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QCCO > SEC Filings for QCCO > Form 10-K on 14-Mar-2013All Recent SEC Filings

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Form 10-K for QC HOLDINGS, INC.


14-Mar-2013

Annual Report


ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following should be read in conjunction with Item 6 "Selected Financial Data" and our Consolidated Financial Statements and Notes included as Item 8 of this report.

EXECUTIVE SUMMARY

We operate primarily through our wholly-owned subsidiaries, QC Financial Services, Inc., QC Auto Services, Inc., QC Loan Services, Inc., QC E-Services, Inc., QC Canada Holdings Inc. and QC Capital, Inc. QC Financial Services, Inc. is the 100% owner of QC Financial Services of California, Inc., Financial Services of North Carolina, Inc., QC Financial Services of Texas, Inc., Express Check Advance of South Carolina, LLC, QC Advance, Inc., Cash Title Loans, Inc. and QC Properties, LLC. QC Canada Holdings Inc. is the 100% owner of Direct Credit Holdings Inc. and its wholly owned subsidiaries (collectively, Direct Credit).

We derive our revenues primarily by providing short-term consumer loans, known as payday loans, which represented approximately 66.0% of our total revenues for the year ended December 31, 2012. We earn fees for various other financial services, such as installment loans, credit services, check cashing services, title loans, open-end credit, debit cards, money transfers and money orders. We operated 466 branches in 23 states at December 31, 2012. In all states in which we offer payday loans, we fund our payday loans directly to the customer and receive a fee. Fees charged to customers vary from state to state, generally ranging from $15 to $20 per $100 borrowed, and in most cases, are limited by state law.

We began offering branch-based installment loans to customers in our Illinois branches during second quarter 2006 and expanded that product offering to customers in additional states during 2009 and 2010. In 2012, we introduced new installment loan products (signature loans and auto equity loans) to meet high customer demand for longer-term loan options. These new products are higher-dollar and longer-term installment loans that are centrally underwritten and distributed through our existing branch network. As of December 31, 2012, we offered the installment loan products to our customers in Arizona, California, Colorado, Idaho, Illinois, Missouri, New Mexico, South Carolina, Utah and Wisconsin. The installment loans are payable in monthly installments (principal plus accrued interest) with terms typically ranging from four months to 48 months, and all loans are pre-payable at any time without penalty. The fee for the installment loan varies based on the amount borrowed and the term of the loan. Generally, the amount that we advance under an installment loan ranges from $400 to $3,000. The average principal amount across all installment loan products originated during 2010, 2011 and 2012 was approximately $488, $518 and $624.

In Texas, through one of our subsidiaries, we operate as a credit service organization (CSO) on behalf of consumers in accordance with Texas laws. We charge the consumer a CSO fee for arranging for an unrelated third-party to make a loan to the consumer and for providing related services to the consumer, including a guarantee of the consumer's obligation to the third-party lender.

In September 2007, we entered into the buy here, pay here segment of the used automotive market in connection with ongoing efforts to evaluate alternative products that serve our customer base. In January 2009, we purchased two buy here, pay here locations in Missouri for approximately $4.2 million. In May 2009, we opened a service center to provide reconditioning services on our inventory of vehicles and repair services for our customers. As of December 31, 2012, we operated five buy here, pay here lots, which are located in Missouri and Kansas. These locations sell used vehicles and earn finance charges from the related vehicle financing contracts. The average principal amount for buy here, pay here loans originated during the year ended December 31, 2012 was approximately $10,245 and the average term of the loan was 33 months.


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On September 30, 2011, QC Canada Holdings Inc, our wholly-owned subsidiary, acquired 100% of the outstanding stock of Direct Credit Holdings Inc. (Direct Credit), a British Columbia company engaged in short-term, consumer Internet lending in certain Canadian provinces. Direct Credit was founded in 1999 and has developed and grown a proprietary Internet-based platform in Canada. The acquisition of Direct Credit is part of the implementation of our strategy to diversify by increasing our product offerings and distribution, as well as expanding our presence into international markets.

