================================================================================
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, 2006
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ___________ to ___________
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 a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
one)
Large accelerated filer [X] Accelerated filer [ ] Non-accelerated filer [ ]
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 on December 1,
2006 was 27,282,718.
================================================================================
FINANCIAL FEDERAL CORPORATION AND SUBSIDIARIES
Quarterly Report on Form 10-Q
for the quarter ended October 31, 2006
TABLE OF CONTENTS
Part I - Financial Information Page No.
-------------------------------------------------------------------- --------
Item 1. Financial Statements:
Consolidated Balance Sheets at October 31, 2006 (unaudited)
and July 31, 2006 (audited) 3
Consolidated Income Statements for the three months ended
October 31, 2006 and 2005 (unaudited) 4
Consolidated Statements of Changes in Stockholders' Equity
for the three months ended October 31, 2006 and 2005
(unaudited) 5
Consolidated Statements of Cash Flows for the three months
ended October 31, 2006 and 2005 (unaudited) 6
Notes to Consolidated Financial Statements (unaudited) 7-13
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 14-22
Item 3. Quantitative and Qualitative Disclosures about Market Risk 22
Item 4. Controls and Procedures 22
Part II - Other Information
--------------------------------------------------------------------
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 23
Item 5. Other Information 23
Item 6. Exhibits 23
Signatures 24
2
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
FINANCIAL FEDERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except par value)
==============================================================================================
October 31, 2006* July 31, 2006
==============================================================================================
ASSETS
Finance receivables $ 2,045,650 $ 1,991,688
Allowance for credit losses (24,047) (24,100)
----------------------------------------------------------------------------------------------
Finance receivables - net 2,021,603 1,967,588
Cash 12,641 8,143
Other assets 8,871 12,613
----------------------------------------------------------------------------------------------
TOTAL ASSETS $ 2,043,115 $ 1,988,344
==============================================================================================
LIABILITIES
Debt:
Long-term ($3,100 at October 31, 2006 and $5,700
at July 31, 2006 owed to related parties) $ 1,266,400 $ 1,252,350
Short-term 285,728 275,311
Accrued interest, taxes and other liabilities 88,456 70,304
----------------------------------------------------------------------------------------------
Total liabilities 1,640,584 1,597,965
----------------------------------------------------------------------------------------------
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):
27,261 at October 31, 2006 and 27,216 at July 31, 2006 13,631 13,608
Additional paid-in capital 125,752 123,091
Retained earnings 262,626 253,128
Accumulated other comprehensive income 522 552
----------------------------------------------------------------------------------------------
Total stockholders' equity 402,531 390,379
----------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 2,043,115 $ 1,988,344
==============================================================================================
* 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, 2006 2005
==============================================================================
Finance income $46,930 $36,553
Interest expense 20,892 14,246
------------------------------------------------------------------------------
Net finance income before provision for credit
losses on finance receivables 26,038 22,307
Provision for credit losses on finance receivables -- --
------------------------------------------------------------------------------
Net finance income 26,038 22,307
Salaries and other expenses 6,109 5,498
------------------------------------------------------------------------------
Income before provision for income taxes 19,929 16,809
Provision for income taxes 7,699 6,564
------------------------------------------------------------------------------
NET INCOME $12,230 $10,245
==============================================================================
EARNINGS PER COMMON SHARE:
Diluted $ 0.46 $ 0.39
==============================================================================
Basic $ 0.47 $ 0.40
==============================================================================
* Unaudited
See accompanying notes to consolidated financial statements
4
FINANCIAL FEDERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY *
(In thousands)
=======================================================================================================
Accumulated
Common Stock Additional Other
------------------ Paid-In Retained Comprehensive
Shares Amount Capital Earnings Income Total
=======================================================================================================
BALANCE - JULY 31, 2005 17,487 $ 8,743 $ 109,226 $ 224,145 $ -- $ 342,114
Net income -- -- -- 10,245 -- 10,245
Stock plan activity:
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)
-------------------------------------------------------------------------------------------------------
BALANCE - OCTOBER 31, 2005 17,550 $ 8,775 $ 111,690 $ 232,635 $ -- $ 353,100
=======================================================================================================
=======================================================================================================
Accumulated
Common Stock Additional Other
------------------ Paid-In Retained Comprehensive
Shares Amount Capital Earnings Income Total
=======================================================================================================
BALANCE - JULY 31, 2006 27,216 $ 13,608 $ 123,091 $ 253,128 $552 $ 390,379
Net income -- -- -- 12,230 -- 12,230
Reclassification adjustment
for realized gain included
in net income, net of tax -- -- -- -- (30) (30)
---------
Comprehensive income 12,200
---------
Common stock repurchased
(retired) (3) (1) (65) (3) -- (69)
Stock plan activity:
Shares issued 54 27 934 -- -- 961
Shares canceled (6) (3) 3 -- -- --
Compensation recognized -- -- 1,663 -- -- 1,663
Excess tax benefits -- -- 126 -- -- 126
Common stock cash dividends -- -- -- (2,729) -- (2,729)
-------------------------------------------------------------------------------------------------------
BALANCE - OCTOBER 31, 2006 27,261 $ 13,631 $ 125,752 $ 262,626 $522 $ 402,531
=======================================================================================================
* 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, 2006 2005
========================================================================================
Cash flows from operating activities:
Net income $ 12,230 $ 10,245
Adjustments to reconcile net income to net cash provided
by operating activities:
Amortization of deferred origination costs and fees 3,904 3,748
Stock-based compensation 928 1,368
Depreciation and amortization 154 194
Decrease in other assets 3,558 165
Increase in accrued interest, taxes and other liabilities 19,578 5,722
Excess tax benefits from stock-based awards (126) (114)
----------------------------------------------------------------------------------------
Net cash provided by operating activities 40,226 21,328
----------------------------------------------------------------------------------------
Cash flows from investing activities:
Finance receivables originated (320,262) (323,345)
Finance receivables collected 263,078 242,895
----------------------------------------------------------------------------------------
Net cash used in investing activities (57,184) (80,450)
----------------------------------------------------------------------------------------
Cash flows from financing activities:
Commercial paper, net increase 152,056 34,100
Bank borrowings, net decrease (103,889) (116,500)
Asset securitization borrowings -- 100,000
Proceeds from term notes -- 50,000
Repayment of term notes (25,000) (7,500)
Common stock cash dividends (2,729) (1,755)
Proceeds from stock option exercises 961 1,014
Excess tax benefits from stock-based awards 126 114
Repurchases of common stock (69) --
----------------------------------------------------------------------------------------
Net cash provided by financing activities 21,456 59,473
----------------------------------------------------------------------------------------
NET INCREASE IN CASH 4,498 351
Cash - beginning of period 8,143 8,456
----------------------------------------------------------------------------------------
CASH - END OF PERIOD $ 12,641 $ 8,807
========================================================================================
* 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 (the "Company") provide
collateralized lending, financing and leasing services nationwide to small and
medium sized 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 including cranes, earthmovers, personnel lifts, trailers
and trucks.
