ITEM 1. BUSINESS
OVERVIEW
We are an integrated, national real estate services and investment Company. Founded in 1977, we were later incorporated in Delaware and became a public Company in 1992. We deliver a complementary array of real estate services. Headquartered in Beverly Hills, we have approximately 535 employees in offices in the U.S. We initially gained recognition through our real estate auction services. Over time, we diversified our business so that we now provide:
• Fund management of real estate and note pool investments;
• Commercial and residential property management and leasing; and
• Commercial and residential brokerage, including auction marketing.
In addition to these real estate related services, we invest primarily through joint venture investments in commercial and residential real estate and discounted loan portfolios. Our clients include large financial institutions, major corporations, pension funds, real estate developers, insurance companies and governmental entities.
Our previously wholly-owned, consolidated subsidiary, Kennedy-Wilson Japan (“KWJ”), has had a presence in Japan for ten years through which we developed significant relationships with Japanese companies and financial institutions. In 2002, the Company completed an initial public offering, a secondary public offering and a private sale of the shares of KWJ. The public offerings and private sale generated gross cash consideration of approximately $35 million. During 2003, the Company completed the sale of its remaining shares of KWJ for total gross cash consideration of approximately $30.3 million. As a result of the public offerings and the sales of shares, the Company recorded net gains of approximately $16.4 million and $12.9 million for the years ended December 31, 2003 and 2002, respectively.
OUR BUSINESS OPERATIONS
FUND MANAGEMENT
KWI Fund Management Group is a vertically integrated real estate services and fund management firm. This group organizes and manages closed-end commingled real estate investment funds that invest in high-quality office, industrial, retail and multifamily income property located in selected markets in the U.S. We serve as the general partner of the funds and co-invest with our pension fund clients as limited partners. We earn fees for services provided to the fund including fees for acquisition, asset management, property management, leasing, and disposition services.
KWI Fund I is a fund with approximately $145 million in assets (at estimated fair market value) comprised of $64 million in equity, which is 5% owned by the Company, and capitalized with limited partners’ capital and $79 million in debt. Through the end of 2003, KWI Fund I owns 10 office properties totaling approximately 1,070,000 square feet. The properties are located in Los Angeles, Orange County, Houston, Austin and Atlanta.
Future funds are expected to be in the $100 million equity range with $250 million in assets. The funds are expected to have the following principal investment objectives:
• Invest in high-quality office, industrial, retail and multifamily income property located in selected markets;
• Properties that need renovation and capital improvements, in major growth markets that are expected to maintain above-average employment and rent growth rates;
• Acquire properties at substantial discounts to replacements cost, make selective capital improvements that are expected to increase income and create significant value in excess of the cost;
• Acquire properties generally in the $5 to $25 million per property price range.
PROPERTY MANAGEMENT AND LEASING
We are a nationwide commercial and residential property management and leasing Company. We provide a full range of services relating to property management, including:
• Commercial and residential building management;
• Leasing;
• Asset management;
• Construction management;
• Engineering services; and
• Technical services.
We have managers in six regional offices-Beverly Hills, New York, Austin, San Francisco, Seattle, and Chicago-supervising approximately 500 employees who assist in managing more than 300 office and industrial buildings, and multi-unit residential complexes in 18 different states. We have approximately 40 million gross square feet of real estate under management.
As part of our strategy for providing our property management clients with the best services possible, we apply the same approach in managing our clients’ properties as we do in managing our own, where our primary objective is to maximize the return on investment. To this end, we work with each client to ascertain their goals and expectations and to design strategic plans for leasing and improving each property in a way that increases the client’s returns. We also strive to maximize our clients’ returns by reducing property operating expenses through the discounts and lower prices that we generally obtain for vendor services and supplies.
REAL ESTATE BROKERAGE
Through our offices in Beverly Hills and New York, we provide specialized brokerage services for both commercial and residential real estate. We market and sell on behalf of our clients and ourselves:
• Office and retail buildings;
• Multi- and single-family residences;
• Industrial sites;
• Hotels and resorts;
• Improved residential lots; and
• Undeveloped land.
We specialize in marketing institutional properties through privately negotiated and sealed bid sales. We develop and implement cost-effective marketing campaigns ranging from local to nationwide in scope. Each marketing campaign is tailored to the client’s objectives and the property’s characteristics, including time parameters, sensitivity to publicity, and cash flow needs. We also investigate and analyze, among other things, the physical condition of the property, its cash flow and tenant characteristics, market rents and market dynamics within submarkets, and comparable transactions.
We also market properties directly to various investors with whom we maintain ongoing business relationships. We believe that through these efforts, we create a sales environment intended to enable our clients to obtain the highest possible prices for their properties. We obtain our commercial brokerage engagements primarily through our existing relationships with over 100 institutional and corporate owners of real estate primarily located in the U.S. and Japan.
We also design marketing programs to sell single-family home developments and condominium projects using conventional sales and auction-marketing programs. We also design and implement sealed bid marketing programs for exclusive estates and land for residential development. Most of the residential properties that we have brokered are located in California. Our clients include builders, developers, private sellers and financial institutions.
On a national basis, we provide our clients with auction marketing services to sell both commercial and residential real estate. Auctions provide a seller an opportunity to concentrate the marketing efforts and sell its holdings on one established date. By doing so, the seller can increase liquidity and avoid long-term carrying costs and the risk of a drop in market value. For these reasons, we believe that the net proceeds to the seller following an auction sale of multiple units often exceeds what the net proceeds would have been had the units been sold individually through conventional brokerage arrangements.
REAL ESTATE INVESTMENTS
We invest in commercial and residential real estate primarily through joint ventures with institutional joint venture partners, who typically contribute the majority of the capital. The investment platforms typically target specific property types. We have joint venture funds for multiple investments with certain institutional partners. These funds enable us to leverage our capital and diversify the risks associated with owning properties. In addition, we earn fees for services provided to the joint venture, including due diligence, acquisition, construction management, asset management, leasing, property management, and disposition services. Profits from fees earned by the Company from entities in which the Company retains an ownership interest are deferred to the extent of the Company’s ownership percentage in amounts capitalized by the joint venture.
We purchase properties that are subperforming in a manner which we believe can be rectified with our expertise or financial resources. For example, a developer of a residential real estate project may find it difficult or impossible to finish a project because it has insufficient cash. In such a situation, we can purchase the project at a discounted price then apply our marketing expertise and draw on our financial resources to finish the project and sell it as a whole or to individual buyers for a profit. With regard to commercial properties, we acquire subperforming buildings, make the improvements necessary to attract tenants, lease to new tenants and then sell the buildings.
One of our strengths is our ability to quickly identify and acquire desirable real estate assets in privately negotiated transactions. We do so by capitalizing on the institutional knowledge we have developed through our brokerage, property management, and investment business and by conducting quick and thorough investigations and analyses of the properties, their financial condition and what we believe to be their financial potential. We have extensive experience in identifying and analyzing the factors that impact property values in the regions in which we do business, such as new construction, the marketability of certain neighborhoods, leasing trends and the types of businesses seeking various types of commercial space. Our due diligence is conducted by our experienced in house team.
Most of the real estate in which we and our joint venture investment platform have invested is located in California and Texas. The current cycle of the U.S. real estate market presents value-added investment potential. Our brokerage and property management operations are the source of many of our real estate acquisitions. These operations provide us with unique investment opportunities in the form of close relationships with our institutional clients that have substantial real estate investments. For example, a financial institution client that has acquired a property through a foreclosure may desire to sell it in less time than it would take for a conventional brokerage sale. We are often able to meet the needs of these types of clients by purchasing their properties quickly and discretely for one of our joint venture funds.
NOTES RECEIVABLE INVESTMENTS
In 2001, we began acquiring discounted loan portfolios that were performing and were secured primarily by real estate. These assets are accounted for under the interest method, which provides that the accretable discount be recorded as interest income over the life of the loans.
Through 1999 our note portfolio acquisitions consisted primarily of pools of assets that contained bankruptcy claims, judgments, credit guarantees, and other residual claims arising from defaulted credit transactions. These assets were typically purchased from financial institutions. Our strategy to collect the asset balances consists of negotiating a cash payoff, restructuring the asset to a performing note, or foreclosing and selling any related collateral. Our last acquisition of these types of assets was in 1999. Most of these notes have been settled, with the majority being paid off in less than two years.
KENNEDY-WILSON JAPAN
The Company had a presence in Japan for over ten years through its formerly wholly-owned subsidiary, Kennedy-Wilson Japan (“KWJ”). The operations in Japan included investment in real estate, the acquisition of pools of discounted Japanese notes and asset management and brokerages services. The notes were typically secured by real estate and personal property. The investment strategy was to acquire the notes on a privately negotiated basis from Japanese financial institutions. KWJ’s investments were typically acquired in joint venture funds with institutional investors who contributed the majority of the capital. Subsequent to the secondary public stock offering of KWJ in September 2002, KWJ became an unconsolidated subsidiary in the Company’s financial statements and was accounted for as an equity method investment. The Company sold its remaining shares of KWJ in 2003.
GOVERNMENT REGULATIONS
Our brokerage and property management operations are subject to various federal, state and local regulations. We must have an officer licensed as a real estate broker or we must associate with a broker licensed by each state within the U.S. in which we provide brokerage or property management services. Each of our employees that performs certain brokerage functions in any particular state must be a licensed real estate salesperson in that state and he or she must work under the supervision of a broker licensed by that state. We are in compliance with all material licensing requirements and regulations in states and countries in which licenses are required and in which we are engaged in brokerage and property management activities.
In various states, governmental entities license individual auctioneers and/or administer various regulations governing their activities and may require that auctioneers post bonds. We are in compliance with all material licensing and bonding requirements in all states in which auctioning licenses and bonds are required and in which we are engaged in material auction activities.
COMPETITION
Because of our unique combination of businesses, we compete with brokerage and property management companies as well as companies that invest in real estate and distressed notes. The brokerage and property management businesses are both highly fragmented and competitive. We compete with real estate brokerage companies on the basis of our relationship with property owners, quality of service, and commissions charged. We compete with property management and leasing firms also on the basis of our relationship with clients, the range and quality of services provided, and fees and commissions charged. Our investment operations compete to varying degrees with real estate investment partnerships and other investment companies. We compete with these other investors on the basis of our relationship with the sellers and the amounts that we pay for the investments acquired.
EMPLOYEES
We have approximately 535 employees. Our compensation policies are designed to attract, retain and motivate employees that are an integral part of our profitability. Our employees typically receive a base salary and performance based incentives including bonuses based primarily on the cash flow of their operational units. As a result, employees are encouraged to meet individual goals as well as to contribute their expertise and efforts on behalf of their group. In addition to promoting the generation of revenues, our compensation structure also encourages our employees to control costs.
AVAILABLE INFORMATION
The Company is subject to the informational requirements of the Securities Exchange Act of 1934 that require the Company to file, most often electronically, reports, proxy and information statements, and other information with the Securities and Exchange Commission (SEC). The public may read and copy the Company’s filings at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. The public can obtain information on the operation of the Public Reference Room by calling 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at www.sec.gov.
ITEM 2.
ITEM 2. PROPERTIES
Our executive and administrative offices are leased and located at 9601 Wilshire Boulevard, Suite 220, Beverly Hills, California. We also lease space for our regional and branch offices and sublease space to third parties. These facilities, including our Beverly Hills headquarters, comprise a total of approximately 100,000 square feet of leased space, with an annual aggregate base rental of approximately $2 million. Each of these leases is scheduled to expire within the next seven years. We believe that we will be able to renew any expiring lease or obtain suitable office space to replace such leased facility, as necessary, without any material increase in our rental costs.