We have elected to organize and report on our business units as three operating segments (Financial Services, Automotive and E-Lending). The Financial Services segment includes branches that offer payday loans, installment loans, credit services, check cashing services, title loans, open-end credit, debit cards, money transfers and money orders. The Automotive segment consists of our buy here, pay here operations. The E-Lending segment includes the Internet lending operations in Canada. We evaluate the performance of our segments based on, among other things, gross profit, income from continuing operations before income taxes and return on invested capital.

Our expenses primarily relate to the operations of our branch network and automotive locations. The most significant expenses include salaries and benefits for our branch employees, provisions for losses, cost of sales and occupancy expense for our leased real estate. Regional and corporate expenses, which include compensation of employees, professional fees and equity award charges, are our other primary costs.

We also evaluate our Financial Services branches, automotive locations, and our Direct Credit operations based on revenue growth and loss ratio (which is losses as a percentage of revenues). With respect to our branch network, we also consider the length of time the branch has been open and its geographic location. We monitor newer branches for their progress to profitability and rate of loan growth.

With respect to our cost structure, salaries and benefits are one of our largest costs and are generally driven by changes in number of branches and loan volumes. Our provision for losses is also a significant expense. If a customer's check is returned by the bank as uncollected, we make an immediate charge-off to the provision for losses for the amount of the customer's loan, which includes accrued fees and interest. Any recoveries on amounts previously charged off are recorded as a reduction to the provision for losses in the period recovered.

We have experienced seasonality in our Financial Services segment, with the first and fourth quarters typically being our strongest periods as a result of broader economic factors, such as holiday spending habits at the end of each year and income tax refunds during the first quarter. Our Automotive locations experience seasonality as automobile sales peak during the first quarter of each year, primarily as a result of the receipt by customers of their income tax refunds, which are used as down payments for a vehicle. Automobile sales in the final three quarters are generally lower than the first quarter. In addition, vehicle acquisition costs tend to increase in the second half of the year as companies build inventories for the expected first quarter volumes.

In response to changes in the overall market, we have closed a significant number of branches over the past five years. During this period, we opened 26 de novo branches, acquired one branch and closed 157 branches. The following table sets forth our de novo branch openings, branch acquisitions and branch closings since January 1, 2008.

                                           2008       2009       2010       2011       2012

    Beginning branch locations               596        585        556        523        482
    De novo branches opened during year       12          3          1          2          8
    Acquired branches during year              1
    Branches closed/sold during year (a)     (24 )      (32 )      (34 )      (43 )      (24 )


    Ending branch locations                  585        556        523        482        466

(a) The number of branches closed during 2012 does not include 38 branches that we decided in December 2012 that we would close during first half of 2013. However, these branches are included as part of discontinued operations in 2012.


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In recent years, we have focused on growing revenue by introducing new products that serve our existing loyal customer base and increasing profitability by streamlining operations. As part of our efforts to introduce new products and diversify our revenue stream, we are currently in the process of accelerating the growth of our longer-term, centrally underwritten installment loan product to our existing branch network. We continually evaluate opportunities for product and geographic expansion and for new branch development to complement existing branches within a given state or market. Additionally, we utilize a disciplined acquisition strategy for both the payday and the buy here, pay here businesses.

We are currently in the process of restructuring our Automotive segment. Historically, we have carried all of our automobile loans receivable on our balance sheet; however, in December 2012, we sold roughly 90% of our automobile loans receivable to a third party. Additionally, while the Automotive segment has been funded from our operations, we are evaluating a forward flow arrangement whereby sales of automobiles are funded directly by a third-party lender. We believe these changes will enhance profitability as a result of improved net credit expense, in addition to enabling us to reduce the capital requirements of the business going forward.

We believe the acquisition of Direct Credit broadens our product platform and distribution, as well as expands our presence by entering into international markets. Although the Canadian market is much smaller than the U.S. market, there is still significant room for organic growth, and Direct Credit is a scalable platform with a competitive method for funding loans. In addition, Direct Credit's online technology can be used as a platform for future growth into other markets, and we are currently leveraging Direct Credit's online business model to develop an Internet-based lending platform for customers in the United States. A viable U.S. Internet presence will help us further diversify our revenue base and offer our customers another financing alternative.

