Item 1. Business.
Recent Developments
IKON Office Solutions, Inc. (“IKON”) entered into a definitive asset purchase agreement (the “Agreement”), dated December 10, 2003, by and among IKON, IOS Capital, LLC (“IOSC” or the “Company”) and General Electric Capital Corporation (“GE”), pursuant to which, among other things, GE will acquire certain assets and liabilities of the Company, including, without limitation, the Company’s servicing functions, facilities, systems and processes. As a condition to the consummation of the transactions contemplated by the Agreement, IKON and GE will enter into a program agreement (“Program Agreement”), under which, among other things, GE will become the preferred lease-financing source for IKON’s customers in the United States and Canada. Under the terms of the Agreement, and subject to closing adjustments, IKON will receive approximately $1.5 billion of gross proceeds. The Company is currently a wholly-owned finance subsidiary of IKON.
Before the closing of the transaction with GE, IKON intends to merge the Company into IKON. Immediately after the effectiveness of the merger, IKON will sell certain former assets and liabilities of the Company to GE or one of its affiliates. IKON will retain approximately $1.4 billion of leases and corresponding residuals, of which $1.2 billion are supported by Notes (as defined below) issued by IKON Receivables Funding, LLC (“IRF”), a wholly-owned direct subsidiary of the Company. After the closing, IRF’s Notes and the underlying Lease Receivables (as defined below) will be serviced or sub-serviced by GE or one of its affiliates. IKON will assume the Company’s $350 million 7.25% notes due 2008 (the “2008 Notes”), $300 million 5% convertible notes due 2007 (the “Convertible Notes”) and the remaining $34,714 of 9.75% notes due 2004 (the “2004 Notes”).
The closing of the transaction is subject to execution of the Program Agreement relating to GE’s relationship with IKON as its preferred lease-financing source, as well as execution of other agreements and customary conditions, including receipt of certain third party consents. This description of the transaction, including the Agreement and the Program Agreement, is qualified in its entirety by reference to the full text of the agreements as included with IKON’s current report on Form 8-K as filed with the Securities and Exchange Commission on December 15, 2003. The transaction is expected to close in the second quarter of fiscal 2004. We cannot assure you that the transactions contemplated by the Agreement will occur.
General
IOSC is a wholly-owned finance subsidiary of IKON and was formed in 1987 to provide lease financing to customers of IKON. The Company’s offices are located at 1738 Bass Road, Macon, Georgia, 31210 (telephone number: 478-471-2300).
IKON is a public company headquartered in Malvern, Pennsylvania that integrates imaging systems and services that help businesses manage document workflow and increase efficiency. IKON represents the industry’s broadest portfolio of document management services, outsourcing and professionals services, on-site copy and mailroom management, fleet management, off-site digital printing solutions, and customized workflow and imaging application development. IKON’s fiscal 2003 revenues were approximately $4.7 billion.
The Company is engaged in the business of arranging lease financing primarily for office equipment marketed by IKON’s U.S. marketplaces. During fiscal 2003, 81% of equipment sold by IKON in the United States was financed through the Company.
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, Hewlett-Packard and Océ. Currently, 91% of the equipment financed by the Company represents digital copiers (including color copiers), 5% analog copiers, 1% facsimile machines and 3% other equipment.
The Company’s customer base (which consists primarily of end users of the equipment marketed by IKON) 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 $23 in amount and 51 months in duration. Although 95% of the leases are scheduled for regular monthly payments, customers are also offered quarterly, semi-annual and annual 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 IKON, 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 represented 96% of the Company’s lease portfolio as of September 30, 2003. Funded leases are contractual obligations between IKON and/or IOSC and the customer which have been financed by the Company, but invoiced by IKON. Funded leases represented approximately 4% of the Company’s lease portfolio as of September 30, 2003. IKON has assigned to the Company its rights to 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, IKON’s) needs. The customer (or IKON 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 IKON) is substantially the same (assuming the exercise of the purchase option under a tax lease).
Tax Leases
Tax leases represented 98% of the Company’s lease portfolio as of September 30, 2003. The Company or IKON 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 24% of MSRP, depending on equipment model and lease term. As of September 30, 2003, the average equipment residual value for all leases in the Company’s portfolio was 9.8% of retail price. Upon early termination of the lease or at the end of the lease term, the Company charges IKON for the stated residual position, if any, and the equipment is returned to IKON. Any gain or loss on the equipment’s residual value is realized by IKON.
Conditional Sales Contracts
Conditional sales contracts represent the remaining 2% of the leases in the Company’s lease portfolio as of September 30, 2003. Under these arrangements, the customer is considered to be the owner of the equipment for tax purposes and receives any tax benefit associated with equipment depreciation. Each conditional sales contract has a stated residual value of 0% of retail price. 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 IKON) 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 IKON maintains 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 IKON at its current book value.
Relationship with IKON
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 fixed charges, and ii) that the Company will maintain a minimum tangible net worth of one-dollar. The 1996 Support Agreement also provides that IKON will maintain 100% direct or indirect ownership of the Company and limits the leverage of debt, net of amounts receivable from IKON, to equity to a maximum of 6.0 to 1.0.
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 debt holders (not including IKON or its affiliates) for all amounts outstanding and 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. The Company was in a net average deposit position with IKON during fiscal 2003 and earned interest income of $4,173 (netted against interest expense) and was in a net average borrowing position with IKON during fiscal 2002 and 2001 and incurred interest expense of $3,009 and $7,788, respectively.
