Item 1. Business
General
IOS Capital, Inc. (“IOSC” or the “Company”), was formed in 1987 to provide lease financing to customers of IKON Office Solutions, Inc. (“IKON”). The Company’s offices are located at 1738 Bass Road, Macon, Georgia, 31210 (telephone number 478-471-2300). The Company is a wholly-owned subsidiary of IKON.
IKON is a public company headquartered in Malvern, Pennsylvania and a leading provider of products and services that help businesses communicate. IKON provides customers with total business solutions for every office, production and outsourcing need, including copiers and printers, color solutions, distributed printing, facilities management, imaging and legal document solutions, as well as network design and consulting and e-business development. IKON has locations worldwide, including in the United States, Canada, Mexico, the United Kingdom, France, Germany, Ireland and Denmark. IKON’s fiscal 2001 revenues were approximately $5.3 billion.
The Company is engaged in the business of arranging lease financing primarily for office equipment marketed by IKON’s U.S. marketplaces. The ability to offer lease financing on equipment through IOSC is considered a competitive marketing advantage which more closely ties IKON to its customer base. During fiscal 2001, 75% of new equipment sold by IKON marketplaces was financed through the Company. The Company and IKON will seek to increase this percentage in the future, as leasing enhances the overall profit margin on equipment and is considered an important customer retention strategy.
The equipment financed by the Company consists of copiers, facsimile machines, and related accessories and peripheral equipment, the majority of which are produced by major office equipment manufacturers including Canon, Ricoh and Océ. Currently 20% of the equipment financed by the Company represents analog copiers, 63% digital copiers, 12% color copiers, 2% fax machines and 3% other equipment.
The Company provides IKON with standard lease rates for use in customer quotes. However, IKON marketplaces may charge the customer more or less than IOSC’s standard rates, and the IKON marketplaces absorb any variances from the standard rates.
The Company’s customer base (which consists of end users of the equipment) is widely dispersed, with the ten largest customers representing less than 3% of the Company’s total lease portfolio. The typical new lease financed by the Company averages $19 in amount and 51 months in duration. Although 96% of the leases are scheduled for regular monthly payments, customers are also offered quarterly, semi-annual, annual and other customized payment terms. In connection with its leasing activities, the Company performs billing, collection, property and sales tax filings, and provides quotes on equipment upgrades and lease-end notification. The Company also provides certain financial reporting services to the IKON marketplaces, such as a monthly report of marketplace leasing activity and related statistics.
Types of Leases
The lease portfolio of the Company includes direct financing leases and funded leases. Direct financing leases are contractual obligations between the Company and the IKON customer (the “customer”) and represent 92% of the Company’s lease portfolio. Funded leases are contractual obligations between the IKON marketplace and the customer which have been financed by the Company.
Funded leases represented approximately 8% of the Company’s leases as of September 30, 2001. The IKON marketplaces have assigned to the Company their rights under the underlying contracts including the right to receive lease and rental payments as well as a security interest in the related equipment.
Direct financing leases and funded leases are structured as either tax leases (from the Company’s perspective) or conditional sales contracts, depending on the customer’s (or, for funded leases, the IKON marketplace’s) needs. The customer (or the IKON marketplace for funded leases) decides which of the two structures is desired. Under either structure, the total cost of the equipment to the customer (or to the IKON marketplace) is substantially the same (assuming the exercise of the purchase option).
Tax Leases
Tax leases represented 97% of the Company’s total lease portfolio as of September 30, 2001. The Company or the IKON marketplace is considered to be the owner of the equipment for tax purposes during the life of these leases and receives the tax benefit associated with equipment depreciation. Tax leases are structured with a fair market value purchase option. Generally at the end of the lease term, the customer may return the equipment, continue to rent the equipment or purchase the equipment for its fair market value.
Each tax lease has a stated equipment residual value generally ranging from 0% to 25% of retail price, depending on equipment model and lease term. As of September 30, 2001, the average equipment residual value for all leases in the Company’s portfolio was 8.6%. Upon early termination of the lease or at the end of the lease term, the Company charges the IKON marketplace for the stated residual position, if any, and the equipment is returned to the IKON marketplace. Any gain or loss on the equipment’s residual value is realized by the IKON marketplace.
Conditional Sales Contracts
Conditional sales contracts account for the remaining 3% of the leases in the Company’s total lease portfolio. Under these arrangements, the customer is considered to be the owner of the equipment for tax purposes and would receive any tax benefit associated with equipment depreciation. Each conditional sales contract has a stated residual value of 0%. Conditional sales contracts are customarily structured with higher monthly lease payments than the tax leases and have a one-dollar purchase option for the equipment at lease-end. Thus, because of the higher monthly payments, the after-tax cost of the equipment to the customer (or, for funded leases, to the IKON marketplace) under a conditional sales contract is substantially the same as under a tax lease (assuming the exercise of the purchase option). Although the customer has the option of returning or continuing to rent the equipment at lease-end, the customer almost always exercises the one-dollar purchase option at the end of the lease term.
Leased Equipment
The Company offers financing for the cost of office equipment that the IKON marketplaces maintain in inventory for short-term rental to customers. This category of leased equipment also includes equipment currently rented to customers where the rental agreements are considered to be cancelable by the customer, based on the terms and conditions of the rental contracts in effect. Under current operating guidelines, any equipment not physically on rental to customers for a period exceeding 120 continuous days must be repurchased by the IKON marketplaces at its current book value.
Relationship With IKON Office Solutions, Inc.
There are several agreements and programs between the Company and IKON, which are described below.