The payday loan industry began its rapid growth in 1996, when there were an estimated 2,000 payday loan branches in the United States. According to Community Financial Services Association, industry analysts estimate that the industry has approximately 18,300 payday loan branches in the United States and approximately 1,400 payday loan and check cashing retail locations in Canada. During 2012, the branches in the United States extended approximately $30 billion in short-term credit to millions of middle-class households that experienced cash-flow shortfalls between paydays. As the branch count grew over the last decade, a greater number of Internet-based payday loan providers emerged. Industry analysts estimated that Internet-based payday loan providers extended approximately $18.6 billion to their customers during 2012. In the last few years, the rate of growth for these Internet providers has exceeded that of the branch-based lenders. We believe this trend will continue into the foreseeable future as consumers become more comfortable transacting electronically.

We believe our industry is highly fragmented, with the larger companies operating approximately 50% of the total industry branches. After a number of years of growth, the industry has contracted slightly in the past few years, primarily due to changes in laws that govern the payday product. Absent changes in regulations and laws, we do not expect significant fluctuations in the industry's number of branches in the foreseeable future.

The payday loan industry has followed, and continues to be significantly affected by, payday lending legislation and regulation in the various states and on a national level. We actively monitor and evaluate legislative and regulatory initiatives in each of the states and nationally, and are closely involved with the efforts of the Community Financial Services Association. To the extent that states enact legislation or regulations that negatively impacts payday lending, whether through preclusion, fee reduction or loan caps, our business has been adversely affected in the past and could be further adversely affected in the future. Over the past few years, legislatures in certain states (and voter initiatives in a few states) have enacted interest rate caps from 28% to 36% per annum on payday lending. A 36% per annum interest rate translates to approximately $1.38 per $100 loaned, which effectively precludes us from offering payday loans in those states unless other transaction fees may be charged to the customer.


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In the last several years, changes in laws governing payday loans have negatively affected our revenues and gross profit.

During 2009, payday loan-related legislation that severely restricts customer access to payday loans was passed in South Carolina, Washington, Virginia and Kentucky. These law changes adversely affected our revenues and operating income during 2010. During 2010, the results from the states in which we have experienced law changes were more negative than we expected, with revenue declines and loss rates exceeding our forecasts. For the year ended December 31, 2010, revenues and gross profit from South Carolina, Washington, Virginia and Kentucky declined by $14.1 million and $9.0 million, respectively, compared to the prior year. During 2011 and 2012, as a group, these states have generated modest profits and will not return to the level of profitability experienced prior to the customer restrictions, indicative of the challenges inherent with a transition to a new law and new products.

In Arizona, the existing payday lending law expired on June 30, 2010. While we are currently offering installment loans to our Arizona customers, our customers have not embraced this product as they did the payday loan product. For the year ended December 31, 2011, revenues and gross profit from our Arizona branches declined by $1.5 million and $1.4 million, respectively, from the prior year. Results in 2012 were slightly ahead of 2011, but we do not expect profitability to return to levels experienced prior to the expiration of the payday law.

In March 2011, a new payday law became effective in Illinois that imposes customer usage restrictions that will negatively affect revenues and profitability. This type of customer restriction, when passed in other states such as Washington, South Carolina and Kentucky, has resulted in a 30% to 60% decline in annual revenues and a more significant decline in gross profit, depending on the types of alternative products that competitors may offer within the state. The Illinois law provides for an overlap of the previous lending approach with loans issued under the new law for a period of one year, which extended the time period over which the negative effects of the new law occurred. During 2011, our revenues declined by $2.4 million and our gross profit declined by $2.2 million. During 2012, our revenues declined by $2.0 million and our gross profit declined by $1.8 million. We expect that revenues and gross profit in Illinois for 2013 will be similar to 2012.

There was an effort in Missouri to place a voter initiative on the statewide ballot in November 2012, which was intended to preclude any lending in the state with an annual rate over 36%. The supporters of the voter initiative did not submit a sufficient number of valid signatures to place the initiative on the ballot in November 2012. However, a similar initiative was submitted to the Missouri Secretary of State in December 2012 for inclusion on the November 2014 ballot subject to the proponents submitting the required number of valid signatures in support of the initiative. If this initiative is placed on the ballot in 2014 and the measure passes, we would be unable to operate our payday loan branches in Missouri and be forced to close those locations in the state.


