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| EPIQ > SEC Filings for EPIQ > Form 10-K on 4-Mar-2009 | All Recent SEC Filings |
4-Mar-2009
Annual Report
The following discussion and analysis of our consolidated results of operations and financial condition should be read in conjunction with the "Forward-Looking Statements," our "Risk Factors," "Selected Financial Data," and "Financial Statements" included in this Form 10-K.
Management's Overview
Electronic Discovery Segment
Our electronic discovery business provides processing and search and review services to companies and the litigation departments of law firms. Our eDataMatrix™ software analyzes, filters, deduplicates and produces documents for review. Produced documents are made available primarily through a hosted environment, and our DocuMatrix™ software allows for efficient plaintiff and defendant counsel review and data requests.
Our electronic discovery customers are typically large corporations that use our products and services cooperatively with their legal counsel to manage the electronic discovery process for complex litigation matters.
The substantial increase of electronic documents in the business community has changed the dynamics of how attorneys support discovery in complex litigation matters. According to the 2008 Socha-Gelbmann Electronic Discovery Survey, 2007 domestic commercial electronic discovery revenues were estimated at $2.8 billion, an approximate 43% increase from 2006. According to this same source, the market is expected to continue to grow at year over year annual rates of 21% for 2008, 20% for 2009 and 15% for 2010. Due to the complexity of cases, the volume of data that are maintained electronically, and the volume of documents that are produced in all types of litigation, we anticipate that law firms will become increasingly reliant on electronic evidence management systems to organize and manage the litigation discovery process.
Following is a description of the significant sources of revenue in our electronic discovery business.
º •
º Fees related to the conversion of data into an organized, searchable
electronic database. The amount we earn varies primarily on the size
(number of documents) and complexity of the engagement.
º •
º Hosting fees based on the amount of data stored.
Bankruptcy Segment
Our bankruptcy business provides solutions that address the needs of Chapter 7, Chapter 11 and Chapter 13 bankruptcy trustees to administer bankruptcy proceedings and of debtor corporations that file a plan of reorganization.
The key participants in a bankruptcy proceeding include the debtor-in-possession, the debtor's legal counsel, the creditors, the creditors' legal counsel, and the bankruptcy judge. Chapter 7 and Chapter 13 cases also have a professional bankruptcy trustee, who is responsible for administering the bankruptcy case.
The end-user customers of our bankruptcy business are debtor corporations that file a plan of reorganization and professional bankruptcy trustees. The Executive Office for United States Trustees, a division of the U.S. Department of Justice, appoints all bankruptcy trustees. A United States Trustee is appointed in most federal court districts and generally has responsibility for overseeing the integrity of the bankruptcy system. The bankruptcy trustee's primary responsibilities include liquidating the debtor's assets or collecting funds from the debtor, distributing the collected funds to creditors pursuant to the
orders of the bankruptcy court, and preparing regular status reports for the Executive Office for United States Trustees and for the bankruptcy court. Trustees manage an entire caseload of bankruptcy cases simultaneously.
The application of Chapter 7 bankruptcy regulations has the practical effect of discouraging trustee customers from incurring direct administrative costs for computer system expenses. As a result, we provide our Chapter 7 products and services to our trustee customers at no direct charge, and they maintain deposit accounts for bankruptcy cases under their administration at a designated banking institution. We have marketing arrangements with various banks under which we provide the bankruptcy trustee case management software and related services and the bank provides the bankruptcy trustee with deposit-related banking services. During the year ended December 31, 2008, a substantial majority of our Chapter 7 trustee clients' deposits were maintained at Bank of America. See Note 9 of the Notes to Consolidated Financial Statements for additional information on this significant customer.
Bankruptcy is an integral part of the United States' economy. As reported by the Administrative Office of the U.S. Courts for the fiscal years ended September 30, 2008, 2007, and 2006, there were approximately 1.04 million, 0.80 million and 1.11 million new bankruptcy filings, respectively.
º •
º Chapter 7 is a liquidation bankruptcy for individuals or businesses
that, as measured by the number of new cases filed in the fiscal year
ended September 30, 2008, accounted for approximately 65% of all
bankruptcy filings. In a Chapter 7 case the debtor's assets are
liquidated and the resulting cash proceeds are used by the Chapter 7
bankruptcy trustee to pay creditors. Chapter 7 cases typically last
several years.
