================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended October 31, 2005
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from to
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Commission file number 1-12006
FINANCIAL FEDERAL CORPORATION
(Exact name of Registrant as specified in its charter)
Nevada 88-0244792
(State of incorporation) (I.R.S. Employer Identification No.)
733 Third Avenue, New York, New York 10017
(Address of principal executive offices)
Registrant's telephone number, including area code: (212) 599-8000
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [ ]
Indicate by check mark whether the registrant is a shell company (as defined
in Rule 12b-2 of the Act). Yes [ ] No [X]
The number of shares outstanding of the registrant's common stock as of
December 1, 2005 was 17,579,616.
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FINANCIAL FEDERAL CORPORATION AND SUBSIDIARIES
Quarterly Report on Form 10-Q
for the quarter ended October 31, 2005
TABLE OF CONTENTS
Part I - Financial Information Page No.
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Item 1. Financial Statements:
Consolidated Balance Sheets at October 31, 2005 (unaudited)
and July 31, 2005 (audited) 3
Consolidated Income Statements for the three months ended
October 31, 2005 and 2004 (unaudited) 4
Consolidated Statements of Changes in Stockholders' Equity
for the three months ended October 31, 2005 and 2004
(unaudited) 5
Consolidated Statements of Cash Flows for the three months
ended October 31, 2005 and 2004 (unaudited) 6
Notes to Consolidated Financial Statements (unaudited) 7-12
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 13-21
Item 3. Quantitative and Qualitative Disclosures about Market Risk 21
Item 4. Controls and Procedures 21
Part II - Other Information
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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 21
Item 5. Other Information 21
Item 6. Exhibits 21
Signatures 22
2
FINANCIAL FEDERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except par value)
==================================================================================================
October 31, 2005* July 31, 2005
==================================================================================================
ASSETS
Finance receivables $1,742,744 $1,666,079
Allowance for credit losses (24,188) (24,225)
--------------------------------------------------------------------------------------------------
Finance receivables - net 1,718,556 1,641,854
Cash 8,807 8,456
Other assets 11,176 11,535
--------------------------------------------------------------------------------------------------
TOTAL ASSETS $1,738,539 $1,661,845
==================================================================================================
LIABILITIES
Debt:
Long-term ($6,400 at October 31, 2005 and $6,300 at
July 31, 2005 due to related parties) $1,040,600 $ 979,700
Short-term 278,100 280,000
Accrued interest, taxes and other liabilities 66,739 60,031
--------------------------------------------------------------------------------------------------
Total liabilities 1,385,439 1,319,731
--------------------------------------------------------------------------------------------------
STOCKHOLDERS' EQUITY
Preferred stock - $1 par value, authorized 5,000 shares -- --
Common stock - $.50 par value, authorized 100,000 shares,
shares issued and outstanding (net of 1,696 treasury
shares): 17,550 at October 31, 2005 and 17,487 at
July 31, 2005 8,775 8,743
Additional paid-in capital 111,690 109,226
Retained earnings 232,635 224,145
--------------------------------------------------------------------------------------------------
Total stockholders' equity 353,100 342,114
--------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $1,738,539 $1,661,845
==================================================================================================
* Unaudited
See accompanying notes to consolidated financial statements
3
FINANCIAL FEDERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED INCOME STATEMENTS *
(In thousands, except per share amounts)
===================================================================================================
Three Months Ended October 31, 2005 2004
===================================================================================================
Finance income $36,553 $29,892
Interest expense 14,246 9,296
---------------------------------------------------------------------------------------------------
Net finance income before provision for credit
losses on finance receivables 22,307 20,596
Provision for credit losses on finance receivables -- 950
---------------------------------------------------------------------------------------------------
Net finance income 22,307 19,646
Salaries and other expenses 5,498 5,681
---------------------------------------------------------------------------------------------------
Income before provision for income taxes 16,809 13,965
Provision for income taxes 6,564 5,405
---------------------------------------------------------------------------------------------------
NET INCOME $10,245 $ 8,560
===================================================================================================
EARNINGS PER COMMON SHARE:
Diluted $ 0.59 $ 0.50
===================================================================================================
Basic $ 0.60 $ 0.51
===================================================================================================
* Unaudited
See accompanying notes to consolidated financial statements
4
FINANCIAL FEDERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY *
(In thousands)
======================================================================================================
Shares of Additional Total
Common Common Paid-In Retained Stockholders'
Stock Stock Capital Earnings Equity
======================================================================================================
BALANCE - JULY 31, 2004 17,269 $8,634 $101,920 $193,336 $303,890
Repurchases of common stock
(retired) (13) (6) (237) (245) (488)
Employee stock plans:
Shares issued 118 59 2,281 -- 2,340
Compensation recognized -- -- 665 -- 665
Tax benefits -- -- 325 -- 325
Net income -- -- -- 8,560 8,560
------------------------------------------------------------------------------------------------------
BALANCE - OCTOBER 31, 2004 17,374 $8,687 $104,954 $201,651 $315,292
======================================================================================================
======================================================================================================
Shares of Additional Total
Common Common Paid-In Retained Stockholders'
Stock Stock Capital Earnings Equity
======================================================================================================
BALANCE - JULY 31, 2005 17,487 $8,743 $109,226 $224,145 $342,114
Employee stock plans:
Shares issued 63 32 982 -- 1,014
Compensation recognized -- -- 1,368 -- 1,368
Excess tax benefits -- -- 114 -- 114
Common stock cash dividends -- -- -- (1,755) (1,755)
Net income -- -- -- 10,245 10,245
------------------------------------------------------------------------------------------------------
BALANCE - OCTOBER 31, 2005 17,550 $8,775 $111,690 $232,635 $353,100
======================================================================================================
* Unaudited
See accompanying notes to consolidated financial statements
5
FINANCIAL FEDERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS *
(In thousands)
===================================================================================================
Three Months Ended October 31, 2005 2004
===================================================================================================
Cash flows from operating activities:
Net income $ 10,245 $ 8,560
Adjustments to reconcile net income to net cash provided by
operating activities:
Amortization of deferred origination costs and fees 3,748 3,910
Stock-based compensation 1,368 665
Provision for credit losses on finance receivables -- 950
Depreciation and amortization 194 197
Decrease in other assets 165 8,275
Increase in accrued interest, taxes and other liabilities 5,722 5,420
Tax benefits from stock plans -- 325
Excess tax benefits from stock-based awards (114) --
---------------------------------------------------------------------------------------------------
Net cash provided by operating activities 21,328 28,302
---------------------------------------------------------------------------------------------------
Cash flows from investing activities:
Finance receivables originated (323,345) (218,299)
Finance receivables collected 242,895 185,138
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Net cash used in investing activities (80,450) (33,161)
---------------------------------------------------------------------------------------------------
Cash flows from financing activities:
Asset securitization borrowings 100,000 --
Commercial paper, net increase 34,100 2,465
Bank borrowings, net (decrease) increase (116,500) 4,140
Proceeds from term notes 50,000 --
Repayment of term notes (7,500) --
Proceeds from stock option exercises 1,014 1,852
Excess tax benefits from stock-based awards 114 --
Common stock cash dividends (1,755) --
---------------------------------------------------------------------------------------------------
Net cash provided by financing activities 59,473 8,457
---------------------------------------------------------------------------------------------------
NET INCREASE IN CASH 351 3,598
Cash - beginning of period 8,456 6,981
---------------------------------------------------------------------------------------------------
CASH - END OF PERIOD $ 8,807 $ 10,579
===================================================================================================
* Unaudited
See accompanying notes to consolidated financial statements
6
FINANCIAL FEDERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(Unaudited)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of Business
Financial Federal Corporation and subsidiaries provide collateralized
lending, financing and leasing services nationwide to middle-market businesses
in the general construction, road and infrastructure construction and repair,
road transportation and waste disposal industries. We lend against, finance and
lease a wide range of new and used revenue-producing, essential-use equipment
such as cranes, earthmovers, personnel lifts, trailers and trucks.