Basis of Presentation and Principles of Consolidation
The accompanying unaudited Consolidated Financial Statements were prepared
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, 2006 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, 2006.
In our opinion, 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, 2006
may not be indicative of full year results.
We split our common stock 3-for-2 in the form of a stock dividend in
January 2006. All share and per share amounts (including stock options,
restricted stock and stock units), excluding treasury stock, in the Consolidated
Financial Statements and accompanying notes were restated to reflect the split.
We did not split treasury stock.
Use of Estimates
GAAP requires us to make significant estimates and assumptions affecting
the 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 from these
estimates significantly.
New Accounting Standards
The Financial Accounting Standards Board ("FASB") issued Interpretation
No. 48, "Accounting for Uncertainty in Income Taxes - An Interpretation of FASB
109", ("FIN No. 48") in July 2006. FIN No. 48 requires companies to determine if
any tax positions taken on their income tax returns lowering the amount of tax
currently due would more likely than not be allowed by a taxing jurisdiction. If
tax positions pass the more-likely-than-not test, companies then record benefits
from them only equal to the highest amount that has a greater than 50% chance of
being realized assuming the tax positions would be challenged by a taxing
jurisdiction. No benefits would be recorded for tax positions failing the
more-likely-than-not test. Tax benefits include income tax savings and the
related interest expense savings. Whether tax positions pass the test or not,
adopting FIN No. 48 could result in additional income tax provisions or expenses
for any interest and penalties on potential underpayments of income tax, or
both. FIN No. 48 is effective in the first quarter of fiscal years beginning
after December 15, 2006. It will become effective for us on August 1, 2007, the
beginning of our fiscal year ending July 31, 2008. We are evaluating how it may
affect our consolidated financial statements.
The FASB issued Statement of Financial Accounting Standards ("SFAS") No.
157, "Fair Value Measurements", ("SFAS No. 157") in September 2006. SFAS No. 157
defines fair value (replacing all prior definitions) and creates a framework to
measure fair value, but does not create any new fair value measurements. SFAS
No. 157 is effective in the first quarter of fiscal years beginning after
November 15, 2007. It will become effective for us on August 1, 2008. We are
evaluating how it may affect our consolidated financial statements.
7
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, 2006 July 31, 2006
=========================================================================
Loans:
Fixed rate $1,689,757 $1,662,805
Floating rate 146,296 131,235
-------------------------------------------------------------------------
Total loans 1,836,053 1,794,040
Direct financing leases * 209,597 197,648
-------------------------------------------------------------------------
Finance receivables $2,045,650 $1,991,688
=========================================================================
* includes residual values of $42,800 at October 31, 2006 and $41,200 at
July 31, 2006
The allowance for credit losses activity is summarized below:
=========================================================================
Three Months Ended October 31, 2006 2005
=========================================================================
Allowance - beginning of period $ 24,100 $ 24,225
Provision -- --
Write-downs (647) (852)
Recoveries 594 815
-------------------------------------------------------------------------
Allowance - end of period $ 24,047 $ 24,188
=========================================================================
Percentage of finance receivables 1.18% 1.39%
=========================================================================
Net charge-offs * $ 53 $ 37
=========================================================================
Loss ratio ** 0.01% 0.01%
=========================================================================
* 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, 2006 July 31, 2006
=========================================================================
Finance receivables classified
as non-accrual $14,109 $13,750
Assets received to satisfy finance
receivables 983 809
-------------------------------------------------------------------------
Non-performing assets $15,092 $14,559
=========================================================================
The allowance for credit losses included $200 at October 31, 2006 and $300
at July 31, 2006 specifically allocated to $3,000 and $6,700 of impaired finance
receivables, respectively. We did not recognize any income in the three months
ended October 31, 2006 or 2005 on impaired loans before we collected our net
investment.
We also provide commitments to extend credit. These commitments contain
off-balance sheet risk and are subject to the same credit policies and
procedures as finance receivables. The unused portion of these commitments was
$29,400 at October 31, 2006 and $23,800 at July 31, 2006.
8
NOTE 3 - DEBT
Debt is summarized below:
=========================================================================
October 31, 2006 July 31, 2006
=========================================================================
Fixed rate term notes:
5.00% due 2010 - 2011 $ 250,000 $ 250,000
5.45% - 5.56% due 2011 - 2013 200,000 200,000
5.92% - 6.80% due 2007 - 2008 36,250 61,250
-------------------------------------------------------------------------
Total fixed rate term notes 486,250 511,250
Fixed rate term notes swapped to
floating rates due 2008 - 2010 143,250 143,250
Floating rate term note -- 10,000
2.0% convertible debentures due 2034 175,000 175,000
-------------------------------------------------------------------------
Total term debt 804,500 839,500
Asset securitization financings 425,000 425,000
Commercial paper 270,895 118,839
Bank borrowings 55,833 149,722
-------------------------------------------------------------------------
Total principal 1,556,228 1,533,061
Fair value adjustment of hedged debt (4,100) (5,400)
-------------------------------------------------------------------------
Total debt $ 1,552,128 $ 1,527,661
=========================================================================
Term Notes
We repaid $25,000 of 5.92% fixed rate term notes at maturity and we
converted a $10,000 floating rate term note from a bank due in fiscal 2008 to a
$15.0 million three-year committed unsecured revolving credit facility in the
first quarter of fiscal 2007.
Convertible Debentures
The conversion rate increased in October 2006 because we paid cash
dividends on our common stock. At October 31, 2006, the conversion rate was
34.87 (number of convertible shares for each $1 (one thousand) of principal),
the conversion price was $28.68 and we would have to deliver the value of
6,102,000 shares of our common stock upon conversion of all the debentures. The
conversion rate, conversion price and number of convertible shares at July 31,
2006 were 34.75, $28.78 and 6,081,000, respectively. Future cash dividends will
cause further conversion rate and convertible shares increases and conversion
price decreases.
In fiscal 2005, we irrevocably elected (under the existing terms of the
debentures and without modifying the debentures) to pay the value of converted
debentures, not exceeding the principal amount, in cash instead of issuing
shares of our common stock. As a result, the 6,102,000 convertible shares are no
longer issuable upon conversion but we would need to pay any value over
principal by issuing shares of common stock. The value of converted debentures
would exceed the principal amount when the price of our common stock exceeds the
conversion price. Shares needed to pay the value over principal would equal the
difference between the price of our common stock on the conversion date and the
conversion price, divided by the price of our common stock on the conversion
date and multiplied by the number of convertible shares. No event allowing for
the debentures to be converted has occurred through October 31, 2006.
Asset Securitization Financings
The $425,000 asset securitization facility provides for committed
revolving financing for one year. If the facility is not renewed before its
current expiration in April 2007, we could convert borrowings outstanding into
term debt. The term debt would be repaid monthly based on the amount of
securitized receivables and would be fully repaid by June 2009. Finance
receivables include $483,000 and $487,000 of securitized receivables at October
31, 2006 and July 31, 2006, respectively. We can securitize an additional
$330,000 of finance receivables at October 31, 2006. Borrowings are limited to
94% of securitized receivables and can be further limited based on the
eligibility of securitized receivables.