Management Fee
Included in general and administrative expenses are corporate expenses charged by IKON of $2,665, $2,535 and $2,210 in fiscal 2003, 2002 and 2001, respectively. These corporate charges represent management’s estimate of costs incurred by IKON on behalf of IOSC. The increase in corporate charges in fiscal 2003 compared to fiscal 2002 and fiscal 2001 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.
Credit Policies and Loss Experience
Effective October 1, 1999, the Company began a shared recourse arrangement with IKON. This arrangement provided for net losses resulting from lease defaults to be shared equally. The lease default reserve was maintained at the Company and the provisions for lease default were shared between the Company and IKON. On October 1, 1999, lease default reserves and the related deferred tax liability were transferred to the Company from IKON.
Effective October 1, 2002, the shared recourse arrangement with IKON was terminated, and the Company currently records the entire provision for lease defaults. During the fiscal year ended September 30, 2003, IKON transferred a loss reserve of $28,745 to the Company due to the termination of the shared recourse arrangement.
The following table provides a rollforward of changes in the lease default reserve from September 30, 2000 to September 30, 2003:
During fiscal 2003 and 2002, accounts classified as current (less than 30 days outstanding) ranged from 93% to 96% of the total portfolio balance on a monthly basis. The aging of the Company’s net lease receivables at September 30, 2003 was as follows:
Funding
In June 2003, the Company issued the 2008 Notes with an interest rate of 7.25% (7.43% yield including the original issue discount) which mature on June 30, 2008. Interest is paid on the 2008 Notes semi-annually in June and December beginning December 30, 2003. With the proceeds from the issuance, the Company tendered $205,786 par value of the 2004 Notes, for $224,904, deposited sufficient funds with an escrow agent to defease the remaining $34,891 of the 2004 Notes not tendered and used the remainder of the proceeds for general
corporate purposes. Amounts held in escrow to defease the remaining $34,714 of the 2004 Notes at September 30, 2003, are included in restricted cash on the Company’s balance sheets. In the first quarter of fiscal 2003, the Company repurchased $9,500 par value of its 2004 Notes for $9,598. As a result of these repurchases, the Company recognized a loss, including the write-off of unamortized costs, of $20,292, which is included in loss from early extinguishment of debt in the fiscal 2003 consolidated statements of income. In connection with the announced transaction with GE, IKON will assume the obligations relating to the 2008 Notes and the 2004 Notes (see “Recent Developments”).
In fiscal 2003, the Company signed promissory notes and pledged $5,061 of lease receivables for $4,346 of proceeds. During fiscal 2003, the Company repaid $10,592 of the promissory notes. In fiscal 2002, the Company signed promissory notes and pledged $16,755 of lease receivables for $14,259 of proceeds. During fiscal 2002, the Company repaid $8,381 of the promissory notes. These notes have various interest rates ranging from 6.74% to 7.23% with maturities through June 2008.
IOSC has three revolving asset securitization conduit financing agreements (the “Conduits”) totaling $680,000, each with a 364 day term that expires in fiscal 2004, but may be renewed subject to certain provisions. The agreements are structured so that as collections reduce previously pledged or transferred interests in the leases, additional leases can be pledged or transferred.
During fiscal 2003 and 2002, IOSC entered into revolving asset securitization transactions whereby it pledged or transferred $998,691 and $716,533, respectively, of finance receivables for $840,027 and $712,411, respectively, in cash. During fiscal 2003, IOSC repaid $638,645 under its Conduits. Repayments were made with proceeds received from the issuance of the Series 2003-1 Notes described below. In fiscal 2002, IOSC repaid $593,411 under its Conduits. Repayments were made with proceeds from the issuance of the Series 2002-1 Notes described below.
IKON Receivables, LLC (“IR”), a wholly-owned subsidiary of the Company, issued Series 2000-1, 2000-2 and 2001-1 lease-backed notes (collectively, together with the lease-backed notes issued by IRF, the “Notes”) as described below (see “Recent Developments”):
IRF issued Series 2002-1 and Series 2003-1 lease-backed notes as described below (see “Recent Developments”):
The Notes are secured by a segregated pool of assets (the “Asset Pool”) that includes a portfolio of chattel paper composed of leases, leases intended as security agreements and installment sales contracts acquired or originated by IOSC (the “Leases”), together with the equipment financing portion of each periodic rental payment due pursuant to the terms of each series of Notes. The Leases, including the security interest of IR or IRF, as the applicable issuer of the Notes (the “Issuer”) in the underlying equipment and other property related to the Leases (such equipment and property herein referred to as the “Equipment”), are referred to as “Lease Receivables.”
The Lease Receivables, including the Equipment, have been transferred to the Issuer and the Lease Receivables have been pledged by the Issuer to the applicable indenture trustee (the “Trustee”) in accordance with the terms of the assignment and servicing agreement applicable to each series of Notes. The Notes are secured solely by the Asset Pool and have no right, title or interest in the Equipment. The sole source of funds available for payment of the Notes are the Asset Pool and any applicable reserve account established in accordance with each applicable indenture and financial guarantee insurance policy. The Trustee has no right, title, or interest in the residual values of any of the Equipment except to the extent of the Issuer’s limited security interest with respect to recoveries on non-performing Leases.
On April 23, 2003, IRF issued $852,085 of lease-backed notes (the “2003 Notes”). Proceeds from the issuance of the 2003 Notes were used to make payments on the Company’s Conduits, repay unsecured credit facility borrowings and increase the Company’s cash balance.
The Notes bear interest from the related issuance date at the stated rates specified above. The variable rate 2000-1 Class A-4, 2000-2 Class A-3, 2000-2 Class A-4, 2001-1 Class A-3, 2001-1 Class A-4, and 2003-1 Class A-3a Notes have been fixed at 7.820%, 6.475%, 6.475%, 4.825%, 5.435% and 2.095%, respectively, through interest rate swaps.
