DIRECT GENERAL CORPORATION 10-Q
UNITED
STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
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þ |
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QUARTERLY REPORT PURSUANT TO SECTION 13 OR
15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended June 30, 2005
or
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o |
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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: 000-50360
DIRECT GENERAL CORPORATION
(Exact name of registrant as specified in its charter)
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Tennessee
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62-1564496 |
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(State or other jurisdiction of
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(I.R.S. Employer Identification No.) |
incorporation or organization) |
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1281 Murfreesboro Road, Nashville, TN
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37217 |
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(Address of principal executive offices)
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(Zip Code) |
(615) 399-0600
(Registrants telephone number, including area code)
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 þ No o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act).
Yes þ No o
Indicate the number of shares outstanding of each of the issuers classes of common stock, as
of the latest practicable date: 21,440,228 shares of common stock, no par value, at August 5, 2005.
TABLE OF CONTENTS
PART I FINANCIAL INFORMATION
Item 1. Financial Statements.
DIRECT GENERAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
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Three Months Ended |
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Six Months Ended |
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June 30, |
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June 30, |
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2005 |
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2004 |
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2005 |
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2004 |
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(In thousands except per share amounts) |
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Revenues |
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Premiums earned |
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$ |
104,737 |
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$ |
93,297 |
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$ |
206,650 |
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$ |
176,304 |
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Finance income |
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12,130 |
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12,702 |
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24,301 |
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25,463 |
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Commission and service fee income |
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11,116 |
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11,980 |
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25,383 |
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25,475 |
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Net investment income |
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3,546 |
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2,621 |
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6,875 |
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4,897 |
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Net realized (losses) gains on securities and other |
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(286 |
) |
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(9 |
) |
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(255 |
) |
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60 |
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Total revenues |
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131,243 |
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120,591 |
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262,954 |
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232,199 |
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Expenses |
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Insurance losses and loss adjustment expenses |
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76,485 |
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68,262 |
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152,367 |
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129,087 |
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Selling, general and administrative costs |
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34,322 |
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25,148 |
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67,106 |
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50,388 |
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Interest expense |
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1,950 |
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1,539 |
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3,260 |
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2,891 |
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Total expenses |
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112,757 |
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94,949 |
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222,733 |
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182,366 |
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Income before income taxes |
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18,486 |
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25,642 |
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40,221 |
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49,833 |
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Income tax expense |
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6,990 |
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9,624 |
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15,142 |
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18,797 |
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Net income |
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$ |
11,496 |
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$ |
16,018 |
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$ |
25,079 |
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$ |
31,036 |
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Earnings per Share |
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Basic earnings per common share |
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$ |
0.53 |
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$ |
0.72 |
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$ |
1.14 |
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$ |
1.42 |
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Diluted earnings per common share |
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$ |
0.53 |
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$ |
0.70 |
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$ |
1.14 |
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$ |
1.37 |
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See notes to condensed consolidated financial statements.
2
DIRECT GENERAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
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(Unaudited) |
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June 30, |
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December 31, |
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2005 |
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2004 |
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(In thousands) |
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Assets |
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Investments: |
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Debt securities available-for-sale at fair value (amortized cost
$357,253 and $334,770 at June 30, 2005 and December 31, 2004,
respectively) |
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$ |
356,706 |
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$ |
334,816 |
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Short-term investments |
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1,623 |
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1,663 |
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Total investments |
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358,329 |
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336,479 |
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Cash and cash equivalents |
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110,541 |
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70,988 |
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Finance receivables, net |
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241,541 |
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214,180 |
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Reinsurance balances receivable |
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32,102 |
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35,671 |
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Prepaid reinsurance premiums |
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27,651 |
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29,544 |
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Deferred policy acquisition costs |
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14,014 |
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12,666 |
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Income taxes recoverable |
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3,551 |
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7,177 |
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Deferred income taxes |
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22,393 |
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20,040 |
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Property and equipment |
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16,686 |
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15,823 |
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Goodwill, net |
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27,309 |
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22,188 |
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Other assets |
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22,941 |
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22,696 |
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Total assets |
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$ |
877,058 |
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$ |
787,452 |
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Liabilities and Shareholders Equity |
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Loss and loss adjustment expense reserves |
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$ |
126,055 |
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$ |
124,858 |
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Unearned premiums |
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245,075 |
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|
223,303 |
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Reinsurance balances payable and funds held |
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36,452 |
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33,996 |
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Accounts payable and accrued expenses |
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15,801 |
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|
11,949 |
|
Notes payable |
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179,202 |
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|
135,626 |
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Capital lease obligations |
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3,229 |
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|
3,772 |
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Other liabilities |
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22,325 |
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8,867 |
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Total liabilities |
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628,139 |
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542,371 |
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Shareholders equity |
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Common stock, no par; authorized shares 100,000.0; issued shares
21,440.0 and 22,360.0 at June 30, 2005 and December 31, 2004,
respectively |
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89,850 |
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109,163 |
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Retained earnings |
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159,508 |
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136,178 |
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Accumulated other comprehensive (loss) income: |
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Net unrealized (depreciation) appreciation on investment securities |
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(356 |
) |
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30 |
|
Net loss on cash flow hedge |
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(83 |
) |
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|
(290 |
) |
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Total shareholders equity |
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248,919 |
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|
245,081 |
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Total liabilities and shareholders equity |
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$ |
877,058 |
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$ |
787,452 |
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See notes to condensed consolidated financial statements.
3
DIRECT GENERAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
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Six Months Ended June 30, |
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2005 |
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2004 |
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(In thousands) |
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Operating activities |
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Net income |
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$ |
25,079 |
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$ |
31,036 |
|
Adjustments to reconcile net income to net cash provided by operating activities: |
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Net realized losses (gains) on securities and other |
|
|
255 |
|
|
|
(60 |
) |
Depreciation and amortization |
|
|
3,334 |
|
|
|
2,675 |
|
Deferred income taxes |
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(2,256 |
) |
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|
(2,406 |
) |
Changes in operating assets and liabilities: |
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|
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|
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Finance receivables |
|
|
(27,361 |
) |
|
|
(35,031 |
) |
Reinsurance balances receivable |
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|
3,569 |
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|
9,001 |
|
Prepaid reinsurance premiums |
|
|
1,893 |
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|
11,495 |
|
Deferred policy acquisition costs |
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(1,348 |
) |
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|
(934 |
) |
Income taxes recoverable/payable |
|
|
3,626 |
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|
(6,735 |
) |
Loss and loss adjustment expense reserves |
|
|
1,197 |
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|
|
4,011 |
|
Unearned premiums |
|
|
21,773 |
|
|
|
35,386 |
|
Reinsurance balances payable and funds held |
|
|
2,456 |
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|
(12,694 |
) |
Accounts payable and accrued expenses |
|
|
3,852 |
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|
(315 |
) |
Other |
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|
4,691 |
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(4,486 |
) |
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|
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Net cash provided by operating activities |
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|
40,760 |
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|
30,943 |
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Investing activities |
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Proceeds from sales and maturities of debt securities available-for-sale |
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51,409 |
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|
85,104 |
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Purchase of debt securities available-for-sale |
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(74,532 |
) |
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(116,235 |
) |
Payable for securities |
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|
9,494 |
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|
1,569 |
|
Net sales (purchases) of short-term investments |
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40 |
|
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|
(716 |
) |
Purchase of property and equipment, net |
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(3,863 |
) |
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|
(3,297 |
) |
Purchase of insurance agency assets |
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(5,560 |
) |
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Purchase of life insurance company |
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|
|
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|
(7,330 |
) |
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Net cash used in investing activities |
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|
(23,012 |
) |
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|
(40,905 |
) |
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Financing activities |
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Repurchase of common stock |
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(20,037 |
) |
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Issuance of common stock |
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|
557 |
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|
16,804 |
|
Net proceeds from borrowings |
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|
43,800 |
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|
4,066 |
|
Payment of principal on borrowings |
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(766 |
) |
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|
(815 |
) |
Payment of stock dividends |
|
|
(1,749 |
) |
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|
(1,754 |
) |
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|
|
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|
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|
Net cash provided by financing activities |
|
|
21,805 |
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|
|
18,301 |
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|
|
|
|
|
|
|
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|
Net increase in cash and cash equivalents |
|
|
39,553 |
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|
|
8,339 |
|
Cash and cash equivalents at beginning of period |
|
|
70,988 |
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|
|
87,342 |
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|
|
|
|
|
|
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|
Cash and cash equivalents at end of period |
|
$ |
110,541 |
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|
$ |
95,681 |
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|
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|
See notes to condensed consolidated financial statements.