Bank Borrowings
We have $495,000 of committed unsecured revolving credit facilities from
ten banks expiring as follows; $187,500 within one year and $307,500 between
September 2008 and October 2011.
9
Other
Our major operating subsidiary's debt agreements have restrictive
covenants including limits on its indebtedness, encumbrances, investments,
dividends and other distributions to us, sales of assets, mergers and other
business combinations, capital expenditures, interest coverage and net worth. We
were in compliance with all debt covenants at October 31, 2006. None of the
agreements have a material adverse change clause. All of our debt is senior.
Long-term debt comprised the following:
=========================================================================
October 31, 2006 July 31, 2006
=========================================================================
Term notes $ 562,900 $ 602,850
Bank borrowings and commercial paper
supported by bank credit facilities 307,500 247,500
expiring after one year
Asset securitization financings 221,000 227,000
Convertible debentures 175,000 175,000
-------------------------------------------------------------------------
Total long-term debt $1,266,400 $1,252,350
=========================================================================
NOTE 4 - DERIVATIVES
We entered into interest rate locks with a total notional amount of
$100,000 with three counterparty banks in September 2006. The rate locks expire
in March 2007. We designated the rate locks as cash flow hedges of an
anticipated issuance of five-year fixed rate term notes hedging the risk of
interest rate changes, on the interest payments of the notes, through the date
the interest rate is set on the note issuance. The rate locks had approximately
no value at October 31, 2006. When we terminate the rate locks, the effective
portion of any gain or loss would be deferred as accumulated other comprehensive
income and recognized as an adjustment to interest expense over the five-year
term of the notes to be issued. Any ineffective portion of any gain or loss
would be recognized currently in interest expense.
We also have fixed to floating interest rate swaps with a total notional
amount of $143,250 at October 31, 2006 and July 31, 2006. The swaps effectively
converted fixed rate term notes into floating rate term notes. We designated the
swaps as fair value hedges of fixed rate term notes. The swaps expire on the
notes' maturity dates. Semiannually, we receive fixed amounts from the swap
counterparty banks equal to the interest we pay on the fixed-rate hedged notes,
and we pay amounts to the swap counterparty banks equal to the swaps' floating
rates multiplied by the swaps' notional amounts. We record the differences
between these amounts in interest expense. The swaps' floating rates change
every six months to a fixed amount over six-month LIBOR. We receive a weighted
average fixed rate of 4.88% and the weighted average floating pay rate was 7.00%
at October 31, 2006 and 6.89% at July 31, 2006. The fair value of the swaps was
a liability of $4,100 at October 31, 2006 and $5,400 at July 31, 2006.
NOTE 5 - STOCKHOLDERS' EQUITY
In the first quarter of fiscal 2007, we paid a quarterly cash dividend of
$0.10 per share of common stock and we received and retired 3,000 shares of
common stock from our CEO at $27.38 per share as payment of income taxes we were
required to withhold on vested shares of restricted stock. At October 31, 2006,
$17,500 was available for future repurchases under our repurchase program. We
declared a quarterly cash dividend of $0.15 per share of common stock in
December 2006 payable in January 2007.
NOTE 6 - STOCK PLANS
Our 1998 Stock Option/Restricted Stock Plan (the "1998 Plan") was approved
by stockholders in fiscal 1999 and expires in September 2008. We amended the
1998 Plan in fiscal 2002 to include restricted stock grants and in December 2005
according to its anti-dilution provisions to increase the number of shares
available for the January 2006 stock split. The 1998 Plan, as amended, provides
for the issuance of 3,750,000 incentive or non-qualified stock options or shares
of restricted stock to officers, other employees and directors. None of the
options or shares of restricted stock awarded under the 1998 Plan are
performance based. The exercise price of incentive stock options can 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.
10
Options granted through the first half of fiscal 2005 were mostly
incentive stock options with a six-year term vesting 25% after two, three, four
and five years, options granted in the second half of fiscal 2005 were
non-qualified options with a four-year term vesting 33 1/3% on July 31, 2005,
2006 and 2007 and options granted in fiscal 2006 were non-qualified options with
a five-year term vesting 25% after one, two, three and four years.
Shares of restricted stock awarded (excluding 435,000 shares awarded to
executive officers in February 2006) vest annually in equal amounts over
original periods of three to eight years (seven year weighted-average). Shares
of restricted stock awarded to executive officers in February 2006 vest six
months after the executive officer attains age 62 or in August 2026 if earlier
(twelve year weighted-average).
The Management Incentive Plan ("MIP") for our Chief Executive Officer
("CEO") was approved by stockholders in fiscal 2002. We amended it in December
2005 according to its anti-dilution provisions to increase the number of shares
for the January 2006 stock split. Under the MIP, the CEO can be awarded a total
of 750,000 shares of restricted stock with an annual limit of 150,000 shares and
cash or stock bonuses if predetermined performance goals are achieved. The MIP
expires in December 2006. We awarded 41,000 shares of restricted stock to the
CEO in November 2005 as part of the fiscal 2006 bonus subject to certain
performance conditions. Shares earned vest annually in equal amounts over four
years. The CEO earned 36,000 of these shares in September 2006 and forfeited
5,000 shares based on our fiscal 2006 performance. The CEO earned 27,000 shares
of restricted stock in September 2005 vesting annually in equal amounts over
four years as a bonus for fiscal 2005. The CEO earned 15,000 shares of
restricted stock in fiscal 2005 vesting annually in equal amounts over five
years as part of the fiscal 2004 bonus. No shares were awarded for fiscal 2007.
At October 31, 2006, 128,000 shares of the CEO's restricted stock awarded under
the MIP were unvested and are scheduled to vest over approximately four years.
We established a Supplemental Retirement Benefit ("SERP") for our CEO in
fiscal 2002. We amended it in December 2005 according to its anti-dilution
provisions to increase the number of units for the January 2006 stock split, and
we amended it in March 2006 to provide for dividend equivalent payments. We
awarded 150,000 stock units vesting annually in equal amounts 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 retires. At October 31, 2006, 75,000
units were vested. Amending the SERP in fiscal 2006 to provide for dividend
equivalent payments increased the fair value of these units to $23.93 from
$22.43 and increased the total cost of the units by $225.
The restricted stock agreements (excluding the executive officers'
February 2006 agreements) and the SERP provide for all unvested shares or stock
units 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. The executive
officers' February 2006 restricted stock agreements provide for (i) all shares
to vest immediately upon the sale of the Company or the executive officer's
death or disability (ii) a portion (based on the percentage of the vesting
period elapsed) of the shares to vest immediately upon a qualifying employment
termination and (iii) forfeiture of all shares upon a non-qualifying employment
termination. Employees receive dividends on all unvested shares of restricted
stock and the CEO receives dividend equivalent payments on stock units. The
restricted stock agreements and the SERP (as amended in March 2006) also allow
employees to pay income taxes required to be withheld at vesting by surrendering
a portion of the shares or units vested.
