NFP National Financial Partners Corp.

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

______________

FORM 10-Q

______________

 

 

FOR THE QUARTERLY PERIOD ENDED September 30, 2008

 

or

 

 

 

Commission File Number: 001-31781

---

NATIONAL FINANCIAL PARTNERS CORP.

(Exact name of registrant as specified in its charter)

---

 

(212) 301-4000

(Registrant’s telephone number, including area code)

---

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  x     No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  o    No  x

 

The number of outstanding shares of the registrant’s Common Stock, $0.10 par value, as of October 31, 2008 was 39,684,319.

 

 

National Financial Partners Corp. and Subsidiaries

Form 10-Q

 

INDEX

 

 

Forward-Looking Statements

 

National Financial Partners Corp. (“NFP”) and its subsidiaries (together with NFP, the “Company”) and their representatives may from time to time make verbal or written statements, including certain statements in this report, which are forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements include, without limitation, any statement that may project, indicate or imply future results, events, performance or achievements, and may contain the words “anticipate,” “expect,” “intend,” “plan,” “believe,” “estimate,” “may,” “will,” “continue” and similar expressions of a future or forward-looking nature. Forward-looking statements may include discussions concerning revenue, expenses, earnings, cash flow, dividends, capital structure, credit facilities, market and industry conditions, premium and commission rates, interest rates, contingencies, the direction or outcome of regulatory investigations and litigation, income taxes and the Company’s operations or strategy.

 

These forward-looking statements are based on management’s current views with respect to future results, and are subject to risks and uncertainties. Forward-looking statements are based on beliefs and assumptions made by management using currently available information, such as market and industry materials, experts’ reports and opinions, and trends. These statements are only predictions and are not guarantees of future performance. Forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those contemplated by a forward-looking statement. These factors include, without limitation:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Additional factors are set forth in this Quarterly Report on Form 10-Q as of and for the quarter and nine months ended September 30, 2008 and in NFP’s filings with the Securities and Exchange Commission (the “SEC”), including its Annual Report on Form 10-K for the year ended December 31, 2007, filed with the SEC on February 19, 2008.

 

Forward-looking statements speak only as of the date on which they are made. NFP expressly disclaims any obligation to update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.

 

Part I – Financial Information

Item 1. Financial Statements (Unaudited)

 

NATIONAL FINANCIAL PARTNERS CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Unaudited) - (in thousands, except per share amounts)

See accompanying notes to consolidated financial statements.

NATIONAL FINANCIAL PARTNERS CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

(in thousands, except per share amounts)

 

______________

 

See accompanying notes to consolidated financial statements.

 

NATIONAL FINANCIAL PARTNERS CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited - in thousands)  

See accompanying notes to consolidated financial statements.  

 

Note 1 - Nature of Operations

 

National Financial Partners Corp. (“NFP”), a Delaware corporation, was formed on August 27, 1998, but did not commence operations until January 1, 1999. The principal business of NFP is the acquisition and management of operating companies it acquires which form a national distribution network that offers financial services, including life insurance and wealth transfer, corporate and executive benefits, financial planning and investment advisory services to high net worth individuals and companies. As of September 30, 2008, NFP and its subsidiaries (the “Company”) owned more than 180 firms.

 

Note 2 - Summary of Significant Accounting Policies

 

Basis of presentation

 

The unaudited interim consolidated financial statements of the Company included herein have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, the unaudited interim consolidated financial statements reflect all adjustments, which are of a normal recurring nature, necessary for a fair presentation of financial position, results of operations and cash flows of the Company for the interim periods presented and are not necessarily indicative of a full year’s results.

 

All material intercompany balances and transactions have been eliminated. These financial statements should be read in conjunction with the Company’s audited consolidated financial statements and related notes for the year ended December 31, 2007, included in NFP’s Annual Report on Form 10-K for the year ended December 31, 2007, filed with the SEC on February 19, 2008.

 

Use of estimates

 

The preparation of consolidated financial statements in accordance with GAAP requires management to make certain estimates and assumptions that affect the reported amounts of the assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results may differ from those estimates.

 

Property, equipment and depreciation

 

Property and equipment are recorded at cost and depreciated using the straight-line method over their estimated useful lives, generally 3 to 7 years. Leasehold improvements are amortized over the shorter of their estimated useful lives or the terms of the leases. Amortization and depreciation expense totaling $5.9 million and $4.9 million for the nine months ended September 30, 2008 and 2007, respectively, has been excluded from operating expenses in Cost of services and included in Corporate and other expenses.

 

Foreign Currency Translation

 

The functional currency of the Company is the United States (“U.S.”) dollar. The functional currency of the Company’s foreign operations is the applicable local currency. The translation of foreign currencies into U.S. dollars is performed for balance sheet accounts using current exchange rates in effect at the balance sheet date and for income and expense accounts using monthly average exchange rates. The cumulative effects of translating the functional currencies into the U.S. dollar are included in Accumulated other comprehensive income.

 

Revenue recognition

 

Insurance and annuity commissions paid by insurance companies are based on a percentage of the premium that the insurance company charges to the policyholder. First-year commissions are calculated as a percentage of the first twelve months’ premium on the policy and earned in the year that the policy is originated. In many cases, the Company receives renewal commissions for a period following the first year, if the policy remains in force. Some of the Company’s firms also receive fees for the settlement of life insurance policies. These fees are generally based on a percentage of the settlement proceeds received by their clients, and recognized as revenue when the policy is transferred and the rescission period has ended. The Company also earns commissions on the sale of insurance policies written for benefit programs. The commissions are paid each year as long as the client continues to use the product and maintain its broker of record relationship with the Company. The Company also earns fees for the development and implementation of corporate and executive benefit programs as well as fees for the duration that these programs are administered. Asset-based fees are earned for administrative services or consulting related to certain benefits plans. Insurance commissions are recognized as revenue when the following criteria are met: (1) the policy application and other carrier delivery requirements are substantially complete, (2) the premium is paid, and (3) the insured party is contractually committed to the purchase of the insurance policy. Carrier delivery requirements may include additional supporting documentation, signed amendments and premium payments. Subsequent to the initial issuance of the insurance policy, premiums are billed directly by carriers. Commissions earned on renewal premiums are generally recognized upon receipt from the carrier, since that is typically when the Company is first notified that such commissions have been earned. The Company carries an allowance for policy cancellations, which approximated $1.2 million at both September 30, 2008 and September 30, 2007, that is periodically evaluated and adjusted as necessary. Miscellaneous commission adjustments are generally recorded as they occur. Contingent commissions are recorded as revenue when received which, in many cases, is the Company’s first notification of amounts earned. Contingent commissions are commissions paid by insurance underwriters and are based on the estimated profit and/or overall volume of business placed with the underwriter. The data necessary for the calculation of contingent commissions cannot be reasonably estimated prior to receipt of the commission.

 

The Company earns commissions related to the sale of securities and certain investment-related insurance products. The Company also earns fees for offering financial advice and related services. These fees are based on a percentage of assets under management and are generally paid quarterly. In certain cases, incentive fees are earned based on the performance of the assets under management. Some of the Company’s firms charge flat fees for the development of a financial plan or a flat fee annually for advising clients on asset allocation. Any investment advisory or related fees collected in advance are deferred and recognized as income on a straight-line basis over the period earned. Transaction-based fees, including performance fees, are recognized when all contractual obligations have been satisfied. Securities and mutual fund commission income and related expenses are recorded on a trade date basis.

 

Some of the Company’s firms earn additional compensation in the form of incentive and marketing support payments from manufacturers of financial services products, based on the volume, persistency and profitability of business generated by the Company from these three sources. Incentive and marketing support revenue is recognized at the earlier of notification of a payment or when payment is received, unless there exists historical data and other information which enable management to reasonably estimate the amount earned during the period.

 

Recently issued accounting pronouncements

 

Business Combinations

 

In December 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 141 (revised 2007) (“SFAS 141R”), “Business Combinations,” which is a revision of SFAS No. 141, “Business Combinations.” Certain changes prescribed by SFAS 141R that may impact the Company are as follows:

 

 

 

 

SFAS 141R is effective as of the beginning of an entity’s first fiscal year beginning after December 15, 2008. Adoption is prospective and early adoption is prohibited. The Company is currently evaluating the impact that the adoption of SFAS 141R will have on its consolidated financial statements and notes thereto.

 

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“SFAS 160”), which is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited. The effective date of SFAS 160 is the same as that of the related SFAS 141R discussed above. SFAS 160 requires that entities provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interest of the noncontrolling owners separately within the consolidated statement of financial position within equity, but separate from the parent’s equity and separately on the face of the consolidated statement of income. Further, changes in a parent’s ownership interest while the parent retains its controlling financial interest in its subsidiary should be accounted for consistently and when a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary should be initially measured at fair value. Management is currently evaluating the effect, if any, of SFAS 160 on the Company’s consolidated financial statements.

 

Other Pronouncements

 

In 2006, the FASB issued SFAS No. 157, “Fair Value Measurement” (“SFAS 157”), which provides enhanced guidance for using fair value to measure assets and liabilities. SFAS 157 also responds to investors’ requests for expanded information about the extent to which entities measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. SFAS 157 applies whenever other standards require or permit assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and for all interim periods within those fiscal years. The Company has adopted SFAS 157 effective January 1, 2008 for financial assets and liabilities and the impact was not deemed to be material to the Company’s consolidated financial statements. In accordance with FASB Staff Position No. 157-2, “Effective Date of FASB Statement No. 157,” the Company delayed the application of SFAS 157 for non-financial assets, such as goodwill, and non-financial liabilities until January 1, 2009. The Company is in the process of evaluating the impact of SFAS 157 for non-financial assets and liabilities on the Company’s consolidated financial statements.

 

In 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB Statement No. 115” (“SFAS 159”), which provides companies with an option to report selected financial assets and liabilities at fair value. The objective of SFAS 159 is to reduce both the complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. SFAS 159 is effective as of the beginning of an entity’s first fiscal year beginning after November 15, 2007. The Company has elected not to report any financial assets or liabilities at fair value under SFAS 159 on January 1, 2008.

 

In May 2008, FASB issued FASB Staff Position APB 14-1, “Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement)” (“FSP APB 14-1”). FSP APB 14-1 is effective for financial statements for fiscal years beginning after December 15, 2008. FSP APB 14-1 would require issuers to separate the convertible senior notes into two components: a non-convertible note and a conversion option. FSP APB 14-1 requires adoption to existing convertible debt instruments and as such NFP will need to recognize interest expense on its convertible debt instruments at its non-convertible debt borrowing rate rather than the stated rate (0.75%). NFP has completed a preliminary analysis of FSP APB 14-1 and believes it will result in a significant decrease in net income and earnings per share. FSP APB 14-1 shall be applied retrospectively to all prior periods presented. Early adoption is not permitted. FSP APB 14-1 will not have any impact on cash payments or obligations due under the terms of NFP’s 0.75% convertible senior notes which mature on February 1, 2012.

 

Note 3 - Earnings Per Share

 

The computations of basic and diluted earnings per share are as follows:

 

 

 

 

Note 4 - Acquisitions

 

During the nine months ended September 30, 2008, the Company acquired fifteen firms that offer life insurance and wealth transfer, corporate and executive benefits and other financial services to high net worth individuals and companies. These acquisitions allowed NFP to expand its presence in desirable geographic locations, further extend its presence in the financial services industry and increase the volume of services currently provided.

 

The purchase price, including direct costs, associated with acquisitions accounted for as purchases, and the allocations thereof, are summarized as follows:

 

The number of shares issued by NFP is generally based upon an average fair market value of NFP’s publicly traded common stock over a specified period of time prior to the closing date of the acquisition.

 

In connection with the fifteen acquisitions, the Company has contingent obligations based upon the future earnings of the acquired entities that are not included in the purchase price that was recorded for these acquisitions at the date of acquisition. Future payments made under this arrangement will be recorded as an adjustment to purchase price when the contingencies are settled. As of September 30, 2008, the maximum amount of contingent obligations for the fifteen firms, which is largely based on growth in earnings, was $58.6 million.

 

As of September 30, 2008, the Company did not capitalize any amounts relating to contingent consideration for firms acquired in 2008 and capitalized $1.1 million relating to contingent consideration for firms acquired during the nine months ended September 30, 2007.

 

In connection with the fifteen acquisitions, the Company expects approximately $11.4 million of goodwill to be deductible over 15 years for tax purposes.

 

In connection with the acquisition of a group benefits intermediary and its subsequent merger with an existing wholly-owned subsidiary of the Company, a portion of the consideration, totaling $23.1 million, was treated as prepaid management fee which will be amortized to management fee expense over the remaining term of the management contract. At September 30, 2008, approximately $0.9 million was amortized to management fee expense; $1.2 million was included in Other current assets; and $21.0 million was included in Other non-current assets.

 

 

The following table summarizes the required disclosures of the pro forma combined entity, as if these acquisitions occurred at January 1, 2008 and 2007, respectively:

 

 

The unaudited pro forma results above have been prepared for comparative purposes only and do not purport to be indicative of the results of operations which actually would have resulted had the acquisitions occurred at January 1, 2008 and 2007, respectively, nor is it necessarily indicative of future operating results.

 

  Note 5 - Goodwill and Other Intangible Assets

 

Goodwill:

 

The changes in the carrying amount of goodwill for the nine months ended September 30, 2008 are as follows:

 

 

 

Acquired intangible assets:

 

 

 

Aggregate amortization expense for intangible assets subject to amortization for the nine months ended September 30, 2008 was $29.3 million. Intangibles related to book of business, management contract and institutional customer relationships are being amortized over a 10-year, 25-year and 18-year period, respectively. Based on the Company’s acquisitions as of September 30, 2008, estimated amortization expense for each of the next five years is $39.6 million per year. Estimated amortization expense for each of the next five years will change primarily as the Company continues to acquire firms.

 

Impairment of goodwill and intangible assets:

 

The Company evaluates its amortizing (long-lived assets) and non-amortizing intangible assets for impairment in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”), and SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”), respectively.