4
DIRECT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. Nature of Operations
Direct General Corporation, headquartered in Nashville, Tennessee, is a financial services
holding company whose principal operating subsidiaries provide non-standard personal automobile
insurance, term life insurance, premium finance and other consumer products and services primarily
on a direct basis and primarily in the southeastern United States. Direct General Corporation owns
four property/casualty insurance companies, two life/health insurance companies, two premium
finance companies, thirteen insurance agencies, two administrative service companies and one
company that provides non-insurance consumer products and services. (Direct General Corporation
and its subsidiaries are sometimes collectively referred to herein as the Company.)
2. Basis of Presentation
The unaudited condensed consolidated financial statements included herein have been prepared
pursuant to the rules and regulations of the Securities and Exchange Commission. Certain
information and footnote disclosures normally included in financial statements prepared in
accordance with accounting principles generally accepted in the United States (GAAP) have been
condensed or omitted pursuant to such rules and regulations. The unaudited condensed consolidated
financial statements reflect all normal recurring adjustments which were, in the opinion of
management, necessary for a fair statement of the results for the interim periods presented. The
results of operations for the period ended June 30, 2005 are not necessarily indicative of the
results that may be expected for the full year. These unaudited condensed consolidated financial
statements and the notes thereto should be read in conjunction with the Companys audited financial
statements and accompanying notes included in the Companys Annual Report on Form 10-K for the year
ended December 31, 2004.
3. Acquisitions
During January 2005, the Company acquired certain assets of All American General Agency, Inc.,
operating primarily under the name AMCO, and the assets of two other insurance agencies,
collectively operating through 82 sales offices in the state of Texas. The assets acquired
included customer records and renewal rights and the operating assets of the sales offices used to
conduct their agency business. The total purchase price, the majority of which is recorded as
goodwill, was $5.6 million. The acquisition of the 82 sales offices increased the Companys future
minimum lease commitments having an initial or remaining term of more than one year by
approximately $3.1 million.
4. Common Stock Repurchase
On January 31, 2005, the Company announced that its Board of Directors approved the repurchase
of up to $20.0 million of its outstanding common stock. As of June 30, 2005, the Company had
repurchased 1,055,572 shares of its outstanding common stock for an aggregate price of
approximately $20.0 million.
5. Notes Payable
The Company maintains a $190.0 million revolving credit facility with a consortium of banks to
fund the working capital of the Companys premium finance operations. As of June 30, 2005, the
amount outstanding under the facility, which matures on June 30, 2007, was $179.0 million. Direct
General Corporation also has a $30.0 million revolving credit facility available to support its
operations and strategic initiatives. No amounts were outstanding under this facility as of June
30, 2005.
5
6. Earnings Per Share
The following table sets forth the computation of basic and diluted earnings per share:
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Three Months Ended |
|
Six Months Ended |
|
|
June 30, |
|
June 30, |
|
|
2005 |
|
2004 |
|
2005 |
|
2004 |
|
|
(In thousands, except per share amounts) |
|
Numerator: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income |
|
$ |
11,496 |
|
|
$ |
16,018 |
|
|
$ |
25,079 |
|
|
$ |
31,036 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
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Denominator: |
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|
|
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|
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|
|
|
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Weighted average common shares outstanding |
|
|
21,634.5 |
|
|
|
22,239.2 |
|
|
|
21,951.6 |
|
|
|
21,871.1 |
|
Dilutive stock options |
|
|
48.4 |
|
|
|
602.5 |
|
|
|
75.4 |
|
|
|
718.1 |
|
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|
|
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|
|
|
|
|
|
|
|
|
|
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|
Weighted average common shares
outstanding for purposes of computing
diluted earnings per common share |
|
|
21,682.9 |
|
|
|
22,841.7 |
|
|
|
22,027.0 |
|
|
|
22,589.2 |
|
|
|
|
|
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|
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
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|
|
Basic earnings per common share |
|
$ |
0.53 |
|
|
$ |
0.72 |
|
|
$ |
1.14 |
|
|
$ |
1.42 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted earnings per common share |
|
$ |
0.53 |
|
|
$ |
0.70 |
|
|
$ |
1.14 |
|
|
$ |
1.37 |
|
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7. Stock Options
The Company follows the provisions of Accounting Principles Board (APB) Opinion No. 25,
Accounting for Stock Issued to Employees, to account for its stock option activity in the
financial statements. The Company generally grants employee stock options at an exercise price
equal to the market price at the date of grant. Employee stock options granted at less than the
market price at the date of grant and options granted to non-employees are expensed. During the
first six months of 2005, the Company recorded $167,000 of expense related to options granted to
both employees and non-employees to purchase 115,000 shares at an exercise price of $31.00 per
share that was less than the current market price at the time of grant.
If the Company had elected to recognize stock compensation expense based on the fair value of
stock options at the grant date, as prescribed by SFAS 123, net income and basic and diluted
earnings per share would have been reported as presented in the following table.
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|
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|
|
|
|
|
|
Three Months Ended |
|
Six Months Ended |
|
|
June 30, |
|
June 30, |
|
|
2005 |
|
2004 |
|
2005 |
|
2004 |
|
|
(In thousands, except per share amounts) |
|
Net income, as reported |
|
$ |
11,496 |
|
|
$ |
16,018 |
|
|
$ |
25,079 |
|
|
$ |
31,036 |
|
Deduct: Total
stock-based employee
compensation expense
determined under the
fair value based
method, net of related
tax effects |
|
|
(213 |
) |
|
|
(188 |
) |
|
|
(431 |
) |
|
|
(440 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income, pro forma |
|
$ |
11,283 |
|
|
$ |
15,830 |
|
|
$ |
24,648 |
|
|
$ |
30,596 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income for purposes of
computing diluted
earnings per share
common, as reported |
|
$ |
11,496 |
|
|
$ |
16,018 |
|
|
$ |
25,079 |
|
|
$ |
31,036 |
|
Deduct: Total
stock-based employee
compensation expense
determined under the
fair value based
method, net of related
tax effects |
|
|
(213 |
) |
|
|
(188 |
) |
|
|
(431 |
) |
|
|
(440 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income for purposes of
computing diluted
earnings per share
common, pro forma |
|
$ |
11,283 |
|
|
$ |
15,830 |
|
|
$ |
24,648 |
|
|
$ |
30,596 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
6
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
Six Months Ended |
|
|
June 30, |
|
June 30, |
|
|
2005 |
|
2004 |
|
2005 |
|
2004 |
|
|
(In thousands, except per share amounts) |
|
Earnings per share |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic as reported |
|
$ |
0.53 |
|
|
$ |
0.72 |
|
|
$ |
1.14 |
|
|
$ |
1.42 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic pro forma |
|
$ |
0.52 |
|
|
$ |
0.71 |
|
|
$ |
1.12 |
|
|
$ |
1.40 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted as reported |
|
$ |
0.53 |
|
|
$ |
0.70 |
|
|
$ |
1.14 |
|
|
$ |
1.37 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted pro forma |
|
$ |
0.52 |
|
|
$ |
0.69 |
|
|
$ |
1.12 |
|
|
$ |
1.35 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
8. Contingencies
The Company is named as defendant in various legal actions arising in the ordinary course of
business. In addition, the Company and certain of our officers and directors are named as
defendants in a putative securities class action lawsuit and two shareholder derivative actions.
The Company believes it has meritorious defenses to these actions and intends to vigorously defend
each of these lawsuits. However, all litigation is unpredictable and the ultimate outcome of these
cases is uncertain. These matters are in their early procedural stages, and thus the Company is
unable to predict the likelihood or range of our potential liability or the potential financial
impact on our future operations, if we are not able to successfully defend these cases.