IOSC services the Leases and 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.
Interest paid amounted to $130,825, $148,048 and $168,574 for the fiscal years ended September 30, 2003, 2002 and 2001, respectively.
At September 30, 2003 and 2002, the fair value of debt outstanding is estimated to be $2,416,887 and $2,553,006, respectively, using a discounted cash flow analysis.
Future maturities of the Notes, based on contractual maturities of the Leases, for each of the succeeding fiscal years are as follows:
Other Notes represent unregistered notes issued as part of a note purchase agreement dated December 1, 2001, with a maturity date of September 30, 2008.
Future maturities of all debt outstanding at September 30, 2003 are as follows:
Restricted cash on the consolidated balance sheets represents the cash that has been collected on the Leases that are pledged as collateral for the Notes. This cash must be segregated within two business days into a trust account and the cash is used to pay the principal and interest on the Notes as well as any associated administrative expenses. The level of restricted cash is impacted from one period to the next by the volume of Leases and timing of collections on such Leases. Restricted cash also includes amounts deposited with an escrow agent to defease the 2004 Notes as discussed above. At September 30, 2003, the remaining amount of restricted cash in escrow related to this defeasance, including accrued interest, was $38,446.
The Company may offer notes 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.
In 2002, IKON obtained a $300,000 unsecured credit facility (the “Credit Facility”), from a group of lenders. Revolving loans are available to the Company under the Credit Facility. As of September 30, 2003, the Company had no borrowings outstanding under the Credit Facility. The Credit Facility also provides support for letters of credit for the Company and its subsidiaries. As of September 30, 2003, letters of credit supported by the Credit Facility amounted to $27,621. The amount available under the Credit Facility is determined by the level of certain of IKON’s unsecured assets and the open letters of credit for IKON and its subsidiaries. The amount available to the Company under the Credit Facility for borrowings or additional letters of credit was $164,500 as of September 30, 2003.
The Credit Facility contains affirmative and negative covenants, including limitations on certain fundamental changes, investments and acquisitions, mergers, certain transactions with affiliates, creation of liens, asset transfers, payment of dividends, intercompany loans and certain restricted payments. The Credit Facility does not affect our ability to continue to securitize lease receivables. The Credit Facility also contains certain
financial covenants, including: (i) corporate leverage ratio; (ii) consolidated interest expense ratio; (iii) consolidated asset test ratios; and (iv) limitations on capital expenditures. The Credit Facility contains default provisions customary for facilities of this type. In order to provide certain additional financial flexibility under the corporate leverage ratio, the covenant was modified during the third quarter of 2003 as follows; (i) at September 30, 2003, 3.75 to 1.00; (ii) at December 31, 2003, 3.60 to 1.00; (iii) at March 31, 2004, 3.40 to 1.00 and (iv) at June 30, 2004 and as of the last day of each quarterly period thereafter, 3.00 to 1.00. This covenant measures a ratio of IKON’s corporate non-finance subsidiary debt to IKON’s business earnings (excluding financing income and interest expense associated with their financing operations). As of September 30, 2003, IKON’s corporate leverage ratio was 3.41 to 1.00. IKON’s failure to be in compliance with any material provision of the Credit Facility, including, without limitation, the financial covenants described above, could have a material adverse effect on our liquidity, financial position and results of operations.
During 2003, Moody’s Investor Services (“Moody’s”) lowered IKON’s senior unsecured credit rating from Baa2 to Ba1 (maintaining IKON’s rating under review for further downgrade), and Standard and Poor’s (“S&P”) placed IKON’s BBB- rating on CreditWatch. On August 1, 2003, S&P designated IKON’s BBB- rating with a negative outlook. Furthermore, in December 2003, S&P placed IKON’s ratings on CreditWatch for possible downgrade as a result of the announced sale of certain assets and liabilities of the Company (see “Recent Developments”). IKON’s and the Company’s access to certain credit markets is dependent upon IKON’s credit ratings. Although IKON is currently rated investment grade by S&P, any negative changes to IKON’s credit ratings, including any further downgrades, could reduce or foreclose IKON’s and the Company’s access to certain credit markets and may require that excess cash flows under the Company’s securitization arrangements be used to pay principal amounts outstanding under such arrangements. There is no assurance that these credit ratings can be maintained by IKON or that the credit markets can be readily accessed.
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, a debt to equity ratio (net of amounts receivable from IKON) of not more than 6.0 to 1.0 and a minimum tangible net worth of one-dollar.
Employees
At September 30, 2003, the Company had approximately 400 employees. The Company believes its relations with its employees are 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 IKON, 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 competes on the basis of technology, performance, price, quality, reliability, distribution, customer service and support.
Item 2.
Item 2. Properties.
The Company’s operations are located in Macon, Georgia in leased facilities occupying approximately 70,000 square feet. In addition, IKON utilizes approximately 27,000 square feet in adjacent facilities leased by the Company for a corporate-wide data center and IKON’s National Collections Group. The Company uses its facilities 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.
There are contingent liabilities for taxes, guarantees, other lawsuits and various other matters occurring in the ordinary course of business. On the basis of information furnished by counsel and others, and after consideration of the defenses available to the Company and any related reserves and insurance coverage, management believes that none of these other contingencies will materially affect the consolidated financial statements of the Company.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
(No response to this item is required.)
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters.