 

In connection with its quarterly evaluation, management proactively looks for indicators of impairment. Indicators of impairment at the Company include but are not limited to: sustained operating losses or a trend of poor operating performance, loss of key personnel, a decrease in NFP’s market capitalization below its book value, and an expectation that a reporting unit will be sold or otherwise disposed of. Indicators of impairment at the reporting unit level may be due to the failure of the firms the Company acquires to perform as expected after the acquisition for various reasons, including legislative or regulatory changes that affect the products and services in which a firm specializes, the loss of key clients after acquisition, general economic factors that impact a firm in a direct way, and the death or disability of significant principals. If one or more indicators of impairment exist, the Company performs an evaluation to identify potential impairments. If an impairment is identified, the Company measures and records the amount of impairment loss.

 

Impairments were identified among six firms and two firms for the nine months ended September 30, 2008 and 2007, respectively. The Company compared the carrying value of each firm’s long-lived assets with an estimate of their respective fair values. The fair value is based upon the amount at which the long-lived assets could be bought or sold in a current transaction between the Company and its principals, and/or the present value of the assets’ future cash flow. Based upon this analysis, the following impairments of amortizing intangible assets were recorded:

 

 

For each firm’s non-amortizing intangible assets, the Company compared the carrying value of each firm with an estimate of its fair value. The fair value is based upon the amount at which the firm could be bought or sold in a current transaction between the Company and its principals, and/or the present value of the assets’ future cash flows. Based upon this analysis, the following impairments of non-amortizing intangible assets were recorded:

 

 

 

 

In accordance with SFAS 144, long-lived assets, such as purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company generally performs its recoverability test on a quarterly basis for each of its acquired firms that have experienced a significant deterioration in its business indicated principally by an inability to produce base earnings for the current and preceding four consecutive quarters. Management believes this is an appropriate time period to evaluate firm performance. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the estimated undiscounted cash flows expected to be generated by the asset and by the eventual disposition of the asset. If the estimated undiscounted cash flows are less than the carrying amount of the underlying asset, an impairment may exist. The Company measures impairments on identifiable intangible assets subject to amortization by comparing a discounted cash flow to the carrying amount of the asset. In the event that the discounted cash flows are less than the carrying amount, an impairment charge will be recognized for the difference in the consolidated statements of income.

 

In accordance with SFAS 142, goodwill and intangible assets not subject to amortization are tested at least annually for impairment, and are tested for impairment more frequently if events and circumstances indicate that the intangible asset might be impaired. The Company generally performs its impairment test on a quarterly basis. In connection with its quarterly evaluation, management proactively looks for indicators of impairment. Indicators at the Company level include but are not limited to: sustained operating losses or a trend of poor operating performance, loss of key personnel, a decrease in NFP’s market capitalization below its book value, and an expectation that a reporting unit will be sold or otherwise disposed of. The Company measures impairments of goodwill and intangible assets not subject to amortization by comparing a discounted cash flow to the carrying amount of the asset. In the event that the discounted cash flow is less than the carrying amount, an impairment charge will be recognized for the difference in the consolidated statements of income.

 

Management uses certain assumptions in its discounted cash flow analysis to determine the asset’s fair value. These assumptions include but are not limited to: the useful life of the asset, the discount rate from a treasury note that most closely matches the useful life of the asset, cash flow trends from prior periods, current-period cash flows, and management’s expectations of future cash flow expectations based on projections or forecasts derived from its understanding of the relevant business prospects, economic or market trends and regulatory or legislative changes which may occur. The Company discounts the expected gross cash flows to be received over the remaining life of the asset.

 

In most cases, the impaired assets were the result of management adjusting downward the projected future cash flows previously expected to be received over the remaining life of the asset. In addition, management may re-evaluate and reduce the asset’s useful life. Future cash flow projections, forecasts, and the assets’ useful lives are evaluated each quarter and may be modified based on certain facts and circumstances that come to management’s attention, including, but not limited to: legislative or regulatory changes that affect the products or services in which a firm specializes, loss of key personnel, inability to implement a business strategy, poor performance of investment products and/or services, the inability to facilitate succession planning, and levels of recurring income.

 

The method to compute the amount of impairment incorporates quantitative data and qualitative criteria including new information that can dramatically change the decision about the valuation of an intangible asset in a very short period of time. The timing and amount of realized losses reported in earnings could vary if management’s conclusions were different.

 

Future events could cause the Company to conclude that impairment indicators exist and that its remaining goodwill and other intangibles are impaired. Any resulting impairment loss could have a material adverse effect on the Company’s reported financial position and results of operations for any particular quarterly or annual period.

 

 

Note 6 – Borrowings

 

Credit Facility

 

NFP has a $250 million credit facility with various financial institutions party thereto and Bank of America, N.A., as administrative agent (the “Administrative Agent”) used primarily to finance acquisitions and fund general corporate purposes. NFP increased the maximum amount of revolving borrowings available under the credit facility from $225 million to $250 million on April 8, 2008. As consideration for the increase, NFP agreed to pay to the Administrative Agent, for the ratable benefit of the increasing lenders, a fee equal to 0.25%, or $62,500. There were no other significant changes to the credit facility.

 

Borrowings under the credit facility bear interest, at NFP’s election, at a rate per annum equal to: (i) at any time when the Company’s Consolidated Leverage Ratio, as defined in the credit facility, is greater than or equal to 2.0 to 1.0, the ABR plus 0.25% per annum or the Eurodollar Rate plus 1.25%, (ii) at any time when the Company’s Consolidated Leverage Ratio is less than 2.0 to 1.0 but greater than or equal to 1.0 to 1.0, the ABR or the Eurodollar Rate plus 1.00% and (iii) at any time when the Company’s Consolidated Leverage Ratio is less than 1.0 to 1.0, the ABR or the Eurodollar Rate plus 0.75%. As used in the credit facility, “ABR” means, for any day, the greater of (i) the federal funds rate in effect on such day plus 0.5% and (ii) the rate of interest in effect as publicly announced by Bank of America as its prime rate.

 

The credit facility is structured as a revolving credit facility and matures on August 22, 2011. NFP’s obligations under the credit facility are secured by all of its and its subsidiaries’ assets. Up to $35 million of the credit facility is available for the issuance of letters of credit and there is a $10 million sublimit for swingline loans. The credit facility contains various customary restrictive covenants that prohibit the Company from, subject to various exceptions and among other things: (i) incurring additional indebtedness or guarantees, (ii) creating liens or other encumbrances on property or granting negative pledges, (iii) entering into a merger or similar transaction, (iv) selling or transferring certain property, (v) declaring dividends or making other restricted payments and (vi) making investments. In addition, the credit facility contains financial covenants requiring the Company to maintain certain ratios, such as a minimum interest coverage ratio. The most restrictive negative covenant in the credit facility concerns the Consolidated Leverage Ratio, which states that NFP may not have a ratio of Consolidated Total Debt to EBITDA, as both terms are defined in the credit facility, exceeding 2.5 to 1 at the last day of any measurement period. As of September 30, 2008, the Company was in compliance with all covenants under the facility.

 

As of September 30, 2008, the year-to-date weighted average interest rate for NFP’s credit facility was 4.53%. The combined weighted average of the credit facility in the prior year period was 6.33%.

 

NFP had balances of $173.0 million outstanding under its credit facility as of September 30, 2008, $126.0 million as of December 31, 2007, and $80.0 million as of September 30, 2007.

 

Convertible Senior Notes

 

In January 2007, NFP issued $230 million (including over-allotment) aggregate principal amount of 0.75% convertible senior notes due February 1, 2012 (the “notes” or the “convertible senior notes”). The notes are senior unsecured obligations and rank equally with NFP’s existing or future senior debt and senior to any subordinated debt. The notes will be structurally subordinated to all existing or future liabilities of NFP’s subsidiaries and will be effectively subordinated to existing or future secured indebtedness to the extent of the value of the collateral. The notes were used to pay the net cost of the convertible note hedge and warrant transactions, repurchase 2.3 million shares of NFP’s common stock from Apollo Investment Fund IV, L.P. and Apollo Overseas Partners IV, L.P. (collectively, “Apollo”) and to repay a portion of outstanding amounts of principal and interest under NFP’s credit facility (all as discussed herein).

 

 

Holders may convert their notes at their option on any day prior to the close of business on the scheduled trading day immediately preceding December 1, 2011 only under the following circumstances: (1) during the five business-day period after any five consecutive trading-day period (the “measurement period”) in which the price per note for each day of that measurement period was less than 98% of the product of the last reported sale price of NFP’s common stock and the conversion rate on each such day; (2) during any calendar quarter (and only during such quarter) after the calendar quarter ending March 31, 2007, if the last reported sale price of NFP’s common stock for 20 or more trading days in a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter exceeds 130% of the applicable conversion price in effect on the last trading day of the immediately preceding calendar quarter; or (3) upon the occurrence of specified corporate events. The notes are convertible, regardless of the foregoing circumstances, at any time from, and including, December 1, 2011 through the second scheduled trading day immediately preceding the maturity date. Default under the credit facility resulting in its acceleration would, subject to a 30-day grace period, trigger a default under the supplemental indenture governing the notes.

 

Upon conversion, NFP will pay, at its election, cash or a combination of cash and common stock based on a daily conversion value calculated on a proportionate basis for each trading day of the relevant 20 trading day observation period. The initial conversion rate for the notes was 17.9791 shares of common stock per $1,000 principal amount of notes, equivalent to a conversion price of approximately $55.62 per share of common stock. The conversion price will be subject to adjustment in some events but will not be adjusted for accrued interest. In addition, if a “fundamental change” (as defined in the First Supplemental Indenture governing the notes) occurs prior to the maturity date, NFP will, in some cases and subject to certain limitations, increase the conversion rate for a holder that elects to convert its notes in connection with such fundamental change.

 

Concurrent with the issuance of the notes, NFP entered into convertible note hedge and warrant transactions with an affiliate of one of the underwriters for the notes. The transactions are expected to reduce the potential dilution to NFP’s common stock upon future conversions of the notes. Under the convertible note hedge, NFP purchased 230,000 call options for an aggregate premium of $55.9 million. Each call option entitles NFP to repurchase an equivalent number of shares issued upon conversion of the notes at the same strike price (initially $55.62 per share), generally subject to the same adjustments. The call options expire on the maturity date of the notes. NFP also sold warrants for an aggregate premium of $34 million. The warrants expire ratably over a period of 40 scheduled trading days between May 1, 2012 and June 26, 2012, on which dates, if not previously exercised, the warrants will be treated as automatically exercised if they are in the money. The warrants provide for net-share settlement. The net cost of the convertible note hedge and warrants to the Company is $21.9 million. Debt issuance costs associated with the notes of approximately $7.6 million are recorded in Other current assets and Other non-current assets and will be amortized over the term of the notes.

 

In accordance with Emerging Issues Task Force (“EITF”) Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock,” the Company recorded the cost incurred in connection with the convertible note hedge, including the related tax benefit, and the proceeds from the sale of the warrants as adjustments to additional paid-in capital and will not recognize subsequent changes in fair value. See “Note 2 - Summary of Significant Accounting Policies – Recently issued accounting pronouncements - Other Pronouncements” for a discussion of FASB Staff Position APB 14-1, “Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement).”

 

 

On June 9, 2006, NFP filed a shelf registration statement on Form S-3 with the SEC. The shelf registration statement allows NFP to issue various types of debt instruments, such as fixed or floating rate, convertible or indexed notes, as well as to issue preferred and/or common stock. In addition, NFP’s restricted stockholders are permitted to use the shelf to sell shares into the secondary market. In 2007, NFP issued $230 million of convertible senior notes (as discussed above) and certain of NFP’s stockholders offered 1,850,105 shares of NFP common stock through a secondary offering under this shelf.

 

Note 7 – Stockholders’ Equity

 

The changes in stockholders’ equity during the nine months ended September 30, 2008 are summarized as follows:  

 

Stock-based compensation

 

The Company is authorized under its various Stock Incentive Plans to grant options, stock appreciation rights, restricted stock, restricted stock units and performance stock units to officers, employees, principals and/or certain entities they own, independent contractors, consultants and non-employee directors.

 

Stock-based compensation expense was $3.3 million and $3.1 million for the three months ended September 30, 2008 and 2007, respectively, and $10.0 million and $9.5 million for the nine months ended September 30, 2008 and 2007, respectively.

 

 

Summarized below is the amount of stock-based compensation allocated between cost of services and corporate and other expenses in the consolidated statements of income.

 

 

Employee Stock Purchase Plan

 

Effective January 1, 2007, NFP established an Employee Stock Purchase Plan (“ESPP”). The ESPP is designed to encourage the purchase of common stock by NFP’s employees, further aligning interests of employees and stockholders and providing incentive for current employees. Up to 3,500,000 shares of common stock are currently available for issuance under the ESPP. The ESPP enables all regular and part-time employees who have worked with NFP for at least one year to purchase shares of NFP common stock through payroll deductions of any whole dollar amount of eligible compensation, up to an annual maximum of $10,000. The employees’ purchase price is 85% of the lesser of the market price of the common stock on the first business day or the last business day of the quarterly offering period. The Company recognizes compensation expense related to the compensatory nature of the discount given to employees who participate in the ESPP, which totaled $0.4 million and $0.3 million for the nine months ended September 30, 2008 and 2007, respectively.

 

Summarized ESPP information is as follows:

 

Secondary Offering

 

In January 2007, certain of NFP’s stockholders offered 1,850,105 shares of NFP common stock in a registered public offering (the “secondary offering”). In connection with the secondary offering, stock options for 349,455 shares were exercised resulting in cash proceeds payable to the Company of $3.8 million. In addition, the Company received a tax benefit, net of related deferred tax asset, of $0.9 million, which was recorded as an adjustment to additional paid-in capital.