Stock options, shares of restricted stock and stock units are the only
incentive compensation we provide (other than a cash bonus for the CEO) and we
believe these stock-based awards further align employees' objectives with those
of our stockholders. We issue new shares when options are exercised or when we
award shares of restricted stock, and we do not have a policy to repurchase
shares on the open market when options are exercised or when we award shares of
restricted stock.
Our stockholders approved the 2006 Stock Incentive Plan (the "2006 Plan")
and the Amended and Restated 2001 Management Incentive Plan (the "Amended MIP")
in December 2006. The 2006 Plan provides for the issuance of 2,500,000 incentive
or non-qualified stock options, shares of restricted stock, stock appreciation
rights and stock units to officers, other employees and directors, and expires
in December 2016. The 1998 Plan terminated upon approval of the 2006 Plan. The
Amended MIP provides for 750,000 shares of restricted stock, with an annual
limit of 200,000 shares, and cash or stock bonuses to be awarded to our CEO and
other selected officers subject to predetermined performance goals. The Amended
MIP expires in December 2011.
11
Stock option activity and related information for the three months ended
October 31, 2006 are summarized below (options and intrinsic value in
thousands):
==============================================================================
Weighted-Average
-----------------------
Exercise Remaining Intrinsic
Options Price Term (years) Value *
==============================================================================
Outstanding - August 1, 2006 1,527 $20.71
Granted -- --
Exercised (54) 17.92
Forfeited (14)
----------------------------------------
Outstanding - October 31, 2006 1,459 $20.81 2.5 $9,800
==============================================================================
Exercisable - October 31, 2006 682 $18.67 1.8 $6,000
==============================================================================
* number of options multiplied by the difference between the $27.52
closing price of our common stock on October 31, 2006 and the
weighted-average exercise price
Information on stock option exercises follows (in thousands, except
intrinsic value per option):
=========================================================================
Three Months Ended October 31, 2006 2005
=========================================================================
Number of options exercised 54 45
Total intrinsic value * $ 500 $ 743
Intrinsic value per option 9.25 16.47
Excess tax benefits realized 120 113
=========================================================================
* options exercised multiplied by the difference between the closing
prices of our common stock on the exercise dates and the exercise
prices
Restricted stock activity under the 1998 Plan and the MIP and related
information for the three months ended October 31, 2006 are summarized below
(shares in thousands):
===================================================================
Weighted-Average
Shares Grant-Date Fair Value
===================================================================
Unvested - August 1, 2006 1,081 $24.66
Granted -- --
Vested (10) 25.95
Forfeited (5)
------------------------------------------
Unvested - October 31, 2006 1,066 $24.64
===================================================================
Information on shares of restricted stock that vested follows (in
thousands, except intrinsic value per share):
=========================================================================
Three Months Ended October 31, 2006 2005
=========================================================================
Number of shares vested 10 3
Total intrinsic value * $ 274 $ 77
Intrinsic value per share 27.38 25.63
Excess tax benefits realized 6 1
=========================================================================
* shares vested multiplied by the closing prices of our common stock on
the dates vested
Future compensation expense (before deferral under SFAS No. 91) for
stock-based awards unvested at October 31, 2006 and expected to vest, and the
weighted-average periods the expense will be recognized over are as follows:
===================================================================
Expense Weighted-Average Years
===================================================================
Restricted stock $19,000 6.4
Stock options 1,700 2.3
Stock units 1,400 3.2
---------------------------------------
Total $22,100 5.9
===================================================================
12
Total compensation recorded, compensation capitalized (deferred
recognizing) under SFAS No. 91, compensation included in salaries and other
expenses and tax benefits recorded for stock-based awards follow:
========================================================================
Three Months Ended October 31, 2006 2005
========================================================================
Compensation for stock options:
-------------------------------
Total recorded $ 289 $ 495
Capitalized under SFAS No. 91 177 290
------------------------------------------------------------------------
Included in salaries and other expenses $ 112 $ 205
========================================================================
Tax benefits recorded $ 16 $ 30
========================================================================
Compensation for shares of restricted
stock and stock units:
-------------------------------------
Total recorded $1,374 $ 873
Capitalized under SFAS No. 91 558 380
------------------------------------------------------------------------
Included in salaries and other expenses $ 816 $ 493
========================================================================
Tax benefits recorded $ 312 $ 190
========================================================================
Total stock-based compensation:
-------------------------------
Total recorded $1,663 $1,368
Capitalized under SFAS No. 91 735 670
------------------------------------------------------------------------
Included in salaries and other expenses $ 928 $ 698
========================================================================
Tax benefits recorded $ 328 $ 220
========================================================================
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, 2006 2005
=========================================================================
Net income $12,230 $10,245
=========================================================================
Weighted average common shares outstanding
(used for basic EPS) 26,196 25,721
Effect of dilutive securities: *
Stock options 287 301
Shares of restricted stock and stock units 271 195
-------------------------------------------------------------------------
Adjusted weighted average common shares
outstanding (used for diluted EPS) 26,754 26,217
=========================================================================
Net income per common share:
Diluted $ 0.46 $ 0.39
=========================================================================
Basic $ 0.47 $ 0.40
=========================================================================
* excludes 150 and 450 antidilutive stock options and shares of
restricted stock in the three months ended October 31, 2006 and 2005,
respectively, that would have increased diluted EPS
The convertible debentures will lower diluted EPS when the quarterly
average price of our common stock exceeds the adjusted conversion price. In
fiscal periods when the average price of our common stock exceeds the adjusted
conversion price, shares of common stock needed to deliver the value of the
debentures over their principal amount based on the average stock price would be
included as shares outstanding in calculating diluted EPS. Shares to be included
would equal the difference between the average stock price and the adjusted
conversion price, divided by the average stock price and multiplied by the
number of convertible shares, currently 6,102,000 (referred to as the treasury
stock method). The average price of our common stock was $27.23 for the three
months ended October 31, 2006 and the adjusted conversion price was $28.68 at
October 31, 2006.
13
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 in the United States 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. We lend money under 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 (money currently available for us to borrow) is important. We borrow
from banks and insurance companies and we issue commercial paper to other
investors. Approximately 75% of our finance receivables were funded with debt at
October 31, 2006.
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 asset quality of our receivables and (iii)
managing our interest rate risk. At October 31, 2006, interest rates on our
finance receivables were 93% fixed and 7% floating, and interest rates on our
debt were 42% fixed and 58% floating. Therefore, changes in market interest
rates affect our profitability significantly. The asset quality of our finance
receivables can also affect our profitability significantly. Asset quality can
affect finance income, provisions for credit losses and operating expenses
through reclassifying receivables to or from non-accrual status, incurring
write-downs 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 operating statistics
are net charge-offs, 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, 2006 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.
Allowance for Credit Losses
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, net 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 customers and guarantors, collateral values and other factors. We
may need to change the allowance level significantly if unexpected changes in
these conditions or factors occur. Increases in the allowance would reduce net
income through higher provisions for credit losses. The allowance was $24.0
million (1.18% of finance receivables) at October 31, 2006 including $0.2
million specifically allocated to impaired receivables.