º •
º Chapter 11 is a reorganization model of bankruptcy for corporations
that, as measured by the number of new cases filed in the fiscal year
ended September 30, 2008, accounted for approximately 1% of all
bankruptcy filings. Chapter 11 generally allows a company, often
referred to as the debtor-in-possession, to continue operating under a
plan of reorganization to restructure its business and to modify
payment terms of both secured and unsecured obligations. Chapter 11
cases may last several years.
º •
º Chapter 13 is a reorganization model of bankruptcy for individuals
that, as measured by the number of new cases filed in the fiscal year
ended September 30, 2008, accounted for approximately 34% of all
bankruptcy filings. In a Chapter 13 case, debtors make periodic cash
payments into a reorganization plan and a Chapter 13 bankruptcy
trustee uses these cash payments to make monthly distributions to
creditors. Chapter 13 cases typically last between three and five
years.
Following is a description of the significant sources of revenue in our bankruptcy business.
º •
º Data hosting fees and volume-based fees.
º •
º Case management professional service fees and other support service
fees related to the administration of cases, including data
conversion, claims processing, claims reconciliation, professional
consulting services, and settlement administration.
º •
º Deposit-based fees, earned primarily on a percentage of Chapter 7
total liquidated assets placed on deposit with a designated financial
institution by our trustee clients, to whom we provide, at no charge,
software licenses, limited hardware and hardware maintenance, and post
contract customer support services. The fees we earn based on total
liquidated assets placed on deposit by our trustee clients may vary
based on fluctuations in short-term interest rates. Interest rate
fluctuations are somewhat mitigated by pricing arrangements with each
financial institution that set ceilings and floors on the interest
rates that we earn.
º •
º Legal noticing services to parties of interest in bankruptcy matters,
including direct notification and media campaign and advertising
management in which we coordinate notification, primarily through
print media outlets, to potential parties of interest for a particular
client engagement.
º •
º Reimbursement for costs incurred, primarily related to postage on
mailing services.
Settlement Administration
Our settlement administration segment provides managed services, including legal notification, claims administration, project administration, and controlled disbursement.
Key participants in this marketplace include law firms that specialize in representing class action and mass tort plaintiffs and other law firms that specialize in representing defendants. Class action and mass tort litigation is often complex and the cases, including administration of any settlement, may last several years.
The customers of our settlement administration segment are corporations that are administering the settlement or resolution of class action cases or administering projects. We sell our services directly to those customers and other interested parties, including legal counsel, which often provide access to these customers. During the year ended December 31, 2008, approximately 22% of our consolidated revenue was derived from one large contract. This revenue was recognized in our settlement administration segment. Revenue related to this contract is expected to decline throughout 2009 as we reach the conclusion of the contract during 2009.
Class action and mass tort refer to litigation in which class representatives bring a lawsuit against a defendant company or other persons on behalf of a large group of similarly affected persons. Mass tort refers to class action cases that are particularly large or prominent. The class action and mass tort marketplace is significant, with estimated annual tort claim costs of approximately $250 billion in 2007, according to a study issued in 2008 by Towers Perrin. Administrative costs, which include costs, other than defense costs, incurred by either the insurance company or self-insured entity in the administration of claims, comprise approximately 24% of this total.
Following is a description of the significant sources of revenue in our settlement administration business.
º •
º Fees contingent upon the month-to-month delivery of case management
services such as claims processing, claims reconciliation, project
management, professional services, call center support, and controlled
disbursements. The amount we earn varies primarily on the size and
complexity of the engagement.
º •
º Legal noticing services to parties of interest in class action
matters; including media campaign and advertising management, in which
we coordinate notification through various media outlets such as
print, radio and television, to potential parties of interest for a
particular client engagement.
º •
º Reimbursement for costs incurred related to postage on mailing
services.
Results of Operations for the Year Ended December 31, 2008 Compared with the Year Ended December 31, 2007
Consolidated Results of Operations
Revenue
Total revenue was $236.1 million in 2008, an increase of $61.7 million, or 35%, as compared to the prior year. A portion of our total revenue consists of reimbursement for direct costs we incur, such as postage related to document management services. We reflect the operating revenue from these
reimbursed direct costs as a separate line item on our accompanying Consolidated Statements of Income. Operating revenue from reimbursed direct costs was $28.3 million, an increase of $5.5 million, or 24%, from $22.8 million in the prior year. This increase directly corresponded to the increase in reimbursed direct costs. Although reimbursed operating revenue may fluctuate significantly from period to period, these fluctuations have a minimal effect on our income from operations as we realize little or no margin from this revenue.
