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COPART INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) CAUTION REGARDING FORWARD-LOOKING STATEMENTS This Annual Report on Form 10-K for the fiscal year ended July 31, 2014, or this Form 10-K, including the information incorporated by reference herein, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the Securities Act), and Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act). In some cases, you can identify forward-looking statements by terms such as "may," "will," "should," "expect," "plan," "intend," "forecast," "anticipate," "believe," "estimate," "predict," "potential," "continue" or the negative of these terms or other comparable terminology. The forward-looking statements contained in this Form 10-K involve known and unknown risks, uncertainties and situations that may cause our or our industry's actual results, level of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these statements. These forward-looking statements are made in reliance upon the safe harbor provision of the Private Securities Litigation Reform Act of 1995. These factors include those listed in Part I, Item 1A under the caption entitled "Risk Factors" in this Form 10-K and those discussed elsewhere in this Form 10-K. Unless the context otherwise requires, references in this Form 10-K to "Copart," the "Company," "we," "us," or "our" refer to Copart, Inc. We encourage investors to review these factors carefully together with the other matters referred to herein, as well as in the other documents we file with the Securities and Exchange Commission (the SEC). We may from time to time make additional written and oral forward-looking statements, including statements contained in our filings with the SEC. We do not undertake to update any forward-looking statement that may be made from time to time by or on behalf of us. All references to numbered Notes are to specific Notes to our Consolidated Financial Statements included in this Annual Report on Form 10-K and which descriptions are incorporated into the applicable response by reference. Capitalized terms used, but not defined, in this Management's Discussion and Analysis of Financial Condition and Results of Operation ("MD&A") have the same meanings as in such Notes. Overview We are a leading provider of online auctions and vehicle remarketing services in the United States (U.S.), Canada, the United Kingdom (U.K.) and Brazil. We also provide vehicle remarketing services in the United Arab Emirates (U.A.E.), Germany and Spain. We provide vehicle sellers with a full range of services to process and sell vehicles primarily over the Internet through our Virtual Bidding Third Generation Internet auction-style sales technology, which we refer to as VB3. Vehicle sellers consist primarily of insurance companies, but also include banks and financial institutions, charities, car dealerships, fleet operators and vehicle rental companies. We sell the vehicles principally to licensed vehicle dismantlers, rebuilders, repair licensees, used vehicle dealers and exporters and, at certain locations, to the general public. The majority of the vehicles sold on behalf of insurance companies are either damaged vehicles deemed a total loss or not economically repairable by the insurance companies, or are recovered stolen vehicles for which an insurance settlement with the vehicle owner has already been made. We offer vehicle sellers a full range of services that expedite each stage of the vehicle sales process, minimize administrative and processing costs, and maximize the ultimate sales price. In the U.S. and Canada (North America), Brazil and the U.A.E., we sell vehicles primarily as an agent and derive revenue primarily from fees paid by vehicle sellers and vehicle buyers, as well as related fees for services such as towing and storage. In the U.K., we operate both on a principal basis, purchasing the salvage vehicles outright from the insurance companies and reselling the vehicles for our own account, and as an agent. In Germany and Spain, we derive revenue from sales listing fees for listing vehicles on behalf of many insurance companies. 34 -------------------------------------------------------------------------------- We monitor and analyze a number of key financial performance indicators in order to manage our business and evaluate our financial and operating performance. Such indicators include: Service and Vehicle Sales Revenue: Our revenue consists of sales transaction fees charged to vehicle sellers and vehicle buyers, transportation revenue, purchased vehicle revenues, and other remarketing services. Revenues from sellers are generally generated either on a fixed fee contract basis, where we collect a fixed amount for selling each vehicle regardless of the selling price of the vehicle or under our Percentage Incentive Program (PIP), where our fees are generally based on a predetermined percentage of the vehicle sales price. Under the consignment or fixed fee program, we generally charge an additional fee for title processing and special preparation. We may also charge additional fees for the cost of transporting the vehicle to our facility, storage of the vehicle, and other incidental costs included in the consignment fee. Under the consignment program, only the fees associated with vehicle processing are recorded in revenue, not the actual sales price (gross proceeds). Sales transaction fees also include fees charged to vehicle buyers for purchasing vehicles, storage, loading, and annual registration. Transportation revenue includes charges to sellers for towing vehicles under certain contracts and towing charges assessed to buyers for delivering vehicles. Purchased vehicle revenue includes the gross sales price of the vehicle, which we have purchased or are otherwise considered to own and is primarily generated in the U.K. We have certain contracts with insurance companies in which we act as a principal, purchasing vehicles and reselling them for our own account. We also purchase vehicles in the open market, primarily from individuals and resell them for our own account. Our revenue is impacted by changes in salvage frequency. Salvage frequency is the percentage of cars involved in accidents which insurance companies salvage rather than repair and is driven by the relationship between repairs costs, used car values, and auction returns. Over the last several years, we believe there has been an increase in overall growth in the salvage market driven by an increase in salvage frequency. The increase in salvage frequency may have been driven by the decline in used car values relative to repair costs. Conversely, increases in used car prices, such as occurred during the most recent recession may decrease salvage frequency and adversely affect our growth rate. Used car values are determined by many factors, including the used car supply, which is tied directly to new car sales, and the average age of cars on the road. New cars sales grew on a year over year basis increasing the supply of used cars. Additionally, the average age of cars on the road continued to increase, growing from 9.6 years in 2002 to 11.4 years in 2014. These factors, among others, have led to a general decline in used car values while repair costs are generally trending upward. The factors that influence repair costs, used car pricing, and auction returns are many and varied and we cannot predict their movements. Accordingly, we cannot predict future trends in salvage frequency. Operating Costs and Expenses:Yard operations consists primarily of operating personnel (which includes yard management, clerical and yard employees), rent, contract vehicle towing, insurance, fuel, equipment maintenance and repair, and costs of vehicles sold under the purchase contracts. General and administrative expenses consist primarily of executive management, accounting, data processing, sales personnel, human resources, professional fees, research and development, and marketing expenses. Other Income and Expense: Other income primarily includes income from the rental of certain real property, foreign exchange rate gains and losses, and gains