As described above, we also buy and sell real estate, primarily through joint venture investments, in the ordinary course of our business.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
We are involved in various legal proceedings generally incidental to our business. These matters are generally covered by insurance. While the ultimate disposition of these proceedings is not known, based upon current available information, we believe that the outcomes will not have a material adverse effect on our financial position or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of our stockholders during the fourth quarter of 2003.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our Company’s Common Stock trades on The NASDAQ National Market under the symbol “KWIC”. The following table sets forth the high and low closing prices of our Common Stock as reported on The Nasdaq National Market.
As of March 1, 2004, there were approximately 1,200 holders of our Common Stock.
EQUITY COMPENSATION PLAN TABLE
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected financial data as of and for each of the five fiscal years ended December 31, 2003. The data set forth below should be read in conjunction with the Consolidated Financial Statements and related Notes to Consolidated Financial Statements appearing elsewhere herein and Item 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
We are an integrated real estate services and investment Company with headquarters in Beverly Hills, California. Through our subsidiaries, we provide a complementary array of real estate services, including fund management, property management and leasing, real estate brokerage services including auction marketing, and asset management. We also invest in commercial and residential real estate and discounted loan portfolios. Our investments in real estate are made primarily through joint venture funds.
In 2002, the Company completed two public stock offerings and two private sales of shares of its formerly wholly-owned subsidiary, Kennedy-Wilson Japan (“KWJ”). The sale of stock reduced the Company’s ownership in the Japan subsidiary to 37%. This change in ownership necessitated a change in the accounting treatment for KWJ from a consolidated entity to an equity investment beginning in the fourth quarter of 2002. Instead of including the various components of KWJ’s revenue and expenses in the individual revenue and expense categories on the income statement, the Company’s 37% of the net income of the Japan subsidiary is shown as a single separate line item. Likewise, on the balance sheet the Company’s investment in KWJ is shown as a single separate line item.
Our current real estate investment strategy favors joint venture investments; however, we occasionally continue to acquire and sell residential and commercial real estate on a wholly owned basis. We are no longer involved in single-family residential development and sales but are investing, through joint venture partnerships, in multi-family apartment projects. We also invest in discounted loan portfolios secured primarily by real estate on our own account and through joint venture partnerships. The discounted asset portfolios acquired prior to 2001 consisted primarily of claims, judgements and guarantees.
COMPARISON OF YEARS ENDED DECEMBER 31, 2003 AND 2002
Our revenues in 2003 and 2002 were $27.1 million and $44.7 million, respectively. Total operating expenses in 2003 and 2002 were $34.8 million and $48.6 million, respectively. Operating income includes combined equity in income of joint ventures and Kennedy-Wilson Japan of $2.6 million and $9.0 million, respectively. Our net income for the same periods was $5.4 million and $6.2 million, respectively.
REVENUE
In 2003 property management and leasing generated revenue of $18.2 million (including related party fees of $3.7 million), representing 67% of our total revenue, compared to approximately $25.8 million (including approximately $4.1 million in related party fees) and 58% of total revenue in 2002. Excluding Kennedy-Wilson Japan’s property management revenue of approximately
$1.8 million in 2002 (prior to the deconsolidation noted above), total property management revenue in the U.S. declined 24%. Property management and leasing revenue includes asset management, construction management, leasing services, engineering and other services to property operators. Property management fees declined approximately 8% due in part to the sale of some of the buildings managed by the Company where property management services were taken “in-house” by the new owners. The Company has obtained new property management assignments, but often at lower rates because of the competitive market. In some cases the new property management assignments have not included leasing assignments. The impact of the past several years’ economic decline has led to a decline in occupancy and rental rates, while the recovery has not yet resulted in significant leasing improvements. Additionally, the terms of new leases and renewals are often at lower rates and for shorter terms than current leases. All of these factors have resulted in a 35% reduction in leasing commissions, construction development fees and engineering services. The Company is aggressively pursuing third party property management and leasing assignments as well as investment opportunities, which should increase revenue in all of the property related services.
Brokerage commission revenues in 2003 decreased 67% to $4.9 million (including approximately $1.5 million in related party fees), representing 18% of total revenues compared to brokerage commission revenues in 2002 of $14.8 million (including related party fees of approximately $9.0 million). Brokerage commissions earned by KWJ accounted for approximately $8.2 million or 55% of the total commission revenue in 2002. Excluding KWJ, brokerage commissions declined by 26% due to a decrease in the number of sales transactions. In connection with our brokerage activities we provide property valuations, development and implementation of marketing plans, sealed bid auctions and open bid auctions.
Interest and other income totaled approximately $4.0 million or 15% of total revenues in 2003, compared to approximately $4.1 million in 2002. Interest and other income includes accretion of discounts on acquired loan portfolios, interest on corporate notes receivable that are held as a result of investment sales, interest on cash investments and other miscellaneous sources of revenue. The accretion of discounts on loan portfolios are accounted for under the interest method, which provides that the accretable discount be recorded as interest income over the life of the loans. The portion of interest and other income from loan portfolios and other sources earned in Japan during 2002 was approximately $2.1 million which, when deducted from the 2002 revenue shows an increase of 98% in the revenue earned in the U.S. in 2003. During 2003, the Company purchased five loan portfolios secured by real property and business assets for approximately $26.7 million.
OPERATING EXPENSES
Operating expenses in 2003 were approximately $34.8 million, representing a decrease of 29% from $48.6 million in 2002. The company has experienced a decrease in all categories of operating expenses during 2003 realizing the results of an aggressive, company-wide expense reduction program that has been in place over the past several years.
Commissions and marketing expenses decreased to $3.8 million in 2003 from $5.5 million in 2002. The reduction in commission expense corresponds with a reduction in leasing and brokerage commission revenue earned by the Company. Typically, the Company pays out approximately 40% to 60% of the gross commission to brokers and employees.
Cost of residential real estate sold was $220,000 in 2002, which related to the sale of real estate by KWJ. As previously discussed, the Company has exited the residential real estate development business resulting in no cost of real estate expense for 2003.
Compensation and related expenses were approximately $18.1 million in 2003, down 30% from $26 million in 2002. The decrease was primarily a result of cost reduction initiatives, bonus reductions and the impact of not consolidating KWJ which accounted for approximately $3.2 million of compensation expense in 2002.
General and administrative expenses were $9.9 million in 2003 representing a 7% decrease from 2002 expenses of $10.7 million. General and administrative expenses in the U.S. increased by 9%, for the most part, relating to the write-off of notes receivable in 2003 in the amount of $850,000 compared to $146,000 in 2002.
Depreciation and amortization expense decreased to $3 million in 2003, a 17% decrease from $3.7 million in 2002. The expense in 2003 was reduced by approximately $633,000 of costs that were amortized during 2002 associated with KWJ.
There were no non-cash write-down of investments during 2003 as compared to approximately $1.5 million for 2002. During 2002, management concluded that the cost basis of a real estate investment was not probable of recovery. Based on the analysis performed by management, the basis of the real estate investment was reduced by approximately $1.5 million, resulting in a cost basis of the associated asset of zero.
There was no non-recurring, non-cash Japan IPO expense in 2003 as compared to the 2002 expense of $1.1 million relating to the discounted stock issued to employees of KWJ. This expense was associated with the gain on sale of stock of subsidiary of $12.9 million classified in non-operating income in 2002.
Equity in joint venture income totaled approximately $2.0 million in 2003, a decrease of 75% compared to $8.1 million realized in 2002. The revenue from joint venture investments includes income from the operation and sale of numerous real estate investments in the U.S. which are owned primarily in joint venture funds with institutional investor partners. During 2003, five residential investments and three commercial investments were sold to third parties and the Company recorded equity in income of approximately $2.1 million related to the sales. Accordingly, no income was deferred in 2003. During 2002, five commercial buildings, and two apartment projects were sold to either third parties or joint ventures in which the Company retained an ownership interest. The Company recorded equity in income of approximately $5.3 million from these sales after deferral of income in the amount of $339,000 related to the Company’s percentage ownership in the acquiring joint venture investment entity. Our current investment portfolio and our plans for future investments focus on commercial buildings and on multiple family residences. Under the Company’s investment strategy, we typically contribute a fully funded initial capital contribution and/or property previously owned by the Company.
Equity in income of KWJ was $610,000 for 2003 compared $907,000 in 2002. The reduced revenue in 2003 correlates with the reduced ownership in KWJ combined with a reduced period of ownership participation. As of September 30, 2003, the Company had sold all of its ownership interest in KWJ.
NON-OPERATING ITEMS
Gain on sale of stock of subsidiary was approximately $16.4 million for 2003 compared to $12.9 million in 2002. The gain in 2003 resulted from the sale of all of the Company’s remaining 24,600 shares owned in KWJ. During 2002, the Company sold 9,000 shares as part of the initial public offering and secondary offering of KWJ’s stock in Japan.
Interest expense was $1.4 million in 2003 a decrease of 45% compared to approximately $2.6 million in 2002 due, in part, to the reduced average interest rates on variable rate loans and a substantial repayment of debt, including the repayment of the 12% senior unsecured notes. Interest expense includes the amortization of loan fees and related loan costs in the amount of $456,000 and $484,000 for the years 2003 and 2002, respectively. Additionally, in both 2003 and 2002, interest expense was reduced by approximately $2.3 million of interest capitalized on several qualifying real estate investments. These investments were undergoing construction or entitlement activities in preparation for their planned principal operations.
The valuation adjustment for the change in the fair value of warrants issued in connection with the issuance of $15 million of 12% senior unsecured notes resulted in a benefit of $35,000 for 2003 compared to $209,000 for 2002. The fair value of the warrants was estimated using a combination of the Black-Scholes Option Pricing Model and Monte Carlo Simulation.
There was no write-down of technology investments in 2003 compared with a $3.2 million write-down in 2002. In 2002, management concluded that the cost basis of two e-commerce investments were not probable of recovery. Based on the analysis performed by management, the basis of the e-commerce investments was reduced by $3.2 million resulting in the cost basis of one of the associated assets being written down to $1 million and the cost basis of the other associated asset being written down to zero. Because the Company is not in the business of investing in internet start-up companies, the write-down of the technology investments is classified as non-operating, as will any income or loss in future periods.
During 2003, there was a loss on extinguishment of debt of $968,000, as compared to a gain on extinguishment of debt of $750,000 in 2002. The loss in 2003 related to prepayment penalties and the write-off of unamortized, capitalized loan fees associated with the early retirement of the balance of the 12% senior notes payable. The gain in 2002 related to the conversion of the convertible subordinated debentures in the amount of $3,977,000 and the issuance of subordinated debentures in the amount of $2,773,000 to retire the $7,500,000 of convertible subordinated debt. Under recently adopted accounting pronouncements (SFAS 145), such gain is not considered an extraordinary item.
The provision for income taxes was approximately $3.4 million for 2003 compared to $3.2 million in 2002 as a result of the change in income before provision for income taxes. The effective tax rate for 2003 was 37.6% compared to 35.8% in 2002.
Loss from discontinued operations for 2003 was $195,000, net of tax benefit, compared to income from discontinued operations for 2002 of $423,000, net of tax expense. The discontinued operations include the results of those properties for which management has implemented a plan of disposal that is likely to result in the sale of the properties within one year.