Basis of Presentation
We prepared the accompanying unaudited Consolidated Financial
Statements according to the Securities and Exchange Commission's rules and
regulations. These rules and regulations permit condensing or omitting certain
information and note disclosures normally included in financial statements
prepared according to accounting principles generally accepted in the United
States of America (GAAP). The July 31, 2005 Consolidated Balance Sheet was
derived from audited financial statements but does not include all disclosures
required by GAAP. However, we believe the disclosures are sufficient to make the
information presented not misleading. These Consolidated Financial Statements
and accompanying notes should be read with the Consolidated Financial Statements
and accompanying notes included in our Annual Report on Form 10-K for the fiscal
year ended July 31, 2005.
We believe the Consolidated Financial Statements include all
adjustments (consisting of only normal recurring items) necessary to present
fairly our financial position and results of operations for the periods
presented. The results of operations for the three months ended October 31,
2005 may not be indicative of full year results.
Use of Estimates
We are required to make significant estimates and assumptions that
affect amounts reported in the Consolidated Financial Statements and
accompanying notes for the allowance for credit losses, non-performing assets,
residual values and stock-based compensation. Actual results could differ
significantly from those estimates.
Stock-Based Compensation Expense
On August 1, 2005, we started recording compensation expense for stock
options as required by Statement of Financial Accounting Standards ("SFAS") No.
123(R), "Share-Based Payment, revised 2004" ("SFAS No. 123R") and according to
the provisions of the Securities and Exchange Commission's Staff Accounting
Bulletin No. 107 using SFAS No. 123R's modified prospective method. This method
requires us to record compensation expense for options unvested at August 1,
2005 and for options subsequently granted or modified. Prior periods will not
be restated. Compensation expense is based on the grant date fair value of
options calculated with an option-pricing model and is recognized over the
vesting period. We are using the Black-Scholes option pricing model.
Before August 1, 2005, we applied Accounting Principles Board Opinion
("APB") No. 25, "Accounting for Stock Issued to Employees," and related
Interpretations to account for our stock options. Under APB No. 25, we did not
record compensation expense for our stock options.
Compensation expense for options unvested at August 1, 2005 is based on
the grant date fair value calculated under SFAS No. 123, "Accounting for
Stock-Based Compensation" ("SFAS No. 123") and will be recognized using the
graded-vesting (accelerated) attribution method (the method used for SFAS No.
123 pro forma disclosure). Compensation expense for options granted after to
July 31, 2005 will be recognized using the straight-line attribution method.
Compensation expense is only recorded for options expected to vest. Therefore,
we are required to estimate the number of options that will be forfeited and
revise our estimate based on actual forfeitures.
7
For the three months ended October 31, 2005, salaries and other
expenses includes $200 of compensation expense for options recognized under SFAS
No. 123R resulting in a tax benefit of $30. Compensation expense for options
required to be capitalized under SFAS No. 91, "Accounting for Nonrefundable Fees
and Costs Associated with Originating or Acquiring Loans and Initial Direct
Costs of Leases" ("SFAS No. 91"), and included in finance receivables was $300
for the three months ended October 31, 2005. Recording compensation expense for
options under SFAS No. 123R reduced basic and diluted earnings per share by
$0.01. The $30 tax benefit only applied to compensation expense from
non-qualified options. Tax benefits cannot be recorded on compensation expense
from incentive stock options unless shares acquired on exercise of incentive
stock options are sold by the employee within one year of exercise.
SFAS No. 123R did not change how we determine or recognize
compensation expense for restricted stock and stock units. Compensation expense
is based on the market value of our common stock on the date of the award and is
recognized over the vesting period using the straight-line method or the
graded-vesting method for awards with a performance condition. For the three
months ended October 31, 2005 and 2004, salaries and other expenses includes
$500 and $370, respectively, of compensation expense for restricted stock and
stock units resulting in tax benefits of $190 and $140. Compensation expense
for restricted stock and stock units required to be capitalized under SFAS No.
91 was $380 and $300 for the three months ended October 31, 2005 and 2004,
respectively.
The effect on net income and earnings per share had we recorded
compensation expense for options under SFAS No. 123 for the three months ended
October 31, 2004 follow:
======================================================================
Net income, as reported $8,560
Add: Compensation expense recorded for stock awards
(after-tax) 230
Deduct: Total stock-based compensation expense determined
under fair value based method for all awards
(after-tax) (762)
----------------------------------------------------------------------
Pro forma net income $8,028
======================================================================
Diluted earnings per common share:
As reported $ 0.50
Pro forma 0.47
======================================================================
Basic earnings per common share:
As reported $0.51
Pro forma 0.48
======================================================================
NOTE 2 - FINANCE RECEIVABLES
Finance receivables comprise installment sale agreements and secured
loans (including line of credit arrangements), collectively referred to as
loans, with fixed or floating (indexed to the prime rate) interest rates, and
direct financing leases as follows:
====================================================================
October 31, July 31,
2005 2005
====================================================================
Loans:
Fixed rate $1,458,876 $1,386,094
Floating rate 109,921 104,999
--------------------------------------------------------------------
Total loans 1,568,797 1,491,093
Direct financing leases * 173,947 174,986
--------------------------------------------------------------------
Finance receivables $1,742,744 $1,666,079
====================================================================
* includes residual values of $36,800 at October 31, 2005 and 37,400
at July 31, 2005
8
The allowance for credit losses activity is summarized below:
====================================================================
Three Months Ended October 31, 2005 2004
====================================================================
Beginning balance $24,225 $24,081
Provision -- 950
Write-downs (852) (1,532)
Recoveries 815 746
--------------------------------------------------------------------
Ending balance $24,188 $24,245
====================================================================
Percentage of finance receivables 1.39% 1.63%
====================================================================
Net charge-offs * $ 37 $ 786
====================================================================
Loss ratio ** 0.01% 0.21%
====================================================================
* write-downs less recoveries
** net charge-offs over average finance receivables, annualized
Non-performing assets comprise finance receivables classified as
non-accrual (income recognition has been suspended and the receivables are
considered impaired) and assets received to satisfy finance receivables
(repossessed equipment, included in other assets) as follows:
====================================================================
October 31, July 31,
2005 2005
====================================================================
Finance receivables classified
as non-accrual $ 9,992 $23,656
Assets received to satisfy finance
receivables 1,831 1,674
--------------------------------------------------------------------
Non-performing assets $ 11,823 $25,330
====================================================================
The allowance for credit losses included $300 at October 31, 2005 and
$800 at July 31, 2005 specifically allocated to $1,400 and $6,700, respectively,
of impaired finance receivables.
We also provide commitments to extend credit. These commitments contain
off-balance sheet risk. We use the same credit policies and procedures in
providing these commitments as we do for finance receivables. At October 31,
2005 and July 31, 2005, the unused portion of these commitments was $20,900 and
$15,100, respectively.
