Newtek Business Services 10-K 2008
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2007
Commission file number: 001-16123
NEWTEK BUSINESS SERVICES, INC.
Registrants telephone number, including area code: (212) 356-9500
Securities Registered Pursuant to Section 12(g) of the Act:
Common Shares, par value $0.02 per share
(Title of class)
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x
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 past 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or a smaller reporting company (all as defined in Rule 12b-2 of the Act).
Large Accelerated filer ¨ Accelerated filer ¨ Non-accelerated filer ¨ Smaller reporting company x
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x
The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant was approximately $50,001,000 as of the last business day of the registrants second fiscal quarter of 2007.
As of March 24, 2008 there were 36,948,524 shares issued and outstanding of the registrants Common Shares, par value $0.02 per share.
TABLE OF CONTENTS
The Companys principal business segments are:
Electronic Payment Processing: Marketing, credit card processing and check approval services to the small- and medium-sized business market.
Web Hosting: CrystalTech Web Hosting, Inc., d/b/a Newtek Technology Services, which offers shared and dedicated web hosting and related services to the small- and medium-sized business market.
SBA Lending: Newtek Small Business Finance, Inc., a nationally licensed, U.S. Small Business Administration (SBA) lender that originates, sells and services lending products to qualifying small businesses, some of which are partially guaranteed by the SBA.
All Other: Includes results from businesses formed from Investments in Qualified Businesses made through Capco programs which cannot be aggregated with other operating segments.
Corporate Activities: Revenue and expenses not allocated to our other segments, including interest income, Capco management fee income and corporate operations expenses.
Capcos: Fifteen certified capital companies, which invest in small- and medium-sized businesses. They generate non-cash income from tax credits and non-cash interest and insurance expenses.
Financial information for each segment can be found in Note 25 to the Consolidated Financial Statements.
Key elements of our strategy to grow our business are:
We were founded in 1998 to participate in the Capco programs. We have since developed our branded line of business services and financial products and services for the small and medium-sized business market. At December 31, 2007, we had 37 subsidiaries, excluding our 15 Capcos, many of which were a result of investments through the Capco programs. From 1999 to 2005, Capcos generated significant cash flows reflected as financing activities on our consolidated cash flow statement. We do not anticipate creating any new Capcos in the foreseeable future, although we continue to invest in small businesses through our existing Capcos and meet the goals of the Capco programs. We are concentrating our efforts on creating a distribution channel for the small- and medium-sized business market.
We believe that Fortune 500 companies are seeking to expand their client base into the lucrative small to medium -size business market. We believe that to enter this market effectively they will require the use of a cost-effective distribution channel such as the one we have built using proprietary technology and systems. We believe that most Fortune 500 companies try to use the same distribution methods used for their existing consumer or corporate customers in order to reach
this market, only to find it too expensive or unproductive to address small to medium-sized businesses. We view the small business owner and decision maker as unique and requiring a different distribution channel, as well as different products, packaging and service tailored to meet the needs of small- and medium-sized businesses.
We market ourselves to our small- and medium-sized business customers through our mottos of we do it differently and we do it better. An example of how we seek to do this is our bilingual 24/7 call center which we believe is a valuable feature for most small business owners that need help during non-business hours and on weekends. We use web-based applications as an in-house tool to make our employees and associates efficient, smart and productive. Instead of using expensive six-figured salaried employees that a typical bank or an insurance company would use to market financial products and business services to small- and medium-sized business customers, we use very smart, efficient, high-quality technology and dedicated loyal non-executive salary plus bonus employees.
We believe that our business service specialists on all product lines understand the needs of the small business owner. We conduct telephone interviews with our target customers across all product lines to deepen our understanding of their needs. We have tailored our offerings so our small- and medium-sized business customers do not have to fill out multiple handwritten forms or type data into a keyboard, which we believe is the most aggravating factor facing our customers. We have modeled our back-office and business operations after customer centered operational models, such as that of Progressive Insurance. We stress our responsive customer service, and we endeavor to excel in addressing and resolving issues and problems that our customers may face. We are now providing our 24/7 customer service functions in Spanish as well as English to service the growing Hispanic owned and operated small business customer base in the United States.
The Newtek Referral System
Our proprietary NewTracker referral system allows us to process new business utilizing a web-based, centralized processing point. Our trained representatives use these web-based applications as a tool to acquire and process data through telephonic interviews, eliminating the need for face-to-face contact and the requirement that a customer complete multiple paper forms or data entry for multiple product lines. This approach is customer friendly, allows us to process applications very efficiently and allows us to store client information for further processing and cross-selling efforts while offering what we believe to be the highest level of customer service. It also assures our alliance partners full transaction transparency. This system permits our alliance partners to have a window to our back office processing 24 hours a day, 7 days a week, to see every communication and interaction between our sales and processing representatives and their referred customers without sharing customer or alliance partner sensitive data on the application. NewTracker enables the processing and tracking of services in a manner similar to the bar code system used by overnight delivery services. We believe that NewTracker is a key differentiating component of our business. It enables us to scale our business services rapidly to meet the demands of our customers or the market. NewTracker enables us to provide clients with our business services suite on the front end, and enable them to offer our services immediately, without having to invest in marketing materials, sales and marketing personnel, training, licensing or office space. Because their customers are driven by our technology to our processing centers, which can handle increased volume of transactions without having to add specialized staff or infrastructure, we offer an efficient back end as there is no need for additional investment.
We are implementing a project of combining all of our data assets into a seamless enterprise, widely accessible master database in order to facilitate cross marketing, selling and servicing, real-time data mining, and business intelligence and further enhance our use of NewTracker.
Each of the operating businesses benefit from the receipt of significant numbers of customer referrals from our alliance partners, pursuant to agreements negotiated and structured by our holding company management and staff. We are focused on using strategic business affiliations to identify likely small- to medium-sized business customers and others to be serviced by our operating businesses. We seek to ally Newtek with companies and organizations that wish to offer one or more of our principal business lines to their customers or members. We provide one-stop shopping for alliance partners that want to launch or expand their business services. For example, many credit unions are serving small business owners with consumer lending applications, and can use our alliance with Credit Union National Association, PSCU Financial Services or Fiserv Solutions, Inc. d/b/a IntegraSys to expand their offering of services. We are also able to white label any of our business services for any alliance partner. We believe our comprehensive portfolio of business services can help small businesses grow, which benefits the business owner and their credit union. In December 2007, we signed our 200th credit union partner.
These alliance partners are able to provide greater service to their customers and members and derive a steady flow of referral payments from us. On the other hand, our operating companies are receiving significant numbers of referrals for our services in the areas of small business loans, insurance and electronic payment processing and are thus acquiring customers at a low cost. NewTracker, our proprietary, internally developed referral system technology, facilitates this transfer of information and also permits our customer service representatives, their supervisors and the referring alliance partners to all observe the real-time processing of each referral, from intake to completion. For a Merrill Lynch financial advisor who refers a customer for electronic payment processing, he or she can track the processing and know when decisions are made, what they are, when the referral fees are earned, as well as observe and oversee the operational performance of our customer service representatives. The process is analogous to the bar code system used by overnight delivery services to track the movement of a package, where critical processing points are input and the customer is able to access the companys password-protected web site and monitor the movement of the package from pick up to delivery.
We have entered into agreements to provide for one or more business services with the following entities:
Principal Business Segments
Electronic Payment Processing
We market payment processing services to small and medium-sized business merchants in the U.S. We are currently a provider of such services to over 13,400 small- and medium-sized business merchants throughout the U.S. We enable our merchants to accept all major credit cards as well as debit and ATM cards for payment whether they are a retail, service, mail-order or Internet merchant. We work with merchants to set up merchant payment processing and to customize value- added programs such as personalized gift card programs and check guarantee services that help drive their customers to them. As of December 31, 2007, on an annualized basis, we process over 23 million transactions with a merchant sales volume exceeding $2.55 billion per year. Our customer base and the related sales volume processed by us has grown significantly during each year of operations since 2002 through a combination of net merchant additions resulting from sales as well as selective merchant portfolio acquisitions. Our merchant base has grown from approximately 1,200 merchants at the end of 2002 to approximately 13,400 merchants at the end of 2007. Similarly, total sales volume in 2007 approximated $2.55 billion, up from $38.4 million in 2002.
Universal Processing Services of Wisconsin, LLC, d/b/a Newtek Merchant Solutions (NMS), which we own through one of our Capcos, markets credit and debit card processing services, check approval services and ancillary processing equipment and software to merchants who accept credit cards, debit cards, checks and other non-cash forms of payment. New merchants are acquired through several sales channels. Our primary focus today is on developing new merchant sales leads as a result of internal sales efforts. NMS has targeted the marketing of its array of services under agreements with alliance partners which today are principally financial institutions, including banks, credit unions and other related businesses. Members of such financial institutions are able to refer potential customers to NMS through Newteks NewTracker referral system. In addition, but to a lesser extent, we selectively maintain agreements with independent sales organizations and independent sales agents throughout the country. These referring organizations and associations are typically paid a percentage of the processing revenue derived from the respective merchants that they successfully refer to us for as long as the merchant remains our customer. We currently have contracts with approximately 150 independent sales consultants as of December 31, 2007.
In addition to our growth in merchants from our internal sales efforts and referral sources, we have acquired the rights to service existing portfolios of merchants serviced by other merchant processors. During 2007 and 2006, we acquired such rights to service 1,108 and 2,915 merchants, respectively, at the dates of their acquisition. The cost of such acquisitions totaled $2.2 million in 2007 and $2.5 million in 2006. The annual estimated merchant sales volume for acquisitions made in 2007 and 2006 is $47.6 million and $26.7 million, respectively.
Certain of our other subsidiaries operate merchant portfolios which are serviced by NMS.
We maintain two main customer service and sales support offices which are located in Milwaukee, Wisconsin and Brownsville, Texas. Our personnel at these locations assist merchants with initial installation of equipment and on-going service, as well as any other special processing needs that they may have.
Our electronic payment processing businesses relies on our ability to obtain data processing services. We contract with several large-scale data processing companies to provide the front-end and back-end processing. As our merchant base has grown, we believe that we have been able to achieve greater economies of scale in terms of negotiating the cost structure for providing such settlement services.
There are two aspects to the processing: the initial authorization of a payment (referred to as the front-end processing) and the merchant credit and cardholder charge transaction (the back end processing). Our payment processing business relies on up to five front-end and back-end processors which reduces our risk of reliance on any one company and also gives us the option of utilizing different processors to match the needs of particular merchants or situations.
As a result of our exposure to liability for merchant fraud, chargebacks and other losses inherent in the merchant payment processing business, we have developed practices and policies which attempt to assess and counter these risks. Activities in which we engage in order to mitigate such risks are:
We believe that these procedures help us to significantly reduce our exposure to merchant or customer fraud and similar potential losses. The development and growth of our business will be primarily through customers identified for us by our alliance partners and, to a much lesser extent, by our independent representatives. We are different than most electronic payment processing companies who acquire their clients primarily through independent agents in that we acquire most of our clients and processing volume through our NewTracker and alliance partner relationships. We believe that our business model provides us with a competitive advantage by enabling us to acquire higher transaction volume electronic payment processing merchants at a lower cost level for third-party commissions than the industry average. Our business model allows us to own the customer as well as the stream of residual payments, as opposed to models which rely on independent agents. We also believe that our clients are more loyal to Newtek than to the industry standard independent agent which tends to move clients around.
Website Hosting Services
Through our subsidiary CrystalTech Web Hosting, Inc. (CrystalTech) we provide website hosting services to what is now more than 69,000 customers with 105,000 domains in over 120 different countries. CrystalTech provides shared and dedicated hosting plans, under the CrystalTech brand, for which it receives recurring monthly fees by website, as well as other fees such as set-up fees, consulting fees, domain name registrations and others. Ninety percent of all fees are paid in advance by credit card. CrystalTech delivers services under the CrystalTech brand not just to customers seeking hosting but also to wholesalers, resellers and web developers by offering a range of tools for them to build, resell and deliver their web content. In 2008, CrystalTech, the core business supporting our web hosting initiatives, will operate as Newtek Technology Services, and CrystalTech will become a Newtek Technology Services brand.
CrystalTechs dedication to superior customer service is reflected in the growth of its customer base under the CrystalTech brand, from approximately 8,300 accounts at the start of 2004 when we acquired CrystalTech to approximately 69,000 at the end of 2007.
CrystalTech primarily uses Microsoft Windows® technology. Microsoft has described CrystalTech as one of the largest hosting services in the world providing Microsoft Windows 2003® hosting. CrystalTech also offers Linux-based web hosting and web-based data storage and back up services. CrystalTech currently operates a 5,000 square foot fortress strength data center located in Scottsdale, Arizona, utilizing redundant networking, electrical and back-up systems, affording customers what management believes to be a great level of performance and protection.
Over 75% of the growth in customers by CrystalTech has come as a result of customer referrals without material expenditures for marketing or advertising. Many of CrystalTechs competitors are very price sensitive, offering minimal services at cut-rate pricing. While being cost competitive with most Linux and Windows-based web hosting services, CrystalTech has emphasized higher quality uptime, service and support.
Historically, the Company has delivered website hosting services under the CrystalTech brand. The Company now intends to diversify its hosting reach by offering these services to small- and medium-sized businesses under different brands under Newtek Technology Services including Newtek Web Services, Newtek Data Storage and Newtek Web Design and Development. The Company will focus specifically on select target markets such as restaurants, financial institutions, medical practices, law firms, accountants, and retail. The Company has announced that during the second half of 2008 it intends to launch a new turnkey solution to satisfy financial institution needs for dedicated servers, hosting and/or data storage, enabling these entities to comply with regulatory requirements with the highest level of safety and security. The Company will offer these services through its strategic alliance partnerships and contracts with Credit Union National Association (CUNA), PSCU Financial Services, Fiserv Solutions, Inc. d/b/a IntegraSys, and over 200 credit unions. The Company also intends to offer insured web hosting services which would bundle web hosting services with insurance such as identity theft, business interruption and PCI security standards compliance.
Small Business Lending
Small Business Lending, Inc., (SBL) which we own approximately 80% of directly and through one of our Capcos, owns 100% of Newtek Small Business Finance, Inc. (NSBF), which specializes in originating, servicing and selling small business loans guaranteed by the SBA for the purpose of acquiring commercial real estate, machinery, equipment and inventory and to refinance debt, fund franchises, working capital and business acquisitions. NSBF is one of 14 SBA licensed Small Business Lending Corporations that provide loans nationwide under the federal section 7(a) loan program for small businesses. This federal program is authorized each year by Congress to guarantee small business loans in an amount determined by Congress. The authorization for 2007 was $17.5 billion. NSBF has received preferred lenders program (PLP) status, a designation whereby the SBA authorizes the most experienced SBA lenders to place SBA guarantees on loans without seeking prior SBA review and approval. Being a national lender, PLP status allows NSBF to serve its clients in an expedited manner since it is not required to present applications to individual SBA offices. The operations of NSBF are heavily dependent on the nature of the regulations imposed on it as a Small Business Loan Company and its ability to remain in compliance with those regulations.
We are currently exploring options to provide lower cost funding to NSBF. We are also considering the expansion of our lending platform beyond the government-backed SBA program which limits our ability to lend by restricting use to one type of loan. In 2007, we evaluated approximately $2.0 billion dollars in lending opportunities, many of which were more suited to non-SBA lending products. By expanding our product offering, Newtek believes we will be able to capture more revenue from those opportunities. We are exploring participating in the U.S. Department of Agriculture loan programs for businesses and community facilities, which would allow us to further expand our lending products to small businesses. We are also exploring the purchase of distressed loan portfolios that we would service and manage using our existing infrastructure.
We originate loans ranging from $3,000 to $5 million to both startup and existing businesses, who use the funds for a wide range of business needs including:
During 2007, we funded 143 SBA 7(a) loans for a total of $43.3 million and sold $34.3 million of the guaranteed portions of our loans. At December 31, 2007 we were servicing a portfolio of loans we originated and funded of $187.0 million. We earn interest income on the $26.4 million of loans we retain, net of the nonperforming loans totaling $5.6 million, and earn servicing income on those guaranteed portions we sell. We also provide servicing functions on loans originated by other SBA lenders for which we earn servicing fees based upon a mutually negotiated fee per loan. In servicing these portfolios, we do not take on any loss risk for the loans of such lenders.
Other Business Lines
We market our services primarily through referrals from our alliance partners such as AIG Small Business, Merrill Lynch, Credit Union National Association, Navy Federal Credit Union and Bank Atlantic, using our proprietary NewTracker referral system. In addition, Electronic Payment Processing is also marketed through independent representatives and CrystalTech services are marketed through third-party development companies, and internet-based marketing. A common thread across all business lines relates to acquiring customers at low cost. We seek to bundle our marketing efforts through our brand, our portal, our proprietary NewTracker technology, and one easy entry point of contact.
We currently cross market primarily at the alliance level. The Credit Union National Association, PSCU Financial Services, Inc., Fiserv Solutions, Inc. d/b/a IntegraSys and AIG Small Business are examples of cross marketing at the alliance level.
We have implemented a multi-channel marketing strategy that consists of:
Direct: We market through our website, www.newtekbusinesssservices.com. We have created a place on our website for small business owners/operators to go to acquire one or more of the Newtek services directly. We anticipate marketing this through ads, seminars, magazine placements and internet key words and/or general promotion.
We are currently in the process of implementing a multi-segment internet marketing approach under our Newtek Technology Services brand, focusing on select target markets such as restaurants, supermarkets, financial institutions, physicians, attorneys, accountants, and retail.
Indirect: Through our BizExec Program, we are recruiting individual professionals such as insurance agents, lawyers, and accountants who will utilize NewTracker either through the establishment of a new website or through a link to NewTracker from their own site. They will have access to the NewTracker system to track their own leads.
Our alliance partners market one or more of our services to their customer base, and utilize NewTracker to submit referrals to Newtek from either their website or directly by their staff. They have access to NewTracker to track their own leads.
Direct Sales Force: We employ contracted, fee- and bonus-based employees that have as their primary responsibility to drive quality referrals into NewTracker thru daily interaction with their assigned alliances and business owners/operators in their territories. We currently have 12 individuals acting in this capacity across the United States.
Direct Alliance: Small business owners/operators go to the website of an alliance partner in order to acquire one or more of the Newtek services, driven by ads, keywords, seminars, conferences and/or general promotion. This is currently in place with AIG, NCMIC Financial, Inc. and Navy Federal Credit Union.
We have contracted with affiliates in Brownsville, Texas to provide back-office support, including customer service, for our business segments.
Newtek has developed software which is the core of its NewTracker referral system and in September 2006 filed a patent application with the United States Patent and Trademark Office covering NewTracker.
CrystalTech uses specialized software to conduct its business under a perpetual, royalty-free license from its developer, the former owner of CrystalTech, acquired at the time of our acquisition of the business.
We have several trademarks and service marks, all of which are of material importance to us.
