets, should not vary by more than 3% for any extended period. The amount of derivatives used is a function of this 3% gap policy with the maturities of the derivatives being correlated to the maturities of the assets being financed.
The notional amounts of derivatives do not represent amounts exchanged by the parties and, thus, are not a measure of FINOVA's exposure through its use of derivatives. The amounts exchanged are determined by reference to the notional amounts and the other terms of the derivatives.
Under interest rate swaps, FINOVA agrees to exchange with the other party, at specified intervals, the payment streams calculated on a specified notional amount, with at least one stream based on a floating interest rate. Generic swap notional amounts do not change for the life of the contract. Basis swaps involve the exchange of floating-rate indices, such as the prime rate, the commercial paper composite rate and LIBOR and are used primarily to protect FINOVA's margins on floating-rate transactions by locking in the spread between FINOVA's lending and borrowing rates.
FINOVA's off-balance sheet derivative instruments involve credit and interest rate risks. The credit risk would be the nonperformance by the other parties to the financial instruments. All financial instruments have been entered into with major financial institutions, which are expected to fully perform under the terms of the agreements, thereby mitigating the credit risk from the transactions, although there can be no assurance that any such institution will perform under its agreement. FINOVA's derivative policy stipulates that the maximum exposure to any one counter-party, relative to the derivative products, is limited on a net basis to 10% of FINOVA's outstanding debt at the time of that transaction. Interest rate risks relate to changes in interest rates and the impact on earnings. FINOVA mitigates interest rate risks through its matched funding policy.
The use of derivatives decreased interest expense by $5.3 million in 1998, a decrease in the aggregate cost of funds of 0.07%. The use of derivatives in 1997 decreased interest expense by $1.0 million, a decrease in the aggregate cost of funds of 0.03%, whereas the use of derivatives increased interest expense $3.0 million in 1996, an increase in the aggregate cost of funds of 0.05%. These changes in interest expense from off-balance sheet derivatives effectively alter on-balance sheet costs and must be viewed as total interest rate management. There were no deferred gains or losses associated with derivatives.
FINOVA also enters into short-term treasury rate locks, options, swaptions and other derivative investments to hedge interest rate risks associated with the warehousing of loans, primarily for FRC. A-31 THE FINOVA GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
In a treasury rate lock, FINOVA agrees to lock in an interest rate on a U.S. Treasury security until a specified date in the future. Prior to the expiration date, if treasury rates decrease, there is an associated loss on the hedge. If treasury rates increase, FINOVA will immediately benefit from an increase in the hedge value.
In a treasury put option, FINOVA pays an up-front fee (premium) to have the right, but not the obligation to sell a pre-determined treasury security at an agreed-upon strike rate. Prior to the expiration date of the option, if treasury rates decrease, the option expires worthless and there is no additional hedge loss. If treasury rates increase and surpass the strike rate, the value of the option will increase. In addition to the level of interest rates, the option value also depends on other variables including volatility and the time to maturity.
A swaption gives FINOVA the right, but not the obligation, to enter into a swap on the exercise date. An up-front premium is the only cost incurred by FINOVA. If swap rates rise above the strike rate, the option value will increase. If swap rates decrease, the option will not be exercised and will expire worthless. In addition to the level of swap rates, the option value also depends on other variables including volatility and time to maturity.
The following table provides annual maturities and weighted-average interest rates for each significant derivative product type in place at December 31, 1998. The rates presented are as of December 31, 1998. To the extent that rates change, variable interest information will change:
For the benefit of its customers, FINOVA enters into interest rate cap agreements. The total notional amount of these agreements at December 31, 1998 was $25.0 million, none of which was in A-32 THE FINOVA GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
a pay or receive position. These agreements will mature as follows: $15.9 million in 1999, $1.5 million in 2000 and $7.6 million in 2001.
Derivative product activity for the three years ended December 31, 1998 is as follows:
NOTE G COMPANY-OBLIGATED MANDATORY REDEEMABLE CONVERTIBLE PREFERRED SECURITIES OF SUBSIDIARY TRUST SOLELY HOLDING CONVERTIBLE DEBENTURES OF FINOVA
In December 1996, FINOVA Finance Trust, a subsidiary trust sponsored and wholly-owned by FINOVA, issued (a) 2,300,000 shares of convertible trust originated preferred securities (the "Preferred Securities" or "TOPrS") to the public for gross proceeds of $115 million (before transaction costs of $3.5 million) and (b) 71,135 shares of common securities to FINOVA. The gross proceeds from these transactions were invested by the trust in $118.6 million aggregate principal amount of 5 1/2% convertible subordinated debentures due 2016 (the "Debentures") newly issued by FINOVA. The Debentures represent all of the assets of the trust. The proceeds from the issuance of the Debentures were contributed by FINOVA to FINOVA Capital, which used the proceeds to repay commercial paper and other indebtedness.