9. Subsequent Events
In April 2005, the Company signed a stock purchase agreement to acquire a property and
casualty company, the assets of which consist of debt securities and licenses to conduct property
and casualty business in 38 states and the District of Columbia. The proposed acquisition has
received regulatory approval and the Company expects the acquisition to close in August 2005. The
purchase price is estimated to be $10.3 million, of which approximately $4.3 million is expected to
be allocated to the value of the licenses and recorded as goodwill.
The Company maintains a $190.0 million variable rate revolving credit agreement with a group
of banks, which subjects the Company to exposures from fluctuations in interest rates under the
agreement. The Company has entered into an Interest Rate Swap agreement effective August 1, 2005,
which has been designated as a hedge of variable cash flows associated with interest rate increases
above the 30-day LIBOR rate of 4.255% on a notional amount of $50.0 million. This derivative
instrument, which expires on August 2, 2010, requires monthly settlements whereby the Company pays
the difference between the current 30-day LIBOR rate and the floor of 4.255% and receives the
excess of the current 30-day LIBOR rate and the cap of 4.255%.
On August 2, 2005, the Company announced that its Board of Directors approved the repurchase
of up to $30.0 million of its outstanding common stock over the next 18 months. This approval
provides management with the discretionary authority to buyback up to $30.0 million of its
outstanding common stock in accordance with its capital management strategies.
10. Recent Accounting Pronouncements
The Company periodically reviews recent accounting pronouncements issued by the Financial
Accounting Standards Board, American Institute of Certified Public Accountants, Emerging Issues
Task Force, and Staff Accounting Bulletins issued by the United States Securities and Exchange
Commission to determine the potential impact on the Companys financial statements. Based on its
most recent review, the Company has determined that the majority of these recently issued
accounting standards either do not apply to the Company or will not have a material impact on its
financial statements. However, in December 2004, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, which will
affect the manner in which the Company accounts for its share-based payment arrangements, including
employee stock options. Accordingly, effective January 1, 2006, the Company will be required to
expense the cost resulting from all share-based payment arrangements in its financial statements.
(See Note 7 hereto.) The Company is currently in the process of determining the impact this
standard will have on its financial statements.
7
Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations.
This Managements Discussion and Analysis of Financial Condition and Results of Operations
should be read in conjunction with the Companys discussion presented under the caption
Managements Discussion and Analysis of Financial Condition and Results of Operations that is
available in the Annual Report on Form 10-K for the year ended December 31, 2004 filed with the
Securities and Exchange Commission.
Overview of Operating Results
Net income for the three months ended June 30, 2005 was $11.5 million or $0.53 per share, on a
diluted basis, as compared to net income of $16.0 million or $0.70 per share, on a diluted basis,
in the second quarter of 2004. The second quarter results were influenced by an increase in
operating expenses largely associated with a decrease in ceding commissions received, increased
costs related to our expansions in Texas, Missouri and Virginia, and a decline in gross premiums
written in our mature states. Overall, gross written premiums decreased 3.3% to $98.4 million in
the second quarter of 2005 from $101.8 million in the same period in 2004, which included a
decrease of approximately $1.3 million associated with the Companys decision, in October 2004, to
cease writing new business policies in the Miami, Florida market. For the quarter, gross premiums
written in our expansion states increased to $14.9 million from $8.0 million in the corresponding
period in 2004, due largely to a shift from issuing monthly policies to annual policies in the
state of Texas. Additionally, the market for nonstandard automobile insurance is extremely
competitive and we have lost some market share in our mature states, which we believe is generally
attributable to the increased advertising by other insurers.
The loss ratio for the second quarter of 2005 was 73.0%, which represents a slight improvement
over the second quarter of 2004. The loss trends in the second quarter reflected the continuing
improvement in the personal injury protection coverage in Florida, which we believe is largely
related to the reduction in new business exposures in the Miami, Florida market. The second
quarter loss ratio includes approximately 0.4 points of net favorable development on reserves for
all prior accident quarters.
For the six months ended June 30, 2005, net income was $25.1 million or $1.14 per share, on a
diluted basis, compared to $31.0 million or $1.37 per share in the corresponding period in 2004.
The annualized return on average equity for the first six months of the year was 20%, which is
consistent with our stated long-term objective.
Summary of Key Measures of Financial Results
The table below summarizes certain operating results and key measures we use in monitoring and
evaluating our operations. The information provided is intended to summarize and supplement
information contained in our consolidated financial statements and to assist the reader in gaining
a better understanding of our results of operations.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(Unaudited) |
|
(Unaudited) |
|
|
Three Months Ended |
|
Six Months Ended |
|
|
June 30, |
|
June 30, |
|
($ in millions) |
|
2005 |
|
2004 |
|
% Change |
|
2005 |
|
2004 |
|
% Change |
|
|
Selected Financial Data |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross premiums written |
|
$ |
98.4 |
|
|
$ |
101.8 |
|
|
|
(3.3 |
) |
|
$ |
259.7 |
|
|
$ |
270.8 |
|
|
|
(4.1 |
) |
Ancillary income |
|
|
23.2 |
|
|
|
24.7 |
|
|
|
(6.1 |
) |
|
|
49.7 |
|
|
|
50.9 |
|
|
|
(2.4 |
) |
Net investment income |
|
|
3.6 |
|
|
|
2.6 |
|
|
|
38.5 |
|
|
|
6.9 |
|
|
|
4.9 |
|
|
|
40.8 |
|
|
Gross revenues |
|
$ |
125.2 |
|
|
$ |
129.1 |
|
|
|
(3.0 |
) |
|
$ |
316.3 |
|
|
$ |
326.6 |
|
|
|
(3.2 |
) |
|
Ceded premiums written |
|
|
(11.4 |
) |
|
|
(16.0 |
) |
|
|
(28.8 |
) |
|
|
(29.4 |
) |
|
|
(47.6 |
) |
|
|
(38.2 |
) |
Change in net unearned premiums |
|
|
17.7 |
|
|
|
7.5 |
|
|
|
136.0 |
|
|
|
(23.6 |
) |
|
|
(46.9 |
) |
|
|
(49.7 |
) |
Net realized (losses) gains on investments |
|
|
(0.3 |
) |
|
|
|
|
|
NM |
|
|
(0.3 |
) |
|
|
0.1 |
|
|
NM |
|
Total revenues |
|
$ |
131.2 |
|
|
$ |
120.6 |
|
|
|
8.8 |
|
|
$ |
263.0 |
|
|
$ |
232.2 |
|
|
|
13.3 |
|
|
Net income |
|
$ |
11.5 |
|
|
$ |
16.0 |
|
|
|
(28.2 |
) |
|
$ |
25.1 |
|
|
$ |
31.0 |
|
|
|
(19.2 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Key Financial Ratios |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss ratio net |
|
|
73.0 |
% |
|
|
73.2 |
% |
|
|
|
|
|
|
73.7 |
% |
|
|
73.2 |
% |
|
|
|
|
Expense ratio net |
|
|
12.4 |
% |
|
|
2.2 |
% |
|
|
|
|
|
|
10.0 |
% |
|
|
1.3 |
% |
|
|
|
|
|
Combined ratio net |
|
|
85.4 |
% |
|
|
75.4 |
% |
|
|
|
|
|
|
83.7 |
% |
|
|
74.5 |
% |
|
|
|
|
|
Ancillary income to gross premiums earned |
|
|
19.4 |
% |
|
|
20.5 |
% |
|
|
|
|
|
|
20.9 |
% |
|
|
21.6 |
% |
|
|
|
|
Ancillary income to net operating expenses |
|
|
64.1 |
% |
|
|
92.5 |
% |
|
|
|
|
|
|
70.6 |
% |
|
|
95.5 |
% |
|
|
|
|
|
8
Explanation of Key Measures
We evaluate our operations by monitoring key measures of growth and profitability. We measure
our growth by examining our gross revenues, which is comprised of gross premiums written and
revenues from all other sources produced through our distribution system. We generally measure our
operating results by examining our net income, return on equity, and our loss, expense and combined
ratios. In addition, we evaluate our performance by comparing the level of our ancillary income to
premiums earned and to operating expenses. The following provides further explanation of the key
measures that we use to evaluate our results:
Gross Premiums Written. Gross premiums written is the sum of direct premiums written and
assumed premiums written. Direct premiums written is the sum of the total policy premiums, net of
cancellations, associated with policies underwritten and issued by our insurance subsidiaries.