 

Treasury Shares

 

On February 5, 2008, NFP’s Board of Directors authorized the repurchase of up to $45.0 million of NFP common stock in the open market, at times and in such amounts as management deems appropriate. The timing and actual number of shares repurchased will depend on a variety of factors, including capital availability, acquisition pipeline, share price and market conditions. As of September 30, 2008, NFP repurchased 994,500 shares at an average cost of $24.75 per share.

 

 

NFP also reacquired 45,657 shares related to the satisfaction of a promissory note, shares from amounts Due from principals and/or certain entities they own, and from the disposal of two subsidiaries and certain assets of a third subsidiary .

 

On January 15, 2007, NFP entered into an agreement with Apollo to repurchase 2.3 million shares of common stock from Apollo in a privately negotiated transaction. Apollo sold these shares to NFP at the same price per share as the initial price per share to the public in the January 17, 2007 secondary offering. After completion of the privately negotiated repurchase and the secondary offering, Apollo received the same proceeds per share, net of underwriting discounts, for the shares it sold pursuant to the repurchase and in the secondary offering, on an aggregate basis, as the other selling stockholders received for the shares they sold in the secondary offering.

 

Convertible Note Hedge and Warrant Transactions

 

In January 2007, concurrent with the issuance of the convertible senior notes, the Company entered into convertible note hedge and warrant transactions with an affiliate of one of the underwriters for the convertible senior notes. Default under NFP’s credit facility would trigger a default under each of the convertible note hedge and warrant. The transactions are expected to reduce the potential dilution to NFP’s common stock upon future conversions of the notes. Under the convertible note hedge, NFP purchased 230,000 call options for an aggregate premium of $55.9 million. Each call option entitles NFP to repurchase an equivalent number of shares issued upon conversion of the convertible senior notes at the same strike price (initially $55.62 per share), generally subject to the same adjustments. The call options expire on the maturity date of the convertible senior notes. NFP also sold warrants for an aggregate premium of $34 million. The warrants expire ratably over a period of 40 scheduled trading days between May 1, 2012 and June 26, 2012, on which dates, if not previously exercised, the warrants will be treated as automatically exercised if they are in the money. The warrants provide for net-share settlement. The net cost of the convertible note hedge and warrants to the Company was $21.9 million. These transactions were recorded as an adjustment to additional paid-in capital.

 

Note 8 – Non-Cash Transactions

 

The following non-cash transactions occurred during the periods indicated:  

 

 

Note 9 – Commitments and Contingencies

 

Legal matters

 

In the ordinary course of business, the Company is involved in lawsuits and other claims. Management considers these lawsuits and claims to be without merit and the Company intends to defend them vigorously. In addition, the sellers of firms that the Company acquires typically indemnify the Company for loss or liability resulting from acts or omissions occurring prior to the acquisition, whether or not the sellers were aware of these acts or omissions. Several of the existing lawsuits and claims have triggered these indemnity obligations.

 

In addition to the foregoing lawsuits and claims, during 2004, several of the Company’s firms received subpoenas and other informational requests from governmental authorities, including the New York Attorney General’s Office, seeking information regarding compensation arrangements, any evidence of bid rigging and related matters. The Company has cooperated and will continue to cooperate fully with all governmental agencies.

 

In March 2006, NFP received a subpoena from the New York Attorney General’s Office seeking information regarding life settlement transactions. One of NFP’s subsidiaries received a subpoena seeking the same information. The Company is cooperating fully with the Attorney General’s investigation. The investigation, however, is ongoing and the Company is unable to predict the investigation’s outcome.

 

Management continues to believe that the resolution of these lawsuits or claims will not have a material adverse impact on the Company’s consolidated financial position.

 

The Company cannot predict at this time the effect that any current or future regulatory activity, investigations or litigation will have on its business. Given the current regulatory environment and the number of its subsidiaries operating in local markets throughout the country, it is possible that the Company will become subject to further governmental inquiries and subpoenas and have lawsuits filed against it. The Company’s ultimate liability, if any, in connection with these matters and any possible future such matters is uncertain and subject to contingencies that are not yet known.

 

  Contingent consideration arrangements

 

The maximum contingent payment which could be payable as purchase consideration based on commitments outstanding as of September 30, 2008 is as follows:

 

 

 

Performance incentives

 

Management fees include an accrual for certain performance-based incentive amounts payable under NFP’s ongoing incentive program. Incentive amounts are paid in a combination of cash and NFP’s common stock. In addition to the incentive award, NFP pays an additional cash incentive equal to 50% of the incentive award elected to be received in the form of NFP’s stock. This election is made subsequent to the completion of the incentive period. For firms that began their incentive period prior to January 1, 2005, the principal can elect from 0% to 100% to be paid in NFP’s common stock. No accrual is made for these additional cash incentives until the related election is made. However, for firms beginning their incentive period on or after January 1, 2005 (with the exception of Highland Capital Holding Corporation firms), the principal is required to take a minimum of 30% (maximum 50%) of the incentive award in common stock. The Company accrues on a current basis for these firms the additional cash incentive (50% of the stock portion of the award) based upon the principal’s election or the minimum percentage required to be received in NFP stock. As of September 30, 2008, the maximum additional payment for this cash incentive that could be payable for all firms was approximately $0.9 million.

 

 

Self insured medical plan

 

Effective January 1, 2008, the Company is primarily self insured for medical insurance benefits provided to employees, and purchases insurance to protect the Company against claims, both on an individual and in aggregate basis, above certain levels. A health insurance carrier adjudicates and processes employee claims and is paid a fee for these services. The Company reimburses the health insurance carrier for paid claims. The Company estimates its exposure for claims incurred but not paid using historical census and other information provided by its health insurance carrier and other professionals. The Company has $1.3 million accrued for self insurance liabilities at September 30, 2008.

 

Deferred compensation plan

 

Effective January 1, 2008, the Company established a non-qualified deferred compensation plan for a select group of management and highly compensated employees. The plan is designed to aid the Company in retaining and attracting executive employees by providing them with tax deferred savings opportunities. Under the plan, participants may elect to defer receipt of a portion of their annual eligible compensation. Amounts deferred under the plan are invested at the direction of the participant. The Company makes a matching contribution of up to 50% of the first 6% of the participant’s eligible compensation, not to exceed the participant’s deferred amounts. Matching contributions are credited to the participant’s deferral account as of the last day of each plan year. Fifty percent (50%) of all matching contributions, plus an additional amount equal to 10% of such matching contributions is deemed to be invested in the Company stock fund, and the remaining 50% of the matching contributions is allocated to investments selected by the participant. The participants are 100% vested in their deferred amounts at all times. Matching contributions vest at the rate of 33.3% each year and are fully vested on the third anniversary of contribution to the plan. A separate deferral account is maintained for each participant. Subject to the terms of the plan, distributions from the participant’s deferral account will be made as soon as practicable after the earlier of: completion of three full years or termination of employment. As of September 30, 2008, the Company’s deferred compensation liability balance was $1.1 million.

 

Note 10 - Management Agreement Buyout

Effective June 30, 2007, NFP acquired an additional economic interest in one of its existing firms through the acquisition of a principal’s ownership interest in a management company. The management company was contracted by NFP to manage and operate one of its wholly-owned subsidiaries in 1999. The acquisition of this ownership interest has been treated as a settlement of an executory contract between parties with a preexisting relationship in accordance with EITF No. 04-1 “Accounting for Preexisting Relationships between the Parties to a Business Combination.”  NFP paid cash, stock and other consideration totaling $13.0 million which has been reflected in the caption entitled “Management agreement buyout” on the Consolidated Statements of Income in the prior year.

 

Note 11 – Other

 

Deferred reduction in management fee

 

During the third quarter of 2008 and 2007, pursuant to the repayment of notes by certain principals, approximately $1.1 million and $1.8 million, respectively, of future obligations of the principals previously being amortized as a deferred reduction in management fee expense was offset against management fee expense. The remaining obligations under the notes receivable due from principals were paid in full.

 

 

Life Settlements Joint Venture

 

On September 17, 2007, a subsidiary of NFP entered into an agreement (the “ILS Agreement”) with GS Re, a subsidiary of Goldman Sachs, to form a joint venture in the life settlements industry. On December 19, 2007, the ILS Agreement was amended to, among other things, add a subsidiary of Genworth Institutional Life Services, Inc. as a member of the joint venture (together with NFP and Goldman Sachs, “Partners”). In furtherance of the joint venture, the Partners have formed Institutional Life Services, LLC (“ILS”), a Delaware limited liability company, and on April 16, 2008 the Partners formed Institutional Life Administration, LLC (“ILA”). NFP owns 45% of ILS through its wholly-owned subsidiary NFP Life Services, LLC. Through the nine months ended September 30, 2008, NFP has contributed capital of $2.25 million to the joint venture, its full commitment, and has recorded a loss of $1.4 million relating to its membership interest in ILS. As of September 30, 2008, ILA has not been capitalized and has not commenced operations at this time.

 

Note 12 – Subsequent Events

 

Acquisitions

 

Subsequent to September 30, 2008 and through November 6, 2008, the Company completed one sub-acquisition. The consideration for this transaction included less than $0.1 million in cash.

 

Other

On November 3, 2008, the Company reduced headcount at its New York-based corporate headquarters. The headcount eliminations are expected to result in severance charges of approximately $1.5 million in the fourth quarter of 2008.

 

Dividends

On November 5, 2008, NFP’s Board of Directors suspended NFP’s quarterly cash dividend.

 

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion should be read in conjunction with the Company’s consolidated financial statements and the related notes included elsewhere in this report. In addition to historical information, this discussion includes forward-looking information that involves risks and assumptions, which could cause actual results to differ materially from management’s expectations. See “Forward-Looking Statements” included elsewhere in this report.

 

Executive Overview

 

The Company is a leading independent distributor of financial services products primarily to high net worth individuals and companies. Founded in 1998 and commencing operations on January 1, 1999, NFP has grown internally and through acquisitions and as of September 30, 2008, operates a national distribution network with over 180 owned firms. During the nine months ended September 30, 2008, revenue increased $12.7 million, or 1.5%, to $851.1 million from $838.4 million during the nine months ended September 30, 2007. Net income decreased $9.5 million, or 27.1%, to $25.5 million during the nine months ended September 30, 2008 from $35.0 million in the same period a year earlier.

 

The Company’s firms earn revenue that consists primarily of commissions and fees earned from the sale of financial products and services to their clients. The Company’s firms also incur commissions and fees expense and operating expense in the course of earning revenue. NFP pays management fees to non-employee principals of its firms and/or certain entities they own based on the financial performance of each respective firm. The Company refers to revenue earned by the Company’s firms less the expenses of its firms, including management fees, as gross margin. The Company excludes amortization and depreciation from gross margin. These amounts are separately disclosed as part of Corporate and other expenses. Management uses gross margin as a measure of the performance of the firms that the Company has acquired. Gross margin declined from $156.4 million, or 18.7% of revenue, during the nine months ended September 30, 2007 to $150.3 million, or 17.7% of revenue, during the nine months ended September 30, 2008.

 

The Company’s gross margin is offset by expenses that NFP incurs at the corporate level, including corporate and other expenses. Corporate and other expenses decreased from $93.5 million during the nine months ended September 30, 2007 to $90.4 million during the nine months ended September 30, 2008. Corporate and other expenses include general and administrative expense, amortization, depreciation, impairment of goodwill and intangible assets, and gain on sale of subsidiaries. General and administrative expense includes the operating expenses of NFP’s corporate headquarters and a portion of stock-based compensation. General and administrative expense grew from $43.9 million during the nine months ended September 30, 2007 to $48.9 million during the nine months ended September 30, 2008. General and administrative expense as a percentage of revenue increased to 5.7% during the nine months ended September 30, 2008 from 5.2% during the nine months ended September 30, 2007. Included in corporate and other expense was the expense incurred due to the buyout of a management agreement in connection with the acquisition of a management company from its former manager for cash, stock and other consideration totaling $13.0 million during the nine months ended September 30, 2007.

 

In light of the current financial environment, NFP has taken certain steps to streamline operations and maintain available cash.  On November 3, 2008, NFP reduced headcount at its New York-based corporate headquarters. The headcount eliminations will result in severance charges of approximately $1.5 million in the fourth quarter of 2008.  A small portion of the terminated positions will be replaced at the Company’s Austin, Texas-based facility.  The Company continues to explore further expense reductions.  Additionally, with the exception of certain sub-acquisitions, NFP does not anticipate completing acquisitions until market conditions and financial results stabilize nor does it anticipate repurchasing additional shares under its current share repurchase authorization.  On November 5, 2008, NFP’s Board of Directors also suspended NFP’s quarterly cash dividend.

 

 

Acquisitions

 

Under NFP’s typical acquisition structure, NFP acquires 100% of the equity of businesses that distribute financial services products on terms that are relatively standard across its acquisitions. To determine the acquisition price, NFP’s management first estimates the annual operating cash flow of the business to be acquired based on current levels of revenue and expense. For this purpose, management defines operating cash flow as cash revenue of the business less cash and non-cash expenses, other than amortization, depreciation and compensation to the business’ owners or individuals who subsequently become principals. Management refers to this estimated annual operating cash flow as “target earnings.” Typically, the acquisition price is a multiple (generally in a range of five to six times) of a portion of the target earnings, which management refers to as “base earnings.” Under certain circumstances, NFP has paid multiples in excess of six times based on the unique attributes of the transaction that justify the higher value. Base earnings averaged 52% of target earnings for all firms owned at September 30, 2008. In determining base earnings, management focuses on the recurring revenue of the business. Recurring revenue refers to revenue from sales previously made (such as renewal commissions on insurance products, commissions and administrative fees for ongoing benefit plans and mutual fund trail commissions) and fees for assets under management.

 

NFP enters into a management agreement with principals and/or certain entities they own. Under the terms of the management agreement, the principals and/or such entities are entitled to management fees consisting of:

 

 

 

NFP retains a cumulative preferred position in the base earnings. To the extent earnings of a firm in any year are less than base earnings, in the following year NFP is entitled to receive base earnings together with the prior years’ shortfall before any management fees are paid. In certain recent transactions involving large institutional sellers, the Company has provided minimum guaranteed compensation to certain former employees of the seller who became principals of the acquired business.