The allowance includes amounts specifically allocated to impaired
receivables and an amount to provide for losses inherent in the remainder of
finance receivables (the "general allowance"). We evaluate the fair value of an
impaired receivable and compare it to the carrying amount. The carrying amount
is the amount the receivable is recorded at when we evaluate the receivable and
may include a prior write-down or specific allowance. If our estimate of fair
value is lower than the carrying amount, we record a write-down or establish a
specific allowance based on how we determined fair value, how
14
certain we are of our estimate and on the level and type of factors and items
other than the primary collateral, such as guarantees and secondary collateral,
supporting our fair value estimate.
To estimate the general allowance, we analyze historical write-down
activity to develop percentage loss ranges by risk profile. Risk profiles are
assigned to receivables based on past due status and the customers' industry. We
then 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 to arrive at the estimated allowance. We record a provision
for credit losses if the recorded allowance differs from our current estimate.
Although our method is designed to calculate probable losses, because
significant estimates are used, the adjusted calculated range of losses may
differ from actual losses significantly.
Non-performing assets
We record impaired finance receivables at their current estimated fair
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 fair value of non-performing assets by
evaluating the expected cash flows of impaired receivables and the 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 the
condition of collateral or assets, or time needed to sell the equipment would
require us to record a write-down. This would lower net income. Impaired finance
receivables and assets received to satisfy receivables (repossessed equipment)
totaled $15.1 million (0.7% of finance receivables) at October 31, 2006.
Residual values
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 or incorrect
projections of future equipment values. This would lower net income. Residual
values totaled $42.8 million (2.1% of finance receivables) at October 31, 2006.
Historically, we have realized the recorded residual value on disposition.
Stock-based compensation
We record compensation expense for stock options under SFAS No. 123R using
the Black-Scholes option pricing model. This model requires us to estimate the
expected volatility of the price of our common stock, the expected life of
options and the expected dividend rate. SFAS No. 123R also requires us to
estimate forfeitures of stock options and shares of restricted stock. Estimating
volatility, expected life, dividend rate and forfeitures requires significant
judgment and an analysis of historical data. If actual results differ from our
estimates significantly, compensation expense for options and shares of
restricted stock and our results of operations could be impacted materially.
RESULTS OF OPERATIONS
Comparison of three months ended October 31, 2006 to three months ended October
31, 2005
========================================================================
Three Months Ended
October 31,
($ in millions, except per ------------------
share amounts) 2006 2005 $ Change % Change
========================================================================
Finance income $ 46.9 $ 36.6 $ 10.3 28%
Interest expense 20.9 14.3 6.6 47
Net finance income before
provision for credit losses 26.0 22.3 3.7 17
Provision for credit losses -- -- -- --
Salaries and other expenses 6.1 5.5 0.6 11
Provision for income taxes 7.7 6.6 1.1 17
Net income 12.2 10.2 2.0 19
Diluted earnings per share 0.46 0.39 0.07 18
Basic earnings per share 0.47 0.40 0.07 18
========================================================================
15
Net income increased by 19% to $12.2 million in the first quarter of
fiscal 2007 from $10.2 million in the first quarter of fiscal 2006. The increase
resulted from receivables growth and the higher net yield on finance
receivables, partially offset by the effects of higher short-term market
interest rates and higher salary expense.
Finance income increased by 28% to $46.9 million in the first quarter of
fiscal 2007 from $36.6 million in the first quarter of fiscal 2006. The increase
resulted from the 19% increase in average finance receivables ($316.0 million)
to $2.02 billion in the first quarter of fiscal 2007 from $1.70 billion in the
first quarter of fiscal 2006 and, to a lesser extent, the higher net yield on
finance receivables. Higher market interest rates and an increase in
non-interest finance income raised the net yield on finance receivables to 9.21%
in the first quarter of fiscal 2007 from 8.51% in the first quarter of fiscal
2006.
Interest expense (incurred on debt used to fund finance receivables)
increased by 47% to $20.9 million in the first quarter of fiscal 2007 from $14.3
million in the first quarter of fiscal 2006. The increase resulted from higher
average short-term market interest rates and the 20% ($256.0 million) increase
in average debt. Increases in short-term market interest rates raised our
weighted average cost of funds to 5.37% in the first quarter of fiscal 2007 from
4.39% in the first quarter of fiscal 2006.
Net finance income before provision for credit losses on finance
receivables increased by 17% to $26.0 million in the first quarter of fiscal
2007 from $22.3 million in the first quarter of fiscal 2006. Net interest margin
(net finance income before provision for credit losses expressed as an
annualized percentage of average finance receivables) decreased to 5.11% in the
first quarter of fiscal 2007 from 5.19% in the first quarter of fiscal 2006
because of the increase in short-term market interest rates.
We did not record provisions for credit losses on finance receivables in
the first quarters of fiscal 2007 and 2006. The provision for credit losses is
the amount needed to change the allowance for credit losses to our estimate of
losses inherent in finance receivables. We did not need to increase the
allowance because of continued low amounts of quarterly net charge-offs and
continued strong asset quality, and we did not need to reduce it because of
receivables growth. Net charge-offs (write-downs of finance receivables less
recoveries) were less than $0.1 million and the loss ratios (net charge-offs
expressed as an annualized percentage of average finance receivables) were 0.01%
in the first quarter of fiscal 2007 and 2006.
Salaries and other expenses increased by 11% to $6.1 million in the first
quarter of fiscal 2007 from $5.5 million in the first quarter of fiscal 2006.
The increase resulted from increased salary expense. Salary expense increased
because of salary increases and an increase in the number of employees. The
expense ratio (salaries and other expenses expressed as an annualized percentage
of average finance receivables) improved to 1.20% in the first quarter of fiscal
2007 from 1.28% in the first quarter of fiscal 2006 because the percentage
increase in receivables exceeded the percentage increase in expenses. The
efficiency ratio (expense ratio expressed as a percentage of net interest
margin) improved to 23.5% in the first quarter of fiscal 2007 from 24.6% in the
first quarter of fiscal 2006 because the percentage increase in net finance
income before provision for credit losses exceeded the percentage increase in
expenses.
The provision for income taxes increased to $7.7 million in the first
quarter of fiscal 2007 from $6.6 million in the first quarter of fiscal 2006.
The increase resulted from the increase in income before income taxes, partially
offset by the decrease in our effective tax rate to 38.6% in the first quarter
of fiscal 2007 from 39.1% in the first quarter of fiscal 2006. Our effective tax
rate decreased because of the new Texas income tax law enacted in our fourth
quarter of fiscal 2006 and effective for fiscal 2007, and the overall decrease
in our effective state income tax rate.
Diluted earnings per share increased by 18% to $0.46 per share in the
first quarter of fiscal 2007 from $0.39 per share in the first quarter of fiscal
2006, and basic earnings per share increased by 18% to $0.47 per share in the
first quarter of fiscal 2007 from $0.40 per share in the first quarter of fiscal
2006.
16
FINANCE RECEIVABLES AND ASSET QUALITY
We discuss trends and characteristics of our finance receivables and our
approach to managing credit risk in this section. The key aspect is asset
quality. Asset quality statistics measure our underwriting standards, skills and
policies and procedures and can indicate the direction and levels of future net
charge-offs and non-performing assets.