COMPARISON OF YEARS ENDED DECEMBER 31, 2002 AND 2001
Our revenues in 2002 and 2001 were $44.7 million and $60.5 million respectively. Total operating expenses in 2002 and 2001 were $48.6 million and $59.3 million, respectively. Our net income for the same periods was $6.2 million and $2.5 million, respectively.
REVENUE
In 2002 property management and leasing generated revenue of $25.8 million (including related party fees of $4.1 million), representing 58% of our total revenue, compared to approximately $33.4 million (including approximately $5.4 million in related party fees) and 55% of total revenue in 2001. Property management and leasing revenue includes asset management, construction management, leasing services, engineering and other services to property operators. Because KWJ is accounted for as an equity investment, their property management revenue is not included in this category after the secondary sale of our investment in the stock of KWJ in September 2002. Property management revenue in the U.S. declined due, in part, to the decrease in the total square footage of properties under management. Lower interest rates and favorable loan terms, resulted in an increased number of building sale transactions including some of the buildings managed by the Company. Similarly, the overall downturn of the economy has led to lower occupancy rates in many markets of the country and has negatively impacted leasing revenue and the other services offered by the Company.
Brokerage commission revenues in 2002 increased 15% to $14.8 million (including approximately $9.0 million in related party fees), representing 33% of total revenues compared to brokerage commission revenues in 2001 of $12.8 million (including related party fees of approximately $4.5 million). Brokerage commissions earned by KWJ prior to the deconsolidation increased 23%, in part, due to an increased number and size of transactions resulting from Japanese financial institutions being motivated to liquidate assets. Because KWJ is accounted for as an equity investment, commissions earned in Japan are not included in this category after September 2002. Brokerage commissions in the U.S. decreased 8% due to the decrease in the number and size of sales transactions. In connection with our brokerage activities we provide property valuations, development and implementation of marketing plans, sealed bid auctions and open bid auctions.
There were no sales of residential real estate in 2002 compared to approximately $11 million in 2001. During 2002, the Company sold two small pieces of land resulting in a loss of approximately $200,000, which was offset by a gain of approximately $200,000 from KWJ. The Company has chosen to exit the development and sales of single family residential real estate projects as a business component in favor of investing, with joint venture partners, in
multi-family apartment projects in selected areas of the country. The sales of residential real estate completed during 2001 included 44 homes in a 109-home development in the Palm Springs area.
Interest and other income totaled approximately $4.1 million or 9% of total revenues compared to approximately $3.3 million in 2001. Interest and other income includes accretion of discounts on acquired loan portfolios, interest on corporate notes receivable that are held as a result of investment sales, interest on cash investments and other miscellaneous sources of revenue. The accretion of discounts on loan portfolios are accounted for under the interest method, which provides that the accretable discount be recorded as interest income over the life of the loans. In 2002 and 2001, $3.4 million and $1.4 million, respectively, was recorded as interest income earned from loan portfolios accounted for under the interest method previously discussed. The portion of interest and other income from loan portfolios and other sources earned in Japan during 2002 and 2001 was $2.1 million and $983,000 respectively. Interest earned on a large note relating to the sale of land in Hawaii earned $353,000 of interest in 2002 and $407,000 in 2001. During 2002, the land collateralizing this note was foreclosed upon and sold to a new joint venture investment entity in which the Company maintains a 50% ownership interest. No gain was recognized on this transaction.
OPERATING EXPENSES
As discussed above, KWJ was consolidated through September 2002. Subsequent to September 2002, the investment is accounted for on the equity method. Therefore, operating expenses for 2002 include nine months of consolidated activity for KWJ compared to a full year of activity included in 2001.
Operating expenses in 2002 were approximately $48.6 million, representing a decrease of 18% from $59.3 million in 2001. Most of the decrease represents the approximately $11.1 million cost associated with the sales of residential real estate in 2001 compared to $220,000 in 2002. As discussed above, the Company has exited the single-family residential real estate development business.
Commissions and marketing expenses decreased to $5.5 million in 2002 from $6.9 million in 2001. The expense represents 37% of the commission revenue in 2002 down from 54% of the commission revenue in 2001. The reduction in the percentage of commission expense to commission revenue represents a reduction in brokerage commissions earned by the property management division of the Company which typically pays out approximately 40% to 60% of the gross commission to brokers and employees as commission expense.
Cost of residential real estate sold was $220,000 in 2002, compared to $11.1 million in 2001. The expense in 2002 relates to the sale of real estate by KWJ. The expense in 2001 related to the sales of 44 homes in a 109-home development in the Palm Springs area. As previously discussed, the Company has exited the residential real estate development business.
Compensation and related expenses were approximately $26.0 million in 2002, down 1% from $26.3 million in 2001. The decrease was primarily a result of cost reduction initiatives, staff reductions and the impact of not consolidating KWJ during the fourth quarter of 2002 versus a full year in 2001. The total number of employees, excluding KWJ was approximately 530 at December 31, 2002 compared to 593 at December 31, 2001.
General and administrative expenses were $10.7 million in 2002 representing a 4% decrease from 2001 expenses of $11.2 million. General and administrative expenses in the U.S. increased by 2%, offset by a decrease from KWJ of 27% through September 2002. Included in general and administrative expense in 2002 is the write-off of notes receivable in the amount of $146,000 compared to $136,000 in 2001.
Depreciation and amortization expense decreased to $3.6 million in 2002, a 4% decrease from $3.8 million in 2001. In the U.S., the reduction results from the elimination of goodwill amortization in accordance with SFAS 142, offset by depreciation of capitalized costs relating to the consolidation of our technology-based real estate auction brokerage and related services business that was previously reported under the equity method of accounting. Depreciation and amortization for KWJ through September 2002 increased due to depreciation related to several properties acquired during 2002 for their own account.
Non-cash write-down of investment was approximately $1.5 million for 2002, compared to no write-down in 2001. During 2002, management concluded that the cost basis of a real estate investment was not probable of recovery. Based on the analysis performed by management, the basis of the real estate investment was reduced by approximately $1.5 million, resulting in a cost basis of the associated asset of zero.
Non-recurring, non-cash Japan IPO expense of $1.1 million relates to the discounted stock issued to employees of KWJ and is associated with the gain on sale of stock of subsidiary of $12.9 million classified in non-operating income.
Equity in joint venture income totaled approximately $8.1 million in 2002, compared to $5.4 million realized in 2001. The revenue from joint venture investments includes income from the operation and sale of numerous real estate investments in the U.S. which are owned primarily in joint venture funds with institutional investor partners. Additionally, as previously discussed, income earned on note pool assets owned in joint venture partnerships is also included in this operating income category. During 2002, five commercial buildings, and two apartment projects were sold to either third parties or joint ventures in which the Company retained an ownership interest. The Company recorded equity in income of approximately $5.3 million from these sales after deferral of income in the amount of $339,000 related to the Company’s percentage ownership in the acquiring joint venture investment entity. During 2001, two apartment projects were sold and the Company’s equity in this income was approximately $1.0 million. Our current investment portfolio and our plans for future investments focus on commercial buildings and on multiple family residences. Under the Company’s investment strategy, we typically contribute a fully funded initial capital contribution and/or property previously owned by the Company.
Equity in income of KWJ was $907,000 in 2002. This represents the equity in the income of the Company’s formerly consolidated subsidiary, KWJ, subsequent to the September 2002 deconsolidation of the entity.
NON-OPERATING ITEMS
Gain on sale of stock of subsidiary was approximately $12.9 million for 2002 compared to no gain in 2001. The gain resulted from the sale of shares owned in KWJ as part of the successful initial public offering, the secondary offering of KWJ’s shares in Japan, and the private sales of shares owned by the Company. The initial public offering consisted of 4,500 newly issued shares and 2,500 shares sold by the Company at a price of approximately $3,319 per
share, for total gross cash consideration of approximately $23 million. The secondary public stock offering consisted of 4,900 shares of KWJ at a price of $1,700 per share, and the private sale of 2,000 shares of the stock of the subsidiary, for total gross cash consideration of approximately $11.7 million. The Company retained ownership of 37% of the subsidiary’s shares after the transactions. Effective with the completion of the secondary offering, KWJ became an unconsolidated subsidiary in the Company’s financial statements and is accounted for as an equity method investment.
Interest expense was $2.6 million in 2002 a decrease of 7% compared to approximately $2.8 million in 2001 due, in part, to the reduced average interest rates on variable rate loans. Interest expense includes the amortization of loan fees and related loan costs in the amount of $484,000 and $302,000 for the years 2002 and 2001, respectively. Additionally, in both 2002 and 2001, interest expense was reduced by approximately $2.3 million of interest capitalized on several qualifying real estate investments. These investments were undergoing construction or entitlement activities in preparation for their planned principal operations.
The valuation adjustment for the change in the fair value of warrants issued in connection with the issuance of $15 million of 12% senior unsecured notes resulted in a benefit of $209,000 for 2002 compared to an expense of $158,000 in 2001. The Company issued the warrants to the purchasers of the notes for 597,888 shares of the common stock of the Company at an exercise price of $6.25 per share. The warrants expire June 22, 2008. The warrants contain a put provision that requires the Company, at the option of the note holders, to repurchase the common shares issued upon exercise of the warrants, at the prevailing market price, during years four through six of the warrant term. The fair value of the warrants was estimated using a combination of the Black-Scholes Option Pricing Model and Monte Carlo Simulation. A liability was recorded for the fair value of the warrants, which is adjusted quarterly to record the warrants at their estimated fair value while they are outstanding, with the change in value recorded as valuation adjustment-warrants. As a result of the partial repayment of $5 million of the notes in 2002, warrants for the purchase of 199,296 shares of common stock were cancelled and the liability for the value of the warrants was reduced by $222,000. The estimated fair value of the warrants was $283,000 and $714,000 at December 31, 2002 and 2001, respectively, and is included in accrued expenses and other liabilities.
Write-down of technology investments in 2002 was $3.2 million compared to no write-down in 2001. Management concluded that the cost basis of two e-commerce investments were not probable of recovery. Based on the analysis performed by management, the basis of the e-commerce investments was reduced by $3.2 million resulting in the cost basis of one of the associated assets being written down to $1 million and the cost basis of the other associated asset being written down to zero. Because the Company is not in the business of investing in Internet start-up companies, the write-down of the technology investments is classified as non-operating, as will any income or loss in future periods.
Gain on extinguishment of debt was $750,000 for 2002 compared to no gain in 2001. The gain on extinguishment of debt related to the conversion of the convertible subordinated debentures in the amount of $3,977,000 and the issuance of subordinated debentures in the amount of $2,773,000 to retire the $7,500,000 of convertible subordinated debt. Under recently adopted accounting pronouncements (SFAS 145), such gain is not considered an extraordinary item.
The provision for income taxes was approximately $3.2 million for 2002 compared to $1.3 million in 2001 as a result of the change in income before provision for income taxes. The effective tax rate for 2002 was 35.8% compared to 34.5% in 2001.
Income from discontinued operations, net of tax expense, was $423,000 for 2002 compared to $110,000 for 2001. The discontinued operations include the results of those properties for which management has implemented a plan of disposal that is likely to result in the sale of the properties within one year.
CRITICAL ACCOUNTING POLICIES
Management’s discussion and analysis of financial condition and results of operations is based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. The Company bases its estimates on historical experience and assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The Company believes the following critical accounting policies affect its significant judgments and estimates used in the preparation of its consolidated financial statements. All material intercompany balances and transactions have been eliminated in the consolidated financial statements.