Assumed premiums written is the sum of total premiums associated with the insurance risk
transferred to us by other insurance companies pursuant to reinsurance contracts. We use gross
premiums written, which excludes the impact of premiums ceded to reinsurers, as a measure of the
underlying growth of our insurance business from period to period.
Net Premiums Written. Net premiums written is the sum of direct premiums written and assumed
premiums written less ceded premiums written. Ceded premiums written is the portion of our direct
and assumed premiums that we transfer to our reinsurers in accordance with the terms of our
reinsurance contracts based upon the risks they accept. We use net premiums written, primarily in
relation to gross premiums written, to measure the amount of business retained after cessions to
reinsurers.
Gross Revenues (a non-GAAP financial measure). Gross revenues are the sum of gross premiums
written plus ancillary income (finance income and commission and service fee income) and net
investment income (excluding net realized gains (losses) on securities). We use gross revenues as
the primary measure of the underlying growth of our revenue streams from period to period. Gross
revenues are reconciled to total revenues in the Managements Discussion and Analysis of Financial
Condition and Results of Operations Results of Operations.
Loss Ratio. Loss ratio is the ratio (expressed as a percentage) of losses and loss adjustment
expenses incurred to premiums earned and measures the underwriting profitability of a companys
insurance business. Loss ratio generally is measured on both a gross (direct and assumed) and net
(gross less ceded) basis. We use the gross loss ratio as a measure of the overall underwriting
profitability of the insurance business we write and to assess the adequacy of our pricing. Our
net loss ratio is meaningful in evaluating our financial results, which are net of ceded
reinsurance, as reflected in our consolidated financial statements. Our loss ratios are generally
calculated in the same way for both GAAP and statutory accounting purposes.
Expense Ratio. Expense ratio is the ratio (expressed as a percentage) of net operating
expenses to premiums earned and measures a companys operational efficiency in producing,
underwriting and administering its insurance business. For statutory accounting purposes,
operating expenses of an insurance company exclude investment expenses, and are reduced by other
income. There is no such industry definition for determining an expense ratio for GAAP purposes.
As a result, we apply the statutory definition to calculate our expense ratio on a GAAP basis. We
reduce our operating expenses by ancillary income (excluding net investment income and realized
gains (losses) on securities) to calculate our net operating expenses. Due to our historically
high levels of reinsurance, we calculate our expense ratio on both a gross basis (before the effect
of ceded reinsurance) and a net basis (after the effect of ceded reinsurance). Although the net
basis is meaningful in evaluating our financial results that are net of ceded reinsurance, as
reflected in our consolidated financial statements, we believe that the gross expense ratio more
accurately reflects the operational efficiency of the underlying business and is a better measure
of future trends.
Combined Ratio. Combined ratio is the sum of the loss ratio and the expense ratio and
measures a companys overall underwriting profit. If the combined ratio is at or above 100, an
insurance company cannot be profitable without investment income (and may not be profitable if
investment income is insufficient). We use the GAAP combined ratio in evaluating our overall
underwriting profitability and as a measure for comparison of our profitability relative to the
profitability of our competitors.
Ancillary Income Measures. We have developed measures of our ability to generate ancillary
income (finance income and commission and service fee income) that reflect the major differences
between our business model and those used by our competitors. We measure our ancillary income as a
percentage of premiums earned and as a percentage of our operating expenses. We believe that most
of our insurance competitors only achieve point of sale contact through an independent agent and
are therefore typically unable to generate significant amounts of ancillary income.
Seasonality. The months of February and March generally represent some of the highest premium
production months of the year as we believe many of our customers have more disposable cash as a
result of income tax refunds. As a result, gross premiums written are generally the highest during
the first quarter of the year. Typically, the Company generally experiences its lowest level of
gross premiums written during the second quarter of the year as cancellations on the business
written in the first quarter occur. Since the majority of our business is financed, finance
receivables and unearned premiums increase during the first quarter. In addition, there are
corresponding increases in notes payable and cash as our premium finance subsidiaries draw on the
revolving line of credit
9
with our banks to settle balances due to our insurance subsidiaries. Since these settlements
occur at the end of each month, our insurance subsidiaries tend to hold a high level of cash during
the second quarter that has yet to be permanently invested in the long term portfolio.
Results of Operations
Revenues
Premiums
The following table presents our gross premiums written in our major markets and provides a
summary of gross, ceded and net premiums written and earned for the periods presented:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(Unaudited) |
|
(Unaudited) |
|
|
Three Months Ended |
|
Six Months Ended |
|
|
June 30, |
|
June 30, |
|
($ in millions) |
|
2005 |
|
2004 |
|
% Change |
|
2005 |
|
2004 |
|
% Change |
|
|
Gross premiums written |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Florida |
|
$ |
46.6 |
|
|
$ |
52.2 |
|
|
|
(10.7 |
) |
|
$ |
124.7 |
|
|
$ |
136.1 |
|
|
|
(8.4 |
) |
Tennessee |
|
|
12.5 |
|
|
|
13.6 |
|
|
|
(8.1 |
) |
|
|
34.8 |
|
|
|
37.0 |
|
|
|
(5.9 |
) |
Georgia |
|
|
5.5 |
|
|
|
6.7 |
|
|
|
(17.9 |
) |
|
|
16.1 |
|
|
|
19.0 |
|
|
|
(15.3 |
) |
Louisiana |
|
|
5.3 |
|
|
|
6.1 |
|
|
|
(13.1 |
) |
|
|
17.1 |
|
|
|
18.6 |
|
|
|
(8.1 |
) |
Texas |
|
|
14.5 |
|
|
|
8.0 |
|
|
|
81.3 |
|
|
|
23.0 |
|
|
|
15.0 |
|
|
|
53.3 |
|
Mississippi |
|
|
5.0 |
|
|
|
5.0 |
|
|
|
0.0 |
|
|
|
15.0 |
|
|
|
15.1 |
|
|
|
(0.7 |
) |
All other states |
|
|
9.0 |
|
|
|
10.2 |
|
|
|
(11.8 |
) |
|
|
29.0 |
|
|
|
30.0 |
|
|
|
(3.3 |
) |
|
Gross premiums written |
|
$ |
98.4 |
|
|
$ |
101.8 |
|
|
|
(3.3 |
) |
|
$ |
259.7 |
|
|
$ |
270.8 |
|
|
|
(4.1 |
) |
Ceded premiums written |
|
|
(11.4 |
) |
|
|
(16.0 |
) |
|
|
(28.8 |
) |
|
|
(29.4 |
) |
|
|
(47.6 |
) |
|
|
(38.2 |
) |
|
Net premiums written |
|
$ |
87.0 |
|
|
$ |
85.8 |
|
|
|
1.4 |
|
|
$ |
230.3 |
|
|
$ |
223.2 |
|
|
|
3.2 |
|
|
Gross premiums earned |
|
$ |
119.7 |
|
|
$ |
120.4 |
|
|
|
(0.6 |
) |
|
$ |
237.9 |
|
|
$ |
235.4 |
|
|
|
1.1 |
|
Ceded premiums earned |
|
|
(15.0 |
) |
|
|
(27.1 |
) |
|
|
(44.6 |
) |
|
|
(31.2 |
) |
|
|
(59.1 |
) |
|
|
(47.2 |
) |
|
Net premiums earned |
|
$ |
104.7 |
|
|
$ |
93.3 |
|
|
|
12.2 |
|
|
$ |
206.7 |
|
|
$ |
176.3 |
|
|
|
17.2 |
|
|
Net premiums written to gross premiums written |
|
|
88.4 |
% |
|
|
84.3 |
% |
|
|
|
|
|
|
88.7 |
% |
|
|
82.4 |
% |
|
|
|
|
Gross premiums earned to gross premiums written |
|
|
121.6 |
% |
|
|
118.3 |
% |
|
|
|
|
|
|
91.6 |
% |
|
|
86.9 |
% |
|
|
|
|
Net premiums earned to net premiums written |
|
|
120.3 |
% |
|
|
108.7 |
% |
|
|
|
|
|
|
89.8 |
% |
|
|
79.0 |
% |
|
|
|
|
|
Gross premiums written decreased $3.4 million or 3.3% for the three months ended June 30, 2005
compared to the second quarter of 2004. For the second quarter of 2005, gross premiums written
from the sale of our core non-standard automobile insurance business decreased 3.7% to $94.5
million while gross premiums written from the sale of our term life insurance business increased
5.4% to $3.9 million as compared to the second quarter of 2004. Included in this decline was a
decrease of approximately $1.3 million related to our decision, in October 2004, to cease writing
new business policies in the Miami, Florida market. Gross premiums earned, a function of gross
premiums written over the current and prior periods, decreased 0.6% to $119.7 million in the second
quarter of 2005 versus the same period in 2004.