There is currently no market for the Company’s equity securities nor is it anticipated that such a market will develop. The Company paid IKON dividends of $75,000 in fiscal 2003 and $174,501 in fiscal 2002. 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 from IKON 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.
Critical Accounting Policies and Estimates
In response to the SEC’s Release No. 33-8040, “Cautionary Advice Regarding Disclosure About Critical Accounting Policies”, we have identified below the accounting principles critical to our business and results of operations. We determined the critical principles by considering accounting policies that involve the most complex or subjective decisions or assessments. We discuss these accounting policies at relevant sections in this discussion and analysis and in the notes to the consolidated financial statements contained in this Report on Form 10-K. In addition, we believe our most critical accounting policies include the following:
Residual Values. IKON and IOSC estimate the residual value of equipment sold under sales-type leases. Our residual values are based on the dollar value of the equipment. Residual values generally range between 0% to 24% of
MSRP, depending on equipment model and lease term. We evaluate residual values quarterly for impairment. Changes in market conditions could cause actual residual values to differ from estimated values, which could accelerate the write-down of the value of the equipment.
Allowance for Receivables. IOSC maintains an allowance for lease defaults for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of IKON’s customers were to significantly deteriorate, resulting in an impairment of their ability to make required payments, changes to our allowance may be required.
Other Accounting Policies. Other accounting policies, not involving the same level of significance as those discussed above, are nevertheless important to an understanding of our financial statements. See note 2 to the consolidated financial statements, Significant Accounting Policies, which discusses other accounting policies.
Our preparation of this Report on Form 10-K requires us 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. In addition, certain policies described above may be modified or affected by our announced sale of certain assets and liabilities of the Company to GE (see “Business - Recent Developments”).
Fiscal 2003 Compared with Fiscal 2002
Comparative results of operations for the fiscal years ended September 30, 2003 and 2002 are set forth in the table below.
Revenues
Total revenues increased by $4,975, or 1.2%, in fiscal 2003 compared to fiscal 2002. Lease finance income increased by $1,381, or 0.4%, due to the increase in the lease portfolio of 3.1% from September 30, 2002 to September 30, 2003. This increase was partially offset by a decrease in the average yield on leases in the portfolio from fiscal 2003 to fiscal 2002.
Office equipment placed on rental, with either cancelable or non-cancelable terms, by IKON to customers, may be purchased by the Company. During fiscal 2003 and 2002, IOSC purchased operating lease equipment of $49,898 and $60,759, respectively. The decrease in purchases is due to a decrease in operating rentals written by IKON. Since the Company can service operating rentals more efficiently than IKON, substantially all of the operating rentals written by IKON are purchased by the Company. Rental income increased by $4,449, or 13.2%, during fiscal 2003 compared to fiscal 2002, primarily due to an increase in the lease portfolio on a year-to-year basis.
Other income consists primarily of late payment charges, various billing fees, and interest income on restricted cash. Overall, income from these sources decreased by $855, or 4.3%, in fiscal 2003 compared to fiscal 2002. Interest income on restricted cash decreased by $985, or 51.5%, during fiscal 2003 compared to fiscal 2002, due to the decline in short-term interest rates. Late payment charges decreased by $1,324, or 9.7%, in fiscal 2003 compared to fiscal 2002, primarily due to the improvement in the delinquency of the lease portfolio. These decreases were partially offset by an increase of $1,283 in new revenues earned from trade accounts receivable recovery fees and commissions from an equipment insurance program.
Expenses
Total expenses increased by $47,151, or 20.7%, during fiscal 2003 compared to fiscal 2002. Borrowings to finance the Leases in the form of convertible subordinated notes, Conduits, lease-backed notes in the public market, net of intercompany receivables from IKON, were $2,699,524 at September 30, 2003 compared to $2,582,064 at September 30, 2002. This increase is due primarily to the issuance of $852,085 of 2003 Notes and $350,000 of 2008 Notes partially offset by the early extinguishment of $215,286 of 2004 Notes and the repayment of $979,698 of Notes. The Company paid a weighted average interest rate on all borrowings of 4.6% during fiscal 2003 compared to 6.0% during fiscal 2002. Primarily as a result of the decrease in the weighted average interest rate on all borrowings, interest expense decreased by $19,054, or 12.6%, during fiscal 2003 compared to fiscal 2002.
The provision for lease defaults, net of recoveries, increased by $37,070, or 256.6%, during fiscal 2003 compared to fiscal 2002. Prior to October 1, 2002, the Company was involved in a shared recourse arrangement with IKON. This arrangement provided for net losses resulting from lease defaults to be shared equally. Effective October 1, 2002, the shared recourse arrangement with IKON was terminated, and the Company currently records the entire provision for lease defaults. The Company has improved its collections process, which resulted in the percentage of accounts classified as delinquent (more than 30 days outstanding) to decrease from 6.8% at September 30, 2002 to 4.8% at September 30, 2003.
Depreciation expense on operating rentals increased by $2,230, or 7.8%, during fiscal 2003 compared to fiscal 2002, due to the volume and mix of leased equipment. General and administrative expenses increased by $6,613, or 20.0%, during fiscal 2003 compared to fiscal 2002. Effective fiscal 2003, the Company is responsible for the cost of the lease sales and marketing staff and certain credit investigation expenses, both of which were previously expensed by IKON.
During fiscal 2003, the Company repurchased $215,286 par value of its 2004 Notes, for $234,502. As a result, the Company recognized a loss from the early extinguishment of debt, including the write-off of unamortized costs, of $20,292 during fiscal 2003.
Income Before Taxes on Income
Income before taxes on income for fiscal 2003 decreased by $42,176, or 24.3%, compared to fiscal 2002 as a result of the items discussed above.