and losses from the disposal of assets, which will fluctuate based on the nature of these activities each period. Other expense consists primarily of interest expense on long-term debt. See Notes to Consolidated Financial Statements, Note 8 - Long-Term Debt. Liquidity and Cash Flows: Our primary source of working capital is cash operating results. The primary source of our liquidity is our cash and cash equivalents. The primary factors affecting cash operating results are: (i) seasonality; (ii) market wins and losses; (iii) supplier mix; (iv) accident frequency; (v) salvage frequency; (vi) increased volume from our existing suppliers; (vii) commodity pricing; (viii) used car pricing; (ix) foreign currency exchange rates; (x) product mix; and (xi) contract mix to the extent appropriate. These factors are further discussed in the Results of Operations and Risk Factors sections of this Annual Report on Form 10-K. 35 -------------------------------------------------------------------------------- Potential internal sources of additional working capital are the sale of assets or the issuance of equity through option exercises and shares issued under our Employee Stock Purchase Plan. A potential external source of additional working capital is the issuance of debt and equity; however, we cannot predict if these sources will be available in the future and, if available, if they can be issued under terms commercially acceptable to us. Acquisitions and New Operations As part of our overall expansion strategy of offering integrated services to vehicle sellers, we anticipate acquiring and developing facilities in new regions, as well as the regions currently served by our facilities. We believe that these acquisitions and openings strengthen our coverage, as we have facilities located in North America, the U.K., the U.A.E., Germany, Spain and Brazil, and are able to provide national coverage for our sellers. All of these acquisitions have been accounted for using the purchase method of accounting. The following table sets forth facilities that we have acquired or opened from August 1, 2011 through July 31, 2014: Locations Acquisition or Greenfield Date Geographic Service Area -------------------------------- ----------------------------- --------------------- -------------------------- Atlanta, Georgia Greenfield August 2011 United States Burlington, North Carolina Greenfield July 2012 United States Webster New Hampshire Greenfield September 2012 United States Gainesville, Georgia Acquisition May 2013 United States Davison, Michigan Acquisition May 2013 United States Ionia, Michigan Acquisition May 2013 United States Kincheloe, Michigan Acquisition May 2013 United States Salvage Parent, Inc.* Acquisition May 2013 United States Seaford, Delaware Greenfield July 2014 United States Edmonton, Canada Acquisition May 2012 Canada Calgary, Canada Acquisition May 2012 Canada Montreal, Canada Acquisition November 2013 Canada Dubai, U.A.E. Acquisition August 2012 United Arab Emirates Embu, Brazil Acquisition November 2012 Brazil Pirapora, Brazil Acquisition November 2012 Brazil Osasco, Brazil Acquisition November 2012 Brazil Castelo Branco, Brazil Acquisition November 2012 Brazil Vila Jaguara, Brazil Acquisition November 2012 Brazil Itaquaquecetuba, Brazil Greenfield January 2014 Brazil Ettlingen, Germany Acquisition November 2012 Germany Cordoba, Spain Acquisition June 2013 Spain -------------------------------------------------------------------------------- * Salvage Parent, Inc. conducts business primarily as Quad City Salvage Auction, Crashed Toys, and Desert View Auto Auctions. The period-to-period comparability of our consolidated operating results and financial position is affected by business acquisitions, new openings, weather and product introductions during such periods. In particular, we have certain contracts inherited through our U.K. acquisitions that require us to act as a principal, purchasing vehicles from the insurance companies and reselling them for our own account. It is our intention, where possible, to migrate these contracts to the agency model in future periods. Changes in the amount of revenue derived in a period from principal transactions relative to total revenue will impact revenue growth and margin percentages. In addition to growth through business acquisitions, we seek to increase revenues and profitability by, among other things, (i) acquiring and developing additional vehicle storage facilities in key markets; 36 -------------------------------------------------------------------------------- (ii) pursuing national and regional vehicle seller agreements; (iii) increasing our service offerings to sellers and members; and (iv) expanding the application of VB3 into new markets. In addition, we implement our pricing structure and auction procedures, and attempt to introduce cost efficiencies at each of our acquired facilities by implementing our operational procedures, integrating our management information systems, and redeploying personnel, when necessary. Results of Operations The following table shows certain data from our consolidated statements of income expressed as a percentage of total service revenues and vehicle sales for fiscal 2014, 2013 and 2012: Year Ended July 31, ----------------------------------- (In percentages) 2014 2013 2012 ---------------------------------------- --------- --------- --------- Service revenues and vehicle sales: Service revenues 82 % 81 % 82 % Vehicle sales 18 % 19 % 18 % Total service revenues and vehicle sales 100 % 100 % 100 % Operating expenses: Yard operations 45 % 44 % 41 % Cost of vehicle sales 15 % 16 % 15 % General and administrative 14 % 13 % 12 % Impairment of long-lived assets 3 % 0 % 1 % Total operating expenses 77 % 73 % 69 % Operating income 23 % 27 % 31 % Other (expense) income: 0 % -1 % -1 % Income before income taxes 23 % 26 % 30 % Income taxes 8 % 9 % 10 % Net income 15 % 17 % 20 % Comparison of Fiscal Years ended July 31, 2014, 2013 and 2012 The following table presents a comparison of service revenues and vehicle sales for fiscal 2014, 2013 and 2012: Year Ended July 31, 2014 vs. 2013 2013 vs. 2012 --------------------------------------------------- --------------------------- --------------------------- (In thousands) 2014 2013 2012 Change % Change Change % Change ------------------------------------------- --------------- --------------- ------------- ------------- ---------- ------------- ---------- Service revenues $ 958,413 $ 849,667 $ 757,272 $ 108,746 12.8 % $ 92,395 12.2 % Vehicle sales 205,076 196,719 166,919 8,357 4.2 % 29,800 17.9 % Total service revenues and vehicle sales $ 1,163,489 $ 1,046,386 $ 924,191 $ 117,103 11.2 % $ 122,195 13.2 % Service Revenues. The increase in service revenues for fiscal 2014 of $108.7 million, or 12.8% as compared to fiscal 2013 came from (i) growth in North America of $76.7 million; (ii) growth in the U.K. of $23.7 million, driven by increased volume from our vehicle suppliers; and, (iii) our international expansion during the prior fiscal year into Germany, Spain, the U.A.E., and Brazil, which represented $8.3 million. Excluding the increase in revenues in fiscal 2013 associated with Hurricane Sandy of $31.2 million, North America service revenue grew by $107.9 million, or 14.7%. The growth in North America was driven primarily by increased volume as revenue per car remained relatively flat. The increase in volume came from the acquisition of Salvage Parent, Inc., which closed in the fourth quarter of fiscal 2013, and increases from existing suppliers as we believe there has been an increase in the overall growth in the salvage market driven by increased salvage frequency. 