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PIONEER FINANCIAL SERVICES INC – 10-K – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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Overview
On a worldwide basis, we purchase consumer loans made exclusively to active-duty or career retired U.S. military personnel orU.S. Department of Defense employees. Our largest source of military loans is MBD, an affiliate who originates direct loans through a network of loan production offices and via the Internet; military personnel use these loan proceeds to purchase goods and services. We also purchase retail installment contracts from retail merchants that sell consumer goods to active-duty or retired career U.S. military personnel orU.S. Department of Defense employees. We plan to hold these military loans and retail installment contracts until repaid. Finance receivables, whether originated by MBD or purchased, are effectively unsecured and consist of loans previously originated by us or purchased from MBD and retail merchants. All finance receivables have fixed interest rates and typically have a maturity of less than 48 months. At acquisition, the size of the average finance receivable was approximately$3,500 during fiscal year 2011. A large portion of our customers are unable to obtain financing from traditional sources due to factors such as age, frequent relocations and lack of credit history. These factors may not allow them to build relationships with traditional sources of financing.
Improvement of our profitability is dependent upon the growth in amount of aggregate finance receivables we are able to acquire from MBD and retail merchants, as well as the maintenance of loan quality.
Sources of Income We generate revenues primarily from interest earned on the military loans purchased from MBD, loans previously originated by us and retail installment contracts purchased from retail merchants. We also earn revenues from our debt protection product and credit reinsurance premiums. For purposes of the following discussion, "revenues" means the sum of our finance income, debt protection income and reinsurance premiums. Interest income and fees. Interest income and fees consists of interest and origination revenue earned on the military loans and retail installment contracts we own (referred to throughout individually as "loan" or collectively as "loans" or "finance receivables"). Our interest revenue is based on the risk adjusted interest rates charged customers for loans that we purchase. Interest rates vary by loan and are based on many factors, including the overall degree of credit risk assumed and the interest rates allowed in the state where the loan is originated. Our finance income comprised approximately 93.5% of our total revenues in fiscal 2011. Non-interest income. Non-interest income consists of debt protection and reinsurance premium income. Prior to the second quarter of fiscal 2010, one of our wholly owned subsidiaries reinsured substantially all of the credit life, credit accident and health insurance sold by MBD on behalf ofAssurant , an unaffiliated insurance carrier. During the second quarter of fiscal 2010, MBD began offering a debt protection product to our customers. During the third quarter of fiscal 2010, our subsidiary ceased assuming the reinsurance policies. Credit reinsurance premiums and debt protection fee income comprised approximately 6.5% of our total revenues in fiscal 2011. Finance Receivables Our finance receivables are comprised of loans purchased from MBD (collectively referred to below as "military loans") and retail installment contracts. The following table sets forth certain information about the components of our finance receivables as of the end of the periods presented: 11 --------------------------------------------------------------------------------
Table of Contents As of and for the Year Ended September 30, 2011 2010 2009 (dollars in thousands, except average note balance and number of notes) Finance receivables: Total finance receivables balance $ 405,234 $ 387,041 $ 364,786 Average note balance $ 2,699 $ 2,533 $ 2,465 Total interest income and fees $ 114,121 $ 105,460 $ 99,690 Total number of notes 150,155 152,788 148,015 Military loans: Total military receivables $ 370,602 $ 344,108 $ 320,805 Percent of total finance receivables 91.45 % 88.91 % 87.94 % Average note balance $ 2,898 $ 2,700 $ 2,534 Number of notes 127,878 127,448 126,613 Retail installment contracts: Total retail installment contract receivables $ 34,632 $ 42,933 $ 43,981 Percent of total finance receivables 8.55 % 11.09 % 12.06 % Average note balance $ 1,555 $ 1,694 $ 2,055 Number of notes 22,277 25,340 21,402 In the normal course of business, we receive customer payments through the Federal Government Allotment System on the first day of each month. If the first day of the month falls on a weekend or holiday, our customer payments are posted on the last business day of the preceding month. OnSeptember 30, 2011 , we collected$14.1 million in customer loan payments in advance of the payment due date ofOctober 1, 2011 . This unapplied cash payment is reflected on the balance sheet as a reduction of "Net finance receivables" in the amount of$11.2 million and corresponding "Accrued interest receivable" in the amount of$2.9 million . The above table does not reflect theOctober 1, 2011 payment received onSeptember 30, 2011 . Net Interest Margin The principal component of our profitability is net interest margin, which is the difference between the interest earned on our finance receivables and the interest paid on borrowed funds. Some states and federal statutes regulate the interest rates that may be charged to our customers. In addition, competitive market conditions also impact the interest rates. Our interest expense is sensitive to general market interest rate fluctuations. These general market fluctuations directly impact our cost of funds. General inability to increase the interest rates earned on new and existing finance receivables restricts our ability to react to increases in cost of funds. Accordingly, increases in market interest rates generally will narrow interest rate spreads and lower profitability, while decreases in market interest rates generally will widen interest rate spreads and increase profitability. The following table presents a three-year history of data relating to our net interest margin as of and for the fiscal years presented. As of and for the Year Ended September 30, 2011 2010 2009 (dollars in thousands) Total finance receivables balance $ 405,234 $ 387,041 $ 364,786 Average total finance receivables (1) 396,999 369,261 349,480 Average interest bearing liabilities (1) 281,790 274,740 234,321 Total interest income and fees 114,121 105,460 99,690 Total interest expense 19,203 18,019 17,855