Support Agreement
The 1996 Support Agreement between the Company and IKON provides that IKON will make a cash payment to the Company (or an investment in the form of equity or subordinated notes) as needed to comply with two requirements: i) that the Company will maintain a pre-tax interest coverage ratio (income before interest expense and taxes divided by interest expense), so that the Company’s pre-tax income plus interest expense will not be less than 1.25 times interest expense, and ii) that the Company will maintain a minimum tangible net worth of one-dollar. The agreement also provides that IKON will maintain 100% direct or indirect ownership of the Company and limits the leverage of debt to equity to a maximum of 6 to 1.
Pursuant to the indentures and other documentation governing debt incurred after June 1, 1994, the Company is not permitted to amend or terminate the 1996 Support Agreement unless: (a) all of the outstanding debt of the Company is repaid, or (b) approval of two-thirds of the debtholders (not including IKON, the Company, or their affiliates) for all amounts outstanding covered by the 1996 Support Agreement (generally, all debt entered into after June 1, 1994) is obtained.
Cash Management Program
The Company participates in IKON’s domestic cash management program. Under this program, the Company has an account with IKON through which cash in excess of current operating requirements is temporarily placed on deposit. Similarly, amounts are periodically borrowed from IKON, with interest paid or charged at market rates on borrowed funds. The Company was in a net average borrowing position with IKON during fiscal 2001 and paid interest expense of $7,788 and was in a net average deposit position with IKON during fiscal 2000 and 1999 and earned interest income of $2,281 and $5,956, respectively (included in interest expense).
Management Fee
Included in general and administrative expenses are corporate expenses charged by IKON of $2,210, $1,500 and $552 in fiscal 2001, 2000 and 1999, respectively. These corporate charges represent management’s estimate of costs incurred by IKON on behalf of IOSC. The increase in corporate charges in fiscal 2001 compared to fiscal 2000 and fiscal 1999 is due to the increase in legal, treasury, tax and marketing support provided by IKON as a result of the increase in the Company’s financing activity.
Federal Income Tax Allocation Agreement
IKON and the Company participate in a Federal Income Tax Allocation Agreement dated June 30, 1989, in which the Company consents to the filing of consolidated federal income tax returns with IKON. IKON agrees to collect from or pay to the Company its allocated share of any consolidated federal income tax liability or refund applicable to any period for which the Company is included in IKON’s consolidated federal income tax return.
Interest on Income Tax Deferrals
The Company provides substantial tax benefits to IKON through the use of the installment sales method on equipment financed through the Company. Taxes deferred by IKON due to this tax treatment totaled a cumulative amount of approximately $493,000 at the end of fiscal 2000. IKON paid the Company interest on the portion of these tax deferrals which arose from intercompany sales. In fiscal 2000 and fiscal 1999, interest was earned by the Company at a rate consistent with the Company’s weighted average outside borrowing rate of interest. Under this program, the Company earned interest at an average rate of 6.7% in fiscal 2000 totaling $16,773 and 6.6% in fiscal 1999 totaling $16,764. Effective October 1, 2000, the Company and IKON agreed to terminate this program.
Lease Bonus Program
The Company sponsored a lease bonus subsidy program which provided incentives to IKON marketplaces when IKON customers leased equipment from the Company. The focus of the bonus subsidy program was to reimburse IKON for third party lease payoffs incurred when buying out the equipment leases of a competitor. During fiscal 1999, bonus payments made to IKON marketplaces or IKON totaled $12,000. Effective October 1, 1999, the Company and IKON agreed to terminate this program.
Credit Policies and Loss Experience
Prior to October 1, 1999, the Company and IKON followed an operating arrangement that required, in the event of default, the IKON marketplace to repurchase the equipment at the net investment value of the lease on the default date. Default is defined as any receivable becoming 120 days past due or otherwise being reasonably declared uncollectible by the Company. At September 30, 1999, all of the Company’s accounts receivable and direct financing leases, including residual values, were subject to such repurchase terms. In view of the foregoing agreement, the Company made no provision in the accompanying financial statements for uncollectible receivables. Effective October 1, 1999, the Company began a shared recourse arrangement with the IKON marketplaces. This arrangement provides for net losses resultant from lease defaults to be shared equally. The lease default reserve is maintained at the Company and the provisions for lease default are shared between the Company and the IKON marketplaces. On October 1, 1999, lease default reserves of $74,305 and the related deferred tax liability of $29,350 were transferred to the Company from the IKON marketplaces. During fiscal 2000, a provision for lease defaults of $58,113 was recorded to increase the reserve. Of this provision, $20,333 was recorded as an expense on the books of the Company and $37,780 was recorded as an expense on the books of the IKON marketplaces. Lease write-offs of $70,152 were recorded to reduce the reserve. During fiscal 2001, a provision for lease defaults of $61,180 was recorded to increase the reserve. Of this provision, $21,413 was recorded as an expense on the books of the Company and $39,767 was recorded as an expense on the books of the IKON marketplaces. Lease write-offs of $64,288 were recorded to reduce the reserve. As a result of the above, the lease default reserve at September 30, 2001 is $59,158.
During fiscal 2001 and 2000, accounts classified as current (less than 30 days outstanding) ranged from 87% to 91% of the total portfolio balance on a monthly basis. The aging of the Company’s lease portfolio receivables at September 30, 2001 was as follows:
Funding
The Company may offer notes to the public from time to time under its medium term note program. These notes are offered at varying maturities of nine months or more from their dates of issue and may be subject to redemption at the option of the Company, in whole or in part, prior to the maturity date in conjunction with meeting specified provisions. Interest rates are determined based on market conditions at the time of issuance. As of September 30, 2001, $82,000 of medium term notes were outstanding with a weighted average interest rate of 6.3% and $1,123,350 remains available under the program.