Revenue Recognition
The Company’s real estate services revenues are recorded when the related services are performed. In the case of real estate sales commissions, this generally occurs when the sale closes escrow. Property management fees are recognized over time as earned based upon the terms of the management agreement.
Leasing commission revenues are accounted for in accordance with the provisions of SAB 104. Accordingly, leasing commissions that are payable upon tenant occupancy, payment of rent or other events beyond the Company’s control are recognized upon the occurrence of such events. In accordance with EITF 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent, the Company records brokerage commission revenues and expenses on a gross basis. Of the criteria listed in the EITF, the Company is the primary obligor in the transaction, does not have inventory risk, performs all, or part, of the service, has credit risk, and has wide latitude in establishing the price of services rendered and discretion in selection of agents and determination of service specifications. Due to these factors, gross reporting is appropriate.
Residential real estate sales revenue and gains on sale of commercial property are recognized at the close of escrow when title to the real property passes to the buyer. The Company follows the requirements for profit recognition as set forth by Statement of Financial Accounting Standards No. 66, Accounting for Sales of Real Estate. Residential real estate is accounted for as inventory because these properties are generally held for less than one year and do not generate income during the holding period. Accordingly, gross revenue and cost of sales are presented separately on the statements of income.
Revenues on notes receivable are recognized on an effective interest basis under the provisions of Practice Bulletin 6 where cash received is accreted into interest income over the estimated holding period. When the future cash flows of a note can not be reasonably estimated, cash payments are applied to the cost basis until fully recovered before any revenue is recognized.
Profit on sales to joint ventures in which the Company retains an ownership interest results in partial sales treatment in accordance with the provisions of SFAS 66 and Statement of Position 78-9, thus deferring a portion of the gain on the Company’s continuing ownership percentage in the joint ventures.
Valuation of Notes Receivable
The Company accounts for any impairment to the basis of notes receivable in accordance with Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan, as amended by Statement of Financial Accounting Standards No. 118, Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures. Accordingly, an impaired loan is measured based upon the present value of expedited future cash flows, discounted at the loan’s effective interest rate or, if readily determinable, the loan’s observable market price or the fair value of the collateral if the loan is collateral dependant.
Impairment of the Company’s basis is infrequent because the Company acquired these notes at a substantial discount, and actively seeks to restructure the notes in a short period of time. Typically the event that causes a write-off and the related bad debt expense occur in the same accounting period. As a result, substantial valuation allowances have historically not been required. The loans are reviewed on a quarterly basis for impairment. Based on the Company’s evaluation, if a loan is deemed to be impaired, a specific write-off is taken. In 2003, 2002 and 2001, the write-off of uncollectable notes receivable was $850,000, $146,000 and $136,000, respectively, and is included in general and administrative expense.
Valuation of Investments
The Company reviews each of its investments in joint ventures on a periodic basis for evidence of impairment. Impairment losses are recognized whenever events or changes in circumstances indicate declines in value of an investment below carrying value and the related discounted cash flows are not sufficient to recover the asset’s carrying amount. The Company accounts for any impairment to the basis of notes receivable in accordance with Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan, as amended by Statement of Financial Accounting Standards No. 118, Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures. At December 31, 2003, no investments were deemed to be impaired as a result of this evaluation. In 2002, the Company recorded impairment losses of approximately $3.2 million on remaining technology investments and approximately $1.5 million on a real estate investment based on this evaluation.
The Company has classified separately on the balance sheet the real estate assets which are held for sale. Assets held for sale principally include those which management, having the proper level of authority to effect a plan of disposal, has implemented such plan, which is likely to result in the sale of the property within one year. As of December 31, 2003, the Company held four properties as available for sale, in accordance with SFAS 144, and the results of the operations of those properties has been reported “net” as discontinued operations for the years ended December 31, 2003, 2002 and 2001.
Valuation of Intangibles
The Company’s intangible assets substantially consist of property management contracts which are amortized on a straight-line basis over seven years, and goodwill representing costs paid in excess of net assets of acquired businesses. Through December 31, 2001, the Company used an undiscounted cash flow methodology to determine whether underlying operating cash flows were sufficient to recover the carrying amount of goodwill.
Beginning January 1, 2002, goodwill is no longer amortized, but is evaluated annually for impairment based on a reporting unit fair value approach as required by SFAS 142. In determining fair value of a reporting unit, the Company relies on the application of generally accepted valuation approaches. During the year ended December 31, 2003, no impairment was indicated by application of the valuation analysis. The effects on earnings and earnings per share of excluding such goodwill amortization from 2001 is as follows:
LIQUIDITY AND CAPITAL RESOURCES
Our liquidity and capital resources requirements include expenditures for joint venture fund investments, real estate held for sale, discounted loan portfolios and working capital needs. Historically, we have not required significant capital resources to support our brokerage and property management operations. We finance our operations with internally generated funds and borrowings under our revolving lines of credit. Our investments in real estate are typically financed by mortgage loans secured primarily by that real estate. These mortgage loans are generally nonrecourse in that, in the event of default, recourse will be limited to the mortgaged property serving as collateral. In some cases, the Company guarantees a portion of the loan related to a joint venture investment, usually until some condition, such as completion of construction or leasing or certain net operating income criteria, has been met. The Company does not expect these guarantees to materially affect liquidity or capital resources. Management estimates the fair value of all guarantees made subsequent to December 31, 2003 to be zero.
In 2003, the Company entered into a second loan agreement with Pacific Western National Bank in the amount of $5 million. The loan bears interest at the bank’s base rate plus 1%. The proceeds of this borrowing were used to repay the balance of the 12% Senior Notes which were issued in 2000.
During 2002, we entered into three credit agreements. The first agreement is an unsecured revolving credit facility for $30 million with US Bank and East-West Bank for use in acquisitions and working capital purposes. This facility replaces the loans from East-West Bank and United California Bank in the total amount of $28 million. We also entered into a loan agreement with Pacific Western National Bank in the amount of $5 million. This borrowing was used to repay a portion of the 12% senior notes and carry a much more favorable rate of interest of prime plus 1%. Lastly, the Company entered into a revolving loan agreement for $30 million with Foothill Capital Corporation for use in the expansion of our loan portfolio acquisition business.
Cash used in operating activities was about $5.3 million in 2003, compared to approximately $3.5 million provided by operating activities in 2002. Although net income for 2003 was approximately $5.4 million, net cash generated from operations excludes gains on the sale of the shares KWJ of approximately $16.4 million, which is included as an investing activity. For the year 2002, the Company had net income of approximately $6.2 million, net cash generated from operations also excludes the approximate $12.9 million gain on the sale of shares in KWJ. The change resulted primarily from the decrease in net income, including the decrease in equity income, offset by the decrease in accounts receivable and contracts and other assets and an increase in accrued expenses and other liabilities. Cash provided by operating activities was about $3.5 million in 2002, compared to approximately $5.2 million in cash used in operating activities in 2001. The change resulted primarily from an increase in net income, including the increase in equity income, offset by the decrease in accounts receivable and contracts and other assets and an increase in accrued expenses and other liabilities.
Cash provided by investing activities was approximately $20.3 million, compared to approximately $11.8 million in cash used in investing activities for 2002. In 2003, approximately $44.3 million in proceeds was received from the sale of shares in KWJ and collections of notes receivable, offset by the acquisition of note pools and the redemption of a joint venture partner in a note receivable venture. Cash used in investing activities was about $11.8 million in 2002, compared to $11.1 million provided by investing activities in 2001. The change resulted primarily from the reduction in cash held by KWJ at deconsolidation, as discussed above, and contributions to joint ventures, offset by the proceeds from the sale of a portion of the Company’s investment in KWJ and a reduction in proceeds from sale of real estate.
Cash used in financing activities was approximately $20.2 million, compared to approximately $8.8 million in cash provided by financing activities for 2002. In 2003, the proceeds from the sale of shares in KWJ described above were used to repay debt and repurchase shares of the Company’s common stock. Cash provided by financing activities was about $8.8 million in 2002, compared to approximately $9,000 used in 2001. The change resulted primarily by the increase in borrowings under notes payable, offset by the decrease in borrowings of mortgages notes payable.
To the extent that we engage in additional strategic investments, including real estate, note portfolio, or acquisitions of other property management companies, we may need to obtain third party financing which could include bank financing or the public sale or private placement of debt or equity securities. We believe that existing cash, plus capital generated from property management and leasing, brokerage, sales of real estate owned, collections from notes receivable, as well as our current lines of credit, will provide us with sufficient capital requirements for the foreseeable future.
Under our current joint venture strategy, we generally contribute property, expertise, and typically a fully funded initial cash contribution (without commitment to additional funding by the Company). Capital required for additional improvements and supporting operations during lease-up and stabilization periods is generally obtained at the time of acquisition via debt financing or third party investors. Accordingly, the Company generally does not have significant capital commitments with unconsolidated entities. Infrequently, there may be some circumstances when the Company, usually with the other members of the joint venture entity, may be required to contribute additional capital for a limited period of time. The Company believes that it has the capital resources, generated from our business activities and our borrowing capacity, to finance any such capital requirements, and does not believe that any additional capital contributions to joint ventures will materially affect liquidity.
Our need, if any, to raise additional funds to meet our capital requirements will depend on many factors, including the success and pace of the implementation of our strategy for growth. We regularly monitor capital raising alternatives to be able to take advantage of other available avenues to support our working capital and investment needs, including strategic partnerships and other alliances, bank borrowings, and the sale of equity or debt securities. The Company expects to meet the repayment obligations of notes payable and borrowings under lines of credit from cash generated by our business activities, including the sale of assets and the refinancing of debt. We intend to retain earnings to finance our growth and, therefore, do not anticipate paying dividends.
CONTRACTUAL OBLIGATIONS AND COMMITMENTS
At December 31, 2003, the Company’s contractual cash obligations, including debt, lines of credit, capital lease obligations and operating leases include the following:
IMPACT OF INFLATION AND CHANGING PRICES
Inflation has not had a significant impact on the results of operations of the Company in recent years and is not anticipated to have a significant impact in the foreseeable future. The Company’s exposure to market risk from changing prices consists primarily of fluctuations in rental rates of commercial and residential properties, market interest rates on residential mortgages and debt obligations and real estate property values. The revenues associated with the commercial services businesses are impacted by fluctuations in interest rates, lease rates, real property values and the availability of space and competition in the market place. Commercial service revenues are derived from a broad range of services that are primarily transaction driven and are therefore volatile in nature and highly competitive. The revenues of the property management operations with respect
to rental properties are highly dependent upon the aggregate rents of the properties managed, which are affected by rental rates and building occupancy rates. Rental rate increases are dependent upon market conditions and the competitive environments in the respective locations of the properties. Employee compensation is the principal cost element of property management. Economic trends in 2003 were characterized by general slowdowns in commercial leasing volume in the U.S.
RECENT ACCOUNTING PRONOUNCEMENTS
In December 2002, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB 51 (“FIN 46”). The primary objectives of FIN 46 are to provide guidance on the identification of entities for which control is achieved through means other than through voting right (variable interest entities, or VIEs) and how to determine when and which business enterprise should consolidate the VIE (the primary beneficiary). In December 2003, the FASB modified and issued a revised Interpretation (“FIN 46R”). FIN 46R clarifies the interpretation’s scope and also extends the requirement to apply its provisions to investments created prior to January 31, 2003 until the end of the Company’s first quarter in 2004. The Company is continuing its study of investments created prior to January 31, 2003 and plans to implement the provisions of FIN 46R in connection with its first quarter in 2004. The implementation extension does not apply to special purpose entities. Consequently, the Company’s sole special purpose entity has been consolidated prospectively as of and for the year ended December 31, 2003 under the provisions of the updated interpretation. This investment is engaged in the development, operation and ultimate disposition of two industrial properties located in San Antonio, Texas.