The following trademarks and service marks are the subject of trademark registrations issued by the United States Patent Trademark Office:
The following trademarks and service marks are the subject of pending trademark applications filed with the United States Patent and Trademark Office:
Litigation, which could result in substantial cost to and diversion of our business, may be necessary to enforce trademarks and service marks issued to us or to determine the enforceability, scope and validity of the proprietary rights of others. Adverse determinations in any litigation or interference proceeding could subject us to costs related to changing names and a loss of established brand recognition. If at any time there was a challenge to these rights and we were not successful in defending our ability to either protect these rights or continue to use them, it may be necessary for us to adopt different trademarks and service marks and thereby lose the value we believe we have built in them.
We compete in a number of markets for the sale of services to small- and medium-sized businesses. Each of our principal operating segments competes not only against suppliers in its particular state or region of the country but also against suppliers operating on a national or even a multi-national scale. None of the markets in which our companies compete are dominated by a small number of companies that could materially alter the terms of the competition.
Our Electronic payment processing segment competes with Heartland Payment Systems, First National Bank of Omaha and Paymentech, L.P. Our Web hosting segment competes with Host My Site®, Discount ASP, Maxum ASP, GoDaddy®, Yahoo!®, BlueHost®, iPowerWeb®, DiscountASP and Microsoft Live. Our Small business lending segment competes with regional and national banks and non-bank lenders such as CIT and Business Loan Express.
In many cases, the competitors whom our companies face are not as able as our companies to take advantage of changes in business practices due to technological developments and, for those with a larger size, are unable to offer the personalized service that many small business owners and operators seem to want.
While we compete with many different providers in our various businesses, we have been unable to identify any direct and comprehensive competitors that deliver the same broad suite of services focused on the needs of the small- and medium-sized business market with the same marketing strategy as we do. Some of our competitive advantages include:
Certified Capital Companies
We have deemphasized our Capco business in favor of growing our operating businesses and do not anticipate creating any new Capcos in the foreseeable future. The features of the Capco programs have facilitated our use of the Capco funds in support of our development as a holding company for a network of small business service providers. While observing all requirements of the Capco programs and, in particular, financing qualified businesses meeting applicable state requirements as to limitations on the proportion of ownership of qualified businesses, we have been able to use this funding source as a means to facilitate the growth of our businesses, which are strategically focused on providing goods and services to small businesses such as those in which our Capcos invest.
Overview: A Capco is either a corporation or a limited liability company established in and chartered by one of the nine jurisdictions currently with authorizing legislation: Alabama, District of Columbia, Florida, Louisiana, Colorado, New York, Texas and Wisconsin (Missouri has an older program which pre-dates the start of our business and in which we do not participate). Aside from seed capital provided by an organizer such as Newtek, a Capco will issue debt and equity instruments exclusively to insurance companies and the Capcos then are authorized under the respective state statutes to make targeted equity or debt investments in companies. In some states, the law permits Capco investments in majority-owned or primarily controlled companies. In others, such as Louisiana, Colorado, Texas and the most recent programs in New York, there are some limitations on the percentage of ownership a Capco may acquire in a qualified business. In conjunction with the Capcos investment in these companies, the Capcos may also provide loans to the companies. In most cases, the tax credits provided by the states are equal to the par amount of investment by the insurance companies in the securities of the Capcos, which can be utilized by them generally over a period of four to ten years. These credits are unaffected by the returns or lack of returns on investments made by the Capcos.
The authorizing statutes in all of the states in which our Capcos operate explicitly allow and encourage the Capcos to take minority equity interests, and in some cases majority or controlling interests, in companies. Consequently, in all of the states in which we operate Capcos, we may, consistent with our business objectives, acquire equity interests in companies through the use of the funds in the Capcos and provide management and other services to these companies. The investments by the Capcos create jobs and foster economic development consistent with the objectives of the programs as stated in most
Capco statutes. Furthermore, because our Capcos have arranged for the repayment of a portion of the Capco notes by The National Union Fire Insurance Company of Pittsburgh or The American International Specialty Lines Insurance Company, both affiliates of The American International Group, Inc., and a portion of the Capco notes is paid through the delivery of tax credits, our Capcos are under no pressure to generate short-term profits and may invest for long-term profitability. Due to the nature of the Capco programs, we are able to accept the higher level of losses common to start up companies because we have the ability to devote the time, attention and resources to these companies which they require to become successful.
We and our Capcos do not generate any revenue for goods or services sold to the companies in which we invest. The companies in which the Capcos invest do provide services, and to a much lesser degree goods, to each other. However, the effect of such inter-company revenues and expenses are eliminated in the consolidated financial statements. We rely on the annual management fees of 2.5% of certified (initial) capital, as fixed by the Capco statutes and profits from non-Capco operations as our contingent source of cash to cover some of our operating expenses. This covers all supportive services generally provided by us; however, the management fee is paid out of Capco cash on hand and is not set aside or reserved for payment out of the funds received by the Capcos. The management fee is protected and established by statute.
In order to make the Capco investments successful, and thus to fulfill the public policy objectives of the Capco programs, we have enhanced the Capco funding mechanism by offering management resources, technical, operational and professional expertise and non-Capco funds to the investee companies. Depending on the state Capco program and to the extent permitted by state law and regulation, the services can range from advice and assistance with strategic relationships to direct and daily involvement in policy making and management. For example, in the state of Louisiana the Capco is precluded from controlling the policy making, management and operations of the investee company and accordingly the Capcos only participate in the policy making of the company by exercising their rights under the terms of the investment.
Tax Credits: In return for the Capcos making investments in the targeted companies, the states provide tax credits, generally equal to funds invested in the Capco by the insurance companies that provide the funds to the Capcos. In order to maintain its status as a Capco and to avoid recapture or forfeiture of the tax credits, each Capco must meet a number of specific investment requirements, including a minimum investment schedule all of which have been met prior to required dates by all of our Capcos. As a result, we believe there is neither any basis for a loss of tax credits nor liability under the Capco insurance described below.
Investment Requirements: Each of the state Capco programs has a requirement that a Capco, in order to maintain its certified status, must meet certain investment requirements, both qualitative and quantitative.
Quantitative Requirements: These include minimum investment amounts and time periods for investment of certified capital (the amount of the original funding of the Capco by the insurance companies) all of which have been met by our
Capcos. For example in the state of New York, a Capco must invest at least 25% of its certified capital within 24 months from the initial investment date, 40% within 36 months and 50% within 48 months. The minimum investment requirements and time periods, along with the related tax credit recapture requirements are set out in detail below. See: Managements Discussion and AnalysisIncome from Tax Credits and Note 1 to the Consolidated Financial StatementsRevenue Recognition. The minimum requirements are calculated on a cumulative basis and allow the Capcos to receive a return of an investment and re-invest the funds for full additional credit towards the minimum requirements.
Qualitative Requirements: These include limitations on the initial size of the recipients of the Capco funds, including the number of their employees, the location within the respective state of the recipients and the recipients commitment to remain therein for a specified period of time, the types of business conducted by the recipients, and the terms of the investments in the recipients. Most significant for our business is the fact that most of the Capco programs generally do not pose any obstacle to investments in qualified businesses which result in significant, majority or, in some cases, controlling ownership positions (the state of Louisiana precludes the Capco from taking controlling and majority ownership positions in investee companies). This enables us to achieve both public policy objectives of the Capco programs, of increasing the number of small businesses and job opportunities in the state, as well as our own objectives of developing a number of small business service companies which may become profitable and generate a meaningful return both to our shareholders and to the local participants in the businesses. In addition, because the businesses that we invest in provide needed, and in managements judgment, cost effective goods and services to other small businesses, the growth of this important segment of a states economy may be accelerated.
Investment Limitations: The states of Louisiana, Colorado, Texas and in the two most recent programs in New York (out of the five we have participated in) have had or recently added, to their Capco programs, limitations on the equity investment Capcos can make in qualified businesses. These programs or program changes seek to preclude a Capco from owning all or a majority of the voting equity of the invested business. While Newtek has made profitable majority-owned investments in the past, we have also made minority or more passive investments in qualified businesses. Newteks Capcos are in full compliance with these types of investment limitations, and management foresees no significant difficulty in continuing to do so.
Enforcement of Requirements: The various states, which administer these programs through their insurance, banking or commerce departments, conduct periodic reviews and on site examinations of the Capcos in order to verify that the Capcos have met applicable investment requirements and are otherwise acting in conformance with the statutes and rules. Capcos are required to maintain detailed records so as to demonstrate to state examiners compliance with all applicable requirements. A failure of a Capco to meet one of the statutory minimum quantitative investment benchmarks within the time specified would constitute grounds for the loss of the Capcos status as a Capco, or its decertification, and the loss and recapture of some or all of the tax credits previously passed through the Capco to its investors. An involuntary decertification of one of our Capcos would have a material adverse effect on our business in that it would require the Capco insurer to make compensatory payments equal to the lost tax credits and would permit the insurer to assume control over the assets of the Capco in order to cover its losses. Compliance with these requirements is reflected in contractual provisions of the agreements between each Capco and its investors. The Capcos covenant to their investors to use the funds only for investments as permitted by the Capco laws or for related expenses and to refrain from taking any action which would cause the Capco to fail to continue in good standing. We believe all of our Capcos have met all applicable minimum qualitative investment requirements.
Compliance: As of the end of 2007, we believe that all of our Capcos were in compliance with all applicable requirements and our 15 operational and one managed Capco had met their final, minimum 50% investment thresholds. This eliminates any material risk of decertification and tax credit recapture or loss for its insurance company investors in these Capcos.
Insurance. The Capco notes require, as a condition precedent to the funding of the notes, that insurance be purchased to cover the risks associated with the operation of the Capcos. This insurance is purchased from American International Specialty Lines Insurance Company and National Union Fire Insurance Company of Pittsburgh, both subsidiaries of American International Group, Inc., (AIG) an international insurer. AIG and its subsidiaries noted above are AA+ rated by Standard & Poors. Under the terms of this insurance, which is for the benefit of the investors, the Capco insurer incurs the primary obligation to repay the investors a substantial portion of the debt as well as to make compensatory payments in the event of a loss of the availability of the related tax credits. In the event of either a threat of or a final decertification by a state, the Capco insurer would be authorized to assume partial or complete control of the business of the particular Capco so as to ensure compliance with investment or other requirements. This would likely avoid final decertification and the necessity of insurance or cash payments in lieu of forfeited or recaptured tax credits. However, control by the Capco insurer would also result in significant disruption of the particular Capcos business and likely result in significant financial loss to that Capco. Decertification would also likely impair our ability to obtain certification for Capcos in additional states as new legislation makes other opportunities available. The Capcos are individually insured, and the assets of one are not at risk for the obligations of the others. AIG itself has not agreed to guarantee the obligations of its subsidiary insurers but has agreed to transfer the obligations to another of its subsidiaries if the insurers are down-rated.
Voluntary Decertification. When each of Newteks Capcos has invested in qualified businesses an amount equal to 100 % of its initial certified capital, it is able to decertify (terminate its status as a Capco) and no longer be subject to any state Capco regulation. Newtek would then be able to continue the business of the investment vehicle or liquidate the investments and/or the Capco. Such a voluntary decertification would eliminate all restrictions on the Capcos operations but would have no effect on the tax credits given to certified investors or on the Capco Insurance. In addition, voluntary decertification is dependent on the maturity date of each Capcos certified investor notes and Capco Insurance policies. Prior to such maturity dates, voluntarily decertification requires the consent of both the certified investors and the Capco insurer; after those dates, no consent other than that of the respective state is required.
Upon voluntary decertification, the programs in about half of the states require that a Capco share any distributions to its equity holders with the state sponsoring the Capco. For those states that require a share of distributions, the sharing percentages vary, but are generally from 10 to 30%, usually on distributions above a specified internal rate of return for the equity owners of the Capco. States not requiring distributions are Wisconsin, Texas and New York (Programs 1, 2 and 3). At this time, Newtek does not believe that the sharing requirements will have a material impact on the companys financial condition or operations.
During 2007, two of Newteks Capcos reached the 100% investment level and in January 2008 the first, Wilshire New York Advisers, LLC, was notified by the New York Insurance Department that it is no longer subject to regulation. A decision as to the second Capco is pending.
Decertification signifies that the Capcos have worked through their business cycles which will minimize the impact of Capco accounting on our business.
Government Regulation: Investment Company Act of 1940
Because of the nature of our business, our management has addressed the question of the effects of the potential application of the Investment Company Act of 1940, as amended (the Investment Company Act), to the business of Newtek. As discussed below, the application of the Investment Company Act to us would impose requirements and limitations that are materially inconsistent with our current and intended business strategy. However, with our increased investment focus on operating companies, management believes that concern for unintended holding company status has been decreased materially.
Companies that are publicly offered in the U.S. and which (1) are, or hold themselves out as being, engaged primarily or proposing to engage primarily in the business of investing, reinvesting or trading in securities, or (2) own or hold investment securities exceeding 40% of the value of their total assets (adjusted to exclude U.S. government securities and cash) and are engaged in the business of investing, reinvesting, owning, holding or trading in securities, are considered to be investment companies under the Investment Company Act. Unless an exclusion from registration were available or obtained by grant of a Securities and Exchange Commission (SEC) order, these companies must register under this Act and, thus, become subject to extensive regulation regarding several aspects of their operations.
The SEC has adopted Rule 3a-1 that provides an exclusion from registration as an investment company if a company meets both an asset and an income test and is not otherwise primarily engaged in an investment company business by, among other things, holding itself out to the public as such or by taking controlling interests in companies with a view to realizing profits through subsequent sales of these interests. A company satisfies the asset test of Rule 3a-1 if it has no more than 45% of the value of its total assets (adjusted to exclude U.S. government securities and cash) in the form of securities other than interests in majority owned subsidiaries and companies which it primarily and actively controls. A company satisfies the income test of Rule 3a-1 if it has derived no more than 45% of its net income for its last four fiscal quarters combined from securities other than interests in majority-owned subsidiaries and primarily and actively controlled companies.
Our business strategy and business activities focus upon participating actively in their management and development of the businesses in which we invest. We believe that this strategy and the scope of our business activities would not cause us to fall within the definition of an investment company or, if so, provide us with a basis for an exclusion from the definition of an investment company under the Investment Company Act.
Government Regulation: State Capco Regulations
Each of the states which operate Capco tax credit programs has established administrative mechanisms to monitor compliance with the requirements of the programs, to verify that the Capcos have met applicable minimum investment requirements and are otherwise acting in conformance with the statutes and rules. Requirements include limitations on the initial size of the recipients of the Capco funds, including the number of their employees, the location within the respective state of the recipients and the recipients commitment to remain therein for a specified period of time, the types of business conducted by the recipients, and the terms of the investments in the recipients. Capcos are required to maintain detailed records so as to demonstrate to state examiners compliance with all applicable requirements. Contrary to other programs, the regulatory requirements applicable to Capcos are generally limited to the minimum investment requirements. We believe that the Capcos we operate are currently in full compliance with all applicable requirements and management anticipates no difficulty in maintaining that status in the future.
Government Regulation: Sarbanes-Oxley Act of 2002
On July 30, 2002, the President of the United States signed the Sarbanes-Oxley Act of 2002 (the Sarbanes-Oxley Act) into law. The Sarbanes-Oxley Act provides for sweeping changes with respect to corporate governance, accounting policies and disclosure requirements for public companies, and also for their directors and officers. Section 302 of the Sarbanes-Oxley Act (Corporate Responsibility for Financial Reports) required the SEC to adopt new rules to implement the requirements of the Sarbanes-Oxley Act. These requirements include new financial reporting requirements and rules concerning corporate governance. New SEC rules require a reporting companys chief executive and chief financial officers to certify certain financial and other information included in our quarterly and annual reports. The rules also require these officers to certify that they are responsible for establishing, maintaining and regularly evaluating the effectiveness of the reporting companys disclosure controls and procedures; that they have made certain disclosures to the auditors and to the audit committee of the board of directors about the reporting companys controls and procedures; and that they have included information in their quarterly and annual filings about their evaluation and whether there have been significant changes to the controls and procedures or other factors which would significantly impact these controls. (See Section 9A for managements current assessment of related control matters).
See: Certifications for certifications by Newteks Chief Executive Officer and Chief Financial Officer of the financial statements and other information included in this Annual Report on Form 10-K. The certifications required by Section 906 of the Sarbanes-Oxley Act also accompany this Form 10-K.
As of December 31, 2007, we and the companies in which we hold a controlling interest had approximately 402 employees, independent representatives and contract employees. We believe our labor relations are good and none of our employees are covered by a collective bargaining agreement.
All our employees have signed confidentiality agreements, and it is our standard practice to require newly hired employees and, when appropriate, independent consultants, to execute confidentiality agreements. These agreements provide that the employee or consultant may not use or disclose confidential information except in the performance of his or her duties for the company, or in other limited circumstances. The steps taken by us may not, however, be adequate to prevent the misappropriation of our proprietary rights or technology.
Revenues and Assets by Geographic Area
During the years ended December 31, 2007, 2006, and 2005 all of our revenue was derived from customers in the United States. For a description of the Companys long-lived assets, see the Notes to the Consolidated Financial Statements.
We are subject to the informational requirements of the Securities Exchange Commission and in accordance with those requirements file reports, proxy statements and other information with the Securities and Exchange Commission. You may read and copy the reports, proxy statements and other information that we file with the Commission under the informational requirements of the Securities Exchange Act at the Commissions Public Reference Room at 450 Fifth Street N.W., Washington, DC 20549. Please call 1-800-SEC-0339 for information about the Commissions Public Reference Room. The
Commission also maintains a web site that contains reports, proxy and information statements and other information regarding registrants that file electronically with the Commission. The address of the Commissions web site is http://www.sec.gov. Our web site is http://www.newtekbusinessservices.com. We make available through our web site, free of charge, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Commission. Information contained on our web site is not a part of this report.
If any of the following risks occur, our business, financial condition and results of operations could be materially and adversely affected. In that case, the value of our common shares could decline and stockholders may lose all or part of their investment. The risks set out below are not the only risks we face.
RISKS RELATING TO OUR BUSINESS GENERALLY
Our business focuses on the investment in and acquisition of small businesses, which typically have a high rate of failure, may take some time to become profitable and may never become profitable.
We have placed emphasis on the investment in and acquisition of small businesses with the objective of developing a network of profitable businesses, most of which will principally serve the small- and medium-sized business market. Early stage businesses historically have a higher rate of failure than larger businesses, and many that do not fail will have only limited profitability. Moreover, profits generated by any of our majority-owned companies or other investments could be offset by losses generated by others. Our profitability resulting from the operations of our businesses may be delayed for the foreseeable future.
We have generated and carry goodwill as an asset resulting from some of our acquisition transactions. In 2005, management wrote down the value of goodwill by approximately $878,000, all related to the Capco segment. We can make no assurance that our current or future additional goodwill will not be written down pursuant to applicable accounting standards. A significant write down of a major asset, such as goodwill, could have a material adverse effect on our business, a negative impact on earnings and the value of our common shares.