Operating revenue exclusive of operating revenue from reimbursed direct costs, which we refer to as operating revenue before reimbursed direct costs, was $207.9 million in 2008, an increase of $56.2 million, or 37%, as compared to the prior year. The increase consists of a $9.1 million increase in the electronic discovery segment and a $47.6 million increase in the settlement administration segment, partially offset by a $0.5 million decrease in the bankruptcy segment. Changes by segment are discussed below.
Operating Expenses
Direct cost of services, exclusive of depreciation and amortization, was $81.9 million in 2008, an increase of $40.4 million, or 98%, as compared to $41.5 million in the prior year. Contributing to this increase was a $26.2 million increase in the cost of outside services, primarily related to telephone, mailing and temporary help services; a $5.3 million increase in legal noticing; a $1.8 million increase in compensation related expense; and a $4.9 million increase in production supplies. Changes by segment are discussed below.
Direct cost of bundled products and services, exclusive of depreciation and amortization, was $3.6 million in 2008, a decrease of $0.1 million, or 2%, compared to $3.7 million in the prior year. Changes by segment are discussed below.
Reimbursed direct costs increased in 2008 to $28.1 million compared to $22.6 million in the prior year. This increase directly corresponded to the increase in operating revenue from reimbursed direct costs. Changes by segment are discussed below.
General and administrative costs increased $8.6 million, or 14%, to $71.1 million in 2008 compared to $62.5 million in the prior year. Contributing to this increase was a $4.9 million increase in compensation, commission and benefits expense, primarily resulting from expanded staffing to meet client demands; a $1.5 million increase in travel expense; a $1.9 million increase in professional services; and a $1.4 million increase in bad debt expense. These increases were partially offset by a decrease of $2.8 million in share-based compensation expense which was the result of a change in the timing of our equity compensation grants. Changes by segment are discussed below.
Depreciation and software and leasehold amortization costs in 2008 were $16.3 million, an increase of $3.5 million, or 28%, compared to the prior year. This increase was primarily the result of increased software amortization expense and increased hardware depreciation largely related to investment in our electronic discovery segment.
Amortization of identifiable intangible assets in 2008 was $9.1 million, a decrease of $0.5 million, or 5%, compared to the prior year. This decrease was primarily the result of certain customer contracts and trade names that became fully amortized during the year, partially offset by an increase in non-compete amortization resulting from our second quarter acquisition of an electronic discovery business in the United Kingdom.
Other operating expense of $0.2 million in 2008 primarily consists of $0.9 million of non-capitalized acquisition-related expenses related to the acquisition of an electronic discovery business in the United Kingdom in the second quarter of 2008, as well as $1.2 million of expenses incurred throughout 2008 related to potential acquisitions that were not completed. The acquisition-related expenses consisted of legal services, executive compensation, indirect and general costs,
accounting services, and valuation services. Partially offsetting these expenses is a $2.4 million gain in 2008 related to interest rate floor options purchased during 2007.
Interest Expense
Interest expense was $1.8 million, compared to $12.0 million in the prior year, a decrease of $10.2 million, or 85%. Contributing to the decline was a $6.3 million decrease in interest expense related to our credit facility, a $3.2 million decrease in expense related to the value of our subordinated convertible note holders' option to extend the maturity of the subordinated convertible notes from June 15, 2007 to June 15, 2010, and a $0.6 million decrease in loan fee amortization.
The $6.3 million decrease in credit facility interest expense resulted from our repayment and termination of the credit facility term loan and the repayment in full of the credit facility revolving loan during 2007 from the proceeds of a common stock offering in November 2007. The $0.6 million decrease in loan fee amortization expense was primarily the result of the completion of the amortization of fees related to the contingent convertible subordinated debt and the credit facility term loan during 2007.
During April 2007, the holders of the contingent convertible subordinated notes exercised their right to extend the maturity of the convertible notes from June 2007 to June 2010. As a result, we will continue to pay interest, at a rate of 4% per annum, during the extension period on any convertible notes that remain outstanding. The holders of the convertible notes may chose at any time to convert some or all of the notes into our common shares. See Note 5 of the Notes to Consolidated Financial Statements for additional information regarding this conversion right.