In fiscal 2001, the Company signed promissory notes and pledged $26,784 of lease receivables for $22,471 of proceeds. During fiscal 2001, the Company repaid $1,179 of the promissory notes. The notes have various interest rates ranging from 7.12% to 8.61% with maturities through March 2006.
In December 1998, the Company entered into an asset securitization transaction whereby it sold $366,600 in financing lease receivables for $250,000 in cash and a retained interest in the remainder. The agreement was for an initial three-year term with certain renewal provisions and was structured as a revolving asset securitization so that as collections reduced previously sold interests in this new pool of leases, additional leases could be sold up to $180,000 ($250,000 in fiscal 2000 and 1999). The terms of the agreement require that the Company continue to service the lease portfolio. The Company recognized a pre-tax gain of $14,333 in fiscal 1999 on this agreement. On May 25, 1999, the Company repurchased the leases sold in this transaction with the proceeds from the lease-backed notes described below. In fiscal 1999, the Company sold an additional $152,098 in leases, replacing leases paid/collected during the year and recognized pre-tax gains of $12,121. On October 7, 1999, these leases were repurchased with a portion of the proceeds received from the issuance of approximately $700,000 of lease-backed notes.
On December 9, 1999, the Company pledged or transferred $311,382 in financing lease receivables for $247,600 in cash in connection with its revolving asset securitization, in a transfer accounted for as a financing. Additionally, in fiscal 2000, the Company pledged or transferred $295,472 in financing lease receivables for $235,400 in cash in connection with its revolving asset securitization, in a transfer accounted for as a financing. The Company repaid $250,000 on June 2, 2000 when it issued the 2000-1 Notes described below.
In September 2000, the Company entered into a revolving asset securitization whereby it pledged or transferred $414,843 in financing lease receivables for $349,795 in cash and a retained interest in the remainder. The agreement is for an initial three-year term with certain renewal provisions and was structured as a revolving asset securitization so that as collections reduce previously pledged or transferred interests in this new pool of leases, additional leases can be pledged or transferred up to $225,000. The terms of the agreement require that the Company continue to service the lease portfolio.
During fiscal 2001, the Company pledged or transferred $539,776 in financing lease receivables for $485,900 in cash in connection with its revolving asset securitization. Also during fiscal 2001, the Company entered into a new revolving asset securitization. The agreement is for an initial 364-day term with certain renewal provisions and was structured as a revolving asset securitization so that as collections reduce previously pledged or transferred interests in this new pool of leases, additional leases can be pledged or transferred up to $300,000. The terms of the agreement require that the Company continue to service the lease portfolio. Under this agreement, the Company pledged or transferred $163,746 in financing lease receivables for $138,600 in cash and a retained interest in the remainder.
As of September 30, 2001, the Company had approximately $511,500 available under its revolving asset securitization conduit financing agreements.
On June 15, 2001, the Company issued $250,000 of notes with an interest rate of 9.75% (10% yield including the original issue discount) which is due on June 15, 2004. Interest is paid on the notes semi-annually beginning December 15, 2001. With the net proceeds from the issuance, the Company repaid $150,000 of 6.73% medium term notes due June 15, 2001 and will use the remainder of the proceeds for general corporate purposes.
The Company filed a shelf registration statement with the Securities and Exchange Commission to register the sale of $300,000 of lease-backed notes.
IKON Receivables, LLC (a wholly-owned subsidiary) has issued Series 1999-1, 1999-2, 2000-1, 2000-2 and 2001-1 Lease-Backed Notes (collectively, the “Notes”) as described below:
The Notes were issued pursuant to an Indenture between IKON Receivables, LLC, IOSC and various Indenture Trustees. The Notes are collateralized by a pool of office equipment leases or contracts and related assets (the “Leases”) acquired or originated by IOSC (together with the equipment financing portion of each periodic lease or rental payment due under the Leases on or after the related indenture date) and all related casualty payments, retainable deposits and termination payments. Payments on the Notes are made from payments on the Leases. The Notes have certain credit enhancement features available to noteholders including reserve accounts, overcollateralization accounts and noncancellable insurance policies from Ambac Assurance Corporation with respect to the Notes. On each payment date, funds available from the collection of lease receivables will be paid to the noteholders in the order of their priority class.
The Notes bear interest from the related issuance date at the stated rates specified above. The variable rate 1999-2 Class A-3b, 2000-1 Class A-3, 2000-1 Class A-4, 2000-2 Class A-3, 2000-2 Class A-4, 2001-1 Class A-3 and 2001-1 Class A-4 Notes have been fixed at 6.63%, 7.802%, 7.82%, 6.475%, 6.475%, 4.825% and 5.435%, respectively, through interest rate swaps.
IOSC services the Leases pursuant to Assignment and Servicing Agreements by and among IOSC, as originator and servicer, IKON Receivables-1, LLC, as seller, and IKON Receivables, LLC, as issuer. IOSC may delegate its servicing responsibilities to one or more sub-servicers, but such delegation does not relieve IOSC of its liabilities with respect thereto. IOSC retains possession of the Leases and related files, and receives a monthly service fee from IKON Receivables, LLC for servicing the Leases.
Restricted cash on the consolidated balance sheets primarily represents cash that has been collected on the Leases which must be used to repay the 1999-1, 1999-2, 2000-1, 2000-2 and 2001-1 Notes, respectively.
As of September 30, 2001, IKON Receivables, LLC has approximately $271,859 available under the $2,000,000 shelf registration statement.