Gross
premiums written in Texas increased 81.3% over the second quarter of
2004, which we believe was largely a result of the continued conversion of the Texas book of business from monthly policies
to annual policies, our advertising campaigns, and an increase in the number of our sales offices
in this market. As of June 30, 2005, approximately 48% of the total policies inforce in Texas were
annual policies, and we expect to continue to convert our monthly policies in Texas to annual
policies over the remainder of the year. Overall, as of June 2005, there has been an approximate
29% increase in the total number of policies inforce in Texas, as compared to June 2004. We
believe that much of our growth in inforce policies is due to an increase in penetration in certain
areas within the state and a slight shift in Texas to more liability-only policies as compared to
full coverage policies, both of which are resulting in lower average premium per inforce policy.
Over the past several months, we have been actively introducing the Direct brand name in our
Texas markets through our regular television and yellow-page advertising. In addition, we engaged
Univison Communications, a leading Spanish-language media company, to produce both television and
radio spots for us that commenced airing in certain Texas markets in July 2005. Furthermore, we
hired a national advertising firm and, among other projects, it currently is producing a campaign to
be directed to the Hispanic market in Texas. These new television advertisements are expected to
air beginning in September.
10
During the current quarter, we continued to experience positive growth in renewal policies in
our mature markets which increased 12.8% over the second quarter of 2004. However, gross premiums
written in our mature states declined in the second quarter as the renewal policy growth did not
completely offset the decline in new business policies, which we generally attribute to the current
competitive environment. While we continue to experience positive trends in the conversion rate of
telephone quotes to policies issued, we believe that the majority of the decline in new business
policies related to a decrease in call volume. In response to the changing competitive
environment, as mentioned above, the national advertising firm we hired is also assisting us in
developing new marketing strategies to attract our target customers in our mature states. We
believe that television advertising is still the most efficient and effective media for reaching
our customers. With the assistance of our new advertising firm, we have created a new campaign and
are currently filming the advertisements, which are initially scheduled to commence in Tennessee in
September.
We also have been closely monitoring our mix of full coverage business, which includes
physical damage coverage, as opposed to liability-only policies in our mature states. In certain of
these states, we were seeing a decline in the percentage of full coverage business, which we
attributed to a portion of our customer base moving to standard carriers. Consistent with our
ongoing review of rates by coverage and state, we have made adjustments to our rates in a number of
states in an effort to improve our new business growth and stabilize our mix of full coverage
versus liability-only business. Rate adjustments were implemented in Tennessee in March, in
Louisiana in June, and in Georgia and Mississippi in July. We are also in the process of making
rate revisions in Florida and South Carolina, which we expect to implement during the third quarter
of 2005.
In addition, we have been actively pursuing a number of growth initiatives. We recently
received regulatory approval to proceed with the acquisition of a property and casualty shell
insurance company with licenses in 38 states and the District of Columbia. This pending
acquisition, which is expected to close in August, should facilitate our entrance into new markets
and give us the flexibility to explore alternative distribution channels and pricing. We have also
been developing our alternative distribution channel initiatives, which include selling our
insurance products over the phone and Internet. We expect to roll out our phone sales in the
fourth quarter and expect to expand our Internet marketing, which is currently only available in
Florida, to additional states in the first quarter of 2006.
Ancillary Income
Ancillary income for the three months ended June 30, 2005 decreased 6.1% to $23.2 million
compared to the corresponding period in 2004. Ancillary income from the sale of our Direct Prepaid
Visa® debit card increased $0.6 million in the current quarter as compared to the second quarter of
2004 when the card was first introduced. The product continues to be well received by our target
customers as we issued approximately 53,000 cards during the second quarter of 2005. The increase
in ancillary income from the debit cards was more than offset by a $0.9 million decline in
administrative service fees received, a $0.6 million decrease in finance income, and a $0.3 million
reduction in commission income on the sale of ancillary insurance products.
We receive administrative service fees for the agency, underwriting, policy administration and
claims adjusting services performed on behalf of unaffiliated insurers, including nonstandard
automobile insurance in Texas and North Carolina. In 2005, we commenced underwriting a portion of
our Texas business through one of our own insurance subsidiaries and, as a result, the volume of
Texas business underwritten by an unaffiliated insurer declined, which reduced our administrative
service fee income by approximately $0.6 million in the current quarter. During the quarter, we
also experienced a 5.3% decline in the sale of ancillary insurance products for which we receive
commissions and administrative service fees. The $0.6 million reduction in finance income primarily
resulted from the decrease in down payments implemented during the first quarter of 2005. In
addition, finance income in Texas was nominal at 1.5% of gross earned premiums in the state,
because we are still in the process of converting our Texas business from monthly policies to
annual policies that are financed by our premium finance company. We expect finance income in
Texas to increase for the remainder of 2005 and ultimately to represent approximately 10% of gross
premiums earned, which is consistent with our historical countrywide average.
The ratio of ancillary income to gross premiums earned was 19.4% and 20.9% for the three and
six months ended June 30, 2005, respectively, as compared to 20.5% and 21.6% for the corresponding
periods in 2004. For these same periods, the ratio of ancillary income to operating expenses
decreased to 64.1% and 70.6% in the 2005 periods, respectively, from 92.5% and 95.5% in the 2004
periods. Because operating expenses are net of ceded reinsurance commissions received and because
we have been reducing our level of reinsurance, our net operating expenses have increased,
resulting in a lower ratio of ancillary income to operating expenses. In addition, our operating
costs in our expansion states exceeded our ancillary income growth in these states.
Net Investment Income
Net investment income was $3.6 million for the three months ended June 30, 2005 compared to
$2.6 million for the second quarter of 2004. The increase was due primarily to an increase in
average invested assets and a slightly higher investment yield as a result of the increasing
interest rate environment and slightly longer portfolio duration. Average invested assets
increased 21.1% to $339.6 million in the second quarter of 2005 from $280.4 million in the second
quarter of 2004. The annualized investment yield was 4.0% and 3.6% for the three months ended
June 30, 2005 and 2004, respectively.
11
Realized Gains on Securities and Other
We realized gross gains of $0.1 million and gross losses of $0.4 million on the sale of
securities for the three months ended June 30, 2005. Comparatively, we realized gross gains on
debt securities of $0.1 million and gross losses of $0.6 million for the comparable period in 2004.
There was no impact on realized losses attributable to adjustments for other than temporary
impairment of securities still held during these periods.
In the second quarter of 2005, we also realized gross gains of $1.0 million and gross losses
of $0.4 million on closed contracts in our trading portfolio. The trading portfolio primarily
consists of futures contracts, swaps, and other derivative instruments. This represents a
speculative investment and does not represent a hedge; accordingly, all open contracts are marked
to market with the change in market values included in net realized losses (gains) on securities
and other in our condensed consolidated statement of operations. During the quarter, the market
value on open contracts decreased by $0.6 million, which was included in net realized losses
(gains) on securities and other. As of June 30, 2005, we had open contracts with gross unrealized
gains of $0.1 million and gross unrealized losses of $0.3 million.