37 -------------------------------------------------------------------------------- The increase in service revenues for fiscal 2013 of $92.4 million, or 12.2% as compared to fiscal 2012 came from growth from (i) our international expansion during the year into Germany, Spain, the U.A.E., and Brazil, which represented $10.1 million; (ii) the acquisition of Salvage Parent, Inc. which closed on May 30, 2013 and represented $8.0 million; (iii) growth in the U.K. of $2.9 million driven by increased revenue per car; and, (iv) growth in North America of $71.4 million. The growth in North America was driven primarily by increased volume as revenue per car remained relatively flat. The increase in volume came from (i) Hurricane Sandy, as the major storm produced an extraordinary volume of flood damaged vehicles; (ii) increased volumes from the full year impact of an exclusive provider contract entered into with a major insurance company at the end of fiscal 2012; and, (iii) what we believe to be a general increase in the overall salvage market as we believe there has been an increase in salvage frequency. Vehicle Sales. The increase in vehicle sales for fiscal 2014 of $8.4 million, or 4.2% as compared to fiscal 2013 primarily came from (i) our international expansion during the prior fiscal year into Germany, Spain, the U.A.E. and Brazil, which represented $4.8 million; (ii) growth in the U.K. of $2.3 million, driven primarily by increased open market purchase activity from the general public; and (iii) growth in North America of $1.3 million, driven primarily by the acquisition of Salvage Parent, Inc. The increase in vehicle sales for fiscal 2013 of $29.8 million, or 17.9% as compared to fiscal 2012 resulted from (i) our international expansion during the year into Germany, Spain, the U.A.E. and Brazil which represented $1.1 million; (ii) the acquisition of Salvage Parent, Inc. which represented $3.2 million; (iii) growth in the U.K. of $13.6 million driven primarily by increased volume from insurance sellers and increased open market purchase activity from the general public; and (iv) growth in the North America of $11.9 million driven primarily by increased open market purchase activity. The following table summarizes operating expenses, total other expenses and income taxes for fiscal 2014, 2013 and 2012: Year Ended July 31, 2014 vs. 2013 2013 vs. 2012 ----------------------------------------------- ---------------------------- ----------------------------- (In thousands) 2014 2013 2012 Change % Change Change % Change ------------------------------- ------------- ------------- ------------- ------------- ----------- ------------- ------------ Operating expenses: Yard operations $ 520,423 $ 458,228 $ 377,604 $ 62,195 13.6 % $ 80,624 21.4 % Cost of vehicle sales 174,493 167,236 136,971 7,257 4.3 % 30,265 22.1 % General and administrative 164,535 137,930 114,492 26,605 19.3 % 23,438 20.5 % Impairment of long-lived assets 29,104 - 8,771 29,104 100.0 % (8,771 ) -100.0 % Total operating expenses $ 888,555 $ 763,394 $ 637,838 $ 125,161 16.4 % $ 125,556 19.7 % Total other expenses $ (4,899 ) $ (6,120 ) $ (8,297 ) $ 1,221 -20.0 % $ 2,177 -26.2 % Income taxes 91,348 96,847 95,937 (5,499 ) -5.7 % 910 0.9 % Yard Operations Expense. The increase in yard operations expense for fiscal 2014 of $62.2 million, or 13.6% as compared to fiscal 2013 primarily came from (i) growth in North America, driven by the acquisition of Salvage Parent, Inc., which closed in the fourth quarter of the fiscal 2013, increased volume from what we believe to be an increase in the overall size of the salvage market due to increased salvage frequency, and increases in volume from non-insurance suppliers; (ii) growth in the U.K., driven by increased volumes from our new and existing suppliers; and (iii) growth in our international activity outside of the U.K. as these operations are in their developmental stages, without the benefit of scale. Included in our yard operations expense in fiscal 2013 was $25.7 million of abnormal costs associated with Hurricane Sandy. Excluding those costs, the average handling cost per car increased, driven primarily by growth in normal subhaul, labor, equipment and titling costs, as well as charges associated with severance and lease termination costs of $2.9 million, primarily associated with the integration of the Salvage Parent, Inc. acquisition. Included in yard operations cost was depreciation and amortization expenses, which were $36.2 million, $40.8 million, and $33.0 million for fiscal 2014, 2013, and 2012 respectively. The decrease in yard operation depreciation and amortization expense in fiscal 2014 was due primarily to our data center assets being fully 38 -------------------------------------------------------------------------------- depreciated. The increase in yard operation depreciation and amortization expense in fiscal 2013 was due primarily to accelerated depreciation from the shorter useful lives of our data center assets. The increase in yard operations expense for fiscal 2013 of $80.6 million, or 21.4% as compared to fiscal 2012, was due to the growth from (i) our international expansion during the year into Germany, Spain, the U.A.E., and Brazil which represented $5.4 million; (ii) the acquisition of Salvage Parent, Inc. which represented $6.4 million; (iii) growth in the U.K. of $1.6 million driven by increased volume associated with general salvage market growth; and (iv) growth in North America of $59.5 million. The growth in North America was driven by increases in both the costs to process each car and in volume which were $31.7 million and $27.8 million, respectively. The increase in volume came from (i) Hurricane Sandy, as the major storm produced an extraordinary volume of flood damaged vehicles; (ii) increased volumes from the full year impact of an exclusive provider contract entered into with a major insurance company at the end of fiscal 2012; and, (iii) what we believe to be a general increase the in overall salvage market as we believe there has been an increase in salvage frequency, which is the percentage of cars involved in accidents that the insurance companies salvage rather than repair. The increase in the cost to process each car was driven primarily by the abnormal costs for temporary storage facilities, premiums for subhaulers, labor costs incurred from overtime, travel and lodging, and equipment associated with Hurricane Sandy. There was also an increase in the normal cost to process each car driven by growth in normal subhaul, labor, equipment and titling costs. Cost of Vehicle Sales. The increase in cost of vehicle sales for fiscal 2014 of $7.3 million, or 4.3% as compared to fiscal 2013 came from (i) our international expansion during the prior fiscal year, which represented $4.8 million; (ii) growth in the U.K. of $2.1 million, driven primarily by increased open market purchase activity from the general public; and (iii) growth in North America of $0.3 million driven primarily by the acquisition of Salvage Parent, Inc. The increase in cost of vehicle sales for fiscal 2013 of $30.3 million, or 22.1% as compared to fiscal 2012 came from (i) our international expansion during the year into Germany, Spain, the U.A.E. and Brazil which represented $1.1 million; (ii) the acquisition of Salvage Parent, Inc. which represented $2.9 million; and (iii) growth in the U.K. and North America of $26.2 million and driven primarily by increased volume from insurance sellers in the U.K. and increased open market purchase activity from the general public in both the U.K. and North America. General and Administrative Expenses. The increase in general and administrative expenses for fiscal 2014 of $26.6 million, or 19.3% as compared to fiscal 2013 increased primarily from (i) our international expansion during the prior fiscal year into Germany, Spain, the U.A.E., and Brazil representing $3.7 million; and, (ii) growth in North America of $19.6 million, driven primarily by the acquisition of Salvage Parent, Inc., which closed in the fourth quarter of fiscal 2013, increased expenditures on technology development, and the overall growth in labor costs, professional services and facilities costs associated with domestic and international expansion. Included in fiscal 2014 was $7.5 million in lease termination, severance and relocation costs associated with the integration of the Salvage Parent, Inc. acquisition and the relocation of our technology department from California to our Dallas, Texas corporate headquarters. Included in general and administrative costs were depreciation and amortization expenses which were $17.5 million, $16.0 million, and $15.1 million for fiscal 2014, 2013, and 2012, respectively. The increase in general and administrative expenses for fiscal 2013 of $23.4 million, or 20.5% as compared to fiscal 2012 is a result of growth from (i) our international expansion during the year into Germany, Spain, the U.A.E. and Brazil representing $5.3 million; (ii) the acquisition of Salvage Parent, Inc. which closed on May 30, 2013 and represents $2.8 million; (iii) relocation costs of $1.7 million; and (iv) growth in North America of $12.8 million. The growth in North America was driven primarily by increased costs associated with new product development, the configuration of a new worldwide ERP operating platform and the transition costs associated with the outsourcing of our IT infrastructure and support which totaled $10.8 million; as well as an overall growth in labor costs, professional services and facilities costs associated with domestic and international expansion. 