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(1) Averages are computed using month-end balances. 12
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Table of Contents Results of Operations
Year Ended
Total Finance Receivables. Our aggregate finance receivables increased 4.7% to$405.2 million onSeptember 30, 2011 from$387.0 million onSeptember 30, 2010 . We increased our loan acquisitions from MBD and retailers by 8.9% to$456.5 million during fiscal 2011 from$419.1 during fiscal 2010. Our aggregate average finance receivables also increased during this period to$397.0 million in fiscal 2011 from$369.3 million in fiscal 2010, an increase of$27.7 million or 7.5%. Total Interest Income and Fees. Total interest income and fees in fiscal 2011 represented 93.5% of our revenue compared to 94.4% in fiscal 2010. Interest income and fees increased to$114.1 million from$105.5 million in fiscal 2010, an increase of$8.6 million or 8.2%. This increase is primarily due to an increase in aggregate average finance receivables of 7.5%. Interest Expense. Interest expense in fiscal 2011 increased to$19.2 million from$18.0 million in fiscal 2010, an increase of$1.2 million or 6.7%. While our average interest bearing liabilities increased by$7.0 million or 2.6%, our weighted average interest rate on our amortizing note debt decreased to 6.19% in fiscal 2011 compared to 6.38% in fiscal 2010. We pay our lenders a minimum interest rate per annum of 5.00% for our revolving facility and 6.25% per annum for our amortizing notes. In addition, we pay our lenders a quarterly uncommitted availability fee in an amount equal to ten basis points multiplied by the average aggregate outstanding principal amount of all amortizing notes held by the lenders. We paid our lenders$0.6 million in uncommitted availability fees during fiscal 2011, the same as fiscal 2010. Also, during fiscal 2011, we paid off our parent note. Provision for Credit Losses. The provision for credit losses in fiscal 2011 increased to$25.6 million from$22.4 million in fiscal 2010, an increase of$3.2 million or 14.3%. This increase is due to an increase in our average finance receivables of$27.7 million or 7.5%. We also saw an increase in our net charge-offs as a percentage of our average total finance receivables to 6.21% in fiscal 2011 compared to 6.11% in fiscal 2010. With our consistent net charge-off ratio over the past three years we have reduced our allowance for credit losses as percent of average finance receivables for fiscal year 2011 to 6.40% compared to 6.63% in fiscal 2010. See further discussion in "Allowance for Credit Losses" section. Non-interest Income. Non-interest income consists of revenue from debt protection income and credit reinsurance premiums. Combined debt protection income and credit reinsurance premiums totaled$7.4 million in fiscal 2011 compared to$6.3 million in fiscal 2010, an increase of$1.1 million or 17.5%. The increase in non-interest income is related to the increase in our loan acquisitions from MBD of$37.4 million or 8.9% and partially due to continued development of the debt protection product. Non-interest Expenses. Non-interest expenses in fiscal 2011 increased to$48.1 million compared to$45.5 million in fiscal 2010, an increase of$2.6 million or 5.7%. The increase was primarily due to the increase in our management and record keeping services fees for the year. Management and record keeping services fees in fiscal 2011 increased by$2.5 million from fiscal 2010 due to a 7.5% increase in our average aggregate finance receivables. Provision for Income Taxes. Our effective tax rate ("ETR") was 40.3% in fiscal 2011, compared to 35.8% in fiscal 2010. The increase in the ETR in fiscal 2011 compared to 2010 was primarily due to the impact of state filings corrections for prior periods, a change in unitary state tax apportionment factors driven by a shift in business mix as a result of the mix product revenue, as well as the rate change to deferred tax assets for the change in apportionment factors. 13 --------------------------------------------------------------------------------
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Year Ended
Total Finance Receivables. Our aggregate finance receivables increased 6.1% to$387.0 million onSeptember 30, 2010 from$364.8 million onSeptember 30, 2009 . We increased our loan acquisitions from MBD and retailers by 6.7% during fiscal 2010 over the same period in fiscal 2009. Our aggregate average finance receivables also increased during this period to$369.3 million in fiscal 2010 from$349.5 million in fiscal 2009, an increase of$19.8 million or 5.7%. Total Interest Income and Fees. Total interest income and fees in fiscal 2010 represented 94.4% of our revenue compared to 94.7% in fiscal 2009. Interest income and fees increased to$105.5 million from$99.7 million in fiscal 2009, an increase of$5.8 million or 6.0%. This increase is primarily due to an increase in aggregate average finance receivables. Interest Expense. Interest expense in fiscal 2010 increased slightly to$18.0 million from$17.9 million in fiscal 2009, an increase of$0.1 million or 0.6%. While our average interest bearing liabilities increased by$6.9 million or 2.6%, our weighted average interest rate on our amortizing note debt decreased to 6.38% in fiscal 2010 compared to 6.54% in fiscal 2009. We pay our lenders a minimum interest rate per annum of 5.00% for our revolving facility and 6.25% per annum for our amortizing notes. In addition, we pay our lenders a quarterly uncommitted availability fee in an amount equal to ten basis points multiplied by the average aggregate outstanding principal amount of all amortizing notes held by the lenders. We paid our lenders$0.6 million in uncommitted availability fees during fiscal 2010 compared to$0.5 million in fiscal 2009. Also, during fiscal 2010, we converted our parent notes allowable under the SSLA from a term facility to revolving line of credit and began drawing on this line of credit. As ofSeptember 30, 2010 , we had subordinated parent debt to MCFC of$11.9 million with an interest rate of 5.0%. Provision for Credit Losses. The provision for credit losses in fiscal 2010 decreased to$22.4 million from$23.5 million in fiscal 2009, a decrease of$1.1 million or 4.7%. This decrease is primarily due to positive trends in net charge-offs and delinquency, as well as increased collection efforts in fiscal 2010. We also saw a decline in our net charge-offs as a percentage of our average total finance receivables to 6.11% in fiscal 2010 compared to 6.24% in fiscal 2009. See further discussion in "Allowance for Credit Losses" section.