NOTE 3 - DEBT
Debt is summarized below:
====================================================================
October 31, July 31,
2005 2005
====================================================================
Fixed rate term notes:
5.00% due 2010 $ 250,000 $ 200,000
5.92% due 2006 - 2007 35,000 42,500
6.23% - 6.98% due 2006 - 2008 61,250 61,250
--------------------------------------------------------------------
Total fixed rate term notes 346,250 303,750
Fixed rate term notes swapped to
floating rates due 2008 - 2010 143,250 143,250
Floating rate term note due 2007 10,000 10,000
2.0% convertible debentures due 2034 175,000 175,000
--------------------------------------------------------------------
Total term debt 674,500 632,000
Asset securitization financings 425,000 325,000
Bank borrowings 96,500 213,000
Commercial paper 128,100 94,000
--------------------------------------------------------------------
Total principal 1,324,100 1,264,000
Fair value adjustment of hedged debt (5,400) (4,300)
--------------------------------------------------------------------
Total debt $1,318,700 $1,259,700
====================================================================
9
Term Notes
In August 2005, we received $50,000 of five-year, 5.0% fixed rate term
notes issued in May 2005. Interest is payable semi-annually. The notes are due
at maturity in August 2010. Prepayment of the notes is subject to a premium
based on a yield maintenance formula.
Convertible Debentures
The convertible debentures were originally convertible into 3,969,000
shares of common stock at the conversion price of $44.10 per share resulting in
an initial conversion rate of 22.6778 shares per $1 (one thousand) of principal.
In December 2004, we irrevocably elected to pay the value of converted
debentures, not exceeding the principal amount, in cash. We will pay any value
over principal with shares of common stock. This eliminated the 3,969,000 shares
of common stock originally issuable upon conversion. At October 31, 2005, no
event occurred that would have allowed for conversion of the debentures.
In October 2005, the conversion rate increased for the fourth time
because we paid cash dividends. At October 31, 2005, the conversion rate was
22.92, the conversion price was $43.63 and we would have to deliver the value of
4,011,000 shares upon conversion of all the debentures. Future cash dividends
will cause further adjustments.
Asset Securitization Financings
In August 2005, our asset securitization facility was increased
$100,000 to $425,000 and we borrowed the additional amount. The facility
provides for committed revolving financing for one year. If the facility is not
renewed before its current April 28, 2006 expiration, we can convert
borrowings outstanding into term debt. Finance receivables include $493,000 and
$381,000 of securitized receivables at October 31, 2005 and July 31, 2005,
respectively. At October 31, 2005, we could securitize an additional $200,000
of finance receivables. Borrowings are limited to 94% of securitized
receivables.
Bank Borrowings
We have $430,000 of committed unsecured revolving credit facilities
with several banks expiring as follows; $222,500 in one year and $207,500
between December 2009 and September 2010.
Other
The debt agreements of our major operating subsidiary have restrictive
covenants including limitations on the subsidiary's indebtedness, encumbrances,
investments, dividends and other distributions to us, sales of assets, mergers
and other business combinations, capital expenditures, interest coverage and net
worth. None of the agreements have a material adverse change clause. All of our
debt is senior.
Long-term debt comprised the following:
====================================================================
October 31, July 31,
2005 2005
====================================================================
Term notes $ 434,100 $410,200
Asset securitization financings 224,000 162,000
Convertible debentures 175,000 175,000
Bank borrowings and commercial paper
supported by bank credit facilities
expiring after one year 207,500 182,500
Bank borrowings refinanced with term
notes in August 2005 -- 50,000
--------------------------------------------------------------------
Total long-term debt $1,040,600 $979,700
====================================================================
NOTE 4 - DERIVATIVES
At October 31, 2005 and July 31, 2005, the notional amount of interest
rate swaps was $143,250. We designated the swaps as fair value hedges of fixed
rate term notes. We receive fixed rates equal to the rates of the hedged notes
and pay floating rates indexed to six-month LIBOR on the swaps' notional
amounts. We record the differences between the amounts we receive and pay as
adjustments to interest expense. The swaps expire on the notes' maturity dates.
The fair value of the swaps was a liability of $5,400 at October 31, 2005 and
$4,300 at July 31, 2005. The weighted average rates we receive and pay on the
swaps were 4.88% and 5.82%, respectively, at October 31, 2005, and 4.88% and
5.02%, respectively, at July 31, 2005.
10
NOTE 5 - STOCKHOLDERS' EQUITY
At October 31, 2005, $18,300 was available for future repurchases under
our repurchase program. In October 2005, we paid a quarterly cash dividend of
$0.10 per share of common stock.
NOTE 6 - STOCK PLANS
Our 1998 Stock Option/Restricted Stock Plan (the "1998 Plan") was
approved by stockholders in December 1998 and was amended in 2002 to include
restricted stock grants. The plan provides for 2,500,000 incentive or
non-qualified stock options or shares of restricted stock to be granted to
officers, other employees and directors. The 1998 Plan expires in September
2008. The exercise price of incentive stock options may not be less than the
fair market value of our common stock when granted and the term of incentive
stock options is limited to ten years.
Options granted through the first half of fiscal 2005 typically were
incentive stock options with a six-year term vesting 25% after two, three, four
and five years. In the second half of fiscal 2005, we granted 95,000
non-qualified options with a four-year term vesting 33 1/3% on July 31, 2005,
2006 and 2007. We made these changes to reduce the fair value calculated for
these options and the after-tax expense to be recorded under SFAS No. 123R.
At October 31, 2005, 510,000 shares of common stock were available for future
grants of stock options and shares of restricted stock under the 1998 Plan.
The Management Incentive Plan ("MIP") for our Chief Executive Officer
("CEO") was approved by stockholders in fiscal 2002. Under the MIP, the CEO can
be awarded shares of restricted stock and a cash or stock bonus if certain
predetermined performance goals are achieved. The MIP provides for 500,000
shares of restricted stock to be awarded with a 100,000 annual limit. In
September 2005, the CEO received 18,000 shares of restricted stock under the
MIP as a bonus for fiscal 2005. The shares vest annually over their four-year
life. At October 31, 2005, 358,000 shares of restricted stock were available
for future awards and 79,000 shares of the CEO's restricted stock were
unvested. In November 2005, we awarded 27,500 shares of restricted stock to the
CEO under the MIP as a bonus for fiscal 2006 subject to certain performance
conditions. Any shares received will vest annually over their four-year life.
We established a Supplemental Retirement Benefit ("SERP") for our CEO
in fiscal 2002. We granted 100,000 stock units (representing an equivalent
number of shares of common stock) vesting evenly over eight years. Subject to
forfeiture, the CEO will receive shares of common stock equal to the number of
stock units vested when the CEO's employment terminates. At October 31, 2005,
62,500 units were unvested. The grant-date fair value of these units was
$33.65.
The restricted stock agreements and the SERP provide for all unvested
shares to vest immediately when certain events occur including the sale of the
Company, the officer's death or disability and qualifying employment
terminations. Unvested shares are also subject to forfeiture.
Stock options, shares of restricted stock and stock units are the only
incentive compensation we provide and we believe these awards better align
employees' interests with the interests of our stockholders. We issue new
shares when options are exercised or restricted stock is granted and we do not
have a policy of repurchasing shares.