Provision for Income Taxes
Taxes on income for fiscal 2003 decreased by $23,702, or 33.3%, compared to fiscal 2002. The decrease in income taxes is attributable to the decrease in income before taxes on income for fiscal 2003 compared to fiscal 2002. In addition, the effective income tax rate was 36.2% for fiscal 2003 and 41.0% for fiscal 2002.
Contractual Obligations
The following summarizes IOSC’s significant contractual obligations and commitments as of September 30, 2003:
Payments on our debt are generally made from collections of our Leases. At September 30, 2003, the Company’s debt was $2,782,735 and net finance receivables were $3,131,129.
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 may 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 Leases. 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 tables present, as of September 30, 2003 and 2002, 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 F-l through of this report.
Quarterly Data
The following table shows comparative summarized unaudited quarterly results for fiscal 2003 and 2002.
The first and third quarters of fiscal 2003 include pre-tax losses from the early extinguishment of debt of $98 and $20,194, respectively.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
(No response to this item is required.)
Item 9A.
Item 9A. Evaluation of Disclosure Controls and Procedures.
The Company’s Principal Executive Officer and Principal Financial Officer have evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 15d-15(e) under the Exchange Act) as of the end of the period covered by this Annual Report on Form 10-K. Based on this evaluation, they have concluded that, as of the evaluation date, the Company’s disclosure controls and procedures are reasonably designed to alert them on a timely basis to material information relating to the Company (including its consolidated subsidiaries) required to be included in its reports filed or submitted under the Exchange Act.
PART III
Item 14.
Item 14. Principal Accountant Fees and Services.
(No response to this item is required.)
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.
(a) (1) and (2) Financial Statements
Page
Report of Independent Auditors
Consolidated Balance Sheets at September 30, 2003 and 2002
Consolidated Statements of Income for Fiscal Years Ended September 30, 2003, 2002 and 2001
Consolidated Statements of Cash Flows for Fiscal Years Ended September 30, 2003, 2002 and 2001
Consolidated Statements of Changes in Member’s Equity for Fiscal Years Ended September 30, 2003, 2002 and 2001
Notes to Consolidated 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
None.
REPORT OF INDEPENDENT AUDITORS
To the Board of Directors and Shareholders
of IKON Office Solutions, Inc.:
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, cash flows and changes in member’s equity, present fairly, in all material respects, the financial position of IOS Capital, LLC and its subsidiaries at September 30, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 2003 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 note 2 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
December 18, 2003
IOS CAPITAL, LLC
CONSOLIDATED BALANCE SHEETS
See notes to consolidated financial statements.
IOS CAPITAL, LLC
CONSOLIDATED STATEMENTS OF INCOME
See notes to consolidated financial statements.
IOS CAPITAL, LLC
CONSOLIDATED STATEMENTS OF CASH FLOWS
See notes to consolidated financial statements.
IOS CAPITAL, LLC
CONSOLIDATED STATEMENTS OF CHANGES IN MEMBER’S EQUITY
See notes to consolidated financial statements.
IOS CAPITAL, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BUSINESS
IOS Capital, LLC (“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 that integrates imaging systems and services that help businesses manage document workflow and increase efficiency. IKON represents the industry’s broadest portfolio of document management services, outsourcing and professional services, on-site copy and mailroom management, fleet management, off-site digital printing solutions, and customized workflow and imaging application development. IKON’s fiscal 2003 revenues were approximately $4.7 billion.
The Company is engaged in the business of arranging lease financing primarily for office equipment marketed by IKON’s U.S. marketplaces. During fiscal 2003, 81% of equipment sold by IKON in the United States was financed through the Company.
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, Hewlett-Packard and Océ. Currently 91% of the equipment financed by the Company represents digital copiers (including color copiers), 5% analog copiers, 1% facsimile machines and 3% other equipment.
The Company’s customer base (which consists primarily of end users of the equipment marketed by IKON) 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 $23 in amount and 51 months in duration. Although 95% of the leases are scheduled for regular monthly payments, customers are also offered quarterly, semi-annual and annual 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 IKON, such as a monthly report of marketplace leasing activity and related statistics.
2. SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its subsidiaries. Intercompany accounts and transactions have been eliminated in consolidation.
Use of Estimates
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America 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.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Revenue Recognition
Lease finance income and rental income are recognized over the related lease term. Revenue from other income is recognized in the period earned.
Property and Equipment
Property and equipment, including leased equipment, is carried on the basis of cost. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets as follows: equipment on operating leases-3-5 years; furniture and office equipment-3-7 years; leasehold improvements-shorter of the asset life or term of lease.
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. 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.
Financial Instruments
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.
The Company follows Statement of Financial Accounting Standards (“SFAS”) 133, as amended, which requires that all derivatives be recorded on the 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.
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 they were executed. 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, 2003, 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 its variable rate classes of lease-backed notes, which results in a lower cost of capital than if it had issued fixed rate notes. During the year ended September 30, 2003, unrealized net gains totaling $12,243, after taxes, were recorded in OCI.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Restricted Cash
Restricted cash on the consolidated balance sheets represents the cash that has been collected on the Leases (as defined below) that are pledged as collateral for lease-backed notes (“Notes”). This cash must be segregated within two business days into a trust account and the cash is used to pay the principal and interest on Notes as well as any associated administrative expenses. The level of restricted cash is impacted from one period to the next by the volume of Leases and timing of collections on such Leases. Restricted cash also includes amounts deposited with an escrow agent to defease $34,891 of the Company’s 9.75% Notes, as discussed in note 6 of the consolidated financial statements. At September 30, 2003, the remaining amount of restricted cash in escrow related to this defeasance, including accrued interest, was $38,446.