Summarized balance sheet data for the VIEs, as of December 31, 2003 and 2002 includes total assets of $488.5 million and $559.4 million, respectively, and total liabilities of $334.4 million and $368.9 million, respectively. Summarized income statement data for the years ended December 31, 2003 and 2002 includes total revenues of $49.7 million and $69.5 million, respectively, and total expenses of $47.5 million and $52.1 million, respectively.
Amounts consolidated as of and for the year ended December 31, 2003 include:
In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (“SFAS 149”). The standard amends and clarifies financial reporting for derivative instruments and for hedging activities accounted for under SFAS 133 and was effective for contracts entered into or modified, and for hedges designated, after June 30, 2003. The Company’s adoption of the standard did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.
In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, Accounting for Certain Instruments with Characteristics of Both Liabilities and Equity (“SFAS 150”). The standard establishes how an issuer classifies and measures certain freestanding financial instruments with characteristics of liabilities and equity and requires that such instruments be classified as liabilities. The standard was effective for financial instruments entered into or modified after May 31, 2003. The Company’s adoption of this standard did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.
FORWARD-LOOKING STATEMENTS AND RISK FACTORS
Certain statements contained in this document may constitute “forward-looking statements” within the meaning of the federal securities laws. Forward-looking statements are statements containing a projection of revenues, income, earnings, capital expenditures, dividends, capital structure or other financial terms or our plans and objectives for future operations.
The forward-looking statements in this document are based on our management’s beliefs, assumptions, and expectations of our future economic performance, taking into account the information currently available to them. These statements are not statements of historical fact. Forward-looking statements involve risks and uncertainties that may cause our actual results, performance or financial condition to be materially different from the expectations of future results, performance or financial condition we express or imply in any forward-looking statements. Some of the important risk factors that could cause our actual results, performance or financial condition to differ materially from our expectations are:
• general volatility of the capital markets;
• changes in the real estate market, interest rates or the general economy of the markets in which we operate;
• our ability to identify and complete acquisitions and successfully integrate businesses we acquire;
• our ability to employ and retain qualified employees;
• changes in government regulations that are applicable to our regulated brokerage and property management businesses;
• changes in the demand for our services; and
• degree and nature of our competition.
When used in our documents or oral presentations, the words “plan”, “believe”, “anticipate”, “estimate”, “expect”, “objective”, “projection”, “forecast”, “goal”, or similar words, are intended to identify forward-looking statements. We qualify any and all such forward-looking statements entirely by these cautionary risk factors.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The table below represents contractual balances of our financial instruments at the expected maturity dates as well as the fair value at December 31, 2003. The expected maturity categories take into consideration actual amortization of principal and do not take into consideration reinvestment of cash. The weighted average interest rate for the various assets and liabilities presented are actual as of December 31, 2003. (See Consolidated Financial Statements-Note 2-Fair Value of Financial Instruments) Management closely monitors the fluctuation in interest rates, and if rates were to increase significantly, the Company believes that it would be able either to hedge the change in the interest rate or to refinance the loans with fixed interest rate debt. All instruments included in this analysis are non-trading.
The Company does not have any derivative financial instruments as of December 31, 2003.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA
Page
Independent Auditors’ Report - KPMG LLP
Independent Auditors’ Report - Deloitte & Touche LLP
Consolidated Balance Sheets as of December 31, 2003 and 2002
Consolidated Statements of Income for each of the years in the three year period ended December 31, 2003
Consolidated Statements of Stockholders’ Equity and Comprehensive Income for each of the years in the three year period ended December 31, 2003 (restated as of January 1, 2001)
Consolidated Statements of Cash Flows for each of the years in the three year period ended December 31, 2003
Notes to Consolidated Financial Statements
INDEPENDENT AUDITORS’ REPORT
To the Board of Directors and Stockholders
Kennedy-Wilson, Inc.:
We have audited the accompanying consolidated balance sheets of Kennedy-Wilson, Inc. and subsidiaries (the “Company”) as of December 31, 2003 and 2002, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the two-year period ended December 31, 2003. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We did not audit the financial statements of certain unconsolidated investee companies (the Investees) for the year ended December 31, 2002. The Company’s investment in the Investees at December 31, 2002, was $17,629,000, and its equity in earnings of the Investees was $2,498,000 for the year ended December 31, 2002. Additionally, one of the unconsolidated Investees was consolidated by the Company through September 20, 2002 and generated revenues of $12,493,000 during the period from January 1, 2002 through September 20, 2002. The 2002 financial statements of the Investees were audited by other auditors whose reports have been furnished to us, and our opinion, insofar as it relates to the amounts included for the Investees in 2002, is based solely on the reports of the other auditors.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, based on our audits and the reports of the other auditors for 2002, the 2003 and 2002 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kennedy-Wilson, Inc. as of December 31, 2003 and 2002 and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 2 to the consolidated financial statements, effective December 31, 2003, the Company adopted the applicable provisions of FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities. The Company implemented FIN 46 prospectively.
KPMG LLP
Los Angeles, California
March 29, 2004
INDEPENDENT AUDITORS’ REPORT
To the Board of Directors and Stockholders
Kennedy-Wilson, Inc.
Beverly Hills, California
We have audited the accompanying consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows of Kennedy-Wilson, Inc. and subsidiaries (the “Company”) for the year ended December 31, 2001. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the results of operations and cash flows of Kennedy-Wilson, Inc. and subsidiaries for the year ended December 31, 2001, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 24 to the consolidated financial statements, consolidated retained earnings as of January 1, 2001, has been restated.
DELOITTE & TOUCHE LLP
Los Angeles, California
March 22, 2002, except for the effects of a restatement of the Company’s 2001 financial statements presented in previously issued financial statements, as to which the date is April 14, 2003 and except for Note 24 and the reclassification of certain property as discontinued operations as discussed in Note 5, as to which the date is March 29, 2004
Kennedy-Wilson, Inc. and Subsidiaries
Consolidated Balance Sheets
* Restated (see Note 24)
See accompanying notes to consolidated financial statements.
Kennedy-Wilson, Inc. and Subsidiaries
Consolidated Statements of Income
See accompanying notes to consolidated financial statements.
Kennedy-Wilson, Inc. and Subsidiaries
Consolidated Statements of Stockholders’ Equity and Comprehensive Income
See accompanying notes to consolidated financial statements.
Kennedy-Wilson, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
Kennedy-Wilson, Inc. and Subsidiaries
Consolidated Statements of Cash Flows (continued)
Supplemental Disclosures of Cash Flow Information:
Supplemental Disclosures of Non-Cash Investing and Financing Activities:
In 2003, as a result of the consolidation of one of the Company’s subsidiaries, accounts receivable increased by $2,000, real estate held for sale increased by $15,833,000, other assets increased by $643,000, accrued expenses increased by $103,000, mortgage notes payable increased by $15,911,000, offset by a decrease in investment in joint ventures of $1,063,000.
In 2003, the Company foreclosed on two notes receivable collateralized by commercial properties. As a result, real estate held for sale increased by $805,000 and notes receivable decreased by $805,000.
During 2003, a note payable in the amount of $2,745,000 was issued for the repurchase of stock.
In May 2002, the Company contributed real estate to a joint venture investment with the following consideration, reduction of real estate of $2,948,000, addition to investments in joint ventures of $2,045,000 and addition to notes receivable of $903,000.
In June 2002, the holder of the convertible subordinated debentures converted the debentures into 749,000 shares of the Company’s common stock at a conversion price of $5.31 per share with the following consideration, extinguishment of $7.5 million of convertible subordinated debt, issuance of $3,977,000 of common stock, issuance of $2,773,000 of subordinated debt and a gain on extinguishment of debt of $750,000.
In September 2002, as a result of the deconsolidation of the Company’s Japan subsidiary, accounts receivable decreased by $599,000, notes receivable decreased by $3,592,000, other assets decreased by $4,358,000, accounts payable decreased by $172,000, accrued expenses decreased by $2,599,000, accrued salaries decreased by $245,000, notes payable decreased by $6,902,000, borrowing under lines of credit decreased by $3,335,000, a decrease in investments in joint ventures of $8,277,000, offset by an increase in investment in Kennedy-Wilson Japan of $3,573,000.
The issuance of 1 million and 700,000 shares of restricted stock in 2002 and 2001, respectively, did not result in the receipt of cash by the Company.
See accompanying notes to consolidated financial statements.
Kennedy-Wilson, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2003, 2002 and 2001
NOTE 1 - ORGANIZATION
Kennedy-Wilson, Inc., a Delaware corporation, and its subsidiaries (the “Company”), provides real estate property management, brokerage and marketing services in the U.S. primarily to institutional investors, financial institutions, developers and government agencies. The Company, principally through joint venture investments, also acquires, renovates and resells commercial and residential real estate, invests in discounted loan portfolios, and invests in real estate.
In February 2002, the Company completed an initial public offering of the shares of its formerly wholly-owned subsidiary, Kennedy-Wilson Japan. The initial public offering consisted of 4,500 newly issued shares and 2,500 shares sold by the Company at a price of approximately $3,319 per share, for total gross cash consideration of approximately $23 million. In September 2002, the Company completed a secondary public stock offering of 4,900 shares of its Japan subsidiary at a price of $1,700 per share, and the private sale of 2,000 shares of the stock of the subsidiary, for total gross cash consideration of approximately $11.7 million. During 2003, the Company completed the sale of its remaining shares of Kennedy-Wilson Japan for total gross cash consideration of approximately $30.3 million.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION - The consolidated financial statements include the accounts of the Company and joint ventures in which the Company has a controlling voting interest. All material intercompany balances and transactions have been eliminated. Assets and liabilities denominated in foreign currencies are translated at rates of exchange prevailing on the date of the consolidated balance sheet, while income statement items are translated at average rates of exchange for the year.
USE OF ESTIMATES - The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. The Company bases its estimates on historical experience and assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
RECLASSIFICATION - Certain amounts for prior years have been reclassified to conform to the 2003 presentation.
REVENUE RECOGNITION - The Company’s real estate services revenues are recorded when the related services are performed. In the case of real estate sales commissions, this generally occurs when the sale closes escrow. Property management fees are recognized over time as earned based upon the terms of the management agreement.
Leasing commission revenues are accounted for in accordance with the provisions of Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin 104. Accordingly, leasing commissions that are payable upon tenant occupancy, payment of rent or other events beyond the Company’s control are recognized upon the occurrence of such events. In accordance with EITF 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent, the Company
records brokerage commission revenues and expenses on a gross basis. Of the criteria listed in the EITF, the Company is the primary obligor in the transaction, does not have inventory risk, performs all, or part, of the service, has credit risk, and has wide latitude in establishing the price of services rendered and discretion in selection of agents and determination of service specifications.
Residential real estate sales revenue and gains on sale of commercial property are recognized at the close of escrow when title to the real property passes to the buyer. The Company follows the requirements for profit recognition as set forth by Statement of Financial Accounting Standards No. 66, Accounting for Sales of Real Estate. Residential real estate is accounted for as inventory because these properties are generally held for less than one year and do not generate income during the holding period. Accordingly, gross revenue and cost of sales are presented separately on the statements of income.