Future maturities of the Notes, based on contractual maturities of the Leases for each of the succeeding fiscal years are as follows:
Employees
At September 30, 2001, the Company had approximately 375 employees. Employee relations are considered to be good.
Proprietary Matters
Other than the “IOS Capital” trade name and service mark, the Company has no names, trademarks, trade names, or service marks which are used in the conduct of its business.
Competition and Government Regulation
The finance business in which the Company is engaged is highly competitive. Competitors include leasing companies, commercial finance companies, commercial banks and other financial institutions. The Company competes primarily on the basis of financing rates, customer convenience and quality customer service.
Certain states have enacted retail installment sales or installment loan statutes relating to consumer credit, the terms of which vary from state to state. The Company does not generally extend consumer credit as defined in those statutes.
The financing activities of the Company are dependent upon sales or leases of office equipment by the IKON marketplaces, who are subject to substantial competition by both independent office equipment dealers and the direct sales forces of office equipment manufacturers. IKON is the largest independent distribution network of office equipment in North America. IKON marketplaces compete on the basis of price, quality of service and product performance.
Item 2.
Item 2. Properties
The Company’s operations are located in Macon, Georgia and occupy approximately 70,000 square feet. In addition, IKON utilizes approximately 27,000 square feet in adjacent facilities owned by the Company for a corporate-wide data center and local IKON marketplace. The Company uses its facility for normal operating activities such as lease processing, customer service, billing and collections. Certain specialized services (such as legal, accounting, treasury, tax and audit services) are also performed for the Company at IKON’s corporate headquarters located in Malvern, Pennsylvania. The Company’s facilities are deemed adequate by management to conduct the Company’s business.
Item 3.
Item 3. Legal Proceedings
A number of ordinary course legal proceedings are pending against the Company. However, there are no material pending legal proceedings to which the Company is a party (or to which any of its property is subject). To the Company’s knowledge, no material legal proceedings are contemplated by governmental authorities against the Company or any of its properties.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters
All outstanding shares of the Company’s common stock are currently owned by IKON. Therefore, there is no market for the Company’s common stock. The Company paid IKON dividends of $60,000 and $30,000 in fiscal 2000 and 1999, respectively. No dividends were paid in fiscal 2001. The Company and IKON will, from time to time, determine the appropriate capitalization for the Company, which will, in part, affect any future payment of dividends to IKON or capital contributions to the Company.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Pursuant to General Instruction I(2)(a) of Form 10-K, the following analysis of the results of operations is presented in lieu of Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Fiscal 2001 Compared with Fiscal 2000
Comparative results of operations for the fiscal years ended September 30, 2001 and 2000 are set forth in the table below. This table also shows the increase (decrease) in the dollar amounts of revenue and expense items between periods, as well as the related percentage change.
Revenues
Total revenues increased by $18,989, or 5.3%, in fiscal 2001 from fiscal 2000. Lease finance income increased by $41,256 due to continued growth in the portfolio of direct financing and funded leases, adjusted for the effects of the asset securitizations. The lease portfolio, net of lease receivables that were sold in asset securitization transactions, increased by 1.0% from September 30, 2000 to September 30, 2001.
Office equipment placed on rental by the IKON marketplaces to customers with cancelable terms may be purchased by the Company. During fiscal 2001 and 2000, IOSC purchased operating lease equipment of $35,611 and $19,624, respectively. Operating leases contributed $31,573 and $36,187 in rental income to total revenues during fiscal 2001 and 2000, respectively.
In fiscal 2000, the Company earned interest income on the deferred tax liabilities of the IKON marketplaces associated with leases funded through the Company at a rate consistent with the Company’s weighted average outside borrowing rate of interest. The Company’s average rate was 6.7% for fiscal 2000. The deferred tax base upon which these payments were calculated was $251,000 at September 30, 2000. Effective October 1, 2000 the Company and IKON discontinued the policy of paying interest income on the deferred tax liability base.
Other income consists primarily of late payment charges and various billing fees. Overall, fee income from these sources decreased by $880 or 3.5%, when comparing fiscal 2001 to fiscal 2000.
Expenses
Average borrowings to finance the lease portfolio in the form of loans from banks and the issuance of medium term notes and lease-backed notes in the public market and intercompany borrowings with IKON increased by 2.7%, with $2,526,714 outstanding at September 30, 2001. The Company paid a weighted average interest rate on all borrowings for fiscal 2001 of 6.4%, compared to 6.7% for fiscal 2000. Primarily as a result of the increased average borrowings, interest expense grew by $17,912, or 12.0%, when comparing fiscal 2001 to fiscal 2000. At September 30, 2001, the Company’s debt to equity ratio was 5.1 to 1.
Total general and administrative expenses decreased by $3,725, or 6.1%, when comparing fiscal 2001 to fiscal 2000. The general and administrative expense category for fiscal 2001 includes depreciation expense on leased equipment totaling $26,414, compared to $30,233 in fiscal 2000. Excluding the effects of depreciation expense on leased equipment, remaining general and administrative expenses increased approximately $94, or 0.3%, when comparing fiscal 2001 to fiscal 2000.
Income Before Income Taxes
Income before income taxes for fiscal 2001 increased by $9,304, or 7.3%, compared to fiscal 2000, as a result of the items described above.
Provision for Income Taxes
Income taxes for fiscal 2001 increased by $3,982, or 8.2%, compared to fiscal 2000. The increase in income taxes is directly attributable to the increase in income before income taxes in fiscal 2001 as compared to fiscal 2000. During fiscal 2001, the Company’s effective income tax rate was 38.2%, as compared to 37.9% in fiscal 2000.
Item 7a.