IKON Stock
Pursuant to the terms of the convertible debt issued on May 13, 2002, the Company may be required to cause IKON to deliver IKON common stock to satisfy all or a portion of its obligation if the debt holders exercise their conversion option. While at this time the Company does not hold any IKON stock, the Company’s policy is to account for such stock as treasury stock, which would be presented as a contra equity account reducing the Company’s contributed capital.
3. AGREEMENT BETWEEN IOSC 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. The Company was in a net average deposit position with IKON during fiscal 2003 and earned interest income of $4,173 (netted against interest expense), and was in a net average borrowing position with IKON during fiscal 2002 and 2001 and incurred interest expense of $3,009 and $7,788, respectively.
Management Fee
Included in general and administrative expenses are corporate expenses charged by IKON of $2,665, $2,535 and $2,210 in fiscal 2003, 2002 and 2001, respectively. These corporate charges represent management’s estimate of costs incurred by IKON on behalf of IOSC for legal, treasury, tax and marketing support.
Lease Defaults
Effective October 1, 1999, the Company began a shared recourse arrangement with IKON. This arrangement provided for net losses resulting from lease defaults to be shared equally. The lease default reserve was maintained at the Company and the provisions for lease default were shared between the Company and IKON. On October 1, 1999, lease default reserves and the related deferred tax liability were transferred to the Company from IKON.
Effective October 1, 2002, the shared recourse arrangement with IKON was terminated, and the Company currently records the entire provision for lease defaults. During the fiscal year ended September 30, 2003, IKON transferred a loss reserve of $28,745 to the Company due to the termination of the shared recourse arrangement.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The following table provides a rollforward of changes in the lease default reserve from September 30, 2000 to September 30, 2003:
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 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 fixed charges, and ii) that the Company will maintain a minimum tangible net worth of one-dollar. The 1996 Support Agreement also provides that IKON will maintain 100% direct or indirect ownership of the Company and limits the leverage of debt, net of amounts receivable from IKON, to equity to a maximum of 6.0 to 1.0.
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 debt holders (not including IKON or its affiliates) for all amounts outstanding and covered by the 1996 Support Agreement (generally, all debt entered into after June 1, 1994) is obtained.
4. UNSECURED CREDIT FACILITY
In 2002, IKON obtained a $300,000 unsecured credit facility (the “Credit Facility”), with a group of lenders. Revolving loans are available to the Company under the Credit Facility. As of September 30, 2003, the Company had no borrowings outstanding under the Credit Facility. The Credit Facility also provides support for letters of credit for the Company and its subsidiaries. As of September 30, 2003, letters of credit supported by the Credit Facility amounted to $27,621. The amount available under the Credit Facility is determined by the level of certain of IKON’s unsecured assets and the open letters of credit for IKON and its subsidiaries. The amount available to the Company under the Credit Facility for borrowings or additional letters of credit was $164,500 as of September 30, 2003.
The Credit Facility contains affirmative and negative covenants, including limitations on certain fundamental changes, investments and acquisitions, mergers, certain transactions with affiliates, creation of liens, asset transfers, payment of dividends, intercompany loans and certain restricted payments. The Credit Facility does not affect our ability to continue to securitize lease receivables. The Credit Facility also contains certain
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
financial covenants including: (i) corporate leverage ratio; (ii) consolidated interest expense ratio; (iii) consolidated asset test ratios; and (iv) limitations on capital expenditures. The Credit Facility contains default provisions customary for facilities of this type. In order to provide certain additional financial flexibility under the corporate leverage ratio, the covenant was modified during the third quarter of 2003 as follows: (i) at September 30, 2003, 3.75 to 1.00; (ii) at December 31, 2003, 3.60 to 1.00; (iii) at March 31, 2004, 3.40 to 1.00 and (iv) at June 30, 2004 and as of the last day of each quarterly period thereafter, 3.00 to 1.00. This covenant measures a ratio of the IKON’s corporate non-finance subsidiary debt to IKON’s business earnings (excluding financing income and interest expense associated with their financing operations). As of September 30, 2003, IKON’s corporate leverage ratio was 3.41 to 1.00. IKON’s failure to be in compliance with any material provision of the Credit Facility, including, without limitation, the financial covenants described above, could have a material adverse effect on our liquidity, financial position and results of operations.
During 2003, Moody’s Investor Services (“Moody’s”) lowered IKON’s senior unsecured credit rating from Baa2 to Ba1 (maintaining IKON’s rating under review for further downgrade) and Standard and Poor’s (“S&P”) placed IKON’s BBB- rating on CreditWatch. On August 1, 2003, S&P designated IKON’s BBB- rating with a negative outlook. Furthermore, in December 2003, S&P placed IKON’s ratings on CreditWatch for possible downgrade as a result of the announced sale of certain assets and liabilities of the Company (as discussed in note 12). IKON’s and the Company’s access to certain credit markets is dependent upon IKON’s credit ratings. Although IKON is currently rated investment grade by S&P, any negative changes to IKON’s credit ratings, including any further downgrades, could reduce or foreclose IKON’s and the Company’s access to certain credit markets and may require that excess cash flows under the Company’s securitization arrangements be used to pay principal amounts outstanding under such arrangements. There is no assurance that these credit ratings can be maintained by IKON or that the credit markets can be readily accessed.