 

Additional purchase consideration is often paid to the former owners based on satisfying specified internal growth thresholds over the three-year period following the acquisition.

 

Sub-acquisitions

A sub-acquisition involves the acquisition by one of the Company’s firms of a business that is generally too small to qualify for a direct acquisition by NFP or where the individual running the business wishes to exit immediately or soon after the acquisition, prefers to partner with an existing principal or does not wish to become a principal. The acquisition multiple paid for sub-acquisitions is typically lower than the multiple paid for a direct acquisition by NFP.

Substantially all of NFP’s acquisitions have been paid for with a combination of cash and NFP common stock, valued at the fair market value at the time of acquisition. NFP typically requires its principals to take at least 30% of the total acquisition price in NFP common stock. However, in transactions involving institutional sellers, the purchase price typically consists of substantially all cash. Through September 30, 2008, principals have taken on average approximately 34% of the total acquisition price in NFP common stock. The following table shows acquisition activity (including sub-acquisitions) in the period:

______________

Revenue

 

The Company’s firms generate revenue primarily from the following sources:

 

Life insurance commissions and estate planning fees . Insurance and annuity commissions paid by insurance companies are based on a percentage of the premium that the insurance company charges to the policyholder. First-year commissions are calculated as a percentage of the first twelve months’ premium on the policy and earned in the year that the policy originates. In many cases, the Company’s firms receive renewal commissions for a period following the first year. Some of the Company’s firms receive fees for the settlement of life insurance policies. These fees are generally based on a percentage of the settlement proceeds. The Company’s firms also earn fees for developing estate plans. Revenue from life insurance activities also includes amounts received by the Company’s life brokerage entities, including its life settlements brokerage entities that assist affiliated and non-affiliated producers with the placement and sale of life insurance.

 

Corporate and executive benefits commissions and fees. The Company’s firms earn commissions on the sale of insurance policies written for benefit programs. The commissions are paid each year as long as the client continues to use the product and maintain its broker of record relationship with the firm. The Company’s firms also earn fees for the development and implementation of corporate and executive benefit programs as well as fees for the duration that these programs are administered. Asset-based fees are also earned for administrative services or consulting related to certain benefits plans. Incidental to the corporate and executive benefits services provided to their customers, some of the Company's firms offer property and casualty insurance brokerage and advisory services. The Company believes that these services complement the corporate and executive benefits services provided to the Company's clients. In connection with these services, the Company earns commissions and fees.

 

Financial planning and investment advisory fees and securities commissions. The Company’s firms earn commissions related to the sale of securities and certain investment-related insurance products, as well as fees for offering financial advice and related services. These fees are based on a percentage of assets under management and are generally paid quarterly. In a few cases, incentive fees are earned based on the performance of the assets under management. Some of the Company’s firms charge flat fees for the development of a financial plan or a flat fee annually for advising clients on asset allocation.  

 

Some of the Company’s firms also earn additional compensation in the form of incentive and marketing support revenue from manufacturers of financial services products, based on the volume, persistency and profitability of business generated by the Company from these three sources. Incentive and marketing support revenue is recognized at the earlier of notification of a payment or when payment is received, unless there exists historical data and other information which enable management to reasonably estimate the amount earned during the period. These forms of payments are earned both with respect to sales by the Company’s owned firms and sales by NFP’s affiliated third-party distributors.

 

NFP Securities, Inc. (“NFPSI”), NFP’s registered broker-dealer and investment adviser, also earns commissions and fees on the transactions effected through it. Most principals of the Company’s firms, as well as many of the Company’s affiliated third-party distributors, conduct securities or investment advisory business through NFPSI.

 

Although NFP’s operating history is limited, historically a significant number of its firms earn approximately 65% to 70% of their revenue in the first three quarters of the year and approximately 30% to 35% of their revenue in the fourth quarter. A worsening economic environment punctuated by a widespread deterioration in credit and liquidity, investment losses and a reduction in consumer confidence may result in a change in this pattern for 2008.

 

Expenses

 

The following table sets forth certain expenses as a percentage of revenue for the periods indicated:

 

 

Cost of services

 

Commissions and fees. Commissions and fees are typically paid to third-party producers, who are producers that are affiliated with the Company’s firms. Commission and fees are also paid to non-affiliated producers who utilize the services of one or more of the Company’s life brokerage entities including the Company’s life settlements brokerage entities. Commissions and fees are also paid to non-affiliated producers who provide referrals and specific product expertise to NFP’s firms. When business is generated solely by a principal, no commission expense is incurred because principals are only paid from a share of the cash flow of the acquired firm through management fees. However, when income is generated by a third-party producer, the producer is generally paid a portion of the commission income, which is reflected as commission expense of the acquired firm. Rather than collecting the full commission and remitting a portion to a third-party producer, a firm may include the third-party producer on the policy application submitted to a carrier. The carrier will, in these instances, directly pay each named producer their respective share of the commissions and fees earned. When this occurs the firm will record only the commissions and fees it receives directly as revenue and have no commission expense. As a result, the NFP firm will have lower revenue and commission expense and a higher gross margin percentage. Gross margin dollars will be the same. The transactions in which an NFP firm is listed as the sole producer and pays commissions to a third-party producer, versus transactions in which the carrier pays each producer directly, will cause NFP’s gross margin percentage to fluctuate without affecting gross margin dollars or earnings. In addition, NFPSI pays commissions to the Company’s affiliated third-party distributors who transact business through NFPSI.

 

Operating expenses. The Company’s firms incur operating expenses related to maintaining individual offices, including compensating producing and non-producing staff. Firm operating expenses also include the expenses of NFPSI and of NFP Insurance Services, Inc. (“NFPISI”), two subsidiaries that serve the Company’s acquired firms and through which the Company’s acquired firms and its third-party distributors who are members of its marketing organizations access insurance and financial services products and manufacturers. The Company records share-based payments related to firm employees and firm activities to operating expenses as a component of cost of services.

 

Management fees. NFP pays management fees to the principals of its firms and/or certain entities they own based on the financial performance of the firms they manage. NFP typically pays a portion of the management fees monthly in advance. Once NFP receives cumulative preferred earnings (base earnings) from a firm, the principals and/or entity the principals own will earn management fees equal to earnings above base earnings up to target earnings. An additional management fee is paid in respect of earnings in excess of target earnings based on the ratio of base earnings to target earnings. For example, if base earnings equal 40% of target earnings, NFP receives 40% of earnings in excess of target earnings and the principals and/or the entities they own receives 60%. A majority of the Company’s acquisitions have been completed with a ratio of base earnings to target earnings of 50%. Management fees also include an accrual for certain performance-based incentive amounts payable under NFP’s ongoing incentive program. Incentive amounts are paid in a combination of cash and NFP’s common stock. In addition to the incentive award, NFP pays an additional cash incentive equal to 50% of the incentive award elected to be received in NFP common stock. This election is made subsequent to the completion of the incentive period. For firms that began their incentive period prior to January 1, 2005, the principal could elect from 0% to 100% to be paid in NFP’s common stock. No accrual is made for these additional cash incentives until the related election is made. However, for firms beginning their incentive period on or after January 1, 2005 (with the exception of Highland Capital Holding Corporation firms), the principal is required to take a minimum of 30% (maximum 50%) of the incentive award in common stock. The Company accrues on a current basis for these firms the additional cash incentive (50% of the stock portion of the award based upon the principal’s election) on the minimum percentage required to be received in company stock. Management fees are reduced by amounts paid by the principals and/or certain entities they own under the terms of the management agreement for capital expenditures, including sub-acquisitions, in excess of $50,000. These amounts may be paid in full or over a mutually agreeable period of time and are recorded as a “deferred reduction in management fees.” Amounts recorded in deferred reduction in management fees are amortized as a reduction in management fee expense generally over the useful life of the asset. The ratio of management fees to gross margin before management fees is dependent on the percentage of total earnings of the Company’s firms capitalized by the Company, the performance of the Company’s firms relative to base earnings and target earnings, the growth of earnings of the Company’s firms in the periods after their first three years following acquisition and the earnings of NFPISI, NFPSI, and a small number of firms without a principal, from which no management fees are paid. Due to NFP’s cumulative preferred position, if a firm produces earnings below target earnings in a given year, NFP’s share of the firm’s total earnings would be higher for that year. If a firm produces earnings at or above target earnings, NFP’s share of the firm’s total earnings would be equal to the percentage of the earnings capitalized by NFP in the initial transaction, less any percentage due to additional management fees earned under the ongoing incentive plan. The Company records share-based payments related to principals as management fees which are included as a component of cost of services.

 

The following table summarizes the results of operations of NFP’s firms for the periods presented and uses non-GAAP measures. Gross margin before management fees represents the profitability of the Company’s business before principals receive participation in the earnings. Gross margin before management fees as a percentage of total revenue represents the base profitability of the Company divided by the total revenue of the Company’s business. Whether or not a principal participates in the earnings of a firm is dependent on the specific characteristics and performance of that firm. Management fees, as a percentage of gross margin before management fees represents the percentage of earnings that is not retained by the Company as profit, but is paid out to principals.

 

The Company uses gross margin before management fees and gross margin before management fees as a percentage of total revenue to evaluate how the Company’s business is performing before giving consideration to a principal’s participation in their firm’s earnings. This measure is the one in which the principal is compensated for their direct operating authority and control and on which the Company measures the principal’s performance. Management fees, as a percentage of gross margin before management fees is a measure that management uses to evaluate how much of the Company’s margin and margin growth is being shared with principals. This management fee percentage is a variable, not a fixed, ratio. Management fees, as a percentage of gross margin before management fees will fluctuate based upon the aggregate mix of earnings performance by individual firms. It is based on the percentage of the Company’s earnings that are capitalized at the time of acquisition, the performance relative to NFP’s preferred position in the earnings and the growth of the individual firms and in the aggregate. Management fees may be higher during periods of strong growth due to the increase in incentive accruals. Higher incentive accruals will generally be accompanied by higher firm earnings. Where firm earnings decrease, management fees and management fee percentage may be lower as incentive accruals are either reduced or eliminated. Further, since NFP retains a cumulative preferred interest in base earnings the relative percentage of management fees generally decreases as firm earnings decline. For firms that do not achieve base earnings, principals earn no management fee. Thus, a principal generally earns more management fees only when firm earnings grow and, conversely, principals earn less should earnings decline. This structure provides the Company with protection against earnings shortfalls through reduced management fee expense. In this manner the interests of both principals and shareholders remain aligned.

 

Management uses these non-GAAP measures to evaluate the performance of its firms and the results of the Company’s model. This cannot be effectively illustrated using the corresponding GAAP measures as management fees would be included in these GAAP measures and produce a less meaningful measure for this evaluation. On a firm-specific basis the Company uses these measures to help the Company determine where to allocate corporate and other resources to assist firm principals to develop additional sources of revenue and improve their earnings performance. The Company may assist these firms in cross selling, providing new products or services, technology improvements, providing capital for sub-acquisitions or coordinating internal mergers. On a macro level, the Company uses these measurements to help it evaluate broad performance of products and services which, in turn, helps shape the Company’s acquisition policy. In recent years the Company has emphasized acquiring businesses with a higher level of recurring revenue, such as benefits businesses, and those which expand its platform capabilities. The Company also may use these measures to help it assess the level of economic ownership to retain in new acquisitions or existing firms. Finally, the Company uses these measures to monitor the effectiveness of its ongoing incentive plan.

 

Management fees were 44.1% of gross margin before management fees for the nine months ended September 30, 2008 compared with 47.9% for the nine months ended September 30, 2007. As gross margin before management fees as a percentage of total revenue has decreased, the principals’ percentage participation in these earnings has also declined.

 

______________

 

Corporate and other expenses

 

General and administrative. At the corporate level, the Company incurs general and administrative expense related to the acquisition of and administration of its firms. General and administrative expense includes both cash and stock-based compensation, occupancy, professional fees, travel and entertainment, technology, telecommunication, advertising and marketing, legal, internal audit and certain corporate compliance costs.

 

Amortization. The Company incurs amortization expense related to the amortization of certain identifiable intangible assets.

 

Depreciation. The Company incurs depreciation expense related to capital assets, such as investments in technology, office furniture and equipment, as well as amortization for its leasehold improvements. Depreciation expense related to the Company’s firms as well as NFP’s corporate office is recorded within this line item.

 

Impairment of goodwill and intangible assets. The Company evaluates its amortizing (long-lived assets) and non-amortizing intangible assets for impairment in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”), and SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”), respectively. In connection with its quarterly evaluation, management proactively looks for indicators of impairment. Indicators of impairment at the Company include but are not limited to: sustained operating losses or a trend of poor operating performance, loss of key personnel, a decrease in NFP’s market capitalization below its book value and an expectation that a reporting unit will be sold or otherwise disposed of. Indicators of impairment at the reporting unit level may be due to the failure of the firms the Company acquires to perform as expected after the acquisition for various reasons, including legislative or regulatory changes that affect the products and services in which a firm specializes, the loss of key clients after acquisition, general economic factors that impact a firm in a direct way, and the death or disability of significant principals. In such situations, the Company may take impairment charges in accordance with SFAS 142 and SFAS 144 and reduce the carrying cost of acquired identifiable intangible assets (including book of business, management contracts, institutional customer relationships and trade name) and goodwill to their respective fair values. Management reviews and evaluates the financial and operating results of the Company’s acquired firms on a firm-by-firm basis throughout the year to assess the recoverability of goodwill and other intangible assets associated with these firms. In assessing the recoverability of goodwill and other intangible assets, management uses historical trends and makes projections regarding the estimated future cash flows and other factors to determine the recoverability of the respective assets. If a firm’s goodwill and other intangible assets do not meet the recoverability test, the firm’s carrying value will be compared with its estimated fair value. The fair value is based upon the amount at which the acquired firm could be bought or sold in a current transaction between NFP and the principals and/or the present value of the assets’ future cash flows. The intangible assets associated with a particular firm may be impaired when the firm has experienced a significant deterioration in its business indicated by an inability to produce at the level of base earnings for a period of more than four consecutive quarters and when the firm does not appear likely to improve its operating results or cash flows in the foreseeable future. Management believes that this is an appropriate time period to evaluate firm performance given the seasonal nature of many firms’ activities.