Revenues on notes receivable are recognized on an effective interest basis under the provisions of Practice Bulletin 6 where cash received is accreted into interest income over the estimated holding period. When the future cash flows of a note can not be reasonably estimated, cash payments are applied to the cost basis until fully recovered before any revenue is recognized.
INVESTMENTS IN JOINT VENTURES - The Company has a number of partnership and joint venture interests, generally ranging from 2% to 50%, that were formed to acquire, manage, develop and/or sell real estate. These investments are accounted for under the equity method. Investments in joint ventures also includes internet investments and mezzanine loans to real estate developers for new single-family residential developments. These investments are accounted for under the cost method. All of the mezzanine loans were repaid by December 31, 2003 and the Company is no longer making these types of loans.
The Company evaluates each of its investments in unconsolidated real estate and technology entities on a periodic basis for evidence of impairment. Impairment losses are recognized whenever events or changes in circumstances indicate declines in value of an investment below carrying value and the related undiscounted cash flows are not sufficient to recover the asset’s carrying amount. At December 31, 2003, no investments were deemed to be impaired as a result of this evaluation. In 2002, the Company recorded impairment losses of approximately $3.2 million on remaining technology investments and approximately $1.5 million on a real estate investment.
In accordance with SEC Staff Accounting Bulletin No. 51 (“SAB 51”), the Company records gains as a result of equity transactions by its subsidiaries in the consolidated statements of operations.
GOODWILL - Goodwill results from the difference between the purchase price and the fair value of net assets acquired based upon the purchase method of accounting for business combinations. Effective January 1, 2002, in accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“SFAS 142”), goodwill of $23,965,000 is not amortized. Rather, it is reviewed for impairment on a regular basis by Company management. During 2001, amortization of goodwill totaled $882,000. Accumulated amortization was $2,478,000 at December 31, 2003 and 2002.
In testing for impairment in accordance with SFAS 142, goodwill was assigned to the reporting units based upon the amount of goodwill generated at the time of acquisition of the businesses by the reporting unit. An earnings multiple appropriate to the respective reporting unit was applied to the cash basis net operating income of the reporting unit. This process enables a fair approximation of the reporting unit’s value, which is then compared to the net book value of the reporting unit. As a result of the evaluation performed of its goodwill as described above, the Company has determined that there was no goodwill impairment as of the transition date or December 31, 2003.
The effects on earnings and earnings per share of excluding such goodwill amortization from 2001 are as follows:
CASH AND CASH EQUIVALENTS - Cash and cash equivalents consists of cash and all highly liquid investments purchased with maturities of three months or less.
RESTRICTED CASH - Restricted cash consists of non-refundable deposits on acquisitions of real estate and marketing funds advanced by clients.
LONG-LIVED ASSETS - The Company reviews long-lived assets, except goodwill, for impairment whenever events or changes in circumstances indicate that an asset’s carrying value may exceed the undiscounted expected future cash flows to be derived from that asset. Whenever undiscounted expected future cash flows are less than the carrying value, the asset is reduced to an amount equal to the net present value of the expected future cash flows and an impairment loss is recognized. The Company evaluates its long-lived assets in the fourth quarter of every year.
The Company has classified separately on the balance sheet the real estate assets which are held for sale. Assets held for sale principally include those which management, having the proper level of authority to effect a plan of disposal, has implemented such plan, which is likely to result in the sale of the property within one year. As of December 31, 2003, the Company held four properties as available for sale, in accordance with SFAS 144, and the results of the operations of those properties has been reported “net” as discontinued operations for the years ended December 31, 2003, 2002 and 2001.
NOTES RECEIVABLE - The Company accounts for any impairment to the basis of notes receivable in accordance with Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan, as amended by Statement of Financial Accounting Standards No. 118, Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures. Accordingly, an impaired loan is measured based upon the present value of expected future cash flows, discounted at the loan’s effective interest rate or, if readily determinable, the loan’s observable market price or the fair value of the collateral if the loan is collateral dependant.
FAIR VALUE OF FINANCIAL INSTRUMENTS - The estimated fair value of the Company’s financial instruments is determined using available market information and appropriate valuation methodologies. Considerable judgement, however, is necessary to interpret market data and develop the related estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that could be realized upon disposition of the financial instruments. The use of different market assumptions or estimation methodologies may have a material impact on the estimated fair value amounts. The carrying amount of cash and cash equivalents, accounts receivable, accounts payable, accrued expenses and other liabilities, accrued salaries and benefits, and deferred and accrued income taxes approximate fair market value due to their short-term maturities. The carrying value of notes receivable approximate market value as they are negotiated based upon the market value of loans with similar characteristics. Bank lines of credit and debt approximate fair market value as the terms are comparable to the terms currently being offered to the Company.
CAPITALIZED INTEREST - The Company capitalizes interest in accordance with Statement of Financial Accounting Standards No. 58, Capitalization of Interest Cost in Financial Statements That Include Investments Accounted for Under the Equity Method (an amendment of FASB Statement No. 34), for qualifying equity investments. Interest is capitalized on investment assets that are undergoing construction or entitlement activities in preparation for their planned principal operations. An appropriate interest rate is applied to the Company’s cash investment in the qualifying asset. The interest is credited against interest expense and added to the basis in the investment. Interest is capitalized when the development or entitlement activity commences and ceases when the investment has begun its planned principal operations.
GUARANTEES - The Company has certain guarantees associated with loans secured by assets held in various joint venture partnerships. The maximum potential amount of future payments (undiscounted) the Company could be required to make under the guarantees is approximately $56 million. The guarantees expire through 2005 and the Company’s performance under the guarantees would be required to the extent there is a shortfall in liquidation between the principal amount of the loan and the net sales proceeds of the property. In one joint venture partnership, the entire loan of approximately $9 million is collateralized by the property and the Company indemnifies the lender under certain conditions such as fraud or bankruptcy. The Company also has a leasing guarantee agreement that expires in 2009. The maximum amount that the Company could be responsible for under the guarantee is approximately $2.1 million. Based upon the Company’s evaluation of guarantees under FIN 45, the estimated fair value of guarantees made after December 31, 2003 is immaterial.
CONCENTRATION OF CREDIT RISK - Financial instruments that subject the Company to credit risk consist primarily of accounts and notes receivable and cash equivalents. Credit risk is generally diversified due to the large number of entities composing the Company’s customer base and their geographic dispersion throughout the U.S. The Company performs ongoing credit evaluations of its
customers and debtors. Cash and cash equivalents are invested in institutions insured by government agencies. Certain accounts contain balances in excess of the insured limits.
EXTINGUISHMENT OF DEBT - In 2002, the FASB issued Statement of Financial Accounting Standards No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections (“SFAS 145”). The provisions of SFAS 145 relating to the early extinguishment of debt were effective for fiscal years beginning after May 15, 2002. The Company’s adoption of these provisions, effective April 1, 2002, resulted in the Company recording a non-operating loss on extinguishment of debt in 2003 of $968,000 and gain on extinguishment of debt in 2002 in the amount of $750,000.
EARNINGS PER SHARE - Basic earnings per share is computed based upon the weighted average number of shares of common stock outstanding during the periods presented. Diluted earnings per share is computed based upon the weighted average number of shares of common stock and dilutive securities outstanding during the periods presented. The weighted average number of shares outstanding for the diluted earnings per share computation also includes the dilutive impact of options and warrants to purchase common stock which were outstanding during the period calculated by the “treasury stock” method.
RECENT ACCOUNTING PRONOUNCEMENTS - In December 2002, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB 51 (“FIN 46”). The primary objectives of FIN 46 are to provide guidance on the identification of entities for which control is achieved through means other than through voting rights (variable interest entities, or VIEs) and how to determine when and which business enterprise should consolidate the VIE (the primary beneficiary). In December 2003, the FASB modified and issued a revised Interpretation (“FIN 46R”). FIN 46R clarifies the interpretation’s scope and also extends the requirement to apply its provisions to investments created prior to January 31, 2003 until the end of the Company’s first quarter in 2004. The Company is continuing its study of investments created prior to January 31, 2003 and is not aware of any investments which are probable of consolidation in connection with the implementation.
The implementation extension does not apply to special purpose entities. Consequently, the Company’s sole special purpose entity has been consolidated prospectively as of and for the year ended December 31, 2003 under the provisions of the updated interpretation. This investment is engaged in the development, operation and ultimate disposition of two industrial properties located in San Antonio, Texas. Summarized balance sheet data for the VIEs, as of December 31, 2003 and 2002 includes total assets of $488.5 million and $559.5 million, respectively, and total liabilities of $334.4 million and $368.9 million, respectively. Summarized income statement data for the years ended December 31, 2003 and 2002 includes total revenues of $49.7 million and $69.5 million, respectively, and total expenses of $47.5 million and $52.1 million, respectively.
Amounts consolidated as of and for the year ended December 31, 2003 include:
In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (“SFAS 149”). The standard amends and clarifies financial reporting for derivative instruments and for hedging activities accounted for under SFAS 133 and was effective for contracts entered into or modified, and for hedges designated, after June 30, 2003. The Company’s adoption of the standard did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.
In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, Accounting for Certain Instruments with Characteristics of Both Liabilities and Equity (“SFAS 150”). The standard establishes how an issuer classifies and measures certain freestanding financial instruments with characteristics of liabilities and equity and requires that such instruments be classified as liabilities. The standard was effective for financial instruments entered into or modified after May 31, 2003. The Company’s adoption of this standard did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.
STOCK-BASED COMPENSATION - Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure (“SFAS 148”) amends Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), to provide alternative methods of transition for a voluntary change from the intrinsic-value-based
method of recognizing stock compensation under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), to the SFAS 123 fair-value-based method of accounting for stock-based employee compensation. SFAS 148 also amends SFAS 123 to require more prominent disclosure in interim and annual financial statements of the effect of all stock-based compensation. The Company continues to apply the intrinsic-value method under APB 25 in accounting for its plans and discloses the effect on net income and earnings per share as if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee and non-employee compensation.
In accordance with APB 25 and related interpretations, compensation expense for stock options is recognized in income based on the excess, if any, of the quoted market price of the stock at the grant date of the award or other measurement date over the amount an employee must pay to acquire the stock. Generally, the exercise price for stock options granted to employees equals or exceeds the fair market value of the Company’s common stock at the date of grant, thereby resulting in no recognition of compensation expense by the Company. For awards that generate compensation expense as defined under APB 25, the Company calculates the amount of compensation expense and recognizes the expense over the vesting period of the award. The fair value of each option granted is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions:
The proforma results of expensing the estimated fair value of stock options is as follows:
NOTE 3 - INVESTMENT IN KENNEDY-WILSON JAPAN
In February 2002, the Company completed an initial public offering of the shares of its formerly wholly-owned subsidiary, Kennedy-Wilson Japan. The initial public offering consisted of 4,500 newly issued shares and 2,500 shares sold by the Company at a price of approximately $3,319 per share, for total gross cash consideration of approximately $23 million. In September 2002, the Company completed a secondary public stock offering of 4,900 shares of its Japan subsidiary at a price of $1,700 per share, and the private sale of 2,000 shares of the stock of the subsidiary, for total gross cash consideration of approximately $11.7 million. During 2003, the Company completed the sale of its remaining shares of Kennedy-Wilson Japan for total gross cash consideration of approximately $30.3 million.