5. INVESTMENT IN LEASES
The Company’s lease portfolio contains direct financing leases and funded leases. Direct financing leases include noncancelable lease agreements which are serviced by the Company. The Company’s funded leases include certain internal lease portfolios and noncancelable rental contracts for IKON, which have been financed by the Company. Under the terms of these funded leases, IKON maintains the contractual relationship with the third-party customer. IKON has assigned to the Company, with full recourse, its rights under the underlying contracts including the right to receive lease and rental payments and a security interest in the related equipment.
At September 30, 2003, aggregate future minimum payments to be received, including residual values, for each of the succeeding fiscal years, under direct financing and funded leases are as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
6. MEDIUM TERM NOTES, CONVERTIBLE SUBORDINATED NOTES, ASSET SECURITIZATION CONDUIT FINANCING AND OTHER NOTES
In June 2003, the Company issued $350,000 of notes payable with an interest rate of 7.25% (7.43% yield including the original issue discount) which mature on June 30, 2008. Interest is paid on the notes semi-annually in June and December beginning December 30, 2003. With the proceeds from the issuance, the Company tendered $205,786 par value of its 9.75% notes due June 15, 2004, for $224,904, deposited sufficient funds with an escrow agent to defease the remaining $34,891 of 9.75% notes not tendered and used the remainder of the proceeds for general corporate purposes. Amounts held in escrow to defease the remaining $34,714 of 9.75% notes at September 30, 2003, are included in restricted cash on the Company’s balance sheets. In the first quarter of fiscal 2003, the Company repurchased $9,500 par value of its 9.75% notes due 2004 for $9,598. As a result of these repurchases, the Company recognized a loss, including the write-off of unamortized costs, of $20,292, which is included in loss from early extinguishment of debt in the fiscal 2003 consolidated statements of income.
In fiscal 2003, the Company signed promissory notes and pledged $5,061 of lease receivables for $4,346 of proceeds. During fiscal 2003, the Company repaid $10,592 of the promissory notes. In fiscal 2002, the Company signed promissory notes and pledged $16,755 of lease receivables for $14,259 of proceeds. During fiscal 2002, the Company repaid $8,381 of the promissory notes. These notes have various interest rates ranging from 6.74% to 7.23% with maturities through June 2008.
IOSC has three revolving asset securitization conduit financing agreements (“Conduits”) totaling $680,000, each with a 364 day term that expires in fiscal 2004, but may be renewed subject to certain provisions. The agreements are structured so that as collections reduce previously pledged or transferred interests in the leases, additional leases can be pledged or transferred.
During fiscal 2003 and 2002, IOSC entered into revolving asset securitization transactions whereby it pledged or transferred $998,691 and $716,533, respectively, of finance receivables for $840,027 and $712,411, respectively, in cash. During fiscal 2003, IOSC repaid $638,645 under its Conduits. Repayments were made with proceeds received from the issuance of the Series 2003-1 Notes described below. In fiscal 2002, IOSC repaid $593,411 under its Conduits. Repayments were made with proceeds from the issuance of the Series 2002-1 Notes described below.
Interest paid amounted to $130,825, $148,048 and $168,574 for the fiscal years ended September 30, 2003, 2002 and 2001, respectively.
At September 30, 2003 and 2002, the fair value of debt outstanding is estimated to be $2,416,887 and $2,553,006, respectively, using a discounted cash flow analysis.
Future maturities of all debt outstanding at September 30, 2003 are as follows:
The Company may offer notes 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, 2003, the Company had no medium term notes outstanding.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
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, a debt to equity ratio (net of amounts receivable from IKON) of not more than 6.0 to 1.0 and a minimum tangible net worth of one-dollar.
7. LEASE-BACKED NOTES
IKON Receivables, LLC, (“IR”), a wholly-owned subsidiary of the Company, issued Series 2000-1, 2000-2 and 2001-1 lease-backed notes (collectively, together with the lease-backed notes issued by IKON Receivables Funding, LLC (“IRF”), a wholly-owned subsidiary of the Company, the “Notes”) as described below:
IRF issued Series 2002-1 and Series 2003-1 Notes as described below:
The Notes are secured by a segregated pool of assets (the “Asset Pool”) that includes a portfolio of chattel paper composed of leases, leases intended as security agreements and installment sales contracts acquired or
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
originated by IOSC (the “Leases”), together with the equipment financing portion of each periodic rental payment due pursuant to the terms of each series of Notes. The Leases, including the security interest of IR or IRF as the applicable issuer of the Notes (the “Issuer”) in the underlying equipment and other property related to the Leases (such equipment and property herein referred to as the “Equipment”), as referred to as “Lease Receivables.”
The Lease Receivables, including the Equipment, have been transferred to the Issuer and the Lease Receivables have been pledged by the Issuer to the applicable indenture trustee (the “Trustee”) in accordance with the terms of the assignment and servicing agreement applicable to each series of Notes. The Notes are secured solely by the Asset Pool and have no right, title or interest in the Equipment. The sole source of funds available for payment of the Notes are the Asset Pool and any applicable reserve account established in accordance with each applicable indenture and financial guarantee insurance policy. The Trustee has no right, title, or interest in the residual values of any of the Equipment except to the extent of the Issuer’s limited security interest with respect to recoveries on non-performing Leases.
On April 23, 2003, IRF issued $852,085 of lease-backed notes (the “2003 Notes”). Proceeds from the issuance of the 2003 Notes were used to make payments on the Company’s Conduits, repay unsecured credit facility borrowings and increase the Company’s cash balance.
The Notes bear interest from the related issuance date at the stated rates specified above. The variable rate 2000-1 Class A-4, 2000-2 Class A-3, 2000-2 Class A-4, 2001-1 Class A-3, 2001-1 Class A-4 and 2003-1 Class A-3a Notes have been fixed at 7.820%, 6.475%, 6.475%, 4.825%, 5.435% and 2.095%, respectively, through interest rate swaps.