Expenses
Insurance Losses and Loss Adjustment Expenses
Insurance losses and loss adjustment expenses increased to $76.5 million for the three months
ended June 30, 2005 from $68.3 million for the same period in 2004. The majority of this increase
was related to the increase in net premiums earned. Net loss ratios for the second quarters of
2005 and 2004 were relatively consistent at 73.0% and 73.2%, respectively. The Companys quarterly
analysis of reserves resulted in a net decrease to prior accident quarters reserves of $0.4 million, which
decreased the net loss ratio by 0.4 points in the second quarter of 2005. The decrease in prior
period reserves included a reduction in the expected ultimate frequency and/or severity of bodily
injury claims in Tennessee, Texas, Mississippi and Louisiana, which was partially offset by a
higher ultimate frequency on property damage claims, primarily in Florida. Also included in the
net favorable development of $0.4 million in the current quarter was an increase in our 2004
accident year reserves for personal injury protection PIP in Florida of approximately $0.5
million as a result of an adjustment to our expected average ultimate payments. Comparatively, the
Companys development on prior years reserves increased the net loss ratio by 0.7 points during
the second quarter of 2004. The net loss ratios, excluding the impact of the adjustments to prior
years reserves, were 73.4% and 72.5% for the three months ended June 30, 2005 and 2004,
respectively.
Our second quarter actuarial review indicated some improvement in the PIP loss ratio in
Florida for accidents that occurred during the first two quarters of 2005, which included both
lower frequency and severity trends. We believe that these improvements are largely related to our
decision, in October 2004, to stop writing new business policies in the Miami market. Since the
fourth quarter of 2004, the number of new business exposures in this market has decreased nearly
72% and the exposures should continue to decrease in the third quarter. Partially offsetting the
improving PIP trend was an increase in the reported frequency of bodily injury claims in several
states in the current quarter. As discussed above, in conjunction of our ongoing review of rates
and trends, we implemented rate adjustments in several states, some of which included adjustments
to our bodily injury rates to address the current trends.
Operating Expenses
Operating expenses increased 35.9% to $36.3 million for the three months ended June 30, 2005,
compared to $26.7 million for the same period of 2004. This increase in operating expenses
reflected the increased operating expenses associated with our expansions in Texas, Missouri, and
Virginia, a lower level of ceding commissions received from reinsurers, net amortization of
deferred policy acquisition costs, and increased overhead. Collectively, the operating expenses
associated with our expansion states represented an increase of approximately $2.0 million over the
second quarter of 2004, which was net of a $0.6 million reduction in assumed reinsurance
commissions in Texas related to the reduction in premium volumes written through an unaffiliated
insurer. The increase in operating expenses also reflected a $2.7 million reduction in ceded
reinsurance commissions received to $1.7 million in the second quarter of 2005 as compared to the
same period in 2004. This reduction in ceding commissions was primarily associated with the
reduction in ceded premiums, but it also included a sliding-scale commission adjustment based upon
updated projected loss experience that reduced our ceding commissions by approximately $0.8
million. We also incurred approximately $1.7 million in net amortization of deferred policy
acquisition costs in the current quarter in our mature states as compared to net capitalized policy
acquisition costs of $0.3 million in the second quarter of 2004 due to the decline in net premiums
written in these markets. The remaining increase in operating costs also included a $0.4 million
increase in professional service fees largely associated with our securities litigation and a $0.4
million increase in interest expenses related to the higher average amount outstanding on our
premium finance revolving line of credit and the higher interest rate environment.
12
The increase in operating expenses resulted in net expense ratios of 12.4% and 10.0% for the
three and six months ended June 30, 2005, respectively, as compared to 2.2% and 1.3%, respectively,
for the corresponding periods in 2004. As we gain scale and maturity in our expansion states, we
would expect our expense ratio to decline over time to be in line with our more mature states. To
put this in perspective, we estimate that the expense ratio for our mature states, which excludes
the impact of our expansions in Texas, Missouri, and Virginia, was approximately 9.0% and 6.8% for
the three and six months ended June 30, 2005, respectively. Based upon current trends, we expect
that our expense ratio for the third quarter of 2005 will generally be consistent with the current
quarter; however, we expect it to begin trending down in the fourth quarter, as we gain penetration
in our expansion states, and our new advertising initiatives begin to improve premium growth.
Income Taxes
Income tax expense decreased to $7.0 million in the second quarter of 2005 as compared to $9.6
million in the second quarter of 2004 due to the reduction in pretax income. Our effective tax
rates remained fairly consistent at 37.8% and 37.5% for the three-month periods ended June 30, 2005
and 2004, respectively.
Financial Condition
Liquidity and Capital Resources
Sources and Uses of Funds
We are organized as a holding company system with all of our operations being conducted by our
wholly-owned insurance, premium finance, agency, administrative and consumer product subsidiaries.
Accordingly, Direct General Corporation receives cash through loans from banks, issuance of equity
securities, subsidiary dividends and other transactions. We may use the proceeds from these sources
to contribute to the capital of our insurance subsidiaries and premium finance companies in order
to support premium growth, to repurchase our common stock, to retire our outstanding indebtedness,
to pay interest, dividends, and taxes, and for other business purposes.
Our operating subsidiaries primary sources of funds are premiums received, finance income,
commission and service fee income, investment income, borrowings under credit facilities and
proceeds from the sale and redemption of investments. Funds are used to pay claims and operating
expenses, to pay interest and principal repayments under the terms of our indebtedness for borrowed
money, to purchase investments and to pay dividends to Direct General Corporation. We had positive
cash flow from operations of approximately $40.8 million and $30.9 million in the first six months
of 2005 and 2004, respectively. We expect our cash flows to be positive in both the short-term and
reasonably foreseeable future.
The Company recently received regulatory approval to proceed with the acquisition of a
property and casualty insurance company, the assets of which consist of debt securities and
licenses to conduct property and casualty business in 38 states and the District of Columbia. The
purchase price is estimated to be $10.3 million, which will be paid from available cash flows.
This pending acquisition, which is expected to close in August 2005, should facilitate the
Companys entrance into new markets and provide flexibility to explore alternative distribution
channels and pricing.
Financing and Capital
During the first two quarters of 2005, we repurchased 1,055,572 shares of our common stock for
an aggregate price of approximately $20.0 million. In addition, our board of directors recently
authorized management to execute an additional stock buyback program of up to $30.0 million through
the end of January 2007, as part of our overall capital management strategies. During the first
six months of 2005, we also paid common stock dividends totaling $1.7 million.
As of June 30, 2005, the maximum aggregate amount available under our revolving credit
agreement used to support our premium finance operations was $190.0 million and the amount
outstanding was $179.0 million. We believe that this facility, which matures on June 30, 2007, is
sufficient to support our premium finance operations through the end of the year. Later in the
year, we plan to reevaluate the size of the facility based on our growth expectations for 2006.
Reinsurance
For the three and six months ended June 30, 2005, we ceded 11.6% and 11.3%, respectively, of
our gross premiums written to third party reinsurers as compared to 15.7% and 17.6%, respectively,
in the corresponding periods in 2004. We plan to cede between 10% and 12% of gross premiums
written for the year. We plan to reassess our insurance subsidiaires capitalization near the end
of the year to determine our reinsurance needs for 2006. In addition to our quota share
reinsurance agreement, we maintain a
13
property catastrophe reinsurance agreement that provides for $13.0 million of reinsurance
coverage in excess of our $2.0 million retention per occurrence.
Investments
Debt securities. Our investment portfolio primarily consists of debt securities, all
classified as available-for-sale and carried at market value with unrealized gains and losses
reported in our financial statements as a separate component of shareholders equity on an
after-tax basis. As of June 30, 2005, our investment portfolio of $356.7 million included $0.6
million in net unrealized losses. The effective duration of our investment portfolio was 4.7
years at June 30, 2005.