Stock option activity and related information for the three months
ended October 31, 2005 is summarized below (options and intrinsic value in
thousands):
=====================================================================================
Weighted-
Weighted- Average
Average Remaining
Exercise Contractual Intrinsic
Options Price Term (in years) Value*
=====================================================================================
Outstanding - August 1, 2005 1,204 $28.63
Granted 5 38.16
Exercised (45) 22.63
Canceled and expired --
----------------------------------------
Outstanding - October 31, 2005 1,164 $28.90 3.10 $10,800
=====================================================================================
Exercisable - October 31, 2005 383 $25.64 2.25 $ 4,800
=====================================================================================
* the difference between the closing price of our common stock and the
exercise prices of options multiplied by the number of options
11
The fair value of the 5,000 non-qualified options granted in the three
months ended October 31, 2005 was $6.90. The intrinsic value of options
exercised in the three months ended October 31, 2005 was $743 or $16.47 per
option.
Restricted stock activity under the 1998 Plan and the MIP and related
information for the three months ended October 31, 2005 are summarized below
(shares in thousands):
===================================================================
Weighted-Average
Grant-Date
Shares Fair Value
===================================================================
Unvested - August 1, 2005 390 $29.30
Granted 18 39.80
Vested (2) 37.00
Forfeited --
-----------------------------------------
Unvested - October 31, 2005 406 $29.72
===================================================================
The intrinsic value of the 2,000 shares of restricted stock that vested
in the three months ended October 31, 2005 was $77 or $38.44 per share.
Future compensation expense for unvested awards outstanding and
expected to vest at October 31, 2005 and the weighted-average period the expense
will be recognized over (before deferral under SFAS No. 91) follows:
======================================================================
Weighted-Average
Expense Years
======================================================================
Restricted stock $10,500 4.80
Stock options 2,500 2.00
Stock units 1,800 4.17
-------------------------------------------
Total $14,800 4.25
======================================================================
NOTE 7 - EARNINGS PER COMMON SHARE
Earnings per common share ("EPS") was calculated as follows (in
thousands, except per share amounts):
=======================================================================
Three Months Ended October 31, 2005 2004
=======================================================================
Net income $10,245 $8,560
=======================================================================
Weighted average common shares outstanding
(used for basic EPS) 17,147 16,893
Effect of dilutive securities:
Stock options * 201 263
Restricted stock and stock units 130 114
-----------------------------------------------------------------------
Adjusted weighted average common shares
outstanding (used for diluted EPS) 17,478 17,270
=======================================================================
Earnings per common share:
Diluted $0.59 $0.50
=======================================================================
Basic $0.60 $0.51
=======================================================================
* excludes 432 stock options and 18 shares of restricted stock in the
three months ended October 31, 2005 that were antidilutive
Our convertible debentures will not lower diluted EPS until the price
of our common stock exceeds the adjusted conversion price of $43.63. In fiscal
periods when the average price of our common stock exceeds $43.63, the number of
shares of common stock needed to deliver the value of the debentures over
principal would be included as shares outstanding in calculating diluted EPS.
The closing price of our common stock was $38.18 on October 31, 2005.
12
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
Financial Federal Corporation is an independent financial services
company operating through three wholly owned subsidiaries. We do not have any
unconsolidated subsidiaries, partnerships or joint ventures. We also do not have
any off-balance sheet assets or liabilities (other than commitments to extend
credit), goodwill, other intangible assets or pension obligations, and we are
not involved in income tax shelters. We have one fully consolidated special
purpose entity we established for our on-balance-sheet asset securitization
facility.
We have one line of business; lending money in the form of installment
sale agreements, secured loans and leases (collectively referred to as "finance
receivables") to small and medium sized businesses for their equipment financing
needs. We earn revenue solely from interest and other fees and amounts earned on
our finance receivables. We need to borrow most of the money we lend; therefore
liquidity is important. We borrow from banks and insurance companies and issue
commercial paper to money market funds and other investors. At October 31, 2005,
approximately 75% of our finance receivables were funded with debt.
We earn interest income on our finance receivables and incur interest
expense on our debt. We focus on (i) maximizing the difference between the rates
we earn on our receivables and the rates we incur on our debt ("net interest
spread") (ii) maintaining the credit quality of our receivables and (iii)
managing our interest rate risk. Interest rates on our finance receivables are
94% fixed and 6% floating, and interest rates on our debt are 39% fixed and 61%
floating. Therefore, changes in market interest rates affect our profitability
significantly. The credit quality of our finance receivables can also affect our
profitability significantly. Credit quality can affect revenue, provisions for
credit losses and operating expenses through reclassifying receivables to or
from non-accrual status, incurring charge-offs and incurring costs associated
with non-performing assets. We use various strategies to manage our interest
rate risk and credit risk.
Our main areas of focus are asset quality, liquidity and interest rate
risk. We discuss each in detail in separate sections of this discussion. These
areas are integral to our long-term profitability. Our key performance measures
are net charge-offs and loss ratio, non-performing assets, delinquencies,
receivables growth, leverage, available liquidity, net interest margin and net
interest spread, and expense and efficiency ratios.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Accounting principles generally accepted in the United States require
judgments, assumptions and estimates that affect the amounts reported in the
Consolidated Financial Statements and accompanying notes. Note 1 to the
Consolidated Financial Statements in our Annual Report on Form 10-K for the
fiscal year ended July 31, 2005 describes the significant accounting policies
and methods used to prepare the Consolidated Financial Statements. Accounting
policies involving significant judgment, assumptions and estimates are
considered critical accounting policies and are described below.
The allowance for credit losses on finance receivables is our estimate
of losses inherent in our finance receivables at the balance sheet date. The
allowance is difficult to determine and requires a significant degree of
judgment. The allowance is based on total finance receivables, charge-off
experience, non-accrual and delinquent finance receivables and our current
assessment of the risks inherent in our finance receivables from national and
regional economic conditions, industry conditions, concentrations, the financial
condition of counterparties (includes the customer, equipment vendors,
manufacturers and the customer's owners or affiliates), collateral values and
other factors. We may need to change the allowance level significantly if
unexpected changes in these factors occur. Increases in the allowance would
reduce net income through higher provisions for credit losses. The allowance was
$24.2 million (1.39% of finance receivables) at October 31, 2005 including $0.3
million specifically allocated to impaired receivables.
The allowance includes amounts specifically allocated to impaired
receivables and a general amount providing for losses inherent in the remainder
of finance receivables. In evaluating the net realizable value of impaired
receivables, we may record a write-down or establish a specific allowance based
on the probability of loss. We record write-downs based on the fair value of the
collateral. We establish specific allowances when collecting all amounts due is
not fully supported solely by the value of the primary collateral depending on
the level and type of other items supporting collectibility. The general
allowance is determined by a quarterly analysis of historical charge-offs for
the prior two years (comparable with the average life of our receivables) used
to develop percentage loss ranges to apply to receivables based on their
13
assigned risk profile. Risk profiles are assigned to receivables based on
industry and past due status. We adjust the calculated range of losses for
expected recoveries and we may also adjust the range for differences between
current and historical loss trends and other factors. Although our method is
designed to calculate probable losses, because significance estimates are used,
the calculated range of losses, as may be adjusted, may differ significantly
from actual losses.
We record impaired finance receivables at their current estimated net
realizable value (if less than their carrying amount). We record assets received
to satisfy receivables at their current estimated fair value less selling costs
(if less than their carrying amount). We estimate these values based on our
evaluation of the expected cash flows and market value and condition of the
collateral or assets. We evaluate market value by analyzing recent sales of
similar equipment and used equipment publications, using our market knowledge
and making inquiries of equipment vendors. Unexpected adverse changes in or
incorrect conclusions on expected cash flows, market value or condition of
collateral or assets, or time needed to sell equipment would require us to
record a write-down. This would lower net income. Impaired finance receivables
and assets received to satisfy receivables totaled $11.8 million (0.7% of
finance receivables) at October 31, 2005.