Item 7a. Quantitative and Qualitative Disclosures About Market Risk
The Company incurs debt to fund the origination of leases for IKON. The interest rates charged on the debt are determined based on current market conditions and include variable measures of interest rates such as LIBOR. The Company monitors interest rates on debt in order to mitigate exposure to unfavorable variations as compared to the interest rate earned on the pledged finance lease receivables. The objective in managing this risk is to achieve fixed-rate financing at the same time the Company establishes the rate to be received by the Company on the leases. As a result, from time to time interest rate swaps are utilized to effectively fix the rate on variable rate debt, as opposed to a direct issuance of fixed rate debt. The risk associated with the use of interest rate swaps is the possible inability of the counterparties to meet the terms of their contracts. The Company does not enter into interest rate swap agreements for trading purposes.
The following table presents, as of September 30, 2001, information regarding the interest rate swap agreements to which we are a party: (i) the notional amount, (ii) the fixed interest rate payable by the Company, (iii) the variable interest rate payable to the Company by the counterparty under the agreement, (iv) the fair value of the instrument, and (v) the maturity date of the agreement.
Item 8.
Item 8. Financial Statements and Supplementary Data
The financial statements of IOSC are submitted herewith on Pages through of this report.
Quarterly Data
The following table shows comparative summarized unaudited quarterly results for fiscal 2001 and 2000.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
(No response to this item is required.)
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a) (1) and (2) Financial Statements
Financial Statements and Schedules other than those listed above are omitted because the required information is included in the financial statements or the notes thereto or because they are inapplicable.
(a) (3) Exhibits
(b) Reports on Form 8-K
On August 3, 2001, the Company filed a Current Report on Form 8-K to file, under Item 5 of the Form, a press release issued by its parent concerning IKON’s earnings for the third quarter of fiscal 2001.
Forward-Looking Information
This Report includes or incorporates by reference information which may constitute forward-looking statements within the meaning of the federal securities laws. Although the Company believes the expectations contained in such forward-looking statements are reasonable, it can give no assurances that such expectations will prove correct. Such forward-looking information is based upon management’s current plans or expectations and is subject to a number of risks and uncertainties that could significantly affect current plans, anticipated actions and the Company’s and/or IKON’s future financial condition and results. These risks and uncertainties, which apply to both the Company and IKON, include, but are not limited to, risks and uncertainties relating to: factors which may affect the Company’s ability to recoup the full amount due on the 1999-1, 1999-2, 2000-1, 2000-2 and 2001-1 Leases (such as lessee defaults or factors impeding recovery efforts); conducting operations in a competitive environment and a changing industry (which includes technical services and products that are relatively new to the industry, IKON, and to the Company); delays, difficulties, management transitions and employment issues associated with consolidations and/or changes in business operations; managing the integration of acquired businesses; existing and future vendor relationships; risks relating to currency exchange; economic, legal and political issues associated with international operations; the Company’s ability to access capital and its debt service requirements (including sensitivity to fluctuation in interest rates); and general economic conditions. As a consequence of these and other risks and uncertainties, current plans, anticipated actions and future financial condition and results may differ materially from those expressed in any forward-looking statements made by or on behalf of the Company.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders
of IKON Office Solutions, Inc.:
In our opinion, the accompanying consolidated balance sheets as of September 30, 2001 and 2000 and the related consolidated statements of income, changes in shareholder’s equity and cash flows, present fairly, in all material respects, the financial position of IOS Capital, Inc. and its subsidiaries at September 30, 2001 and 2000, and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. 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 audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in notes 2 and 10 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 133, as amended, Accounting for Derivative Instruments and Hedging Activities, in fiscal 2001.
/s/ PricewaterhouseCoopers LLP
Philadelphia, PA
October 26, 2001
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
Board of Directors
IKON Office Solutions, Inc.
We have audited the accompanying consolidated statements of income, changes in shareholder’s equity, and cash flows of IOS Capital, Inc. (a wholly-owned subsidiary of IKON Office Solutions, Inc.) for the year ended September 30, 1999. 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 audits.
We conducted our audit in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated results of operations and cash flows of IOS Capital, Inc. and subsidiaries for the year ended September 30, 1999, in conformity with accounting principles generally accepted in the United States.
/s/ ERNST & YOUNG LLP
Ernst & Young LLP
Philadelphia, Pennsylvania
October 25, 1999, except for the first sentence of
the fourth paragraph of Note 5, as to which the
date is December 9, 1999
IOS CAPITAL, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands except share and per share amounts)
See notes to consolidated financial statements.
IOS CAPITAL, INC.
CONSOLIDATED STATEMENTS OF INCOME
See notes to consolidated financial statements.
IOS CAPITAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See notes to consolidated financial statements.
IOS CAPITAL, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDER’S EQUITY
*
Amount is less than one thousand dollars.
See notes to consolidated financial statements.
IOS CAPITAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(in thousands)
1. Business
IOS Capital, Inc. (“IOSC” or the “Company”), a wholly-owned subsidiary of IKON Office Solutions, Inc. (“IKON”), is engaged in the business of arranging lease financing exclusively for office equipment marketed by IKON’s U.S. marketplaces (“IKON marketplaces”), which sell and service copier equipment, facsimile machines and other equipment. The equipment financed by the Company consists of copiers, facsimile machines, and related accessories and peripheral equipment, the majority of which are produced by major office equipment manufacturers including Canon, Ricoh and Océ. At September 30, 2001, 20% of the equipment financed by the Company represents analog copiers, 63% digital copiers, 12% color copiers, 2% facsimile machines and 3% other equipment.
2. Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, after elimination of all intercompany transactions, accounts and profits.