Each of our major investments and affiliated companies may be impacted by a variety of adverse economic, governmental, industrial and internal company factors unique to that business and outside our control. If our investments and affiliated companies do not succeed in overcoming these adverse factors, the value of our assets and the price of our shares would likely fall.
In the past few years we have increasingly concentrated our investments in companies participating in small business lending, electronic payment processing, web hosting and insurance. Each of these businesses has numerous risks associated with it and should be read in conjunction with the specific risk factors set forth below with respect to each of these businesses.
As we have concentrated our investments in companies which are part of our nationwide marketing strategy of providing a variety of services to small and medium-sized businesses, our exposure and that of our affiliated companies to risks specific to these business lines has increased. We discuss below some of the risks of our significant operations in government-guaranteed small business lending, acting as an independent sales organization in the electronic card processing business, web hosting business and operating as an insurance agency. If we are not successful in implementing this business strategy and developing and marketing our new products and services, our results of operations will be negatively impacted.
If we do not manage our growth effectively, our financial performance could be harmed.
Our rapid revenue growth has placed, and will continue to place, certain pressures on our management, administrative, operational and financial infrastructure. As we continue to grow our business, such growth could require capital, systems development and human resources beyond current capacities. As evidence of our internal growth, on December 31, 2001, we and all of our consolidated and majority-owned affiliates had approximately 20 employees, and on December 31, 2007 we had approximately 402 employees and independent contractors. The increase in the size of our operations may make it more difficult for us to ensure that we execute our present businesses and future strategies. The failure to manage our growth effectively could have a material adverse effect on our financial condition, results of operations and cash flows.
If we are unable to obtain the resources required for the growth and development of our affiliated companies, they will be highly susceptible to failure, which would directly affect our profitability and value.
Early-stage businesses often fail due to their limited capital and human resources. The effective implementation of our business model is dependent upon the ability of the affiliated companies, with assistance from us, to arrange for the managerial capital and other resources which they usually require in order to become and remain profitable.
We may not be able to integrate acquired companies into our company and, as we acquire more and larger interests in affiliated companies, our resources available to assist our affiliated companies may be insufficient.
We have made strategic acquisitions, and we intend to continue to make acquisitions in accordance with our business plan. Each acquisition involves a number of risks, including:
Any strain on our ability to assist our affiliated companies as intended or to acquire and integrate businesses under our business plan could have a negative impact on our operations, financial results and cash flows.
Our business may be adversely affected by the highly regulated industries in which we operate.
Many of the industries in which we operate are highly regulated and we cannot assure you that we or our affiliated companies are, or that we will continue to be, in full compliance with current laws, rules and regulations. If we or our affiliated companies are unable to comply with applicable laws or regulations or if new laws limit or eliminate some of the benefits of our business lines, our financial condition, results of operations and our cash flows could be materially adversely affected.
Our method of income recognition derived from the Capco tax credits causes most of such income to be received in the first five years of the programs. In the absence of income from our investments or other sources, we would sustain material losses in later years.
In our Capco programs we recognize the majority of our income from the tax credits in the early years of the programs because income recognition is tied to the schedule by which the tax credits become irrevocable and beyond recapture (approximately five years). We recognize the majority of our income from an average ten year Capco program in the first five years and will not be recognizing significant tax credit income in the latter part of the program. However, we will continue to incur costs for the administration of the Capcos and (non-cash) interest expense on the Capco notes and amortization of the prepaid insurance. In the absence of income from other sources, such as returns on our qualified investments, we will likely sustain material non-cash losses in the programs.
Our success depends upon our ability to enforce and maintain our intellectual property rights.
Our success depends, in significant part, on the proprietary nature of our technology, including both patentable and non-patentable intellectual property related to our NewTracker referral system. We have filed a patent application with the United States Patent office but there can be no assurance that such patent will be granted. To the extent that a competitor is able to reproduce or otherwise capitalize on our technology, it may be difficult, expensive or impossible for us to obtain necessary legal protection. In addition to patent protection of intellectual property rights, we consider elements of our product designs and processes to be proprietary and confidential. We rely upon employee, consultant and vendor non-disclosure agreements and contractual provisions and a system of internal safeguards to protect our proprietary information. However, any of our registered or unregistered intellectual property rights may be challenged or exploited by others in the industry, which might harm our operating results. We have several trademarks and service marks which are of material importance to us. Litigation, which could result in substantial cost to and diversion of our efforts, may be necessary to enforce trademarks issued to us or to determine the enforceability, scope and validity of the proprietary rights of others. Adverse determinations in any litigation or interference proceeding could subject us to costs related to changing brand names and a loss of established brand recognition.
Our affiliated companies depend upon the ability to utilize the Internet for the conduct of a significant portion of their business; disruption to that system could make it impossible for them to continue to conduct their current businesses.
Possible disruption to the normal functioning of the Internet through, for example, power failure or terrorist sabotage, could make it impossible for aspects of the lending, electronic payment processing, web hosting and in fact our referral system to function. Each of our businesses has addressed the possibilities of short term disruptions and planned accordingly. However, in the event of a major disruption, and assuming that such disruptions would be long lived, we would be required to make extensive changes in the way these companies do business. There is no assurance that we will have the time and resources to make these changes.
We and our affiliated companies depend on our ability to attract and retain key personnel and any loss of ability to attract these personnel could adversely affect us.
Our success depends upon the ability of our affiliated companies and other investments to attract and retain qualified personnel and our ability to supplement those capabilities with our senior management personnel. Competition for qualified employees is intense. If our affiliated companies lose the services of key personnel, or are unable to attract additional qualified personnel, the business, financial condition, results of operations and cash flows of us or one or more of our affiliated companies could be materially adversely affected. It can take a significant period of time to identify and hire personnel with the combination of skills and attributes required in carrying out our strategy.
Our business relies heavily on the expertise of our senior management, particularly Messrs. Barry Sloane and Seth A. Cohen, our CEO and CFO, respectively. Mr. Sloane currently serves pursuant to an employment agreement which expires on June 30, 2008. The loss of the services of these individuals could have a material adverse effect on our financial condition, results of operations and cash flows and it is likely that it will be difficult to find adequate replacements.
Our success depends on our ability to compete effectively in the highly competitive industries in which we operate.
We face intense competition in providing web hosting services, processing electronic payments and originating SBA loans, as well as in the other industries in which we or our affiliated companies operate. Low barriers to entry often result in a steady stream of new competitors entering certain of these businesses. Current and potential competitors are or may be better established, substantially larger and have more capital and other resources than we do. If we expand into additional geographical markets, we will face competition from others in those markets as well.
Our success also depends on our ability to use effectively our electronic referral and processing system.
We have developed an electronic referral and processing system for the applications necessary for the sales of each of our business lines other than web site hosting. This system is critical to our ability to process such business with a low cost advantage and to obtain referrals from our alliance partners. In particular, the ability to access the referral system and to track the progress of a referred customer is a major feature of the perceived attractiveness of our system. If this referral system should develop problems which we cannot address, it would have a material negative impact on our business strategy.
A major feature of our business strategy is the development of opportunities for our service and product provider businesses to market to the customers of our other business lines and to the customer bases of our alliance partners.
Although our business strategy contemplates the referral of prospects between wholly-owned and partially-owned companies in our network, there is no history of such cross-selling and there can be no assurances that any effort to make referrals across our network of affiliated companies will result in additional revenue opportunities. In order for our referral network to achieve the desired result, each of the constituent companies must have proper incentives and feel comfortable making such introductions, and furthermore, the service provider receiving such referral must properly service such referred client. In addition, our marketing alliances are terminable and, if we make serious errors or fail to produce sufficient revenues for our alliance partners, we are at risk of losing these relationships.
The inability of any one of our business segments to service customers adequately referred to it from within our other companies could impair our overall relationship with such customers.
A significant benefit of our structure and strategy is the ability to cross market between our SBA, electronic payment processing and other business customers. However, should the business relationship between one of our business segments and customers deteriorate for any reason, such customers may opt to withdraw their business from our other businesses. Such a loss of business could negatively impact our results of operations and cash flows.
We rely on information processing systems; the interruption, loss or failure of which would materially and adversely affect our business. Our strategy of cross marketing to customers among our majority-owned subsidiaries will increase this reliance.
Our ability to provide business services depends, and will increasingly depend, on our capacity to store, retrieve, process and manage significant amounts of data, and expand and upgrade our information processing capabilities. Interruption or loss of our information processing capabilities through loss of stored data, breakdown or malfunctioning of computer equipment and software systems, telecommunications failure or damage caused by acts of nature or other disruption, could have a material adverse effect on our business, financial condition, results of operations and cash flows. We cannot be certain that our disaster recovery systems or insurance will continue to be available at reasonable prices to cover all our losses or compensate us for the possible loss of clients occurring during any period that we are unable to provide outsourced business services.
RISKS RELATING TO OUR ELECTRONIC PAYMENT PROCESSING BUSINESS
We rely currently on a single bank sponsor, which has substantial discretion with respect to certain elements of our business practices, in order to process bankcard transactions. If this sponsorship is terminated, and we are not able to secure or transfer merchant portfolios to new bank sponsors, we will not be able to conduct our electronic payment processing business.
Because we are not a bank, we are unable to belong to and directly access the Visa® and MasterCard® bankcard associations. The Visa® and MasterCard® operating regulations require us to be sponsored by a bank in order to process bankcard transactions. We are currently registered with Visa® and MasterCard® through the sponsorship of one bank that is a member of the card associations. If this sponsorship is terminated and we are unable to secure a bank sponsor, we will not be able to process bankcard transactions which would have a material adverse effect on our business. Furthermore, our agreement with our sponsoring bank gives the sponsoring bank substantial discretion in approving certain elements of our business practices, including our solicitation, application and qualification procedures for merchants, the terms of our agreements with merchants, the processing fees that we charge, our customer service levels and our use of independent sales organizations. We cannot guarantee that our sponsoring banks actions under these agreements will not be detrimental to us.
If we or our processors or bank sponsor fail to adhere to the standards of the Visa® and MasterCard® bankcard associations, our registrations with these associations could be terminated and we could be required to stop providing payment processing services for Visa® and MasterCard®.
Substantially all of the transactions we process involve Visa® or MasterCard®. If we, our bank sponsor or our processors fail to comply with the applicable requirements of the Visa® and MasterCard® bankcard associations, Visa® or MasterCard® could suspend or terminate our registration. The termination of our registration or any changes in the Visa® or MasterCard® rules that would impair our registration could require us to stop providing payment processing services, which would have a material adverse effect on our business.
We and our electronic payment processing subsidiaries rely on other card payment processors and service providers. If they no longer agree, or are unable to provide their services, our merchant relationships could be adversely affected and we could lose business.
Our electronic payment processing business relies on agreements with several other large payment processing organizations to enable us to provide card authorization, data capture, settlement and merchant accounting services and access to various reporting tools for the merchants we serve. We also rely on third parties to whom we outsource specific services, such as reorganizing and accumulating daily transaction data on a merchant-by-merchant and card issuer-by-card issuer basis and forwarding the accumulated data to the relevant bankcard associations. Many of these organizations and service providers are our competitors. The termination by our service providers of these arrangements with us or their failure to perform these services efficiently and effectively may adversely affect our relationships with the merchants whose accounts we serve, and may cause those merchants to terminate their processing agreements with us.
On occasion, we experience increases in interchange and sponsorship fees. If we cannot pass these increases to our merchants, our profit margins will be reduced.
Our electronic payment processing subsidiaries pay interchange fees or assessments to bankcard associations for each transaction we process using their credit, debit and gift cards. From time to time, the bankcard associations increase the interchange fees that they charge processors and the sponsoring banks. At their sole discretion, our sponsoring banks have the right to pass any increases in interchange fees on to us. In addition, our sponsoring banks may increase their Visa® and MasterCard® sponsorship fees, all of which are based upon the dollar amount of the payment transactions we process. If we are not able to pass these fee increases along to merchants through corresponding increases in our processing fees, our profit margins in this line of business will be reduced.
Unauthorized disclosure of merchant or cardholder data, whether through breach of our computer systems or otherwise, could expose us to liability and business losses.
Through our electronic payment processing subsidiaries, we collect and store sensitive data about merchants and cardholders, and we maintain a database of cardholder data relating to specific transactions, including payment, card numbers and cardholder addresses, in order to process the transactions and for fraud prevention and other internal processes. If anyone penetrates our network security or otherwise misappropriates sensitive merchant or cardholder data, we could be subject to liability or business interruption. We cannot guarantee that our systems will not be penetrated in the future. If a breach of our system occurs, we may be subject to liability, including claims for unauthorized purchases with misappropriated card information, impersonation or other similar fraud claims. Similar risks exist with regard to the storage and transmission of such data by our processors.
We have potential liability if our merchants refuse or cannot reimburse charge-backs resolved in favor of their customers.
If a billing dispute between a merchant and a cardholder is not ultimately resolved in favor of the merchant, the disputed transaction is charged back to the merchants bank and credited to the account of the cardholder. If we or our processing banks are unable to collect the charge-back from the merchants account, or if the merchant refuses or is financially unable due to bankruptcy or other reasons to reimburse the merchants bank for the charge-back, we bear the loss for the amount of the refund paid to the cardholders bank. Most of our merchants deliver products or services when purchased, so a contingent liability for chargebacks is unlikely to arise, and credits are issued on returned items. However, some of our merchants do not provide services until some time after a purchase, which increases the potential for contingent liability.
We face potential liability for customer or merchant fraud.
Credit card fraud occurs when a merchants customer uses a stolen card (or a stolen card number in a card-not-present transaction) to purchase merchandise or services. In a traditional card-present transaction, if the merchant swipes the card, receives authorization for the transaction from the card issuing bank and verifies the signature on the back of the card against the paper receipt signed by the customer, the card issuing bank remains liable for any loss. In a fraudulent card-not-present transaction, even if the merchant receives authorization for the transaction, the merchant is liable for any loss arising from the transaction. Many of our business customers are small and transact a substantial percentage of their sales over the Internet or by telephone or mail orders. Because their sales are card-not-present transactions, these merchants are more vulnerable to customer fraud than larger merchants and we could experience charge-backs arising from cardholder fraud more frequently with these merchants.
Merchant fraud occurs when a merchant, rather than a customer, knowingly uses a stolen or counterfeit card or card number to record a false sales transaction or intentionally fails to deliver the merchandise or services sold in an otherwise valid transaction. Anytime a merchant is unable to satisfy a charge-back, we are responsible for that charge-back. We have established systems and procedures to detect and reduce the impact of merchant fraud, but we cannot assure you that these measures are or will be effective. Failure to effectively manage risk and prevent fraud could increase our charge-back liability.
Our payment processing systems may fail due to factors beyond our control, which could interrupt our business or cause us to lose business and likely increase our costs.
We depend on the uninterrupted operations of our computer network systems, software and our processors data centers. Defects in these systems or damage to them due to factors beyond our control could cause severe disruption to our business and other material adverse effects on our payment processing businesses.
RISKS RELATING TO OUR OPERATION OF A WEBSITE HOSTING BUSINESS
CrystalTech operates in a competitive industry in which technological change can be rapid.
The website hosting business and its related technology involve a broad range of rapidly changing technologies. CrystalTechs equipment and the technologies on which it is based may not remain competitive over time, and others may develop superior technologies that render CrystalTechs products non-competitive without significant additional capital expenditures.
The website hosting industry is highly competitive, and we may be unable to compete effectively.
The website hosting industry is highly competitive, rapidly evolving, and subject to intense marketing by providers with similar products and services. Some of our potential competitors are significantly larger and have substantially greater market presence as well as greater financial, technical, operational, marketing and other resources and experience than we do. In the event that such a competitor expends significant sales and marketing resources in one or several markets, we may not be able to compete successfully in such markets. We believe that competition will continue to increase, placing downward pressure on prices. Such pressure could adversely affect our gross margins if we are not able to reduce our costs commensurate with such price reductions. In addition, some of our competitors may offer free or substantially reduced services. There can be no assurances that we will remain competitive.
Our website hosting business depends on the efficient and uninterrupted operation of its computer and communications hardware systems and infrastructure.
Despite precautions taken by CrystalTech against possible failure of its systems, interruptions could result from natural disasters, power loss, the inability to acquire fuel for our backup generators, telecommunications failure, terrorist attacks and similar events. CrystalTech also leases telecommunications lines from local, regional and national carriers whose service may be interrupted. CrystalTechs business, financial condition and results of operations could be harmed by any damage or failure that interrupts or delays our operations and cash flows. There can be no assurance that CrystalTechs insurance will cover all of CrystalTechs losses or compensate CrystalTech for the possible loss of clients occurring during any period that CrystalTech is unable to provide service.
Service interruptions due to malicious attacks could result in a loss of revenues and harm CrystalTechs reputation.
On occasion, hackers have managed to penetrate our network infrastructure for a short time before being detected. There can be no assurance that we will continue to be able to successfully address such threats. Any future network shut downs can have a significant negative impact on revenue and cash flows, as well as harm our reputation.
Of primary importance to our website hosting customers is the integrity of our infrastructure and the privacy of confidential information.
CrystalTechs infrastructure is potentially vulnerable to physical or electronic break-ins, viruses or similar problems. If a person circumvents CrystalTechs security measures, he or she could jeopardize the security of confidential information stored on CrystalTechs systems, misappropriate proprietary information or cause interruptions in CrystalTechs operations. We may be required to make significant additional investments and efforts to protect against or remedy security breaches. Security breaches that result in access to confidential information could damage our reputation and expose us to a risk of loss or liability. The security services that CrystalTech offers in connection with customers networks cannot assure complete protection from computer viruses, break-ins and other disruptive problems. The occurrence of these problems may result in claims against CrystalTech or us or liability on our part. These claims, regardless of their ultimate outcome, could result in costly litigation and could harm our business and reputation and impair CrystalTechs ability to attract and retain customers.
Our business depends on Microsoft Corporation and others for the licenses to use software as well as other intellectual property in the website hosting business.
CrystalTechs website hosting business is built on a technological platform relying on the Microsoft Windows® products and other intellectual property that CrystalTech currently licenses. As a result, if we are unable to continue to have the benefit of those licensing arrangements or if the products upon which CrystalTechs platform is built become obsolete, our business could be materially and adversely affected.
We depend on the services of a few key personnel in managing our website hosting business, and the loss of one or more of them could materially impair our ability to maintain current levels of customer service and the proper technical operations of our business.
We depend upon the continued management of the operations of CrystalTechs website hosting business by its President and Chief Operating Officer, along with three or four other individuals to supervise CrystalTechs technical operations and the customer technical service response. If we were to lose the services of one or more of these persons and were unable to replace them expeditiously, our website hosting business could be significantly diminished.
RISKS RELATING TO OUR SBA LENDING BUSINESS
We may be adversely affected by the regulated environment in which we operate.
The activities of our SBA lending business are subject to the supervision and regulation by the federal government, and to a lesser degree, the state governments, as well as various laws and judicial and administrative decisions. Our possible inability to remain in compliance with these multiple requirements could result in the revocation or suspension of our license or the imposition of fines and penalties.
We have specific risks associated with small business administration loans.