We record residual values on direct financing leases at the lowest of
(i) any stated purchase option (ii) the present value at the end of the initial
lease term of rentals due under any renewal options or (iii) our projection of
the equipment's fair value at the end of the lease. We may not fully realize
recorded residual values because of unexpected adverse changes in equipment
values. This would lower net income. Residual values were $36.8 million (2.1% of
finance receivables) at October 31, 2005. Historically, we have realized the
recorded residual value on disposition.
We record compensation expense for stock options under SFAS No. 123R
using the Black-Scholes option pricing model. This model requires estimates of
expected volatility of the price of our common stock, the expected life of the
option and the expected dividend rate. Estimating volatility, expected life and
dividend rate requires significant judgment and our estimates were based on
historical experience. Also, SFAS No. 123R requires us to estimate stock
options expected to vest (also based on historical experience). If actual
results differ significantly from these estimates, compensation expense for
options and our results of operations could be impacted materially.
RESULTS OF OPERATIONS
Comparison of three months ended October 31, 2005 to three months ended October
31, 2004
=============================================================================
Three Months Ended
October 31,
($ in millions, except per ------------------
share amounts) 2005 2004 $ Change % Change
=============================================================================
Finance income $36.6 $29.9 $ 6.7 22%
Interest expense 14.3 9.3 5.0 53
Net finance income before
provision for credit losses 22.3 20.6 1.7 8
Provision for credit losses -- 1.0 (1.0) (100)
Salaries and other expenses 5.5 5.7 (0.2) (3)
Provision for income taxes 6.6 5.3 1.3 21
Net income 10.2 8.6 1.6 20
Diluted earnings per share 0.59 0.50 0.09 18
Basic earnings per share 0.60 0.51 0.09 18
=============================================================================
Net income increased by 20% to $10.2 million in the first quarter of
fiscal 2006 from $8.6 million in the first quarter of fiscal 2005. The increase
resulted from receivables growth and the effects of significantly fewer
non-performing assets, partially offset by the effects of significantly higher
short-term market interest rates.
Finance income increased by 22% to $36.6 million in the first quarter
of fiscal 2006 from $29.9 million in the first quarter of fiscal 2005. The
increase resulted from the 15% increase in average finance receivables ($228.0
million) to $1.70 billion in the first quarter of fiscal 2006 from $1.48 billion
in the first quarter of fiscal 2005 and, to a lesser extent, the higher net
yield on finance receivables. Higher market interest rates, lower non-accrual
receivables and an increase in non-interest finance income raised the net yield
on finance receivables to 8.51% in the first quarter of fiscal 2006 from 8.04%
in the first quarter of fiscal 2005.
Interest expense (incurred on borrowings used to fund finance
receivables) increased by 53% to $14.3 million in the first quarter of fiscal
2006 from $9.3 million in the first quarter of fiscal 2005. The increase
14
resulted from higher average short-term market interest rates and the 16%
($182.0 million) increase in average debt. Increases in short-term market
interest rates, partially offset by the lower average rate on our fixed rate
term debt and better credit spreads, raised our weighted average cost of funds
to 4.39% in the first quarter of fiscal 2006 from 3.34% in the first quarter of
fiscal 2005.
Net finance income before provision for credit losses on finance
receivables increased by 8% to $22.3 million in the first quarter of fiscal 2006
from $20.6 million in the first quarter of fiscal 2005. Net interest margin (net
finance income before provision for credit losses expressed as an annual
percentage of average finance receivables outstanding) decreased to 5.19% in the
first quarter of fiscal 2006 from 5.54% in the first quarter of fiscal 2005
because of the significant increase in short-term market interest rates.
We did not record a provision for credit losses on finance receivables
in the first quarter of fiscal 2006. The provision was $1.0 million in the first
quarter of fiscal 2005. The provision for credit losses is the amount needed to
change the allowance for credit losses to the appropriate estimated level. Based
on the low amount of net charge-offs and current and expected asset quality, we
did not need to record a provision to increase the allowance. Net charge-offs
(write-downs of finance receivables less recoveries) decreased to less than $0.1
million in the first quarter of fiscal 2006 from $0.8 million in the first
quarter of fiscal 2005. The loss ratio (net charge-offs expressed as an annual
percentage of average finance receivables) decreased to 0.01% in the first
quarter of fiscal 2006 from 0.21% in the first quarter of fiscal 2005. Net
charge-offs decreased because of significantly fewer non-accrual receivables and
improved equipment values.
Salaries and other expenses decreased by 3% to $5.5 million in the
first quarter of fiscal 2006 from $5.7 million in the first quarter of fiscal
2005. The decrease resulted from cost savings created by significantly fewer
non-performing assets and the decrease in Sarbanes-Oxley compliance costs,
partially offset by increased salary expense. Salary expense increased because
(i) we were required to record compensation expense for stock options starting
in the first quarter of fiscal 2006 (ii) salary increases and (iii) an increase
in the number of employees. Salary expense includes $0.2 million of compensation
expense for options recognized under SFAS No. 123R. The expense ratio (salaries
and other expenses expressed as an annual percentage of average finance
receivables) improved to 1.28% in the first quarter of fiscal 2006 from 1.53% in
the first quarter of fiscal 2005 because of the increase in receivables and the
decrease in expenses. The efficiency ratio (expense ratio expressed as a
percentage of net interest margin) improved to 24.6% in the first quarter of
fiscal 2006 from 27.6% in the first quarter of fiscal 2005 because of the
increase in net interest margin and the decrease in expenses.
Diluted earnings per share increased by 18% to $0.59 per share in the
first quarter of fiscal 2006 from $0.50 per share in the first quarter of fiscal
2005, and basic earnings per share increased by 18% to $0.60 per share in the
first quarter of fiscal 2006 from $0.51 per share in the first quarter of fiscal
2005.
Recording compensation expense for stock options under SFAS No. 123R in
the first quarter of fiscal 2006 reduced net income by $0.2 million and reduced
basic and diluted earnings per share by $0.01.
FINANCE RECEIVABLES AND ASSET QUALITY
We discuss trends and characteristics of our finance receivables and
our approach to managing credit risk in this section. The key aspect is asset
quality. Asset quality statistics measure our underwriting standards, skills and
policies and procedures and can indicate the direction and levels of future
charge-offs and non-performing assets.
===================================================================================
October 31, July 31,
($ in millions) 2005* 2005* $ Change % Change
===================================================================================
Finance receivables $1,742.7 $1,666.1 $ 76.6 5%
Allowance for credit losses 24.2 24.2 -- --
Net charge-offs ** 0.0 0.2 (0.1) (76)
Non-performing assets 11.8 25.3 (13.5) (53)
Delinquent finance receivables 8.0 10.2 (2.2) (22)
As a percentage of receivables:
-------------------------------
Allowance for credit losses 1.39% 1.45%
Net charge-offs (annualized) 0.01 0.04
Non-performing assets 0.68 1.52
Delinquent finance receivables 0.46 0.61
===================================================================================
* as of and for the quarter ended
** net charge-offs were $37,000 in the first quarter of fiscal 2006
15
Finance receivables comprise installment sale agreements and secured
loans (collectively referred to as loans) and direct financing leases. Finance
receivables increased by 5% ($77 million) to $1.74 billion at October 31, 2005
from $1.67 billion at July 31, 2005. At October 31, 2005, loans were 90% ($1.57
billion) of finance receivables and leases were 10% ($174 million).