Use of Estimates
The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect amounts reported in the consolidated financial statements and notes. Actual results could differ from those estimates and assumptions.
Revenue Recognition
Unearned lease finance income is amortized into revenue using the effective interest method over the term of the lease agreements.
Property and Equipment
Property and equipment, including leased equipment, is carried on the basis of cost. Depreciation is principally computed using the straight-line method over the estimated useful lives of the assets.
Income Taxes
The Company’s deferred tax expense and the related liability are primarily the result of the difference between the financial statement and income tax treatment of direct financing leases.
Interest Rate Swap Agreements
The Company uses interest rate swap agreements for purposes other than trading. Interest rate swap agreements are used by the Company to modify variable rate obligations to fixed rate obligations, thereby reducing the exposure to market rate fluctuations. The interest rate swap agreements are designated as hedges, and effectiveness is determined by matching the principal balance and terms with that specific obligation. Such an agreement involves the exchange of amounts based on fixed interest rates for amounts based on variable interest rates over the life of the agreement without an exchange of the notional amount upon which payments are based. Gains and losses on terminations of interest rate swap agreements are deferred and amortized over the remaining term of the original contract life of the terminated swap agreement. In the event of early extinguishment of the obligation, any realized or unrealized gain or loss from the swap would be recognized in income at the time of extinguishment.
Adoption of SFAS 133
IOSC adopted Statement of Financial Accounting Standards (“SFAS”) 133, as amended by SFAS 138, “Accounting for Derivative Instruments and Hedging Activities”, on October 1, 2000. SFAS 133 requires that all derivatives be recorded on the consolidated balance sheet at their fair value. Changes in the fair value of derivatives are recorded each period in earnings or Other Comprehensive Income (Loss) (“OCI”) depending on the type of hedging instrument and the effectiveness of those hedges. In accordance with the transition provisions of SFAS 133, IOSC recorded a cumulative loss adjustment to OCI of $3,471, after taxes, to recognize the fair value of its derivatives as of the date of adoption.
All of the derivatives used by IOSC as hedges are highly effective as defined by SFAS 133 because all of the critical terms of the derivatives match those of the hedged item. All of the derivatives used by IOSC have been designated as cash flow hedges at the time of adoption of SFAS 133 or at the time they were executed, if later than October 1, 2000. All derivatives are adjusted to their fair market values at the end of each quarter. Unrealized net gains and losses for cash flow hedges are recorded in OCI.
As of September 30, 2001, all of IOSC’s derivatives designated as hedges are interest rate swaps which qualify for evaluation using the “short cut” method for assessing effectiveness. As such, there is an assumption of no ineffectiveness. IOSC uses interest rate swaps to fix the interest rates on our variable rate classes of lease-backed notes, which results in a lower cost of capital than if we had issued fixed rate notes. During the year ended September 30, 2001, unrealized net losses totaling $30,374, after taxes, were recorded in OCI, including the $3,471 cumulative effect adjustment as of October 1, 2000.
3. Agreements between IOS Capital and IKON
Cash Management Program
The Company participates in IKON’s domestic cash management program. Under this program, the Company has an account with IKON through which cash in excess of current operating requirements is temporarily placed on deposit. Similarly, amounts are periodically borrowed from IKON, with interest paid or charged at market rates on borrowed funds. The Company was in a net average borrowing position with IKON during fiscal 2001 and paid interest expense of $7,788 and was in a net average deposit position with IKON during fiscal 2000 and 1999 and earned interest income of $2,281 and $5,956, respectively (included in interest expense). The Company considers its account with IKON to represent a cash balance. Accordingly, the accompanying Consolidated Statements of Cash Flows includes the changes in Cash and “Due to IKON”.
Management Fee
Included in general and administrative expenses are corporate overhead expenses charged by IKON of $2,210, $1,500 and $552 in fiscal 2001, 2000 and 1999, respectively. These corporate charges represent management’s estimate of costs incurred by IKON on behalf of IOSC.
Interest on Income Tax Deferrals
The Company charged IKON interest on IKON’s income tax deferrals associated with the Company’s leasing transactions. Such charges were calculated at 6.7% and 6.6% in fiscal 2000 and 1999, respectively. Effective October 1, 2000, the Company and IKON agreed to terminate this program.
IOS CAPITAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(in thousands)
Lease Defaults
Prior to October 1, 1999, the Company and IKON followed an operating arrangement that required, in the event of default, the IKON marketplace to repurchase the equipment at the net investment value of the lease on the default date. Default is defined as any receivable becoming 120 days past due or otherwise being reasonably declared uncollectible by the Company. At September 30, 1999, all of the Company’s accounts receivable and direct financing leases, including residual values, were subject to such repurchase terms. In view of the foregoing agreement, the Company made no provision in the accompanying financial statements for uncollectible receivables. Effective October 1, 1999, the Company began a shared recourse arrangement with the IKON marketplaces. This arrangement provides for net losses resultant from lease defaults to be shared equally. The lease default reserve is maintained at the Company and the provisions for lease default are shared between the Company and the IKON marketplaces. On October 1, 1999, lease default reserves of $74,305 and the related deferred tax liability of $29,350 were transferred to the Company from the IKON marketplaces. During fiscal 2000, a provision for lease defaults of $58,113 was recorded to increase the reserve. Of this provision, $20,333 was recorded as an expense on the books of the Company and $37,780 was recorded as an expense on the books of the IKON marketplaces. Lease write-offs of $70,152 were recorded to reduce the reserve. During fiscal 2001, a provision for lease defaults of $61,180 was recorded to increase the reserve. Of this provision, $21,413 was recorded as an expense on the books of the Company and $39,767 was recorded as an expense on the books of the IKON marketplaces. Lease write-offs of $64,288 were recorded to reduce the reserve. As a result of the above, the lease default reserve at September 30, 2001 is $59,158.