We have generally sold the guaranteed portion of SBA loans in the secondary market. Such sales have resulted in our earning premiums and creating a stream of servicing income. There can be no assurance that we will be able to continue originating these loans, or that a secondary market will exist for, or that we will continue to realize premiums upon the sale of the guaranteed portions of the SBA loans. In addition, we have experienced a decline in premiums received; there can be no assurance that premiums will remain at the current levels.
Since we sell the guaranteed portion of substantially our entire SBA loan portfolio, we incur credit risk on the non-guaranteed portion of the SBA loans. We share pro rata with the SBA in any recoveries. In the event of default on an SBA loan, our pursuit of remedies against a borrower is subject to SBA approval, and where the SBA establishes that its loss is attributable to deficiencies in the manner in which the loan application has been prepared and submitted, the SBA may decline to honor its guarantee with respect to our SBA loans or it may seek the recovery of damages from us. If we should experience significant problems with our underwriting of SBA loans, such failure to honor a guarantee or the cost to correct the problems could have a material adverse effect on us. Although the SBA has never declined to honor its guarantees with respect to SBA loans made by us since our acquisition of the lender, no assurance can be given that the SBA would not attempt to do so in the future.
Curtailment of the government-guaranteed loan programs could cut off an important segment of our business.
There can be no assurance that the federal government will maintain the SBA program, or that it will continue to guarantee loans at current levels. If we cannot continue making and selling government-guaranteed loans, we will generate fewer origination fees and our ability to generate gains on sale of loans will decrease. From time-to-time, the government agencies that guarantee these loans reach their internal budgeted limits and cease to guarantee loans for a stated time period. In addition, these agencies may change their rules for loans. Also, Congress may adopt legislation that would have the effect of discontinuing or changing the programs. Non-governmental programs could replace government programs for some borrowers, but the terms might not be equally acceptable. If these changes occur, the volume of loans to small business and industrial borrowers of the types that now qualify for government-guaranteed loans could decline, as could the profitability of these loans.
Changing interest rates may reduce our income from lending.
Fluctuations in general economic conditions and in interest rates may affect customer demand for our loans and other products and services as well as the performance of our existing loan portfolio. Our lending business may increase during times of falling interest rates and, conversely, decrease during times of significantly higher interest rates. Significant fluctuations in interest rates and loan demand could have a potentially adverse effect on our results of operations and cash flows.
An increase in non-performing assets would reduce our income and increase our expenses.
If our level of non-performing assets in our SBA lending business rises in the future, it could adversely affect our revenue and earnings. Non-performing assets are primarily loans on which borrowers are not making their required payments. Non-performing assets also include loans that have been restructured to permit the borrower to have smaller payments and real estate that has been acquired through foreclosure of unpaid loans. To the extent that our loan assets are non-performing, we will have less cash available for lending and other activities.
Our reserve for credit losses may not be sufficient to cover unexpected losses.
Our business depends on the behavior of our customers. In addition to our credit practices and procedures we maintain a reserve for credit losses on our SBA loans which management has judged to be adequate given the loans we originate. We periodically review our reserve for adequacy considering current economic conditions and trends, collateral values, charge-off experience, levels of past due loans and non-performing assets and adjust our reserve accordingly. However, based on the increased volume in recent originated loans, along with changes in the credit quality of our customers, our reserves could materially be impacted thus affecting our financial condition and results of operations.
We compete with numerous financing sources.
We compete for our customers primarily on the basis of pricing, terms and service. Competition from both traditional lenders and new entrants is intense due to the recent strong economy and the ease with which the securitization process has increased the access to capital. While we have attempted to utilize our referral system as a means of obtaining customers at a low cost and processing the applications efficiently, there can be no assurance that we will be able to match the terms of our competitors without incurring losses. In addition, due to our relatively small size and capitalization, our larger competitors may be able to originate loans when we are not due to our dependence on external warehouse financing.
We could be adversely affected by weakness in the residential housing market.
Weakness in residential home values could impair our ability to collect on defaulted SBA loans as residential real estate is pledged in many of our SBA loans as part of the collateral package.
RISKS RELATING TO OUR INSURANCE AGENCY BUSINESS
We cannot assure that the insurance services we offer will be price competitive or accepted by our customers.
Despite our efforts to design, market and deliver integrated services to our customers, our proposed insurance services may not be widely accepted and we may not be able to compete with other larger and better capitalized providers of such services.
We depend on third parties, particularly property and casualty insurance companies, to supply the products marketed by our agents.
Our contracts with property and casualty insurance companies typically provide that the contracts can be terminated by the supplier without cause. Our inability to enter into satisfactory arrangements with these suppliers or the loss of these relationships for any reason would adversely affect the results of our new insurance business.
Termination of our professional liability insurance policy may adversely impact our financial prospects and our ability to continue our relationships with insurance companies.
We must maintain professional liability insurance in connection with the operation of this business. If we lose this insurance, it is unlikely that our relationships with insurance companies would continue.
If we fail to comply with government regulations, our insurance agency business could be adversely affected.
Our insurance agency business is subject to comprehensive regulation in the various states in which we plan to conduct business. Our success will depend in part upon our ability to satisfy these regulations and to obtain and maintain all required licenses and permits. Our failure to comply with any statutes and regulations could have a material adverse effect on us. Furthermore, the adoption of additional statutes and regulations, changes in the interpretation and enforcement of current statutes and regulations or the expansion of our business into jurisdictions that have adopted more stringent regulatory requirements than those in which we currently conduct business could have a material adverse effect on us.
We do not have any control over the commissions our insurance agency expects to earn on the sale of insurance products which are based on premiums and commission rates set by insurers and the conditions prevalent in the insurance market.
Our insurance agency earns commissions on the sale of insurance products. Commission rates and premiums can change based on the prevailing economic and competitive factors that affect insurance underwriters. In addition, the insurance industry has been characterized by periods of intense price competition due to excessive underwriting capacity and periods of favorable premium levels due to shortages of capacity. We cannot predict the timing or extent of future changes in commission rates or premiums or the effect any of these changes will have on the operations of our insurance agency.
RISKS RELATED TO OUR CAPCO BUSINESS
The Capco programs and the tax credits they provide are created by state legislation and implemented through regulation, and such laws and rules are subject to possible action to repeal or retroactively revise the programs for political, economic or other reasons. Such an attempted repeal or revision would create substantial difficulty for the Capco programs and could, if ultimately successful, cause us material financial harm.
The tax credits associated with the Capco programs and provided to our Capcos investors are to be utilized by the investors over a period of time, which is typically ten years. Much can change during such a period and it is possible that one or more states may revise or eliminate the tax credits. Any such revision or repeal could have a material adverse economic impact on our Capcos, either directly or as a result of the Capcos insurers actions. During 2002 a single legislator in Louisiana did introduce such a proposed bill, on which no action was taken, and in Colorado in 2003 and 2004 bills to modify (not repeal) its Capco program were introduced; the 2003 Colorado legislation was defeated in a legislative committee. The 2004 Colorado legislation was adopted and as a result, in 2004 our Colorado Capco initiated a lawsuit regarding some of the provisions of these amendments and the implementing regulations which we believe increased the cost of doing business by the Capco, but would have no further material effects. We reached a settlement with the State of Colorado in 2006 after incurring expenses in connection with such action. There can be no assurance that we will not be subject to further legislative or regulatory action which might adversely impact our Capco business, or that we will be able to successfully challenge any such action.
Because our Capcos are subject to requirements under state law, a failure of any of them to meet these requirements could subject the Capco and our shareholders to the loss of one or more Capcos.
Involuntary decertification of all or substantially all of our Capcos would result in a material loss to us and our shareholders. A final involuntary loss of Capco status, referred to as a decertification as a Capco, will result in a loss of the tax credits for us and our insurance company investors. It would also enable the Capco insurer, which has the obligation to make compensatory payments to offset the lost tax credits, to take control of one or more Capcos and manage or liquidate the Capco investments to offset its losses. This would deprive us of the value of the investments and make participation in future Capco programs highly unlikely.
In the event of a threat of decertification by a state, the Capco insurer is authorized to assume partial or complete control of a Capco which would likely result in financial loss to the Capco and possibly us and our shareholders.
Under the terms of insurance policies purchased by all but one of our Capcos for the benefit of the investors, the Capco insurer is authorized, in the event of a formal written threat of decertification by a state and absent appropriate corrective action by the Capco, to assume partial or complete control of a Capco in order to avoid final decertification and the requirement to pay compensatory interest to the certified investors under the policies. While avoiding final decertification, control by the insurer would result in significant disruption of the Capcos business and likely result in financial loss to the Capco and our business.
RISKS RELATING TO OUR COMMON SHARES
Two of our shareholders, one of whom is an executive officer, beneficially own approximately 27% of our common shares, and are able to exercise significant influence over the outcome of most shareholder actions.
Because of their ownership of our shares, Messrs. Sloane and Rubin will be able to have significant influence over actions requiring shareholder approval, including the election of directors, the adoption of amendments to the certificate of incorporation, approval of stock incentive plans and approval of major transactions such as a merger or sale of assets. This could delay or prevent a change in control of our company, deprive our shareholders of an opportunity to receive a premium for their common shares as part of a change in control and have a negative effect on the market price of our common shares.
Future issuances of our common shares or other securities, including preferred shares, may dilute the per share book value of our common shares or have other adverse consequences to our common shareholders.
Our board of directors has the authority, without the action or vote of our shareholders, to issue all or part of the approximately 19,000,000 authorized but unissued shares of our common stock. Our business strategy relies upon investment in and acquisition of businesses using the resources available to us, including our common shares. We have made acquisitions during each of the years from 2002 to 2005 involving the issuance of our common shares, and we expect to make additional acquisitions in the future using our common shares. Additionally, we anticipate granting additional options or restricted stock awards to our employees and directors in the future. We may also issue additional securities, through public or private offerings, in order to raise capital to support our growth, including in connection with possible acquisitions or in connection with purchases of minority interests in affiliated companies or Capcos. Future issuances of our common shares will dilute the percentage of ownership interest of current shareholders and could decrease the per share book value of our common shares. In addition, option holders may exercise their options at a time when we would otherwise be able to obtain additional equity capital on more favorable terms.
Pursuant to our certificate of incorporation, our board of directors is authorized to issue, without action or vote of our shareholders, up to 1,000,000 shares of blank check preferred shares, meaning that our board of directors may, in its
discretion, cause the issuance of one or more series of preferred shares and fix the designations, preferences, powers and relative participating, optional and other rights, qualifications, limitations and restrictions thereof, including the dividend rate, conversion rights, voting rights, redemption rights and liquidation preference, and to fix the number of shares to be included in any such series. The preferred shares so issued may rank superior to the common shares with respect to the payment of dividends or amounts upon liquidation, dissolution or winding-up, or both. In addition, the shares of preferred stock may have class or series voting rights.
The authorization and issuance of blank check preferred shares could have an anti-takeover effect detrimental to the interests of our shareholders.
Our certificate of incorporation allows our board of directors to issue preferred shares with rights and preferences set by the board without further shareholder approval. The issuance of shares of this blank check preferred shares could have an anti-takeover effect detrimental to the interests of our shareholders. For example, in the event of a hostile takeover attempt, it may be possible for management and the board to impede the attempt by issuing the preferred shares, thereby diluting or impairing the voting power of the other outstanding common shares and increasing the potential costs to acquire control of us. Our board has the right to issue any new shares, including preferred shares, without first offering them to the holders of common shares, as they have no preemptive rights.
We have adopted a classified board of directors that could have an anti-takeover effect detrimental to the interests of our shareholders.
In 2006, our shareholders approved an amendment to the Companys amended and restated certificate of incorporation to provide for the classification of the Board of Directors into three classes. This makes removal of current management and members of the Board more difficult. It could also have the effect of deterring potential interested parties from initiating proxy contests or from acquiring substantial blocks of our common shares.
We know of no other publicly-held company that sponsors and operates Capcos as a material part of its business. As such, there are, to our knowledge, no other companies against which investors may compare our Capco business, operations, results of operations and financial and accounting structures.
In the absence of any meaningful peer group comparisons for our Capco business, investors may have a difficult time understanding and judging the strength of our business. This, in turn, may have a depressing effect on the value of our shares.
Provisions of our certificate of incorporation and New York law place restrictions on our shareholders ability to recover from our directors.
As permitted by New York law, our amended and restated certificate of incorporation limits the liability of our directors for monetary damages for breach of a directors fiduciary duty except for liability in certain instances. As a result of these provisions and New York law, shareholders have restrictions and limitations upon their rights to recover from directors for breaches of their duties. In addition, our certificate of incorporation provides that we must indemnify our directors and officers to the fullest extent permitted by law.
We conduct our principal business activities in facilities leased from unrelated parties at market rates. Our headquarters are located in New York, New York. Our operating subsidiaries have properties which are material to the conduct of their business as noted below. In addition, our Capcos maintain offices in each of the states in which they operate.
Below is a list of our leased offices and space as of December 31, 2007 which are material to the conduct of our business:
We believe that our leased facilities are adequate to meet our current needs and that additional facilities are available to meet our development and expansion needs in existing and projected target markets.
We are not involved in any material pending litigation.
(a) Market Information: Our common stock is traded on the NASDAQ National Stock Market under the symbol NEWT. High and low prices for the common stock over the previous two years are set forth below, based on the highest and lowest trading price during that period.
(b) Holders: As of March 24, 2008 there were approximately 248 holders of record of the common shares of Newtek.
(c) Dividends: We have never declared or paid any cash or stock dividends on our common stock. We do not anticipate paying any cash or stock dividends on our common stock in the foreseeable future. We currently intend to retain future earnings, if any, to finance our operations and to expand our business. Any future determination to pay cash and stock dividends will be at the discretion of our board of directors and will be dependent upon our financial condition, operating results, capital requirements and other factors that our board of directors considers appropriate
(d) Securities Authorized for Issuance Under Equity Compensation Plans:
During the year ended December 31, 2007, we issued 125,002 shares of restricted securities, valued at $196,500, to our independent directors as compensation for directors fees. These issuances were exempt from registration under the Securities Act in reliance on Section 4(2) of the Securities Act.
The following chart and graph, which were prepared by management, compare the cumulative total return on our Common Shares over a measurement period beginning December 31, 2002 with (i) the cumulative total return on the securities included in the Russell 3000 Index and (ii) the cumulative total return on the stock of a company we have determined provides a peer comparison, CBIZ, Inc. (CBIZ). All of these cumulative returns are computed assuming the quarterly reinvestment of dividends paid during the applicable time period.
We have used CBIZ as a peer comparison due to the fact that it is approximately the same in market capitalization and provides a variety of services to small and medium-sized businesses. However, as we are the only publicly traded company with a material portion of our business in the operation of certified capital companies, it may not be possible to make a direct comparison of us to any other company.
The following selected statements of operations and balance sheet data have been derived from the audited financial statements for each of the five years ended December 31, 2007. The Consolidated Financial Statements for the years ended December 31, 2007 and 2006 have been audited by J.H. Cohn LLP, and the Consolidated Financial Statements for the three years ended December 31, 2005 have been audited by PricewaterhouseCoopers LLP, both independent registered public accounting firms. The comparability of the information below is affected by the acquisitions of CrystalTech Web Hosting, Inc. (CrystalTech) in July 2004, and Vistar Insurance Agency, Inc., (Vistar or Keyosk) in July 2004. The selected financial data set forth below should be read in conjunction with, and is qualified by reference to, Managements Discussion and Analysis of Financial Condition and Results of Operations and our Consolidated Financial Statements, including the Notes thereto, appearing elsewhere in this report.
Introduction and Certain Cautionary Statements
The following discussion and analysis of our financial condition and results of operations is intended to assist in the understanding and assessment of significant changes and trends related to the results of operations and financial position of the Company together with its subsidiaries. This discussion and analysis should be read in conjunction with the consolidated financial statements and the accompanying notes.
The statements in this Annual Report may contain forward-looking statements relating to such matters as anticipated future financial performance, business prospects, legislative developments and similar matters. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. In order to comply with the terms of the safe harbor, we note that a variety of factors could cause our actual results to differ materially from the anticipated results expressed in the forward looking statements such as intensified competition and/or operating problems in its operating business projects and their impact on revenues and profit margins or additional factors as described in Newtek Business Services previously filed registration statements.
We also need to point out that our Capcos operate under a different set of rules in each of the eight jurisdictions and that these place varying requirements on the structure of our investments. In some cases, particularly in Louisiana, we dont control the equity or management of a qualified business but that cannot always be presented orally or in written presentations.
We are a direct distributor of business services to the small and medium-sized business market. Our target market represents a very significant marketplace in the United States GDP. According to statistics published by the U.S. Small Business Administration, approximately 51% of the GDP and private sector employment in the United States comes from small businesses and 99% of businesses in the United States which have one or more employees fit into this market segment. As of December 31, 2007, we had over 87,000 business accounts. We use state-of-the-art web-based proprietary technology to be a low cost acquirer and provider of products and services to our small-and medium- size business clients. We partner with AIG, Merrill Lynch, Morgan Stanley, the Credit Union National Association with its 8,700 credit unions and 80 million members, Navy Federal Credit Union with 2.7 million members, PSCU Financial Services, Inc., the nations largest credit union service organization, Fiserv Solutions, Inc. d/b/a IntegraSys, General Motors Minority Dealers Association and Daimler Chrysler Minority Dealers Association, all of whom have elected to offer certain of our business services and financial products rather than provide some or all of them directly for their customers. We have deemphasized our Capco business in favor of growing our operating businesses and do not anticipate creating any new Capcos in the foreseeable future.
We have reported on our balance sheet at December 31, 2007 $38 million in aggregate of cash and cash equivalents and restricted cash, $77 million in shareholders equity, and $2.13 in net book value per share. Total assets were $218 million and total liabilities $136 million, a decline of $23 million and $13 million from 2006, respectively. Our shareholders equity, which grew significantly from $27 million in 2002 to $87 million in 2006, declined to $77 million in 2007 reflecting our net loss of $11 million for 2007.
Over 50% of our net loss was primarily due to the non-cash loss attributable to our Capcos. The remaining loss reflects increased expenses associated with corporate activities primarily related to salaries and benefits, losses in our All Other segment, and the reduction in earnings in our three business service segments. Electronic payment processing incurred an estimated loss provision related to a charge-back for a single merchant, Web hosting incurred increased rent and electricity in connection with a move to a larger server facility as well as increased payroll expenses, and SBA lending sold fewer loans held for investment while experiencing a material decrease in the pricing of the premium received and servicing income created upon NSBFs sale of guaranteed portions of loans because of marketplace conditions.
As we continue to transition out of our Capco-dominated business model, our focus is on building the core businesses which provide services to small and medium- sized business customers and reducing the non-core businesses (including Capco). Our client base is growing rapidly and, importantly, the proportion of our non-tax-credit revenue is growing significantly year after year. Revenue from our three business service segments (Electronic payment processing, Web hosting and SBA lending) totaled $80.3 million in 2007, a 20% increase as compared with $66.7 million in 2006 which in turn was a 23% increase as compared with $54.1 million in 2005. These segments represented 87% of total revenue in 2007, 76% in 2006 and 56% in 2005. Our three major operating segments earned $5.5 million in 2007, a decrease of 22% from $7.0 million in 2006 which was a 21% increase as compared with $5.8 million in 2005.