 

Management agreement buyout. From time to time, NFP may seek to acquire an additional economic interest in one of its existing firms through the acquisition of a principals’ ownership interest in a management company which has been contracted by NFP to manage and operate one of its wholly-owned subsidiaries. The acquisition of this ownership interest will be treated for accounting purposes as the settlement of an executory contract in a business combination between parties with a preexisting relationship and expensed as part of corporate and other expenses.

 

(Gain) loss on sale of subsidiaries. From time to time, NFP has disposed of acquired firms or certain assets of acquired firms. In these dispositions, NFP may realize a gain or loss on the sale of the acquired firms or certain assets of acquired firms.

 

Effect of New Accounting Pronouncements.

 

Business Combinations

 

In December 2007, the Financial Accounting Standards Board (the “FASB”) issued SFAS No. 141 (revised 2007) (“SFAS 141R”), “Business Combinations,” which is a revision of SFAS No. 141, “Business Combinations.” Certain changes prescribed by SFAS 141R that may impact the Company are as follows:

 

 

 

SFAS 141R is effective as of the beginning of an entity’s first fiscal year beginning after December 15, 2008. Adoption is prospective and early adoption is prohibited. The Company is currently evaluating the impact that the adoption of SFAS 141R will have on its consolidated financial statements and notes thereto.

 

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“SFAS 160”), which is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited. The effective date of SFAS 160 is the same as that of the related SFAS 141R discussed above. SFAS 160 requires that entities provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interest of the noncontrolling owners separately within the consolidated statement of financial position within equity, but separate from the parent’s equity and separately on the face of the consolidated statement of income. Further, changes in a parent’s ownership interest while the parent retains its controlling financial interest in its subsidiary should be accounted for consistently and when a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary should be initially measured at fair value. Management is currently evaluating the effect, if any, of SFAS 160 on the Company’s consolidated financial statements.

 

Other Pronouncements

 

In 2006, the FASB issued SFAS No. 157, “Fair Value Measurement” (“SFAS 157”), which provides enhanced guidance for using fair value to measure assets and liabilities. SFAS 157 also responds to investors’ requests for expanded information about the extent to which entities measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. SFAS 157 applies whenever other standards require or permit assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and for all interim periods within those fiscal years. The Company has adopted SFAS 157 effective January 1, 2008 for financial assets and liabilities and the impact was not deemed to be material to the Company’s consolidated financial statements. In accordance with FASB Staff Position No. 157-2, “Effective Date of FASB Statement No. 157,” the Company delayed the application of SFAS 157 for non-financial assets, such as goodwill, and non-financial liabilities until January 1, 2009. The Company is in the process of evaluating the impact of SFAS 157 for non-financial assets and liabilities on the Company’s consolidated financial statements.

 

In 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB Statement No. 115” (“SFAS 159”), which provides companies with an option to report selected financial assets and liabilities at fair value. The objective of SFAS 159 is to reduce both the complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. SFAS 159 is effective as of the beginning of an entity’s first fiscal year beginning after November 15, 2007. The Company has elected not to report any financial assets or liabilities at fair value under SFAS 159 on January 1, 2008.

 

In May 2008, FASB issued FASB Staff Position APB 14-1, “Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement)” (“FSP APB 14-1”). FSP APB 14-1 is effective for financial statements for fiscal years beginning after December 15, 2008. FSP APB 14-1 would require issuers to separate the convertible senior notes into two components: a non-convertible note and a conversion option. FSP APB 14-1 requires adoption to existing convertible debt instruments and as such NFP will need to recognize interest expense on its convertible debt instruments at its non-convertible debt borrowing rate rather than the stated rate (0.75%). NFP has completed a preliminary analysis of FSP APB 14-1 and believes it will result in a significant decrease in net income and earnings per share. FSP APB 14-1 shall be applied retrospectively to all periods presented including prior periods. Early adoption is not permitted. FSP APB 14-1 will not have any impact on cash payments or obligations due under the terms of NFP’s 0.75% convertible senior notes which matures on February 1, 2012.

 

Results of Operations

 

NFP’s management monitors acquired firm revenue, commissions and fees expense and operating expense from new acquisitions as compared with existing firms. For this purpose, a firm is considered to be a new acquisition for the twelve months following the acquisition. After the first twelve months, a firm is considered to be an existing firm. Within any reported period, a firm may be considered to be a new acquisition for part of the period and an existing firm for the remainder of the period. Additionally, NFPSI and NFPISI are considered to be existing firms. Sub-acquisitions that do not separately report their results are considered to be part of the acquiring firm. The results of firms disposed of are also included in the calculations and the results of operations discussion set forth below include analysis of the relevant line items on this basis.

 

Three months ended September 30, 2008 compared with three months ended September 30, 2007

 

The following table provides a comparison of the Company’s revenue and expenses for the periods presented:

 

______________

NM indicates amount is not meaningful

 

 

Summary

 

Net income. Net income was $5.1 million in the three months ended September 30, 2008 compared with $16.1 million in the three months ended September 30, 2007. Net income as a percentage of revenue was 1.8% for the three months ended September 30, 2008 compared with 5.2% for the three months ended September 30, 2007. A worsening economic environment punctuated by a widespread deterioration in credit and liquidity, investment losses and a reduction in consumer confidence have resulted in a continuation of the longer and more restrictive life underwriting and life settlements diligence process, greatly reduced availability of capital for premium financing and reduced contributions into executive benefit plans. While certain expenses, particularly commissions, move largely in line with revenues, changes in operating expenses take longer to effect. The Company has been actively engaged in cost reduction initiatives across its corporate offices and more than 180 owned firms. Certain expenses, including impairments and account write-offs, will usually accelerate during these times as existing challenges may exceed a reasonable timeframe to achieve sufficient earnings to recover the carrying value of its assets.

 

Revenue

 

Commissions and fees. Commissions and fees decreased $33.9 million, or 10.9%, to $277.3 million in the three months ended September 30, 2008 compared with $311.2 million in the same period last year. Commissions and fees generated from new acquisitions totaled $9.0 million in the three months ended September 30, 2008, which was largely offset by a $42.9 million decline in revenue at existing firms. Revenue at the Company’s Austin, Texas-based utilities, which are included as part of existing firms, rose $0.5 million from $66.5 million in the three months ended September 30, 2007 to $67.0 million in the three months ended September 30, 2008. Also included in the decline in revenue at existing firms was a decrease in revenue resulting from firms disposed subsequent to the third quarter of 2007 totaling $9.8 million. Retail life, life brokerage and life settlements revenue during the third quarter of 2008 were negatively impacted by the broader worsening economic environment. Further impacting these life products was a change in the mortality tables by a leading underwriting agency in September 2008 that affected the pricing of life policies and settlements. Benefits revenues were largely flat and financial advisory revenues were modestly higher in the third quarter of 2008 compared with the prior year quarter.

 

Cost of services

 

Commissions and fees. Commissions and fees expense decreased $16.5 million, or 16.2%, to $85.2 million in the three months ended September 30, 2008 compared with $101.7 million in the same period last year. New acquisitions accounted for an increase of $1.5 million in commissions and were largely offset by an $18.0 million decline in commissions at existing firms. As a percentage of revenue, commissions and fees expense was 30.7% in the three months ended September 30, 2008 compared with 32.7% in the same period last year. The decrease in commissions and fees expense both in dollars and as a percentage of revenue was directly attributable to the decline in revenue, principally retail life products and life settlements.

 

Operating expenses. Operating expenses increased $9.6 million, or 10.3%, to $102.4 million in the three months ended September 30, 2008 compared with $92.8 million in the same period last year. Approximately $3.5 million of the increase was due to additional operating expenses from new acquisitions and approximately $6.1 million from increased operating expenses at existing firms. As a percentage of revenue, operating expenses increased to 37.0% in the three months ended September 30, 2008 from 29.8% in the same period last year. Personnel and related costs continues to comprise more than 60% of firm operating expenses and nearly 70.0% of the operating expense increase in the quarter to quarter comparison. The increase as a percentage of revenue largely resulted from both the impact of lower revenues in the quarter to quarter comparison and the acquisition of firms that focus on the sale of benefit products which tend to have higher operating costs in acquiring and servicing those products. Stock-based compensation to firm employees and for firm activities included in operating expenses as a component of cost of services in both the third quarter of 2008 and the third quarter of 2007 was $1.0 million.

 

Management fees. Management fees decreased $18.4 million, or 30.9%, to $41.1 million in the three months ended September 30, 2008 compared with $59.5 million in the three months ended September 30, 2007. Management fees were 45.9% of gross margin before management fees in the three months ended September 30, 2008 compared with 51.0% in the same period last year. Management fees as a percentage of revenue decreased to 14.8% in the three months ended September 30, 2008 from 19.1% in the same period last year. Included in management fees was an accrual of $1.7 million for ongoing incentive plans in the third quarter of 2008 compared with $5.9 million in the 2007 quarter. Incentive accruals will vary from period to period based on the mix of firms participating in the program and the volatility of their earnings. This decrease in management fees as a percentage of gross margin before management fees reflects the lower level of firm earnings as well as the higher economic ownership percentages of firms acquired in 2007 and 2008. In aggregate, the economic ownership percentage of owned firms was 52% as of September 30, 2008 compared with 50% as of September 30, 2007. In addition, management fees included $0.5 million of stock-based compensation expense in the three months ended September 30, 2008 compared with $0.3 million in the three months ended September 30, 2007.

 

Gross margin. Gross margin decreased $8.6 million, or 15.0%, to $48.6 million in the three months ended September 30, 2008 compared with $57.2 million in the same period last year. As a percentage of revenue, gross margin was 17.5% in the three months ended September 30, 2008 compared with 18.4% in the same period last year. Gross margin and gross margin percentage declined in the third quarter of 2008 compared with the third quarter of 2007 due to lower revenues and increased operating expenses which were only partially offset by lower commissions and fees expense and a decline in management fee expense.

 

Corporate and other expenses  

General and administrative. General and administrative expense, which includes stock-based compensation, increased $2.3 million, or 16.1%, to $16.6 million in the three months ended September 30, 2008 compared with $14.3 million in the same period last year. As a percentage of revenue, general and administrative expense increased to 6.0% in the three months ended September 30, 2008 compared with 4.6% in the prior year period. Included in the third quarter of 2008 was $1.6 million of additional rent expense related to the relocation of the corporate headquarters in 2008, an additional reserve of $1.6 million related to a note receivable from a principal and a decrease of $0.5 million in personnel and personnel-related costs. Stock-based compensation included in general and administrative expense was $1.9 million and $1.8 million in the three months ended September 30, 2008 and 2007, respectively.

Amortization. Amortization increased $1.3 million, or 15.1%, to $9.9 million in the three months ended September 30, 2008 compared with $8.6 million in the same period last year. Amortization expense increased as a result of a 13.2% increase in amortizing intangible assets resulting primarily from new acquisitions. As a percentage of revenue, amortization was 3.5% in the three months ended September 30, 2008 compared with 2.8% in the three months ended September 30, 2007.

Depreciation. Depreciation expense increased $0.7 million, or 25.0%, to $3.5 million in the three months ended September 30, 2008 compared with $2.8 million in the same period last year. The increase in depreciation resulted from an increase in the number of owned firms and capital expenditures at the Company’s existing firms and at the corporate office. As a percentage of revenue, depreciation expense was 1.3% in the three months ended September 30, 2008 compared with 0.9% in the same period last year. Depreciation expense attributable to firm operations totaled $2.0 million in the three months ended September 30, 2008 compared with $1.8 million in the same period last year.

 

Impairment of goodwill and intangible assets. Impairment of goodwill and intangible assets increased $2.6 million to $5.2 million in the third quarter of 2008 compared with $2.6 million in the prior year period. The impairment related to three firms in the third quarter of 2008 and two firms in the 2007 quarter, resulting in a reduction of the carrying value of the identifiable intangible assets and goodwill associated with these firms to their estimated fair value. As a percentage of revenue, impairment of goodwill and intangibles was 1.9% for the three months ended September 30, 2008 and 0.8% for the three months ended September 30, 2007.

 

Gain on sale of subsidiaries. During the third quarter of 2008, the Company recognized a net gain from the sale of certain assets of three subsidiaries totaling $0.6 million. During the third quarter of 2007, the Company did not have any disposition activity.

 

Interest and other income. Interest and other income decreased $0.7 million, or 31.8%, to $1.5 million in the three months ended September 30, 2008 compared with $2.2 million in the three months ended September 30, 2007. The decrease in interest and other income is comprised of a decrease in interest income of $0.8 million and the Company’s proportional share of its loss in its joint venture, Institutional Life Services, of $0.7 million partially offset by an increase in sublet rental income earned on the Company’s former headquarters. The decrease in interest income is the result of a sharp decline in interest rates partially offset by a small increase in average available cash balances.

 

Interest and other expense. Interest and other expense was $2.8 million and $2.6 million in the three months ended September 30, 2008 and 2007, respectively. The increase results from higher average outstanding borrowings under the Company’s line of credit largely offset by lower interest rates in 2008. Borrowings increased during the fourth quarter of 2007 and first quarter of 2008 due to acquisition activity. Weighted average interest rates on borrowings declined from 6.47% in the third quarter of 2007 to 3.92% in the current quarter.