The 1996 Support Agreement
The 1996 Support Agreement between the Company and IKON provides that IKON will make a cash payment to the Company (or an investment in the form of equity or subordinated notes) as needed to comply with certain requirements.
4. Investments in Leases
The Company’s lease portfolio contains direct financing leases and funded leases. Direct financing leases include non-cancelable lease agreements which are serviced by the Company. The Company’s funded leases include certain internal lease portfolios and non-cancelable rental contracts for IKON marketplaces, which have been financed by the Company. Under the terms of these funded leases, the IKON marketplace maintains the contractual relationship with the third-party customer. The IKON marketplaces have assigned to the Company, with full recourse, their rights under the underlying contracts including the right to receive lease and rental payments and a security interest in the related equipment.
IOS CAPITAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(in thousands)
At September 30, 2001, aggregate future minimum payments to be received, including guaranteed residual values, for each of the succeeding fiscal years under direct financing and funded leases are as follows:
5. Medium Term Notes, Asset Securitization Conduit Financing and Other Notes
The Company may offer notes to the public from time to time under its medium term note program. These notes are offered at varying maturities of nine months or more from their dates of issue and may be subject to redemption at the option of the Company, in whole or in part, prior to the maturity date in conjunction with meeting specified provisions. Interest rates are determined based on market conditions at the time of issuance. As of September 30, 2001, $82,000 of medium term notes were outstanding with a weighted average interest rate of 6.3% and $1,123,350 remains available under the program.
In December 1998, the Company entered into an asset securitization transaction whereby it sold $366,600 in financing lease receivables for $250,000 in cash and a retained interest in the remainder. The agreement was for an initial three-year term with certain renewal provisions and was structured as a revolving asset securitization so that as collections reduced previously sold interests in this new pool of leases, additional leases could be sold up to $180,000 ($250,000 in fiscal 2000 and 1999). The terms of the agreement require that the Company continue to service the lease portfolio. The Company recognized a pre-tax gain of $14,333 in fiscal 1999 on this agreement. On May 25, 1999, the Company repurchased the leases sold in this transaction with the proceeds from the lease-backed notes described below. In fiscal 1999, the Company sold an additional $152,098 in leases, replacing leases paid/collected during the year and recognized pre-tax gains of $12,121. On October 7, 1999, these leases were repurchased with a portion of the proceeds received from the issuance of approximately $700,000 of lease-backed notes.
On December 9, 1999, the Company pledged or transferred $311,382 in financing lease receivables for $247,600 in cash in connection with its revolving asset securitization, in a transfer accounted for as a financing. Additionally, in fiscal 2000, the Company pledged or transferred $295,472 in financing lease receivables for $235,400 in cash in connection with its revolving asset securitization, in a transfer accounted for as a financing. The Company repaid $250,000 on June 2, 2000 when it issued the 2000-1 Notes described below.
In September 2000, the Company entered into a revolving asset securitization whereby it pledged or transferred $414,843 in financing lease receivables for $349,795 in cash and a retained interest in the remainder. The agreement is for an initial three-year term with certain renewal provisions and was structured as a revolving asset securitization so that as collections reduce previously pledged or transferred interests in this new pool of leases, additional leases can be pledged or transferred up to $225,000. The terms of the agreement require that the Company continue to service the lease portfolio.
During fiscal 2001, the Company pledged or transferred $539,776 in financing lease receivables for $485,900 in cash in connection with its revolving asset securitization. Also during fiscal 2001, the Company entered into a new revolving asset securitization. The agreement is for an initial 364-day term with certain renewal provisions and was structured as a revolving asset securitization so that as collections reduce previously pledged or transferred interests in this new pool of leases, additional leases can be pledged or transferred up to $300,000. The terms of the agreement require that the Company continue to service the lease portfolio. Under this agreement, the Company pledged or transferred $163,746 in financing lease receivables for $138,600 in cash and a retained interest in the remainder.
As of September 30, 2001, the Company had approximately $511,500 available under its revolving asset securitization conduit financing agreements.
On June 15, 2001, the Company issued $250,000 of notes with an interest rate of 9.75% (10% yield including the original issue discount) which is due on June 15, 2004. Interest is paid on the notes semi-annually beginning December 15, 2001. With the net proceeds from the issuance, the Company repaid $150,000 of 6.73% medium term notes due June 15, 2001 and will use the remainder of the proceeds for general corporate purposes.
In fiscal 2001, the Company signed promissory notes and pledged $26,784 of lease receivables for $22,471 of proceeds. During fiscal 2001, the Company repaid $1,179 of the promissory notes. The notes have various interest rates ranging from 7.12% to 8.61% with maturities through March 2006.
The Company must comply with certain restrictive covenants under the terms of its loan agreements. The Company agrees to maintain earnings before fixed charges of not less than 1.25 times fixed charges and a tangible net worth of not less than $1.
Interest paid amounted to $168,574, $156,974 and $124,947 for the fiscal years ended September 30, 2001, 2000 and 1999, respectively.
At September 30, 2001 and 2000, the fair value of debt outstanding is estimated to be $2,200,331 and $2,201,161, respectively, using a discounted cash flow analysis.