Non-interest Income. Non-interest income consists of revenue from credit reinsurance premiums and debt protection income which replaced credit reinsurance in
Non-interest Expenses. Non-interest expenses in fiscal 2010 increased to$45.5 million compared to$42.0 million in fiscal 2009, an increase of$3.5 million or 8.3%. The increase was primarily due to the increase in our management and record keeping services fees for the year. Management and record keeping services fees in fiscal 2010 increased by$2.8 million from fiscal 2009 due to a 5.7% increase in our aggregate finance receivables. 14 --------------------------------------------------------------------------------
Table of Contents Delinquency Experience Our customers are required to make monthly payments of interest and principal. Our servicer, MBD, under our supervision, analyzes our delinquencies on a recency delinquency basis utilizing our guidelines. A loan is delinquent under the recency method when a full payment (95% or more of the contracted payment amount) has not been received for 30 days after the last full payment. We rarely grant extensions or deferments, or allow account revision, rewriting, renewal or rescheduling in order to bring otherwise delinquent accounts current. The increase in delinquency for fiscal 2011, when compared to fiscal 2010, is primarily due to the increase in repayments via electric funds transfer ("EFT"). A greater portion of our customers originating loans via MBD's internet origination channel have chosen the EFT system over the federal allotment system for making loan payments.
The following table sets forth the three-year history of our delinquency experience for accounts of which payments are 60 days or more past due.
As of and for the Year Ended 2011 2010 2009 (dollars in thousands) Total finance receivables $ 405,234 $ 387,041 $ 364,786 Total finance receivables balances 60 days or more past due $ 13,954 $ 11,857 $
10,837
Total finance receivables balances 60 days or more past due as a percent of total finance receivables 3.44 % 3.06 % 2.97 %
Credit Loss Experience and Provision for Credit Losses
General. The allowance for credit losses is maintained at an amount that management considers sufficient to cover estimated future losses. We utilize a statistical model based on potential credit risk trends incorporating both historical and prospective factors to estimate losses. These results and management's judgment are used to estimate future losses and in establishing the current provision and allowance for credit losses. These estimates are influenced by factors outside our control, such as economic conditions, current or future military deployments and completion of military service prior to repayment of loan. There is uncertainty inherent in these estimates, making it reasonably possible that they could change in the near term. See "Item 1A. Risk Factors-If a customer leaves the military prior to repaying loans, there is an increased risk loans will not be repaid." Military Loans. Our charge-off policy is based on an account-by-account review of delinquent receivables on a recency basis. Our primary sources of charge-offs occur when a customer leaves the military prior to repaying the finance receivable or is subject to longer term and more frequent deployments. Generally, loans purchased or originated by us are structured so that the entire amount is repaid prior to a customer's estimated separation from the military. When buying loans, however, we cannot predict when or whether a customer may depart from the military early. Accordingly, we cannot implement policies or procedures for MBD to follow to ensure that we will be repaid in full prior to a customer leaving the military; nor can we predict when a customer may be subject to deployment at a duration or frequency that causes a default on their loans. Another source of loss is when a customer declares bankruptcy. See "Item 7. - Nonperforming Assets." 15
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The following table shows a three-year historical picture of net charge-offs on military loans and net charge-offs as a percentage of military loans:
As of and for the Year Ended September 30, 2011 2010 2009 (dollars in thousands) Military loans: Military loans charged-off $ 26,349 $ 25,096 $ 24,279 Less recoveries 3,693 3,206 2,914 Net charge-offs $ 22,656 $ 21,890 $ 21,365 Average military receivables (1) $ 358,242 $ 322,995 $ 315,044 Percentage of net charge-offs to average military receivables 6.32 % 6.78 % 6.78 %
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(1) Averages are computed using month-end pro forma balances.