The Preferred Securities accrue and pay cash distributions quarterly when declared by FINOVA at a rate of 5 1/2% per annum of the stated liquidation amount of $50 per preferred security. FINOVA has guaranteed, on a subordinated basis, distributions and other payments due on the Preferred Securities (the "Guarantee"). The Guarantee, when taken together with FINOVA's obligations under the Debentures, the indenture under which the Debentures were issued and FINOVA's obligations under the Amended and Restated Declaration of Trust governing the trust, provides a full and unconditional guarantee on a subordinated basis of amounts due on the Preferred Securities. FINOVA can defer making distributions on the Debentures for up to 20 consecutive quarters, but does not anticipate doing so. The Preferred Securities are mandatory redeemable upon the maturity of the Debentures on December 31, 2016, or earlier to the extent of any redemption by FINOVA of any Debentures. The redemption price in either case will be $50 per share plus accrued and unpaid distributions to the date fixed for redemption.
A-33 THE FINOVA GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
Prior to their maturity, the Preferred Securities are convertible into FINOVA's common stock at the election of the holders of the Preferred Securities individually. Each debenture is convertible into 1.2774 shares of FINOVA's common stock (equivalent to a conversion price of $39.14 per share), subject to adjustment in specified circumstances. FINOVA can terminate the conversion rights noted above on 30 days notice on or after December 31, 1999 if it is current on its payments for the Debentures and the closing prices of its common stock trade at or above 120% of the conversion price of the Preferred Securities ($46.97, assuming no adjustments).
NOTE H SHAREOWNERS' EQUITY
On August 14, 1997, the Board of Directors declared a two-for-one stock split of FINOVA's common stock effected as a stock distribution on October 1, 1997 to shareowners of record as of September 1, 1997. All share and per share data have been restated to reflect the split.
At December 31, 1998, 1997 and 1996, The FINOVA Group Inc. had 58,555,000, 58,555,000 and 56,844,000 shares of common stock issued, with 55,721,000, 56,282,000 and 55,058,000 shares of common stock outstanding, respectively. Approximately 6,917,000, 7,972,000 and 8,632,000 common shares were reserved for issuance under the 1992 Stock Incentive Plan at December 31, 1998, 1997 and 1996, respectively.
In addition to the convertible preferred securities issued by FINOVA Finance Trust in 1996, FINOVA has 5,000,000 shares of preferred stock authorized, none of which was issued at December 31, 1998. The Board of Directors is authorized to provide for the issuance of shares of preferred stock in series, to establish the number of shares to be included in each series and to fix the designation, powers, preferences and rights of the shares of each series. In connection with FINOVA's stock incentive plan, 250,000 shares of preferred stock are reserved for issuance of awards under that plan.
Each outstanding share of FINOVA's common stock has a tandem junior participating preferred stock purchase right ("Right") attached to it. The Rights contain provisions to protect shareowners in the event of an unsolicited acquisition or attempted acquisition of 20% or more of FINOVA's common stock, which is not believed by the Board of Directors to be in the best interest of shareowners. The Rights are represented by the common share certificates and are not exercisable or transferable apart from the common stock until such a situation arises. The Rights may be redeemable by FINOVA at $0.01 per right prior to the time any person or group has acquired 20% or more of FINOVA's shares. FINOVA has reserved 600,000 shares of Junior Participating Preferred Stock for issuance in connection with the Rights.
FINOVA periodically repurchases its securities on the open market to fund its obligations pursuant to employee stock options, benefit plans and similar obligations. During the years ended December 31, 1998 and 1997, FINOVA repurchased 1,299,200 and 1,035,800 shares, respectively. No shares were repurchased in 1996. The program may be discontinued at any time.