Future maturities of all debt outstanding at September 30, 2001 are as follows:
IOS CAPITAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(in thousands)
6. Lease-Backed Notes
IKON Receivables, LLC (a wholly-owned subsidiary) has issued Series 1999-1, 1999-2, 2000-1, 2000-2 and 2001-1 Lease-Backed Notes (collectively, the “Notes”) as described below:
The Notes were issued pursuant to an Indenture between IKON Receivables, LLC, IOSC and various Indenture Trustees. The Notes are collateralized by a pool of office equipment leases or contracts and related assets (the “Leases”) acquired or originated by IOSC (together with the equipment financing portion of each periodic lease or rental payment due under the Leases on or after the related indenture date) and all related casualty payments, retainable deposits and termination payments. Payments on the Notes are made from payments on the Leases. The Notes have certain credit enhancement features available to noteholders, including reserve accounts, overcollateralization accounts and noncancellable insurance policies from Ambac Assurance Corporation with respect to the Notes. On each payment date funds available from the collection of lease receivables will be paid to the noteholders in the order of their priority class.
The Notes bear interest from the related issuance date at the stated rates specified above. The variable rate 1999-2 Class A-3b, 2000-1 Class A-3, 2000-1 Class A-4, 2000-2 Class A-3, 2000-2 Class A-4, 2001-1 Class A-3 and 2001-1 Class A-4 Notes have been fixed at 6.63%, 7.802%, 7.82%, 6.475%, 6.475%, 4.825% and 5.435%, respectively, through interest rate swaps.
IOSC services the Leases pursuant to Assignment and Servicing Agreements by and among IOSC, as originator and servicer, IKON Receivables-1, LLC, as seller, and IKON Receivables, LLC, as issuer. IOSC may delegate its servicing responsibilities to one or more sub-servicers, but such delegation does not relieve IOSC of its liabilities with respect thereto. IOSC retains possession of the Leases and related files, and receives a monthly service fee from IKON Receivables, LLC for servicing the Leases.
Restricted cash on the consolidated balance sheets primarily represents cash that has been collected on the Leases which must be used to repay the 1999-1, 1999-2, 2000-1, 2000-2 and 2001-1 Notes, respectively.
Future maturities of the Notes, based on contractual maturities of the Leases for each of the succeeding fiscal years are as follows:
7. Lease Commitments
Total rent expense under all operating leases aggregated $1,988, $1,580 and $1,842 in fiscal 2001, 2000 and 1999, respectively. At September 30, 2001, future minimum payments under noncancelable operating leases with initial or remaining terms of more than one year were: 2002-$2,715; 2003-$2,591; 2004-$722.
IOS CAPITAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(in thousands)
8. Income Taxes
Taxable income of the Company is included in the consolidated federal income tax return of IKON and all estimated tax payments and refunds, if any, are made through IKON. The provision for income taxes was determined as if the Company was a separate taxpayer.
Provision for income taxes:
The components of deferred income tax assets and liabilities were as follows:
Credit carryforwards consist principally of federal and state alternative minimum tax credits of approximately $66,710 (with no expiration date).
The components of the effective income tax rate were as follows:
IOS CAPITAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(in thousands)
The Company made net income tax payments, including amounts paid to IKON, of $8,775, $20,006 and $16,976 in fiscal years 2001, 2000 and 1999, respectively.
9. Pension and Stock Purchase Plan
The Company participates in IKON’s defined benefit pension plan covering the majority of its employees. The Company’s policy is to fund pension costs as accrued. Pension expense was $189, $276 and $197 in fiscal 2001, 2000 and 1999, respectively.
The majority of the Company’s employees were eligible to participate in IKON’s Retirement Savings Plan (“RSP”). The RSP allows employees to invest 1% to 16% of regular compensation before taxes in nine different investment funds. The Company contributes an amount equal to two-thirds of the employees’ investments, up to 6% of regular compensation, for a maximum company match of 4%. All Company contributions are invested in IKON’s common shares. Employees vest in a percentage of the Company’s contribution after two years of service, with full vesting at the completion of five years of service. The Company’s cost of the plans amounted to $304, $214 and $186 in fiscal 2001, 2000 and 1999, respectively.
10. Derivative Financial Instruments
The Company incurs debt to fund the origination of leases for IKON. The interest rates charged on the debt are determined based on current market conditions and include variable measures of interest rates such as LIBOR. The Company monitors interest rates on debt in order to mitigate exposure to unfavorable variations as compared to the interest rate earned on the pledged finance lease receivables. The objective in managing this risk is to achieve fixed-rate financing at the same time the Company establishes the rate to be received by the Company on the leases. As a result, from time to time interest rate swaps are utilized to effectively fix the rate on variable rate debt, as opposed to a direct issuance of fixed rate debt. The risk associated with the use of interest rate swaps is the possible inability of the counterparties to meet the terms of their contracts. The Company does not enter into interest rate swap agreements for trading purposes.
The following table presents, as of September 30, 2001, information regarding the interest rate swap agreements to which we are a party: (i) the notional amount, (ii) the fixed interest rate payable by the Company, (iii) the variable interest rate payable to the Company by the counterparty under the agreement, (iv) the fair value of the instrument, and (v) the maturity date of the agreement.
SIGNATURES
Pursuant to the requirements of section 13 or 15(d) of the Securities Act of 1934, the registrant has duly caused this Form 10-K for the fiscal year ended September 30, 2001 to be signed on its behalf by the undersigned, thereunto duly authorized.
IOS CAPITAL , INC .
Date: December 21, 2001
By:
/s/ HARRY G. KOZEE
Vice President-Finance
Pursuant to the requirements of the Securities Exchange Act of 1934, this Form 10-K has been signed below on December 21, 2001 by the following persons on behalf of the registrant and in the capacities indicated.
INDEX OF EXHIBITS