Retail Installment Contracts. Under many of our arrangements with retail merchants, we typically withhold a percentage (usually between five and ten percent) of the principal amount of the retail installment contract purchased. The amounts withheld from a particular retail merchant are recorded in a specific reserve account. As ofSeptember 30, 2011 , the aggregate amount of retail merchant reserves totaled$2.0 million , a decrease of$0.4 million or 20%, from the same period last year. The decrease is due to reduced acquisitions of retail installment contracts as well as increased utilization of the dealer reserve for non performing contracts. This represents a 5.2% reserve as a percentage of average retail installment contract receivables. Any losses incurred on the retail installment contracts purchased from that retail merchant are charged against its specific reserve account. Upon the retail merchant's request, and no more often than annually, we will pay the retail merchant the amount by which its specific reserve account exceeds 15% of the aggregate outstanding balance on all retail installment contracts purchased from them, less losses we have sustained, or reasonably could sustain, due to debtor defaults, collection expenses, delinquencies and breaches of our agreement with the retail merchant. Our allowance for credit losses is utilized to the extent that the loss on any individual retail installment contract exceeds the retail merchant's aggregate reserve account at the time of the loss. Currently, we have instances where we have extinguished all or a portion of two merchants' reserves and may sustain additional charge-offs as these merchants' portfolios liquidate. Due to the liquidation of merchant reserves, we have experienced greater net charge-offs on our retail installment contracts. The impact of potential future losses is deemed to be immaterial to the overall financial condition and results of operations of the Company. The following table shows a three-year historical picture of net charge-offs on retail installment contracts and net charge-offs as a percentage of retail installment contracts: As of and for the Year Ended September 30, 2011 2010 2009 (dollars in thousands) Retail installment contracts: Contracts charged-off $ 2,516 $ 1,127 $ 762 Less recoveries 506 459 312 Net charge-offs $ 2,010 $ 668 $ 450 Average retail installment contracts receivables (1) $ 38,757 $ 46,265 $ 34,436 Percentage of net charge-offs to average retail installment contracts receivable 5.19 % 1.44 % 1.31 %
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(1) Averages are computed using month-end pro forma balances.
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Allowance for Credit Losses. The following table sets forth the three-year history of our allowance for credit losses:
As of and for the Year Ended September 30, 2011 2010 2009 (dollars in thousands) Average total finance receivables (1) $ 396,999 $ 369,260 $ 349,480 Provision for credit losses $ 25,566 $ 22,433 $ 23,454 Net charge-offs $ 24,666 $ 22,558 $ 21,815 Net charge-offs as a percentage of average total finance receivables 6.21 % 6.11 % 6.24 % Allowance for credit losses $ 25,396 $ 24,496 $ 24,621 Allowance as a percentage of average total finance receivables 6.40 % 6.63 % 7.05 %
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(1) Averages are computed using month-end pro forma balances.
The allowance for credit losses in fiscal 2011 increased to
The following table sets forth the three year history of the components of our allowance for credit losses: As of and for the Year Ended September 30, 2011 2010 2009 (dollars in thousands) Balance, beginning of period $ 24,496 $ 24,621 $ 22,982
Finance receivables charged-off (28,865 ) (26,223 )
(25,041 ) Recoveries 4,199 3,665 3,226 Net charge-offs (24,666 ) (22,558 ) (21,815 ) Provision for credit losses 25,566 22,433 23,454 Balance, end of period $ 25,396 $ 24,496 $ 24,621 Nonperforming Assets The accrual of interest income is suspended when a full payment has not been received for 90 days or more, and the interest due exceeds an amount equal to 60 days of interest charges. The accrual is resumed when a full payment (95% or more of the contracted payment amount) is received. Nonperforming assets represent those finance receivables on which both the accrual of interest income has been suspended and for which no full payment of principal or interest has been received for more than 90 days. 17 --------------------------------------------------------------------------------
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Loan Acquisition / Origination
Asset growth is an important factor in determining our future revenues. We are dependent upon MBD and retail merchants to increase their originations for our future growth. In connection with purchasing the loans, we pay MBD a fee in the amount of$30.00 for each military consumer loan originated by MBD and purchased by us. This fee is adjusted annually on the basis of the annual increase or decrease in MBD's deferred acquisition cost analysis. For fiscal 2011, loans purchased from MBD and retail merchants increased to$456.5 million from$419.1 million in fiscal 2010, an increase of$37.4 million or 8.9%. The primary reason for this increase is because the average note amount, at acquisition, increased by$192 The following table sets forth the three-year history of overall loan acquisitions / originations and lending activities:
For the Year Ended September 30, 2011 2010 2009 (dollars in thousands) Total loans acquired/originated: Gross balance $ 456,476 $ 419,098 $395,768
Number of finance receivable notes 129,899 126,141 129,120 Average note amount $ 3,514 $ 3,322 $ 3,065 Military loans: Gross balance $ 425,588 $ 379,702 $ 348,984 Number of finance receivable notes 116,834 110,913 111,664 Average note amount $ 3,643 $ 3,423 $ 3,125 Retail installment contracts: Gross balance $ 30,888 $ 39,396 $ 46,784Number of finance receivable notes 13,065 15,228 17,456 Average note amount
$ 2,364 $ 2,587 $ 2,680Liquidity and Capital Resources
A relatively high ratio of borrowings to invested capital is customary in the consumer finance industry. Our principal use of cash is to purchase military loans and retail installment contracts. We use borrowings to fund the difference, if any, between the cash used to purchase military loans and retail installment contracts and operations, and the cash generated from loan repayments and operations. Cash used in investing activities in fiscal 2011 was approximately$27.9 million and cash used in financing activities was$20.6 million which was funded from operating activities of$47.8 million . Cash used in investing activities in fiscal 2010 was approximately$41.6 million and cash used in financing activities was$3.5 million which was funded from$43.8 million of cash from operating activities. The majority of our liquidity requirements are secured by our funding through our SSLA. Additional sources of funds are generated through our sales of investment notes and borrowings with our parent. We have increased our liquidity position this fiscal year with additional senior funding of$54.0 million under the SSLA. In addition, we must repay borrowings of$14.9 million from withdrawing banks who had previously participated in the SLA. Further, we have increased our investment notes to$59.7 million in 2011 from$40.0 million in 2010, an increase of$19.7 million or 49.3%. During 2011, we repaid$13.9 million in subordinated borrowings from our parent. As ofSeptember 30, 2011 , the outstanding balance on the parent debt was zero. This increase in available funds has offset the diminished capacity from our withdrawing banks and provided us with additional liquidity in fiscal 2011 and beyond, allowing us the liquidity necessary to grow our finance receivables. We plan to continue to attract new banks to the SSLA and sell additional investment notes to fund our growth in fiscal 2012. 18--------------------------------------------------------------------------------Table of Contents
Senior Indebtedness-Bank Debt.