39 -------------------------------------------------------------------------------- Impairment. During fiscal 2014, we terminated a contract with KPIT (formerly known as Sparta Consulting, Inc.), whereby KPIT was engaged to design and implement an SAP-based replacement for our existing business operating software that, among other things, would address our international expansion needs. Following a review of KPIT's work performed to date, and an assessment of the cost to complete, deployment risk, and other factors, we ceased development of KPIT's software and are now pursuing an internally developed proprietary solution in its place. As a result, we recognized a charge of $29.1 million resulting primarily from the impairment of costs previously capitalized in connection with the development of the software. Other (Expense) Income. The decrease in total other expense for fiscal 2014 of $1.2 million, or 20.0% as compared to fiscal 2013 was primarily due to a decrease in interest expense as a result of principal payments on long-term debt. See Notes to Consolidated Financial Statements, Note 8 - Long-Term Debt. The decrease in total other expense for fiscal 2013 of $2.2 million, or 26.2% as compared to fiscal 2012 was primarily due to a decrease in interest expense as a result of principal payments on long-term debt, partially offset by a gain on sale of assets. Income Taxes. Our effective income tax rates were 33.8%, 35.0%, and 34.5% for fiscal 2014, 2013 and 2012, respectively. The change in the overall tax rate was driven by fluctuations in the U.S. tax laws and the geographical allocation of our taxable income. Liquidity and Capital Resources The following table presents a comparison of key components of our liquidity and capital resources for fiscal 2014, 2013 and 2012: July 31, 2014 vs. 2013 2013 vs. 2012 ------------------------------------------- --------------------------- ---------------------------- (In thousands) 2014 2013 2012 Change % Change Change % Change ------------------------- ------------ ----------- ------------ ------------ ----------- ------------- ----------- Cash and cash equivalents $ 158,668 $ 63,631 $ 140,112 $ 95,037 149.4 % $ (76,481 ) -54.6 % Working capital 168,007 67,893 134,908 100,114 147.5 % (67,015 ) -49.7 % Year Ended July 31, 2014 vs. 2013 2013 vs. 2012 ------------------------------------------------- ---------------------------- ------------------------------- (In thousands) 2014 2013 2012 Change % Change Change % Change -------------------------------------------- ------------- -------------- -------------- ------------- ----------- -------------- ------------- Operating cash flows $ 262,594 $ 199,326 $ 229,673 $ 63,268 31.7 % $ (30,347 ) -13.2 % Investing cash flows (92,103 ) (208,021 ) (48,087 ) 115,918 -55.7 % (159,934 ) 332.6 % Financing cash flows (76,823 ) (65,891 ) (114,873 ) (10,932 ) 16.6 % 48,982 -42.6 % Capital expenditures, including acquisitions $ (95,810 ) $ (214,287 ) $ (57,396 ) $ 118,477 -55.3 % $ (156,891 ) 273.3 % Payments on long-term debt (75,000 ) (96,660 ) (56,250 ) 21,660 -22.4 % (40,410 ) 71.8 % Acquisitions (14,300 ) (84,022 ) (2,564 ) 69,722 -83.0 % (81,458 ) 3,177.0 % Working capital and cash and cash equivalents increased for fiscal 2014 as compared to fiscal 2013 primarily due to cash generated from operations, partially offset by decreases in capital expenditures, payments on long-term debt and cash used in acquisitions. Cash equivalents consisted of bank deposits and funds invested in money market accounts, which bear interest at variable rates. Cash and cash equivalents decreased for fiscal 2013 as compared to fiscal 2012 due to increases of capital expenditures and acquisitions as well as payments on long-term debt, partially offset by a reduction in share repurchase activity, proceeds from stock option exercises and increased accounts payable balances. Historically, we have financed our growth through cash generated from operations, public offerings of common stock, equity issued in conjunction with certain acquisitions and debt financing. Our primary source of cash generated by operations is from the collection of sellers' fees, members' fees and reimbursable advances from the proceeds of vehicle sales. Our business is seasonal as inclement weather during the winter months increases the frequency of accidents and consequently, the number of cars involved in accidents which the insurance companies salvage rather than repair. During the winter months, most of our facilities process 40 -------------------------------------------------------------------------------- 10% to 30% more vehicles than at other times of the year. This increased volume requires the increased use of our cash to pay out advances and handling costs of the additional business. We believe that our currently available cash and cash equivalents and cash generated from operations will be sufficient to satisfy our operating and working capital requirements for at least the next 12 months. However, if we experience significant growth in the future, we may be required to raise additional cash through the issuance of new debt or additional equity. Although the timing and magnitude of growth through expansion and acquisitions are not predictable, the opening of new greenfield yards is contingent upon our ability to locate property that (i) is in an area in which we have a need for more capacity; (ii) has adequate size given the capacity needs; (iii) has the appropriate shape and topography for our operations; (iv) is reasonably close to a major road or highway; and (v) most importantly, has the appropriate zoning for our business. Costs to develop a new yard generally range from $1.0 to $13.0 million, depending on size, location and developmental infrastructure requirements. As of July 31, 2014, $57.0 million of the $158.7 million of cash and cash equivalents was held by our foreign subsidiaries. If these funds are needed for our operations in the U.S., we would be required to accrue and pay U.S. taxes to repatriate these funds. However, our intent is to permanently reinvest these funds outside of the U.S. and our current plans do not demonstrate a need to repatriate them to fund our U.S. operations. Net cash provided by operating activities increased for fiscal 2014 as compared to fiscal 2013 due to improved cash operating results from an increase in revenue and changes in operating assets and liabilities. The change in operating assets and liabilities was related to the lower growth in accounts receivables of $18.3 million, primarily due to the prior year effect of Hurricane Sandy; a decrease in prepaid and other assets of $11.3 million; offset by an increase in accounts payable of $9.3 million. Net cash provided by operating activities decreased during fiscal 2013 as compared to fiscal 2012 primarily due to increases in prepaid and other assets of $28.8 million, accounts receivable of $15.2 million, and income taxes receivable of $7.8 million, partially offset by increases in accounts payable of $18.6 million. The remaining decrease of $2.8 million was due to the timing of routine changes in working capital items. Net cash used in investing activities decreased for fiscal 2014 as compared to fiscal 2013 due