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KEY DEVELOPMENTS

Sale of Auto Receivables. In December 2012, we completed two transactions involving $17.2 million principal amount of our automobile loans receivable. We received approximately $11.9 million in cash proceeds in exchange for relinquishing our right, title and interest in the automobile loans receivable. We are subject to recourse provisions requiring us to re-purchase certain automobile loans receivable in the event of a default. We used the net proceeds we received to make a prepayment of the term loan under our credit agreement.

With respect to the transfer of $17.2 million in automobile loans receivable, we treated $16.1 million of this amount as a sale and recognized a $2.6 million loss from the sale in the other income component of the Consolidated Statements of Income. We were unable to satisfy certain criteria for sale accounting treatment with respect to the transfer of $1.1 million in principal amount of automobile loans receivable. These transferred assets have been classified as collateralized receivables and the cash proceeds received (approximately $618,000) from the transfer of these automobile loans receivable have been classified as a secured borrowing in the consolidated balance sheets.

Direct Credit On September 30, 2011, we acquired 100% of the outstanding stock of Direct Credit, a British Columbia company engaged in short-term, consumer Internet lending in certain Canadian provinces. We paid an aggregate initial consideration of $12.4 million. We also agreed to pay a supplemental earn-out payment to the extent the EBITDA of Direct Credit's operations as specifically defined in the Stock Purchase Agreement (generally Direct Credit's earnings before interest, income taxes, depreciation and amortization expenses) exceeds a defined target for the twelve month period ending September 30, 2012. On the date of the acquisition, the estimated fair value of the earn-out liability was approximately $1.0 million, which was recorded as additional goodwill. In accordance with the stock purchase agreement, a supplemental earn-out payment was not required as Direct Credit's EBITDA for the 12 month period ended September 30, 2012 did not exceed the defined target. In 2012, the full amount of the earn out liability was eliminated as a gain (approximately $1.1 million) pursuant to accounting guidance. We believe the acquisition of Direct Credit broadens our product platform and distribution, as well as expands our presence by entering into international markets.

As part of our annual impairment testing performed as of December 31, 2012, we determined that the fair value of the E-Lending reporting unit in Canada did not exceed its carrying value. As a result, we recorded a $1.6 million non-cash impairment charge to goodwill during the year ended December 31, 2012.

Amended and Restated Credit Agreement. On September 30, 2011, we entered into an amended and restated credit agreement with a syndicate of banks to replace our prior credit agreement, which was previously amended on December 7, 2007. The prior credit agreement provided for a term loan of $50 million maturing December 2012 and a revolving line of credit (including provisions permitting the issuance of letters of credit and swingline loans) of up to $45.0 million. The current credit agreement provides for a term loan of $32 million and a revolving line of credit (including provisions permitting the issuance of letters of credit and swingline loans) in the aggregate principal amount of up to $27 million. See additional information in the Liquidity and Capital Resources discussion below.


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Closure of Branches. During 2012, we closed 24 of our lower performing branches in various states (which included four branches that were consolidated into nearby branches). In addition, we decided we would close 38 underperforming branches during first half of 2013. We recorded approximately $699,000 in pre-tax charges during 2012 associated with branch closures. The charges included a $398,000 loss for the disposition of fixed assets, $263,000 for lease terminations and other related occupancy costs and $38,000 for other costs. The charges recorded in 2012 do not include lease termination and severance costs associated with the 38 branches that are scheduled to close during first half of 2013 as notification to the landlords and employees occurred in January 2013.

During 2011, we closed 24 of our branches in various states (which included four branches that were consolidated into nearby branches) and sold one branch. We recorded approximately $553,000 in pre-tax charges during the year ended December 31, 2011 associated with these closures. The charges included a $283,000 loss for the disposition of fixed assets, $252,000 for lease terminations and other related occupancy costs and $18,000 for other costs.

During 2010, we closed 34 of our branches in various states and, as a result of the negative impact from changes in payday lending laws, we decided to close 21 branches in Arizona, Washington and South Carolina during first half 2011. During 2011, we closed 18 of the 21 branches and decided that the remaining three branches would remain open. We recorded approximately $1.8 million in pre-tax charges during the year ended December 31, 2010 associated with these closings. The charges included $916,000 representing the loss on the disposition of fixed assets, $671,000 for lease terminations and other related occupancy costs, $155,000 in severance and benefit costs and $33,000 for other costs.