OnJune 12, 2009 , we entered into the SSLA with the lenders listed on the SSLA ("the lenders") andUMB Bank, N.A. (the "Agent"). The SSLA replaces and supersedes the Senior Lending Agreement, dated as ofJune 9, 1993 , as subsequently amended and restated (the "SLA"). The term of the current SSLA ends onMarch 31, 2012 and is automatically extended annually unless any lender gives written notice of its objection byMarch 1 of each calendar year. Our assets secure the loans extended under the SSLA for the benefit of the lenders and other holders of the notes issued pursuant to the SSLA or the SLA (the "Senior Debt"). The facility is an uncommitted facility that provides common terms and conditions pursuant to which the individual lenders that are a party to the SSLA may choose to make loans to us in the future. Any lender may elect not to participate in any future fundings at any time without penalty. As ofSeptember 30, 2011 , we could request up to$102.7 million in additional funds and remain in compliance with the terms of the SSLA. No lender, however, has any contractual obligation to lend us these additional funds. As ofSeptember 30, 2011 , the lenders have indicated a willingness to participate in fundings up to an aggregate of$319.2 million during the next 12 months, including$214.5 million which is currently outstanding. In addition, we have borrowings of$14.9 million which need to be repaid from withdrawing banks who had previously participated in the SLA. The aggregate notional balance outstanding under amortizing notes was$214.5 million and$210.7 million atSeptember 30, 2011 and 2010, respectively. Interest on the amortizing notes is fixed at 270 basis points over the 90-day moving average of like-term treasury notes when issued. The interest rate for notes created afterJune 12, 2009 may not be less than 6.25%; prior toJune 12, 2009 the interest rate was variable. All amortizing notes have terms not to exceed 48 months, payable in equal monthly principal and interest payments. There were 370 and 338 amortizing term notes outstanding atSeptember 30, 2011 and 2010, respectively, with a weighted-average interest rate of 6.19% and 6.39%, respectively. In addition, we are paying our lenders a quarterly uncommitted availability fee in an amount equal to ten basis points multiplied by the average aggregate outstanding principal amount of all amortizing notes held by the lenders. We paid our lenders$0.6 million in uncommitted availability fees for fiscal 2011 and 2010. Advances outstanding under the revolving credit line were zero and$21.4 million atSeptember 30, 2011 and 2010, respectively. When a lender elects not to participate in future fundings, any existing borrowings from that lender under the revolving credit line are payable in 12 equal monthly installments. Interest on borrowings under the revolving credit line is payable monthly and is based on prime or 5.00%, whichever is greater. Interest on borrowings was 5.00% atSeptember 30, 2011 and 2010, respectively. Substantially all of our assets secure this debt under the SSLA. The SSLA also limits, among other things, our ability to (1) incur additional debt from the lenders beyond that allowed by specific financial ratios and tests, (2) borrow or incur other additional debt except as permitted in the SSLA, (3) pledge assets, (4) pay dividends, (5) consummate certain asset sales and dispositions, (6) merge, consolidate or enter into a business combination with any other person, (7) pay fees to MCFC each year except as provided in the SSLA, (8) purchase, redeem, retire or otherwise acquire any of our outstanding equity interests, (9) issue additional equity interests, (10) guarantee the debt of others without reasonable compensation and only in the ordinary course of business or (11) enter into agreements with our affiliates. Under the SSLA, we are subject to certain financial covenants that require that we, among other things, maintain specific financial ratios and satisfy certain financial tests. In part, these covenants require us to: (1) maintain an allowance for credit losses equal to or greater than the allowance for credit losses shown on our audited financial statements as of the end of our most recent fiscal year and at no time less than 5.25% of our consolidated net receivables, unless otherwise required by GAAP, (2) limit our senior indebtedness as of the end of each quarter to not greater than four times our tangible net worth, (3) maintain a positive net income in each fiscal year, (4) limit our senior indebtedness as of the end of each quarter to not greater than 80% of our consolidated receivables, and (5) maintain a consolidated total required capital of at least$75 million plus 50% of the cumulative positive net income earned by us during each of our fiscal years ending afterSeptember 30, 2008 , which is approximately$98.5 million as ofSeptember 30, 2011 . Any part of the 50% of positive net income not distributed by us as a dividend for any fiscal year within 120 days after the last day of such fiscal year must be added to our consolidated total required capital and may not be distributed as a dividend or otherwise. No part of the consolidated total required may be distributed as a dividend. We may not make any payment to MCFC in any fiscal year for services performed or reasonable expenses incurred in an aggregate amount greater than$750,000 plus reimbursable expenses in 2011 compared to$735,000 in 2010. Such amount may be increased on each anniversary of the SSLA by the percentage increase in the CPI published by theUnited States Bureau of Labor for the calendar year than most recently ended. The breach of any of these covenants could result in a 19 --------------------------------------------------------------------------------Table of Contents