We estimated the fair value of the option to extend immediately prior to the note holders' vote to extend and recorded a final adjustment to the fair value of the option to extend the subordinated convertible notes' maturity. We are currently amortizing the exercise date fair value of the option as a reduction to interest expense over the term of the extension. During 2008 we recognized a reduction to interest expense of approximately $1.6 million related to the amortization of the carrying value of the option to extend the maturity term subsequent to the extension date.
Effective Tax Rate
Our effective tax rate was 43.2% for 2008 compared with an effective rate of 37.0% for the prior year. Our tax rate is generally higher than the statutory federal rate primarily due to state and local taxes. Several of our subsidiaries operate in New York City and are subject to state and local tax rates which are higher than the tax rates assessed by other jurisdictions where we operate. The increase in the effective tax rate compared with the prior year is primarily due to a larger proportion of our income being taxed in high tax rate jurisdictions and the reversal of a valuation allowance related to our United Kingdom net operating loss carryforward in 2007. During the fourth quarter of 2007, we determined that it was more likely than not that the United Kingdom net operating loss would be fully utilized within the carryforward period. Accordingly, we reversed the valuation allowance related to the remaining net operating loss carryforward asset resulting in a lower effective tax rate in 2007.
Net Income
We had net income of $13.8 million for 2008 compared to $6.9 million for the prior year, an increase of $6.9 million, or 100%. Growth in our settlement administration segment, resulting from a large contract, as well as the decline in net interest expense, contributed to the increase in net income. These increases were offset in part by the bankruptcy segment, which declined as a result of reduced short-term interest rates throughout 2008, combined with lower bankruptcy deposits.
Results of Operations by Segment
The following segment discussion is presented on a basis consistent with our segment disclosure contained in Note 14 of our Notes to Consolidated Financial Statements.
Electronic Discovery Segment
Electronic discovery operating revenue before reimbursed direct costs in 2008 was $58.1 million, an increase of $9.1 million, or 18%, compared to the prior year. This increase is attributable to additional projects from existing clients, as well as an expansion of our client base, which resulted in an increase in hosting and processing revenue.
Electronic discovery direct and administrative expenses, including reimbursed direct costs, were $32.0 million in 2008, an increase of $7.2 million, or 29%, compared to the prior year. Factors contributing to this increase include a $4.0 million increase in compensation, commission and benefits expense, resulting from expanded staffing to support increased operating revenue; a $0.2 million increase in bad debt expense; a $0.4 million increase in promotional expense; a $0.2 million increase in professional services; a $0.4 million increase in purchased software; a $0.7 million increase in building and equipment lease expense, primarily related to data center expansion; and an $0.8 million increase in maintenance expense.
Bankruptcy Segment
Bankruptcy operating revenue before reimbursed direct costs was $59.8 million in 2008, a decrease of $0.5 million, or 1%, compared to the prior year. This slight decrease was the result of an $8.6 million decline in our bankruptcy trustee fees; offset in part by an $8.2 million increase in bankruptcy restructuring engagements.
Revenue from our bankruptcy trustee business could continue to be lower with comparable periods if short-term interest rates do not increase. This effect could be partly mitigated by an increase in bankruptcy trustee revenue as an increase in bankruptcy filings could result in an increase in the bankruptcy trustee deposit portfolio. Noticing services depend on the timing of a case and will fluctuate from period to period.
Bankruptcy direct and administrative expenses, including reimbursed direct costs, were $34.1 million in 2008, an increase of $4.2 million, or 14%, compared to the prior year. This increase was primarily the result of a $0.3 million increase in compensation, commission and benefits expense, primarily due to increased headcount; a $1.3 million increase in bad debt expense, resulting from several clients moving from Chapter 11 to Chapter 7 bankruptcy and additional accruals; and a $1.9 million increase in outside services expense, resulting from several large noticing engagements.
Settlement Administration
Settlement administration operating revenue before reimbursed direct costs was $89.9 million in 2008, an increase of $47.6 million, or 113%, compared to the prior year. This increase was due to a $38.3 million increase in call center and direct mailing revenue, primarily related to a large contract; a $5.5 million increase in legal notification revenue, resulting from several large class action cases; and an $8.8 million increase in professional services. These increases were partially offset by a $3.4 million decrease in transaction processing revenue.