===============================================================================
October 31, July 31,
($ in millions) 2006 * 2006 * $ Change % Change
===============================================================================
Finance receivables $ 2,045.7 $ 1,991.7 $54.0 3%
Allowance for credit losses 24.0 24.1 (0.1) --
Non-performing assets 15.1 14.6 0.5 4
Delinquent finance receivables 7.0 8.6 (1.6) (18)
Net charge-offs (recoveries) 0.1 (0.1) 0.2 --
As a percentage of receivables:
-------------------------------
Allowance for credit losses 1.18% 1.21%
Non-performing assets 0.74 0.73
Delinquent finance receivables 0.34 0.43
Net charge-offs (annualized) 0.01 (0.01)
===============================================================================
* as of and for the quarter ended
Finance receivables grew 3% ($54 million) during the first quarter of
fiscal 2007 to $2.05 billion at October 31, 2006 from $1.99 billion at July 31,
2006. Finance receivables comprise installment sale agreements and secured loans
(collectively referred to as loans) and direct financing leases. Loans were 90%
($1.84 billion) of finance receivables and leases were 10% ($210 million) at
October 31, 2006.
Finance receivables originated in the first quarter of fiscal 2007 and
2006 were $320 million and $323 million, respectively. Finance receivables
collected in the first quarter of fiscal 2007 and 2006 were $263 million and
$243 million, respectively. Collections increased because of higher average
finance receivables.
Our primary focus is the credit quality of our receivables. We manage our
credit risk by using disciplined and sound 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 equipment
possessing these characteristics can mitigate potential net 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. This limit was $36.0 million at October 31, 2006. Our ten largest
customers accounted for 6.1% ($124.0 million) of total finance receivables at
October 31, 2006.
Our allowance for credit losses was $24.0 million at October 31, 2006 and
$24.1 million at July 31, 2006. The allowance level declined to 1.18% of finance
receivables at October 31, 2006 from 1.21% at July 31, 2006 because of continued
low net charge-offs, favorable asset quality and receivables growth. We
determine the allowance quarterly based on our analysis of historical losses and
the past due status of receivables at the end of each quarter adjusted for
expected recoveries and any differences between current and historical loss
trends and other factors. The allowance level may decline further if our asset
quality statistics remain at favorable levels.
Net charge-offs of finance receivables (write-downs less recoveries) were
$53,000 in the first quarter of fiscal 2007 compared to net recoveries of
$73,000 in the fourth quarter of fiscal 2006 and the loss ratios were 0.01% and
(0.01)%. Net charge-offs are at these low levels because of the low amount of
non-performing assets and strong demand for and strong market values of the
equipment we finance.
17
The net investments in non-accrual (impaired) finance receivables,
repossessed equipment (assets received to satisfy receivables), total
non-performing assets and delinquent finance receivables (transactions with more
than a nominal portion of a contractual payment 60 or more days past due) follow
($ in millions):
=========================================================================
October 31, July 31, October 31,
2006 2006 2005
=========================================================================
Non-accrual finance receivables * $14.1 $13.8 $10.0
Repossessed equipment 1.0 0.8 1.8
-------------------------------------------------------------------------
Total non-performing assets $15.1 $14.6 $11.8
=========================================================================
Delinquent finance receivables $ 7.0 $ 8.6 $ 8.0
=========================================================================
Percentage of non-accrual
receivables not delinquent 75% 54% 46%
=========================================================================
* before specifically allocated allowance of $0.2 million at October 31,
2006, $0.3 million at July 31, 2006 and $0.3 million at October 31, 2005
Our asset quality statistics stayed at favorable levels during the first
quarter of fiscal 2007. 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 moderate increases would not
necessarily indicate the start of a negative trend. Because our asset quality
statistics are so favorably low, if receivables from any of our larger customers
become delinquent, impaired or repossessed, our asset quality statistics could
worsen significantly even though the overall trend may remain positive.
LIQUIDITY AND CAPITAL RESOURCES
We describe our need for raising capital (debt and equity), our need for
having a substantial amount of liquidity (money currently available for us to
borrow), our approach to managing liquidity and our current funding sources in
this section. Key indicators are leverage (the number of times debt exceeds
equity), available liquidity and credit ratings. Our leverage is low for a
finance company, we have been successful in issuing debt, we have ample
liquidity available and the maturities of our debt are staggered over five
years.
Liquidity and access to capital are vital to our operations and growth. We
need continued availability of funds to originate or acquire 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 bank credit facilities, dealer placed and direct issued
commercial paper and sales of common and preferred equity. We believe our
liquidity sources are diversified, and we are not dependent on any funding
source or provider.
Our term notes are rated 'BBB+' by Fitch Ratings, Inc. ("Fitch", a
Nationally Recognized Statistical Ratings Organization) and commercial paper
issued by our major operating subsidiary ($260.0 million at October 31, 2006) is
rated `F2' by Fitch. As a condition of our `F2' credit rating, commercial paper
outstanding is limited to the unused amount of our bank credit facilities. Fitch
last affirmed its investment grade ratings on our debt in August 2005 and
maintained its stable outlook. Our access to capital markets and our credit
spreads are partly dependent on these investment grade credit ratings.
We had $179.2 million available to borrow under our bank credit facilities
(after subtracting commercial paper outstanding) at October 31, 2006. Our asset
securitization facility could be increased by $310.0 million and we believe we
can issue more term notes. We believe, but cannot assure, sufficient capital is
available to sustain our future operations and growth.
Our major operating subsidiary's debt agreements have restrictive
covenants including limits on its indebtedness, encumbrances, investments,
dividends and other distributions to us, sales of assets, mergers and other
business combinations, capital expenditures, interest coverage and net worth. We
were in compliance with all debt covenants at October 31, 2006. None of the
agreements have a material adverse change clause.
18
Debt increased by 2% ($24.5 million) to $1.55 billion at October 31, 2006
from $1.53 billion at July 31, 2006 and stockholders' equity increased by 3%
($12.1 million) to $402.5 million at October 31, 2006 from $390.4 million at
July 31, 2006. Leverage remained low at 3.9 allowing for substantial asset
growth. Historically, our leverage has not exceeded 5.5 which is also considered
low for a finance company.
Debt comprised the following ($ in millions):
=================================================================================
October 31, 2006 July 31, 2006
---------------- ----------------
Amount Percent Amount Percent
=================================================================================
Term notes $ 629.5 41% $ 664.5 43%
Asset securitization financings 425.0 27 425.0 28
Commercial paper 270.9 17 118.9 8
Convertible debentures 175.0 11 175.0 11
Borrowings under bank credit facilities 55.8 4 149.7 10
---------------------------------------------------------------------------------
Total principal 1,556.2 100% 1,533.1 100%
Fair value adjustment of hedged debt (4.1) (5.4)
---------------------------------------------------------------------------------
Total debt $1,552.1 $1,527.7
=================================================================================
Term Notes
We repaid $25.0 million of 5.92% fixed rate term notes at maturity and we
converted a $10.0 million floating rate term note from a bank due in fiscal 2008
to a $15.0 million three-year committed unsecured revolving credit facility in
the first quarter of fiscal 2007.