default under the SSLA, in which event the lenders could seek to declare all amounts outstanding to be immediately due and payable. As of
September 30, 2011 , we were in compliance with all loan covenants.Once an event of default has occurred, the Agent has the right, on behalf of all holders of the Senior Debt, to immediately take possession and control of the collateral. When the Agent notifies us of an event of default, the interest rate on all Senior Debt will automatically increase to a default rate equal to 2% above the interest rate otherwise payable on such Senior Debt. The default rate will remain in effect so long as any event of default has not been cured. In connection with the execution of the SSLA, MCFC entered into an Unlimited Continuing Guaranty. MCFC guaranteed the Senior Debt and accrued interest in accordance with the terms of the Unlimited Continuing Guaranty. Under the Unlimited Continuing Guarantee, MCFC also agreed to indemnify the lenders and the Agent for all reasonable costs and expenses (including reasonable fees of counsel) incurred by the lenders or the Agent for payments made under the Senior Debt that are rescinded or must be repaid by lenders to us. If MCFC is required to satisfy any of borrowers' obligations under the Senior Debt, the lenders and the Agent will assign without recourse the related Senior Debt to MCFC. Concurrently, in connection with the execution of the SSLA, MCFC entered into a Negative Pledge Agreement in favor of the Agent. Under the Negative Pledge Agreement, MCFC represented that it will not pledge, sell, assign or transfer its ownership of all or any part of the issued and outstanding capital stock of PFS and will not otherwise or further encumber any of such capital stock beyond the currently existing negative pledge thereof in favor ofBranch Banking and Trust Company , aNorth Carolina banking corporation headquartered inWinston-Salem, North Carolina ("BB&T"). Once the pledge of the capital stock of PFS toBB&T is terminated, MCFC will pledge all of its capital stock in PFS to the Agent for the benefit of the lenders to secure payment of all Senior Debt. In the third quarter of fiscal 2010, we amended the SSLA to allow additional banks to become parties to the SSLA under a modified non-voting role. We have identified each lender that has voting rights under the SSLA as "voting bank(s)" and lenders that do not have voting rights under the SSLA, as "non-voting bank(s)". While all voting and non-voting banks have the same rights to the collateral and are party to the same terms and conditions of the SSLA, all of the non-voting banks acknowledge and agree that they have no right to vote on any matter nor to prohibit or hinder any action by us, or the voting banks.As
of
September 30, 2011 , we had 22 non-voting banks from which we initially borrowed$44.5 million compared to 10 non-voting banks and initial borrowings of$19.8 as ofSeptember 30, 2010 . The amortized balance of these notes as ofSeptember 30, 2011 and 2010 was$36.8 million and$19.4 million , respectively.20 --------------------------------------------------------------------------------Table of Contents
The following table sets forth a three-year history of the total borrowings and availability under the SSLA and the former Senior Lending Agreement:
As of and for the Year Ended September 30, Actual Pro forma (1) September 30, September 30, September 30, September 30, 2011 2011 2010 2009 Revolving credit line: Total facility $ 40,000 $ 40,000 $ 30,500 $ 32,500 Balance at end of period - 14,100 21,373 20,770 Maximum available credit (2) 40,000 25,900 9,127 11,730 Term notes (3): Voting banks $ 227,500 $ 227,500 $ 183,000 $ 183,726 Withdrawing banks 14,852 14,852 34,314 53,162 Non-voting banks 36,823 36,823 19,391 - Total facility $ 279,175 $ 279,175 $ 236,705 $ 236,888 Balance at end of period 214,491 214,491 210,668 221,187 Maximum available credit (2) 64,684 64,684 26,037 16,098 Total revolving and term notes(3): Voting banks $ 267,500 $ 267,500 $ 213,500 $ 216,226 Withdrawing banks 14,852 14,852 34,314 53,162 Non-voting banks 36,823 36,823 19,391 - Total facility $ 319,175 $ 319,175 $ 267,205 $ 269,388 Balance at end of period 214,491 228,591 232,041 241,957 Maximum available credit (2) 102,714 90,584 35,164 27,431 Credit facility available (4) 104,684 90,584 35,164 27,828 Percent utilization of voting banks 61.60 % 66.14 % 83.53 % 87.31 % Percent utilization of the total facility 67.20 % 71.62 % 86.84 % 89.67 %--------------------------------------------------------------------------------
(1) Total facility pro forma assumes the early allotment payments received
September 30, 2011 that were dueOctober 1, 2011 .(2) Maximum available credit assumes proceeds in excess of the amounts shown below under "Credit facility available" are used to increase qualifying finance receivables and all terms of the SSLA are met, including maintaining a senior indebtedness to consolidated net receivable ratio of not more than 80.0%. (3) Includes 48-month amortizing term notes.(4) Credit available is based on the existing asset borrowing base and maintaining a senior indebtedness to consolidated net notes receivable ratio of not more than 80%. Does not include withdrawing banks.