 

Income tax expense

 

Income tax expense. Income tax expense was $7.6 million in the three months ended September 30, 2008 compared with $12.4 million in the same period last year. The estimated effective tax rate in the third quarter of 2008 was 59.5%. This compares with an estimated effective tax rate of 43.5% in the third quarter of 2007. For the full year 2007, the effective tax rate was 46.1%. The effective tax rate for the 2008 third quarter increased, as compared to the prior year period, due to an increase in non-deductible amortization resulting from the impairment of three firms taken during the quarter and lower pretax income. The estimated effective tax rate may be affected by future impairments, restructurings, state tax changes and factors which may be recognized as discrete items in the quarters in which they arise and, as a result, may impact income tax expense both in terms of absolute dollars and as a percentage of income before income taxes.

 

Nine months ended September 30, 2008 compared with Nine months ended September 30, 2007

 

The following table provides a comparison of the Company’s revenue and expenses for the periods presented:

 

______________

NM indicates amount is not meaningful

 

 

Summary

 

Net income. Net income decreased $9.5 million, or 27.1%, to $25.5 million in the nine months ended September 30, 2008 compared with $35.0 million in the same period last year. Net income as a percentage of revenue was 3.0% for the nine months ended September 30, 2008, from 4.2% for the nine months ended September 30, 2007. The decrease in net income was due to lower gross margin and higher net interest and other partially offset by lower corporate and other expenses. The decline in gross margin reflected the challenging economic and market environment which worsened in the third quarter of 2008 leading to declining revenues and margins in that period and offsetting the gains in gross margin earned through the end of the second quarter of 2008.

 

Revenue

 

Commissions and fees. Commissions and fees increased $12.7 million, or 1.5%, to $851.1 million in the nine months ended September 30, 2008 compared with $838.4 million in the same period last year. Commissions and fees generated from new acquisitions totaled $48.1 million in the nine months ended September 30, 2008 and was offset by a $35.4 million decline in revenue from existing firms. Revenue growth early in 2008 benefited from increased carrier capacity in the senior life markets. However, a weakening financial and market environment led to a slowing of revenue growth particularly in retail life, life settlements and executive benefit plan products commissions and fees during the second quarter of 2008. The economic environment worsened in the third quarter of 2008 and revenues, particularly in life, life settlements and executive benefit plan products, declined from prior year levels. Revenues from benefits, excluding executive benefit plan products, and financial advisory products and services remain higher in the year to date period compared to the prior year.

 

Cost of services

 

Commissions and fees. Commissions and fees expense increased $4.1 million, or 1.5%, to $275.5 million in the nine months ended September 30, 2008 compared with $271.4 million in the same period last year. New acquisitions accounted for an increase of $9.3 million in commissions and fees expense and was offset by a $5.2 million decline in revenue from existing firms. As a percentage of revenue, commissions and fees expense was 32.4% in both the nine months ended September 30, 2008 and 2007.

 

Operating expenses. Operating expenses increased $39.9 million, or 15.0%, to $306.6 million in the nine months ended September 30, 2008 compared with $266.7 million in the same period last year. Approximately $18.5 million of the increase was due to new acquisitions and approximately $21.4 million was a result of increased operating expenses at the Company’s existing firms. As a percentage of revenue, operating expenses increased to 36.0% in the nine months ended September 30, 2008 from 31.8% in the same period last year. Operating expenses as a percentage of revenues rose in 2008 from a combination of lower revenues related to life, life settlements and executive benefit plan products and an increase in benefits, excluding executive benefit plan products, products which generally have higher operating costs needed to acquire and service these products. Personnel and related costs continue to make up a significant portion of firm operating expenses and comprised 76.5% of the operating expense increase in the year over year comparison. Included in the nine months ended September 30, 2008 was $1.6 million of additional rent expense incurred related to the relocation of seven firms to the new corporate headquarters in 2008. Stock-based compensation to firm employees and for firm activities included in operating expenses as a component of cost of services was $3.1 million in both the nine months ended September 30, 2008 and 2007.

 

Management fees. Management fees decreased $25.2 million, or 17.5%, to $118.7 million in the nine months ended September 30, 2008 compared with $143.9 million in the nine months ended September 30, 2007. Management fees were 44.1% of gross margin before management fees in the nine months ended September 30, 2008 compared with 47.9% in the prior year period. Management fees as a percentage of revenue decreased to 13.9% in the nine months ended September 30, 2008 from 17.1% in the same period last year. Included in management fees is an accrual of $5.4 million for ongoing incentive plans in the nine months ended September 30, 2008 compared with $11.5 million in the nine months ended September 30, 2007. Incentive accruals will vary from period to period based on the mix of firms participating in the program and the volatility of their earnings. This decrease in management fees as a percentage of gross margin before management fees reflects the lower levels of firm earnings as well as the higher economic ownership percentages of firms acquired in 2007 and early 2008. In addition, management fees included $1.4 million of stock-based compensation expense in the nine months ended September 30, 2008 compared with $0.7 million in the nine months ended September 30, 2007.

 

Gross margin. Gross margin decreased $6.1 million, or 3.9%, to $150.3 million in the nine months ended September 30, 2008 compared with $156.4 million in the same period last year. As a percentage of revenue, gross margin decreased to 17.7% in the nine months ended September 30, 2008 compared with 18.7% in the same period last year. The gross margin percentage was lower as the increase in commissions and fees expense and operating expenses as a percentage of revenue more than offset the decline in management fees.

 

Corporate and other expenses  

General and administrative. General and administrative expense, which includes stock-based compensation, increased $5.0 million, or 11.4%, to $48.9 million in the nine months ended September 30, 2008 compared with $43.9 million in the same period last year. As a percentage of revenue, general and administrative expense was 5.7% and 5.2% in the nine months ended September 30, 2008 and 2007, respectively. Included in the nine months ended September 30, 2008 was $4.6 million of additional rent expense related to the relocation of the corporate headquarters and an additional reserve of $1.6 million related to a note receivable. Stock-based compensation included in general and administrative expense was $5.6 million in the nine months ended September 30, 2008 and $5.7 million in the nine months ended September 30, 2007.

Amortization. Amortization increased $4.3 million, or 17.2%, to $29.3 million in the nine months ended September 30, 2008 compared with $25.0 million in the same period last year. Amortization expense increased as a result of a 14.8% increase in amortizing intangible assets resulting primarily from new acquisitions. As a percentage of revenue, amortization was 3.5% in the nine months ended September 30, 2008 compared with 3.0% in the nine months ended September 30, 2007.

Depreciation. Depreciation expense increased $1.8 million, or 22.8%, to $9.7 million in the nine months ended September 30, 2008 compared with $7.9 million in the same period last year. The increase in depreciation resulted from an increase in the number of owned firms and capital expenditures at the Company’s existing firms and at the corporate office. As a percentage of revenue, depreciation expense was 1.1% in the nine months ended September 30, 2008 compared with 0.9% in the same period last year. Depreciation expense attributable to firm operations totaled $5.9 million in the nine months ended September 30, 2008 compared with $4.9 million in the prior year period.

 

Impairment of goodwill and intangible assets. Impairment of goodwill and intangible assets increased $4.5 million to $10.2 million in the nine months ended September 30, 2008 compared with $5.7 million in the prior year period. The impairment relates to seven firms in the nine months ended September 30, 2008 and three firms in the nine months ended September 30, 2007. As a percentage of revenue, impairment of goodwill and intangibles was 1.2% for the nine months ended September 30, 2008 and 0.7% for the nine months ended September 30, 2007.

 

Management agreement buyout. Effective June 30, 2007, NFP acquired an additional economic interest in one of its existing firms through the acquisition of a principal’s ownership interest in a management company. The management company was contracted by NFP to manage and operate one of its wholly-owned subsidiaries. The acquisition of the ownership interest has been treated as a settlement of an executory contract in a business combination between parties in a preexisting relationship in accordance with EITF No. 04-1 “Accounting for Preexisting Relationships between the Parties to a Business Combination.” The Company paid cash, stock and other consideration totaling $13.0 million which has been reflected in the caption entitled “Management agreement buyout” in the Consolidated Statements of Income.

 

Gain on sale of subsidiaries. During the nine months ended September 30, 2008, the Company recognized a net gain from the sale of two subsidiaries and certain assets of four other subsidiaries totaling $7.7 million. The more significant gain was $6.5 million related to the sale of a wholesale group benefits subsidiary resulting from the strategic decision by its largest carrier to bring all wholesale distribution in-house, either by acquisition or cancellation of distribution arrangements. During the nine months ended September 30, 2007, the Company recognized a gain from the sale of three subsidiaries and contingent consideration for the sale of assets in a prior year totaling $2.0 million.

 

Interest and other income. Interest and other income decreased $2.7 million, or 39.1% to $4.2 million in the nine months ended September 30, 2008 compared with $6.9 million in the nine months ended September 30, 2007. The decrease resulted from the Company’s proportional share in the loss of its startup joint venture, ILS of $1.4 million, lower rental income and less interest earned on average available cash balances.

 

Interest and other expense. Interest and other expense increased $1.3 million, or 17.8%, to $8.6 million in the nine months ended September 30, 2008 compared with $7.3 million in the same period last year. The increase was primarily due to higher average borrowings under NFP’s line of credit partially offset by a lower interest rate environment.

 

Income tax expense

 

Income tax expense. Income tax expense was $30.0 million in the nine months ended September 30, 2008 compared with $27.5 million in the same period last year. The estimated effective tax rate for the nine months ended September 30, 2008 was 54.0% as compared with an estimated effective tax rate of 44.1% for the nine months ended September 30, 2007. For the full year 2007, the effective tax rate was 46.1%. The increase in the effective tax rate resulted from the sale of a subsidiary with a tax basis substantially less than its book basis which resulted in a large tax gain, an increase in non-deductible amortization from the impairment of seven firms taken during 2008 and lower pretax income. The estimated effective tax rate may be affected by future impairments, restructurings, state tax changes and factors which may be recognized as discrete items in the quarters in which they arise and, as a result, may impact income tax expense both in terms of absolute dollars and as a percentage of income before income taxes.

 

Liquidity and Capital Resources

 

The Company historically experiences its highest cash usage during the first quarter of each year as balances due to principals and/or certain entities they own for management fees and incentive bonuses earned are finalized and paid out, more acquisitions are completed and revenue and earnings decline from the fourth quarter of the prior year. The increase in cash usage during the first quarter generally requires increased borrowings under NFP’s credit facility. As the year progresses cash flows are expected to improve as earnings increase and acquisition activities moderate. With this increase in cash flow NFP generally reduces the borrowings under its credit facility. A change in this historical pattern of earnings growth and cash usage could impact the Company’s ability to reduce borrowings and meet its debt covenants. As of September 30, 2008, the Company had a working capital deficiency. This deficiency is the result of NFP’s classification of its credit facility as a current liability. NFP’s credit facility is structured as a revolving credit facility and matures on August 22, 2011. NFP may elect to pay down its outstanding balance at any time before August 22, 2011 but repayment is not required before that date. NFP’s classification of this obligation as a current liability has been driven by NFP’s practice of drawing against the credit line during the year and subsequently repaying significant amounts of the borrowing. The debt is current in the sense of NFP’s practice of frequent draws and repayments; it is not current in that repayment is not required in the next twelve months.

 

As of September 30, 2008, the Company was in compliance with all of its debt covenants. However, if the Company’s earnings deteriorate, it is possible that NFP would fail to comply with the terms of its credit facility, such as the consolidated leverage ratio covenant, and therefore be in default under the credit facility. Upon the occurrence of such event of default, the majority of lenders under the credit facility could cause amounts currently outstanding to be declared immediately due and payable. Such an acceleration could trigger “cross acceleration provisions” under NFP’s indenture governing the notes; see “—Borrowings—Convertible Senior Notes” below. Like many companies, NFP has initiated discussions with its bank group regarding the potential need for additional flexibility to navigate through the current downturn. Changes to the credit facility may result in an increase in borrowing costs in future periods.

 

A summary of the changes in cash flow data is provided as follows:  

 

As the financial crisis has deepened, NFP has performed additional assessments to determine the impact of recent market developments, including a review of access to liquidity in the capital and credit markets and macroeconomic conditions. If the financial crisis intensifies, leading to longer term disruptions in the capital and credit markets as a result of uncertainty, reduced capital alternatives could adversely affect the Company’s access to liquidity needed for its business. The inability to obtain adequate financing from debt or capital sources could force the Company to forgo certain opportunities. Any disruption in NFP’s access to capital could require the Company to take measures to conserve cash until the markets stabilize or until alternative credit arrangements or other funding for business needs can be arranged. Such measures could include deferring capital expenditures, reducing or eliminating future share repurchases, dividend payments, acquisitions or other discretionary uses of cash. On November 5, 2008, NFP’s Board of Directors directed management to suspend repurchasing additional shares under the current share repurchase authorization and also suspended NFP's quarterly cash dividend.

 

Current tightening of credit in the financial markets also adversely affects the ability of customers to obtain financing for the products and services the Company distributes, which could result in a decrease in revenues generated, reducing the Company’s liquidity.

 

Operating activities

 

During the nine months ended September 30, 2008, cash provided by operating activities was $24.3 million, compared with cash provided during the same period of the prior year of $44.6 million. During the nine months ended September 30, 2008, cash was provided primarily from net income adjusted for non-cash charges, which totaled $77.2 million, plus the net effect of collecting receivables outstanding at the beginning of the period and new receivables established at the end of the period, which totaled $44.5 million. Cash used during the nine months of 2008 and 2007 was largely the result of payments reducing balances due to principals and/or certain entities they own ($33.2 million and $19.7 million, respectively), accrued liabilities ($22.3 million and $9.6 million, respectively), and accounts payable ($12.4 million and $14.7 million, respectively). The large decrease in accrued liabilities included $18.2 million in payments related to ongoing incentive plans. Included and reducing cash provided by operating activities during the nine months ended September 30, 2008 was $14.4 million paid in connection with the acquisition of a group benefits intermediary and subsequent merger with an existing wholly-owned subsidiary of the Company which has been treated as prepaid management fee. A portion of this payment has been amortized with the remaining balance included in Other current assets and Other non-current assets.