As of June 30, 2005, our investment portfolio included gross unrealized gains of $2.8 million
and gross unrealized losses of $3.4 million. During the quarter, net unrealized losses on our
investment portfolio decreased by $4.8 million, which is included in accumulated other
comprehensive income, net of applicable taxes, in the stockholders equity section of the balance
sheet. Our quarterly procedures include an examination of our investment portfolio for evidence of
impairment. The assessment of whether such impairment has occurred is based on managements
evaluation, on an individual security basis, of the underlying reasons for the decline in fair
value. In such cases, changes in fair value are discussed with our investment advisors and
evaluated to determine the extent to which such changes are attributable to interest rates,
market-related factors other than interest rates, as well as financial conditions, business
prospects and other fundamental factors specific to the issuer. Declines attributable to issuer
fundamentals are reviewed in further detail. When one of our securities has a decline in fair value
that is determined to be other than temporary, we reduce the carrying value of such security to its
current fair value as required by GAAP.
Based upon our analysis, we believe that we will recover all contractual principal and
interest payments related to those securities that currently reflect unrealized losses and that we
have the ability to hold these securities until they mature or recover in value. Should either of
these beliefs change with regard to a particular security, a charge for impairment would likely be
required. While it is not possible to accurately predict if or when a specific security will become
impaired, charges for other than temporary impairment could be material to our results of
operations in a future period. Management believes it is not likely that future impairment charges
will have a significant effect on our liquidity.
The following table shows the composition by our internal industry classification of the
amortized cost, gross unrealized gains, gross unrealized losses and fair value of debt securities
available-for-sale as of June 30, 2005:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross |
|
Gross |
|
|
|
|
Amortized |
|
Unrealized |
|
Unrealized |
|
Fair |
($ in millions) |
|
Cost |
|
Gains |
|
Losses |
|
Value |
|
U.S. Treasury securities and
obligations of U.S. government
corporations and agencies |
|
$ |
56.3 |
|
|
$ |
0.3 |
|
|
$ |
0.7 |
|
|
$ |
55.9 |
|
Obligations of states and
political subdivisions |
|
|
65.0 |
|
|
|
1.0 |
|
|
|
0.2 |
|
|
|
65.8 |
|
Corporate debt securities |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Banks and financial institutions |
|
|
89.6 |
|
|
|
0.5 |
|
|
|
0.9 |
|
|
|
89.2 |
|
Credit cards and auto loans |
|
|
67.6 |
|
|
|
0.1 |
|
|
|
0.9 |
|
|
|
66.8 |
|
Industrial |
|
|
44.9 |
|
|
|
0.5 |
|
|
|
0.5 |
|
|
|
44.9 |
|
Telecommunications |
|
|
16.5 |
|
|
|
0.2 |
|
|
|
0.1 |
|
|
|
16.6 |
|
Utilities and electric services |
|
|
17.4 |
|
|
|
0.2 |
|
|
|
0.1 |
|
|
|
17.5 |
|
|
Corporate debt securities |
|
|
236.0 |
|
|
|
1.5 |
|
|
|
2.5 |
|
|
|
235.0 |
|
|
Total |
|
$ |
357.3 |
|
|
$ |
2.8 |
|
|
$ |
3.4 |
|
|
$ |
356.7 |
|
|
14
The amortized cost and fair value of debt securities available-for-sale as of June 30, 2005,
by contractual maturity, is shown below:
|
|
|
|
|
|
|
|
|
($ in millions) |
|
Amortized Cost |
|
Fair Value |
|
Years to maturity: |
|
|
|
|
|
|
|
|
One or less |
|
$ |
8.5 |
|
|
$ |
8.5 |
|
After one through five |
|
|
159.1 |
|
|
|
157.8 |
|
After five through ten |
|
|
116.4 |
|
|
|
117.3 |
|
After ten |
|
|
73.3 |
|
|
|
73.1 |
|
|
Total |
|
$ |
357.3 |
|
|
$ |
356.7 |
|
|
The Securities Valuation Office of the National Association of Insurance Commissioners
(NAIC) evaluates the bond investments of insurers for regulatory reporting purposes and assigns
securities to one of six investment categories called NAIC designations. The NAIC designations
parallel the credit ratings of the Nationally Recognized Statistical Rating Organizations for
marketable bonds. NAIC designations 1 and 2 include bonds considered to be investment grade, rated
BBB- or higher by Standard & Poors (S&P). NAIC designations 3 through 6 include bonds
considered below investment grade, rated BB+ or lower by S&P. All of the debt securities in our
portfolio were rated investment grade by the NAIC and S&P as of June 30, 2005. Investment grade
securities generally bear lower yields and lower degrees of risk than those that are unrated or are
rated non-investment grade.
The quality distribution of our investment portfolio as of June 30, 2005 was as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
($ in millions) |
NAIC |
|
S&P |
|
Amortized |
|
|
|
|
Rating |
|
Rating |
|
Cost |
|
Fair Value |
|
|
% |
|
|
1 |
|
AAA |
|
$ |
130.1 |
|
|
$ |
129.5 |
|
|
|
36.3 |
% |
1 |
|
AA |
|
|
33.4 |
|
|
|
33.7 |
|
|
|
9.5 |
% |
1 |
|
A |
|
|
104.6 |
|
|
|
104.7 |
|
|
|
29.4 |
% |
2 |
|
BBB |
|
|
32.6 |
|
|
|
32.6 |
|
|
|
9.1 |
% |
3 |
|
BB |
|
|
0.8 |
|
|
|
0.8 |
|
|
|
0.2 |
% |
1 |
|
Agency |
|
|
55.8 |
|
|
|
55.4 |
|
|
|
15.5 |
% |
|
|
|
|
|
|
|
$ |
357.3 |
|
|
$ |
356.7 |
|
|
|
100.0 |
% |
|
We evaluate the risk versus reward tradeoffs of investment opportunities, measuring their
effects on the stability, diversity, overall quality and liquidity of our investment portfolio.
The primary market risk exposure to our debt securities portfolio is interest rate risk, which is
limited by managing duration to a defined range of three to four years. Interest rate risk
includes the risk from movements in the underlying market rate and in credit spreads of the
respective sectors of debt securities held in our portfolio. The fair value of our fixed maturity
portfolio is directly impacted by changes in market interest rates.
The following table provides information about our investments that are sensitive to interest
rate risk and provides estimates of expected changes in fair value based upon a 100 basis-point
increase and decrease in market interest rates as of June 30, 2005:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
-100 Basis Point |
|
|
|
|
|
+100 Basis Point |
($ in millions) |
|
Change |
|
Fair Value |
|
Change |
|
Debt securities, available-for-sale |
|
$ |
373.5 |
|
|
$ |
356.7 |
|
|
$ |
339.9 |
|
|
Short-term investments. We have a managed trading account with a commodities trading company
and, as of June 30, 2005, the total fair value of open trades in this account was a $0.3 million
loss, which represents less than 1% of our entire investment portfolio. We invest in commodities,
primarily cattle futures and swaps. U.S. Treasury securities of $1.9 million, included in
short-term investments and cash of $1.9 million, included in cash and cash equivalents, are held as
collateral for this account. We recognized a net realized gain of $0.6 million on closed contracts
and a $0.6 million loss on open contracts during the second quarter of 2005. Because this is a
speculative investment and not a hedge, both the realized gains on closed contracts and the change
in the fair value of open contracts are reported as net realized (losses) gains on securities and
other in our consolidated statement of operations.
Cash and cash equivalents. Our balance in cash and cash equivalents was $110.5 million as of
as of June 30, 2005, which was 55.7% higher than the balance of cash held at December 31, 2004.
The increase included approximately $24.9 million of cash that was in the process of being
permanently invested in our long-term bond portfolio.
15
Forward-Looking Statements
This report contains forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as
amended. All statements made in the report, other than statements of historical fact, are
forward-looking statements. You can identify these statements from our use of the words may,
should, could, potential, continue, plan, forecast, estimate, project, believe,
intend, anticipate, expect, target, is likely, will, or the negative of these terms,
and similar expressions. These statements are made pursuant to the safe harbor provisions of the
Private Securities Litigation Reform Act of 1995. These forward-looking statements may include,
among other things:
|
|
|
statements and assumptions relating to future growth, earnings, earnings per
share and other financial performance measures, as well as managements short-term and
long-term performance goals; |
|
|
|
|
statements relating to the anticipated effects on results of operations or
financial condition from recent and expected developments or events; |
|
|
|
|
statements relating to our business and growth strategies; and |
|
|
|
|
any other statements or assumptions that are not historical facts. |
We believe that our expectations are based on reasonable assumptions. However, these
forward-looking statements involve known and unknown risks, uncertainties and other important
factors that could cause our actual results, performance or achievements, or industry results, to
differ materially from our expectations of future results, performance or achievements expressed or
implied by these forward-looking statements. In addition, our past results of operations do not
necessarily indicate our future results. We discuss these and other uncertainties in the Business
Risks Related to our Business section of the Annual Report on Form 10-K for the year ended
December 31, 2004 filed with the Securities and Exchange Commission on March 16, 2005.