21 --------------------------------------------------------------------------------Table of Contents Subordinated Debt - Parent. In the second quarter of fiscal 2010, we amended our SSLA to convert the parent note from a term facility to a revolving line of credit. Funding on this line of credit is provided as needed at our discretion and dependent upon the availability of our parent with a maximum principal balance of$25.0 million . Interest is payable monthly and is based on prime or 5.0%, whichever is greater. As ofSeptember 30, 2011 , the outstanding balance under this facility was zero. Investment Notes. We fund certain capital and financial needs through the sale of investment notes. These notes have varying fixed interest rates and are subordinate to all senior indebtedness. We can redeem these notes at any time upon 30 days' written notice. OnJanuary 28, 2011 , the Securities and Exchange Commission ("SEC") declared effective our registration statement on Form S-1 (Amendment No. 1) registering$50 million of investment notes. We filed our final prospectus and prospectus supplement containing certain pricing information onJanuary 31 , 2011andFebruary 1, 2011 respectively. We began offering these investment notes onFebruary 2, 2011 . As ofSeptember 30, 2011 , we had outstanding$59.7 million (with accrued interest), of which$7.6 million is from our recent offering. The amount includes a$0.4 million purchase adjustment relating to fair value adjustments recorded as part of the Transaction. These notes had a weighted average interest rate of 9.12% as ofSeptember 30, 2011 . Dividends From Subsidiaries. Our reinsurance subsidiary is subject to the laws and regulations of the state ofNevada which limit the amount of dividends our reinsurance subsidiary can pay to us and require us to maintain a certain capital structure. In the past, these regulations have not had a material impact on our reinsurance subsidiary or its ability to pay dividends to us.We
do not expect these regulations will have a material impact on our business or the business of our reinsurance subsidiary in the future.
Impact of Inflation and General Economic Conditions
Although inflation has not had a material adverse effect on our financial condition or results of operations, increases in the inflation rate generally are associated with increased interest rates. A significant and sustained increase in interest rates could unfavorably impact our profitability by reducing the interest rate spread between the rate of interest we receive on military loans and retail installment contracts and interest rates paid under our SSLA and investment notes. Inflation also may negatively affect our operating expenses. With the ongoing strains in the financial markets, we see liquidity, capital and earnings challenges for some lenders in our credit group which may reduce their ability to participate in the credit or may cause a decrease in their willingness to lend at the current levels. In addition, we have borrowings of$14.9 million from withdrawing banks who previously participated in the SLA. See "Liquidity and Capital Resources."Critical Accounting Policies
General. Our accounting and reporting policies are in accordance with GAAP and conform to general practices within the finance company industry. The significant accounting policies used in the preparation of the consolidated financial statements are discussed in Note 1 to the Consolidated Financial Statements. Critical accounting policies require management to make estimates and assumptions, which affect the reported amounts of assets, liabilities, income and expenses. As a result, changes in these estimates and assumptions could significantly affect our financial position and results of operations. Allowance for Credit Losses and Provision for Credit Losses. We consider our policy regarding the allowance and resulting provision for credit losses to be our most important accounting policy due to the significant degree of management judgment applied in establishing the allowance and the provision.We utilize a statistical model which incorporates both historical and prospective estimates to better forecast probable losses or credit risk trends to determine the appropriate amount of allowance for credit losses.