primarily to significant land acquisitions during fiscal 2013, related to our first facilities in Brazil and Germany, and a decrease in cash used for acquisitions. Our capital expenditures are primarily related to lease buyouts of certain facilities, opening and improving facilities, software development, and acquiring yard equipment. We continue to expand and invest in new and existing facilities and standardize the appearance of existing locations. We have no material non-cancelable commitments for future capital expenditures as of July 31, 2014. Included in capital expenditures for fiscal 2014 were capitalized software development costs for new software for internal use and major software enhancements to existing software. The capitalized costs were $16.5 million, $19.3 million and $8.2 million for fiscal 2014, 2013 and 2012, respectively. If, at any time it is determined that capitalized software provides a reduced economic benefit, the unamortized portion of the capitalized development costs will be impaired. During fiscal 2014, we recognized a charge of $29.1 million resulting primarily from the impairment of costs previously capitalized in connection with the development of business operating software. See Notes to Consolidated Financial Statements, Capitalized Software Costs in Note 1 - Summary of Significant Accounting Policies. Net cash used in investing activities increased for fiscal 2013 as compared to fiscal 2012 due primarily to increases in capital expenditures, including significant land acquisitions related to our first facilities in Brazil and Germany, lease buyouts of certain facilities, opening and improving facilities, software development, and acquiring yard equipment. Acquisition related capital expenditures for fiscal 2013 were $84.0 million primarily for the acquisition of Salvage Parent, Inc. and acquisitions for international expansion. Net cash used in financing activities increased for fiscal 2014 as compared to fiscal 2013, predominantly due to a $16.3 million change in bank overdraft, decreased proceeds of $11.0 million from the exercise of stock options, a $14.4 million decrease in common stock repurchases and a $3.8 million reduction in tax 41 -------------------------------------------------------------------------------- benefits from stock-based payment compensation, partially offset by a $21.7 million decrease in payments on long-term debt. See Notes to Consolidated Financial Statements, Note 10 - Stockholders' Equity. On September 22, 2011, our Board of Directors approved a 40 million share increase in the stock repurchase program that was originally implemented in 2003, bringing the total current authorization to 98 million shares. The repurchases may be effected through solicited or unsolicited transactions in the open market or in privately negotiated transactions. No time limit has been placed on the duration of the stock repurchase program. Subject to applicable securities laws, such repurchases will be made at such times and in such amounts as we deem appropriate and may be discontinued at any time. For fiscal 2014, we did not repurchase any shares of our common stock. For fiscal 2013, we repurchased 500,000 shares of our common stock at a weighted average price of $27.77. For fiscal 2012, we repurchased 8,880,708 shares of our common stock at a weighted average price of $22.51. As of July 31, 2014, the total number of shares repurchased under the program was 50,286,782 and 47,713,218 shares were available for repurchase under our program. Net cash used in financing activities decreased for fiscal 2013 as compared to fiscal 2012 due to a $188.3 million decrease in common stock repurchases, a $16.3 million change in bank overdraft and increased proceeds of $7.8 million from the exercise of stock options, partially offset by a $125.0 million decrease in proceeds from the issuance of long-term debt and a $40.4 million increase in payments on long-term debt. In the first, second and third quarters of fiscal 2012 and the second quarter of fiscal 2013, certain executives exercised stock options through cashless exercises. In the first quarter of fiscal 2014, certain employees exercised stock options through cashless exercises. A portion of the options exercised were net settled in satisfaction of the exercise price and federal and state minimum statutory tax withholding requirements. We remitted $0.1 million, $0.6 million, and $2.6 million in fiscal 2014, 2013 and 2012, respectively, to the proper taxing authorities in satisfaction of the employees' minimum statutory withholding requirements. The exercised stock options are summarized in the following table: Shares Net Shares Net Share Tax Options Exercise Settled for Withheld Shares to Price for Withholding Period Exercised Price Exercise for Taxes(1) Employee Withholding (in 000s) ------------- --------------- ------------- --------------- ---------------- --------------- --------------- --------------- FY 2012-Q1 40,000 $ 9.00 16,082 8,974 14,944 $ 22.39 $ 201 FY 2012-Q2 20,000 9.00 7,506 4,584 7,910 23.98 110 FY 2012-Q3 322,520 10.74 131,299 85,683 105,538 26.38 2,260 FY 2013-Q2 73,228 8.89 18,127 17,461 37,640 35.91 627 FY 2014-Q1 14,000 16.43 7,241 2,519 4,240 31.77 80 -------------------------------------------------------------------------------- (1) Shares withheld for taxes are treated as a repurchase of shares for accounting purposes but do not count against the Company's stock repurchase program. 42 -------------------------------------------------------------------------------- Contractual Obligations We lease certain domestic and foreign facilities, and certain equipment under non-cancelable operating leases. In addition to the minimum future lease commitments presented, the leases generally require us to pay property taxes, insurance, maintenance and repair costs which are not included in the table because we have determined these items are not material. The following table summarizes our significant contractual obligations and commercial commitments as of July 31, 2014: Payments due by Fiscal Year ----------------------------------------------------------------------------------------------- Less than More than (In thousands) 1 year 1-3 Years 3-5 Years 5 Years Other Total ----------------------------------------------- ------------- ------------- ------------ ------------ ------------ ------------- Contractual Obligations ----------------------------------------------- Long-term debt including current portion $ 75,000 $ 218,750 $ - $ - $ - $ 293,750 Interest payments on long-term debt including current portion 5,881 1,589 - - - 7,470 Operating leases (1) 23,357 39,052 28,736 76,189 - 167,334 Capital leases (1) 1,407 1,350 2 - - 2,759 Tax liabilities (2) - - - - 23,771 23,771 Total contractual obligations $ 105,645 $ 260,741 $ 28,738 $ 76,189 $ 23,771 $ 495,084 Amount ofCommitment Expiration Per Period ------------------------------------------------------------------------------------- Less than More than Commercial Commitments(3) 1 year 1-3 Years 3-5 Years 5 Years Other Total ------------------------- ----------- ------------ ------------ ------------ ------- ----------- Letters of Credit $ 17,379 $ - $ - $ - $ - $ 17,379 -------------------------------------------------------------------------------- (1) Contractual obligations consist of future non-cancelable minimum lease payments under capital and operating leases, used in the normal course of business. (2) Tax liabilities include the long-term liabilities in the consolidated balance sheet for unrecognized tax positions. At this time, we are unable to make a reasonably reliable estimate of the timing of payments in individual years beyond 12 months due to uncertainties in the timing of tax audit outcome. (3) Commercial commitments consist primarily of letters of credit provided for insurance programs and certain business transactions. Credit Facility On December 14, 2010, we entered into an Amended and Restated Credit Facility Agreement (Credit Facility), which superseded our previously disclosed credit agreement with Bank of America, N.A. (Bank of America). The Credit Facility is an unsecured credit agreement providing for (i) a $100.0 million revolving credit facility, including a $100.0 million alternative currency borrowing sublimit and a $50.0 million letter of credit sublimit (Revolving Credit) and (ii) a term loan facility of $400.0 million (Term Loan). On January 14, 2011, the full $400.0 million provided under the Term Loan was borrowed. On September 29, 2011, we amended the Credit Facility increasing the amount of the Term Loan from $400.0 million to $500.0 million. On March 1, 2013, we amended the Credit Facility to increase the net leverage ratio at which restrictive spending covenants are introduced from 1:1 to 1.5:1. The Term Loan, which at July 31, 2014 had $293.8 million outstanding, amortizes $18.8 million each quarter beginning December 31, 2011, with all outstanding borrowings due on December 14, 2015. All amounts borrowed under the Term Loan may be prepaid without premium or penalty. During fiscal 2014, we made principal repayments of $75.0 million. We currently have $0.7 million of deferred financing costs in other assets as of July 31, 2014. 