 

Investing activities

 

During the nine months ended September 30, 2008 and 2007, cash used in investing activities was $71.6 million and $141.7 million, respectively, in both cases for the acquisition of firms and property and equipment. During the nine months of 2008 and 2007, the Company used $63.8 million and $135.3 million, respectively, for payments for acquired firms and contingent consideration. In each period, payments for acquired firms represented the largest use of cash in investing activities. During the nine months ended September 30, 2008, capital expenditures included approximately $20.2 million due to construction and other costs related to the relocation of the corporate headquarters and the concurrent consolidation of space with seven firms.

 

Financing activities

 

During the nine months ended September 30, 2008 and 2007, cash provided by financing activities was $0.5 million and $87.6 million, respectively. During the nine months ended September 30, 2008, net borrowings under the Company’s line of credit were $47.0 million. Cash dividends paid in the nine months ended September 30, 2008 were $24.7 million. During the nine months ended September 30, 2008, pursuant to NFP’s share repurchase authorization, NFP repurchased 994,500 shares of its common stock for $24.6 million.

 

During the nine months ended September 30, 2007, NFP issued convertible senior notes resulting in proceeds to NFP, net of associated costs, of $222.4 million. NFP utilized $106.6 million to repurchase 2.3 million shares of its common stock from Apollo Investment Fund IV, L.P. and Apollo Overseas Partners IV, L.P. (collectively, “Apollo”) in a privately negotiated transaction. NFP also sold warrants for aggregate proceeds of $34.0 million and purchased a convertible note hedge for $55.9 million for a net cost to the Company of $21.9 million. The Company also received $7.0 million in cash proceeds payable to the Company from the exercise of principal and employee stock options. This $7.0 million of cash proceeds included $4.7 million (including tax benefit) from the exercise of 349,455 shares in connection with a secondary public offering in January 2007.

 

Cash provided by financing activities was primarily the result of net borrowings under NFP’s credit facility. The Company uses this credit facility primarily to finance acquisitions and fund general corporate purposes.

 

Some of the Company’s firms maintain premium trust accounts, which represent payments collected from insureds on behalf of carriers. Funds held in these accounts are invested in cash, cash equivalents and securities purchased under resale agreements overnight. As of September 30, 2008, the Company had cash, cash equivalents and securities purchased under resale agreements in premium trust accounts of $81.9 million, an increase of $1.5 million from the balance of $80.4 million at December 31, 2007. Increases or decreases in these accounts relate to the volume and timing of payments from insureds and the timing of the Company’s remittances to carriers. These increases or decreases are largely offset by changes in premiums payable to insurance carriers.

 

Management believes that the Company’s existing cash, cash equivalents, funds generated from its operating activities and funds available under its credit facility will provide sufficient sources of liquidity to satisfy its financial needs for the next twelve months, despite disruptions in the capital markets. However, if circumstances change, the Company may need to raise debt or additional capital in the future.

 

Management will continue to closely monitor the Company's liquidity and the credit markets. However, management cannot predict with certainty the impact to the Company of any further disruption in the credit environment.

 

Borrowings

 

Credit Facility

On January 16, 2007, NFP entered into an amendment (the “Amendment”) to its $212.5 million credit facility, dated as of August 22, 2006, with various financial institutions party thereto and Bank of America, N.A., as administrative agent (the “Administrative Agent”). The Amendment, among other things, modified certain covenants to which NFP was subject under the Credit Agreement, dated as of August 22, 2006 (as amended, the “Credit Agreement”) and made other changes in contemplation of the issuance by NFP of the 0.75% convertible senior notes due February 1, 2012 (discussed separately below). Under the Amendment, NFP can incur up to $250 million in aggregate principal amount outstanding in unsecured indebtedness and unsecured subordinated indebtedness subject to certain conditions; previously, NFP could incur $75 million of unsecured subordinated debt. The Amendment also provides that cumulative Restricted Payments (as defined in the Amendment), which include but are not limited to dividends and share repurchases, may not exceed 50% of consolidated net income for the then completed fiscal quarters of the Company commencing with the fiscal quarter ending March 31, 2006 plus $150 million; previously, Restricted Payments could not exceed 50% of consolidated net income for the then completed fiscal quarters of the Company commencing with the fiscal quarter ending March 31, 2006 plus $125 million. In addition, to induce the credit facility lenders to consent to the Amendment, NFP agreed to pay to the administrative agent for the ratable benefit of the credit facility lenders that signed the Amendment an amendment fee equal to 0.05% of the commitments of such lenders. The $212.5 million credit facility replaced NFP’s previous $175 million credit facility and is used primarily to finance acquisitions and fund general corporate purposes.

On May 29, 2007, a new lender was added pursuant to a Lender Joinder Agreement, which increased the $212.5 million credit facility to $225 million. On April 7, 2008, NFP received an increase in the maximum amount of revolving borrowings available under the credit facility (the “Increase”). The Increase was in the amount of $25 million and raised the maximum amount of revolving borrowings available from $225 million to $250 million, which is pursuant to the Credit Agreement among NFP, as borrower, the several lenders from time to time party thereto and the Administrative Agent. As consideration for the Increase, NFP agreed to pay to the Administrative Agent, for the ratable benefit of the increasing lenders, a fee equal to 0.25% of the increased amount of such increasing lenders’ commitment, or approximately $62,500. Other than the changes mentioned above, there were no other significant changes to the Credit Agreement.

 

Borrowings under the credit facility bear interest, at NFP’s election, at a rate per annum equal to: (i) at any time when the Company’s consolidated leverage ratio is greater than or equal to 2.0 to 1.0, the ABR plus 0.25% per annum or the Eurodollar Rate plus 1.25%, (ii) at any time when the Company’s consolidated leverage ratio is less than 2.0 to 1.0 but greater than or equal to 1.0 to 1.0, the ABR or the Eurodollar Rate plus 1.00% and (iii) at any time when the Company’s consolidated leverage ratio is less than 1.0 to 1.0, the ABR or the Eurodollar Rate plus 0.75%. As used in the credit facility, “ABR” means, for any day, the greater of (i) the federal funds rate in effect on such day plus 0.5% and (ii) the rate of interest in effect as publicly announced by Bank of America as its prime rate.

 

NFP’s access to funds under its credit facility is dependent on the banks that are parties to the facility to meet their funding commitments and the Company’s compliance with all covenants under the facility. Those banks may not be able to meet their funding commitments to NFP if they experience shortages of capital and liquidity or if they experience excessive volumes of borrowing requests from other borrowers within a short period of time. Any disruption in the ability to borrow could require NFP to take measures to conserve cash until the markets stabilize or until alternative credit arrangements or other funding for its business needs could be arranged.

 

NFP’s credit facility is structured as a revolving credit facility and matures on August 22, 2011. NFP may elect to pay down its outstanding balance at any time before August 22, 2011. NFP’s obligations under the credit facility are secured by all of its and its subsidiaries’ assets. Up to $35 million of the credit facility is available for the issuance of letters of credit and there is a $10 million sublimit for swingline loans. The credit facility contains various customary restrictive covenants that prohibit the Company from, subject to various exceptions and among other things: (i) incurring additional indebtedness or guarantees, (ii) creating liens or other encumbrances on property or granting negative pledges, (iii) entering into a merger or similar transaction, (iv) selling or transferring certain property, (v) declaring dividends or making other restricted payments and (vi) making investments. In addition, the credit facility contains financial covenants requiring the Company to maintain certain ratios, such as a minimum interest coverage ratio. The most restrictive negative covenant in the credit facility concerns the consolidated leverage ratio, which states that NFP may not have a ratio of Consolidated Total Debt to EBITDA, as both terms are defined in the credit facility, exceeding 2.5 to 1 at the last day of any measurement period.

 

As of September 30, 2008, the Company was in compliance with all of its debt covenants. However, if the Company’s earnings deteriorate, it is possible that NFP would fail to comply with the terms of its credit facility, such as the consolidated leverage ratio covenant, and therefore be in default under the credit facility. Upon the occurrence of such event of default, the majority of lenders under the credit facility could cause amounts currently outstanding to be declared immediate due and payable. Such an acceleration could trigger “cross acceleration provisions” under NFP’s indenture governing the notes; see “—Convertible Senior Notes” below. Like many companies, NFP has initiated discussions with its bank group regarding the potential need for additional flexibility to navigate through the current downturn. Changes to the credit facility may result in an increase in borrowing costs in future periods.

 

As of September 30, 2008, the year-to-date weighted average interest rate for NFP’s credit facility was 4.53 %. The combined weighted average of its credit facility in the prior year period was 6.33%

 

NFP had outstanding borrowings of $173.0 million under the credit facility at September 30, 2008 and $80.0 million at September 30, 2007. At December 31, 2007, outstanding borrowings were $126.0 million. NFP has historically drawn upon its credit facilities from time to time to fund its acquisitions which tend to occur more frequently earlier in the year and reduce borrowings during the latter part of the year.

 

Convertible Senior Notes

 

In January 2007, NFP issued $230 million (including over-allotment) aggregate principal amount of 0.75% convertible senior notes due February 1, 2012 (the “notes”). The notes are senior unsecured obligations and rank equally with NFP’s existing or future senior debt and senior to any subordinated debt. The notes will be structurally subordinated to all existing or future liabilities of NFP’s subsidiaries and will be effectively subordinated to existing or future secured indebtedness to the extent of the value of the collateral. The notes were used to pay the net cost of the convertible note hedge and warrant transactions, repurchase 2.3 million shares of NFP’s common stock from Apollo and to repay a portion of outstanding amounts of principal and interest under NFP’s credit facility (all as discussed herein).

 

Holders may convert their notes at their option on any day prior to the close of business on the scheduled trading day immediately preceding December 1, 2011 only under the following circumstances: (1) during the five business-day period after any five consecutive trading-day period (the “measurement period”) in which the price per note for each day of that measurement period was less than 98% of the product of the last reported sale price of NFP’s common stock and the conversion rate on each such day; (2) during any calendar quarter (and only during such quarter) after the calendar quarter ending March 31, 2007, if the last reported sale price of NFP’s common stock for 20 or more trading days in a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter exceeds 130% of the applicable conversion price in effect on the last trading day of the immediately preceding calendar quarter; or (3) upon the occurrence of specified corporate events. The notes are convertible, regardless of the foregoing circumstances, at any time from, and including, December 1, 2011 through the second scheduled trading day immediately preceding the maturity date. Default under the credit facility resulting in its acceleration would, subject to a 30-day grace period, trigger a default under the supplemental indenture governing the notes, in which case the trustee under the notes or the holders of not less than 25% in principal amount of the notes could accelerate the payment of the notes.

 

Upon conversion, NFP will pay, at its election, cash or a combination of cash and common stock based on a daily conversion value calculated on a proportionate basis for each trading day of the relevant 20 trading day observation period. The initial conversion rate for the notes was 17.9791 shares of common stock per $1,000 principal amount of notes, equivalent to a conversion price of approximately $55.62 per share of common stock. The conversion price will be subject to adjustment in some events but will not be adjusted for accrued interest. In addition, if a “fundamental change” (as defined in the First Supplemental Indenture governing the notes) occurs prior to the maturity date, NFP will, in some cases and subject to certain limitations, increase the conversion rate for a holder that elects to convert its notes in connection with such fundamental change.

 

Concurrent with the issuance of the notes, NFP entered into a convertible note hedge and warrant transactions with an affiliate of one of the underwriters for the notes. A default under NFP’s credit facility would trigger a default under each of the convertible note hedge and warrant transactions, in which case the counterparty could designate early termination under either, or both, of these instruments. The transactions are expected to reduce the potential dilution to NFP’s common stock upon future conversions of the notes. Under the convertible note hedge NFP purchased 230,000 call options for an aggregate premium of $55.9 million. Each call option entitles NFP to repurchase an equivalent number of shares issued upon conversion of the notes at the same strike price ($55.62 per share), generally subject to the same adjustments. The call options expire on the maturity date of the notes. NFP sold warrants for an aggregate premium of $34 million. The warrants expire ratably over a period of 40 scheduled trading days between May 1, 2012 and June 26, 2012, on which dates, if not previously exercised, the warrants will be treated as automatically exercised if they are in the money. The warrants provide for net-share settlement. The net cost of the convertible note hedge and warrants to the Company is $21.9 million. Debt issuance costs associated with the notes of approximately $7.6 million are recorded in Other current assets and Other non-current assets and will be amortized over the term of the notes.

 

In accordance with EITF Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock,” the Company recorded the cost incurred in connection with the convertible note hedge, including the related tax benefit, and the proceeds from the sale of the warrants as adjustments to additional paid-in capital and will not recognize subsequent changes in fair value.

 

NFP received proceeds from the issuance of the notes, net of underwriting fees and the cost of the convertible note hedge and warrant transactions, of approximately $201.2 million of which $106.6 million was used to repurchase 2.3 million shares of NFP’s common stock from Apollo in a privately negotiated transaction and $94.6 million was used to pay down balances outstanding under NFP’s credit facility. Apollo received the same proceeds per share, net of underwriting discounts, for the shares it sold pursuant to the repurchase and in the secondary offering, on an aggregate basis, as the other selling stockholders received for the shares they sold in the offering.

 

Dividends

 

NFP paid a quarterly cash dividend of $0.21 per share of common stock on January 7, 2008, April 7, 2008, July 7, 2008 and October 7, 2008. On November 5, 2008, NFP’s Board of Directors suspended NFP’s quarterly cash dividend. Based on the most recent quarterly dividends declared of $0.21 per share of common stock and the number of shares held by stockholders of record on September 16, 2008, the total annual cash requirement for dividend payments would be approximately $33.3 million.

 

Off-Balance Sheet Arrangements

 

The Company had no material off-balance sheet arrangements during the nine months ended September 30, 2008.

 

Item 3. Quantitative and Qualitative Disclosures about Market Risk

 

Through the Company’s broker-dealer subsidiaries, it has market risk on buy and sell transactions effected by its firms’ customers. The Company is contingently liable to its clearing brokers for margin requirements under customer margin securities transactions, the failure of delivery of securities sold or payment for securities purchased by a customer. If customers do not fulfill their obligations, a gain or loss could be suffered equal to the difference between a customer’s commitment and the market value of the underlying securities. The risk of default depends on the creditworthiness of the customers. The Company assesses the risk of default for each customer accepted to minimize its credit risk.