You should not place undue reliance on any forward-looking statements. These statements speak
only as of the date of this report. Except as otherwise required by applicable laws, we undertake
no obligation to publicly update or revise any forward-looking statements or the risk factors
described in this report, whether as a result of new information, future events, changed
circumstances or any other reason after the date of this report.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
Please see the caption Financial Condition Liquidity and Capital Resources in Part I
FINANCIAL INFORMATION, Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations of this report for a description of our quantitative and qualitative
disclosures about market risks.
Item 4. Controls and Procedures.
Our management, with the participation of our chief executive officer and chief financial
officer, has evaluated the effectiveness of the design and operation of our disclosure controls and
procedures (as defined in Exchange Act Rule 13a-15(e)) as of the end of the period covered by this
report. Based on that evaluation, the chief executive officer and chief financial officer have
concluded that our disclosure controls and procedures are effective to ensure that material
information relating to us and our consolidated subsidiaries is made known to such officers by
others within these entities, particularly during the period this quarterly report was prepared, in
order to allow timely decisions regarding required disclosure. There have not been any changes in
our internal control over financial reporting during the period covered by this report that have
materially affected, or are reasonably likely to materially affect, our internal control over
financial reporting.
16
PART II OTHER INFORMATION
Item 1. Legal Proceedings.
We and our subsidiaries are named from time to time as defendants in various legal actions
that are incidental to our business and arise out of or are related to claims made in connection
with our insurance policies, claims handling, premium finance agreements and other contracts, and
employment related disputes. The plaintiffs in some of these lawsuits have alleged bad faith or
extracontractual damages and some have claimed punitive damages. We believe that the resolution of
these legal actions will not have a material adverse effect on our financial position or results of
operations.
In addition to legal actions that are incidental to our business, one or more of our
subsidiaries has been named as a defendant in a number of currently pending putative class action
lawsuits. For descriptions of these legal actions, in addition to the information provided below,
please see the caption Business Legal Proceeding included in our Annual Report on Form 10-K
for the year ended December 31, 2004 (Form 10-K) filed with the Securities and Exchange
Commission (SEC) on March 16, 2005 and our periodic reports filed with the SEC under the
Securities Exchange Act of 1934 since the filing of our Form 10-K.
In the first quarter of 2005, we, and certain of our officers and directors were named as
defendants in six putative class action lawsuits filed in the United States District Court for the
Middle District of Tennessee. These cases have been consolidated and Lead Plaintiffs have been
appointed. Lead Plaintiffs allege that we and certain of our officers and directors made false and
misleading statements with respect to liabilities that had been recorded for unpaid losses and loss
adjustment expenses. Lead Plaintiffs assert claims under the Securities Exchange Act of 1934 and
the Securities Act of 1933. Lead Plaintiffs generally contend that we and certain of our officers
and directors knew that certain legislation in Florida, which became effective in October 2003,
would necessarily negatively impact our business by increasing our liability and risk of litigation
and that we failed to timely strengthen our loss reserves to account for this alleged known
increased future risk. Lead Plaintiffs further assert that certain officers and directors sold
shares of our stock while they were aware of the allegedly known
future negative impact of the
legislation, but before the reserves were strengthened. Lead Plaintiffs seek to recover damages on
behalf of all purchasers of our stock during a class period to be determined and attorneys fees.
We recently filed a motion to dismiss all claims.
Also in the first quarter of 2005, we, our directors and certain of our officers were named in
three shareholder derivative actions filed in the United States District Court for the Middle
District of Tennessee, which have been consolidated, and three shareholder derivative actions filed
in the Chancery Court for the State of Tennessee, which also have been consolidated. These actions
assert various claims for breaches of fiduciary duties based upon the same alleged misleading
statements and allegations that form the basis of the putative class action described above. Our
motion to dismiss the federal derivative action was recently denied.
We believe we have meritorious defenses to these securities and derivative actions and intend
to vigorously defend these lawsuits. Although we are optimistic regarding our successful defense
of these cases, because of the inherent uncertainties related to this type of litigation, we are
unable to predict the ultimate outcome of these cases, or the likelihood or amount of our potential
liability, if any, of these cases if they are not successfully defended or settled, or the effect
that these pending cases may have on our business, operations, profitability, or financial
condition, if they are not successfully defended.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
On January 31, 2005, the Company announced that its Board of Directors approved the repurchase
of up to $20.0 million of its outstanding common stock. As of June 30, 2005, the Company had
repurchased 1,055,572 shares of its outstanding common stock for an aggregate price of
approximately $20.0 million. The following table summarizes our common stock repurchase activity
for the three-month period ended June 30, 2005 and the approximate value of shares of common stock
that may yet be repurchased.
Issuer Purchases of Equity Securities
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Total number of |
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Approximate dollar |
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|
|
|
|
|
|
|
|
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shares purchased as |
|
value of shares that |
|
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Total number of |
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Average price |
|
part of publicly |
|
may yet be purchased |
Period |
|
shares purchased |
|
paid per share |
|
announced program |
|
under the program |
|
April 1 to April 30 |
|
|
252,353 |
|
|
$ |
19.70 |
|
|
|
252,353 |
|
|
$ |
5,045,832 |
|
May 1 to May 31 |
|
|
309,869 |
|
|
$ |
16.28 |
|
|
|
309,869 |
|
|
$ |
0 |
|
June 1 to June 30 |
|
|
0 |
|
|
$ |
0.00 |
|
|
|
0 |
|
|
$ |
0 |
|
Total |
|
|
562,222 |
|
|
$ |
17.82 |
|
|
|
562,222 |
|
|
$ |
0 |
|
17
Item 4. Submission of Matters to a Vote of Security Holders.
On May 4, 2005, we held the annual meeting of our stockholders to vote on the election of
directors. The common stockholders voted to elect two directors to serve until the 2008 annual
meeting of stockholders. Our common stockholders re-elected Jacqueline C. Adair to the Board of
Directors by a vote of 21,259,613 for, 429,019 withheld and 0 abstentions and broker non-votes.
Our common stock holders also re-elected Fred H. Medling to the Board of Directors by a vote of
21,518,344 for, 170,288 withheld, and 0 abstentions and broker non-votes.
William C. Adair, Jr., Raymond L. Osterhout and Stephen L. Rohde continue to serve as members
of the Board of Directors.
Item 6. Exhibits.
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31.1 |
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Rule 13a-14(a) Certifications of CEO (pursuant to Section 302 of the Sarbanes-Oxley Act of 2002). |
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31.2 |
|
Rule 13a-14(a) Certifications of CFO (pursuant to Section 302 of the Sarbanes-Oxley Act of 2002). |
|
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32.1 |
|
Rule 1350 Certifications of CEO (pursuant to Section 906 of the Sarbanes-Oxley Act of 2002). |
|
|
32.2 |
|
Rule 1350 Certifications of CFO (pursuant to Section 906 of the Sarbanes-Oxley Act of 2002). |
18
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.
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DIRECT GENERAL CORPORATION, |
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(Registrant) |
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August 9, 2005
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By:
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/s/ William C. Adair, Jr. |
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Date
|
|
|
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(Signature) |
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Name:
|
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William C. Adair, Jr. |
|
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Title:
|
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Chairman and Chief Executive Officer |
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|
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August 9, 2005
|
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By:
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/s/ Barry D. Elkins |
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Date
|
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(Signature) |
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Name:
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Barry D. Elkins |
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Title:
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Senior Vice President and Chief Financial Officer |
19