43 -------------------------------------------------------------------------------- Amounts borrowed under the Credit Facility bear interest, subject to certain restrictions, at a fluctuating rate based on (i) the Eurocurrency Rate; (ii) the Federal Funds Rate; or (iii) the Prime Rate as described in the Credit Facility. We have entered into two interest rate swaps to exchange our variable interest rate payments commitment for fixed interest rate payments on the Term Loan balance. See Notes to Consolidated Financial Statements, Note 9 - Derivatives and Hedging. A default interest rate applies on all obligations during an event of default under the credit facility at a rate per annum equal to 2.0% above the otherwise applicable interest rate. Our interest rate as of July 31, 2014 was the 0.15% Eurocurrency Rate plus the 1.5% Applicable Rate. The Applicable Rate can fluctuate between 1.5% and 2.0% depending on our consolidated net leverage ratio, as defined in the Credit Facility. The Credit Facility is guaranteed by our material domestic subsidiaries. The carrying amount of the Credit Facility is comprised of borrowings under which interest accrues under a fluctuating interest rate structure. Accordingly, the carrying value approximates fair value as of July 31, 2014, and was classified within Level II of the fair value hierarchy. Amounts borrowed under the Revolving Credit may be repaid and reborrowed until the maturity date of December 14, 2015. The Credit Facility requires us to pay a commitment fee on the unused portion of the Revolving Credit. The commitment fee ranges from 0.075% to 0.125% per annum depending on our leverage ratio. We had no outstanding borrowings under the Revolving Credit at July 31, 2014. The Credit Facility contains customary representations and warranties and may place certain business operating restrictions on us relating to, among other things, indebtedness, liens and other encumbrances, investments, mergers and acquisitions, asset sales, dividends and distributions and redemptions of capital stock. In addition, the Credit Facility provides for the following financial covenants: (i) earnings before interest, income tax, depreciation and amortization (EBITDA); (ii) leverage ratio; (iii) interest coverage ratio; and (iv) limitations on capital expenditures. The Credit Facility contains events of default that include, among others, non-payment of principal, interest or fees, violation of covenants, inaccuracy of representations and warranties, cross-defaults to certain other indebtedness, bankruptcy and insolvency defaults, material judgments, invalidity of the loan documents and events constituting a change of control. We were in compliance with all covenants as of July 31, 2014. Restructuring We relocated our corporate headquarters to Dallas, Texas in 2012. The restructuring costs were as follows: Year Ended July 31, ----------------------------------------- (In thousands) 2014 2013 2012 -------------------------------- ----------- ----------- ----------- General and administrative Severance $ 4,598 $ 978 $ 1,675 Relocation 491 759 534 Total general and administrative $ 5,089 $ 1,737 $ 2,209 Yard operations Relocation $ (28 ) $ 189 $ 745 Impairment - - 1,123 Total yard operations $ (28 ) $ 189 $ 1,868 Off-Balance Sheet Arrangements As of July 31, 2014, we had no off-balance sheet arrangements pursuant to Item 303(a)(4) of Regulation S-K promulgated under the Securities Exchange Act of 1934, as amended. 44 -------------------------------------------------------------------------------- Critical Accounting Policies and Estimates The preparation of consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including costs related to vehicle pooling, self-insured reserves, allowance for doubtful accounts, income taxes, revenue recognition, stock-based payment compensation, purchase price allocations, long-lived asset impairment calculations and contingencies. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Management has discussed the selection of critical accounting policies and estimates with the Audit Committee of the Board of Directors and the Audit Committee has reviewed our disclosure relating to critical accounting policies and estimates in this Annual Report on Form 10-K. Our significant accounting policies are described in the Notes to Consolidated Financial Statements, Note 1 - Description of Business and Summary of Significant Accounting Policies. The following is a summary of the more significant judgments and estimates included in our critical accounting policies used in the preparation of our consolidated financial statements. We discuss, where appropriate, sensitivity to change based on other outcomes reasonably likely to occur. The following discussion and analysis should be read in conjunction with our Consolidated Financial Statements and related Notes in Part I., Item I., "Financial Statements." Revenue Recognition We provide a portfolio of services to our sellers and buyers that facilitate the sale and delivery of a vehicle from seller to buyer. These services include the ability to use our Internet sales technology and vehicle delivery, loading, title processing, preparation and storage. We evaluate multiple-element arrangements relative to our member and seller agreements. The services we provide to the seller of a vehicle involve disposing of a vehicle on the seller's behalf and, under most of our current North American contracts, collecting the proceeds from the member. Pre-sale services, including towing, title processing, preparation and storage, as well as sale fees and other enhancement service fees meet the criteria for separate units of accounting. The revenue associated with each service is recognized upon completion of the respective service, net of applicable rebates or allowances. For certain sellers who are charged a proportionate fee based on high bid of the vehicle, the revenue associated with the pre-sale services is recognized upon completion of the sale when the total arrangement is fixed and determinable. The selling price of each service is determined based on management's best estimate and is allotted based on the relative selling price method. Vehicle sales, where vehicles are purchased and remarketed on our own behalf, are recognized on the sale date, which is typically the point of high bid acceptance. Upon high bid acceptance, a legal binding contract is formed with the member, and we record the gross sales price as revenue. We also provide a number of services to the buyer of the vehicle, charging a separate fee for each service. Each of these services has been assessed to determine whether we have met the requirements to separate them into units of accounting within a multiple-element arrangement. We have concluded that the sale and the post-sale services are separate units of accounting. The fees for sale services are recognized upon completion of the sale. The fees for the post-sale services are recognized upon successful completion of those services using the relative selling price method. We also charge members an annual registration fee for the right