IOSC services the Leases and 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.
Future maturities of the Notes, based on contractual maturities of the Leases, for each of the succeeding fiscal years are as follows:
Other Notes represent unregistered lease-backed notes issued as part of a note purchase agreement dated December 1, 2001 with a maturity date of September 30, 2008.
8. LEASE COMMITMENTS
Total rent expense under all operating leases aggregated $3,410, $3,504 and $1,988 in fiscal 2003, 2002 and 2001, respectively. At September 30, 2003, future minimum payments under noncancelable operating leases with initial or remaining terms of more than one year for each of the succeeding fiscal years are as follows: 2004-$1,788; 2005-$1,001; 2006-$1,001; 2007-$1,009; 2008-$1,023; and thereafter-$9,341.
9. INCOME TAXES
During fiscal 2002, the Company converted into a limited liability company and is therefore treated as a disregarded entity for tax purposes. The Company and IKON are treated as a single entity for tax purposes. 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 federal provision for income taxes was determined as if the Company was a separate taxpayer.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Provision for income taxes:
The components of deferred income tax assets and liabilities were as follows:
Net operating loss carryforwards consist primarily of federal carryforwards of approximately $357,014, which will expire in fiscal 2023. Credit carryforwards consist primarily of federal and state alternative minimum tax credits of approximately $80,346 (with no expiration date). A valuation allowance has been established against certain state alternative minimum tax credit carryforwards. The reduction in the valuation allowance is due to the utilization of state AMT credit carryforwards for which a valuation allowance had been established.
The components of the effective income tax rate were as follows:
The decrease in state taxes was due to the conversion to an LLC in fiscal 2002. The state tax provision is computed on a consolidated basis, with no legal liability to the Company as an LLC. The Company made net income tax payments, including amounts paid to IKON, of $349, $194 and $8,775 in fiscal years 2003, 2002 and 2001, respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
10. PENSION AND STOCK PURCHASE PLAN
The Company participates in IKON’s defined benefit pension plan covering the majority of its employees. The benefits generally are based on years of service and compensation. The Company’s policy is to fund pension costs as accrued. Pension expense was $349, $209 and $189 in fiscal 2003, 2002 and 2001, respectively.
The majority of our employees are eligible to participate in our Retirement Savings Plan (“RSP”). The RSP allows employees to invest 1% to 16% of regular compensation before taxes in nine different investment funds. Effective January 1, 2003, IKON reduced its matching contribution to an amount equal to 50% of the employees’ investment, up to 6% of regular compensation, for a maximum Company match of 3%. Substantially all of our contributions are invested in IKON common stock. However, effective November 1, 2002, RSP participants with at least two years of employment may elect to allocate the Company’s matching contribution in investment options other than IKON common stock. Employees vest in a percentage of IKON’s contribution after two years of service, with full vesting at the completion of five years of service. Total expense related to the plans was $322, $302, and $304 in fiscal 2003, 2002 and 2001, respectively. Prior to January 1, 2003, we contributed an amount equal to two-thirds of the employees’ investment, up to 6% of regular compensation, for a maximum Company match of 4%.
11. 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 may 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 Leases. 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 tables present, as of September 30, 2003 and 2002, 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.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
12. SUBSEQUENT EVENT
IKON entered into a definitive asset purchase agreement (the “Agreement”), dated December 10, 2003, by and among IKON, IOSC and General Electric Capital Corporation (“GE”) pursuant to which, among other things, GE will acquire certain assets and liabilities of the Company, including, without limitation, the Company’s servicing functions, facilities, systems and processes. As a condition to the consummation of the transactions contemplated by the Agreement, IKON and GE will enter into a program agreement (“Program Agreement”), under which, among other things, GE will become the preferred lease-financing source for IKON’s customers in the United States and Canada. Under the terms of the Agreement, and subject to closing adjustments, IKON will receive approximately $1.5 billion of gross proceeds. Before the closing of the transaction with GE, the Company and its subsidiaries will be merged with IKON. Immediately after the effectiveness of the merger, IKON will transfer certain former assets and liabilities of the Company to GE or one of its affiliates. The carrying amount of assets and liabilities that will be sold to GE were as follows as of September 30, 2003:
IKON will retain approximately $1.4 billion of the Company’s net lease receivables and corresponding residuals, of which approximately $1.2 billion is supported by Notes primarily related to the two most recent asset-backed notes offerings. IKON’s retained portfolio will be serviced by GE, and most of the retained portfolio is expected to run-off over the next twenty-four months. IKON will assume the Company’s $350 million 7.25% notes due 2008, $300 million 5% convertible notes due 2007 and the remaining $34,714 9.75% notes due 2004.
The closing of the transaction is subject to execution of a definitive program agreement relating to GE’s relationship with IKON as its preferred lease-financing source, as well as execution of other agreements and customary conditions, including receipt of third party consents. The transaction is expected to close in the second quarter of fiscal 2004.
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 on Form 10-K for the fiscal year ended September 30, 2003 to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Form 10-K has been signed below on December 29, 2003 by the following persons on behalf of the registrant and in the capacity indicated.
Signatures
Title
/s/ RUSSELL S. SLACK
Russell S. Slack
President (Principal Executive Officer)
/s/ HARRY G. KOZEE
Harry G. Kozee
Vice President-Finance (Principal Financial Officer and Principal Accounting Officer)
/s/ WILLIAM S. URKIEL
William S. Urkiel
Director