In 2007, we prepaid the remaining $1.0 million of the $8.0 million note payable to Technology Investment Capital Corp. (TICC), which was incurred in 2005 in conjunction with the purchase of CrystalTech Web Hosting, Inc. In addition, we repaid approximately $4.8 million in 2007 of the AI Credit debt incurred in connection with the financing of our Capco activities. The remaining principal of $732,000 will be repaid in 2008. These decreases in notes payable were offset by increases in bank notes payable, our credit lines from GE, North Fork, and Wells Fargo described below, of approximately $5.7 million.
Results of Operations
Consistent with managements focus, the revenue and expenses from the consolidated operating entities, specifically revenues related to the Electronic payment processing, Web hosting and SBA lending segments, continue to increase as a percentage of revenue, with a correlating decrease in revenues from Capco-related tax credits. The following table sets forth certain data from our statements of operations, expressed as a percentage of total revenues, for each of the periods presented.
Comparison of the years ended December 31, 2007 and December 31, 2006
Revenue and expenses which are specific to a segment are discussed in Segment Results, which follows. Electronic payment processing revenue and electronic payment processing costs are included in the Electronic Payment Processing segment. Web hosting revenue is included in the Web hosting segment. Premium income revenue, servicing fee revenue and provision for loan losses expense are included in the SBA Lending segment. Income from tax credits revenue is included in the Capco segment.
Total revenues increased by $4,930,000, or 5.6%, to $92,835,000 for the year ended December 31, 2007, from $87,905,000 for the year ended December 31, 2006 primarily due to the increase in revenues in the Electronic payment processing, Web hosting and All Other segments of $11,376,000, $2,627,000 and $1,422,000, respectively, offset by the decrease in Capco non-cash revenues of $10,293,000.
Interest income is generated from SBA lending activities, excess cash balances that are invested in money market accounts, U.S. Treasury Notes, federal government-backed securities, mutual funds, non-cash accretions of structured
insurance product and on held-to-maturity investments. The following table details the changes in these different forms of interest. The overall decrease in interest income is due mainly to a decrease in invested cash balances and qualified investments from 2006 to 2007:
Other income increased by $2,186,000, or 66%, to $5,500,000 for the year ended December 31, 2007 from $3,314,000 for the year ended December 31, 2006 principally due to the consolidation of CDS Business Services, Inc. (CDS) during 2007:
In 2007 other income consisted primarily of a gain on the sale/recoveries of investments in qualified businesses of $1,112,000, equity earnings on an investment of $357,000, NSBF recoveries and lender-related fees of $718,000 and the consolidation of CDS, which produced revenues of $2,166,000 during 2007 (we invested in CDS in January 2007). The remaining balance of $1,047,000 consisted of operating revenues from companies that are included in the All Other segment (excluding insurance commissions), other miscellaneous income, and $100,000 of an employee incentive credit received by our Texas qualified businesses.
In 2006, other income consisted primarily of a gain on the sale of an investment held by one of our Capcos of $1,706,000, equity earnings on an investment of $128,000, NSBF recoveries and lender related fees of $745,000 and miscellaneous income and operating revenues (excluding insurance commissions) from companies that are included in the All Other segment.
Salaries and benefits increased by $5,307,000, or 31%, to $22,293,000 for the year ended December 31, 2007 from $16,986,000 for the year ended December 31, 2006. This increase was primarily due to the addition of personnel to our customer service, web hosting, and sales support teams, and an increase in corporate staff. Corporate staff provides coordinated sales and marketing, IT, finance and legal support for the Company and its subsidiaries. These increases enabled the Company to continue to implement its business model and better integrate its operations. The increase also reflects the consolidation of CDS which occurred in January 2007.
Changes in interest expense by segment are summarized as follows for the year ended December 31:
The decrease in Web hosting interest expense is due to the decrease in the average outstanding balance on the TICC debt from $3,792,000 in 2006 to $833,000 in 2007. TICC was paid off in full in September 2007. The decrease in SBA lender interest expense is attributable to the decrease in the average outstanding lines of credit from $21,096,000 during the year ended December 31, 2006 to $19,146,000 for the year ended December 31, 2007. Additionally, in December 2006, GE and NSBF entered into a Second Amendment to its credit line, dropping the line from $75,000,000 to $50,000,000 and reducing the interest rate by 25 basis points. The decrease in Capco interest expense relates to the decrease in the principal outstanding on the notes payable to AI Credit from $5,519,000 as of December 31, 2006 to $732,000 as of December 31, 2007. In addition, the non-cash interest accretion decreased by $1,225,000 and will continue to decrease each year. The All Other interest expense in 2007 represents interest expense generated by CDS on the Wells Fargo line of credit. We invested in CDS in January 2007.
Professional fees increased by $1,628,000, or 26%, to $7,930,000 for the year ended December 31, 2007 from $6,302,000 for the year ended December 31, 2006 primarily due to an increase in residual payments to independent sales agents and offices, offset by a decrease in audit and consulting fees. The increase in residual payments to independent sales agents and offices is a result of the Companys increased organic sales growth in the Electronic payment processing segment.
Depreciation and amortization expense increased by $1,212,000, or 20%, to $7,360,000 for the year ended December 31, 2007 from $6,148,000 for the year ended December 31, 2006. This is due to the purchase of $3,850,000 of fixed assets (primarily website hosting servers in the Web hosting segment) during the year ended December 31, 2007.
Other general and administrative costs (consisting of occupancy, selling, general and administrative) increased by $1,808,000, or 16%, to $12,794,000 for the year ended December 31, 2007 from $10,986,000 for the year ended December 31, 2006. The increase in overall other general and administrative costs reflects the Companys investment in infrastructure to develop its business operations and primarily relates to the costs associated with the move to a larger data center to support growth at CrystalTech, to the addition of CDS (which added other general and administrative costs of $736,000 for 2007), and to additional expenses incurred in connection with the growth of our business including employee head count.
The Companys effective tax rate from continuing operations was 36% in 2007 and 18.1% in 2006. The 2007 state and local tax rate, net of federal benefit, was 5.6% in 2007 and 4.6% in 2006. In 2007, the Company reduced its deferred tax benefit by a $270,000 provision due to losses from subsidiaries that are not part of the consolidated tax group, goodwill impairment and an adjustment to the prior year NOL for a permanent difference. In addition, the Company recorded a $396,000 provision due to an increase in the deferred tax asset valuation. In 2006, the Company reduced its benefit by a $780,000 provision due to the inability to utilize losses from two of our subsidiaries that do not file as part of the consolidated group.
Net loss increased by $9,099,000, or 429%, to $11,219,000 for the year ended December 31, 2007 from $2,120,000 for the year ended December 31, 2006, due an increase in total expenses of $18,805,000, a decrease in minority interest of $20,000, and a decrease in discontinued operations of $998,000, offset by an increase in revenues of $4,930,000 and an increase in the benefit for income taxes of $5,794,000.
Comparison of the years ended December 31, 2006 and December 31, 2005
Total revenues decreased by $7,965,000, or 8%, to $87,905,000 for the year ended December 31, 2006, from $95,870,000 for the year ended December 31, 2005, predominately due to the decline in Capco revenues, or income from tax credits, as discussed below.
Interest is generated from SBA lending activities, excess cash balances that are invested in money market accounts, U.S. Treasury notes, federal government backed securities mutual funds, non-cash accretions on the structured insurance product, and on held-to-maturity investments. The following table details the changes in these different forms of interest income:
The increase generated from Treasury and other investments is attributable to an increase in the average outstanding balances in cash and cash equivalents, US Treasury Notes and Short term investments during 2006, and increased interest rates (generally a 1-2% increase) on interest bearing accounts for the year ended December 31, 2006 as compared to the prior year.
Insurance commissions decreased by $287,000, or 24%, to $916,000 for the year ended December 31, 2006 from $1,203,000 for the year ended December 31, 2005. The difference is due to the Company earning commissions from two large insurance policies in 2005 versus 2006.
Other income decreased by $1,726,000, or 34%, to $3,314,000 for the year ended December 31, 2006 from $5,040,000 for the year ended December 31, 2005. In 2006, other income was mainly comprised of a gain on the sale of an investment held by one of our Capcos of $1,706,000, and miscellaneous income and operating revenues (excluding insurance commissions) from companies that are included in the All Other segment. In 2005, other income was primarily comprised of equity earnings of $993,000 in an investment, a $700,000 settlement from Citibank for the early termination of our contract with them, a $900,000 recovery of a Capco investment, and the balance relating to miscellaneous income and operating revenues (excluding insurance commissions) from companies that are included in the All Other segment.
Salaries and benefits increased by $802,000 to $16,986,000 for the year ended December 31, 2006 from $16,184,000 for the year ended December 31, 2005. The increase was primarily due to the increased employee headcount from 360 to approximately 382 employees.
Changes in interest expense are summarized as follows:
The increase in Capco interest expense in 2006 relates to the two new Capcos formed in June and December 2005 (WTX1 and WNYV), which had a full year of expense in 2006, compared to a partial year in 2005. The increase in SBA lender interest expense is attributable to the increase in the Prime rate as well as an increase in the lending rate. Under the previous lines of credit with Deutsche Bank and Banco Popular, NSBFs lending rate was Prime minus 50 basis points and Prime, respectively. Under the Line of Credit Agreement with GE, the weighted average lending rate is Prime plus 58 basis points or Base LIBOR plus 283 basis points. These increases were offset by the decrease in the average outstanding lines of credit from $30,236,000 during the year ended December 31, 2005 to $21,096,000 for the year ended December 31, 2006. The decrease in other interest expense was due to the Company paying down approximately $3,731,000 of its notes payable AI Credit, and prepaying $7,000,000 of the note payable TICC.
Professional fees decreased by $1,500,000, or 19%, to $6,302,000 for the year ended December 31, 2006, from $7,802,000 for the year ended December 31, 2005. This decrease is primarily attributable to a decrease in audit and consulting fees in 2006.
Depreciation and amortization expense increased by approximately $1,640,000, or 36%, to $6,148,000 for the year ended December 31, 2006 from $4,508,000 for the year ended December 31, 2005. This is due to the acquisition of customer accounts and purchase of fixed assets in 2006 compared to 2005.
Insurance expense increased by $199,000, or 6%, to $3,316,000 for the year ended December 31, 2006, from $3,117,000 for the year ended December 31, 2005. This increase is due to the additional insurance relating to the two new Capcos in 2005 (Wilshire Texas Partners I, LLC, and Wilshire New York Partners, V, LLC), which had a full year of insurance expense amortization in 2006 compared to a partial year in 2005.
Provision for loan losses decreased by $1,853,000, or 82%, to $405,000 for the year ended December 31, 2006 from $2,258,000 for the year ended December 31, 2005. This large differential was attributable to management recording an additional $900,000 in reserves in 2005, of which $300,000 was associated with hurricane Katrina. The $300,000 reserve was established to cover known and probable future losses due to business interruptions and material property losses, as well as indirect economic effects outside of the hurricane region which could result in decreases in revenue to some of our other borrowers. The remaining $600,000 reserve was established due to then current economic conditions, specifically the rising interest rate environment and the high price of oil and gas, in addition to the potential economic impact to those small businesses in Louisiana, Alabama, Mississippi and other parts of the country that were not directly impacted by the storm as addressed in the reserves above. Consideration in this evaluation included past and then current loss experience, then current portfolio composition and the evaluation of real estate collateral as well as economic conditions in 2005. Management believed that such additional reserves would be adequate to absorb probable loan losses inherent in the Companys entire loan portfolio at December 31, 2005. Additionally, NSBFs charge-offs, in both the acquired CCC portfolio as well as newly originated loans, were significantly higher in 2005 ($1,914,000) as compared with 2006 ($465,000) due to the completion of the liquidation process on certain loans from the acquired CCC portfolio and unexpected credit events from the acquired portfolio and newly originated loans. These factors required management to establish an additional provision in order to maintain its allowance for loan losses at a level which management believed adequately covered inherent losses in the existing loan portfolio.
Managements ongoing estimates of the allowance for loan losses are particularly affected by the changing composition of the loan portfolio over the last few years. The loans acquired from Commercial Capital Corp. (CCC) in December 2002, which are more seasoned than those originated by NSBF, comprise 17% of total loans held for investment as of December 31, 2006. Other portfolio characteristics, such as industry concentrations and loan collateral, which also impacts managements estimates of the allowance for loan losses, have also changed since the acquisition. The changing nature of the portfolio and the limited past loss experience on the newly originated portfolio has resulted in managements estimates of the allowance for loan losses being based more on subjective factors and less on empirically derived loss rates. Such estimates could differ from actual results, which may have a material effect on the Companys results of operations or financial condition.
Other than temporary decline in value of investments decreased by $395,000, or 100%, to $0 for the year ended December 31, 2006, from $395,000 for the year ended December 31, 2005, due to the Companys determination that a greater amount of its investment values were impaired in 2005 versus no impairments in 2006. During the year ended December 31, 2005, Newtek determined that there was $200,000 of an other than temporary decline in the value of one if its equity investments, $177,000 for a debt investment and $18,000 for smaller cost method equity investment from one of our investment Bidcos in Louisiana.
Other general and administrative costs (consisting of occupancy, selling, general and administrative) increased by $2,360,000, or 27%, to $10,986,000 for the year ended December 31, 2006 from $8,626,000 for the year ended December 31, 2005. The increase in overall other expenses relates to additional expenses incurred in connection with the growth of our business and head count.
Income from discontinued operations, net of tax, increased by $202,000, or 66%, to $508,000 in 2006 from $306,000 in 2005. Discontinued operations are related to Phoenix Development Group, LLC, a Capco investment made during the fourth quarter of 2005 which provided services to and reconstruction of New Orleans, primarily in the form of temporary housing and related services. Total revenues increased by $1,325,000, or 143%, to $2,254,000 from $929,000 for the year ended December 31, 2005. This was offset by an increase in total expenses of $1,042,000, to $1,359,000 in 2006 from $318,000 in 2005, an increase in minority interest by $28,000, to $89,000 in 2006 from $61,000 in 2005, and an increase in the provision for income taxes of $77,000, to $322,000 in 2006 from $244,000 in 2005. These changes are due to the fact that Phoenix Development Group, LLC was in existence for a full year in 2006, versus a partial year in 2005.
The Companys effective tax rate from continuing operations decreased to 18.1% in 2006 from 46.9% in 2005. The 2006 state and local tax rate, net of federal benefit, decreased to 4.6% in 2006 from 8.9% in 2005. In 2006, the Company reduced its benefit by a $780,000 provision due to the inability to utilize losses from two of our subsidiaries that do not file as part of the consolidated group, as compared to a $299,000 provision due to goodwill impairment and a $324,000 provision due to an increase in a deferred tax asset valuation.
Net income decreased by $9,847,000, to a net loss of $2,120,000 for the year ended December 31, 2006, compared to net income of $7,727,000 for the year ended December 31, 2005, due to the decrease in revenue of $7,965,000, offset by an increase in total expenses of $8,856,000, and a decrease in minority interest of $357,000, offset by a decrease in the tax provision of $7,129,000 and an increase in discontinued operations of $202,000.
The results of the Companys reportable segments are discussed below.
Electronic Payment Processing
Revenues increased by $11,376,000, or 26%, to $54,969,000 due to an increase in electronic payment processing revenue; interest and other income were flat year-over-year. This consisted of $10,837,000 from organic growth and $539,000 in revenue from merchant portfolios that were acquired, both net of attrition. The growth in 2007 organic revenue was from a combination of increased number of merchants, additional processed sales volume, and additional processed transactions against 2006: our average number of merchants for 2007 increased by 1,097, or 15%, to 8,387 from 7,290 for 2006; total processed MasterCard®/Visa® volume for all of our merchants increased $385.0, million or 28%, to $1.8 billion from $1.4 billion; and total processed transactions, including MasterCard®/Visa®, increased 5.4 million transactions, or 37%, to 20.0 million transactions during 2007 from 14.6 million transactions during 2006.
Expenses increased by $11,960,000, or 29%, to $52,607,000. Electronic payment processing costs increased $10,239,000, or 33%, to $41,363,000. The increase in electronic payment processing costs included a $1,800,000 estimated loss provision related to a charge-back for a single merchant; excluding the impact of this loss, electronic payment processing costs would have increased 27% over 2006. The slightly greater percentage increase in electronic payment processing costs versus percentage increase in revenue reflects the addition of several higher volume, lower margin merchants in 2007. The remaining increase in expenses primarily reflect a $1,125,000, or 33%, increase in professional fees principally due to residual expenses paid to independent merchant referral sources, a $494,000, or 33%, increase in depreciation and amortization due to the amortization of portfolio acquisitions, and a $136,000, or 4%, increase in salaries and benefit costs.
Revenues increased by $10,840,000 to $43,593,000 due to a $12,213,000 increase in electronic payment processing revenue offset, in part, by a $1,373,000 decrease in interest and other income. The $12,213,000 increase in electronic payment processing revenue was due to an $11,777,000 increase in organic growth and $436,000 in revenue from merchant portfolios that were acquired. The decrease in other income was primarily due to insignificant income in 2006 as compared with $700,000 from Citibank for early termination of a contract with them and a $900,000 recovery of an investment in Merchant Data Systems.
Expenses increased by $10,110,000 to $40,647,000 due primarily to a $8,232,000 increase in electronic payment processing costs, a $935,000 increase in professional fees, a $482,000 increase in depreciation and amortization, and a $469,000 increase in payroll and benefit costs.
Revenue is derived primarily from monthly recurring fees from hosting dedicated and shared websites.
Revenue increased by $2,627,000, or 19%, to $16,237,000 due to organic growth of hosted websites. In 2007, CrystalTech improved website hosting performance for its customers by upgrading the architecture on its new servers to 64
bit from the previous 32 bit, introducing new dedicated plans offering Adobe ColdFusion for internet applications, offering new shared plans upgraded to .NET 3.5, and adding support for PHP 5 server scripting language to all shared plans. These service and plan enhancements were combined with promotions, including free setup fees and/or free additional months of service for new customers who prepay for a period of time ranging from two to 12 months, to help drive growth in sites and revenue during the year. The increase in revenue reflects that the years average of the month-end number of total websites increased 10,760 in 2007, or 20%, to 63,540 from 52,780 in 2006 while the average monthly revenue for dedicated and shared websites combined remained stable in 2007 as compared to 2006. The average number of dedicated websites, which generate a higher monthly fee versus shared websites, increased by 550 in 2007, or 38%, to an average of 2,010 per month from an average of 1,460 per month in 2006. The average number of shared websites increased 10,220, or 20%, to an average of 61,520 per month in 2007, from an average of 51,300 per month in 2006.