to participate in our vehicle sales program, which is recognized ratably over the term of the arrangement, and relist and late-payment fees, 45 -------------------------------------------------------------------------------- which are recognized upon receipt of payment by the member. No provision for returns has been established, as all sales are final with no right of return, although we provide for bad debt expense in the case of non-performance by our members or sellers. We allocate arrangement consideration based on the relative estimated selling prices of the separate units of accounting containing multiple deliverables. Estimated selling prices are determined using management's best estimate. Significant inputs in our estimates of the selling price of separate units of accounting include market and pricing trends, pricing customization and practices, and profit objectives for the services. We allocate arrangement consideration based on the relative estimated selling prices of the separate units of accounting containing multiple deliverables. Estimated selling prices are determined using management's best estimate. Significant inputs in our estimates of the selling price of separate units of accounting include market and pricing trends, pricing customization and practices, and profit objectives for the services. Fair Value of Financial Instruments We record our financial assets and liabilities at fair value in accordance with the framework for measuring fair value in U.S. GAAP. In accordance with ASC 820, Fair Value Measurements and Disclosures, as amended by Accounting Standards Update 2011-04, we consider fair value as an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants under current market conditions. This framework establishes a fair value hierarchy that prioritizes the inputs used to measure fair value: Level I Observable inputs that reflect unadjusted quoted prices for identical assets or liabilities traded in active markets. Level II Inputs other than quoted prices included within Level I that are observable for the asset or liability, either directly or indirectly. Interest rate hedges are valued at exit prices obtained from the counter-party. Level III Inputs that are generally unobservable. These inputs may be used with internally developed methodologies that result in management's best estimate. The amounts recorded for financial instruments in our consolidated financial statements, which included cash, accounts receivable, accounts payable and accrued liabilities approximate their fair values for fiscal 2014 and 2013, due to the short-term nature of those instruments, and are classified within Level II of the fair value hierarchy. Cash equivalents are classified within Level II of the fair value hierarchy because they are valued using quoted market prices of the underlying investments. See Notes to Consolidated Financial Statements, Note 8 - Long-Term Debt for additional fair value disclosures. Vehicle Pooling Costs We defer in vehicle pooling costs certain yard operation expenses associated with vehicles consigned to and received by us, but not sold as of the balance sheet date. We quantify the deferred costs using a calculation that includes the number of vehicles at our facilities at the beginning and end of the period, the number of vehicles sold during the period and an allocation of certain yard operation expenses of the period. The primary expenses allocated and deferred are certain facility costs, labor, and vehicle processing. If our allocation factors change, then yard operation expenses could increase or decrease correspondingly in the future. These costs are expensed as vehicles are sold in subsequent periods on an average cost basis. Given the fixed cost nature of our business, there is not a direct correlation for an increase in expenses or units processed on vehicle pooling costs. We apply the provisions of accounting guidance for subsequent measurement of inventory to our vehicle pooling costs. The provision requires that items such as idle facility expense, double freight and rehandling costs be recognized as current period charges, regardless of whether they meet the criteria of "abnormal" as 46 -------------------------------------------------------------------------------- provided in the guidance. In addition, the guidance requires that the allocation of fixed production overhead to the costs of conversion be based on the normal capacity of production facilities. In early November 2012, Hurricane Sandy hit the northeastern coast of the United States. As a result of the extensive flooding that it caused, we expended additional costs for (i) temporary storage facilities; (ii) premiums for subhaulers as they were reassigned from other regions; and (iii) labor costs incurred for overtime, travel and lodging due to the reassignment of employees to the affected region. These costs, which are characterized as "abnormal" under ASC 330, Inventory, were expensed as incurred and not included in inventory. As of July 31, 2013, the incremental salvage vehicles received as a result of Hurricane Sandy, were sold. Derivatives and Hedging We have entered into two interest rate swaps to eliminate interest rate risk on our variable rate Term Loan, and the swaps are designated as effective cash flow hedges under ASC 815, Derivatives and Hedging. See Notes to Consolidated Financial Statements, Note 9 - Derivatives and Hedging. Each quarter, we measure hedge effectiveness using the "hypothetical derivative method" and record in earnings any hedge ineffectiveness with the effective portion of the hedges' change in fair value recorded in other comprehensive income or loss. Long-lived Asset Valuation, Including Intangible Assets We evaluate long-lived assets, including property and equipment, and certain identifiable intangibles, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets is measured by comparing the carrying amount of an asset to the estimated undiscounted future cash flows expected to be generated by the use of the asset. If the estimated undiscounted cash flows change in the future, we may be required to reduce the carrying amount of an asset. Capitalized Software Costs We capitalize system development costs and website development costs related to our enterprise computing services during the application development stage. Costs related to preliminary project activities and post implementation activities are expensed as incurred. Internal-use software is amortized on a straight-line basis over its estimated useful life, generally three years. Management evaluates the useful lives of these assets on an annual basis and tests for impairment whenever events or changes in circumstances occur that could impact the recoverability of these assets. Total gross capitalized software as of July 31, 2014 and 2013 was $61.7 million and $74.3 million, respectively. Accumulated amortization expense related to software as of July 31, 2014 and 2013 totaled $38.6 million and $28.6 million, respectively. During fiscal 2014, we terminated a contract with KPIT (formerly known as Sparta Consulting, Inc.), whereby KPIT was engaged to design and implement an SAP-based replacement for our existing business operating software that, among other things, would address our international expansion needs. Following a review of KPIT's work performed to date, and an assessment of the cost to complete, deployment risk, and other factors, we ceased development of KPIT's software and are now pursuing an internally developed proprietary solution in its place. As a result, we recognized a charge of $29.1 million resulting primarily from the impairment of costs previously capitalized in connection with the development of the software. Allowance for Doubtful Accounts We maintain an allowance for doubtful accounts in order to provide for estimated losses resulting from disputed amounts billed to sellers or members and the inability of our sellers or members to make required payments. If billing disputes exceed expectations and/or if the financial condition of our sellers or members were to deteriorate, additional allowances may be required. The allowance is calculated by taking