Finance receivables originated in the first quarter of fiscal 2006 and
2005 were $323 million and $218 million, respectively. Originations increased
because of greater demand for domestic equipment financing. Finance receivables
collected in the first quarter of fiscal 2006 and 2005 were $243 million and
$185 million, respectively. Collections increased because of higher average
receivables and increased prepayments.
Our primary focus is the credit quality of our receivables. We manage
our credit risk by using disciplined and proven underwriting policies and
procedures, by monitoring our receivables closely and by handling non-performing
accounts effectively. Our underwriting policies and procedures require a
first lien on equipment financed. We focus on financing equipment with an
economic life longer than the term financed, historically low levels of
technological obsolescence, use in more than one type of business, ease of
access and transporting, and broad, established resale markets. Securing our
receivables with this equipment can mitigate potential charge-offs. We may also
obtain additional equipment or other collateral, third-party guarantees,
advance payments or hold back a portion of the amount financed. We do not
finance or lease aircraft or railcars, computer related equipment,
telecommunications equipment or equipment located outside the United States, and
we do not lend to consumers.
Our underwriting policies limit our credit exposure with any single
customer. At October 31, 2005, this limit was $31.0 million. Our ten largest
customers accounted for $81.0 million (4.7%) of total finance receivables at
October 31, 2005.
The allowance for credit losses was $24.2 million at October 31, 2005
and July 31, 2005. The allowance level declined to 1.39% of finance receivables
at October 31, 2005 from 1.45% at July 31, 2005, because of lower credit losses
and continued favorable asset quality. We determine the allowance quarterly
based on an analysis of historical losses and the past due status of receivables
at the end of the quarter as adjusted for expected recoveries and differences
between current and historical loss trends and other factors. During fiscal
2005, we adjusted the allowance higher because we expected higher oil prices
would adversely affect our receivables and the economy. At October 31, 2005, we
discontinued this adjustment because (i) high oil prices have not meaningfully
affected asset quality and have not significantly impacted the economy (ii) oil
prices have declined recently and (iii) high oil prices existed during part of
the historical loss period used to determine the allowance. The allowance level
may decline further if our asset quality statistics remain favorable.
Net charge-offs of finance receivables (write-downs less recoveries)
were $37,000 in the first quarter of fiscal 2005 and $0.2 million in the fourth
quarter of fiscal 2005 and the loss ratios were 0.01% and 0.04%. Net charge-offs
have been decreasing because of fewer non-performing assets and improved
equipment values.
The net investment in non-performing assets, comprise non-accrual
(impaired) finance receivables and repossessed equipment (assets received to
satisfy receivables), and delinquent finance receivables (transactions with more
than a nominal portion of a contractual payment 60 or more days past due) follow
($ in millions):
==================================================================================
October 31, July 31, October 31,
2005 2005 2004
==================================================================================
Non-accrual finance receivables* $10.0 $23.6 $27.1
Repossessed equipment 1.8 1.7 1.3
----------------------------------------------------------------------------------
Total non-performing assets $11.8 $25.3 $28.4
==================================================================================
Delinquent finance receivables $ 8.0 $10.2 $14.2
==================================================================================
Percentage of non-accrual receivables
not delinquent 46% 65% 63%
==================================================================================
* before specifically allocated allowance of $0.3 million at October
31, 2005, $0.8 million at July 31, 2005 and $0.6 million at October
31, 2004
Our asset quality statistics stayed at favorable levels during the
quarter. Net charge-offs, non-accrual receivables, repossessed equipment and
delinquencies were far below expected levels. Therefore, we do not expect
further improvement in these measures and reasonable increases would not
necessarily indicate the start of a negative trend. Non-accrual receivables
decreased because we removed the non-accrual classification from several large
16
receivables we no longer consider impaired. We believe we will collect the
full amount of principal and interest due on these receivables based on payment
performance and collateral coverage.
Although we expect our asset quality statistics to stay at favorable
levels, the high price of oil and higher market interest rates could adversely
affect our statistics. Gasoline and interest are significant costs for most of
our customers and higher than normal increases in these costs could impact
significantly their operating cash flows and their ability to remit payments.
Increases in these costs can also adversely affect the economy. In addition,
several customers owe us over $5.0 million. If any of these receivables become
delinquent, impaired or repossessed, our asset quality statistics could worsen
even though the overall trend may remain positive. Hurricane related losses in
the first quarter of fiscal 2006 were not significant and we do not expect
future hurricane related losses to be significant.
LIQUIDITY AND CAPITAL RESOURCES
We describe our needs for substantial amounts of capital (debt and
equity), our approach to managing liquidity and our current funding sources in
this section. Key indicators are leverage, available liquidity and credit
ratings. Our credit ratings were affirmed in August 2005, our leverage is low
for a financial company, we have ample liquidity available and the maturities of
our debt are staggered and exceed the maturities of our finance receivables.
Liquidity and access to capital are vital to our operations and growth.
We need continued availability of funds to originate or acquire finance
receivables, to purchase portfolios of finance receivables and to repay debt. To
ensure we have enough liquidity, we project our financing needs based on
estimated receivables growth and maturing debt, we monitor capital markets
closely and we diversify our funding sources. Funding sources available to us
include operating cash flow, private and public issuances of term debt, conduit
and term securitizations of finance receivables, committed unsecured revolving
credit facilities, dealer placed and direct issued commercial paper and sales of
common and preferred equity. We believe that our liquidity sources are
diversified and we are not dependent on any funding source or any credit
provider.
At October 31, 2005, we had $205.0 million available under our bank
credit facilities (net of commercial paper outstanding). Our asset
securitization facility can be increased by $188.0 million and we can issue more
term debt. We believe, but cannot assure, sufficient liquidity is available to
support our future operations and growth.
Our term debt is rated 'BBB+' by Fitch Ratings, Inc. ("Fitch, a
Nationally Recognized Statistical Ratings Organization) and commercial paper
issued by our major operating subsidiary ($116.0 million at October 31, 2005) is
rated 'F2' by Fitch. In August 2005, Fitch affirmed its investment grade ratings
on our debt and maintained its stable outlook. Our access to capital markets and
our credit spreads are partly dependent on these investment grade credit
ratings.
Our major operating subsidiary's debt agreements have restrictive
covenants including limits on indebtedness, encumbrances, investments, dividends
and other distributions to us, sales of assets, mergers and other business
combinations, capital expenditures, interest coverage and net worth. None of the
agreements have a material adverse change clause.
Total debt increased by 5% ($59.0 million) to $1.32 billion at October
31, 2005 from $1.26 billion at July 31, 2005 and stockholders' equity increased
by 3% ($11.0 million) to $353.1 million at October 31, 2005 from $342.1 million
at July 31, 2005. Leverage (debt-to-equity ratio) remained at a low 3.7 allowing
for substantial asset growth. Historically, our leverage has not exceeded 5.5.
Debt comprised the following ($ in millions):
======================================================================================
October 31, 2005 July 31, 2005
------------------- -------------------
Amount Percent Amount Percent
======================================================================================
Term notes $ 499.5 38% $ 457.0 36%
Asset securitization financings 425.0 32 325.0 26
Convertible debentures 175.0 13 175.0 14
Borrowings under bank credit facilities 96.5 7 213.0 17
Commercial paper 128.1 10 94.0 7
--------------------------------------------------------------------------------------
Total principal 1,324.1 100% 1,264.0 100%
Fair value adjustment of hedged debt (5.4) (4.3)
--------------------------------------------------------------------------------------
Total debt $1,318.7 $1,259.7
======================================================================================
17
Term Notes
In August 2005, we received $50 million of five-year, 5.0% fixed rate
term notes issued in May 2005. Interest is payable semi-annually. The notes are
due at maturity in August 2010. We also repaid $7.5 million of term notes at
maturity.