The $3,180,000 increase in expenses in 2007 as compared with 2006 was primarily due to a $690,000 increase in salaries and benefits, a $704,000 increase in depreciation and amortization, and a $2,269,000 increase in other expenses, offset, in part, by a $133,000 decrease in professional fees and a $381,000 decrease in interest expense due to lower borrowings and eventual pay off of debt from TICC during 2007. Other expenses increased primarily due to a $753,000 increase in additional software licenses required for additional servers, a $1,230,000 increase in rent and utilities due to the move of the primary office and the 2,000 square foot data center locations to larger spaces and due to the rental of temporary additional space for the overconsumption of space prior to the move of the data center location, a $154,000 increase in telephone and Internet costs mainly due to the added expense of maintaining connectivity between the old and the new data center locations during the transition in order to keep continuity of service and ease of transition for the customers, and a $34,000 increase in marketing costs. Salaries and benefits increased due to additional personnel added to service the increased customer base. Depreciation and amortization increased due to capital expenditures of approximately $2,757,000 primarily for additional website hosting servers.
The income before provision for income taxes decreased $553,000 in 2007 as compared to 2006, primarily due to the added rent and electricity expense for the new 5,000 square foot data center location required for growing operations. We do not expect to fully utilize this space in 2008.
The average number of total websites increased 30% to 52,780 in 2006, from 40,620 in 2005. The average number of dedicated websites, which generate a higher monthly fee, increased 87%, to 1,460 per month in 2006, from 780 in 2005. The average number of shared websites increased 29% to 51,300 per month in 2006, from 39,800 in 2005. The average monthly fee for both dedicated and shared websites decreased in 2006 as compared to 2005, due to competitive pressures.
The $2,813,000 increase in expenses in 2006 as compared with 2005 was primarily due to a $1,333,000 increase in salaries and benefits, a $657,000 increase in depreciation and amortization, and a $1,090,000 increase in other expenses, offset, in part, by a $195,000 decrease in interest expense due to lower borrowings from TICC during 2006. Salaries and benefits increased due to additional personnel added to service the increased customer base and to extend the hours of operation in customer service. Depreciation and amortization increased due to capital expenditures of approximately $2,900,000 primarily for additional servers. Other expenses increased primarily due to $567,000 in additional software required for additional servers, a $225,000 legal settlement, a $194,000 increase in rent and utilities and a $104,000 increase in marketing costs.
Revenue is derived primarily from premium income generated by the sale of the guaranteed and unguaranteed portions of SBA loans, interest income on SBA loans held for investment, servicing fee income on the guaranteed portions of
SBA loans previously sold, and servicing income for loans originated by other lenders for which NSBF is the servicer. Most SBA loans originated by NSBF charge an interest rate equal to the Prime rate plus an additional percentage amount; the interest rate will reset to the current Prime rate on a monthly or quarterly basis which will result in change to the amount of interest accrued for that month and going forward and a re-amortization of a loans payment amount until maturity.
Revenue decreased by $386,000 in 2007 as compared to 2006, primarily due to premium income declining $109,000, or 3.6%, to $2,914,000 for the year ended December 31, 2007 from $3,023,000 for the year ended December 31, 2006, a decrease in interest income of $266,000, or 7.0%, from $3,791,000 for the year ended December 31, 2006 to $3,525,000 for the year ended December 31, 2007, a decrease in other income of $27,000, or 3.6%, to $718,000 for the year ended December 31, 2007 from $745,000 for the year ended December 31, 2006, offset by an increase of $17,000, or 0.9%, in servicing fee income to $1,949,000 for the year ended December 31, 2007 from $1,932,000 for the year ended December 31, 2006.
The $109,000 decrease in premium income primarily reflects NSBFs decision to sell fewer of its loans held for investment in 2007 than it did in 2006. This resulted in a decline in premium income recognized on the sale loans previously classified as held for investment of $336,000. In the year ended December 31, 2007, NSBF sold $2,900,000 loans previously classified as held for investment for aggregate proceeds of $3,043,000 while in 2006 the Company sold $7,300,000 of loans previously classified as held for investment for aggregate proceeds of $7,650,000. The 2007 sales resulted in total premium recognized of $345,000 consisting of the received value above the carrying amount sold of $134,000 plus $211,000, representing the allocated portion of the remaining discount recorded at the time of loan origination. The 2006 sales resulted in total premium recognized of $681,000 consisting of the received value above the carrying amount sold of $326,000 plus $355,000 representing the allocated portion of the remaining discount recorded at the time of loan origination.
The decrease in premium income recognized on the sale loans previously classified as held for investment was partially offset by the $227,000 increase in premium income from the sale of guaranteed portions of loans to $2,570,000 in 2007 from $2,343,000 in 2006. The increase resulted from NSBF selling $4,800,000 more in guaranteed portions of loans in the year ended December 31, 2007, for a total of $34,300,000, as compared to $29,500,000 guaranteed portions of loans sold in the prior year. The increase in sale volume was offset by a decrease in the percentage of premium recognized on the sales; beginning in the third quarter of 2007 NSBF experienced a material reduction in the pricing of the guaranteed portion of SBA loans due to market conditions. The Company recognized an average premium on sale of 109.86% for 2006 and the first half of 2007 as compared with an average of 108.32% for the second half of 2007. Should the pricing remain at this level or decline it will continue to adversely affect revenues, and therefore the segments performance in the future.
Interest income decreased due to a slight decrease in the weighted average Prime rate for 2007 as compared with 2006 as well as a $3,000,000 average decrease in performing loan balances year over year. Such decrease in the performing portfolio is attributable to normal amortization as well as $7,300,000 of unguaranteed loan sales in June and August, 2006 and $2,900,000 of unguaranteed loan sales in June and December, 2007, offset by new loans booked in 2007.
The increase in servicing fee income related to SBA loans was attributable to the Company recognizing $210,000 in servicing fee income associated with the servicing of an SBA portfolio for a savings bank in New York. This increase was partially offset as a result of a decrease in the NSBF servicing portfolio year over year. The average NSBF portfolio in which we earned servicing fee income for the year ended December 31, 2007 was $133,900,000 compared with $144,900,000 for the year ended December 31, 2006. Beginning in the third quarter of 2007, NSBF experienced a reduction in the servicing retained on the guaranteed portion of SBA loans sold from an average of 1.23% for the first half of 2007 to an average of 1.0%, the minimum allowed by the SBA, for the second half of 2007. This reduction did not result in a material decrease in servicing fee income recognized on the guaranteed portion of SBA loans sold in 2007; however, it will negatively impact servicing fee income in the future.
Expenses increased by $21,000 in 2007 as compared to 2006, primarily due to an increase of $435,000 in provision for loan losses and a $263,000 increase in other expenses, offset, in part, by a $342,000 decrease in interest expense, $253,000 decrease in professional fees and a $46,000 decrease in salaries.
Provision for loan losses increased by $435,000 from $405,000 in 2006 to $840,000 in 2007 as a result of an increase in charge-offs as well as an increase in the average non-performing portfolio from $4,507,000 for the year ended December 31, 2006 to $5,637,000 for the year ended December 31, 2007. This increase in nonperforming loans is attributable to the portfolio being more seasoned and as a result higher non-performing percentages are expected versus the earlier years.
The increase of $263,000 in other expenses was primarily a result of incurring significant costs associated with maintaining the Companys interests in other real estate owned (OREO) property. Specifically, in 2007 the Company operated an increased number of businesses and properties, through receiverships, that were connected with the OREO property whereby in 2006, a majority of the business associated with the properties held in OREO were already closed at foreclosure. To the extent these costs were greater than the expected proceeds from the sale of OREO as well as any decrease in the fair market value of such property, the Company incurred total write downs of OREO in the year ended December 31, 2007 of $252,000 as compared with $12,000 in 2006.
These additional costs were offset by the reduction in interest expense, professional fees and salaries and benefits. Interest expense decreased by $341,000 to $1,752,000 for the year ended December 31, 2007 from $2,093,000 for the same period in 2006 as a result of a decrease in the average outstanding balance under the Companys credit facility with GE. The average outstanding balance for the year ended December 31, 2007 was $19,100,000 as compared with $21,100,000 for the year ended December 31, 2006. Additionally, as a result of the second amendment of the Companys credit facility entered into in December 2006, the interest rate was decreased by 25 basis points and as a result of reducing the overall line from $75,000,000 to $50,000,000, the fees being charged to the unused portion of the line decreased as well. Professional fees decreased by $253,000 due to a reduction in audit, tax and legal accruals. Salaries and benefits decreased by $46,000 due to an average reduction in headcount of one employee year over year.
Revenue decreased by $1,193,000 in 2006 as compared to 2005, primarily due to $1,386,000 less in premium income and $108,000 less other income offset by an additional $301,000 in interest income. In 2006, $29,500,000 of guaranteed portions and $7,300,000 of unguaranteed portions were sold as compared to $45,000,000 of guaranteed portions and $8,500,000 of unguaranteed portions in 2005. Interest income increased due to a 3% increase in rates charged to borrowers offset, in part, by approximately $3,000,000 less in loan balances.
Expenses decreased by $1,538,000 in 2006 as compared to 2005, primarily due to $1,853,000 less in provision for loan losses and $215,000 less in professional fees offset, in part, by a $593,000 increase in depreciation and amortization.
Revenue is derived primarily from non-cash income from tax credits recorded when a Capco achieves defined investment percentage thresholds and from accretion of income from tax credits between the time the thresholds are achieved and the tax credits are utilized by the certified investor. Income from tax credits for the years ended December 31 is as follows:
Expenses consist primarily of non-cash accretion of interest expense and the amortization of the prepaid insurance purchased at the funding date. Expenses for the years ended December 31 are as follows:
In summary, the non-cash (loss) income which is represented by the income from tax credits, less interest expense and amortization of prepaid insurance, for the years ended December 31 are as follows:
In addition, other interest relating to notes payableAI Credit, totaling $182,000, $713,000, and $598,000, was incurred in the years ended December 31, 2007, 2006, and 2005, respectively. Management fees, which were payable to Newtek and included as revenue in the corporate activities segment, totaled $4,061,000, $4,955,000, and $4,665,000 for the years ended December 31, 2007, 2006, and 2005, respectively. If a Capco does not have current or projected cash sufficient to pay management fees then they are not accrued. Management fee expense will continue to decline over the next five years. Although management fee expense is included in the Capco segment and management fee revenue is included in the Corporate activities segment, it is eliminated on consolidation.
Since the Company does not anticipate creating any new Capcos in the foreseeable future, we anticipate incurring losses going forward. Income from tax credits will consist solely of accretion of income from thresholds previously achieved since we have achieved all investment percentage thresholds as of December 31, 2006. We will continue to incur non-cash expenses consisting of accretion of interest expense and amortization of prepaid insurance on our existing Capcos.
The non-cash revenue and expenses are projected as follows:
We will continue to earn cash investment income on our cash balances and incur cash management fees and operating expenses. The amount of cash available for investment and to pay management fees will be primarily dependent upon future returns generated from qualified businesses.
The All Other segment includes revenues and expense primarily from businesses formed from investments in qualified businesses made through Capco programs which cannot be aggregated with other operating segments. Revenues and expenses associated with Phoenix Development Group LLC in 2005 were reclassified to discontinued operations.
The revenue increase of $1,422,000 in 2007 as compared with 2006 is primarily due to the consolidation of CDS Business Services, Inc., which has been consolidated with the Company since January 2007, and generated $2,166,000 of revenues for the period. Additionally, the Company recognized a gain on a sale and recoveries of investments in qualified businesses of $1,112,000, and earnings on an equity investment of $357,000 during 2007, as compared to a one-time gain on the sale of an investment of $1,706,000 and equity earnings on an investment of $128,000 during 2006. The Company also had a net reduction in revenues generated by entities that were dissolved during 2007 and a reduction in insurance commissions of approximately $275,000 and $64,000, respectively.
Loss before benefit for income taxes increased by $1,132,000 in 2007 as compared with 2006 primarily due to an increase in losses from our Texas qualified investments of approximately $750,000, CDS of $234,000, consolidated as of January 2007, increased losses from 2006 to 2007 in insurance related entities of approximately $199,000 and a reduction in the gain on sale/recoveries of investments in qualified businesses and equity earnings of approximately $594,000 from 2006 to 2007. The Texas entity losses were attributable to the increased amount of employees in these companies which represents our customer service and sales support offices. These increased losses were offset by a reduction of $556,000 of losses incurred in 2006 from Where Eagles Fly, a Washington D.C. Capco investment in a theatrical play that ran in 2006 only.
The revenue increase of $1,564,000 in 2006 as compared with 2005, is primarily due to a $1,706,000 gain on the sale of a qualified Capco investment and operating revenue and interest income derived from new qualified businesses made by WTXI, WNYIII and WNYIV. This increase was offset, in part, by a decrease in revenue of $790,000 from Exponential Business Development Co., Inc., due primarily to a comparison with a one time gain in the prior period from the sale of an investment and a $270,000 decrease in revenue from insurance related entities.
Loss before provision for income taxes decreased by $2,950,000 in 2006 to $316,000 from $3,266,000 in 2005 primarily due to gains on the sale of qualified Capco investments totaling $1,765,000 and a net reduction of $1,859,000 in losses from 9 smaller companies which ceased operation in 2006. This was offset, in part, by a decrease in income of $653,000 from Exponential Business Development Co., Inc. and a $466,000 increase in a loss in Where Eagles Fly, a Washington D.C. Capco investment.
Revenue is derived primarily from management fees earned from the Capcos, which amount to 2.5% of certified capital. Management fee revenue totaled $3,936,000, $4,369,000 and $4,665,000 for the years ended December 31, 2007, 2006 and 2005, respectively. If a Capco does not have current or projected cash sufficient to pay management fees then they are not accrued. Management fee revenue will continue to decline over the next five years. Although management fee expense is included in the Capco segment and management fee revenue is included in the Corporate activities segment, it is eliminated on consolidation.
The decrease in management fee revenue of $433,000 in 2007 as compared to 2006 is due primarily to a reduction in management fees being accrued for two New York Capcos totaling $525,000 and the Wisconsin Capco of $208,000, and the reversal of the Wisconsin Capcos management fees for the first two quarters 2007 totaling $208,000, offset in part by management fees being accrued in 2007 for the first time from one of our subsidiaries totaling $460,000 for the year.
The $2,692,000 increase in expenses in 2007 as compared to 2006 was primarily due to a $2,900,000 increase in payroll and benefits, a $257,000 increase in other expenses which includes $106,000 of expenses related to the consolidation of our New York City offices, offset, in part, by a $583,000 decrease in professional fees and a $76,000 decrease in insurance expense.
The increase in salaries and benefits was primarily a result of the Company consolidating its marketing and sales staff from its subsidiaries to the holding company to implement corporate strategy, an additional cost of approximately $1,050,000, and the addition of employees to the accounting finance, IT and human resource departments. Increases in accounting staff costs were offset by the decrease in professional fees for audit services of approximately $433,000 as a result of our auditing firm change during 2006 as well as a reduction of $229,000 for consultants brought in to assist the accounting and finance department in 2006 that were not rehired in 2007. Professional fees were increased by $137,000 for Sarbanes 404 work provided by an outside party to the Company.
The decrease in management fee revenue of $296,000 in 2006 as compared with 2005 is due to less management fees being accrued for WA and WNYPIII totaling $487,000 offset, in part, by an increase in WNYV, which was formed in 2005, totaling $191,000.
The $462,000 decrease in expenses in 2006 as compared to 2005 was primarily due to a $642,000 decrease in professional fees and a $734,000 decrease in goodwill impairment offset, in part, by a $983,000 increase in other expenses, primarily attributable to a $459,000 lawsuit settlement and an overall increase in other general and administrative expenses.
A summary of the Companys cash flows provided by (used in) operating activities by segment is as follows:
NEWTEK BUSINESS SERVICES INC. AND SUBSIDIARIES
Cash Flows from Operating Activities by Segment
For the year ended December 31, 2007 (In thousands)
Liquidity and Capital Resources
Newtek historically has funded its operations primarily through the issuance of notes to insurance companies through the Capco programs. Through December 31, 2007, Newtek has received in the aggregate $235,718,000 in proceeds from the issuance of long-term debt, Capco warrants, and Newtek common shares through the Capco programs. In 2004, Newtek raised $20,762,000 (net of related offering costs) in a secondary public offering. Newteks principal funding requirements have been to purchase Coverage A insurance policies ($124,065,000) and Coverage B Capco insurance policies ($28,060,000) related to the notes issued to the insurance companies, the acquisitions of CrystalTech and Newtek Insurance Agency, formerly Vistar, ($9,836,000), investments in Capco qualified businesses, and working capital needs resulting from operating and business development activities of its consolidated operating entities.
In summary, Newtek generated and used cash as follows:
Cash requirements and liquidity needs in 2007 and the foreseeable future are primarily funded through our capacity to borrow from our $10 million North Fork line of credit through CrystalTech, $50 million GE line of credit to originate and warehouse the guaranteed and unguaranteed portion of loans of our SBA lending unit, $10 million Wells Fargo line of credit to purchase receivables through CDS, and available cash and cash equivalents. The availability of the lending facilities is subject to the compliance with certain covenants and in addition, for the GE and Wells Fargo lines, the amount of collateral and collateral requirements, as set forth in the agreements. At December 31, 2007, our unused sources of liquidity consisted of unrestricted cash and cash equivalents of $25,372,000, and $7,500,000, $765,000 and $97,000 available through the North Fork, GE, and Wells Fargo lines of credit, respectively.
Newtek believes its loan loss reserves, which are evaluated monthly on a loan-by-loan basis, along with its collateral monitoring practices are adequate. While Newtek is aware of the changing conditions occurring nationally in the residential real estate market, loans within the portfolio are typically repaid by the business cash flow and secured by business collateral and personal assets of the business owner and/or guarantors which may include residential real estate as supplemental collateral. We follow the SBA standard operating procedure with respect to obtaining collateral on our loans. This typically includes all business assets and frequently includes personal assets of the owners and/or guarantors.
Our lender derives liquidity and profits from selling guaranteed portions of its SBA 7a loan originations. Our recent bids for the guaranteed portion of our loans have decreased from prior periods, yet the market for such portions remains active in the current environment. This decrease in pricing has had a material impact on the SBA lender. From time-to-time we may sell the unguaranteed portion of our loans. We do not depend on such sales to fund our operations. Should the pricing for the un-guaranteed portions become less attractive and we elect not to sell them, funds available under our credit facility will be sufficient to permit us to make loans.
Restricted cash totaling $12,948,000 which is primarily held in the Capcos, can be used in managing and operating the Capcos, making qualified investments, to repay debt obligations and for the payment of income taxes.
Net cash (used in) provided by operating activities was $(2,007,000) in 2007 and $1,881,000 in 2006. The $3,888,000 decrease in cash flows in 2007 was primarily caused by the increase in the net loss of $9,099,000 from 2006 to 2007, the non-cash increase of $5,936,000 in the deferred tax benefit from 2006 to 2007, an increase from 2006 to 2007 in cash used of $751,000 for accounts payable, accrued expenses and deferred revenues, offset by an increase in depreciation and amortization of $991,000, an increase in non-cash losses generated by our Capco segments of $9,061,000 and a positive change in cash provided by lender activities of $2,057,000.