Asset Securitization Financings
We have a $425.0 million asset securitization facility. We established the
facility in July 2001. The facility was renewed a fifth time in April 2006 and
expires in April 2007 subject to further 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 and would be fully repaid
by June 2009 based on the contractual payments of the $483.0 million of
securitized receivables at October 31, 2006.
The unsecured debt agreements of our major operating subsidiary allow 40%
of its finance receivables to be securitized ($813.0 million at October 31,
2006). Therefore, we could securitize an additional $330.0 million of finance
receivables at October 31, 2006. Borrowings are limited to 94% of securitized
receivables and can be further limited based on the eligibility of securitized
receivables.
Convertible Debentures
The convertible debentures were convertible into 6.1 million shares (as
adjusted) of common stock at the adjusted conversion price of $28.68 per share
resulting in an adjusted conversion rate of 34.87 shares for each $1,000 of
principal. In fiscal 2005, we irrevocably elected to pay the value of converted
debentures, not exceeding the principal amount, in cash instead of issuing
shares of our common stock. As a result, the 6.1 million convertible shares are
no longer issuable upon conversion, but we would need to pay any value over
principal by issuing shares of common stock. The value of the convertible
debentures equals the number of convertible shares multiplied by the market
value of our common stock. No event allowing for the debentures to be converted
has occurred through October 31, 2006.
Bank Credit Facilities
We have $495.0 million of committed unsecured revolving credit facilities
from ten banks (a $25.0 million increase from July 31, 2006). This includes
$307.5 million of facilities with original terms ranging from two to five years
and $187.5 million of facilities with an original term of one year. Borrowings
under these facilities can mature between 1 and 270 days. 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 with
maturities between 1 and 270 days. The combined amount of commercial paper and
bank borrowings ($326.7 million October 31, 2006) was limited to $495.0 million
because commercial paper outstanding is limited to the unused amount of our bank
credit facilities. Commercial paper outstanding increased during the first
quarter of fiscal 2007 because added a commercial paper dealer.
19
Stockholders' Equity
We paid $2.7 million of cash dividends, we received $1.1 million from
stock option exercises and tax benefits from stock-based awards and we
repurchased 3,000 shares of common stock for $69,000 in the first quarter of
fiscal 2007. At October 31, 2006, $17.5 million was available for future
repurchases under our repurchase program.
MARKET INTEREST RATE RISK AND SENSITIVITY
We discuss how changes in market interest rates affect our net interest
spread and how we manage interest rate risk in this section. Net interest spread
(the net yield of finance receivables less the weighted average cost of debt) is
an integral part of a finance company's profitability and is calculated below:
=========================================================================
Three Months Ended October 31, 2006 2005
=========================================================================
Net yield of finance receivables 9.21% 8.51%
Weighted average cost of debt 5.37 4.39
-------------------------------------------------------------------------
Net interest spread 3.84% 4.12%
=========================================================================
Our net interest spread was 0.28% (28 basis points) lower in the first
quarter of fiscal 2007 compared to the first quarter of fiscal 2006 because the
effects of the 1.6% (160 basis points) increase in average short-term market
interest rates exceeded the increase in the net yield of finance receivables.
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 occurred during our prior
two fiscal years) and decreases in short-term rates increase our net interest
spread because our floating rate debt (includes short-term debt) exceeds our
floating rate finance receivables significantly. Because 58% of our debt is
floating rate compared to floating rate finance receivables of only 7%, interest
rates on our debt change faster than the yield on our receivables. Our net
interest spread is also affected when the differences between short-term and
long-term rates change. Long-term rates normally exceed short-term rates. When
the differences between long and short-term rates narrow (resulting in a
"flattening yield curve") or when short-term rates exceed long-term rates (an
"inverted yield curve"), our net interest spread should decrease and when the
yield curve 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 fixed rate debt.
Short-term market interest rates changed little during the first quarter
of fiscal 2007 after rising substantially and consistently over the prior two
years, and the yield curve was inverted. Because short-term market interest
rates did not rise during the quarter, our weighted-average cost of debt
increased by 0.11% (11 basis points) compared to quarterly increases during the
prior two fiscal years of about 0.25% (25 basis points).
Our income is subject to the risk of rising short-term market interest
rates and a flat or inverted yield curve at October 31, 2006 because floating
rate debt exceeded floating rate receivables by $748.7 million (see the table
below). The terms and prepayment experience of our fixed rate receivables
mitigate this risk. Finance receivables are collected monthly over short terms
of two to five years and have been accelerated by prepayments. At October 31,
2006, $682.0 million (36%) of fixed rate finance receivables are scheduled to be
collected in one year and the weighted average remaining life of fixed rate
finance receivables excluding prepayments is approximately twenty months. We do
not match the maturities of our debt to our finance receivables. The fixed and
floating rate amounts and percentages of our finance receivables and capital at
October 31, 2006 follow ($ in millions):
===============================================================================
Fixed Rate Floating Rate
------------------ ----------------
($ in millions) Amount Percent Amount Percent Total
===============================================================================
Finance receivables $1,899.4 93% $146.3 7% $2,045.7
===============================================================================
Debt (principal) $ 661.2 42% $895.0 58% $1,556.2
Stockholders' equity 402.5 100 -- -- 402.5
-------------------------------------------------------------------------------
Total debt and equity $1,063.7 54% $895.0 46% $1,958.7
===============================================================================
20
Floating rate debt (asset securitization financings, commercial paper,
floating rate swaps of fixed rate notes and bank borrowings) reprices (interest
rate changes based on current short-term market interest rates) as follows at
October 31, 2006: $604.7 million (67%) within one month, $175.3 million (20%) in
two to three months and $115.0 million (13%) in four to six months. Most of the
floating rate swaps of fixed rate notes last repriced in October 2006. The
repricing frequency of floating rate debt follows (in millions):
==========================================================================
Balance Repricing Frequency
==========================================================================
Asset securitization financings $425.0 generally daily
Commercial paper 270.9 1 to 100 days (30 day average)
Floating rate swaps of fixed
rate notes 143.3 semiannually (150 day average)
Bank borrowings 55.8 generally daily
==========================================================================
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.
This hypothetical change in rates would reduce quarterly net income by
approximately $0.6 million at October 31, 2006 based on scheduled repricings of
floating rate debt, fixed rate debt maturing within one year and the expected
effects on the yield of new receivables. This amount increases to $1.1 million
excluding the expected increase in the yield of new receivables. We believe
these amounts are acceptable considering the cost of floating rate debt has
been historically lower than fixed rate debt. Actual future changes in market
interest rates and the effect on net income may differ materially from these
amounts. 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 potential adverse changes in market
interest rates by using certain derivative financial instruments and by changing
the proportion of our fixed and floating rate debt. We may use derivatives to
hedge our exposure to interest rate risk on existing debt and debt expected to
be issued. We do not speculate with or trade derivatives.