At October 31, 2005, the $499.5 million of term notes comprised $464.5
million of private placements and medium term notes issued to insurance
companies and $35.0 million of bank term loans.
Asset Securitization Financings
Our asset securitization facility was increased by $100.0 million to
$425.0 million in August 2005. We used the proceeds to repay borrowings under
bank credit facilities. We established the facility in July 2001. The facility
expires in April 2006 subject to renewal. The facility limits borrowings to a
minimum level of securitized receivables. If borrowings exceed the minimum
level, we must repay the excess or securitize more receivables. We can
securitize more receivables during the term of the facility. On expiration and
nonrenewal of the facility, we must repay borrowings outstanding or convert them
into term debt. The term debt would be repaid monthly based on the amount of
securitized receivables. Based on the contractual payments of the $493.0 million
of securitized receivables at October 31, 2005, the term debt would be fully
repaid by May 2008.
The unsecured debt agreements of our major operating subsidiary allow
40% of its finance receivables to be securitized ($693.0 million at October 31,
2005). Therefore, we could securitize an additional $200.0 million of finance
receivables at October 31, 2005. Borrowings are limited to 94% of securitized
receivables.
Convertible Debentures
The convertible debentures were convertible into 4.0 million shares (as
adjusted) of common stock at the adjusted conversion price of $43.63 per share
resulting in an adjusted conversion rate of 22.92 shares for each $1,000 of
principal. In December 2004, we irrevocably elected to pay the value of
converted debentures, not exceeding the principal amount, in cash. We will pay
any value over principal with shares of common stock. This eliminated the 4.0
million shares of common stock issuable upon conversion. At October 31, 2005, no
event occurred that would have allowed for conversion of the debentures.
Bank Credit Facilities
We have $430.0 million of committed unsecured revolving credit
facilities from nine banks (a $35.0 million increase from July 31, 2005). This
includes $222.5 million of facilities with original terms ranging from three to
five years and $207.5 million of facilities with an original term of one year.
These facilities are a dependable, low-cost source of funds and support our
commercial paper program. We can borrow the full amount under each facility.
These facilities may be renewed when they expire.
Commercial Paper
We issue commercial paper direct and through a $350.0 million program.
Commercial paper matures between 1 and 270 days. As a condition of our credit
rating, our unused committed revolving bank credit facilities must exceed
commercial paper outstanding. Therefore, at October 31, 2005, the combined
amount of commercial paper and bank borrowings was limited to $430.0 million
($224.6 million was outstanding at October 31, 2005).
MARKET INTEREST RATE RISK AND SENSITIVITY
We discuss how changes in market interest rates affect our
profitability and our approach to managing interest rate risk in this section.
Higher short-term market interest rates increased interest expense significantly
in the first quarter of fiscal 2006 and reduced our net interest spread (the net
yield of finance receivables less the weighted average cost of borrowed funds),
an integral part of a finance company's profitability. We explain the reasons
below.
Our net interest spread is sensitive to changes in short-term and
long-term market interest rates (includes LIBOR, rates on U.S. Treasury
securities, money market rates, swap rates and the prime rate). Increases in
short-term rates reduce our net interest spread (this is occurring currently)
and decreases in short-term rates increase our net interest spread because
floating rate debt (includes short-term debt) significantly exceeds floating
rate finance receivables. Since 61% of our debt is floating rate and only 6% our
finance receivables are floating rate, our cost of funds changes faster than the
yield on our receivables. Our net interest spread is also affected when
short-term and long-term rates do not similarly change. Long-term rates normally
exceed short-term rates. When the difference between long and short-term rates
18
narrows (resulting in a "flattening yield curve"), our net interest spread
should decrease and when the difference widens our net interest spread should
increase because the rates we charge our customers are partially determined by
long-term market interest rates and rates on our floating rate debt are largely
determined by short-term market interest rates. Potential mitigating factors are
(i) the rates we charge are also determined by the prime rate and equipment
financing demand and (ii) issuing long-term debt at low rates.
Our net interest spread is calculated below:
====================================================================
Three Months Ended October 31, 2005 2004
====================================================================
Net yield of finance receivables 8.51% 8.04%
Weighted average cost of borrowed funds 4.39 3.34
--------------------------------------------------------------------
Net interest spread 4.12% 4.70%
====================================================================
From the end of fiscal 2004, short-term market interest rates rose 3.0%
(300 basis points) and the yield curve flattened significantly. These trends may
continue. Rising short-term market interest rates and a flattening yield curve
cause our cost of funds to increase faster and by a greater amount than the
yield on our receivables reducing our net interest spread.
Our earnings are subject to the risks of rising short-term interest
rates and a flattening yield curve at October 31, 2005 because floating rate
debt exceeded floating rate receivables by $693.0 million (see the table below).
The terms and prepayment experience of our fixed rate receivables mitigate this
risk. Finance receivables are repaid monthly over short periods of two to five
years that have been accelerated by prepayments. At October 31, 2005, $604.0
million (37%) of fixed rate finance receivables are due in one year and the
weighted average remaining life of fixed rate finance receivables is
approximately twenty months. We do not match the maturities of our debt to our
finance receivables.
==================================================================================
Fixed Rate Floating Rate
------------------ ----------------
($ in millions) Amount Percent Amount Percent Total
----------------------------------------------------------------------------------
Finance receivables $1,632.8 94% $109.9 6% $1,742.7
==================================================================================
Debt (principal) $ 521.2 39% $802.9 61% $1,324.1
Stockholders' equity 353.1 100 -- -- 353.1
----------------------------------------------------------------------------------
Total debt and equity $ 874.3 52% $802.9 48% $1,677.2
==================================================================================
Floating rate debt (asset securitization financings, floating rate
swaps of fixed rate notes, bank borrowings, commercial paper and floating rate
term note) at October 31, 2005 reprices (interest rate changes) as follows:
$622.8 million (78%) within one month, $65.4 million (8%) in two to three months
and $114.7 million (14%) in four to seven months. Most of the floating rate
swaps of fixed rate notes last repriced in October 2005. The repricing periods
of floating rate debt follow (in millions):
====================================================================
Balance Repricing Frequency
--------------------------------------------------------------------
Asset securitization financings $425.0 generally daily
Floating rate swaps of fixed
rate notes 143.3 semi-annually
Bank borrowings 96.5 generally daily
Commercial paper 128.1 1 to 200 days
(22 day average)
Floating rate term note 10.0 monthly
====================================================================
We quantify interest rate risk by calculating the effect on net income
of a hypothetical, immediate 100 basis point (1.0%) rise in market interest
rates. At October 31, 2005, this hypothetical adverse change in rates would
reduce quarterly net income by approximately $0.6 million based on scheduled
repricings of floating rate debt and fixed rate debt maturing within one year
and the expected effects on the yield of new receivables. We believe this is
acceptable considering the lower cost of floating rate debt. Actual future
changes in market interest rates and the effect on net income may differ
materially from this amount. In addition, other factors that may accompany an
actual immediate 100 basis point increase in market interest rates were not
considered in the calculation.
We monitor and manage our exposure to changes in market interest rates
through risk management procedures that include using certain derivative
financial instruments and changing the proportion of our fixed and floating rate
debt. We may use derivatives to hedge our exposure to interest rate risk on
existing and forecast debt. We do not speculate with or trade derivatives.