Introduction of Alternative Loan Products. In 2012, we introduced new installment loan products (signature loans and auto equity loans) to meet high customer demand for longer-term loan options. These new products are higher-dollar and longer-term installment loans that are centrally underwritten and distributed through our existing branch network. The installment loans are payable in monthly installments (principal plus accrued interest) with terms ranging from 6 to 48 months, and all loans are pre-payable at any time without penalty. The fee for an installment loan varies based on the amount borrowed and the term of the loan. Signature loans are unsecured installment loans with a typical term of 6 to 36 months and a principal balance of up to $3,000. Fees and interest vary based on the size and term of the loan and whether the customer pays with cash/check or uses recurring ACH payments. During 2012, the average principal amount of a signature loan was $1,882 and the average term was 18 months. Auto equity loans are higher-dollar installment loans secured by the borrower's auto title with a typical term of 12 to 48 months and a principal balance of up to $15,000. Fees and interest vary based on the size and term of the loan. During 2012, the principal amount of an auto equity loan was $3,068 and the average term was 25 months.

In fourth quarter 2011, we re-introduced the open-end credit product with various key structural changes to our customers in a limited number of Virginia branches. The open-end credit product is similar to a credit card as the customer is granted a grace period of 25 days to repay the loan without incurring any interest. In addition, we are responsible for providing our customer with a monthly statement and we require the customer to make a monthly payment based on the outstanding balance. In addition to interest earned on the outstanding balance, the open-end credit product also includes a monthly membership fee.


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DISCUSSION OF CRITICAL ACCOUNTING POLICIES

Our consolidated financial statements and accompanying notes have been prepared in accordance with accounting principles generally accepted in the United States of America applied on a consistent basis. The preparation of these financial statements requires us to make a number of estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. We evaluate these estimates and assumptions on an ongoing basis. We base these estimates on the information currently available to us and on various other assumptions that we believe are reasonable under the circumstances. Actual results could vary materially from these estimates under different assumptions or conditions.

We believe that the following critical accounting policies affect the more significant estimates and assumptions used in the preparation of our financial statements.

Revenue Recognition

We record revenue from payday loans and title loans upon issuance. The term of a loan is generally two to three weeks for a payday loan and 30 days for a title loan. At the end of each month, we record an estimate of the unearned revenue, which results in revenues being recognized on a constant-yield basis ratably over the term of each loan.

We record revenues from installment loans using the simple interest method.

With respect to our CSO services in Texas, we earn a CSO fee for arranging for an unrelated third-party to make a loan to the consumer and for providing related services to the consumer, including a guarantee of the consumer's obligation to the third-party lender. We also service the loan for the lender. The CSO fee is recognized ratably over the term of the loan.

We recognize revenue (net of sales tax) from the sale of automobiles at the time the vehicle is delivered to the customer and title has passed. In cases where we finance the vehicles, we originate an installment sale contract and use the simple interest method to recognize interest.

With respect to our open-end product, we earn interest on the outstanding balance and the product also includes a monthly non-refundable membership fee.

Generally, we recognize revenue for our other consumer financial products and services, which includes check cashing, money transfers and money orders, at the time those services are rendered to the customer, which is generally at the point of sale.

Provision for Losses and Returned Item Policy

We record a provision for losses associated with uncollectible loans. For payday loans, all accrued fees, interest and outstanding principal are charged off on the date we receive a returned check, generally within 14 days after the due date of the loan. Accordingly, the majority of payday loans included in our loans receivable balance at any given point in time are typically not older than 30 days. These charge-offs are recorded as expense through the provision for losses. Any recoveries on losses previously charged to expense are recorded as a reduction to the provision for losses in the period recovered. With respect to title loans, no additional fees or interest are charged after the loan has defaulted, which generally occurs after attempts to contact the customer have been unsuccessful. Based on state regulations and operating procedures, we stop accruing interest on installment loans between 60 to 90 days after the last payment. On automotive loans, we stop accruing interest on 60 days after the last payment.

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