In 1999, the Board of Directors approved and recommended to the shareowners that they approve an amendment to FINOVA's certificate of incorporation. That amendment would increase the authorized common stock from 100 million to 400 million shares and the preferred stock from 5 million to 20 million shares. The shareowners are expected to vote on the measure at the 1999 annual meeting. The Board recommends approval of the proposal.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
NOTE I STOCK OPTIONS
During 1992, the Board of Directors of FINOVA adopted The FINOVA Group Inc. 1992 Stock Incentive Plan (the "Plan") for the grant of options, restricted stock and stock appreciation rights to officers, directors and employees. The Plan provides for the following types of awards: (a) stock options (both incentive and non-qualified stock options), (b) stock appreciation rights and (c) restricted stock. The Plan generally authorizes the issuance of awards for up to 2 1/2% of the total number of shares of common stock outstanding as of the first day of each year, with some modifications. In addition, 250,000 shares of preferred stock are reserved for awards under the Plan.
The stock options outstanding at December 31, 1998 were granted for terms of 10 years and generally become exercisable between one month to five years from the date of grant. Stock options are issued at market value at the date of grant, unless a higher exercise price is established. Since 1993, the Board has issued multi-year, multi-priced stock options to senior executives. The exercise price of those option grants range in price from the fair market value on the grant date to prices up to 58.7% in excess of the grant date value. Those option grants are intended to cover anticipated grants during the years the grants are scheduled to vest, although the Board may issue additional grants at its discretion. In 1998, premium-priced options were granted with exercise prices ranging from $54.47 to $83.21.
Information with respect to options granted and exercised for the three years ended December 31, 1998 is as follows:
At December 31, 1998, stock options with respect to 3,957,642 common shares were outstanding at exercise prices ranging from $6.35 to $83.21 per share.
A-35 THE FINOVA GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
The following table summarizes information about stock options outstanding at December 31, 1998:
Since April 1992, the Board of Directors has only granted performance based restricted stock to employees. Performance based restricted stock awards (78,985 shares in 1998, 90,100 shares in 1997 and 138,160 shares in 1996), vest generally over five years from the date of grant. The holder of the performance based restricted stock, like restricted stock, has the right to receive dividends and vote the target number of shares but may not sell, assign, transfer, pledge or otherwise encumber the performance based restricted stock. All performance based restricted stock grants since 1992 were based on FINOVA share performance and may result in greater or lesser numbers of shares ultimately being delivered to the holder, depending on that performance. The target number of shares are deemed received on the grant date. Additional vesting over the target are reported as new grants as of the vesting dates. Vestings below target would be reported as a forfeiture of amounts below the target number of shares.
The Company applies APB Opinion 25 and related Interpretations in accounting for its plans. No compensation cost has been recognized for its fixed stock option plans because FINOVA grants options at market price on the date of grant. The compensation cost that has been charged against income for its performance-based plan was $5.5 million, $7.9 million and $2.9 million for 1998, 1997 and 1996, respectively. Had compensation cost for the Company's stock based compensation plans been determined based on the fair value at the grant dates for awards under those plans consistent with the fair market value method, FINOVA's net income would have been $162.7 million, $135.6 million and $115.0 million for 1998, 1997 and 1996, respectively. Basic earnings per share would have been $2.91, $2.49 and $2.11 and diluted earnings per share would have been $2.74, $2.36 and $2.05 for 1998, 1997 and 1996, respectively.
The fair value of the options was estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions used for grants in 1998: dividend yield of 1.75%, expected volatility of 26%, risk-free interest rates of 5.7% and 5.8% and expected lives of five to seven years.
A-36 THE FINOVA GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
NOTE J INCOME TAXES
The consolidated provision for income taxes consists of the following for the years ended December 31:
Income taxes paid in 1998, 1997 and 1996 were approximately $26.0 million, $30.3 million and $31.3 million, respectively.
The significant components of deferred tax liabilities and deferred tax assets at December 31, 1998 and 1997 consisted of the following:
A-37 THE FINOVA GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
The federal statutory income tax rate is reconciled to the effective income tax rate as follows:
NOTE K PENSION AND OTHER BENEFITS
Net periodic pension costs were $3.0 million, $1.9 million and $1.7 million for the years ended December 31, 1998, 1997 and 1996, respectively. FINOVA's pension costs were accrued at $5.5 million at December 31, 1998 and $2.8 million at December 31, 1997.
Net periodic other postretirement benefit costs were $0.7 million, $0.5 million and $0.7 million for each of the years ended December 31, 1998, 1997 and 1996, respectively. FINOVA's accrued postretirement benefit costs were $3.5 million at December 31, 1998 and $2.8 million at December 31, 1997.