Net cash provided by investing activities primarily includes the purchase or sale of fixed assets and customer accounts, activity regarding the unguaranteed portions of SBA loans, changes in restricted cash and activities involving investments in qualified businesses. During 2007 and 2006, cash was used to purchase $3,850,000 and $2,771,000, respectively, in fixed assets primarily to support increased customers in our web hosting segment. We also used cash to acquire customer merchant accounts in our Electronic payment processing segment of $2,544,000 during 2007 and $2,861,000 during 2006, and to make $1,612,000 in qualified investments. A net increase in the unguaranteed portion of SBA loans held for investment resulted in a use of cash of $1,180,000. Cash was provided by investing activities through the net proceeds of $5,042,000 from the sale of U.S. Treasury Notes, $4,097,000 from the return of investments in qualified businesses, $1,572,000 from the sale of asset held for sale and insurance recoveries, and proceeds of $1,112,000 from the recovery of investments in qualified businesses previously written off.
Net cash used in financing activities primarily includes repayments on notes payable (AI Credit, the proceeds of which were used to finance Capco activities; TICC, which were funds borrowed by CrystalTech Web Hosting, Inc., and paid off in full during 2006 and 2007), and the net borrowings (repayments) on bank notes payable to North Fork, Wells Fargo, and GE lines of credit. During 2007 and 2006, the Company used cash to repay approximately $4,787,000 and $3,731,000, respectively, of its notes payable to AI Credit, leaving one final principal balance due in 2008 of $732,000. Payments on the TICC debt were $1,000,000 and $7,000,000 during 2007 and 2006, respectively. In addition, the Company used $249,000 to purchase treasury shares during 2007. In 2006, cash was used for net repayments on the GE line of $4,897,000 and to repay $1,714,000 of the mortgages payable. In 2007, cash was provided through net borrowings from bank notes payable of $2,410,000, a $2,050,000 reduction in restricted cash in CDS, as well as $1,000,000 of proceeds from a note payable, which was converted to preferred stock.
Historically Newtek has funded its operations through the issuance of notes to insurance companies through the Capco programs. We are not anticipating any cash flow from new Capco programs for the foreseeable future. We believe our cash flow generated by our operating companies, available borrowing capacity, existing cash and cash equivalents, and other investments should provide adequate funds for continuing operations and to fund principal and interest payments on our debt.
The Company believes that its cash and cash equivalents, its anticipated positive cash flow from operations, and its ability to access private and public debt and equity markets will provide it with sufficient liquidity to meet its short and long-term capital needs. The failure of the Capco insurer, which is primarily liable for the repayment of the Capco debt cash payments of $76,191,000, would require the Capcos to assume this cash repayment obligation of the notes. Management has determined that the likelihood of the Capcos becoming primarily liable for a material portion of this debt due to the failure of the insurers, which are subsidiaries of The American International Group, Inc., and are currently rated as AA+ for financial strength by Standard & Poors, is remote. The parent company, AIG, has not agreed to guarantee the obligations of the subsidiary insurers, but it has provided written assurance that, in the event a Capco insurer experiences a downgrade in its credit rating, it will transfer the policy obligations to a stronger affiliate, if possible.
The following chart represents Newteks obligations and commitments, as of December 31, 2007, other than Capco debt repayment discussed above, for future cash payments under debt, lease and employment agreements:
This chart excludes distributions for taxes due to Capco minority owners (which can not be anticipated).
In September 2005, NSBF closed a three year, $75,000,000 senior revolving loan transaction with General Electric Capital Corp. (GE). This facility is primarily utilized to originate and warehouse the guaranteed and unguaranteed portions of loans under the SBA 7(a) loan program and for other working capital purposes. The facility refinances the previous facility with Deutsche Bank and a $4,000,000 revolving credit facility with another financial institution. In February 2006, GE and NSBF entered into a First Amendment to the GE Line of Credit Agreement. The amendment made adjustments to various financial covenants, including a net-worth maintenance level that NSBF had breached. GE waived, upon the effectiveness of the amendment, specific defaults that would have resulted from the terms of the original agreement. In December 2006, the parties entered into a Second Amendment, decreasing the line to $50,000,000 and extending the term by one year, through September 2009, in addition to making adjustments to various financial covenants and interest rates. As of December 31, 2007, NSBF had $18,418,000 outstanding on the line of credit. Under the Second Amendment, the GE line of credit allows for two alternatives for interest rates (the Prime interest rate plus 25 basis points or Base LIBOR plus 2.50%). These rates may be increased or decreased by 25 basis points based on certain thresholds. The line is collateralized by the unguaranteed portions and the guaranteed portions of the held-for-sale portion of the SBA loans receivable made by NSBF in addition to all assets of NSBF. The weighted average interest rate at December 31, 2007 was 7.50%. Interest on the line is payable monthly in arrears. Through December 31, 2007, NSBF has capitalized $2,000,000 of deferred financing costs attributable to the GE facility, which is included in other assets in the accompanying balance sheet. The agreement includes such financial covenants as minimum net worth thresholds, senior-charge ratios and fixed-charge ratios, limitations on capital expenditures and charge-offs, in addition to loan loss reserve requirements.
In February 2007, CDS closed a two year $10,000,000 line of credit with Wells Fargo. This new facility will be used to purchase receivables and for other working capital purposes. As of December 31, 2007, CDS had $1,141,000 outstanding on the line of credit. The interest rate is at prime plus 2% with interest on the line being paid monthly in arrears and on a minimum outstanding line balance of $2,000,000. Total interest expense for the year ended December 31, 2007 was approximately $204,000. The line is collateralized by the receivables purchased, as well as all other assets of the Company. Through December 31, 2007, CDS has capitalized $148,000 of deferred financing costs attributable to the Wells Fargo line. The agreement includes such financial covenants as minimum tangible net worth, minimum quarterly net income and minimum quarterly net cash flow.
In October 2007, CrystalTech entered into a Loan and Security Agreement with North Fork Bank, a division of Capital One, N. A., which provides for a revolving credit facility of up to $10,000,000 (the Loan) available to both CrystalTech and the Company, for a term of two years. The line may be used for working capital and acquisition needs within the Companys business lines; loans for acquisitions having a five year repayment term. The interest rate is LIBOR plus 2.5%. The agreement also includes a quarterly facility fee equal to 25 basis points on the unused portion of the Revolving Credit calculated as of the end of each calendar quarter. The agreement includes such financial covenants as a minimum fixed- charge coverage ratio and a maximum funded debt to EBITDA. In connection with the Loan, on October 19, 2007, we entered into a Guaranty of Payment and Performance with North Fork Bank and entered into a Pledge Agreement with North Fork Bank pledging all CrystalTech stock as collateral.
Management of Newtek expects to have three basic working capital requirements in the near term. These are:
Newtek expects to finance other ventures principally with existing funds or new additional borrowings under current or future bank facilities.
Newtek funds its current operations through cash on-hand, profits from operating businesses, and the receipt of annual management fees from the Capcos equal to 2.5% of initial funding. However, the management fees do not represent revenues to Newtek on a consolidated basis as this is a transfer of funds from Newteks Capcos to Newtek, and all intercompany transactions and balances are eliminated in consolidation. These fees from current Capcos are expected to decrease over the next few years as the Capcos mature in their business cycle. In the absence of either new Capcos or additional increases in the profitability of its operating companies, Newtek will experience a decrease in its liquidity. Management believes that numerous, realistic options are available to the Company to compensate for this, such as borrowings or additional offerings in the capital markets. However, if new Capcos are not created, and if the operating companies do not continue to grow to produce significant cash flow surpluses, and if the capital markets should be inaccessible to Newtek and if other borrowings are unavailable, Newtek would be forced to diminish materially its operations so as to conform its expenditures to the cash then available.
Income from Capco Tax Credits
In general, the Capcos issue debt and equity instruments to insurance company investors. For a description of the debt and equity instruments and warrants issued by Newteks Capcos, see Notes to the Consolidated Financial Statements. The Capcos then make targeted investments, as defined under the respective state/jurisdiction statutes, with the funds raised. Each Capco has a contractual arrangement with the particular state/jurisdiction that entitles the Capco to receive (earn) tax credits from the state/jurisdiction upon satisfying quantified, defined investment percentage thresholds and time requirements. In order for the Capcos to maintain their state or jurisdiction-issued certifications, the Capcos must make targeted investments in accordance with these requirements, which requirements are consistent with Newteks overall business strategy. Each Capco statute provides specific rules and regulations under which the Capcos must operate. For example, the State of Louisiana program precludes the Capco from making controlling and majority-owned investments. Accordingly, investments made by the Louisiana Capco are considered portfolio companies and are majority-owned operated and controlled by their boards of directors and management. These portfolio companies operate independently of Newtek although Newtek participates on the board of directors of these companies (but in all cases we do not control a majority of the board of director positions unless there is a default under the terms of the investment) and makes available to them technology, services and products to sell.
Each Capco also has separate, contractual arrangements with the insurance company investors obligating the capco to pay interest on the aforementioned debt instruments. The Capco may satisfy this interest obligation by delivering the tax credits or paying cash. The insurance company investors have the legal right to receive and use the tax credits and would, in turn, use these tax credits to reduce their respective state tax liabilities in an amount usually equal to 100% (110% in some cases in Louisiana) of their investments in the Capcos. The tax credits generally can be utilized over a four to ten-year period and in some instances are transferable and can be carried forward. Newteks revenue from tax credits may be used solely for the purpose of satisfying the Capcos obligations to the insurance company investors.
A description is set forth above of the manner in which Newtek and its Capcos account for the tax credit income. See Critical Accounting PoliciesRevenue Recognition.
The table below is a summary of each Capco, state and date of certification, total certified capital, 50% minimum investment requirement and the total percentage of certified capital invested as of December 31, 2007 and 2006. The result as shown on the following chart, in the column Percentage Invested, demonstrates that in all cases in 2006 all of our operational Capcos had met or exceeded the 50% minimum investment requirement. The 16th Capco, Exponential of New York, LLC, which is managed and not owned, also has exceeded the 50% minimum investment requirement. In all cases, the minimum investment benchmarks were met 12 months or more in advance of the statutory minimum investment benchmark dates. By meeting the 50% minimum investment requirement, the Capco eliminates the risk of decertification and loss of tax credits.
SUMMARY OF CAPCO ORGANIZATION, CERTIFICATION AND
The amount earned and recorded as income is determined by multiplying the total amount of tax credits allocated to the Capco by the percentage of tax credits immune from recapture (the earned income percentage) at that point. To the extent that the investment requirements are met ahead of schedule, and the percentage of non-recapturable tax credits is accelerated, the present value of the tax credit earned is recognized currently and the asset, credits in lieu of cash, is accreted up to the amount of tax credits deliverable to the certified investors. The obligation to deliver tax credits to the certified investors is recorded as notes payable in credits in lieu of cash. On the date the tax credits are utilizable by the certified investors, the Capco decreases credits in lieu of cash with a corresponding decrease to notes payable in credits in lieu of cash.
During the years ended December 31, 2006 and 2005, the Capcos satisfied certain investment benchmarks and the related recapture percentage requirements and accordingly, earned a portion of the tax credits. In addition, in 2007, 2006 and 2005 Newtek recognized income from the accretion of the discount attributable to tax credits earned in prior years. See Notes to the Consolidated Financial Statements.
Our operating businesses are dependent on the health of the small and medium-sized segments of the U.S. economy. The reduction in the availability of credit and a weakening economy, along with the rise in gasoline and commodity prices, could have a negative impact on consumer and commercial spending which could adversely impact Newteks small business customers. This could also negatively impact the value of commercial and residential real estate, which could adversely impact the loan portfolio of our SBA Lending segment.
Critical Accounting Policies and Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. The most significant estimates include:
Management continually evaluates its accounting policies and the estimates it uses to prepare the consolidated financial statements. In general, the estimates are based on historical experience, on information from third party professionals and on various other sources and assumptions that are believed to be reasonable under the facts and circumstances at the time such estimates are made. The Companys critical accounting policies are reviewed periodically with the audit committee of the board of directors. Management considers an accounting estimate to be critical if:
Actual results could differ from those estimates. Significant accounting policies are described in Note 1 to the consolidated financial statements, which are included in Item 15 in this Form 10-K filing. In many cases, the accounting treatment of a particular transaction is specifically indicated by Accounting Principles Generally Accepted in the United States of America.
Certain of our accounting policies are deemed critical, as they require managements highest degree of judgment, estimates and assumptions. The following critical accounting policies are not intended to be a comprehensive list of all of our accounting policies or estimates.
Electronic payment processing revenue: Electronic payment processing and fee income is derived from the electronic processing of credit and debit card transactions that are authorized and captured through third-party networks. Typically, merchants are charged for these processing services on a percentage of the dollar amount of each transaction plus a flat fee per transaction. Certain merchant customers are charged miscellaneous fees, including fees for handling charge-backs or returns, monthly minimum fees, statement fees and fees for other miscellaneous services. In accordance with Emerging Issues Task Force (EITF) 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent, revenues derived from the electronic processing of MasterCard® and Visa® sourced credit and debit card transactions are reported gross of amounts paid to sponsor banks.
Web Hosting revenue: The Companys revenues in this segment are primarily derived from monthly recurring services fees for the use of its web hosting and software support services. Customer set-up fees are billed upon service initiation and are recognized as revenue over the estimated customer relationship period of 2.5 years. Deferred revenues represent customer
prepayments for upcoming web hosting and related services, and are generally received one month to three years in advance. Such revenues are recognized as services are rendered, provided that evidence of an arrangement exists, the price to the customer is fixed or determinable, no significant Company obligations remain and collection of the related receivable is reasonably assured.
Income from tax credits: Following an application process, a state will notify a company that it has been certified as a Capco. The state or jurisdiction then allocates an aggregate dollar amount of tax credits to the Capco. However, such amount is neither recognized as income nor otherwise recorded in the financial statements since it has yet to be earned by the Capco. The Capco is entitled to earn tax credits upon satisfying defined investment percentage thresholds within specified time requirements. Newtek has Capcos in seven states and the District of Columbia. Each statute requires that the Capco invest a threshold percentage of certified capital (the funds provided by the insurance company investors) in businesses defined as qualified within the time frames specified. As the Capco meets these requirements, it avoids grounds under the statute for its disqualification for continued participation in the Capco program. Such a disqualification, or decertification as a Capco results in a permanent recapture of all or a portion of the allocated tax credits. The proportion of the possible recapture is reduced over time as the Capco remains in general compliance with the program rules and meets the progressively increasing investment benchmarks. As the Capco progresses in its investments in Qualified Businesses and, accordingly, places an increasing proportion of the tax credits beyond recapture, it earns an amount equal to the non-recapturable tax credits and records such amount as income, with a corresponding asset called credits in lieu of cash in the balance sheet.
The amount earned and recorded as income is determined by multiplying the total amount of tax credits allocated to the Capco by the percentage of tax credits immune from recapture (the earned income percentage) at that point. To the extent that the investment requirements are met ahead of schedule, and the percentage of non-recapturable tax credits is accelerated, the present value of the tax credit earned is recognized currently and the asset, credits in lieu of cash, is accreted up to the amount of tax credits deliverable to the certified investors. The obligation to deliver tax credits to the certified investors is recorded as notes payable in credits in lieu of cash. On the date the tax credits are utilizable by the certified investors, the Capco decreases credits in lieu of cash with a corresponding decrease to notes payable in credits in lieu of cash.
SBA lending: Interest income on SBA loans is recognized as earned. When a SBA loan is 90 days past due with respect to principal or interest and, in the opinion of management, interest or principal on individual loans is not collectible, or at such earlier time as management determines that the collectibility of such principal or interest is unlikely, the accrual of interest is discontinued and all accrued but uncollected interest income is reversed. Cash payments subsequently received on nonaccrual loans are recognized as income only where the future collection of the recorded value of the SBA loan is considered by management to be probable. Certain related direct costs to originate loans (including fees paid to financial consultants) are deferred and amortized over the contractual life of the SBA loan using a method that approximates the effective interest method.
Insurance commissions: Revenues are comprised of commissions earned on premiums paid for insurance policies and are recognized at the time the commission is earned. At that date, the earnings process has been completed and the Company can estimate the impact of policy cancellations for refunds and establish reserves. The reserve for policy cancellations is based on historical cancellation experience adjusted by known circumstances.
Other income: Other income represents revenues derived from operating units that cannot be aggregated with other business segments. In addition, other income represents one time recoveries or gains on investments. Revenue is recorded when there is strong evidence of an agreement, the related fees are fixed, the service and, or product has been delivered, and the collection of the related receivable is assured.
Capco Debt Issuance. The Capco notes require, as a condition precedent to the funding of the notes, that insurance be purchased to cover the risks associated with the operation of its Capcos. This insurance has been purchased from American International Specialty Lines Insurance Company and National Union Fire Insurance Company of Pittsburgh, both subsidiaries of American International Group, Inc. (AIG), an international insurer. In order to comply with this condition precedent to the funding, the notes closing is structured as follows: (1) the certified investors wire their funds directly into an escrow account; (2) the escrow agent, pursuant to the requirements under the note and escrow agreement, automatically and simultaneously funds the purchase of the insurance contract from the proceeds received. Newteks Capco is not entitled to the use and benefit of the net proceeds received until the escrow agent has completed the purchase of the insurance. AIG and its subsidiaries noted above are AA+ credit rated by Standard & Poors.
Under the terms of this insurance, which is for the benefit of the certified investors, the Capco insurer incurs the primary obligation to repay the certified investors a substantial portion of the debt (including all cash payments) as well as to make compensatory payments in the event of a loss of the availability of the related tax credits. The Capco remains secondarily liable for such payments and must periodically assess the likelihood that it will become primarily liable and, if necessary, record a liability at that time. The parent company, AIG, has not guaranteed the obligations of its subsidiary insurers, although it has committed to move the payment obligations to an affiliated company in the event the Capco insurer is materially downgraded in its credit rating.
Investment Accounting and Valuation. The various interests that the Capcos and Newtek acquire as a result of their investments are accounted for under three methods: consolidation, equity method and cost method. The applicable accounting method is generally determined based on our voting interest in a company and FIN 46, and quarterly valuations are performed so as to keep our records current in reflecting the operations of all of its investments.
Companies in which we directly or indirectly owns more than 50% of the outstanding voting securities, those Newtek has effective control over, or are deemed as a variable interest entity that needs to be consolidated under the provisions of FIN 46 Consolidation of Variable Interest Entities, are generally accounted for under the consolidation method of accounting. Under this method, an investments results of operations are reflected within our Consolidated Statement of Income. All significant inter-company accounts and transactions are eliminated. The results of operations and cash flows of a consolidated entity are included through the latest interim period in which Newtek owned a greater than 50% direct or indirect voting interest, exercised control over the entity for the entire interim period or was otherwise designated as the primary beneficiary under FIN 46. Upon dilution of voting interest at or below 50%, or upon occurrence of a triggering event requiring reconsideration as to the primary beneficiary of a variable interest entity, under FIN 46, the accounting method is adjusted to the equity or cost method of accounting, as appropriate, for subsequent periods.