 

The Company has market risk on the fees its firms earn that are based on the market value of assets under management or the value of assets held in certain mutual fund accounts and variable insurance policies for which ongoing fees or commissions are paid. Certain of the performance-based fees of the Company’s firms are impacted by fluctuations in the market performance of the assets managed according to such arrangements.

 

NFP has a credit facility and cash, cash equivalents and securities purchased under resale agreements in premium trust accounts. Interest income and expense on the preceding items are subject to short-term interest rate risk. Based on the weighted average borrowings under NFP’s credit facility during the nine months ended September 30, 2008 and 2007, a 1% change in short-term interest rates would have affected the Company’s income before income taxes by approximately $1.8 million for the nine months ended September 30, 2008 and $0.8 million for the nine months ended September 30, 2007. Based on the weighted average amount of cash, cash equivalents and securities purchased under resale agreements in premium trust accounts during the nine months ended September 30, 2008 and 2007, a 1% change in short-term interest rates would have affected the Company’s income before income taxes by approximately $1.6 million and $1.4 million, respectively. As further discussed in “Liquidity and Capital Resources,” broad economic and credit market conditions may impact the Company’s access to capital and the availability or attractiveness of certain products from which the Company earns revenue.

 

The Company has not entered into any derivative financial instrument transactions to manage or reduce market risk or for speculative purposes, other than a convertible note hedge and warrant transactions entered into concurrently with NFP’s convertible senior notes offering. Such transactions were entered into to lessen or eliminate the potential dilutive effect of the conversion feature of the convertible senior notes on NFP’s common stock.

 

The Company is further exposed to credit risk for commissions received from clearing brokers and insurance companies. This credit risk is generally limited to the amount of commissions receivable. Given current market conditions, any potential defaults by, or even rumors about, financial institutions such as insurers could result in losses by these institutions. To the extent that questions about an insurance carrier's perceived stability and financial strength ratings contribute to such insurer’s failure in the market, the Company could be exposed to losses resulting from such insurer’s inability to pay commissions or fees owed.

 

There have been disruptions in the financial markets during the past year and many financial institutions have reduced or ceased to provide funding to borrowers. The availability of credit, confidence in the financial sector, and volatility in financial markets has been adversely affected. Although NFP does not invest in any collateralized debt obligations or collateralized mortgage obligations, these disruptions are likely to have some impact on all financial institutions in the United States, including the Company. Further, there can be no assurance that future changes in interest rates, creditworthiness or solvency of counterparties, liquidity available in the market and other general market conditions will not have a material adverse impact on the Company’s results of operations, liquidity or financial position.

 

Item 4. Controls and Procedures

 

As of the end of the period covered by this report, NFP’s management carried out an evaluation, under the supervision and with the participation of NFP’s Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness of NFP’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) or 15d-15(e) under the Securities Exchange Act of 1934 (“Exchange Act”)). Based on this evaluation, the CEO and CFO have concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective.

 

Changes in Internal Control over Financial Reporting

 

On July 1, 2008, NFP acquired a Canadian-based employee benefits firm. The functional currency of the Company is the United States (“U.S.”) dollar. Excluding the translation of foreign currency into the U.S. dollar put in place as a direct result of this acquisition, there have been no significant changes in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act) during the nine months ended September 30, 2008 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting. Changes to certain processes, information technology systems and other components of internal control over financial reporting resulting from the acquisition of the Canadian-based firm may occur and will be evaluated by management as such integration activities are implemented.

 

Part II – Other Information

 

Item 1. Legal Proceedings

 

In the ordinary course of business, the Company is involved in lawsuits and other claims. Management considers these lawsuits and claims to be without merit and the Company intends to defend them vigorously. In addition, the sellers of firms that the Company acquires typically indemnify the Company for loss or liability resulting from acts or omissions occurring prior to the acquisition, whether or not the sellers were aware of these acts or omissions. Several of the existing lawsuits and claims have triggered these indemnity obligations.

 

In addition to the foregoing lawsuits and claims, during 2004, several of the Company’s firms received subpoenas and other informational requests from governmental authorities, including the New York Attorney General’s Office, seeking information regarding compensation arrangements, any evidence of bid rigging and related matters. The Company has cooperated and will continue to cooperate fully with all governmental agencies.

 

In March 2006, NFP received a subpoena from the New York Attorney General’s Office seeking information regarding life settlement transactions. One of NFP’s subsidiaries received a subpoena seeking the same information. The Company is cooperating fully with the Attorney General’s investigation. The investigation, however, is ongoing and the Company is unable to predict the investigation’s outcome.

 

Management continues to believe that the resolution of these lawsuits or claims will not have a material adverse impact on the Company’s consolidated financial position.

 

The Company cannot predict at this time the effect that any current or future regulatory activity, investigations or litigation will have on its business. Given the current regulatory environment and the number of its subsidiaries operating in local markets throughout the country, it is possible that the Company will become subject to further governmental inquiries and subpoenas and have lawsuits filed against it. The Company’s ultimate liability, if any, in connection with these matters and any possible future such matters is uncertain and subject to contingencies that are not yet known.

 

Item 1A. Risk Factors

 

The information below should be considered in conjunction with the other risk factors identified in NFP’s Annual Report on Form 10-K for the year ended December 31, 2007, filed with the SEC on February 19, 2008.

 

In light of current market conditions, the Company’s inability to access the capital markets on favorable terms may adversely affect the Company’s future operations, including continued acquisition activity. NFP may seek to amend the financial covenants of its Credit Agreement which could include an increase in borrowing costs or additional fees.

 

As of September 30, 2008, NFP was in compliance with all of its debt covenants. However, NFP may be unable to satisfy financial covenants in the future, which could materially and adversely affect NFP’s ability to finance future operations, such as acquisitions or capital needs. If the Company’s earnings deteriorate, it is possible that NFP would fail to comply with the terms of its credit facility, such as the consolidated leverage ratio requirement, and therefore be in default under the credit facility. Default under NFP’s credit facility would trigger a default under each of the convertible note hedge and warrant transactions, in which case the counterparty could designate early termination under either, or both, of these instruments. Default under NFP’s credit facility resulting in its acceleration would, subject to a 30-day grace period, trigger a default under the supplemental indenture governing the notes. In that case, the trustee under the notes or the holders of not less than 25% in principal amount of the notes could accelerate their payment.

Due to the existing uncertainty in the capital and credit markets, NFP’s access to capital may not be available on acceptable terms, and this may result in the Company’s inability to achieve present objectives for strategic acquisitions and internal growth. To provide financial flexibility, NFP may seek to amend the financial covenants of its Credit Agreement; however, there can be no assurances that NFP will be able to secure such amendments or that such amendments will be on acceptable terms. Even if NFP were able to secure such facilities, NFP could experience an increase in borrowing costs. Any disruption in NFP’s access to capital could require the Company to take measures to conserve cash until the markets stabilize or until alternative credit arrangements or other funding for business needs can be arranged. Such measures could include deferring capital expenditures, reducing or eliminating future share repurchases, dividend payments, acquisitions or other discretionary uses of cash.

 

48

---

Dislocation in financial markets may adversely impact the Company.

 

The financial services industry has recently experienced unprecedented change and volatility. Disruptions in the financial markets may have an adverse effect in the U.S. market, which could negatively impact business and consumer spending patterns. There is no assurance that government responses to the disruptions in the financial markets will restore business and consumer confidence, stabilize the markets or increase liquidity and the availability of credit.

 

Current tightening of credit in financial markets also adversely affects the ability of customers to obtain financing for the products and services the Company distributes, which could result in a decrease in revenues generated. Demand for many types of insurance generally rises and falls as economic growth expands or slows. To the extent the Company’s clients become adversely affected by declining business conditions, they may choose to limit their purchases of insurance coverage or registered investment advisory services, which would inhibit the Company’s ability to generate revenue. Moreover, insolvencies associated with an economic downturn could adversely affect the Company’s business through the loss of clients or by hampering the Company’s ability to place insurance and reinsurance business.

 

The failure of insurances carriers may impact the Company. In addition, NFP may need to expend resources to address questions regarding its relationship with financial institutions.

 

Any potential defaults by, or even rumors about, financial institutions such as insurers could result in losses by these institutions. Questions about an insurance carrier's perceived stability and financial strength ratings may contribute to such insurers’ strategic decisions to focus on certain lines of insurance to the detriment of others. Consequently, the potential for a significant insurer to cease writing certain insurance the Company offers its customers could negatively impact overall capacity in the industry, which in turn could have the effect of reduced placement of certain lines and types of insurance and reduced revenues and profitability for the Company. Further, to the extent that questions about an insurance carrier's viability contribute to such insurers’ failure in the market, the Company could be exposed to losses resulting from such insurers’ inability to pay commissions or fees owed.

 

The Company has relationships with many financial institutions, including insurers which are regulated by state insurance departments for solvency issues and are subject to reserve requirements. NFP cannot guarantee that all insurance carriers it does business with will maintain these traditional ratings. The Company may need to expend resources to address questions or concerns regarding its relationships with these insurers, diverting management resources away from operating the Company’s business.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

(a) Recent Sales of Unregistered Securities

 

Since January 1, 2008 and through September 30, 2008, NFP has issued the following securities:

 

NFP has issued 669,471 shares of common stock with a value of approximately $18.5 million to principals in connection with the acquisition of firms. NFP has issued 78,023 shares of common stock with a value of approximately $1.8 million to principals related to contingent consideration and other.

 

Since October 1, 2008 and through November 6, 2008, NFP has not issued any unregistered securities.

 

The issuances of common stock described above were made in reliance upon the exemption from registration under Section 4(2) of the Securities Act of 1933, as amended (the "Securities Act"), and Regulation D promulgated thereunder, for transactions by an issuer not involving a public offering. The Company did not offer or sell the securities by any form of general solicitation or general advertising, informed each purchaser that the securities had not been registered under the Securities Act and were subject to restrictions on transfer, and made offers only to “accredited investors” within the meaning of Rule 501 of Regulation D and a limited number of sophisticated investors, each of whom the Company believed had the knowledge and experience in financial and business matters to evaluate the merits and risks of an investment in the securities and had access to the kind of information registration would provide.

 

49

---

(c) Issuer Purchases of Equity Securities

 

 

Period		Total Number of Shares (or Units) Purchased		Average Price Paid per Share (or Unit)			Total Number of Shares (or Units) Purchased as Part of Publicly Announced Plans or Programs (d)		Maximum number (or Approximate Dollar Value) of Shares (or Units) that May Yet Be Purchased Under the Plans or Programs (d)
July 1, 2008 – July 31, 2008		9,822	(a)	$	21.36		—		$	—
August 1, 2008 – August 31, 2008		133,100	(b)	$	20.22		133,100		$	20,387,827
September 1, 2008 – September 30, 2008		1,800	(c)	$	19.72		—		$	—
Total		144,722		$	20.29		133,100

 

(a)

5,925 shares were reacquired relating to the satisfaction of a promissory note. No gain or loss was recorded on this transaction. 3,897 shares were reacquired relating to the sale of certain assets of a subsidiary.

(b)

133,100 shares were reacquired relating to NFP’s share repurchase authorization.

(c)

1,800 shares were reacquired relating to the partial satisfaction of a promissory note. No gain or loss was recorded on this transaction.

(d)

On February 5, 2008, NFP’s Board of Directors authorized the repurchase of up to $45.0 million of NFP’s common stock in the open market, at times and in such amounts as management deems appropriate.

 

Item 5. Other Information

 

Departure of Directors or Certain Officers

 

On November 3, 2008, Robert S. Zuccaro resigned from his position as Executive Vice President and Chief Accounting Officer of NFP, effective December 31, 2008.  Mr. Zuccaro’s decision was made in connection with broader reductions in workforce at the Company and did not involve a disagreement with the Company on any matter relating to the Company’s operations, policies or practices.  Donna J. Blank, Executive Vice President and Chief Financial Officer of NFP, oversees NFP’s accounting functions. 

 

Other Information

 

On November 3, 2008, Mark C. Biderman, former Chief Financial Officer, announced his retirement from his position as Executive Vice President and Vice Chairman of NFP, effective December 31, 2008.  Mr. Biderman’s decision did not involve a disagreement with the Company on any matter relating to the Company’s operations, policies or practices.   Any material compensatory plan, contract or arrangement subsequently entered into with Mr. Biderman in connection with his retirement will be publicly disclosed as required. As previously disclosed, effective September 1, 2008, Donna J. Blank, Executive Vice President and Chief Financial Officer of NFP, oversees NFP’s financial functions.

 

50

---

EXHIBIT INDEX

Item 6. Exhibits

 

Exhibit   No.		Description
12.1		Computation of Ratio of Earnings to Combined Fixed Charges and Preferred Dividends
31.1		Certification of Chief Executive Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities Exchange Act of 1934
31.2		Certification of Chief Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities Exchange Act of 1934
32.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2		Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

 

 

---

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

National Financial Partners Corp.

 

Signature		Title		Date
/ S / J ESSICA M. B IBLIOWICZ		Chairman, President and Chief Executive Officer		November 6, 2008
Jessica M. Bibliowicz
/ S / Donna J. B LANK		Executive Vice President and Chief Financial Officer		November 6, 2008
Donna J. Blank

 

---

EXHIBIT INDEX

 

Exhibit   No.		Description
12.1		Computation of Ratio of Earnings to Combined Fixed Charges and Preferred Dividends
31.1		Certification of Chief Executive Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities Exchange Act of 1934
31.2		Certification of Chief Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities Exchange Act of 1934
32.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2		Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

 

 

National Financial Partners (NYSE:NFP)
Historical Stock Chart
From Jun 2024 to Jul 2024

National Financial Partners (NYSE:NFP)
Historical Stock Chart
From Jul 2023 to Jul 2024