FINOVA's investment of $49 million in trust for nonqualified compensation plans consists of securities held for trading and is recorded at market.
NOTE L EARNINGS PER SHARE
Basic earnings per share exclude the effects of dilution and are computed by dividing income available to common shareowners by the weighted average amount of common stock outstanding for the period. Diluted earnings per share reflect the potential dilution that could occur if options, convertible preferred stock or other contracts to issue stock were exercised or converted into common stock. These per share calculations are presented for the years ended December 31, 1998, 1997 and 1996 on the Statements of Consolidated Income and are detailed below:
A-38 THE FINOVA GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
NOTE M LITIGATION AND CLAIMS
FINOVA is party either as plaintiff or defendant to various actions, proceedings and pending claims, including legal actions, some of which involve claims for compensatory, punitive or other damages in significant amounts. That litigation often results from FINOVA's attempts to enforce its lending agreements against borrowers and other parties to those transactions. Litigation is subject to many uncertainties and it is possible that some of the legal actions, proceedings or claims referred to above could be decided against FINOVA. Although the ultimate amount for which FINOVA may be held liable, if any, is not ascertainable, FINOVA believes that any resulting liability should not materially affect FINOVA's financial position, results of operations or cash flows.
NOTE N FAIR VALUE OF FINANCIAL INSTRUMENTS
The following disclosure of the estimated fair value of financial instruments has been determined by FINOVA using market information obtained by FINOVA and the valuation methodologies described below. However, considerable judgment is required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein may not be indicative of the amounts that FINOVA could realize in a current market exchange. The use of different market assumptions or valuation methodologies may have a material effect on the estimated fair value amounts.
A-39 THE FINOVA GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
The carrying amounts and estimated fair values of FINOVA's financial instruments are as follows for the years ended December 31:
The carrying values of cash and cash equivalents, fee-based receivables, financing contracts held for sale, accounts payable and accrued expenses, due to clients and interest payable (including accrued amounts related to interest rate swaps and interest rate hedge agreements) approximate fair values due to the short-term maturity of these items.
The methods and assumptions used to estimate the fair values of other financial instruments are summarized as follows:
LOANS AND OTHER FINANCING CONTRACTS:
The fair value of loans and other financing contracts was estimated by discounting expected cash flows using the current rates at which loans of similar credit quality, size and remaining maturity would be made as of December 31, 1998 and 1997. Management believes that the risk factor embedded in the current interest rates on performing loans results in a fair valuation of performing loans. As of December 31, 1998 and 1997, the fair value of nonaccruing impaired contracts with a carrying amount of $119.7 million and $121.5 million, respectively, was not estimated because it is not practical to reasonably assess the credit adjustment that would be applied in the marketplace for such loans. As of December 31, 1998 and 1997, the carrying amount of loans and other financing contracts excludes repossessed assets with a total carrying amount of $119.7 million and $89.6 million, respectively.
SENIOR DEBT:
The fair value of senior debt was estimated by discounting future cash flows using rates currently available for debt of similar terms and remaining maturities. The carrying values of commercial paper and borrowings under revolving credit facilities, if any, were assumed to approximate fair values due to their short maturities.
A-40 THE FINOVA GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
INTEREST RATE SWAPS:
The fair values of interest rate swaps are based on quoted market prices obtained from participating banks and dealers.
INTEREST RATE HEDGE AGREEMENTS:
The fair value of interest rate hedge agreements in place at December 31, 1998 are based on quoted market prices obtained from participating loans and dealers for transactions of similar remaining durations.
The fair value estimates presented herein were based on information obtained by FINOVA as of December 31, 1998 and 1997. Although management is not aware of any factors that would significantly affect the estimated fair values, such values have not been updated since December 31, 1998 and 1997. Therefore, current estimates of fair value may differ significantly from the amounts presented herein.
NOTE O OPERATING EXPENSES
The following represents a summary of the major components of operating expenses for the three years ended December 31:
NOTE P COMPREHENSIVE INCOME
Effective for the year ended December 31, 1998, FINOVA adopted the provisions of SFAS No. 130, "Reporting Comprehensive Income" ("SFAS No. 130"), which establishes standards for reporting and display of comprehensive income and its components in the financial statements.
Accumulated other comprehensive income activity for the three years ended December 31, 1998 is as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
For comparative purposes, financial statements presented for prior years have been reclassified to conform to the requirements of SFAS No. 130. The adoption of SFAS No. 130 had no impact on FINOVA's consolidated results of operations, financial position, or cash flows.