Companies that are not consolidated, but over which we exercise significant influence, are accounted for under the equity method of accounting. Whether or not Newtek exercises significant influence with respect to a company depends on an evaluation of several factors including, among others, representation on the board of directors and ownership level, which is generally a 20% to 50% interest in the voting securities, including voting rights associated with Newteks holdings in common, preferred and other convertible instruments. Under the equity method of accounting, a companys accounts are not reflected within our Consolidated Statement of Income; however, Newteks share of the investees earnings or losses are reflected in other income in the Companys Consolidated Statements of Operations.
Companies not accounted for under the consolidation or the equity method of accounting are accounted for under the cost method of accounting, for which quarterly valuations are performed. Under this method, our share of the earnings or losses of such companies is not included in the consolidated statements of operations, but the investment is carried at historical cost. In addition, cost method impairment charges are recognized as necessary, in the Consolidated Statement of Income if circumstances suggest that this is an other than temporary decline in the value of the investment, particularly due to losses. Subsequent increases in value, if any, of the underlying companies are not reflected in our financial statements until realized in cash. We record as income amounts previously written off only when and if we receive cash in excess of its remaining investment balance.
On a quarterly basis, the investment committee of each Capco meets to evaluate each of our investments. Newtek considers several factors in determining whether an impairment exists on the investment, such as the companies net book value, cash flow, revenue growth and net income. In addition, the investment committee looks at larger variables, such as the economy and the particular companys industry, to determine if an other than temporary decline in value exists in each Capcos and Newteks investment.
Impairment of Goodwill. Management of the Company considers the following to be some examples of important indicators that may trigger an impairment review outside its annual goodwill impairment review under the provisions of SFAS 142: (i) significant under-performance or loss of key contracts acquired in an acquisition relative to expected historical or projected future operating results; (ii) significant changes in the manner or use of the acquired assets or in the Companys overall strategy with respect to the manner or use of the acquired assets or changes in the Companys overall business strategy; (iii) significant negative industry or economic trends; (iv) increased competitive pressures; (v) a significant decline in our stock price for a sustained period of time; and (vi) regulatory changes. In assessing the recoverability of our goodwill and intangibles, we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. The fair value of an asset could vary, depending upon the estimating method employed, as well as assumptions made. This may result in a possible impairment of the intangible assets and/or goodwill, or alternatively an acceleration in amortization expense. During the years ended December 31, 2007 and 2005, management determined that impairment of goodwill was triggered as a result of the annual impairment test and appropriately recorded a charge in the accompanying Consolidated Statements of Operations. For the year ended December 31, 2006, the amount was immaterial.
Allowance for SBA Loan Losses. The allowance for loan losses is established by management through provisions for loan losses charged against income. Amounts deemed to be uncollectible are charged against the allowance for loan losses and subsequent recoveries, if any, are credited to the allowance.
The amount of the allowance for loan losses is inherently subjective, as it requires making material estimates which may vary from actual results. Managements ongoing estimates of the allowance for loan losses are particularly affected by the changing composition of the loan portfolio over the last few years. The loans acquired from CCC in December 2002, which are more seasoned than those originated by NSBF, comprise 17% of total loans held for investment as of December 31, 2007. Other portfolio characteristics, such as industry concentrations and loan collateral, which also impacts managements estimates of the allowance for loan losses, have also changed since the acquisition. The changing nature of the portfolio and the limited past loss experience on the newly originated portfolio has resulted in managements estimates of the allowance for loan losses being based more on subjective factors, as noted below, and less on empirically derived loss rates.
The adequacy of the allowance for loan losses is reviewed by management on a monthly basis at a minimum, and as adjustments become necessary, they are reflected in operations during the periods in which they become known. Considerations in this evaluation include past and current loss experience, risks inherent in the current portfolio and evaluation of real estate collateral as well as current economic conditions. In the opinion of management, the allowance, when taken as a whole, is adequate to absorb estimated loan losses inherent in NSBFs entire loan portfolio.
The allowance consists of specific and general components. The specific component relates to loans that are classified as either loss, doubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors.
A loan is considered impaired when, based on current information and events, it is probable that NSBF will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Other factors considered by management in determining impairment include payment status and collateral value. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrowers prior payment record, and the amount of the shortfall in relation to the principal and interest owed.
NSBFs charge-off policy is based on a loan-by-loan review for which the estimated uncollectible portion of nonperforming loans is charged off against the corresponding loan receivable and the allowance for loan losses.
Sales and Servicing of SBA Loans. NSBF originates loans to customers under the SBA program that generally provides for SBA guarantees of 50% to 85% of each loan, subject to a maximum guarantee amount. NSBF sells the guaranteed portion of each loan to a third party and retains the unguaranteed principal portion in its own portfolio. A gain is recognized on the guaranteed portions of these loans through collection on sale of a premium over the adjusted carrying value. Gain on sale of the guaranteed portion of the loans is recognized at the date of settlement, under the terms of SFAS No. 156 Accounting for Servicing of Financial Assetsan amendment of FASB Statement No. 140 for 2007 and SFAS No. 140 Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilitiesa Replacement of FASB Statement No. 125 for 2006.
In each loan sale, the Company retains servicing responsibilities and receives servicing fees of a minimum of 1% of the guaranteed loan portion sold. The Company is required to estimate its adequate servicing compensation in the calculation of its servicing asset. The purchasers of the loans sold have no recourse to the Company for failure of customers to pay amounts contractually due.
In accordance with SFAS 156, upon sale of the loans to third parties, NSBF separately recognizes at fair value any servicing assets or servicing liabilities first, and then allocates the previous carrying amount between the assets sold and the interests that continue to be held by the transferor (the unguaranteed portion of the loan) based on their relative fair values at the date of transfer. The difference between the proceeds received and the allocated carrying value of the financial assets sold is recognized as a gain on sale of loans.
In accordance with SFAS 140, upon sale of the loans to third parties, the Companys investment in an SBA loan is allocated among the retained portion of the loan (unguaranteed), the sold portion of the loan (guaranteed) and the value of loan servicing retained, based on the relative estimated fair market values of each component at the sale date. The difference between the proceeds received and the allocated carrying value of the loan sold is recognized as a gain on sale of loans.
Servicing assets are subsequently measured under SFAS 156 using either the amortization method or the fair value measurement method. The amortization method, which NSBF has chosen to continue applying to its servicing asset as was
performed in 2006, amortizes the asset in proportion to, and over the period of, the estimated future net servicing income on the underlying sold portion of the loans (guaranteed) and assesses the servicing asset for impairment based on fair value at each reporting date. In the event future prepayments are significant or impairments are incurred and future expected cash flows are inadequate to cover the unamortized servicing assets, additional amortization or impairment charges would be recognized. The Company uses an independent valuation specialist to estimate the fair value of the servicing asset.
The servicing fees are reflected as an asset which is amortized over an estimated life using a method approximating the effective interest method; in the event future prepayments are significant or impairments are incurred and future expected cash flows are inadequate to cover the unamortized servicing asset, additional amortization or impairment charges would be recognized. In the calculation of its servicing asset, NSBF is required to estimate its adequate servicing compensation.
In evaluating and measuring impairment of servicing assets, NSBF stratifies its servicing assets based on one or more of the predominant risk characteristics of the underlying loan pools. The fair value of servicing assets is determined by calculating the present value of estimated future net servicing cash flows, using assumptions of prepayments, defaults, servicing costs and discount rates that NSBF believes market participants would use for similar assets.
If NSBF determines that the impairment for a stratum is temporary, a valuation allowance is recognized through a charge to current earnings for the amount the amortized balance exceeds the current fair value. If the fair value of the stratum were to later increase, the valuation allowance may be reduced as a recovery. However, if NSBF determines that an impairment for a stratum is other than temporary, the value of the servicing asset and any related valuation allowance is written-down.
For the years ended December 31, 2007 and 2006, managements impairment analysis indicated $120,000 and $82,000, respectively, of an impairment.
Stock-Based Compensation. Prior to January 1, 2006, the Company applied the disclosure-only provisions of SFAS 123,Accounting for Stock-Based Compensation (SFAS 123). In accordance with the provisions of SFAS 123, the Company applied APB 25, Accounting for Stock Issued to Employees (APB 25), and related interpretations in accounting for stock-based compensation plans and, accordingly, did not recognize compensation expense for stock options because we issued options at exercise prices equal to the market value at date of grant.
Effective January 1, 2006, the Company adopted SFAS 123 (revised 2004), Share-Based Payment (SFAS 123R), which revises SFAS 123 and supersedes APB 25. SFAS 123R requires all share-based payments to employees to be recognized in the financial statements based on their fair values using an option-pricing model at the date of grant. The Company has elected to use the modified prospective method for adoption, which requires compensation expense to be recorded for all unvested stock options and restricted shares beginning in the first quarter of adoption, based on the fair value at the original grant date. Prior year financial statements have not been restated.
In November 2005, the FASB issued FASB Staff Position No. FAS 123R-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards. The Company has elected to adopt the alternative transition method provided in the FASB Staff Position for calculating the tax effects of share-based compensation pursuant to SFAS 123R. The alternative transition method includes a simplified method to establish the beginning balance of the additional paid-in capital pool related to the tax effects of employee share-based compensation, which is available to absorb tax deficiencies subsequent to the adoption of SFAS 123R.
Income Taxes. Deferred tax assets and liabilities are computed based upon the differences between the financial statement and income tax basis of assets and liabilities using the enacted tax rates in effect for the year in which those temporary differences are expected to be realized or settled. If available evidence suggests that it is more likely than not that some portion or all of the deferred tax assets will not be realized, a valuation allowance is required to reduce the deferred tax assets to the amount that is more likely than not to be realized.
New Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 157, Fair Value Measurements(SFAS 157), which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company has not completed an analysis as to the impact of this statement on its financial statements.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159). SFAS 159 permits companies to choose to measure many financial instruments and certain other items at fair value. SFAS 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company is exploring adoption of SFAS 159 in connection with the accounting for the Capco segment operations commencing January 1, 2008. If adopted and applied by the Company to certain financial instruments in the Capco segment, SFAS 159 will have a material non-cash effect on the Companys statement of operations and financial position. The Company expects that adoption will result in a decrease in future non-cash losses associated with the Capco segment and a one-time reduction of the Companys retained earnings.
In December 2007, the FASB issued SFAS No. 141 (R), Business Combinations (SFAS 141(R)), and SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements (SFAS 160). SFAS 141 (R) requires an acquirer to measure the identifiable assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree at their fair values on the acquisition date, with goodwill being the excess value over the net identifiable assets acquired. SFAS 160 clarifies that a noncontrolling interest in a subsidiary should be reported as equity in the consolidated financial statements. The calculation of earnings per share will continue to be based on income amounts attributable to the parent. SFAS 141 (R) and SFAS 160 are effective for financial statements issued for fiscal years beginning after December 15, 2008. Early adoption is prohibited. We do not expect the adoption of SFAS 141 (R) and SFAS 160 to have a material impact on our consolidated financial statements
Off Balance Sheet Arrangements
Impact of Inflation
The impact of inflation on our results of operations is not material.
All of our business activities contain elements of risk. We consider the principal types of risk to be fluctuations in interest rates and loan portfolio valuations. We consider the management of risk essential to conducting our businesses. Accordingly, risk management systems and procedures are designed to identify and analyze our risks, to set appropriate policies and limits and to continually monitor these risks and limits by means of reliable administrative and information systems and other policies and programs.
Because the SBA lender borrows money to make loans and investments, our net operating income is dependent upon the difference between the rate at which we borrow funds and the rate at which we invest these funds. The Company has outstanding bank notes payable of approximately $22,065,000 at December 31, 2007. Interest rates on such notes are variable ranging between Prime plus 0.25%-2.0% or LIBOR plus 2.50%. As a result, there can be no assurance that a significant change in market interest rates will not have a material adverse effect on our interest income. In periods of sharply rising interest rates, our cost of funds would increase, which would reduce our net operating income. We have analyzed the potential impact of changes in interest rates on interest income net of interest expense. Assuming that the balance sheet were to remain constant and no actions were taken to alter the existing interest rate sensitivity, a hypothetical immediate 1% change in interest rates would have the effect of a net increase (decrease) in assets by less than 1% for 2007. Although management believes that this measure is indicative of our sensitivity to interest rate changes, it does not adjust for potential changes in credit quality, size and composition of the assets on the balance sheet, and other business developments that could affect a net increase (decrease) in assets. Accordingly, no assurances can be given that actual results would not differ materially from the potential outcome simulated by this estimate.
Additionally, we do not have significant exposure to changing interest rates on invested cash which were approximately $38,320,000 and $42,976,000 (includes U.S. Treasury notes in 2006) at December 31, 2007 and 2006, respectively. The Company invests cash mainly in money market accounts and other investment-grade securities and does not purchase or hold derivative financial instruments for trading purposes. All of our transactions are conducted in U.S. dollars and we do not have any foreign currency or foreign exchange risk. We do not trade commodities or have any commodity price risk.
Financial statements and supplementary data are included as separate sections of this Form 10-K. See Item 15.
(a) Evaluation of Disclosure Controls and Procedures.
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)), as of December 31, 2007. Based on their evaluation, they have concluded that our disclosure controls and procedures as of the end of the period covered by this report were adequate to ensure that (1) information required to be disclosed by us in the reports filed or furnished by us under the Securities Exchange Act of 1934, (the Exchange Act) as amended, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and (2) such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures as of December 31, 2007 were effective at reaching a reasonable level of assurance of achieving the desired objective.
(b) Managements Report on Internal Control Over Financial Reporting.
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as that term is defined in Exchange Act Rule 13a-15(f). Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of our financial statements for external purposes in accordance with U.S. generally accepted accounting principles. Our control environment is the foundation for our system of internal control over financial reporting and is an integral part of our Code of Ethics for the Chief Executive Officer and Chief Financial Officer, which sets the tone of our company. Our internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect our transactions and dispositions of our assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of our financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements.
In order to evaluate the effectiveness of our internal control over financial reporting as of December 31, 2007, as required by Section 404 of the Sarbanes-Oxley Act of 2002, our management conducted an assessment, including testing, based on the criteria set forth in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO Framework). Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. In addition, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting and, based on that assessment, concluded that as of December 31, 2007 our internal controls over financial reporting are effective based on these criteria.
Management Report on Internal Control Over Financial Reporting.
Our Management Report on Internal Controls Over Financial Reporting can be found on page 59 of this report.
(c) Change in Internal Control over Financial Reporting.
There were no other changes in our internal control over financial reporting, identified in connection with the evaluation of such internal control that occurred during our last fiscal year that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
MANAGEMENTS REPORT TO THE STOCKHOLDERS OF NEWTEK BUSINESS SERVICES, INC. AND SUBSIDIARIES
Managements Report on Internal Control Over Financial Reporting
As management, we are responsible for establishing and maintaining adequate internal control over financial reporting for Newtek Business Services, Inc. and its subsidiaries. In order to evaluate the effectiveness of internal control over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act of 2002, we have conducted an assessment, including testing, using the criteria in Internal Control-Integral Framework issued by the Committee of Sponsoring Organization of the Treadway Commission (COSO). Newtek Business Services, Inc.s system of internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. Because of its inherent limitation, internal control over financial reporting may not prevent or detect misstatements. Based on our assessment, we have concluded that Newtek Business Services, Inc. maintained effective internal control over financial reporting as of December 31, 2007, based on criteria in Internal Control-Integrated Framework issued by the COSO. The effectiveness of Newtek Business Services, Inc.s internal control over financial reporting is not required to be audited by our independent registered public accounting firm, until the Company files its annual report for its fiscal year ending on or after December 15, 2008.
This Annual Report does not include an attestation report of the Companys independent registered public accounting firm regarding internal control over financial reporting. Managements report was not subject to attestation by the Companys independent registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only managements report in this Annual Report.
The certifications of Newtek Business Services, Inc. Chief Executive Officer and Chief Financial Officer required by the Sarbanes-Oxley Act of 2002 have been included as Exhibits 31 and 32 in Newtek Business Services, Inc. Form 10-K.
NEWTEK BUSINESS SERVICES, INC.
The information required by this Item is incorporated herein by reference to the sections entitled Management and Principal Stockholders in the proxy statement for our 2008 Annual Meeting of Stockholders.
We have adopted a code of ethics, referred to as our Code of Conduct, that applies to all directors and employees, including the principal executive, financial and accounting officers. A copy of the Code of Conduct will be made available upon request to executive offices of the Company and may be viewed on our web site (www.Newtekbusinessservices.com).
We intend to post on our website any amendments to, or waivers from, our Code of Conduct and Ethics that apply to our principal executive officer and principal financial and accounting officer.
The information required by this Item is incorporated herein by reference to the section entitled Executive Compensation in the proxy statement for our 2008 Annual Meeting of Stockholders.
The information required by this Item is incorporated herein by reference to the section entitled Principal Stockholders in the proxy statement for our 2008 Annual Meeting of Stockholders.
The information required by this Item is incorporated herein by reference to the section entitled Related-Party Transactions in the proxy statement for our 2008 Annual Meeting of Stockholders.
The information required by this Item is incorporated herein by reference to the section entitled Principal Accounting Fees and Services in the proxy statement for our 2008 Annual Meeting of Stockholders.
In accordance with Section 13 of 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
INDEX TO FINANCIAL STATEMENTS
Table of Contents
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of
Newtek Business Services, Inc.
We have audited the accompanying consolidated balance sheets of Newtek Business Services, Inc. and Subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of operations, changes in shareholders equity and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Newtek Business Services, Inc. and Subsidiaries as of December 31, 2007 and 2006, and their consolidated results of operations and cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 2, in 2006 the Company changed its method of accounting for stock-based compensation upon adoption of Statement of Financial Accounting Standards No. 123R, Share-Based Payment.
As discussed in Note 2, in 2007 the Company changed its method of accounting for servicing of financial assets upon adoption of Statement of Financial Accounting Standards No. 156, Accounting for Servicing of Financial Assetsan Amendment of FASB Statement No. 140.
/s/ J.H. Cohn LLP
Jericho, New York
March 31, 2008
401 Broad Hollow Rd.
Melville NY 11747
Telephone (631) 753 2700
Facsimile (631) 753 2800
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of Newtek Business Services, Inc.:
In our opinion, the accompanying consolidated statements of operations, changes in shareholders equity and cash flows present fairly, in all material respects, the results of Newtek Business Services, Inc. and Subsidiaries operations and their cash flows for year ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
/s/ PricewaterhouseCoopers, LLP
New York, New York
May 4, 2006, except for the effects of discontinued operations discussed in Note 3 to the consolidated financial statements, as to which the date is March 31, 2007.
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 2007, 2006, AND 2005
See accompanying notes to these consolidated financial statements.
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2007 AND 2006
(In Thousands, except for Per Share Data)
See accompanying notes to these consolidated financial statements.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2007, 2006, AND 2005