Effective with the completion of the secondary offering and until the sale of the balance of the Company’s remaining shares, Kennedy-Wilson Japan was an unconsolidated subsidiary in the Company’s financial statements and was accounted for as an equity method investment. As a result of the public offerings and the sale of shares, the Company recorded net gains of approximately $16.4 million and $12.9 million for the years ended December 31, 2003 and 2002, respectively. In accordance with SAB 51, the Company records gains as a result of equity transactions by its subsidiaries in the consolidated statements of operations. Non-recurring, non-cash Japan IPO expense for the year ended December 31, 2002, includes $1.1 million related to incentive stock issued to employees of the Company in connection with the initial public offering.
Summarized financial data for Kennedy-Wilson Japan is as follows:
NOTE 4 - NOTES RECEIVABLE
Notes receivable consists primarily of discounted loan portfolios and other related assets acquired from financial institutions, and notes resulting from the sale of assets to third parties or joint ventures. A majority of these notes are collateralized by real estate, personal property or guarantees.
Impairment of the Company’s basis is infrequent because the Company acquires these notes at a substantial discount, and actively seeks to restructure the notes in a short period of time. Typically the event that causes a write-off and the related bad debt expense occur in the same accounting period. As a result, no valuation allowances are required as of December 31, 2003, 2002 and 2001. The loans are reviewed on a quarterly basis for impairment. Based on the Company’s evaluation, if a loan is deemed to be impaired, a specific write-off is taken. In 2003, 2002 and 2001, the write-off of uncollectable notes receivable was $850,000, $146,000 and $136,000, respectively, and is included in general and administrative expense.
Notes receivable consists of the following:
NOTE 5 - REAL ESTATE HELD FOR SALE
Real estate held for sale is comprised of commercial and industrial properties and residential land. The real estate is accounted for at the lower of carrying amount or fair value. The industrial property and residential land are encumbered by non-recourse mortgage loans. Real estate held for sale includes the following:
In 2003, a portion of the industrial property was sold for approximately its $7.8 million book value.
Summarized operating results for the real estate held for sale, presented as discontinued operations in the accompanying consolidated statements of income, are as follows:
The interest expense incurred is for property specific debt. For the years ended December 31, 2002 and 2001, the operations of real estate held for sale were accounted for under the equity method. Consequently, the amounts reported as equity in joint venture income in 2002 and 2001 relative to real estate held for sale were $423,000 and $110,000, respectively.
NOTE 6 - INVESTMENTS IN JOINT VENTURES
The Company has a number of partnership and joint venture interests, generally ranging from 2% to 50%, that were formed to acquire, manage, develop and/or sell real estate. The Company has significant influence over these entities, but not voting control and accordingly, these investments are accounted for under the equity method. Investments in joint ventures also include internet investments and mezzanine loans to real estate developers for new single-family residential developments. These investments are accounted for under the cost method. All of these mezzanine loans were repaid by December 31, 2003 and the Company is no longer making these types of loans.
Summarized financial data of the joint ventures are as follows:
The Company has certain investments in joint ventures in which the Company’s investment is in the form of preferred stock. These investments and other investments where the Company does not have significant influence are accounted for under the cost method of accounting.
Profit on sales to joint ventures in which the Company retains an ownership interest results in partial sales treatment in accordance with the provisions of SFAS 66 and Statement of Position 78-9, thus deferring a portion of the gain on the Company’s continuing ownership percentage in the joint ventures. At December 31, 2003 and 2002, $339,000 of gain was deferred and recorded against investments in joint ventures.
NOTE 7 - CONTRACTS AND OTHER ASSETS
The Company amortizes acquired property management contracts over a seven-year period. Contracts and other assets consist of the following:
Depreciation and amortization expense related to the above depreciable assets was $3,013,000, $3,639,000 and $2,924,000 for the years ended December 31, 2003, 2002 and 2001, respectively.
NOTE 8 - NOTES PAYABLE
Notes payable were incurred primarily in connection with the acquisition of discounted loan portfolios and joint venture investments, and include the following:
The notes payable become due in the years 2004 and 2005 in the amounts of $4,936,000 and $16,798,000, respectively.
NOTE 9 - BORROWINGS UNDER LINES OF CREDIT
The Company has entered into a loan agreement with US Bank and East-West Bank that provides the Company with an unsecured revolving credit facility for use in acquisitions and for working capital purposes in the amount of $30 million. The loan bears interest at a range of rates from prime to prime plus 0.50%, or, at the borrower’s option, LIBOR plus 2.50% to LIBOR plus 3.00%. At December 31, 2003, the borrowings under this loan had interest rates ranging from 4.146% to 4.50%. The loan becomes due in June 2005. The principal amount outstanding under this loan was $16,209,000 at December 31, 2003 and $24,224,000 at December 31, 2002. The principal repayments under this facility are $6,658,000 and $9,551,000 for the years 2004 and 2005, respectively.
The Company’s ability to borrow under this facility is subject to compliance with certain financial covenants, including maximum balance sheet leverage and fixed charge coverage ratios. As of December 31, 2003, the Company was in compliance with the covenants.
NOTE 10 - MORTGAGE LOANS PAYABLE
The mortgage loans payable become due in the years 2004 and 2005 in the amounts of $7,876,000 and $8,150,000, respectively.
NOTE 11 - SENIOR UNSECURED NOTES
The Company has entered into two loan agreements with Pacific Western National Bank (“PWNB”). The first loan in the principal amount of $5,000,000 was entered into in 2002. The loan bears interest at the bank’s base rate plus 1%, 5.00% at December 31, 2003, and interest is payable monthly. The loan becomes due in September 2005. At December 31, 2003, the outstanding principal balance of this loan was $3,333,000. The principal repayments under this loan for the years 2004 and 2005 are $1,667,000 and $1,666,000, respectively.
In 2003, the Company entered into a second loan agreement with PWNB in the principal amount of $5 million. The loan bears interest at the bank’s base rate plus 1%, 5.00% at December 31, 2003, and interest is payable monthly. The loan becomes due in 2006. The principal repayments under this loan for the years 2004, 2005 and 2006 are $1,667,000, $1,667,000 and $1,666,000, respectively.
In 2003, the Company repaid the remaining balance of $10 million of the 12% Senior Notes which were issued by GATX and Aon in 2000. The Company recorded a loss on the early extinguishment of the debt in the amount $968,000 for prepayment penalties and the write-off of unamortized capitalized loan fees associated with the early retirement of the notes.
The valuation adjustment for the change in the fair value of warrants issued in connection with the issuance of $15 million of 12% senior unsecured notes resulted in a benefit of $35,000 and $209,000 for 2003 and 2002, respectively, and an expense of $158,000 in 2001. The Company issued the warrants to the purchasers of the notes for 597,888 shares of the common stock of the Company at an exercise price of $6.25 per share. The warrants expire June 22, 2008. The warrants contain a put provision that requires the Company, at the option of the note holders, to repurchase the common shares issued upon exercise of the warrants, at the prevailing market price, during years four through six of the warrant term. The fair value of the warrants was estimated using a combination of the Black-Scholes Option Pricing Model and Monte Carlo Simulation. A liability was recorded for the fair value of the warrants, which is adjusted quarterly to record the warrants at their estimated fair value while they are outstanding, with the change in value recorded as valuation adjustment - warrants. As a result of the partial repayment of $5 million of the notes in 2002, warrants for the purchase of 199,296 shares of common stock were cancelled and the liability for the value of the warrants was reduced by $222,000. The estimated fair value of the warrants was $283,000 at December 31, 2002 and is included in accrued expenses and other liabilities.
NOTE 12 - SUBORDINATED DEBT
In 2002, the Company issued $2,773,000 of unsecured subordinated debentures. The debentures have an interest rate of 6%, interest payable monthly and are due March 31, 2004. The Company has executed a new loan agreement, the proceeds of which will be used to repay the subordinated debt.
NOTE 13 - RELATED PARTY TRANSACTIONS
In 2003, the firm of Kulik, Gottesman & Mouton Ltd. was paid $563,000 for legal services provided by the firm and director’s fees for Kent Mouton, a partner in the firm and a member of the Company’s Board of Directors. For 2002 and 2001, the amounts were $325,000 and $205,000, respectively.
The firm of Solomon, Winnett & Company was paid $173,000, $151,000 and $181,000 for income tax services provided by the firm during the years ended December 31, 2003, 2002 and 2001, respectively. Jerry Solomon is a partner in the firm and a member of the Company’s Board of Directors since 2001 and Chairman of the Audit Committee.
During 2003, 2002 and 2001, the Company received property management, brokerage, leasing commissions and other fees from affiliates and entities in which the Company holds ownership interests in the amounts of $5,224,000, $13,543,000 and $10,022,000, respectively.
In 2003, the Company received a commission fee in advance of the sale of a property owned by 1055 Wilshire, LLC, an affiliate the Company, in the amount of $1,640,000 and an advance on distributions from the same property in the amount of $360,000. Recognition of the commission fee as revenue was deferred and is recorded against investments in joint ventures at December 31, 2003.
In 2002, the Company foreclosed on the land collateralizing a note receivable held by the Company from the sale of land in Hawaii. Concurrently, the land was sold to a joint venture investment in which the Company holds an ownership interest. The gain on this transaction in the amount of $1,465,000 was deferred and is included in accrued expenses and other liabilities at December 31, 2003 and 2002.
In 2002, the Company sold its 50% interest in a building and parcel of land to KWI Property Fund I, L.P. in which the Company has a 5% ownership interest. The Company sold its 50% interest in a separate parcel of land to the third-party member of the partnership in exchange for cash and a note receivable. The Company recorded a gain of approximately $2.7 million in equity in joint venture income from these two transactions, after deferral of the Company’s 5% interest from the sale of the building to KWI Property Fund I, L.P.
In 2002, KWI Property Fund I, L.P. sold a building to a joint venture partnership in which the Company has a 47% ownership interest. The Company recorded a gain on the transaction of approximately $583,000 as equity in joint venture income. The Company’s equity in earnings from this transaction was reduced by deferral of income of the Company’s 47% ownership percentage in the new joint venture partnership.
In 2002, an apartment property owned by a joint venture partnership in which the Company had a 20% ownership interest, was sold to a new joint venture partnership in which the Company has a 17.7% ownership interest. The Company recorded a gain of approximately $1 million as equity in joint venture income after deferral of that portion of the gain representing the Company’s ownership interest in the new joint venture partnership.
NOTE 14 - INCOME TAXES
The Company’s income before provision for income taxes is as follows:
The provision for income taxes consists of the following:
A reconciliation of the statutory federal income tax rate with the Company’s effective income tax rate is as follows:
The following summarizes the effect of deferred income tax items and the impact of “temporary differences” between amounts of assets and liabilities for financial reporting purposes and such amounts as measured by tax laws. Temporary differences and carryforwards which give rise to deferred tax assets and liabilities are as follows:
Based upon the level of historical taxable income and projections for future taxable income over the periods which the Company’s gross deferred tax assets are deductible, management believes it is more likely than not the Company will realize the benefits of these deductible differences at December 31, 2003.
NOTE 15 - COMMITMENTS AND CONTINGENCIES
Future minimum lease payments under scheduled capital and operating leases, net of minor subleases, that have initial or remaining noncancelable terms in excess of one year are as follows:
Net rental expense amounted to $2,251,000, $3,006,000, and $3,527,000 for the years ended December 31, 2003, 2002 and 2001, respectively.