NOTE Q SEGMENT REPORTING
Management's Policy for Identifying Reportable Segments
FINOVA's reportable business segments are strategic business units that offer distinctive products and services that are marketed through different channels.
Types of Products and Services
FINOVA has three market groups that are also its reportable segments: Commercial Finance, Specialty Finance and Capital Markets. Commercial Finance includes traditional asset-based businesses that lend against collateral such as cash flows, inventory, receivables and leased assets. Specialty Finance includes businesses which lend to a variety of highly focused, industry-specific niches. Capital Markets, in conjunction with institutional investors, provides commercial mortgage banking services and debt and equity capital funding.
Reconciliation of Segment Information to Consolidated Amounts
Management evaluates the business performance of each group based on total net revenue, income before allocations and managed assets. Total net revenue is operating margin plus gains on disposals of assets. Income before allocations is income before income taxes and preferred dividends, excluding allocation of corporate overhead expenses and the unallocated portion of provision for credit losses. Managed assets includes each segment's investment in financing transactions plus securitizations and participations sold.
Information for FINOVA's reportable segments reconciles to FINOVA's consolidated totals as follows:
A-42 THE FINOVA GROUP INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN THOUSANDS IN TABLES, EXCEPT PER SHARE DATA)
Segment information was not presented for 1996 due to restructuring within the Company which made such presentation impracticable.
GEOGRAPHIC INFORMATION
FINOVA attributes income earned from financing transactions and managed assets to geographic areas based on the location of the customer. Income earned from financing transactions and managed assets at December 31, 1998 by geographic area are as follows:
MAJOR CUSTOMER INFORMATION
FINOVA has no single customer that accounts for 10% or more of revenue.
NOTE R NEW ACCOUNTING STANDARDS
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," (SFAS No. 133) which is effective for fiscal years beginning after June 15, 1999. This statement standardizes the accounting for derivative instruments, including certain derivative instruments embedded in other contracts, by recognition of those items as assets or liabilities in the statement of financial position and measurement at fair value. FINOVA will adopt this standard effective January 1, 2000, as required. The impact of SFAS No. 133 on the Company's financial position and results of operations has not yet been determined.
NOTE S SUBSEQUENT EVENT -- DEFINITIVE AGREEMENT TO ACQUIRE SIRROM CAPITAL CORPORATION
On January 7, 1999, The FINOVA Group Inc. announced that it had reached a definitive agreement to acquire Sirrom Capital Corporation ("Sirrom"), a specialty finance company headquartered in Nashville, Tenn.
Under the terms of the agreement, Sirrom shareholders will receive 0.1634 shares of FINOVA common stock for each share of Sirrom common stock they own, subject to possible increases. Based on the conversion rate and FINOVA's share value when the agreement was signed, the aggregated purchase price of the Sirrom common stock will be approximately $343 million. A-43
THE FINOVA GROUP INC.
SUPPLEMENTAL SELECTED FINANCIAL DATA CONDENSED QUARTERLY RESULTS (UNAUDITED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
The following represents the condensed quarterly results for the three years ended December 31, 1998, 1997 and 1996:
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THE FINOVA GROUP INC.
AVERAGE BALANCES/OPERATING MARGIN/AVERAGE ANNUAL RATES (UNAUDITED)(1) (DOLLARS IN THOUSANDS)
The following represents the breakdown of FINOVA's average balance sheet, operating margin and average annual rates for the years ended December 31, 1998 and 1997:
- --------------- (1) Averages are calculated based on monthly balances. (2) The average rate is calculated based on average earning assets ($8,544,431 and $7,356,845 for 1998 and 1997, respectively) which are net of average deferred taxes on leveraged leases and average nonaccruing assets. (3) For the year ended December 31, 1998, excluding the impact of derivatives, interest expense would have been $474,076 or 5.55% of average earning assets and operating margin would have been $554,543 or 6.50% of average earning assets. For the year ended December 31, 1997, excluding the impact of derivatives, interest expense would have been $417,140 or 5.67% of average earning assets and operating margin would have been $454,595 or 6.18% of average earning assets. (4) For the years ended December 31, 1998 and 1997 interest income is shown net of operating lease depreciation.
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THE FINOVA GROUP INC. COMMISSION FILE NUMBER 1-11011 EXHIBIT INDEX DECEMBER 31, 1998 FORM 10-K
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- --------------- * Filed with this report.
+ Relating to management compensation.
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