both seller and buyer accounts receivables written off during the previous 12 month period as a percentage of the total 47 -------------------------------------------------------------------------------- accounts receivable balance. A one percentage point adverse change to the write-off percentage would have resulted in an increase to the allowance for doubtful accounts balance of $1.7 million. Valuation of Goodwill We evaluate the impairment of goodwill for our operating segments annually or on an interim basis if certain indicators are present by comparing the fair value of the operating segment to its carrying value. Future adverse changes in market conditions or poor operating results of the operating segments could result in an inability to recover the carrying value of the investment, thereby requiring impairment charges in the future. Income Taxes and Deferred Tax Assets We account for income tax exposures as required under ASC 740, Income Taxes. We are subject to income taxes in the U.S., Canada, the U.K., Brazil, Spain and Germany. In arriving at a provision of income taxes, we first calculate taxes payable in accordance with the prevailing tax laws in the jurisdictions in which we operate. Then we analyze the timing differences between the financial reporting and tax basis of our assets and liabilities, such as various accruals, depreciation and amortization. The tax effects of the timing difference are presented as deferred tax assets and liabilities in the consolidated balance sheets. We assess the probability that the deferred tax assets will be realized based on our ability to generate future taxable income. In the event that it is more likely than not, the full benefit would not be realized from deferred tax assets, we record a valuation allowance to reduce the carrying value of the deferred tax assets to the amount expected to be realized. As of July 31, 2014, we have $2.2 million of valuation allowance arising from both our U.S. and foreign operations. To the extent we establish a valuation allowance or change the amount of valuation allowance in a period, we reflect the change with a corresponding increase or decrease in our income tax provision in the consolidated statements of income. Historically, our income tax provision has been sufficient to cover our actual income tax liabilities among the jurisdictions in which we operate. Nonetheless, our future effective tax rate could still be adversely affected by several factors, including (i) the geographical allocation of our future earnings; (ii) the change in tax laws or our interpretation of tax laws; (iii) the changes in governing regulations and accounting principles; (iv) the changes in the valuation of our deferred tax assets and liabilities; and (v) the outcome of the income tax examinations. We routinely assess the possibilities of material changes resulting from the aforementioned factors to determine the adequacy of our income tax provision. Based on our results for the twelve months ended July 31, 2014, a one percentage adverse change in our provision for income taxes as a percentage of income before taxes would have resulted in an increase in the income tax expense of $2.7 million. We apply the provision of ASC 740, Income Taxes, which contains a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon settlement. Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made. The provision for income taxes, including the impact of reserve provisions and changes to the reserves that are considered appropriate, as well as the related net interest settlement of any particular position, could require the use of cash. In addition, we are subject to the continuous examination of our income tax returns by various taxing 48 -------------------------------------------------------------------------------- authorities, including the Internal Revenue Service and U.S. states. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. Stock-based Payment Compensation We account for our stock-based awards to employees and non-employees using the fair value method. Compensation cost related to stock-based payment transactions are recognized based on the fair value of the equity or liability instruments issued. Determining the fair value of options using the Black-Scholes Merton option pricing model, or other currently accepted option valuation models, requires highly subjective assumptions, including future stock price volatility and expected time until exercise, which greatly affect the calculated fair value on the measurement date. If actual results are not consistent with our assumptions and judgments used in estimating the key assumptions, we may be required to record additional compensation or income tax expense, which could have a material impact on our consolidated results of operations and financial position. Retained Insurance Liabilities We are partially self-insured for certain losses related to medical, general liability, workers' compensation and auto liability. Our insurance policies are subject to a $250,000 deductible per claim, with the exception of our medical policy which has a $225,000 stop loss per claim and a stop loss limiting total exposure to 120% of expected claims. In addition, each of our policies contains an aggregate stop loss to limit our ultimate exposure. Our liability represents an estimate of the ultimate cost of claims incurred as of the balance sheet date. The estimated liability is not discounted and is established based upon analysis of historical data and actuarial estimates. The primary estimates used in the actuarial analysis include total payroll and revenue. Historically, our estimates have not materially fluctuated from actual results. While we believe these estimates are reasonable based on the information currently available, if actual trends, including the severity of claims and medical cost inflation, differ from our estimates, our consolidated results of operations, financial position or cash flows could be impacted. The process of determining our insurance reserves requires estimates with various assumptions, each of which can positively or negatively impact those balances. The total amount reserved for all policies is $5.7 million as of July 31, 2014. If the total number of participants in the medical plan changed by 10%, we estimate that our annual medical expense would change by $1.5 million and our accrual for medical expenses would change by $0.4 million. If our total payroll changed by 10%, we estimate that our annual workers' compensation expense and our accrual for workers' compensation expenses would change by less than $0.2 million. A 10% change in revenue would change our insurance premium for the general liability and umbrella policy by an insignificant amount. Accounting for Acquisitions We recognize and measure identifiable assets acquired and liabilities assumed in acquired entities in accordance with ASC 805, Business Combinations. The accounting for acquisitions involves significant judgments and estimates, including the fair value of acquired intangible assets, which involve projections of future revenues, cash flows and terminal value, which are then either discounted at an estimated discount rate or measured at an estimated royalty rate, and the fair value of other acquired assets and assumed liabilities, including potential contingencies and the useful lives of the assets. The projections are developed using internal forecasts, available industry and market data and estimates of long-term growth rates of our business. Historical experience is additionally utilized, in which historical or current costs have approximated fair value for certain assets acquired. Segment Reporting Our North American and U.K. regions are considered two separate operating segments, which have been aggregated into one reportable segment because they share similar economic characteristics. 49 -------------------------------------------------------------------------------- Recently Issued Accounting Standards For a description of the new accounting standards that affect us, refer to the Notes to Consolidated Financial Statements - Note 1. Summary of Significant Accounting Policies. |