We entered into interest rate locks with a total notional amount of $100.0
million with three counterparty banks in September 2006. The rate locks expire
in March 2007. We designated the rate locks as cash flow hedges of an
anticipated issuance of five-year fixed rate term notes hedging the risk of
interest rate changes, on the interest payments of the notes, through the date
the interest rate is set on the note issuance. The rate locks had approximately
no value at October 31, 2006. When we terminate the rate locks, the effective
portion of any gain or loss would be deferred as accumulated other comprehensive
income and recognized as an adjustment to interest expense over the five-year
term of the notes to be issued. Any ineffective portion of any gain or loss
would be recognized currently in interest expense.
We also have fixed to floating interest rate swaps with a total notional
amount of $143.3 million at October 31, 2006 and July 31, 2006. The swaps
effectively converted fixed rate term notes into floating rate term notes.
Semiannually, we receive fixed amounts from the swap counterparty banks equal to
the interest we pay on the fixed rate hedged notes, and we pay amounts to the
swap counterparty banks equal to the swaps' floating rates multiplied by the
swaps' notional amounts. The swaps' floating rates change every six months to a
fixed amount over six-month LIBOR (5.40% at October 31, 2006). The swaps
increased interest expense by $0.8 million in the first quarter of fiscal 2007
and by $0.1 million in the first quarter of fiscal 2006. The weighted average
pay rate of 7.00% at October 31, 2006 exceeded the 4.88% weighted average
receive rate by 212 basis points (2.12%). The weighted average remaining term of
the swaps at October 31, 2006 is 1.8 years.
NEW ACCOUNTING STANDARDS
The Financial Accounting Standards Board ("FASB") issued Interpretation
No. 48, "Accounting for Uncertainty in Income Taxes - An Interpretation of FASB
109", ("FIN No. 48") in July 2006. FIN No. 48 requires companies to determine if
any tax positions taken on their income tax returns lowering the amount of tax
currently due would more likely than not be allowed by a taxing jurisdiction. If
tax positions pass the more-likely-than-not test, companies then record benefits
from them only equal to the highest amount that has a greater than 50% chance of
being realized assuming the tax positions would be challenged by a taxing
jurisdiction. No benefits would be recorded for tax positions failing the
more-likely-than-not test. Tax benefits include income tax savings and the
related interest expense savings. Whether tax positions pass the test or not,
adopting FIN No. 48 could result in additional income tax provisions or expenses
for any interest and penalties on potential underpayments of income tax, or
both. FIN No. 48 is effective in the first quarter of fiscal years beginning
after December
21
15, 2006. It will become effective for us on August 1, 2007, the beginning of
our fiscal year ending July 31, 2008. We are evaluating how it may affect our
consolidated financial statements.
The FASB issued Statement of Financial Accounting Standards ("SFAS") No.
157, "Fair Value Measurements", ("SFAS No. 157") in September 2006. SFAS No. 157
defines fair value (replacing all prior definitions) and creates a framework to
measure fair value, but does not create any new fair value measurements. SFAS
No. 157 is effective in the first quarter of fiscal years beginning after
November 15, 2007. It will become effective for us on August 1, 2008. We are
evaluating how it may affect our consolidated financial statements.
FORWARD-LOOKING STATEMENTS
Statements in this report including the words or phrases "can be,"
"expect," "anticipate," "may," "believe," "estimate," "intend," "could,"
"should," "would," "if" and similar words and phrases are "forward-looking
statements" within the meaning of 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 any
forward-looking information provided by us or on our behalf is not a guarantee
of future performance. Our actual results could differ from those anticipated by
forward-looking statements materially because of the uncertainties and risks
described in "Part I, Item 1A Risk Factors" in our Annual Report on Form 10-K
for the year ended July 31, 2006 and other sections of this report. These risk
factors include (i) an economic slowdown (ii) the inability to collect finance
receivables and the sufficiency of the allowance for credit losses (iii) the
inability to obtain capital or maintain liquidity (iv) rising short-term market
interest rates and adverse changes in the yield curve (v) increased competition
(vi) the inability to retain key employees and (vii) adverse conditions in the
construction and road transportation industries. Forward-looking statements
apply only as of the date made and we are not required to update forward-looking
statements for future or unanticipated events or circumstances.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
See Item 2, Market Interest Rate Risk and Sensitivity.
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)
at the end of the period covered by this report. Based on this evaluation, our
Chief Executive Officer and Chief Financial Officer concluded 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 recorded, processed, summarized and reported timely.
Changes in Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting
during the first quarter of fiscal 2007 that materially affected or are
reasonably likely to materially affect our internal control over financial
reporting.
22
PART II - OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
ISSUER PURCHASES OF EQUITY SECURITIES
For the Quarter Ended October 31, 2006
===================================================================================
Month (a) Total (b) Average (c) Total Number of (d) Maximum Number
Number Price Paid Shares Purchased (or Approximate Dollar
of Shares per Share as Part of Value) of Shares that May
Purchased Publicly Announced Yet Be Purchased Under
Plans or Programs the Plans or Programs
===================================================================================
September 2006 1,764 $27.12 1,764 $17,489,000
October 2006 794 27.96 794 17,467,000
--------------------------------------------------------
Total 2,558 $27.38 2,558
===================================================================================
We did not sell any unregistered shares of our common stock during the
first quarter of fiscal 2007. In September and October 2006, we received 2,558
shares of common stock from our CEO as payment of income taxes we were required
to withhold on vested shares of restricted stock. We established our common
stock repurchase program in August 1996 and expanded it in August 1998 to
include repurchases of convertible debt. A total of $40.7 million was authorized
for repurchases of common stock and convertible debt and we repurchased $16.1
million of common stock and $7.2 million of convertible debt through October 31,
2006.
Item 5. Other Information
On December 5, 2006, we issued a press release reporting our results for
the quarter ended October 31, 2006. 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.
On December 6, 2006, we issued a press release announcing (i) our Board of
Directors declared a quarterly dividend of $0.15 per share on our common stock
and (ii) our stockholders approved the Amended and Restated 2001 Management
Incentive Plan and the 2006 Stock Incentive Plan. The press release is attached
as Exhibit 99.2. The dividend is payable on January 10, 2007 to stockholders of
record at the close of business on December 22, 2006. The dividend rate is $0.05
per share (50%) higher than the previous quarter's dividend of $0.10 per share.
Item 6. Exhibits
Exhibit No. Description of Exhibit
------------------------------------------------------------------------------
3.1 (a) Articles of Incorporation
3.2 (b) Certificate of Amendment of Articles of Incorporation dated
December 9, 1998
3.3 (c) Restated By-laws as amended through March 7, 2000
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, 2006
99.2 Press release dated December 6, 2006
Previously filed with the Securities and Exchange Commission as an exhibit to
our:
-----------------------------------------------------------------------------
(a) Registration Statement on Form S-1 (Registration No. 33-46662)
filed May 28, 1992
(b) Form 10-Q for the quarter ended January 31, 1999
(c) Form 10-Q for the quarter ended January 31, 2000
23
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 7, 2006
----------------
(Date)
24