EMPLOYMENT AGREEMENTS - The Company has entered into employment agreements with all of its principal officers which provide for annual base compensation in the aggregate amount of $1,950,000 and expire at various dates through December 2004, with one expiring in December 2009. The employment agreements provide for the payment of an annual bonus based upon the achievement of certain agreed-upon earnings objectives. The Company also has employment agreements with various other non-officer employees, which provide for minimum annual compensation of $2,916,000 in total, expiring at various dates through December 2004.
LITIGATION - The Company is currently a defendant in certain routine litigation arising in the ordinary course of business. It is the opinion of management and legal counsel that the outcome of these actions will not have a material effect on the financial position or results of operations of the Company.
NOTE 16 - STOCK OPTION PLANS AND WARRANTS
The Company currently has the 1992 Incentive and Non-statutory Stock Option Plan, which includes a Plan A and a Plan B and the 1992 Non-Employee Director Stock Option Plan (“Plan C”). An aggregate of 1,700,000 shares of common stock are reserved for issuance under Plan A and B. The Company has 81,000 shares of common stock reserved for issuance under Plan C.
Plan A permits the granting of Incentive Stock Options to employees, including employee-directors. Plan B permits the granting of nonstatutory stock options to employees, including employee-directors and consultants.
Plan C permits the granting of options to non-employee-directors. Options granted under Plan A and B have an option price of 100% of the fair market value of the common stock on the date of grant.
Under Plan C each director, upon being elected to the Board of Directors, is automatically granted an option to purchase 13,500 shares at the fair market value at the date of grant. Additionally, each director is granted an option to purchase an additional 540 shares at the fair market value on the date of grant when re-elected.
The vesting schedule for options granted under Plan A and Plan B is determined by the Compensation Committee of the Board of Directors. Options granted under Plan A may be exercised for a period of up to five years from the grant date; options granted under Plan B may be exercised for a period of up to 10 years from the grant date. Options granted under Plan C become exercisable on the first anniversary of the date of the initial grant provided that the optionee continues to serve as a director for at least one year from the date of such initial grant. Under Plan C, options expire on the earlier of the tenth anniversary of the date of grant and 90 days after the individual ceases to be a director of the Company.
The following table sets forth activity under the plans:
The number of options exercisable at December 31, 2003, 2002 and 2001 were 645,404, 720,961 and 861,704, respectively.
At December 31, 2003, total warrants for the purchase of 596,631 shares of the Company’s common stock were outstanding. The warrants have exercise prices ranging from $3.72 to $10.00 per share and expire between 2005 and 2010.
NOTE 17 - CAPITAL STOCK TRANSACTIONS
During 2003, the Company acquired approximately 2.4 million shares of its stock for total consideration of approximately $11.5 million.
In 2002, the Company acquired approximately 203,000 shares of its stock for total consideration of $709,000.
In 2002, the Company’s chairman was awarded a grant of 1,000,000 shares of restricted stock. The shares vest over a period of eight years. The market value of the restricted stock at the date of grant of $5,750,000 was recorded as deferred compensation, a separate component of stockholders’ equity, and is being amortized over the eight-year vesting period.
In 2001, the Company granted 700,000 shares under a restricted stock agreement with the Company’s chairman pursuant to the terms of his employment agreement. The shares vest over a period of ten years. The market value of the restricted stock at the date of grant of $2,975,000 has been recorded as deferred compensation and is being amortized over the ten-year vesting period.
For the years ended December 31, 2003, 2002 and 2001, compensation expense for the restricted stock grants was $1,015,000, $794,000 and $298,000, respectively.
NOTE 18 - COMPREHENSIVE INCOME
Comprehensive income consists of net income and other comprehensive income. Accumulated other comprehensive income consists of foreign currency translation adjustments. The tax benefit associated with items included in other comprehensive income was $21,000 for the year ended December 31, 2003. The tax provision associated with items included in other comprehensive income was $120,000 for the year ended December 31, 2002. The following table provides a summary of the comprehensive income:
NOTE 19 - EMPLOYEE BENEFIT ARRANGEMENTS
EMPLOYEE PROFIT SHARING PLAN - The Company maintains a profit sharing plan covering all full-time employees over the age of 21, who have completed three months of service prior to January 1 and July 1 of each year. Contributions to the profit sharing plan are made solely at the discretion of the Company’s Board of Directors. No contributions were made for the years ended December 31, 2003, 2002 and 2001.
In addition, the Company has a qualified plan under the provisions of Section 401(k) of the Internal Revenue Code. Under this plan, participants are able to make salary deferral contributions of up to 15% of their total compensation, up to a specified maximum. The 401(k) plan also includes provisions, which authorize the Company to make discretionary contributions. During 2003, 2002 and 2001 the Company made matching contributions of $116,000, $35,000 and $197,000, respectively, to this plan.
DEFERRED COMPENSATION PLAN - The Company has a non-qualified deferred compensation plan to provide specified benefits to a select group of management and key employees and directors who contribute materially to the continued growth, development and future business success of the Company. Under this plan, participants are able to make salary deferral contributions of up to 100% of their total compensation. The plan also includes provisions, which authorize the Company to make discretionary contributions. The Company made no matching contributions during 2003, 2002 and 2001. The Company’s liability under this plan was $611,000 and $820,000 as of December 31, 2003 and 2002, respectively, and is included in accrued salaries and benefits.
NOTE 20 - SEGMENT INFORMATION
The Company’s business activities currently consist of property management, commercial and residential brokerage, and various type of real estate investments. The Company’s segment disclosure with respect to the determination of segment profit or loss and segment assets is based on these services and its various investments:
PROPERTY MANAGEMENT - The Company is a nationwide commercial and residential property management and leasing Company, providing a full range of services relating to property management. The Company also provides asset management services for some of its joint ventures.
BROKERAGE - Through its various offices, the Company provides specialized brokerage services for both commercial and residential real estate and provides other real estate services such as property valuations, development and implementation of marketing plans, arranging financing, sealed bid auctions and open bid auctions.
INVESTMENTS - With joint venture partners and on its own, the Company invests in commercial and residential real estate and purchases and manages pools of discounted notes. The Company’s current real estate portfolio focuses on commercial buildings and multiple-family residences.
The Company did not generate material intersegment revenues for the periods ended December 31, 2003, 2002 and 2001. The Company does not include capital
expenditures by segment as part of the decision making process. The amounts representing investments with related parties and non-affiliates are included in the investment segment. No single external customer provided the Company with 10% or more of its revenues during any period presented in these financial statements.
The following tables reconcile the Company’s income and expense activity for the year ended December 31, 2003 and balance sheet data as of December 31, 2003.
2003 Reconciliation of Reportable Segment Information
The following tables reconcile the Company’s income and expense activity for the year ended December 31, 2002 and balance sheet data as of December 31, 2002.
2002 Reconciliation of Reportable Segment Information
Segment information on geographic areas is as follows:
The following tables reconcile the Company’s income and expense activity for the year ended December 31, 2001 and balance sheet data as of December 31, 2001.
2001 Reconciliation of Reportable Segment Information
Segment information on geographic areas is as follows:
NOTE 21 - EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted net income per share:
Potentially dilutive securities excluded from the diluted earnings per share calculation for being anti-dilutive are as follows:
NOTE 22 - UNAUDITED CONSOLIDATED QUARTERLY INFORMATION
Adjustment for prior years’ deferred compensation expense
Adjustment of provision for income taxes for above adjustment
NOTE 23 - SUBSEQUENT EVENTS
In January 2004, the Company entered into an agreement with a former employee to purchase approximately 1.3 million shares of the Company’s common stock. The agreement also includes the cancellation of the employee’s consulting agreement, which had remaining payments due of about $1.3 million, and the cancellation of options to purchase 90,000 shares of the Company’s stock valued at $377,000. The total purchase price was approximately $12.5 million. The Company issued an unsecured note in the amount of $12.5 million, which has a zero percent stated interest and will be paid in eight installments through March 2007. Using an imputed interest rate of 8% on the note, the present value of the portion of the purchase price related to the 1.3 million shares purchased equates to about $6.75 per share. The Company will record a charge in the first quarter of 2004 related to this transaction.
Also in January 2004, the Company purchased approximately 339,000 shares of the Company’s stock from another former employee for approximately $1.9 million.
In February 2004, the Company, through a joint venture investment, purchased a commercial real estate development located in downtown Los Angeles that includes an office building, retail center, hotel and parking garage. The Company contributed 10% of the joint venture’s equity in the approximate amount of $3.1 million.
NOTE 24 - RESTATEMENT
During the fourth quarter of 2003, the Company’s management determined that the accounting for a deferred compensation plan initiated in 1997 (the Plan) required revision. Based on an analysis of the prior accounting, management
concluded that the liability for the Plan was understated by $1,900,000 and it was further determined that the understatement occurred during the period from the Plan’s 1997 inception through December 31, 2000. As a result, retained earnings as of January 1, 2001, has been restated to increase the liability by $1,900,000 to properly state accrued salaries and benefits at $9,355,000, less the related tax benefit of $722,000 (included in deferred and accrued income taxes). The net of tax impact of $1,178,000 on retained earnings is reflected as a restatement to the January 1, 2001 balance of retained earnings in the accompanying consolidated statement of stockholders’ equity and comprehensive income, as follows:
Retained earnings, accrued salaries and benefits and deferred and accrued income taxes in the accompanying consolidated balance sheets at December 31, 2002 have been modified from the amounts previously reported to reflect the 2001 restatement.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Information regarding the change in our independent accountants can be found in our report on Form 8-K filed on October 30, 2002. We incorporate the information contained in such report by reference.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commissions rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As of December 31, 2003, the end of the fiscal year covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on the foregoing, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective at the reasonable assurance level.
There have been no significant changes in the Company’s internal control over financial reporting or identified in connection with the evaluation referenced above that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information relating to the Directors and Executive Officers of the Company will be set forth in the Company’s definitive proxy statement which is to be filed pursuant to Regulation 14A within 120 days after the Company’s fiscal year ended December 31, 2003, and such information is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information relating to Executive Compensation will be set forth in the Company’s definitive proxy statement which is to be filed pursuant to Regulation 14A within 120 days after the end of the Company’s fiscal year ended December 31, 2003 and such information is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Information relating to Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters will be set forth in the Company’s definitive proxy statement which is to be filed pursuant to Regulation 14A within 120 days after the end of the Company’s fiscal year ended December 31, 2003, and such information is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information relating to Certain Relationships and Related Transactions will be set forth in the Company’s definitive proxy statement which is to be filed pursuant to Regulation 14A within 120 days after the end of the Company’s fiscal year ended December 31, 2003, and such information is incorporated herein by reference.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information relating to Principal Account Fees and Services will be set forth in the Company’s definitive proxy statement which is to be filed pursuant to Regulation 14A within 120 days after the end of the Company’s fiscal year ended December 31, 2003, and such information is incorporated herein by reference.
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Financial Statements, Financial Statement Schedules and Exhibits
1. Financial Statements. Reference is made to the Index to Financial Statements and Schedules in Item 8 hereof.
2. Financial Statement Schedules.
Schedule III - Real Estate Owned
Supplemental financial statement schedules not listed above are omitted because either they are not applicable, not required or because the information required is included in the consolidated financial statements, including the notes thereto.
(b) Exhibits:
* Filed herewith.
(c) Current reports on Form 8-K
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the dates indicated.
Kennedy-Wilson, Inc.
Schedule III-Real Estate Owned
For the year ended December 31, 2003
The aggregate cost for federal income tax purposes is approximately $16,900,000 at December 31, 2003.
See accompanying independent auditor’s report.