We evaluate the finance receivable portfolio quarterly. Our portfolio consists of a large number of relatively small, homogenous accounts. No account is large enough to warrant individual evaluation for impairment. We consider numerous qualitative and quantitative factors in estimating losses in our finance receivable portfolio, including the following: † Prior credit losses and recovery experience † Current economic conditions † Current finance receivable delinquency trends † Demographics of the current finance receivable portfolio 22--------------------------------------------------------------------------------Table of Contents
We also use several ratios to aid in the process of evaluating prior finance receivable loss and delinquency experience. Each ratio is useful, but each has its limitations. These ratios include:† Delinquency ratio - finance receivables 60 days or more past due as a percentage of finance receivables
† Allowance ratio - allowance for finance receivable losses as a percentage of finance receivables
† Charge-off ratio - net charge-offs as a percentage of the average of finance receivables at the beginning of each month during the period
† Charge-off coverage - allowance for finance receivable losses to net charge-offs
In addition to these models, we exercise our judgment, based on our experience in the consumer finance industry, when determining the amount of the allowance credit losses. We consider this estimate to be a critical accounting estimate that affects its net income in total and the pretax operating income of our business. See "Item 7. Management Discussion and Analysis of Financial Conditions and Results of Operations-Credit Loss Experience and Provision for Credit Losses." Goodwill and Other Intangible Assets. Goodwill represents the cost in excess of the fair value of net assets acquired (including identifiable intangibles) in transactions accounted for as purchases. Other intangible assets represent other identifiable assets. Goodwill is not amortized over an estimated useful life, but rather tested at least annually for impairment. Intangible assets other than goodwill, which are determined to have finite lives, continue to be amortized on straight-line or accelerated bases over their estimated useful lives. Recoverability of these assets is assessed only when events have occurred that may give rise to impairment. The provisions of Accounting Standard Codification ("ASC") 350 require that a two-step impairment test be performed on goodwill. We have one reporting unit. In the first step, we compare the fair value of our reporting unit to its carrying value. If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to the reporting unit, goodwill is not considered impaired and we are not required to perform further testing. If the carrying value of the net assets assigned to the reporting unit exceeds the fair value of the reporting unit, then we must perform the second step of the impairment test in order to determine the implied fair value of the reporting unit's goodwill. If upon completing the second step of the impairment test the carrying value of a reporting unit's goodwill exceeds its implied fair value, then we would record an impairment loss equal to the difference. The fair value of our reporting unit was determined using the income approach and the market approach. The income approach is a valuation technique whereby we calculate the fair value the reporting unit based on the present value of estimated future cash flows, which are formed by evaluating historical trends, current budgets, operating plans and industry data. The market approach is a valuation technique whereby we calculate the fair value the reporting unit by comparing it to publicly traded companies in similar lines of business or to comparable transactions or assets. Management evaluated our goodwill atSeptember 30, 2011 , and determined that there was no impairment as the estimated fair value substantially exceeded the carrying value. 23--------------------------------------------------------------------------------Table of Contents Contractual Obligations We have the following payment obligations under current financing arrangements as ofSeptember 30, 2011 : Payments Due By Period Less thanContractual obligations: Total 1 year 1-3 years 4-5 years After 5 years Debt
$ 273,833 $ 104,564 $ 145,085 $ 13,421 $ 10,763 Interest on Debt (1) 18,690 6,818 9,666 1,224 982 Total contractual cash obligations $ 292,523 $ 111,382 $ 154,751 $ 14,645 $ 11,745-------------------------------------------------------------------------------- (1) Interest on long term debt is calculated using the weighted average interest rate of 6.19% for amortizing term notes and 9.12% for investment notes as ofSeptember 30, 2011 . Amount ofCommitment Expiration Per Period
Total Amounts Less thanOther commercial commitments: Committed 1 year 1-3 years
4-5 years Over 5 years Lines of credit $ - $ - $ - $ - $ - Interest on lines of credit - - - - - Total lines of credit $ - $ - $ - $ - $ ---------------------------------------------------------------------------------
(1) Interest on lines of credit is calculated using the fixed rate of 5.00% as of
September 30, 2011 .24 --------------------------------------------------------------------------------Table of Contents
Impact of New and Emerging Accounting Pronouncements Not Yet Adopted
The FASB recently issued Accounting Standards Update ("ASU") 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in GAAP and International Financial Reporting Standards ("IFRS"), to substantially converge the guidance in GAAP and IFRS on fair value measurements and disclosures.The amended guidance changes several aspects of the fair value measurement guidance in FASB ASC 820, Fair Value Measurement, including the following provisions:
† Application of the concepts of highest and best use and valuation premise
† Introduction of an option to measure groups of offsetting assets and liabilities on a net basis
† Incorporation of certain premiums and discounts in fair value measurements
† Measurement of the fair value of certain instruments classified in shareholders' equity
In addition, the amended guidance includes several new fair value disclosure requirements, including, among other things, information about valuation techniques and unobservable inputs used in Level 3 fair value measurements and a narrative description of Level 3 measurements' sensitivity to changes in unobservable inputs. Some of the new disclosures are not required for nonpublic entities.The amended guidance must be applied prospectively and is effective for all entities in 2012.
The FASB recently issued ASU 2011-05 which amends ASC 220 Financial reporting of other comprehensive income for public and private companies. The objective is to improve consistency and transparency of items reported in other comprehensive income by reporting changes in stockholder's equity in a single continuous statement of comprehensive income or in two separate, but consecutive statements. As it pertains to PFS, other comprehensive income will be removed from Statement of Stockholder's Equity and reported as one of these statement types. InSeptember 2011 , the FASB issued ASU 2011-08, Testing Goodwill for Impairment ("ASU 2011-08"). The amendments in ASU 2011-08 will allow an entity to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. Under these amendments, an entity would not be required to calculate the fair value of a reporting unit unless the entity determines, based on a qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. The amendments include a number of events and circumstances for an entity to consider in conducting the qualitative assessment. ASU 2011-08 is effective for annual and interim goodwill impairment tests performed for fiscal years beginning afterDecember 15, 2011 . Early adoption is permitted. We are currently evaluating the impact of ASU 2011-08 on our goodwill impairment testing process.Pioneer will comply with these changes in fiscal year 2012.
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