19
At October 31, 2005, floating rate swaps of fixed rate notes totaled
$143.3 million. We receive fixed rates equal to the rates on the hedged notes
and pay floating rates indexed to six-month LIBOR (4.5% at October 31, 2005).
The swaps increased interest expense by $0.1 million in the first quarter of
fiscal 2005. The current weighted average pay rate (5.82%) exceeded the weighted
average receive rate (4.88%) by 94 basis points (0.94%) at October 31, 2005.
Information on the swaps at October 31, 2005 follows ($ in millions):
================================================================================
Notional Receive
Issued Expires Amount Rate Pay Rate Reprices
================================================================================
April 2003 April 2010 $12.5 4.96% 5.59% April 2006
July 2003 April 2008 25.0 4.37 5.22 April 2006
July 2003 June 2008 12.5 4.37 5.92 April 2006
July 2003 June 2008 25.0 4.37 5.73 April 2006
July 2003 June 2010 12.5 4.96 5.90 April 2006
August 2003 April 2008 24.5 4.37 5.13 April 2006
April 2004 August 2007 31.3 6.23 6.93 January 2006
================================================================================
NEW ACCOUNTING STANDARDS
On August 1, 2005, we started recording compensation expense for stock
options as required by Statement of Financial Accounting Standards ("SFAS") No.
123(R), "Share-Based Payment, revised 2004" ("SFAS No. 123R") and according to
the provisions of the Securities and Exchange Commission's Staff Accounting
Bulletin No. 107 using SFAS No. 123R's modified prospective method. This method
requires us to record compensation expense for options unvested at August 1,
2005 and for options subsequently granted or modified. Prior periods will not
be restated. Compensation expense is based on the grant date fair value of
options calculated with an option-pricing model and is recognized over the
vesting period. We are using the Black-Scholes option pricing model. Before
August 1, 2005, we applied Accounting Principles Board Opinion ("APB") No. 25,
"Accounting for Stock Issued to Employees," and related Interpretations to
account for our stock options. Under APB No. 25, we did not record compensation
expense for our stock options.
Compensation expense for options unvested at August 1, 2005 is based on
the grant date fair value calculated under SFAS No. 123, "Accounting for
Stock-Based Compensation" ("SFAS No. 123") and will be recognized using the
graded-vesting (accelerated) attribution method (the method used for SFAS No.
123 pro forma disclosure). Compensation expense for options granted after July
31, 2005 will be recognized using the straight-line attribution method.
Compensation expense is only recorded for options expected to vest. Therefore,
we are required to estimate the number of options that will be forfeited and
revise our estimate based on actual forfeitures.
For the first quarter of fiscal 2006, salaries and other expenses
includes $0.2 million of compensation expense for options recognized under SFAS
No. 123R resulting in a tax benefit of $30,000. Compensation expense for options
required to be capitalized under SFAS No. 91, "Accounting for Nonrefundable Fees
and Costs Associated with Originating or Acquiring Loans and Initial Direct
Costs of Leases" ("SFAS No. 91"), and included in finance receivables was
$0.3 million for the first quarter of fiscal 2006. Recording compensation
expense for options under SFAS No. 123R reduced basic and diluted earnings per
share by $0.01. The $30,000 tax benefit only applied to compensation expense
from non-qualified options. Tax benefits cannot be recorded on compensation
expense from incentive stock options unless shares acquired on exercise of
incentive stock options are sold by the employee within one year of exercise.
SFAS No. 123R did not change how we determine or recognize compensation
expense for restricted stock and stock units. Compensation expense is based on
the market value of our common stock on the date of the award and is recognized
over the vesting period using the straight-line method or the graded-vesting
method for awards with a performance condition. For the first quarter of fiscal
2006 and 2005, salaries and other expenses includes $0.5 million and $0.4
million, respectively, of compensation expense for restricted stock and stock
units resulting in tax benefits of $0.2 million and $0.1 million. Compensation
expense for restricted stock and stock units required to be capitalized under
SFAS No. 91 was $0.4 million and $0.3 million for the first quarter of fiscal
2006 and 2005, respectively.
FORWARD-LOOKING STATEMENTS
This report may include the words or phrases "can be," "expect,"
"anticipate," "may," "believe," "estimate," "intend," "could," "should,"
"would," "if" and similar words and phrases that are "forward-looking
20
statements" as defined in Section 27A of the Securities Act of 1933 and Section
21E of the Securities Exchange Act of 1934. Forward-looking statements are
subject to various known and unknown risks and uncertainties and we caution you
that any forward-looking information provided by us or on our behalf is not a
guarantee of future performance. Our actual results could differ materially from
those anticipated by forward-looking statements because of the following: (i)
our ability to obtain funding at acceptable terms (ii) changes in risks inherent
in finance receivables and the adequacy of our allowance for credit losses (iii)
changes in market interest rates (iv) changes in economic, financial, and market
conditions (v) changes in competitive conditions and (vi) the loss of key
executives or personnel. Forward-looking statements apply only as of the date
made and we are not required to update forward-looking statements for subsequent
or unanticipated events or circumstances.
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
See the Market Interest Rate Risk and Sensitivity section in Item 2
Item 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures.
Our management (with our Chief Executive Officer's and Chief Financial
Officer's participation) evaluated our disclosure controls and procedures (as
defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934)
as of the end of the period covered by this report. Based on this evaluation,
our Chief Executive Officer and Chief Financial Officer concluded that our
disclosure controls and procedures are effective to ensure information required
to be disclosed in reports we file or submit under the Securities Exchange Act
of 1934 is timely recorded, processed, summarized and reported.
Changes in Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting
during the first quarter of fiscal 2006 that materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.
PART II
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
We did not make any purchases or unregistered sales of our common stock
during the first quarter of fiscal 2006.
We established our common stock repurchase program in August 1996 and
expanded it to include repurchases of convertible debt. A total of $40.7 million
was authorized for repurchases of common stock and convertible debt, and through
October 31, 2005, we repurchased $15.2 million of common stock and $7.2 million
of convertible debt.
Item 5. OTHER INFORMATION
On December 5, 2005, we issued a press release reporting our results
for the quarter ended October 31, 2005. The press release is attached as Exhibit
99.1. Exhibit 99.1 shall not be deemed "filed" for purposes of Section 18 of the
Securities Exchange Act of 1934, as amended (the "Exchange Act"), or subject to
the liabilities of that section, nor shall it be deemed incorporated by
reference in any filing under the Securities Act of 1933, as amended, or the
Exchange Act, except as shall be expressly set forth by specific reference.
Item 6. EXHIBITS
Exhibit No. Description of Exhibit
--------------------------------------------------------------------------------
10.38 Restricted Stock Agreement dated September 28, 2005 between the
Registrant and its CEO
10.39 Restricted Stock Agreement dated November 2, 2005 between the
Registrant and its CEO
31.1 Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer
31.2 Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer
32.1 Section 1350 Certification of Chief Executive Officer
32.2 Section 1350 Certification of Chief Financial Officer
99.1 Press release dated December 5, 2005
21
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
FINANCIAL FEDERAL CORPORATION
(Registrant)
By: /s/ Steven F. Groth
------------------------------
Senior Vice President and
Chief Financial Officer
(Principal Financial Officer)
By: /s/ David H. Hamm
------------------------------
Vice President and Controller
(Principal Accounting Officer)
December 8, 2005
----------------
(Date)