Settlement administration direct and administrative expenses, including reimbursed direct costs, were $93.2 million in 2008, an increase of $41.9 million, or 82%, compared to the prior year. This increase is primarily the result of a $29.2 million increase in call center, outside service, and mailing supplies costs to support the large contract referenced above. Also contributing to the increase was a $5.3 million increase in the cost of legal noticing that is directly related to the increase in legal
notification revenue; and a $5.3 million increase in reimbursable expenses, which is offset directly by an increase in operating revenue from reimbursable costs. Additional staffing requirements to meet client demands resulted in a $1.1 million increase in compensation, commissions and benefits, and a $0.6 million increase in outside services.
Results of Operations for the Year Ended December 31, 2007 Compared with the Year Ended December 31, 2006
Consolidated Results of Operations
Revenue
Total revenue from operations was $174.4 million in 2007, a decrease of $49.8 million, or 22%, from the prior year. A portion of our total revenue consists of reimbursement for direct costs we incur, such as postage related to document management services. We reflect the operating revenue from these reimbursed direct costs as a separate line item on our accompanying Consolidated Statements of Income. Although reimbursed operating revenue may fluctuate significantly from period to period, these fluctuations have a minimal effect on our income from operations as we realize little or no margin from this revenue.
Operating revenue before reimbursed direct costs in 2007 was $151.6 million, a decrease of $48.1 million, or 24%, as compared to the same period in the prior year. This decrease is primarily the result of a $58.4 million decrease in bankruptcy revenue before reimbursed direct costs and a $7.4 million decrease in settlement administration revenue before reimbursed direct costs, partly offset by a $17.7 million increase in electronic discovery operating revenue before reimbursed direct costs. As more fully explained under the caption "Significant Accounting Policies-Revenue Recognition" in Note 1 to our Consolidated Financial Statements, the decrease in bankruptcy operating revenue before reimbursed direct costs is primarily attributable to the recognition, during 2006, of approximately $59.7 million of revenue, deferred beginning in October 2003, following delivery of the final specified software upgrade pursuant to a specific arrangement that expired September 30, 2006. All revenue is directly related to a segment and changes in revenue by segment are discussed below.
Operating Expenses
Direct cost of services, exclusive of depreciation and amortization, was $41.5 million in 2007, a decrease of $6.9 million, or 14%, as compared to the prior year. This decrease is primarily attributable to a $6.2 million decrease in legal noticing combined with a $3.2 million decrease in the cost of outside services, partly offset by a $1.1 million increase in compensation related expense and a $0.8 million increase in rent expense. Changes by segment are discussed below.
Direct cost of bundled products and services, exclusive of depreciation and amortization, was $3.7 million in 2007, a decrease of $0.2 million, or 6%, from the prior year, primarily as a result of decreased compensation expense. Changes by segment are discussed below.
Reimbursed direct costs in 2007 decreased $2.0 million, or 8%, to $22.6 million. This decrease directly corresponds to the decrease in operating revenue from reimbursed direct costs.
General and administrative expenses in 2007 were $62.5 million, an increase of $8.4 million, or 16%, compared to the prior year. The increase is attributable to a $7.3 million increase in compensation expense, and a $3.1 million increase in bonus expense, primarily resulting from additional staffing to support growth in our electronic discovery business. Also contributing to the increase was a $0.7 million increase in travel expenses and a $0.4 million increase in rent expense. Changes by segment are discussed below.
Depreciation and software and leasehold amortization costs in 2007 were $12.8 million, an increase of $2.7 million, or 26%, compared to the prior year. The increase primarily resulted from an increase of $2.5 million in depreciation and amortization expense related to purchased and internally developed software and the related hardware required to support the expansion of our electronic discovery business.
Amortization of identifiable intangible assets in 2007 was $9.5 million, a decrease of $2.1 million, or 18%, compared to the prior year as certain customer contract intangibles, primarily related to our settlements and claims business; and certain trade name intangibles, primarily related to our electronic discovery business; became fully amortized in 2007.
Other operating expenses, which include the mark-to-market adjustment for the purchased interest rate floor options as well as acquisition related expenses, reflect $1.1 million of income for 2007 compared with $0.3 million of expense for the prior year. A portion of our bankruptcy trustee pricing is tied . . .
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